How international capital flows may negatively affect developing countries and what can these countries do to protect themselves?
By Luciano Figari Graduate Diploma in Economics SOAS, University of London 604636
Introduction: ‘Hot money’, a destabilizing force in the global economy The February 2014 G20 summit revealed that protecting emerging markets from the negative effects of cross-border capital flows will be the next challenge facing the global economy. Some say that history repeats itself and in the case of international capital flows this seems to be true. In February 1993, exactly 21 years before, the World Bank advised Latin American countries to protect their economies from the adverse effects of the capital that by that time was flooding into the region. One of the reasons for the flow to Latin America was that “the U.S. recession and its low interest rates [had] turned investors' attention to high-yield opportunities elsewhere. And with the growing globalization of capital markets, speculators [found] it easier to get in and take advantage of high interest rates and stock market booms” (Kiguel and Caprio, 1993: 1). This was precisely the same reason that, 21 years later, created distress between emerging markets and the U.S. during the G20 summit. When the U.S. economy collapsed after the financial crash of 2007, the Federal Reserve (Fed) created money to buy Treasury notes, bank debt and mortgagebacked securities from its member banks, driving the interest rate to record low levels. This monetary policy, which began in late 2008 and is known as quantitative easing, helped the U.S. to recover from the recession. However, it also provided speculators with cheap money to invest in other parts of the world which offered higher returns than the U.S., in financial operations known as cross-border “carry trades”. Emerging markets and developing countries became popular destinations to invest the cheap money in. Yet, since former Fed Chairman Ben Bernanke stated in the second quarter of 2013 that he may taper the bond-buying programme, capital started flowing out of emerging markets because international investors expected an increase in U.S. interest rates and, therefore, higher returns. When the Fed implemented its tapering policy, the phenomenon sharpened, jeopardizing the stability of emerging markets and consequently of the global economy. Moreover, this situation is likely to get worse as sooner or later the Fed will increase the interest rates (Feroli et al., 2014). Over the last 20 years, the phenomenon of cross-border capital flows has taken on a new magnitude with the evolution of an international financial architecture where funds move increasingly quickly from one country to another, often solely due to speculation. Graph 1 (World Bank, 2014: 96) shows the unstable trend of private international capital inflows to developing countries. Graph 1
As the OECD states, “financial globalisation can be both a blessing and a curse” (2011: 288). Understanding that international capital flows may bring considerable benefits to an economy, this essay will focus exclusively on the negative effects of cross-border capital flows (from now on, capital flows) and the possible measures to protect against them. In order to do that, Part 1 lists the negative effects of capital flows to developing countries whereas Part 2 discusses the four main approaches developing countries have taken to protect their economies from capital flows. Finally, the essay will conclude with some thoughts on the consequences of the findings.
Part 1: How ‘hot money’ can burn down a developing economy The Asian Development Bank notes that massive capital inflows can create too much credit, excessive investment and speculation, which in turn may cause inflation, asset market bubbles and potential vulnerabilities in the balance sheets of banks, households and companies. Moreover, sudden stops or reversals in capital inflows can lead to a currency crisis, the bursting of asset price bubbles, investment collapse, banking sector stress and economic difficulties (Kawai and Lamberte, 2010: ix). What follows is a brief explanation of some of the negative effects of international capital flows: a) Overheating Capital inflows can expand aggregate demand or investment so quickly that there is disequilibrium between the market supply and demand, creating serious imbalances to an economy. b) Inflation and asset market bubbles As mentioned above, capital inflows may cause inflation (Desai and Hines 1999), especially on consumer prices. Inflation encourages money wages increases during the collective bargain process in order to protect real wages, what can cause more inflation and the need to re-adjust wages, in a phenomenon known as a „wage-price spiral‟. Asset prices, especially equity and real-estate prices are also likely to go up as a consequence of capital inflows. Inflation discourages savings, disrupts business and Governments budget plans, and generates an arbitrary redistribution of income, among other negative effects. c) Exchange rate appreciation Bakardzhieva, Ben Naceur and Kamar (2010) indicate that capital inflows could lead to real exchange rate appreciation, which diminishes the competitiveness of developing countries and jeopardizes their exports and growth. Prasad, Rajan, and Subramanian (2006: 14) point out that this can lead to the „Dutch Disease‟. d) Widening external current account deficits Large capital inflows generate a current account deficit because the quantity of money that is going into a country exceeds the quantity leaving it. Even though this phenomenon is not bad in itself, it can be harmful when it generates an appreciation of the exchange rate, as seen in point c. e) Credit booms and financial crisis After examining macro-financial indicators in 71 countries from 1975 to 2010, Calderon and Kubota (2012) concluded that surges of capital flows are good predictors of periods of rapid credit expansion that end up in financial crises. Bad credit booms are more likely to occur when surges are driven primarily by bank inflows, the authors found.
