International Balance Sheets, Global Imbalances and Governance

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International Balance Sheets, Global Imbalances
and Governance
The External Wealth of Malaysia
Andrew Sheng
Preliminary analysis
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Contents
Introduction
Global Overview
Brief overview of the current trends in global
external position
Comparative perspective of regional countries
through the crisis and after
Regional Perspective
Malaysian Scenario
A closer look into Malaysias external position
Conclusions
Implications for policy imperatives and future
directions for research and surveillance
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Introduction
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Introduction
Financial crises, growing external imbalances and
financial globalisation have resulted in
increasing interest in looking at economies from
a balance sheet perspective.
The balance sheet approach focuses on net assets
and liabilities (stock) rather than the IMF
practice of looking at flow variables.
Recently, IMFs Lane and Milesi-Ferritti
introduced estimation of external positions for
140 countries from 1970-2004, presenting a
valuable set of data previously not consistently
available for scrutiny. This is a rich data-set.
Lane, Philip R., and Gian Maria
Milesi-Ferretti 2006, "The External Wealth of
Nations Mark II Revised and Extended Estimates
of Foreign Assets and Liabilities, 1970-2004" IMF
Working Paper no 06/69, IMF
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Exciting New Data Source
The balance sheet data, which are derived from
flow data and partially stock data, give us an
unprecedented total picture of inter-connectivity
of stock and flow relationships between trading
partners.
In the past, IMF surveillance focused on
countries, not on the linkages and transmission
mechanisms of trade and capital flow shocks.
The Lane and Milesi-Ferritti estimates allow a
rich analysis of where shocks emanate and how
they flow through balance sheets, creating
vulnerabilities that authorities were not able to
detect before such data.
Lane, Philip R., and Gian Maria
Milesi-Ferretti 2006, "The External Wealth of
Nations Mark II Revised and Extended Estimates
of Foreign Assets and Liabilities, 1970-2004" IMF
Working Paper no 06/69, IMF
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Global Overview
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Major trends in global external positions
Three trends are particularly notable

1. International financial integration has increased
   significantly
2. Global imbalances have widened sharply
3. Differences in rates of return between external
   assets and liabilities lead to significant shifts
   in international resources

