POVERTY POVERTY THE WORLD BANK REDUCTION REDUCTION AND ECONOMIC MANAGEMENT MANAGEMENT NETWORK (PREM) NETWORK (PREM) Economic Premise JUNE 2010 · Number 19 JUNE · Number 18 55266 Dealing with the Challenges of Capital Inflows in the Context of Macrofinancial Links Trade and the Competitiveness Agenda Swati R. Ghosh José Guilherme Reis and Thomas Farole In the wake of the recent global financial crisis, emerging markets have seen a significantly higher degree of volatility in their The global economic crisis has forced a major rethinking of the respective roles of governments and markets in the capital flows. At the onset, all countries experienced sudden stops and increases in risk premia. Following this initial period of processes of trade and growth. Indeed, industrial policy seems to be back in most developing regions have regained it is. uncertainty, financial markets began to differentiate between the countries, and whilefashion--or, at least, talking about access But a renewed "activism" by the pace of recovery trade and growth been particularly mean a return to countries. to both debt and equity issuance, government in theof capital inflows hasagenda need not remarkable for someold-style policies of import substitution and low interest rates in Instead, it may mean a stronger focus on competitiveness the Given the likelihood that the prevailing"picking winners." the developed world will remain for some time to come, and givenby unlocking faster growth in to private sector­led growth. some emerging markets will experience significant surges in trade prospects of the constraintsemerging markets, it is likely thatThis note discusses the renewed role of government in capital and in the near future. This note examines potential policy responses to maintain macroeconomic new competitiveness agenda. flows growth policy from the competitiveness angle, and it suggests some priorities for the and financial sector stability in the face of increased capital inflows. Why Has the Issue of Capital Flows to to emerging markets are still below 2008 and 2007 levels (see Export-Led Growth, the Crisis, and the End pacts of the crisis on the policy environment regarding trade Emerging Markets Surfaced Again? table 1). of an Era and growth were becoming more apparent. Indeed, in addi- The expansion of global liquidity1 in response to the financial Policy Challenges Presented by These tion to raising concerns over the global commitment to trade global rates over recent decades liberalization, the crisis has also led to some serious rethink- The dramatic expansion ininterest tradein advanced econo- crisis and the consequent low Capital Flows has contributed significantly to diversification, growth, and ing of some of the conventional wisdom regarding the mies have restarted large capital flows to emerging markets. Capital inflows, and capital mobility more broadly, can yield poverty reduction in many developing countries. This period growth agenda--the most important result of which is the Because of weaker bank lending though, overall capital flows many benefits: allow countries with limited savings to attract of rapid export growth has been enabled by two critical likelihood that governments will play a much more activist structural changes in global trade: (1) the vertical and spatial role in the coming years. There are three principal reasons Table 1. Gross Capital Flows to Emerging Markets (US$ billions) fragmentation of manufacturing into highly integrated why governments are likely to be more actively involved in "global production networks," and (2) the rise of services industrial and trade policy in the coming years. 2008 2009 2010 of trade and the growth Q1 "offshoring." Both of these, in turn, Total First, the crisis has undone faith in markets and discred- Capital flows Total Q1 January February March Q1 were made possible by major technological revolutions; and 353 laissez-faire approaches that rely simply on trade policy Total 103 390 48 ited 33 17 44 94 Bonds 65 18 they were supported 12 multilateral trade policy reforms 115 by 21 5 21 48 liberalization. Instead, governments and local markets have Banks 71 257 22 129 4 5 10 19 and broad liberalizations in domestic trade and investment 109 Equity 20 68 8 been "rediscovered." In this sense, the13 7 7 demand for 27activist Latin America environments worldwide. 19 90 21 137 9 4 16 29 government is likely to go well beyond financial markets and Bonds 5 20 10 62 8 2 10 19 The global Eastern Europe economic crisis came crashing into the middle 72 36 157 6 regulation, and it will affect the policy environment in which 12 2 9 24 this ofBonds long-running export-led growth party during 2008 33 2 35 4 7 1 8 trade and industrial strategies are designed. 