CAPITAL FLOWS AND CAPITAL FLOWS AND MACROPRUDENTIAL MACROPRUDENTIAL

REGULATIONREGULATION

José Antonio OcampoColumbia University

CHARACTERISTICSCHARACTERISTICSOF CAPITAL FLOWSOF CAPITAL FLOWS

IMF WEO: Capital flows are erratic (fickle)

Volatility has increased over time and is higher for EMEs than for AEs

Flows towards EMEs are highly sensitive to monetary policy in AEs, and to risk perception

Different types of flows differ in terms of volatility and persistence (though differences have narrowed down)

Recent surge is peculiar because of pace rather than level

Bank and portfolio flows are highly Bank and portfolio flows are highly sensitive to interest/risk mixsensitive to interest/risk mix

-1

-0.5

0

0.5

1

1.5

2

2.5

3

3.5

Low interest, low risk

Low interest, high risk

High interest, low risk

High interest, high risk

Bank and other

Net portfolio debt

Net portfolio equity

Net FDI

Debt portfolio flows are the distinctive Debt portfolio flows are the distinctive feature of the recent surge in Latin Americafeature of the recent surge in Latin America

Emerging Asia

-0.5

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

1991–97 2004–07 2010 Q1-Q3

FDI Portfolio equity Portfolio debt Bank and others

Emerging Latin America

-0.5

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

1991–97 2004–07 2010 Q1-Q3

FDI Portfolio equity Portfolio debt Bank and other

Volatility has increased, particularly for FDI. Volatility has increased, particularly for FDI. Persistence is low and has declined.Persistence is low and has declined.

Volatility

0

0.5

1

1.5

2

2.5

3

3.5

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

FDI Portfolio equity Portfolio debt Bank and other

Persistence

-0.1

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

FDI Portfolio equity Portfolio debt Bank and other

Some additional featuresSome additional features Integration into global financial markets is a

integration into a market that is segmented by risk categories.

The riskier segments behave in a clearly pro-cyclical way.

Segmentation has declined due to reserve accumulation and development of domestic bond markets…

… but these achievements of EMEs have become a double-edge sword, as they attract capital flows.

EMEs markets are relatively small A small portfolio decision in AEs has major effects on EMEs

Riskier markets are pro-cyclical, Riskier markets are pro-cyclical, but segmentation has declinedbut segmentation has declined

Emerging Markets' Spreads and Yields, 1998-2010

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

20.0

22.0

1-Jan-98

1-Jul-9

8

1-Jan-99

1-Jul-9

9

1-Jan-00

1-Jul-0

0

1-Jan-01

1-Jul-0

1

1-Jan-02

1-Jul-0

2

1-Jan-03

1-Jul-0

3

1-Jan-04

1-Jul-0

4

1-Jan-05

1-Jul-0

5

1-Jan-06

1-Jul-0

6

1-Jan-07

1-Jul-0

7

1-Jan-08

1-Jul-0

8

1-Jan-09

1-Jul-0

9

1-Jan-10

1-Jul-1

0

Spreads Yields

Due to massive reserve accumulation …

Foreign exchange reserves (% of GDP)

0%

5%

10%

15%

20%

25%

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%High income, excluding JapanJapanMiddle-income, excluding ChinaLow-incomeChina

… … and domestic market development in EMEsand domestic market development in EMEs

Capital markets in EMEs are small Capital markets in EMEs are small compared to AEscompared to AEs

Domestic debt securities (Sept. 2010)

37.9%

48.5%

13.6%USA

Other advanced

EMEs

Domestic + International

33.9%

55.0%

11.1%USA

Other advanced

EMEs

The current surge: explanationsThe current surge: explanationsand paradoxesand paradoxes

The problem has not been QEs, which has been unable to increase the money supply in the US…

… but the interest rate differentials, which will continue to be with us due to: Reduced risk perception regarding EMEs Two-speed world economy

Two paradoxes: “Self-insurance” is good for financial stability but

increases the flood of capitalDomestic financial market development has the same

effect

Monetary base expansion in the US has led to Monetary base expansion in the US has led to increasing reserves deposited in the Fedincreasing reserves deposited in the Fed

US Monetary base and non-borrowed reserves (billion dollars)

-500

0

500

1,000

1,500

2,000

2,500

3,000

Jan-

04

May

-04

Sep

-04

Jan-

05

May

-05

Sep

-05

Jan-

06

May

-06

Sep

-06

Jan-

07

May

-07

Sep

-07

Jan-

08

May

-08

Sep

-08

Jan-

09

May

-09

Sep

-09

Jan-

10

May

-10

Sep

-10

Jan-

11

Monetary base Non-borrowed reserves

The two speed world economy, The two speed world economy, which has its mirror in monetary policieswhich has its mirror in monetary policies

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

1970

1975

1980

1985

1990

1995

2000

2005

2010

Developed Developing 1971-2002 2003-2012

Major implications

Stability of EMEs and free capital movements may just be inconsistent objectives.