The analyses presented here are mainly drawn
from the Lane and Milesi-Ferretti (2006) dataset.
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Financial Globalisation Rising
International asset trade increased markedly,
especially since mid-1990s. Total foreign assets
and liabilities in most countries are much higher
than the level of GDP
Source Lane and Milesi-Ferretti (2006)
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Financial Globalisation in Equity instruments
This heightened financial integration is true for
both developed and developing countries,
especially in cross-border equity holdings
Source Lane and Milesi-Ferretti (2006)
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Global Imbalances Widening for US EU
Recent years saw sharp widening of global
imbalances
Source Lane and Milesi-Ferretti (2006)
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Asia and OPEC are now net creditors
Japan, emerging Asia and oil producing countries
are clear creditors, while the United States saw
sharp deterioration in net external position. The
rest of the world are essentially net debtors.
Source Lane and Milesi-Ferretti (2006)
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Rate of Return Differentials Matter
Differences in rates of return on assets and
liabilities significantly affect net external
positions of countries and lead to shifts in
resources across borders
US superior return differential explains its
relatively stable net external position despite
massive net external borrowings in recent years
Asset Returns Asset Returns Returns on Liabilities Returns on Liabilities Return Differentials Return Differentials
1995-1999 2002-2004 1995-1999 2002-2004 1995-1999 2002-2004
United States 11.8 9.6 10.5 0.9 1.3 8.7
Japan 6.2 2.8 10.1 5.8 -3.9 -3.0
Euro -4.2 -1.0 -3.2
Malaysia -0.1 13.2 -13.4
Notes 1. Figures are in real domestic-currency
terms 2. Malaysia figures are returns on direct
investment only for 2000-2004, due to the lack of
publicly available financial account flow
data. Sources Lane, Philip R., and Gian Maria
Milesi-Ferretti, 2005, A Global Perspective on
External Positions" IMF Working Paper no 05/161,
IMF Authors Estimates
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Regional Perspective
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Onset of the Asian Crisis
Except for Korea, countries affected by the
crisis saw significant worsening of net foreign
positions prior to the crisis, breaching negative
60 of respective GDPs.
Source Lane and Milesi-Ferretti (2006)
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After the Asian Crisis
After 1998, net foreign positions improved in all
crisis countries, but Malaysia made the most
progress, putting the countrys external balance
sheet virtually at balance.
Source Lane and Milesi-Ferretti (2006)
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A Wider Comparison
Except Korea, the crisis countries clearly have
very different net external positions compared to
the Asian tigers China was relatively
unaffected by the crisis, and enjoyed improving
net external position due to peg to dollar
Source Lane and Milesi-Ferretti (2006)
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China Currency Peg forced Structural Adjustment
Chinas GDP powered ahead during and after
crisis, while others only recovered to pre-crisis
level in the past two years
Source Lane and Milesi-Ferretti (2006)
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China FDI driver of growth competitiveness
Stock of FDI liabilities relative to GDP have
declined for crisis economies since 1998, while
FDI to China kept on expanding
Source Lane and Milesi-Ferretti (2006)
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Malaysian Scenario
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Net External Position Composition
The profile of foreign asset for Malaysia evolved
considerably from 1970 to 2004. The 1980s
witnessed large buildup of debt liabilities.
Source Lane and Milesi-Ferretti (2006)
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Net External Position Composition
The 1990s saw an increase in net portfolio equity
liabilities
Source Lane and Milesi-Ferretti (2006)
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Net External Position Composition
After the crisis, Malaysia saw buildup in foreign
reserves and overall improvement of net external
position
Source Lane and Milesi-Ferretti (2006)
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Net External Position Composition
Source Lane and Milesi-Ferretti (2006)
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External Wealth and the Economy Some
Observations
Income Total foreign assets and liabilities ( of
GDP), especially the former, have grown in line
with income. This suggests a positive
relationship between level of income and the
holding of foreign assets
Sources Lane and Milesi-Ferretti (2006)
Department of Statistics, Malaysia
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If NEP worsens to -50 of GDP, crisis looms
Vulnerabilities Both cases of crises (1985, 1997)
were preceded by bouts of worsening net external
position, both breaching negative 50 of GDP
Sources Lane and Milesi-Ferretti (2006)
Department of Statistics, Malaysia
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Real Effective Exchange Rate NEP
Net external position shows a negative
correlation with REER, pointing to a probable
link between exchange rate policy and the
improvement in external position after the crisis
Sources Lane and Milesi-Ferretti (2006) Bank
for International Settlement Authors estimates
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Public Investment associated with Debt FDI
growth
Investment Capital formation, particularly public
investment, showed very significant positive
relationship with foreign debt and FDI
liabilities The relationship was clearest in
late 1980s up to 1998, in which up to 90 of
variations in investment can be explained by
changes in foreign debt liabilities
Note Calculated as correlation between rate of
change of respective nominal variables,
investment variables lagged 2 years. Sources
Lane and Milesi-Ferretti (2006) DOSM Authors
estimates
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Foreign Portfolio Flows drive Equity Market
Share Market Foreign portfolio equity liabilities
are very significantly correlated to share market
movements The high level of share market
activities for the period 1992 to 1998 was
clearly related to the steep inflow in portfolio
equities
Sources Lane and Milesi-Ferretti (2006) KLSE
Authors estimates
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Further Analysis Valuation Effect

• The difference between net external position and
  cumulated current account provides an estimate of
  the valuation component of net external assets,
  which represents
• cumulated value of net capital gains and
• exchange rate adjustments

Sources Lane and Milesi-Ferretti (2006) DOSM
Authors estimates
Estimate using methodology presented in
Gourinchas, Pierre-Olivier, and Helene Rey, 2005,
From World Banker to World Venture Capitalist
US External Adjustment and the Exorbitant
Privilege, NBER Working Papers 11563, National
Bureau of Economic Research
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Persistent Negative Valuation Effect

