Committee on the Global Financial System CGFS Papers No 33 Capital flows and emerging market economies Report submitted by a Working Group established by the Committee on the Global Financial System This Working Group was chaired by Rakesh Mohan of the Reserve Bank of India January 2009 JEL Classification: F21, F32, F36, G21, G23, G28 Copies of publications are available from: Bank for International Settlements Press & Communications CH 4002 Basel, Switzerland E mail: [email protected] Fax: +41 61 280 9100 and +41 61 280 8100 This publication is available on the BIS website (www.bis.org). © Bank for International Settlements 2009. All rights reserved. Brief excerpts may be reproduced or translated provided the source is cited. ISBN 92-9131-786-1 (print) ISBN 92-9197-786-1 (online) Contents A. Introduction......................................................................................................................1 The macroeconomic effects of capital account liberalisation ................................ 1 An outline of the Report .........................................................................................5 B. The macroeconomic context of capital flows...................................................................7 Introduction ............................................................................................................7 Capital flows in historical perspective ....................................................................8 Capital flows in the 2000s ....................................................................................17 The macroeconomic drivers of capital flows ........................................................19 C. Composition of capital flows and financial stability........................................................25 Composition and risk exposures ..........................................................................25 Volatility................................................................................................................26 Changing composition..........................................................................................28 Foreign direct investment.....................................................................................30 Private portfolio investment..................................................................................32 Bank flows............................................................................................................36 D. Intervention, sterilisation and domestic financial intermediation....................................41 Introduction ..........................................................................................................41 The exchange rate, monetary policy and intervention .........................................43 A key policy dilemma ...........................................................................................47 Intervention and sterilisation: the main elements .................................................49 Withdrawing excess liquidity: non-market versus market-based approaches......51 The impact on commercial banks ........................................................................59 Impact on the public finances and balance sheets ..............................................62 E. Capital flows and domestic financial markets................................................................65 Introduction ..........................................................................................................65 Trends in foreign participation and asset price patterns ......................................65 Capital inflows and the depth and liquidity of domestic capital markets ..............68 Issues for financial stability ..................................................................................76 F. Banks and capital flows.................................................................................................81 Introduction ..........................................................................................................81 External funding for EME banks...........................................................................82 Bank credit growth ...............................................................................................87 Capital inflows and credit growth .........................................................................90 Capital inflows and forex exposures ....................................................................94 Impact of tighter global liquidity on EM banking systems.....................................96 CGFS – Capital flows and emerging market economies iii Challenges for supervisors and central banks in host countries ......................... 98 G. Intermediation of private outflows of portfolio capital.................................................. 101 Introduction........................................................................................................ 101 Institutional investors and portfolio investment flows......................................... 101 Pension funds.................................................................................................... 102 Investment funds ............................................................................................... 108 H. Global financial crisis and capital flows in 2008: a preliminary assessment............... 111 Introduction........................................................................................................ 111 Developments in the markets for securities and foreign exchange................... 112 Bank funding markets........................................................................................ 117 Liquidity stress on banks ................................................................................... 119 Policy responses ............................................................................................... 123 A preliminary assessment ................................................................................. 126 I. Conclusion ..................................................................................................................131 References ...........................................................................................................................135 Annex 1: Mandate ................................................................................................................143 Annex 2: Members of Working Group ..................................................................................144 Annex 3: Acknowledgments .................................................................................................145 Annex 4: Data on net private capital flows............................................................................147 Annex 5: Sovereign wealth funds: implications for capital flows ......................................... 151 iv CGFS – Capital flows and emerging market economies A. Introduction This Report reviews the growing integration of the major emerging market economies (EMEs) into global financial markets. Greater financial integration is evident from the sustained rise in both gross capital inflows (ie non-resident purchases of domestic assets) and outflows (ie resident purchases of foreign assets) to and from the EMEs. Although the structure of flows has become more stable, capital flows continue to be very volatile and this has major macroeconomic implications for recipient countries. The size and the structure of inflows are heavily conditioned by, and exert a major influence on, the state of development of local financial markets. The benefits and costs of capital market integration have been a controversial topic of debate among academics and among policymakers. In principle, access to foreign savings helps a country to lift future income streams (by undertaking investments whose prospective returns exceed the cost of finance) and to better smooth consumption over time. In practice, however, capital inflows – in terms of sheer size, volatility and form – have very often put emerging market countries in major difficulty. During 2006 and 2007, the very rapid rise of gross private capital inflows into the EMEs (now over $1 trillion a year, compared with the previous peak of $300 billion in 1996) caused considerable strains in some countries. In contrast, the current year (2008) to date has witnessed large equity outflows by portfolio investors. Such large swings, over a very short period of time, complicate the conduct of monetary policy and liquidity management in the EMEs. And many feel that the financial stability risks have increased or at least become harder to monitor. The next section briefly reviews the extensive academic debate on this topic. This debate, somewhat inconclusive on the surface, yields several valuable insights on closer inspection. The final section of this chapter outlines the plan of the Report. The macroeconomic effects of capital account liberalisation Economists have long debated the relationship between capital account liberalisation and economic performance. One theoretical approach, forcefully advocated in the mid-1990s, follows the first-best prescription of the neoclassical model (assuming, in particular, perfect capital markets): allowing the free flow of capital across borders would lead to a more efficient allocation of resources and be welfare-enhancing for both borrowers and lenders, in a fashion similar