A Pragmatic Approach to Capital Account Liberalization Eswar Prasad Cornell University
Presentation partly based on my joint work with: Ayhan Kose, Kenneth Rogoff, Shang-Jin Wei (2003, 2006) Raghuram Rajan (2005, 2008) Raghuram Rajan and Arvind Subramanian (2007)
Benefits of Financial Integration: Theory Efficient international allocation of capital Consumption smoothing via international risk sharing Large welfare effects for developing economies
Figure 4. GDP (per capita, PPP weighted): 1970-2004 350 Advanced Economies 300 Emerging Markets Emerging (excluding China and India) 250 Other Developing Economies 200 150 100 1970 1975 1980 1985 1990 1995 2000
Figure 5B. Change in Financial Openness and GDP Growth, 1985-2004 Unconditional Relationship Growth rate of per capita GDP 0.06 0.05 0.04 0.03 0.02 0.01 0-0.01 CRI KOR THA MUS CHL IND IDN MYS LKA DOM TUN ESP PRT BGDEGY TUR AUS NOR PAK NPLJPN GHA ISR URY GRC USA FIN CAN TZA TTO ITA DEU AUT DNK FRA SWE JAM IRN SLV ZMB COL NZL GTM MEX PHL BRA SEN PERBOL ECU FJI ARG HND KENMWI DZA PRYZAF VEN TGO NER ZWE CMR -0.02-150 -50 50 150 250 350 450 Change in financial openness
0.06 Figure 5B. Change in Financial Openness and GDP Growth, 1985-2004 Conditional Relationship 0.05 Growth rate of per capita GDP 0.04 0.03 MUS CHL 0.02 EGY MYS CRI DOM TUN IND GTM KOR 0.01 ISR SLV TUR GHA COL TTO USA BGD LKA PAK IDN URY AUS 0 TZA SEN ZAF MEX IRN FJI THA CAN ESP BOLBRA VEN ITA AUT NOR PRT HND DNK FRA FINSWE KEN PRY GRCARG ECU NZL DEU JAM NER DZA NPL -0.01 ZMB CMR PHL JPN PER TGO MWI -0.02 ZWE -0.03-150 -50 50 150 250 350 450 Change in financial openness
Growth Benefits of Financial Integration: Evidence About 25 studies of growth effects No effect: 4 Mixed: 18 Positive: 3 No robust macroeconomic evidence of growth benefits
Correlation between Growth and Current Account Balances Non-industrial Countries, 1970-2004 Per capita GDP growth -2 0 2 4 6 8 MLI TZA MWI ZMB SEN CHN KOR MYS CYP THA MUS LKA IDN TUN DOM EGY IND PAK CHL PAN TTO ISRGHA BRATUR ECU MAR RWA COL BGD CRI PRY ETH MEXPHL URY CMR DZA ZAF NGAIRN HND SLV BOL GTM HTI CIV JAM ARG PERUGA ZWE KEN JOR SLE MDG VEN -10-5 0 5 Average current account balance to gdp
Why Doesn t Foreign Capital Boost Growth? 1. Domestic financial system cannot effectively intermediate foreign capital
Figure 6. Current Accounts, Investment and Growth in Developing Countries 3.00 Average Per Capita GDP Growth 2.00 1.00 Above Median 0.00 Above Median Below Median Current Account/GDP Investment/GDP Below Median
Why Doesn t Foreign Capital Boost Growth? 2. Foreign capital leads to exchange rate appreciation (overvaluation) => Lower exports, returns to investment, and overall growth
Foreign Capital and Overvaluation, 1970-2004 Residuals of average overvaluation -50 0 50 100 KOR IRN ISR TUR MDG URY ETH ZAF DZA GUY IND LKA BGD ZWE MUS HTI GHA VEN UGA ARG BRA CMR SEN CIV CHL HND MWI KEN JOR DOM MLI COL THA PER RWA MARGTM EGY ECU IDN SLV PAKPRY PHL TZA CHN JAM MEX CRI TUN CYP NGA SLE ZMB PAN TTO MYS BOL -.02 -.01 0.01.02.03 Residuals of average net fdi flows to GDP coef = 837.49992, (robust) se = 363.32526, t = 2.31
Financial Integration and Volatility: Evidence Capital mobility does not increase probability of crises Banking crises are most disruptive and occur frequently in closed economies No evidence that financial integration by itself is proximate determinant of financial crises
But Two Issues on Volatility Relative volatility of consumption growth increases at low and intermediate levels of integration Developing economies, including emerging markets, have not attained better risk sharing