• Two clear stylised patterns are notable
• Valuation effect has been persistently negative
  suggesting large net capital losses, especially
  during period when foreign liabilities was large
• Depreciation of ringgit corresponded to worsening
  valuation effect, as shown in the shaded areas

Sources Lane and Milesi-Ferretti (2006) BNM
Authors estimates
Given the conceptual relationship, this can
potentially explain the large return differential
between foreign assets and liabilities
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Preliminary Conclusions
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Implications of Analysis

• Malaysia clearly in much better shape and less
  vulnerable to external flow shocks - fiscal
  retrenchment has worked

• Malaysia is not short of savings and therefore
  improvement of domestic financial intermediation
  would cushion Malaysia against external shocks

• Letting excessive savings flow out, while
  deepening domestic intermediation clearly reduces
  overall risks (equity return swap).

• We need NATIONAL RISK MANAGEMENT strategy and
  policy. The way we finance development and
  growth exposes us to different risks. When we
  are net debtor (negative NEP), we are exposed to
  shocks on our debt. When we are net creditors,
  we must learn how to manage our return on assets.
  

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Implications on Policy

• Policy Management for rich country (net
  creditor) very different from poor country (net
  borrower).

• Example If net assets are held in USD and
  liabilities are in Yen, then Malaysia would be in
  double squeeze, a declining asset and
  appreciating liability.

• This is true not only of Public Sector Risk
  Management, but also for Private Sector.

• This makes the case for faster development of
  Asian financial markets, so that we can invest in
  countries and currencies that appreciate together
  relative to USD/Euro, rather than being
  depreciated on our asset holdings.

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Direction of Research
Increase in international financial integration
increases exposure to external financial shocks,
meaning that balance sheet vulnerabilities will
need to be closely monitored.
Thus, research initiatives should be directed to
improve the understanding of the economy through
the balance sheet perspective.
The devil is in the details. We need to study
more carefully not just the components of our
balance sheet and flows, but also the
inter-relationship with other economies.
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A Macro-Micro Prudential Framework
Surveillance should be reemphasised to include
the balance sheet approach to complement the
existing surveillance effort. Macro-behaviour
have micro-origins, and micro-behaviour have
macro-implications
Comprehensive surveillance would require detailed
understanding of balance sheet conditions of all
the different sectors of the economy, from the
financial sector to the public sector and so on.
This means that different departments within the
central bank and with other regulators need to
have greater co-operation and information sharing
in order to have a holistic view of potential
shocks to the financial system.
Mathisen, J. and Anthony Pellechio, 2006,
Using the Balance Sheet Approach in
Surveillance Framework, Data Sources, and Data
Availability" IMF Working Paper no 06/100, IMF,
provides an excellent starting point for the
understanding of the balance sheet surveillance
approach.
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Growth, Stability and Governance
Economic Growth can only occur in environment of
political and financial stability. Central Bank
is in charge of monetary stability and systemic
financial stability. Central Bank challenges
are very different from emerging market to middle
income market to developed economy.
As markets get more sophisticated, regulation and
oversight of systemic stability becomes much more
complicated. This is because we are in global
competition and local regulation. You have to
help locals compete globally, but you have much
greater difficulty regulating large foreign
giants, some of which may be much larger than the
whole economy.
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Learning to trust Market, but carry big stick
In order to regulate market, you have to learn to
think how the market thinks. Hence, there must
be greater inter-change of staff between the
regulators and the regulatees. Example how do
we regulate Hedge Funds who now account for 50
of turnover in London and New York?
You have to learn how they operate and use the
language they understand in order to influence
their behaviour. Example Fraga handling
Brazilian crisis. WTO rules require regulators
to use International standards to regulate
financial markets. This means that we must use
the Big Regulators to regulate Big Financial
Groups. In order to compete regionally and
globally, we must learn to both cooperate and
compete with the Big Financial Groups.
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Thank You Questions to as_at_andrewsheng.net