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Capital Flows to Emerging Market Economies


Capital Flows to Emerging Market Economies Forecast,Analysis and Policy Recommendations April 2011 September 2010 * * Capital Controls: A reversal of Policy ... – PowerPoint PPT presentation

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Title: Capital Flows to Emerging Market Economies

Capital Flows to Emerging Market Economies
Forecast,Analysis and Policy
April 2011
February 22, 2011
Capital Flows to
Emerging Market Economies
  • Overview
  • Net private capital inflows to emerging economies
    are estimated to have been 908 billion in 2010,
    which is 50 higher than in 2009.
  • Private flows are projected to increase to 960
    billion in 2011 and is 1009billion in 2012.
  • The 2010 estimate is 83 billion greater than in
    October and 187 billion higher than the
    projection a year ago.
  • Rising flows are supported by strong emerging
    market fundamentals, long-term investor portfolio
    rebalancing and abundant global liquidity.
  • Resurgent capital inflows raise important policy
    questions most emerging economies need tighter
    monetary policy but would also benefit from
    tighter fiscal and macroprudential policies, and
    allowing more currency appreciation.
  • For emerging Asia, Inflows this year and next are
    likely to average around 430 billion, with the
    region again accounting for more than 40 of ...
    flows to emerging markets.
  • Flows of foreign direct investment should exceed
    150 billion a year, more than half of which will
    go to China and 36 billion to India. Foreign
    purchases of domestic stocks should stabilize at
    around 120 billion a year, again dominated by
    China and India.
  • In the past year, the world has seen another
    boom, with a tsunami of capital, portfolio equity
    and fixed-income investments surging into
    emerging-market countries perceived as having
    strong macro-economic, policy and financial
  • Such inflows are driven in part by short-term
    cyclical factors (interest-rate differentials and
    a wall of liquidity chasing higher-yielding
    assets as zero policy rates and more quantitative
    easing reduce opportunities in the sluggish
    advanced economies).
  • Add to the mix of factors behind the inflows are
    Longer-term secular factors such as emerging
    markets long-term growth differentials relative
    to advanced economies investors greater
    willingness to diversify beyond their home
    markets and the expectation of long-term nominal
    and real appreciation of emerging-market

Capital Controls A reversal of Policy
Capital Controls A reversal of Policy
  • The IMF has reversed its position and is allowing
    developing countries under some circumstances to
    control the free flow of capital to protect their
  • This very pragmatic view is a product of a new
    policy framework outlined by the fund to use
    policy tools like taxes, interest rates to curb
    the flows of cash in and out of countries.
  • EM should try to deepen their capital markets to
    help absorb cash inflows and prevent surges from
    causing damaging distortions in their economies.
  • Since that takes time, however, governments
    should adjust monetary or fiscal policies as the
    first line of defense, such as by boosting the
    value of their currencies, buying
    foreign-exchange reserves, adjusting interest
    rates and tightening budget.
  • The framework also lays the foundations for the
    Group of 20 industrial and developing nations as
    they devise a "code of conduct" on capital
  • The main concern is that the treatment of
    capital-flow issues will be based on a biased
    approach and deficient analysis. The new
    framework could also be viewed as a tool for the
    IMF to heighten surveillance of emerging markets.

February 22, 2011
Capital Flows Analysis
and Empiric International Financial Integration
  • Capital Flows to Developing Countries
  • An international debt cycle.
  • Reasons for flows to emerging markets in the
    1990s 2000s.
  • Pros and Cons of Open Financial Markets
  • Advantages
  • The theory of intertemporal optimization
  • Other advantages
  • Disadvantages of financial integration
  • Procyclical capital inflows
  • Periodic crises

stop (Asia crisis)
3rd boom
2nd boom
1st boom
stop (international debt crisis)

start (recycling petro-dollars)
Three booms in capital flows to developing
Capital Flows Dissecting
The Causes
  • Econominc. Liberalization
  • Privatization
  • Monetary stabilization
  • Removal of capital controls

Domestic Economic Reforms
  • pro-market environment
  • assets for sale
  • higher returns
  • open to inflows

External factors
More of Northern portfolios in mutual funds
Cross-border factors
  • New vehicles country funds, ADRs
  • Brady Plan lifted debt overhang of 1980s
  • Moral hazard from earlier bailouts

The third emerging market boom began in 2003.
Between 2003-07, emerging markets used the
inflows to build up Forex Reserves rather than to
finance Current Account Deficits
In the early 1990s, portfolio investment
dominated. This time (2003-07) Foreign Direct
Investment (FDI) was bigger.
Both China and India used reserve accumulation to
finance Capital inflows
Latin America ran CA surpluses
and added to reserves
Central/Eastern Europe is the one emerging
markets group that ran worrisome current account
deficits, esp. Hungary, Ukraine, Latvia...
February 22, 2011
Advantages of financial opening in
emerging-market countries
  • Investors in richer countries can earn a higher
    return on their saving by investing in the
    emerging market than they could domestically
  • Everyone benefits from the opportunity to
    diversify away risks and smooth disturbances
  • Letting foreign financial institutions into the
    country improves the efficiency of domestic
    financial markets.
  • Governments face the discipline of the
    international capital markets in the event they
    make policy mistakes