Mihaljek (2008: 25) gives a reasonable explanation to this phenomenon stating that the growing presence of foreign financial institutions in developing economies has increased the credit risk because their risk management and measurement systems have been designed for mature financial markets, not for developing economies. Another factor that increases the credit risk of foreign financial institutions in developing countries is that the bonus payments to the subsidiaries‟ managers are often assessed by the expansion of lending, encouraging a rapid credit growth that can generate deterioration in credit quality. “By the time most of these loans mature and some (or sometimes many) turn out to be non-performing, the manager who oversaw the credit expansion in country A might be already busy repeating the task in country B or C”, Mihaljek highlights (2008: 26). f) Volatility and contagion As developing countries receive capital flows and become more integrated in the international financial system, the distribution of information in markets remains asymmetric, increasing the possibility of volatility and cross-border contagion (Lopez Mejia, 1999).
Part 2: Managing the capital flows’ roller coaster Having examined the negative effects of capital flows, the question this essay will answer is what can developing countries do to protect themselves or, as the head of the Institute of International Finance (IIF) would say, how can they “manage the roller coaster” of capital flows (Collyns, 2013). The IIF distinguishes four major approaches developing countries have taken to deal with the negatives effects of capital flows: Classical Chinese Defense It is known as the ´Classical Chinese Defense´ because it is the approach China used to take. However, the Asian giant has gradually moved away from this technique. India implemented this set of policy responses in the 1990s and Malaysia in 1998, while they can currently be observed in Argentina. The technique consists of a largely closed capital account with the use of capital controls. It remains open to FDI, but limits other kinds of inflows, especially „hot money'. The exchange rate is fixed to avoid appreciation. Foreign reserves are used to sterilize capital flows as needed. Moreover, financial repression is sometimes used to finance the sterilization of capital flows. Pros: The technique maintains the competitiveness of the economy by generating a strong growth of exports. It also reduces the risk of external crises by not allowing capital flows to either flow in or out of the economy. Cons: A repressed financial system means that credit isn't allocated according to market criteria, leading to less investment and, therefore, less growth. Eventually, over time, this can lead to a misallocation of capital, which is the reason why China has moved away from this approach. At the beginning of the process a developing country can sterilize capital flows with foreign reserves, but over time sterilization becomes more costly, particularly as the financial system develops and the degree of financial repression is reduced. If capital flows are not sterilized, the developing country is exposed to a potential loss of monetary control, inflation and a rapid expansion of credit, symptoms that Argentina has been experiencing over recent years.