Other Ways of Looking at the Data Effects of different types of private capital flows: > Equity flows > FDI > Debt Macroeconomic vs. microeconomic evidence
Summary of New Evidence Equity market liberalization seems to work FDI benefits becoming more apparent Benefits more evident in micro data More risk-sharing benefits from FDI, portfolio equity flows; debt not good for risk-sharing
The Traditional View Financial Globalization More efficient international allocation of capital Capital deepening International risk-sharing GDP growth Consumption volatility
A Different Perspective Traditional Channels Financial Globalization Potential Collateral Benefits Financial market development Institutional development Better governance Macroeconomic discipline GDP / TFP Growth Consumption volatility
FG and Financial Development Foreign ownership of banks improves efficiency of domestic banking system Inflows add to depth of equity markets Financial sector FDI has benefits
1.2 Figure 6A. Financial Openness and Financial Development: 1985-2004 Private Credit/ GDP 1 JPN DEU Private Credit/ GDP 0.8 0.6 0.4 0.2 0 AUT PRT FRA ESP NZL MYS THA KOR ZAF AUS ISR FIN ITA NOR DNK CAN TUN SWE CHL MUS GRC USA SLV IDN EGY FJI TTO BOLURY PHL IND BRA BGD PAK HND DZA LKA KEN IRN SEN ECU PNG TGOJAM ZWE NPL DOM MEX GTMCOL PRY CMRPER CRI ARG TUR VEN NER GHATZAMWI ZMB 0 50 100 150 200 250 300 Mean financial openness
Figure 6A. Financial Openness and Financial Development: 1985-2004 Stock Market Capitalization/ GDP 1.6 1.4 ZAF MYS Stock Market Capitalization/ GDP. 1.2 1 0.8 0.6 0.4 0.2 0 USA JPN FIN SWE AUS CAN CHL FRA ESP JAM DNK THAPHL ISR NZL KOR GRC TTO DEU MUS ITA NOR IND CHN ZWE BRA ARG PRT MEX IRN TUR EGY PAKCOL SLVLKA KEN IDN PER GHA AUT NPL FJI CRI ECUVEN TUN BOL MWI HND ZMB BGD GTM PRY TZAURY 0 50 100 150 200 250 300 Mean financial openness
FG and Quality of Institutions, Governance Openness to foreign capital provides incentives for improving corporate governance Corruption, lack of transparency discourage FDI, portfolio flows => incentives for improving public governance
2.5 Figure 6B. Financial Openness and Quality of Institutions: 1985-2004 Institutional Quality Institutional Quality. 2 1.5 1 0.5 0-0.5-1 NZL FIN AUS NOR CAN DEU AUT USA ESP PRT JPN CHL CRI ITA MUS GRC ISRURY KOR TTO MYS ZAF THA TUN BRAMEX SLV ARG JAM IND FJI PHLGHA TUR DOM CHN LKA EGY PERSEN BOL TZAMWI HND GTM BGD NPL COL PNG NER ECU IRN PRY PAK CMR KEN IDN VEN TGO ZWE DZA FRA DNK SWE ZMB -1.5 0 50 100 150 200 250 300 Mean financial openness
3 Figure 6B. Financial Openness and Quality of Institutions: 1985-2004 Control of Corruption 2.5 2 USA AUS NZL NOR CAN DEU FIN AUT DNK SWE Control of Corruption 1.5 1 0.5 0-0.5-1 ESPCHL PRT JPN ISR CRI ITA GRC URY MUS ZAF MYS KOR TUN FJI TTO BRA TUR LKA EGY CHN PER IND MEX THA SEN PHL GHA JAM NPL COL DOM SLV ARG IRN DZA BGDZWE GTM PNGMWI NER TGO PAK VEN BOL HND PRY IDN ECU TZA CMR KEN FRA ZMB -1.5 0 50 100 150 200 250 300 Mean financial openness
FG and Macroeconomic Policy Discipline Capital account liberalization as commitment device Even Stiglitz is on board! Sadly, limited evidence
Complication: Threshold Effects Above Thresholds GDP / TFP growth Risks of Crises Financial Globalization X Threshold Conditions Financial market development Institutional Quality, Governance Macroeconomic policies Trade integration Below Thresholds GDP / TFP growth Risks of Crises?