With structural imbalances in the world economy, interest rate arbitrage is a source of instability

So, global (i.e., not only national) capital account regulations may be necessary to manage persistent incentives to interest-rate arbitrage.

What remains of the advantages of capital mobility / liberalization?

Allow countries with limited savings to attract financing for productive investment

… if countries can manage to run stable current account deficits; and, in any case, most financing does not lead to investment.

Foster the diversification of investment risk Certainly for source countries; for recipient countries, there

are increased risks

Contributes to the development of financial markets This is partly correct, so long as funds are stable

Access to global capital markets is good, but capital account liberalization has unclear benefits.

THE POLICY DEBATETHE POLICY DEBATE

The central policy issues (1)The central policy issues (1)

Medium-term cycles, not short-term volatility are the most difficult to manage.

The reasons are simple: Capital flows directly generate pro-cyclical effects They also reduce the room of maneuver for counter-

cyclical macroeconomic policies Fiscal policy can always be counter-cyclical, but:

Pro-cyclical financing reduces the room of maneuver for counter-cyclical fiscal policies.

Austerity during crises generates pressures to spend during the recovery, thus a pro-cyclical dynamics of a political economy character.

The medium-term cycleFinancial flows to LA (% of GDP)

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

Inflows Net

The central policy issues (2)The central policy issues (2)Monetary/exchange rate autonomy: with free capital

movements, countries may be just choose where they want the instability of capital flows to be reflected in the domestic economy.

Exchange rate flexibility has real costs: It can easily lead to overvaluation and a risky growth

pattern. It increases the risk of producing tradables = it is a

tax on international specialization (Kindleberger)These two issues explain the revealed preference

for intermediate exchange rate regimes.But the essential instrument, heavy counter-cyclical

reserve accumulation, also has costs.

Exchange rate regimes: recent Latin American experience (1)

Coefficient of variation of the real exhange rate, 2004-2011

0.0% 3.0% 6.0% 9.0% 12.0% 15.0% 18.0% 21.0%

ArgentinaBrazilChile

ColombiaGuatemala

MexicoPeru

Uruguay

BoliviaCosta RicaDom. Rep.HondurasNicaraguaParaguay

Venezuela

EcuadorEl Salvador

Panama

Exchange rate regimes: recent Latin American experience (2)

Real appreciation: May 2011 vs. average 2004-11-10.00 -5.00 0.00 5.00 10.00 15.00 20.00 25.00 30.00

ArgentinaBrazilChile

ColombiaGuatemala

MexicoPeru

Uruguay

BoliviaCosta RicaDom. Rep.HondurasNicaraguaParaguay

Venezuela

EcuadorEl Salvador

Panama

The central policy issues (3)The central policy issues (3)

Counter-cyclical policies require many more instruments, indeed more instruments than objectives, including an acceptable level and stability of the real exchange rate.

Counter-cyclical prudential and capital account regulations are essential ingredients of such policies (macroprudential framework).

Thus, they are not measures of “last resort”. They are essential ingredients of the policy package.

This is particularly true of capital account regulations, as they target the major direct source of shocks.

Macroprudential regulations There is a continuum between three types of regulations:

Strict counter-cyclical prudential regulations (capital, provisions and/or liquidity)

Foreign-exchange related prudential measuresCapital-account regulations (capital management

techniques, capital flow management measures)Their use should be based on certain criteria:

Consistency with characteristics of financial system.Effectiveness.But this may imply that simple quantity-based regulations

(prohibitions, quantitative limits) may be better, and that selective policies may be preferable.

Some operate as “speed bumps” and must be dynamically strengthened.

Institutional capacity: it is better to have permanent regimes that are managed in a counter-cyclical way.

CAPITAL FLOWS AND CAPITAL FLOWS AND MACROPRUDENTIAL MACROPRUDENTIAL

REGULATIONREGULATION

José Antonio OcampoColumbia University