Had fiscal and financial volatility not spiked in the US and Eurozone this August, it is a safe bet that the topic of how emerging markets should manage the capital inflows unleashed by quantitative easing would have featured prominently at the 2011 Annual Meetings of the IMF and World Bank.
As events transpired, the Eurozone debt crisis stole the show, but the issue of capital flows has not been buried. Indeed, the September 2011 issue of the Global Financial Stability Report (IMF 2011, p 28) notes: “…with the increase in global stability risks, emerging markets may face an external shock in the form of a sharp reduction in global growth and a reversal in capital flows….”
In short, the spectre of a sudden stop has not been exorcised. In fact, the Brazilian real dropped some 9% against the US dollar the week of 14-21 September 2011, the biggest weekly plunge since 2008. Nevertheless, based on a recent survey (Aizenman and Pinto 2011), we submit that, this time, things are different. This is mainly because emerging markets crossed a threshold after their own string of crises during 1997-2001 and that, this time, there are well-defined pressure points emerging-market policymakers need to worry about in managing capital inflows.
According to Bretton Woods II, global imbalances were mutually beneficial because emerging market current-account surpluses provided the US with a cheap source of funding for its deficits while the US in turn allocated emerging-market savings efficiently and powered emerging-market growth as the demander of last resort (Dooley et al. 2003). But the global financial crisis of 2008-09 has chipped away at the viability of this interpretation by exposing the weaknesses of the US financial system. Besides, emerging markets have become the engine of global growth even as the US and the Eurozone are faltering. But, as we caution in the opening paragraph, emerging markets have by no means decoupled from the advanced economies and are still vulnerable to capital flow reversals.
Capital flows: Growth versus crisis
In looking anew at how emerging markets should respond to the resurgence of capital inflows, a good starting point is the past two decades. Over this period, financial integration is less likely to have supported fast growth than fuelled a costly macroeconomic crisis. Four results are worth noting on the growth front.
- First, fast-growing countries tend to self-finance their growth (Aizenman, Pinto, Radziwill 2007, Prasad et al. 2007) and on average run current-account surpluses.
- Second, this finding does not change over the 1990s in spite of the massive financial liberalisation within emerging markets.
- Third, in addition to these empirical findings which contradict the predictions of neoclassical growth theory, simulations based on a neoclassical model find paltry gains in switching from autarky to full capital mobility – unless financial integration somehow contrives to significantly bridge the large gap in total factor productivity levels (or technology) between advanced and emerging-market economies, which is by no means automatically assured (Gourinchas and Jeanne 2006).
- And fourth, perhaps not surprisingly, the type of financial inflow matters. Net portfolio debt and equity inflows tend to have a negative effect on manufacturing growth, although the effect varies over time and depends upon whether a given sector is financially constrained or not. FDI inflows tend to have the most positive effects overall, on aggregate manufacturing as well as financially-constrained sectors (Aizenman and Sushko 2011).
On the crisis front, the most eloquent testimony on the tendency of financial integration to end up in tears is the series of emerging-market crises which began with Mexico in 1994-95, Thailand and East Asia in 1997, and then went on to engulf Russia (1998), Brazil (1999), and Argentina and Turkey (2000-01). Without a doubt, these crises also laid bare the domestic vulnerabilities in these countries. What is impressive is the recognition by emerging markets that they were on their own – high flying proposals about a sovereign debt restructuring mechanism and debt instruments with equity-type features did not take root. These countries accepted that they would have to assume primary responsibility for correcting the situation.
How did emerging markets react to their crises?
In the 1980s, most emerging markets exhibited low financial integration, rampant capital controls combined with fixed exchange rates and active monetary policy, and low levels of international reserves to GDP. This configuration changed dramatically as emerging markets learnt first from the crises of the 1980s, and then from those of 1997-2001.
First, they moved to the middle ground of the policy space defined by the macroeconomic policy trilemma, which refers to the ability to accomplish at most two out of the following three policy objectives: financial integration (or an open capital account), exchange-rate stability (or a fixed exchange rate), and monetary policy autonomy (or the ability to choose interest rates). They sharply increased their degree of financial integration after 1990, while settling for moderate levels of exchange-rate flexibility and monetary policy autonomy (Aizenman et al. 2009). In contrast, industrialised countries opted for a very high degree of financial integration, relatively stable exchange rates (especially after the adoption of the euro in 1999) and correspondingly lower monetary autonomy.
Second, emerging markets embarked on a massive accumulation of international reserves, from single-digit percentage levels of GDP in the 1980s to 15-30% for most with some, like China, Hong Kong, and Singapore, exceeding 50% by 2007. Leading factors accounting for the large hoarding, beyond mercantilism, include self-insurance, especially after the crises of 1997-2001 when the scale and speed of capital flow reversals shocked most observers and exposed hidden balance-sheet vulnerabilities in domestic banks and the corporate sector, leading to severe recessions and huge fiscal bailout costs. In response, emerging markets moved to the trilemma middle ground, built up reserves and adopted what we label a “public finance approach” to financial integration and managing macroeconomic risks; their evolving response is outlined in Table 1 below. The public finance approach has three elements:
- One, putting the fiscal house in order to create space for addressing tail risks.