Why Do Thresholds Matter? Financial Market Development - Allocates financial flows efficiently - Enhances macroeconomic stability Institutional Quality - Affects the volume and stability of financial flows - Shifts the composition of flows towards FDI and equity Trade Openness - Makes less vulnerable to sudden stops - Mitigates the adverse effects of financial crises
TENSION!! Financial integration can catalyze financial development, improve governance, impose discipline on macro policies... But, in the absence of a basic pre-existing level of these supporting conditions, financial integration can wreak havoc
Collateral Benefits Framework May Help Make Progress Unified conceptual framework Country-specific requirements, initial conditions can be taken into account Selective approach to liberalization based on prioritization of collateral benefits Can manage risks during transition to thresholds, but can not eliminate them
Has the Benefit-Cost Tradeoff Improved? Composition of inflows and stocks of external liabilities has become more favorable
International Financial Integration:Distribution of Gross Inflows (% of Total) Emerging Markets 80-84 90-94 00-04 100 80 60 40 20 0 FDI Equity Debt
Has the Benefit-Cost Tradeoff Improved? Composition of inflows and stocks of external liabilities has become more favorable High levels of foreign exchange reserves
3.5 Foreign Exchange Reserves Held by Non-industrial Economies (in trillions of US dollars) 3.0 2.5 2.0 All Non-industrial Economies All Non-industrial Economies excluding China 1.5 1.0 0.5 0.0 1980 1985 1990 1995 2000 2005
30 Foreign Exchange Reserves Held by Non-industrial Economies (as percent of nominal GDP) 25 All Non-industrial Economies 20 15 All Non-industrial Economies excluding China 10 5 0 1980 1985 1990 1995 2000 2005
Has the Benefit-Cost Tradeoff Improved? Composition of inflows and stocks of external liabilities has become more favorable High levels of foreign exchange reserves Greater exchange rate flexibility, with inflation targeting Rising trade openness
Trade Openness (the sum of imports and exports as a ratio to GDP, in 2000 constant prices) Emerging Markets 100 90 80 25th Percentile Median 75th Percentile 70 60 50 40 30 20 1980 1985 1990 1995 2000
Has the Benefit-Cost Tradeoff Improved? Composition of inflows and stocks of external liabilities has become more favorable High levels of foreign exchange reserves Greater exchange rate flexibility, with inflation targeting Rising trade openness New players, new instruments have made international financial markets deeper and more efficient
But Many developing economies still below threshold levels of financial, institutional development Still de facto fixed or tightly-managed exchange rates Real exchange rate appreciations hurts poor and undeveloped economies Herding behavior of unregulated investors such as hedge funds + risks in system harder to trace
CAL: The Reality on the Ground Capital account becoming de facto more open De jure controls increasingly ineffective as channels for capital to flow in and out expand Rising trade flows Increasing sophistication of international and domestic investors Other aspects of financial globalization
Implications of Rising Financial Openness Controls not very effective, especially beyond short horizons Controls on inflows have large distortionary costs Government constantly playing catch-up, which makes policy environment unpredictable Maintaining de jure controls despite rising de facto openness => economy has to deal with complications of open capital account but doesn t get full indirect benefits
Dealing with the Reality of CAL Key problem is mismatch between level of de facto openness and other policy settings Synchronize other policies to deal with open capital account: monetary policy that can respond nimbly to shocks and focus on domestic objectives well regulated and supervised financial markets broadening of financial markets to reduce effects of capital flow and exchange rate volatility fiscal discipline trade openness
Pragmatic Approach to CAL Manage rather than resist CAL (latter futile in any case) Opportunistically liberalizing outflows makes sense in present circumstances But need to remove fetters on financial markets to promote vehicles for international portfolio diversification Increasing de jure openness can generate positive spillovers for financial market development--e.g., removing restrictions on participation of foreign investors in domestic bond markets Level of reserves makes CAL safer (but not riskless)
Complications from an Open Capital Account Monetary policy has to cope with domestic liquidity consequences of capital inflows Exchange rate management harder, both in terms of level and volatility Risks to financial system (if underdeveloped and/or weakly supervised) -- inflows could feed into asset price bubbles Regulatory and supervisory capacity may not be sufficient to keep up with foreign firms and financial innovations that they introduce (transitional risks)
Implications for Macro Policies Policy objective of tightly managed exchange rate could be counterproductive if capital account is de facto open Rising sterilization costs make exchange rate objective untenable Monetary stability essential to deal with volatile inflows Need a new nominal anchor to take place of exchange rate objective and to manage inflation expectations Reducing fiscal deficits and level of government debt is key medium-term objective, esp. to support monetary policy
Implications for Financial Market Regulation Financial market regulation must adapt to allow broad range of markets (e.g., currency derivatives) to develop and deepen This would provide a buffer against external shocks, and take some of the pressure off monetary policy as a short-term stabilization tool
Broader Policy Messages Financial integration can support and catalyze other reforms, especially financial development Best to actively manage the process of capital account liberalization rather than fight the inevitable Seize windows of opportunity when benefit-risk tradeoff improves; but coast is never completely clear. Capital account liberalization not an end in itself; needs to be put in the context of a more complete policy/reform agenda