Capital flows to the emerging market economies: a perspective on policy challenges
Speech by Mr Jaime Caruana, General Manager of the BIS, at the Forty-sixth SEACEN Governors' Conference, Colombo, Sri Lanka, 24-26 February 2011.
Capital flows to emerging market economies (EMEs) have displayed a dramatic pattern over the past decade. Following the collapse during 2008, capital inflows have rebounded since 2009 to pre-crisis levels. The recent increase in international capital flows is a sign of strength for the world economy, but it also poses unusual policy challenges. Global accommodative financial conditions can spur capital inflows and make it more difficult for EM policymakers to pursue their internal stabilisation objectives. Growing inflation pressures in EMEs and a multispeed global recovery put a premium on the pursuit of sound macroeconomic policy, especially monetary policy. Fiscal policy should aim at reducing debt in good times. Real exchange rate appreciation should form part of the response in rapidly growing EMEs. Macroprudential policies can usefully complement, but not substitute for, such sound macroeconomic policies. Capital controls can only temporarily respond to highly unusual circumstances. Sound national policy action can contribute to better global outcomes, but policymakers in both advanced and emerging economies should take into account the implications of their actions beyond their own borders.
It is a great pleasure to be here. The SEACEN Centre has a long and distinguished record in promoting a better understanding of economic and financial matters that are of interest to central banks. Today's conference fits well with this tradition, focusing as it does on the post-crisis challenges to central banks in emerging market economies (EMEs).
Capital flows to EMEs have displayed a dramatic pattern over the past decade. From 2002 to 2007, private net financial flows to EMEs increased by a factor of 10, to almost $700 billion. The trend reversed temporarily on heightened risk aversion following the Lehman failure: overall net inflows to EMEs fell by about 75%, to around $200 billion in 2008. But these flows have quickly rebounded since mid-2009: in particular, net inflows to emerging Asia returned to their pre-crisis peak levels in the first three quarters of 2010.
Strong capital inflows bring benefits as well as challenges. The good news is that strong fundamentals in many EMEs have reduced their vulnerability to sudden variations in capital flows. In fact, and quite unlike past experience, this financial crisis was limited in its impact, especially in emerging Asia. Better fundamentals, much improved external positions and the buffers provided by accumulated forex reserves all played a part in this outcome.
On the other hand, EMEs now face new difficulties associated with abundant capital inflows. These raise a number of significant policy challenges.
In my remarks today, I would like to develop three main arguments:
- First, the greater integration of EMEs in international capital markets is a welcome development for the world economy.
- Second, strong capital inflows pose important policy challenges.
- Third, these challenges put a premium on the sound conduct of macroeconomic policy.
1. The greater integration of EMEs in international capital markets is welcome
Let me start by emphasising that the recent increase in international capital flows should be considered as a sign of strength for the world economy.
First, international capital flows can contribute to channelling financial resources more efficiently. EM assets display a favourable risk-return profile, especially in Asia. Asia's economic dynamism suggests that capital should yield high returns - higher than those in industrial countries. Also, the riskiness of investing in EMEs has decreased, thanks to the steady improvement in their economic fundamentals. In particular, the contrast has sharpened between the greater macroeconomic stability observed in the emerging world and the large-scale deterioration in fiscal positions in many advanced economies. This new role of EMEs in the world economy is a long-term trend that has been under way for a decade - the crisis has only highlighted its importance.
Second, the increased integration of EMEs into international capital markets brings welcome diversification benefits - at both the national and the global level. So far, holdings of EM assets in the portfolios of advanced economy investors remain rather limited: by the end of 2009, the share of G7 countries' total portfolio investment assets in all EMEs was 9% (of which 4.6% was in emerging Asia). We can expect these shares to increase significantly in the years ahead. Increased financial globalisation also lets emerging market savers diversify into foreign assets. In fact, total gross capital outflows from major EMEs have already risen, from an average of less than $100 billion per year in the 1990s to $1.2 trillion in 2007.
Third, growing capital flows signal greater economic integration among EMEs themselves. By the end of 2009, the total amount of outstanding portfolio investments by major EMEs in each other's assets had reached almost $400 billion, up from about $150 billion just four years earlier. Such integration arises from financial liberalisation, the development of local currency bond markets, and growing internationalisation of the production chain, among other factors. This is particularly obvious in emerging Asia, where intraregional foreign direct investment has risen sharply in recent years. To take one example, China's direct investment flow into the ASEAN countries surged from $1.5 billion in 2005 to $27 billion in 2009. In Sri Lanka, China is investing in not only the Hambantota port but also a special economic zone not far from Colombo.