17 Asia 38 98 18 122 12 7 14 33 and 2009. Between the3 last quarter of 2007 and the second 16 Second, the crisis has highlighted the0critical importance Bonds 7 5 7 2 9 quarter of 2009, global trade contracted by 36 percent. But 22 diversification (of sectors, products, and trading partners) Others 11 45 3 of 0 3 5 8 as the recovery started to Sources: Dealogic; World Bank 2010. strengthen in 2010 (at least until in reducing the risks of growth volatility. The recent era of the clouds began to form over Europe), the longer-term im- globalization contributed to substantial specialization of 1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise 1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise financing for productive investments, foster the diversification of investment risk, and contribute to the development of finan- Box 1. Examples of Capital Inflows and Banking Sector cial markets. Vulnerability Nonetheless, capital inflow surges can be of concern to recipi- Foreign exchange (FX) mismatches: Following the surge ent economies. The current surge of inflows is likely to have a in capital inflows into East Asia in the early to mid-1990s, sizable transitory component to them because a major driver is there was a rapid increase in FX exposures (with the ratio the low interest rates in advanced countries that will most likely of FX liabilities to FX assets) of the banking systems in be reversed in the near future. Capital flow volatility can trans- several countries, including Thailand, Indonesia, and late into significant macroeconomic volatility in the domestic Malaysia. economy. Even when capital inflows may be of a more perma- nent nature, reflecting equilibrium conditions, they can compli- Figure B.1. Ratio of Banks' FX Liabilities to FX Assets cate macroeconomic management and entail tradeoffs in attain- ing macroeconomic objectives. Large surges in capital inflows can lead to strong upward pressure on the exchange rate and contribute to macroeconom- ic overheating, widening current account imbalances through an appreciating exchange rate as well as inflationary pressures and asset price bubbles to the extent that a nominal exchange rate appreciation is resisted and monetary sterilization is either not undertaken or is ineffective (box 1). The financial sector generally plays an important role in amplifying these asset price bubbles and can exacerbate macroeconomic challenges. And in the process, the financial itself sector can become vulnerable, particularly in the context of weak institutions. If financial markets are segmented--as is the case in many emerging mar- kets to the degree that some borrowers can only access external borrowing through the banking system, then a "credit chan- nel"2 may be operative, meaning that changes in bank credit Maturity mismatches: Using bank level data from 18 can influence investment or consumption (Bernanke and emerging economies, Aysun (2006) investigates the Blinder 1988, 1992). Specifically, inflows into the banking sec- impact of capital flows on bank's maturity mismatches and finds a statistically significant positive relationship tor that are then extended as credit to the private sector can between the two and that further maturity mismatches lead to the validation of demand that would otherwise be li- play a key role in determining external vulnerability. quidity constrained (see figure 1). In other words, banks can Specifically, the study finds that maturity mismatches further exacerbate macroeconomic cycles. Even if some banks increase significantly during periods of high capital are unable to borrow or issue bonds abroad directly--as is likely inflows and banks with high maturity mismatches report larger losses if there is a capital reversal--despite being to be the case with smaller domestic banks--these banks may more profitable in more tranquil periods. play a role indirectly. This can happen if residents who are able Source: Author's compilation. to raise funds abroad then deposit their externally borrowed funds in these domestic banks, and if these smaller banks then extend credit to firms and consumers who would otherwise be liquidity constrained. Moreover, because banks are only re- Appropriate Policy Responses Are quired to hold a certain proportion of their funds in reserve, State Contingent the money supply multiplier operates so that banks can extend Macroeconomic Policies credit by several times of any initial increase in deposits. Be- Given the potential impacts of capital inflows, countries gener- cause banks direct much of their credit to sectors such as real ally have three objectives: i) avoiding domestic macroeconomic estate and the stock market, they also play a role in asset infla- overheating; ii) avoiding a buildup in financial sector fragility; tion, which can occur with inflows of private capital. If asset and iii) avoiding a loss of competitiveness through exchange price inflation leads to an increase in the collateral value of rate appreciation, which is of particular importance when the banks' clients, against which banks lend, the cycle can be rein- surge in capital flows is deemed likely to be temporary. So what forced. Bank portfolios and balance sheets can become vulner- are some of the policy options available? Not surprisingly, the able with exposure to risky sectors (for example, real estate, policy options depend on the prevailing domestic macroeco- foreign exchange, and maturity mismatches; box 1). nomic conditions and the key objectives (see figure 2). A combi- 2 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise Figure 1. Interaction of Capital Inflows, the Macroeconomy, and Financial Sector Concerns Source: Author's compilation. nation of policies