Textbook strategy This strategy is so called because it uses measures that the IMF was suggesting until the financial crisis of 2007. This approach advises sequentially opening up the capital account, but also getting the macroeconomic policies of the developing country “right” beforehand. In order to do that, the strategy suggests a critically conservative fiscal policy with low public deficit, low public debt and a medium-term framework to anchor international investors‟ expectations of fiscal sustainability. The exchange rate should be floating and inflation targets have to be met. Currency intervention is considered to be an option for smoothing currency swings only, not to steer the exchange rate. Pros: The strategy provides room for seekable responses to adverse short-term effects if the developing country has a credible inflation targeting strategy and a medium-term fiscal framework. It also encourages financial and economic development. If the developing country gets into trouble it can always ask the IMF for help. Cons: Competitiveness falls as a result of the appreciation of the currency. Moreover, in reality is very hard for a developing country to implement a perfect discipline in macroeconomic policies. In particular, it is difficult to maintain a tight fiscal policy in times of credit boom when the economy is growing quickly. The political pressures to start spending the money instead of running a fiscal surplus are usually very strong. Furthermore, medium-term frameworks are not common in developing countries because of political instability. Another weakness of the Textbook strategy is that it doesn't tackle the problem of credit booms and busts. Furthermore, if the developing economy does get into trouble, it is not so easy for the Government to go the IMF, because it is usually seen politically as surrendering the sovereignty of the country to a foreign body. Brazilian Defense strategy This approach takes from the textbook strategy the floating exchange rates and the inflation targeting but is more pragmatic in terms of getting the macroeconomic policies „right‟, keeping in mind that it is not so easy to achieve. It intervenes in the currency more than what the textbook approach would suggest in order to avoid an overvalued exchange rate. Macroprudential and tax tools are also used to lean against capital flows. Chile invented this approach in the 1990s, but they have moved away from it. Brazil, India and Turkey have moved on to this approach over recent years. Pros: The approach tackles the problem of exchange rates swings and credit booms and busts. It is also very pragmatic and responsive to circumstances. Cons: Even though it is recognized to be effective in the short-term, it is not so clear if this set of policies can be maintained over time. Critics say that the market will always find ways to get money into a country if it offers high-returns. Therefore, it is hard to maintain these measures unless the developing country continuously broadens capital controls and taxes, which can generate financial distortions and illiquid markets, affecting investment and growth. Moreover, the Brazilians Defense affects the composition of the flows more than the volume, so the exchange rate still has pressures of appreciation. New Orthodoxy As a result of a continuing debate on how to balance the three approaches, the IMF is trying to reach a consensus known as the New Orthodoxy. This strategy recognizes that there are some
circumstances in which short-term capital controls can be useful when an economy reaches a certain point. However, it emphasises that before getting to that point developing countries should get their macroeconomic policies „right‟, including tight fiscal policy, low public deficit and inflation targeting. Countries should allow the exchange rate to appreciate, particularly if the currency was undervalued at the start. Therefore, it encourages a commitment of the country to liquid financial markets and an open capital account. Chile, Malaysia, Mexico, Poland, and the Czech Republic are currently following the New Orthodoxy. Pros: This approach provides room for counter-cyclical responses, such as lowering interest rates and aggressive fiscal policies Cons: The economy is still vulnerable to exchange rate swings and credit booms and busts. On the next page, Graph 2 (Ostry et al., 2010: 7) shows the complexity of the New Orthodoxy and how difficult it is to get to a situation where capital controls are justified in the new IMF´s view.
Dealing with capital outflows On the other hand, the World Bank summarizes in Graph 3 (World Bank, 2014: 112) the range of policies developing countries have at their disposal to deal with weaker capital inflows and capital outflows. The multilateral bank suggests that the appropriate mix will vary depending on the individual country's situation and policy regime.