Taken together, we should welcome the secular trend towards stronger capital inflows into EMEs. Policymakers should not lose sight of this when thinking about how to deal with current challenges.
2. Strong capital inflows present important policy challenges
Let me now turn to key policy challenges. But before I address the first challenge, I would like to make a general observation. Perhaps it could be considered challenge number 0: the challenge of properly analysing capital flows and financial stability issues.
All too often, the analysis of capital flows gets trapped in the discussion about global imbalances. Flows tend to be analysed from the perspective of savings, investments and current account positions. However, from the monetary and financial stability viewpoint, a narrow focus on current account deficits and surpluses rarely provides enough information about relevant accumulations of risks and financial imbalances. And these financial imbalances led, among other factors, to the recent crisis.
I am not saying that global imbalances are unimportant. Clearly, they are relevant and raise policy issues of the first order. My point is that, by construction, they can capture only some of the risks.
What I am saying is that it is also important to monitor gross capital flows and their composition. It is gross rather than net flows that often matter for monetary and financial stability. Current accounts and the corresponding net capital flows say very little about financing activity, intermediation patterns, leverage use or liquidity mismatches. It is important, therefore, to analyse gross flows and complement this data with balance sheet analysis and market indicators.
Since the early 1990s, for example, the increase in gross capital flows into and out of the United States (that is, the change in gross claims) has expanded three times more rapidly than the increase in net claims on the country, which mirrors the current account deficit. These larger flows involve financial transactions not captured in the net current account financing but which are nonetheless relevant in explaining market and economic developments. A better understanding of these gross flows, balance sheet data and other indicators should help in choosing more effective financial stability policies.
Having made this point, let me move to the challenges.
A first challenge arises from the intrinsic volatility of financial flows. Looking at cross-border bank flows into EMEs, for instance, they have rebounded since the 2007 financial crisis, thanks to robust EM macroeconomic performance, favourable interest rate differentials, progress in the rebuilding of international banks' balance sheets and a move by institutional investors to correct the underweighting of EM assets in their portfolios. Yet cross-border lending has remained volatile from one quarter to another. Preliminary data indicate that the cross-border lending of international banks to emerging Asia rose by $77 billion in the third quarter of 2010, up 8.5% in that quarter alone. This inflow contrasts with an outflow of twice that size in the fourth quarter of 2008 (-$158 billion, of which Korea suffered -$56 billion). And we have also seen portfolio outflows in some countries over the past few weeks.
This volatility raises the threat of a sudden drying-up of market liquidity in key segments, leading to potential financial instability. Many EMEs felt the knock-on effects of such liquidity problems in global markets during the recent crisis.
Volatility also makes it hard for policymakers to distinguish between the underlying secular trend of flows that should be welcomed from transitory flows subject to reversal.
A second challenge lies in how EMEs can best avoid importing accommodative financial conditions. Weaker growth prospects and persistent financial fragilities in advanced countries have led to a prolonged period of near zero interest rates and unconventional policies in the largest economies. This has raised the attractiveness of EM assets and sharpened the incentives for capital inflows.
Concurrently, inflationary pressures have picked up in emerging markets. It is important to note that recent increases in food prices partly reflect the current food shortage. As such, they could persist and exert a still larger impact on EMEs, which tend to have higher food weights in their consumption baskets.
Global accommodative financial conditions have made it more difficult for EM policymakers to pursue their internal stabilisation objectives. This is perhaps particularly obvious in the case of bank flows, which directly contribute to local credit growth.
More generally, strong capital flows put upward pressure on the value of EM exchange rates, thus raising concerns over export competitiveness. As a result, policymakers hesitate to raise interest rates in response to upward pressure on domestic prices arising from increasing commodity costs and rapid demand growth. Ultimately, unavoidable monetary tightening widens interest rate differentials vis-à-vis advanced economies. This, in turn, can suck additional global capital flows into EM assets, thus driving exchange rates even higher. Meanwhile, large-scale sterilised foreign exchange market interventions may lose their effect or become increasingly costly as domestic rates continue to rise. In these conditions, the clear risk is that EME central banks will fall behind the curve.
But even if EM central banks raise short-term rates, global bond market developments may limit the effect of tightening on local bond market yields. Large-scale asset purchases seek to lower benchmark bond yields, especially those of US Treasury bonds. This policy is difficult to calibrate, not least because it takes us into partially uncharted waters. In theory, the direct purchase of securities can influence bond market yields via portfolio balance effects as private investors seek to replace the duration removed from the market and bid up the price of other financial assets.