should be used to avoid excessive tradeoffs in ever, if inflation and domestic macroeconomic overheating are its macroeconomic objectives. For example, a country may be a concern, sterilization of the liquidity injected by interven- able to sustain some appreciation of the exchange rate and un- tions may be necessary. But sterilization can be costly: the dif- dertake some sterilization and some fiscal tightening to achieve ference between the interest rate paid by the central bank to its exchange rate and domestic macroeconomic objectives. the commercial banks to drain liquidity and the interest rate Exchange rate adjustment. Allowing the exchange rate to ap- received on official reserves will likely reduce central bank preciate may be the first policy option for a country with an un- profitability, especially under high global liquidity conditions dervalued exchange rate. Allowing the exchange rate to adjust that keep interest rates in advanced economies low. Moreover, toward its equilibrium rate can mitigate the transmission of glob- sterilization may: i) elicit further inflows by maintaining the al liquidity and capital inflows. An exchange rate appreciation in differential between domestic and international lending rates, countries where the exchange rate is not misaligned, however, particularly if the market expects an appreciation of the ex- can have significant repercussions on the economy, particularly change rate--and the flows are likely to be short-term flows that on the competitiveness of the tradeables sector. And in countries are more responsive to interest rate differentials; ii) encourage with a fixed exchange rate regime, the need to preserve the cred- domestic borrowers to switch to foreign currency borrowing ibility of the exchange rate peg may preclude the policy option of and liabilities, potentially raising financial stability concerns; a temporary change in the exchange rate level. and iii) be limited by the size of the country's financial Intervention in the foreign exchange market. If losing compe- market. tiveness is a concern, and the exchange rate is not undervalued, Fiscal policy. Fiscal tightening can support tight monetary countries may intervene to keep the exchange rate at the cur- policy by reducing the budget's financing needs and thus allow- rent level or to slow the appreciation. Intervention may also be ing for lower domestic interest rates (and less incentives for useful in economies that need to increase their reserves. How- capital inflows). Fiscal tightening could also mitigate asset bub- 3 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise Figure 2. Macroeconomic Policy Responses Depend on Macroeconomic Objectives and Constraints Source: Author's illustration. bles directly by reducing aggregate demand growth and sup- where the surge in inflows is deemed to be driven by factors porting a capital account adjustment. However, significant fis- that are likely to quickly reverse. cal adjustment is not always feasible at the necessary time and Prudential Regulation and Supervision to Reduce Financial may involve a lag. Sector Vulnerability Imposition of capital controls. When available macropolicy Empirical evidence suggests certain types of capital inflows can options are not sufficient, or cannot provide a timely response make a country vulnerable to financial crisis. In particular, as to an abrupt or large surge in capital inflows, capital controls already discussed, flows intermediated through the banking may be a useful tool. However, the efficacy of capital controls sector can fuel credit booms, asset price bubbles, and foreign may be of limited duration; empirically, capital controls have exchange lending, with the banks themselves becoming vulner- been found to enable countries to initially reduce the pressures able in the process. on the exchange rate and to maintain a difference between do- The objective of strengthened prudential regulation and su- mestic and foreign interest rates, but over time, countries were pervision is to reduce financial sector vulnerability and limit generally not able to achieve both the interest rate and exchange systemwide distress to avoid potential output losses associated rate targets. Moreover, to be effective even for a limited dura- with financial instability. Traditionally the focus has been on tion, controls need to be comprehensive and need to be force- microprudential regulations, that is, regulations that concen- fully implemented. Capital controls have also been found to be trate on individual financial institutions, such as certification more effective in affecting (lengthening) the maturity of the of those working in the financial sector, rules on how financial flows and generally less successful in affecting the overall mag- institutions operate, and measures to ensure stability of the in- nitude of the flows. Such controls tend to lose effectiveness dividual financial institution. when the return on the controlled transaction exceeds the cost Increasingly--particularly following the onset of recent global of circumvention, providing the incentives for market partici- financial crisis--attention has turned to the importance of mac- pants to circumvent the controls, which