- Two, recognising that good management of the public finances is not enough – steps have to be taken to minimise contingent liabilities from private sector balance sheets, especially in the financial sector.
- Three, strengthening financial sector regulation and supervision.
The efficacy of self-insurance combined with the public finance approach has been demonstrated by the surprising resilience of emerging markets during the global crisis of 2008-09 (Development Committee 2010). To put this in context, considerable scepticism had been expressed (Caballero 2003) about whether it was feasible at all for emerging markets to self-insure against a sudden stop.
Managing risks from capital flows
How should emerging markets respond to the resumption of large capital inflows in the wake of quantitative monetary easing in the advanced economies? The fact that the global crisis originated in the financial sector of the US underlines the need for policymakers to balance the interests of the financial and real sectors. With vulnerability from capital inflows endogenous to what the private sector does, an optimal approach calls for a mixture of partial insurance and preventive methods. Emerging markets must supplement reserve accumulation with policies to reduce the risk of sudden stops and deleveraging shocks. Three particular pressure points are worth highlighting.
- First, keeping public debt on a sustainable trajectory will limit borrowing requirements and rollover risks.
- Second, through a combination of supervision and macro-prudential regulation, decisive steps must be taken to ensure commercial banks remain largely deposit-based and limit their reliance on external, wholesale funding. This will also minimise currency mismatches, which had ruinous effects during the 1997-2001 crises.
- Third, monitoring lending to the real estate and housing sectors to minimise the occurrence of bubbles and bad loans is of vital importance; if things go wrong here, the negative externalities for the rest of the economy, not to mention the size of the fiscal costs, are immense.
Chances are that dynamic imposition of loan-to-value ceilings (LTVC) as in China, Hong Kong, and Singapore could reduce the probability of a bubble. Similarly, taxing external borrowing surges by commercial banks recognises that the social benefits to the real sector may fall short of the social cost to the taxpayers of bailing out systemic financial players when times turn bad. Indeed, emerging markets have been adopting various measures to tax external borrowing and hot money. The key is to have a framework for regulation and supervision which evolves dynamically over time to avoid a situation where regulations lose their bite.
The steps emerging markets took to reduce their exposure to the 2008-09 crisis included sound management of the public finances to achieve sustainable debt trajectories, building up international reserves, prudential steps to reduce contingent liabilities from private sector balance sheets, and moving to the trilemma middle ground with its emphasis on controlled exchange-rate flexibility. This package of self-insurance combined with the public finance approach to financial integration may well be an optimal second-best while emerging markets wait for the G20 to collectively resolve global imbalances and under-regulated capital flows.
Authors' note: The views herein are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organiSations, or those of the Executive Directors of the World Bank or the governments they represent.
Aizenman, Joshua, Brian Pinto, and Artur Radziwill (2007), “Sources for Financing Domestic Capital – Is Foreign Saving a Viable Option for Developing Countries?”, Journal of International Money and Finance, 26(5):682–702.
Aizenman J and V Sushko (2011), “Capital Flow Types, External Financing Needs, and Industrial Growth: 99 countries, 1991-2007”,NBER Working Paper No. 17228.
Aizenman, Joshua and Brian Pinto (2011), “Managing Financial Integration and Capital Mobility: Policy Lessons from the Past Two Decades”, Policy Research Working Paper WPS5786, The World Bank.
Caballero, Ricardo (2003), “On the International Financial Architecture: Insuring Emerging Markets”, NBER Working Paper No. 9570.
Development Committee (2010), How Resilient Have Developing Countries Been During the Global Crisis? DC2010-0015, September 30.
Dooley, Michael, David Folkerts-Landau, and Peter Garber (2003), “An Essay on the Revived Bretton Woods System”, NBER Working Paper No. 9971.
Gourinchas, Pierre-Olivier, and Olivier Jeanne (2006), “The Elusive Gains from International Financial Integration”, Review of Economic Studies, 73:715-741.
Pinto, Brian (forthcoming), Sovereign Debt and Growth: Practical Lessons from Developing Country Experience.
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Table 1. Evolving crisis response of emerging markets
|1. Restore sustainable debt dynamics
||• Raise primary fiscal surpluses for prolonged period
• Improve expenditure composition and tax regime
• Strengthen fiscal institutions.
|Might have to cut even good public investments in order to raise primary surpluses (similar to external debt overhang of 1980s)
|2. Lower contingent liabilities associated with private sector
||• Shift to flexible exchange rates
• Monitor private external borrowing and currency mismatches
• Strengthen financial institutions.
|Flexible exchange rates will reduce incentive for currency mismatches but direct controls may also be needed by central bank on volume of private external debt and loan-to-deposit ratios of commercial banks
|3. Insure against shifting market sentiment and possible sudden stops
||• Build up foreign exchange reserves
• Restrict currency mismatches on government and private balance sheets.
|“Ideal” level of reserves will depend upon short-term external debt, flexibility of exchange rates and extent of currency mismatches
Source: Chapter 7, Pinto (forthcoming).