The analysis becomes more complicated when debt management policies are considered. In the case of the United States, recent changes in government debt issuance policies have worked in the opposite direction: the duration of US government debt issuance is indeed lengthening, which tends to drive up longer-term yields. The Federal Reserve has estimated that the November 2010 decision to purchase another $600 billion worth of Treasuries may have lowered the 10-year Treasury yield by 25 basis points, all else being equal. This suggests that the impact of unconventional policies is relatively modest, not least in comparison with the normal volatility displayed by long-term interest rates as they respond to growth prospects, fiscal policy and anticipated inflation.
To the extent that central banks outside the United States buy dollars to resist currency appreciation and invest them in US government bonds, they stand shoulder to shoulder with the Federal Reserve on the bid side of the bond market.
Yet there are other channels through which bond-buying programmes influence global financial conditions, some of which raise financial stability risks. One is through the exchange rate, with lower bond yields reinforcing downward pressure on the industrial currencies and thereby heightening the challenges already faced by EMEs. A worrying prospect, which I trust that we can avoid, would be for misunderstandings over currency policy to degenerate into protectionism.
Another channel is the impact of very low yields on commodities, equities and real estate. Global commodity prices may be signalling global inflation pressures. I have already alluded to the influence of globally integrated bond markets on EM bond markets, and the same point can be made about global equity markets, despite the underperformance of EM markets over the last several months. One market that is less globally integrated is real estate, which is of particular importance in populous emerging Asia, where real estate prices are trending upwards.
Finally, strongly reinforced expectations that short-term rates will remain low for an extended period can whet risk appetite and spur the search for yield. For instance, global investors may be further attracted to risky carry trade strategies with potentially important financial stability implications at the global level. For example, events could lead to a disorderly unwinding of positions.
The upshot of all this is that it is unusually difficult for policymakers to distinguish capital flows that reflect structural improvements in the EMEs from transitory flows that only make sense while near zero interest rates prevail in leading economies. In this environment, the risk of monetary policy falling behind the curve is larger than usual.
3. Dealing with the challenges posed by capital flows puts a premium on strong macroeconomic policies
What should be the public policy responses to these challenges? We know that a range of policies and tools is available. Among them macroprudential policies, a concept very dear to the BIS, are gaining prominence and we all are studying and learning from the rich experience of Asia in this domain. Today, however, against the backdrop of a multispeed recovery, I would like to emphasise that the circumstances put a premium on the sound conduct of macroeconomic policy, especially - but not only - in EMEs.
The first priority for EMEs that face strong capital inflows is to preserve domestic monetary stability. This calls for tighter monetary policy to contain domestic price pressures and support sustainable growth in the longer run. Central banks in emerging regions have, in fact, already taken substantial steps to counter inflation - China, India, Korea, Malaysia and Thailand have recently raised policy rates by significant increments and Indonesia has made its first move. This tightening demonstrates an appropriate awareness of inflationary risks. Monetary stability is the precondition for both sustainable long-run growth and the continued credibility and independence of central banks.
Given the challenges posed by capital flows, however, other measures can usefully complement monetary policy. An obvious auxiliary tool in countries where domestic demand is particularly buoyant is to err on the side of budgetary caution by building up fiscal buffers during the present good times. The sharp deterioration in the post-crisis fiscal position of industrial countries has highlighted the advantages of following prudent budgetary policies throughout the cycle, and most importantly during good times.
Second, real exchange rate appreciation forms part of the necessary adjustment to a new equilibrium in rapidly growing EMEs. In fact, Asian currencies have already witnessed a significant appreciation in recent years. Since mid-2009, when capital flows began to return to emerging Asia, most regional currencies have appreciated by around 5-6% in real effective terms. The Indian rupee and Indonesian rupiah have risen even more sharply, by more than 12%, during this period. Singapore has opted for tighter financial conditions by adjusting its exchange rate band upwards. International attention has focused primarily on China. The renminbi has climbed by 14.5% in nominal terms against the currencies of its trading partners since June 2005, but a further appreciation would be helpful in dealing with rising domestic inflationary pressures. Each country's authorities can accept currency appreciation more readily if neighbours are doing likewise.
Moving gradually towards more flexibility in exchange rates would help market forces play their part in adjusting growth patterns, as well as counter the build-up of imbalances and establish two-way risk for investors in financial markets. More flexibility would also be conducive to the further opening of Asian capital markets.