is easier to do in coun- roprudential policies and regulations. Macroprudential policy tries with more developed and sophisticated financial markets. can be defined as policies that focus on the financial system as a Hence, capital controls may be best used in circumstances whole and treat aggregate risk as partly endogenous with respect 4 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise to the collective behavior of financial institutions. A macropru- 2009; Calomaris 2009; Mayes, Pringle, and Taylor 2009; De dential approach recognizes the interdependence and endogene- Larosiere Group 2009; G-20 2009; FSF 2009). ities in the system that can lead financial institutions to behave Countercyclical macroprudential regulation can be intro- homogenously, and in turn, reduces the resilience of the finan- duced either through banks' provisions and/or through their cial system. The premise underlying macroprudential regula- capital. It is important that this be accomplished using simple tions is that relying on individual bank regulation and supervi- rules to ensure that regulators cannot relax them in boom sion at a microlevel is not sufficient. Indeed, in some cases times. microprudential regulations--in as much as they can some- Introducing countercyclical bank provisions has already oc- times encourage homogenous behavior of institutions in peri- curred in Spain and Portugal. The Spanish provisioning system ods of distress--can exacerbate the problem.3 As Persaud requires higher provisions when credit grows more than the (2009a, 20) stresses: historical average, linking provisioning to the credit cycle. Un- Wherever possible micro prudential regulations need to be der this system, provisions built up during an upswing can be designed in a way that minimizes macro-prudential conse- accumulated in a fund which can then be drawn down in a quences and, given that this will not always be possible, micro- prudential regulation must be complemented with macro- slump to cover loan losses. This counters the financial cycle as prudential regulations. it discourages (but does not eliminate) excessive lending in The macroprudential (or systemic) regulatory frameworks booms and strengthens the banks during bad times. Counter- have two dimensions: first, managing cross-sectional risk distri- cyclical bank regulation can also be introduced via capital re- bution across the financial system at any given time and second, quirements. Table 2 lists several proposals for dealing with addressing the evolution of the aggregate risk over time. The cross-sectional or pro-cyclical risks. challenge in the first dimension is to deal with common (related) Summary exposures to similar asset classes or links among them. The key issue of the second dimension is to deal with pro-cyclicality, or The benefits of capital inflows notwithstanding, large surges of how systemwide risk is amplified over the credit cycle, by interac- capital inflows can pose challenges to macroeconomic and fi- tions within the financial system as well as between the financial nancial sector stability. The appropriate response to deal with system and the real economy. "During expansions, declining risk the challenges posed by large capital inflows depends on the perceptions, rising risk tolerance, weakening financial con- specific country conditions. The recent financial crisis has also straints, rising leverage, higher market liquidity, booming asset highlighted the importance of broadening the toolkit to in- prices and growing expenditures mutually reinforce each other, clude macroprudential regulations as well as the traditional potentially leading to the overextension of balance sheets" (Borio microprudential regulations to safeguard the macroeconomic 2009). Dampening the pro-cyclicality of the financial system is and financial sector stability. Much of the debate now centers increasingly being regarded as a priority (Brunnermeier et al. on exactly how these macroprudential regulations should be Table 2. Proposals to Reduce Macroprudential Risks/Consequences Objective: To reduce the risk of pro-cyclicality Automatic or indexed increases in capital adequacy of institutions when aggregate borrowing (or some other index of systemic riskiness) in an economy or a sector is above average (Persaud 2009). Link capital adequacy to macroprudential factors reflecting maturity mismatches, credit expansion and asset prices, with a multiplicative effect that would be greater in a boom than during de-leveraging (Brunnermeier et al. 2009). Objective: To reduce cross-sectional risk Impose capital ratios based on the individual institutions contribution to systemwide risks (Borio, Furfine, and Lowe 2001; Brunnermeier et al. 2009). Impose capital charges on behavior that is typically common across banks compared to that which is idiosyncratic, that is, areas where banks are susceptible to herding behavior and where there is a high correlation of balance sheet risk (for example, real estate lending). This could include loan-to-value ratios for property loans or restrictions on income gearing. Design capital surcharges based on interbank correlations of returns (Acharya 2009). Design capital surcharges based on co-movements of banks' risks (for example, co-value at risk; Adrian and Brunnermeier 2009). Objective: To reduce systemic risk by better matching of risk taking with risk bearing in the financial system capacity Systemic rules to incentivize financial firms to better match risk taking with risk-taking capacity, for example, capital requirements for maturity mismatches (administered in a way that reduces also pro-cyclicality). Source: Author's compilation. 