February 22, 2011
Assessing The effects of opening stock
Markets to foreign investors
Cost of Equity capital falls.
February 22, 2011
Assessing The effects of opening stock
Markets to foreign investors
Rate of capital formation rises
gt domestic residents borrow from abroad, so
that they can consume more in Period 0.
Financial opening with elastic output
Assume interest rates in the outside world are
closer to 0 than they were at home.
Shift production from Period 0 to 1,
and yet consume more in Period 0,
thanks to foreign capital flows.
Welfare is higher at point C.
Capital Flows to Emerging Market
Economies Key Findings
What accounts for the Cautious nature of the

Limited Supply Capacity
Fear of tighter controls on Capital Inflows
  • Financial Institutions in deleveraging mode
  • Reduction in debt-related flows
  • Moderate FDI flow caused by anaemic global
    investment spending
  • Fear of floating and undue appreciation

Fear of Tightening
  • Limited degree of economic slack
  • Solid Case for CB to move to a tighter monetary
  • Concern to attract undue short-term capital
  • Staggering increase in the Price of market assets
  • A moderate increase in net inflows of portfolio
    equity capital

Benefits of international capital flows
  • Enhance growth
  • Augment domestic saving and allow higher
    investment and growth
  • Reduce volatility
  • Allow consumption smoothing
  • Enable portfolio diversification
  • Improve institutions
  • Prevent fiscal profligacy and monetary
    mismanagement, enhance rule of law and contract
    enforcement, improve policy0making

Do capital inflows help growth?
Period covered is 1970-2000. Source Prasad,
Rajan, and Subramanian (2006)
Capital flows and financial crises
Source Laeven and Valencia, 2008
Do capital flows help risk diversification and
consumption smoothing?
Source Kose et al. (2007)
  • Capital Flows to Emerging Market Economies The
    Case For Regulation
  • Externalities of capital flows
  • The welfare theoretic case for regulating capital
    flows is based on the notion that such flows
    impose externalities on the recipient countries.
  • Risky forms of capital inflows create
    externalities because individual borrowers find
    it optimal to ignore the effects of their
    financing decisions on aggregate financial
  • Individual borrowers take the risk of financial
    crisis in their economy as given and do not
    recognise that their individual actions
    contribute to this risk.
  • This prisoners dilemma where individual
    borrowers could not all agree to use less risky
    financing instruments and less external finance
    thus making the economy as a whole more stable,
    creates a natural role for policy intervention.
  • By implication policymakers can make everybody
    better off (i.e. achieve a Pareto-improvement) by
    regulating and discouraging the use of risky
    forms of external finance, in particular of
    foreign currency-denominated debts.
  • Mechanism of financial crises
  • A specific market imperfection that plays a
    crucial role during emerging market financial
    crises provides the economic rational for
    capital flow regulation
  • International investors typically demand explicit
    or implicit collateral when providing finance.
  • However, the value of most of a countrys
    collateral depends on exchange rates.
  • When an emerging economy is hit by an adverse
    economic shock, its exchange rate depreciates,
    the value of its domestic collateral declines,
    and international investors become reluctant to
    roll over their debts.
  • The resulting capital outflows depreciate the
    exchange rate even further and trigger an adverse
    feedback cycle of declining collateral values,
    capital outflows, and falling exchange rates

February 22, 2011
February 22, 2011
An optimal framework of capital flow regulation
  • The level of complexity of capital controls has
    to be weighed against the administrative capacity
    of regulators. If capital flow regulation taxes
    risky forms of flows more than safe forms, then
    it will achieve a shift in the liability
    structure of emerging economies towards safer
    forms of finance. This composition effect would
    make the economy more robust to shocks.
  • Tax-like measures are likely to be more effective
    than unremunerated reserve requirements in the
    current economic environment. Both forms of
    capital controls have been used in practice, and
    economic theory suggests that the two measures
    are largely equivalent since the opportunity cost
    of not receiving interest on reserves amounts to
    a tax.
  • Controls on the stock of foreign capital in the
    country are more desirable than controls that are
    solely based on inflows, since potential capital
    flow reversals depend on the stock of foreign
    capital in the country. This can be implemented
    e.g. by requiring foreigners to hold their
    investments in designated non-resident
    investment accounts and by accruing regulatory
    taxes on these accounts on a daily basis.
  • Controls should adapt to macroeconomic
    circumstances. The vulnerability of emerging
    economies and therefore the externalities
    created by capital inflows fluctuates with the
    domestic business cycle in emerging economies as
    well as with global liquidity conditions Just as
    central bankers adjust interest rates in response
    to inflationary pressure, regulators in emerging
    markets have to regularly adjust their policy
    measures to reflect the given macroeconomic

Capital Flows to Emerging Market Economies
Main Intuitions
  • It is difficult to argue that investors punish
    countries when and only when governments follow
    bad policies
  • Large inflows often give way suddenly to large
    outflows, with little news appearing in between
    to explain the change in sentiment.
  • Second, contagion sometimes spreads to where
    fundamentals are strong.
  • Recessions hitting emerging markets in such
    crises have been so big,it is hard to argue that
    the system is working well.
  • More generally, capital flows have often been
    procyclical, not countercyclical,been the
    disturbance source, not the smoother