Another, increasingly popular, approach is to rely on so-called macroprudential measures. Emerging Asia has been in the forefront here, using a wide variety of instruments. For example, some countries have used tools that target mortgage lending. Among these are loan-to-value (LTV) ratios that serve to moderate credit growth or prevent the build-up of risk in the banking system. Other authorities have tightened capital requirements against mortgages and household credit.
What can we say about the effectiveness of such tools? This is not easy to answer, not least because they have been frequently applied in conjunction with other measures. But there is growing evidence that they have helped to address exuberance in real estate markets, which - as shown by the 2007 financial crisis - can lead to severe financial instability. In general terms, macroprudential tools appear to have been effective in strengthening the resilience of the financial system and in dampening house price inflation.
However, I would like to caution against excessive reliance on macroprudential policies. Macroprudential measures should only complement, and not substitute for, sound macroeconomic policies. The use of macroprudential tools in preference to interest and exchange rates may reflect the difficulty of judging whether the driving factors behind strong capital flows are transitory. Yet, as I have just argued, this is a risky strategy if it delays needed adjustments in line with long term trends. Any rise in inflation expectations could undermine long-run macroeconomic performance.
We also should be cautious about widening too much the use of the macroprudential objectives or terminology. Macroprudential tools should not be confused with other measures, such as administrative capital controls. Temporary capital controls can address transitory capital inflows, but they should be just that: a temporary response to highly unusual circumstances. The longer such controls are left in place, the greater the chance of adverse economic side effects and resource misallocations. Furthermore, the private sector is quick to develop avoidance strategies - for instance, using offshore derivatives markets. Perhaps in the light of these considerations, few EMEs have made any noticeable shift towards discouraging capital inflows in recent months. India has even raised its limits on government bond investment for foreigners. And in Thailand, the Government Pension Fund is looking to diversify its portfolio internationally.
As an alternative to capital controls, other measures can be considered that aim precisely at liberalising existing controls. In the Philippines, the central bank has approved measures to encourage greater outflows, including higher ceilings on residents' foreign exchange purchases and outward investments.
Overall, there is a clear hierarchy of policy responses to strong capital inflows. The first and foremost is to use macroeconomic policies - including monetary, fiscal and exchange policies - to ensure domestic monetary stability. Macroprudential measures represent the second line of defence. They hold particular promise in addressing risk build-ups in the banking sector or in specific markets - especially real estate. Capital controls are measures of last resort. They can act as a safety valve in extraordinary circumstances - but not more than that. Finally, structural financial policies such as deepening capital markets and enhancing regulatory and supervisory frameworks continue to form part of the toolkit.
Let me conclude by emphasising three points.
First, strong and volatile capital flows present central banks in EMEs with unusual challenges. A tectonic shift of global economic activity towards EMEs together with unusually accommodative monetary conditions in major advanced economies makes it all the more difficult to distinguish transitory from structural changes in capital flows. Yet both types of shift exist, and it would be a mistake to address the long-term kind with temporary measures that delay the necessary adjustments.
On top of that, increasing price pressures raise the danger that monetary policies will fall behind the curve because they have underestimated the risks arising from easy domestic financial conditions and rising commodity prices. Low and stable inflation expectations and central bank credibility are too important and too precious to be put at risk. Macroprudential tools can supplement, but not substitute for, sound macroeconomic policies. And, lastly, administrative measures such as capital controls may ease some policy dilemmas but should always be seen as short-term palliatives.
Second, sound national policy actions can contribute to better global outcomes. Some observers have expressed the view that the current divide between still weak activity in industrial countries and incipient tensions in EMEs raises the risk of a "prisoner's dilemma" -that is, individual countries could shrink from pursuing sound domestic policies because they are uncertain about others' choices. This should not be the case: sounder macroeconomic policies in each jurisdiction will benefit the global economy as a whole, for instance by helping to gradually whittle down today's large current account imbalances.
Third, current conditions highlight the importance of properly factoring in the interactions among national policy decisions. Domestic policymakers in both advanced and emerging economies are better off if they carefully consider the implications of their actions beyond their own borders. Piecemeal approaches and fragmented responses could erode the benefits of global financial integration. Uncoordinated approaches may simply shift risks among recipient countries. A frank exchange of views on the international dimension of domestic policy action can therefore lead to better domestic policymaking. As its core mission, the BIS promotes such international dialogues; and conferences like this one today contribute immeasurably to better coordinated approaches.