5 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise designed and what changes may be needed in regulatory struc- References tures to implement these regulations effectively. Acharya, V. 2009. "A Theory of Systemic Risk and Design of Prudential Bank Regulation." Journal of Financial Stability 5 (3) 224­25. Notes Adrian, T., and M. Brunnermeier. 2009. "CoVAR." Federal Reserve Bank of 1. For the purpose of this article, global liquidity is measured New York Staff Report No. 348, New York. by the GDP-weighted average of reserve money and M2 of the Aysun, U. 2006. "Capital Flows, Maturity Mismatches and Profitability in Emerging Markets: Evidence from Bank Level Data." WP 2006-29 Univer- United States, the United Kingdom, the Euro area, and Japan. sity of Connecticut, Department of Economics, revised October 2007. 2. The "credit channel" view also implies that monetary policy Bernanke, Ben S., and Alan S. Blinder. 1988. "Credit, Money, and Aggregate Demand."American Economic Review, Papers and Proceedings 78 (May) can work not only through its impact on the bond market inter- 435­39. est rate, but also through its independent impact on the supply ------. 1992. "The Federal Funds Rate and the Channels of Monetary Transmis- of intermediated loans. For this, three conditions must hold: sion." American Economic Review 82 (September) 901­21. first, intermediated loans and open market operations must Borio, C. 2009. "The Macroprudential Approach to Regulation and Supervi- not be perfect substitutes for some firms on the liability side, sion." VOX. www.banquedefrance.fr/gb/publications/telechar/seminaires /2009 /280109/borio.ppt. that is, some firms must depend on bank credit alone for fi- Borio, C., C. Furfine, and P. Lowe. 2001. "Pro-Cyclicality of the Financial Sys- nancing; second, the central bank must be able, by changing tem and Financial Stability Issues and Policy Options." In Marrying the the quantity of reserves available to the banking system, to af- Macro and Micro Prudential Dimensions of Financial Stability (BIS Papers fect the supply of intermediated loans: the intermediary sector No. 1), 1­57. Basel, Switzerland: Bank for International Settlements. as a whole must not be able to insulate its lending activities Brunnermeier, M., A. Crockett, C. Goodhart, M. Hellwig, A. Persaud, and H. Shin. 2009. The Fundamental Principles of Financial Regulation. Geneva from shocks to reserves, either by switching from deposits to Reports on the World Economy 11, ICMB. less reserve intensive forms of finance (for example, certificates Calomiris, C. 2009. "Financial Innovation, Regulation and Reform." Cato of deposit, commercial paper, equity, and so forth) or by paring Journal 29 (1). its net holdings of bonds. De Larosiere Group. 2009. The High-Level Group on Financial Supervision. De Larosiere Report, ec.europa.eu/internal_market/finances/docs/de_laro 3. For example, selling an asset when it appears to be risky may siere_report_en.pdf. be considered as prudent response for an individual bank and FSF (Financial Stability Forum). 2009. Report of the Financial Stability Forum on is supported by much current regulation. But if many banks do Addressing Procyclicality in the Financial System. Basel, Switzerland. this, the asset price will collapse, forcing risk averse institutions G-20 (Group of Twenty). 2009. "Enhancing Sound Regulation and Strength- ening Transparency." G-20 Working Group 1, March. to sell more and leading to general decline in asset prices, high- Mayes, D., R. Pringle, and M. Taylor. 2009. "Towards a New Framework for Fi- er correlations and volatility across markets, spiraling losses, nancial Stability." Central Banking Publications, http://www.centralbank and collapsing liquidity. Microprudential behavior can cause ing.com. or worsen systemic risk (Persaud 2009b). Persaud, A. 2009a. The Warwick Commission on International Financial Re- form: In Praise of an Unlevel Playing Field, 20. Coventry, UK: University of About the Author Warwick. ------. 2009b. "Macro-Prudential Regulation." Crisis Response Note 6, IFC and Swati R. Ghosh is a lead economist in the Eastern Europe and World Bank. Central Asia Poverty Reduction and Economic Management World Bank. 2010. Weekly Global Economic Brief No. 45. DEC Prospects Network at the World Bank, Washington, DC. Group, April 15. The Economic Premise note series is intended to summarize good practices and key policy findings on topics related to economic policy. They are produced by the Poverty Reduction and Economic Management (PREM) Network Vice-Presidency of the World Bank. The views expressed here are those of the authors and do not necessarily reflect those of the World Bank. The notes are available at: www.worldbank.org/economicpremise. 6 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise