Open International Capital Markets: Is financial integration worth the trouble? Financial Liberalization in Emerging Markets: Harbinger of Growth or Currency Crisis?
Darryl McLeod Economics, Fordham University
[email protected] www.fordham.edu/economics/mcleod/
References Arteta, Carlos, Eichengreen B. and Charlse Wyplosz (2001) “When Does Capital Account Liberalization Help more than it hurts?” NBER Working Paper #8414. Eichengreen, Barry (1999) Toward a New International Financial Architecture, Institute for International Economics, Wash. D.C. Chapt. 1 Appendix B. Gruben, William and Mcleod, Darryl (2001) “Capital Account Liberalization and Inflation in the 1990s” Federal Reserve Bank of Dallas, Working Paper IMF, World Economic Outlook, October 2001, Chapter 4, “International Financial Integration and Development” Klein, Michael and Giovanni Olivei (1999), “Capital Account Liberalization, Financial Depth and Economic Growth” NBER Working Paper #7384 . World Bank (2000) Global Development Finance 2000, Chapter 2, “Private Capital Flows to Developing Countries” www.worldbank.org
Open International Capital Markets: Is financial integration worth the trouble? Financial Liberalization in Emerging Markets: Harbinger of Growth or Financial Crisis?
1. Net Capital Flows from OECD to Emerging should be distinguished from capital mobility— net vs. gross flows—free convertibility vs. capital controls—both have implications. 2. Are the benefits of Capital Flows and Mobility: faster growth, lower inflation—higher TFP growth? 3. Minimizing the costs of Capital Mobility: Why so many generations currency crisis models? Why can some countries only borrow in foreign currencies? This means bank and fx crises go together (see Eichengreen Appendix B and ) 4. Evidence from the 1990s? • Growth Performance: LDCs outperformed DCs • Global disinflation: especially in Latin America—despite and even after a move to floating exchange rates. • Domestic financial market development—interrupted by frequent crises in Asia and Latin America. • Rapid growth of trade and capital flows through out the 1990s.
5. International Capital Markets- can LDCs take advantage of global capital markets while avoiding costly currency crises? Do we need a new IMF or a new Financial Architecture? or, just better domestic policy and bank supervision? The big IMF bailouts of the 1990s—boom or bain? Do we need a bankruptcy court for countries? Regional lending facilities—Asian IMF, etc.? Fixed or flexible exchange rates? Capital controls or open Capital markets? FDI or portfolio flows?
Private Capital Flows to LDCs: a brief history. 1. 1950s-1960s FDI and Official flows – Savings Gap Models Official aid flows were much higher than today, but there was a Nationalist backlash against FDI (the reverse of the 1990s) Little private bond or equity flows from North to South —1930s defaults.
2. 1970-89: Commercial Bank Lending, General Obligation Lending Boom—LDC growth rates soared but so did risk. a. External shocks and policy mistakes—deficits and fixed rates were a dangerous policy mix—very vulnerable to speculative attacks. b. Short-term GOL entails high commercial, sovereign and currency risk c. Concerted vs. voluntary lending—7 years of slow growth/low investment d. The debt Laffer Curve—high external debt a tax on investment
3. Early 1990s: Brady Plan Debt Relief and privatization creates the Brady Bond Market leading to large equity and bond flows into Latin America—Mexico’s 1995 and Brazil’s 1998 crises. a. Mexico and Brazil’s multilateral lending packages were large compared to previous programs, but their recessions were short. b. A better distribution of risk but still perceptions of moral hazard – calls for new financial architecture, transparency and controls on ST flows. c. Mexico, Brazil and Chile (and Korea and Indonesia) made the transition to floating exchange rates (without a big resurgence in inflation). 4. 1997-98: Commercial bank lending and bond boom in Asia ends
with a major crises in Thailand that quickly spreads to Korea, Indonesia and Malaysia (Philippines and Hong Kong escape). a. Large assistance packages aim to quickly restoring access to private capital markets. Asia and Mexico crises did have quick recoveries— b. Short-term bank-to-bank lending, moral hazard and lack of prudential regulation within these countries. c. A new type of currency crisis or a classic financial crisis?–Chang and Velasco –Diamond Dybig Model- see Chapter 7 of Agénor A&G.
5. 1998-2001: Russia and Ecuador and now Argentina–contagion via financial market linkages? Emerging market herd behavior? a. “Bailing in” the private sector… a general decline in emerging market bond and equity flows with a return to FDI—less financial intermediation. b. FDI rises again, led by privatization and opening in Brazil, Mexico and China… and by bargain equity prices. But not just resource extraction— manufacturing FDI driven reform and profit opportunities. c. Argentina defaults, closes its banks and does not recover—no adjustment.
Benefits of Capital Inflows: 1. Consumption Augmenting effect of capital inflows. Capital inflows allow higher investment earlier. Higher MPK in LDCs— cheaper labor and land create profit-making investments— capital leaves the North, driving up profits their and driving down profits in the LDCs (bidding up wages). Consumption rises in both the OECD and LDCs due to a higher average world MPK—as in the McDougal Model. 2. Consumption & Investment Smoothing: when commodity prices and export revenues drop, for example, countries can borrow abroad to smooth consumption or to prevent a big increase in domestic interest rates that lowers investment. 3. Consumption Tilting: borrowing against future export earnings—tilt consumption forward over many years… often referred to as the “debt cycle.” Consumers in the South are more impatient than in the North—higher discount rate. Benefits of Capital Mobility—gross flows of FDI and equity investment sometimes matched by capital outflows : 1. Reduced Risk – higher savings and investment? Portfolio diversification (despite home bias)—reduced capital flight. 2. Policy discipline—rewards reform, punishes bad macroeconomic policy—e.g. taxing money is common in LDCs but can be inflationary. 3. Development of domestic financial markets—perhaps not higher domestic savings but more productive investment. 4. Institutional Convergence—central bank interdependence, trade liberalization, WTO, intellectual property law, democracy – post Nafta Mexico is a good case study.
Potential Costs of Capital Mobility : 1. Net flows: loss of sovereignty—FDI, Mobility: foreign bank ownership. 2. Currency crises caused sudden reversals of capital flows—especially short term bank lending—volatility of capital flows. 3. Contagion, competitive devaluation—beggar thy neighbor and spillover effects (on innocent bystanders??). 4. Real exchange rate appreciation—Dutch Disease—inflation or unsustainable nontraded goods boom along with a large trade deficit. Causes of Currency Crises : 1.
Sudden reversals in capital flows:
Calvo, Leiderman and Reinhart find “push” factors from North south more important… lower U.S. interest rates lead to “exogenous” capital inflows: they fear “sudden reversals” FDI only and fixed exchange rates are safer.
2. Moral Hazard Problems: IMF bailouts may encourage private investors—though countries certainly have an incentive to avoid financial crises—how implicated are countries?? 3. Domestic policy missteps: excess money creation leading to a boom in nontraded goods (real estate) high interest rates to defend an overvalued exchange rate, short-term bank to bank or bank to state lending, financial liberalization too fast or out of sequence.
Financial and Currency Crises in LDCs: • Explaining Financial/Currency Crises: three questions: 1. What “causes” currency and financial crisis? What determines the timing and vulnerability to crisis—at one particular time? Bad policy and bad luck— domestic policy mistakes vs. international systemic risk. . 2. What makes a given financial costly and/or not costly? Who pays the cost of adjustment—does this lead to moral hazard or inequitable burden sharing? Stabilization policy issues – but also structural reforms. 3. How can future crises be prevented? Reforms domestic and international need to reduce the likelihood and spread the cost of future crises—change in fx regime. Evolution of thinking on Financial Crises: • Fiscal Deficits—Generation I models—solution: reduce fiscal deficit, but Mexico 1994 did not have a large fiscal deficit—unless one adds in implicit loan guarantees. • After Mexico focus turned to large current account deficits low domestic savings, but Asian countries had high savings rates and most had modest CA deficits. • After Asia, focus on moral hazard due to big IMF loan packages and local loan guarantees combined with fixed exchange rates and overly accommodative Central Banks.
Newer Models of Financial Crises– see Obstfeld (2001) and Calvo(1999): • Solvency Crises: inevitable consequence of weak fundamentals— crises are useful corrective for misallocation of resources caused by weak fundamentals—fiscal or current account deficits. Solution: correct fundaments. • Liquidity Crises: unnecessary panics such crises are inefficient and serve no useful purpose… but solvency crises may sometimes appear to be liquidity crises. Self-fufilling or expectations driven. Contagion is a problem. Short-term debt creates vulnerability.
Liquidity Crises: • Financial market liberalization—large expansion of bank lending • Sudden reversals of capital inflows—large RER changes can be contractionary. • Contagion—Russian virus—specialized traders lead the pack as information is costly and there are great economies of scale in information gathering.
Contagion: • Definition 1: a crisis in a neighboring country raises the probability of a crisis in your country (Kaminski & Reinhart) they find some evidence for this type of conditional probability • Definition 2 (Forbes): correlations among markets increase during crises – be careful to adjust for heteroskedasticity… limited evidence given empirical correlations are already high among these markets—they don’t increase but then why should they? • Shock transmission mechanisms: New information—“wake up call” Trading areas: common trading partners – competitive devaluation Borrowing Areas: common creditors Calvo & Mendoza: Herd behavior—sophisticated traders. Mixed evidence.
IV. Containing and preventing future Banking/currency Crises: Policy steps for crisis prevention—domestic & international—lender of last resort, prudential regulation. • Fiscal deficit management—macro stabilization funds, conservative fiscal policy. Limit short term borrow • Flexible exchange usually better… except in some cases— ending hyperinflations or very small countries or countries with shared external shocks and few internal shocks. • Sterilization leads to quasi-fiscal deficits and more capital inflows—raises or lowers local interest rates artificially. • Domestic prudential standards and regulation of banks. • Extend maturity structure of debt whenever possible. • Controls on capital inflows??? V. Policy measures for Stabilization—the control of inflation and exchange rates—orthodox IMF program. VI. Policy measures designed to restore growth and boost exports— structural adjustment—privatization, trade liberalization, tax and fiscal reform, financial reform. Causes—Why Thailand in 1997? Why Mexico in 1982 and 1995? Why Brazil in 1998? IMF excess expansion of domestic credit leads to: 1. Large current account deficit leads to a speculative attack. 2. Capital flow reversals—contagion, i.e. other countries’ crises. 3. Expansion of domestic credit leads to overvalued fx rate. 4. Excessive short-term borrowing, usually bank to bank.
Synthesis and Lessons: • Financial crises are unavoidable, especially in the early stages of developing a financial sector—domestic supervision of banks, macro stabilization funds can reduce and smooth shocks. • Like trade, capital mobility does more good than harm. Speeds institutional and monetary policy convergence. • Floating exchange rates are better for countries which trade with all three currency blocks—large swings in the yen/Euro/dollar rates make it impossible for Emerging markets to peg. Caveats: • Mexico’s floating peso has not done what the Canadian dollar does: allow Canada to grow faster that the U.S. by devaluing. • IMF “bailouts” are under siege, but the U.S. Treasury and Ann Krueger. • Poverty alleviation--