Part 3: Conclusion The idea that one solution will fit all countries is damaging. The Textbook and New Orthodoxy approaches follow this direction and still rely on the assumption that markets are rational. They expect developing countries´ large domestic investors will invest abroad when there is a surge of capital inflows. However, as the OECD notes (2011: 297), not all countries have large domestic investors that can bounce back the effect of a surge in capital flows. In the opinion of the Nobel laureate in Economics Joseph Stiglitz “it´s not fair to insist that developing countries with a barely functioning banking system risk opening their markets. It‟s bad economics” (2003: 17). As the head of the U.K. Financial Conducts Authority recently recognized during a lecture at SOAS, financial authorities always bear in mind that over-regulating a country can cause the capital to flow to another economy with more relaxed regulations. Therefore, the response of developing countries to protect against the negative effects of capital flows cannot be taken individually; they should be taken at an international or at least regional level. Reforming the financial architecture in such a way that speculative flows will be no longer profitable can contribute to mitigate the negative effects of capital flows. To this end, proposals such as the Tobin tax should be implemented. Moreover, central banks in developed countries´ should take into further consideration the effects that their loose monetary policies have on the rest of the world, not only out of solidarity but because these policies can have a boomerang effect which could damage the developed economies in the medium term, especially in the eventual case of emerging markets not overcoming the challenge posed by capital flows.
References Bakardzhieva, D., Ben Naceur, S. and Kamar, B. (2010) The Impact of Capital and Foreign Exchange Flows on the Competitiveness of Developing Countries. IMF Working Paper WP/10/154. IMF Institute. Calderon, C. and Kubota, M. (2012). Gross inflows gone wild : gross capital inflows, credit booms and crises. Policy Research Working Paper Series 6270. The World Bank. Chuhan, P.; Perez-Quiros, G.; Popper, H. (1996) International capital flows: do short-term investment and direct investment differ? World Bank Claessens, S., Dooley, M.P. and Warner, A. (1995, March). Portfolio Capital Flows: Hot or Cold? Development Discussion Paper No. 501. Harvard Institute for International Development. Collyns, C. (2013) Riding the Roller Coaster: Managing Capital Flows to Emerging Markets.[Online], Available: http://www.iif.com/emr/resources+3227.php [28 Feb 2014] IIF Corden, W. M., (1994) Economic Policy, Exchange Rates and the International System. Oxford University Press. Desai, M.A. and Hines, J.R. (1999). Excess Capital Flows and the Burden of Inflation in Open Economies in The Costs and Benefits of Price Stability. National Bureau of Economic Research. University of Chicago Press. Feroli, M., Kashyap, A., Schoenholtz, K. and Song Shin, H. (2014) Market Tantrums and Monetary Policy. US Monetary Policy Forum. Ghose, A.K. (2004) Capital inflows and investment in developing countries. International Labour Organization Kawai, M. and Lamberte, M. (2010) Managing large capital flows: in search of a framework. InterAsian Development Bank. Kiguel, M. and Caprio, G. (1993) February Capital inflows--hot or cool? Policy Views from the Policy Research Department. Outreach #8. World Bank. Lopez Mejia, A. (1999) Large Capital Flows. Causes, Consequences and Policy Responses. In Finance&Development quarterly magazine (Number 3, Volume 36). International Monetary Fund. Lupo Pasini, F. (2011) The International Regulatory Regime on Capital Flows. ADBI Working Paper 338. Asian Development Bank Institute. Tokyo. Mihaljek, D. (2008) The financial stability implications of increased capital flows for emerging market economies. BIS Papers, 44-02, no. 44, May. BIS OECD (2011). Getting the most out of international capital flows. OECD Economic Outlook. Chapter 6, Volume 2011/1. Ostry, M. J. D., Qureshi, M. S., Habermeier, M. K. F., Reinhardt, D. B., Chamon, M. M., & Ghosh, M. A. R. (2010). Capital Inflows: The Role of Controls International Monetary Fund. Prasad, E., Rajan, R. and Subramanian, A. (2006) Patterns of International Capital Flows and Their Implications for Economic Development. Research Department IMF. Stiglitz, J. E. (2003) Globalization and its Discontents WW Norton & Company.
Wang, Q. (2008, July 01). China: Counting hot money. Morgan Stanley Research. Hong Kong. World Bank (2014) January Global Economic Prospects World Bank.