The financial stability implications of increased capital flows for emerging market economies

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The financial stability implications of increased
capital flows for emerging market economies

• Dubravko Mihaljek
• Bank for International Settlements
• Presentation at the Economics Institute Zagreb
• Zagreb, 11 November 2008
• The views expressed are those of the author and
  not necessarily those of the BIS.

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Outline

• Data description
• Recent trends in capital flows to/from EMEs
• Financial stability implications of increased
  capital flows
• Focus on bank-intermediated capital inflows and
  CEE
• Policy responses
• Financial stability implications of debt
  portfolio outflows

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Data description

• Focus (mostly) on private capital flows
• Gross vs. net flows
• Gross flows to study financial integration,
  financial stability issues composition of flows
  important for macroeconomic management
• Net flows key for macroeconomic (demand)
  management
• Sample
• Mostly 2001-2006
• Some comparisons with 1990s
• 3 EM regions Asia and Latin America, CEE
  (Baltics, central Europe, SEE)

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Data description (2)

• Data sources
• BoP data (IMF, International Financial
  Statistics)
• BIS locational and consolidated statistics
• Look at average of countries in the region, and
  regional totals

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Recent trends gross inflows
of GDP, regional totals
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Recent trends gross inflows (2)
of GDP, regional totals
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Recent trends regional distribution
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Gross inflows and outflows for CEE
Inflows
Outflows
of GDP, unweighted country average except net
flows (regional average).
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Net flows to CEE - latest data
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Recent trends breakdown of gross inflows
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Recent trends breakdown of gross outflows
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Portfolio outflows- mostly for purchases of
foreign debt securities - mostly from China (70
of Asian total, 140 bn. from 2002-06)-
private sector probably includes SOCBs
of gross outflows
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Two main developments from FS perspective(a)
other investment inflows (b) portfolio
outflows Other investment flows to banks and
to other sectors non-financial corporations,
NBFIs, households
of gross inflows/gross outflows of other
investment unweighted country average for
2004-06.
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Other investment flows increased very strongly in
CEE
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The increase was most pronounced in the past
three years
Cross-border claims of BIS reporting
banksvis-à-vis emerging markets Changes in
amounts outstanding at end-period, as a
percentage of GDP Cumulative increase in CEE
since 2005 7.5 of
GDP
5.7 of GDP
Source BIS, Locational Banking Statistics IMF,
World Economic Outlook.
16
Cross-border loans account for a large share of
domestic credit in CEE
Cross-border and domestic bank creditin emerging
market economies As a percentage of total bank
credit
Sources IMF national data BIS locational
banking statistics.
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Financial stability implications of cross-border
loans

• In the past, pure cross-border loans
• Latin America in 1980s ? debt crisis
• Asia in 1990s ? 1997/98 crisis
• Now parent banks ? loans to subsidiaries in EMEs
• Pure cross-border loans mainly to large
  corporations from EMEs

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Financial stability implications of cross-border
loans (2)

• Parent banks ? loans to subsidiaries
• Most pronounced in CEE and Mexico, where banking
  systems are 80-95 foreign-owned
• In CEE, cross-border loans are convergence flows
  economic, financial, institutional integration
  with EU, which is different from Asia in the
  1990s
• Cross-border loans were taking place in
  financially repressed banking systems in Latin
  America in the 1980s and Asia in the 1990s
  banking systems in CEE are competitive and open
• Cross-border loans were financing
  import-substituting development in Latin America,
  not the case in CEE

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Financial stability implications of cross-border
loans (3)

• Risk of a solvency crisis smaller
• Parent banks large, well-capitalised, well
  supervised, focus on traditional commercial
  banking, did not invest in subprime/structured
  products
• But the risk to sustainability of cross-border
  flows still large
• Underestimation of credit risk during credit boom
• High targets for ROE (to exploit franchise value)

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Financial stability implications of cross-border
loans (4)
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Financial stability implications of cross-border
loans (5)

• Risk of regional contagion
• Parent banks pursue similar strategies across
  regions (eg, lending to households)
• Transmission of shocks from home countries (eg,
  via funding in wholesale markets)
• Asymmetry of host country vs. parent bank
  exposures
• Other channels short maturity of cross-border
  loans, concentration of foreign creditors, common
  creditors across region

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Financial stability implications of cross-border
loans (5)
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Risks at the current juncturesudden
stop/reversal of bank intermediated flows
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Risks at the current juncturesudden
stop/reversal of bank intermediated flows (2)
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Risks at the current juncturesudden
stop/reversal of bank intermediated flows (3)
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Risks at the current juncturesudden
stop/reversal of bank intermediated flows (4)
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Policy responses how to deal with these risks?

• Macroeconomic policies
• Allow greater exchange rate flexibility
  trade-off between the consequences of ER
  appreciation and sterilisation
• Reduce policy rates trade-off between the
  consequences of capital inflows and domestic
  objectives (inflation target, domestic credit
  growth)
• May have limited room for manoeuvre on ER, IR
• Relax controls on capital outflows eg, for
  institutional portfolio investors
• Fiscal tightening best approach should focus
  on expenditure restraint

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Policy responses (2)

• Macroprudential and microprudential responses
• Tighten oversight of banks management of credit
  risk (to make sure banks hold sufficient capital)
• Improve quality of creditor information (accurate
  company financial reports, credit registry for
  households, tighter debt/income debt service/
  income ratios, etc)
• Diversify sources of bank funding
• Temporary capital controls

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Policy responses (3)

• Funding sources of EME banks are poorly
  diversified

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Policy responses (4)

• Home-host supervisory cooperation
• International scope of banking institutions vs.
  national scope of regulation and supervision
• Conflict between macroeconomic and financial
  stability concerns in small economies hosting
  large international banks
• Divided responsibilities for financial stability
  and financial sector supervision within home and
  host countries

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Policy responses (5)

• Home-host supervisory cooperation (contd)
• Subsidiaries vs. branches
• MOUs, supervisory colleges, joint supervision
• Resolution of cross-border bank failures

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Are there any financial stability implications of
EME investments in foreign portfolio capital?

• Redirecting FX inflows helps macroeconomic policy
  (no need to deal with impact of capital
  inflows)
• But is it good investment?
• Interest rate differential vis-à-vis US
• Assets denominated in depreciating currency (USD)
• If investments are made by SWFs, additional
  issues
• Protectionist backlash
• SWFs might not be subject to supervisory
  oversight in their home jurisdictions