Capital flows to developing countries
- Countercyclical Prudential Regulation and Supervision
- Adequate Official Liquidity for Crises
Since the 1970s, business cycles in many developing countries have been characterized by fluctuations in international capital flows. This has been particularly true for economies integrated into world financial markets. Fluctuations in capital flows lead to variations in the availability of financing (absence or presence of credit rationing ) and in length of loans (maturities). This involves short-term volatility, such as the very intense upward movement of spreads (margin over basic interest rate that reflects perceived risk) and the interruption (rationing) of capital flows observed during the Mexican (1994 95), Asian (1997 98), and Russian (1998) crises. They also involve medium-term cycles, as the experience of the past fewdecades (since the last quarter of the 20th century) indicates.
The developing world experienced two full medium-term cycles between 1970 and 2000: a boomof external financing in the 1970s, followed by a major debt crisis, mainly in Latin America, in the 1980s; and a new boom in the 1990s, followed by a sharp reduction in net flows after the Asian and Russian crises of 1997 98. By 2007, international capital flows to developing countries had recovered, but new sources of potential procyclicality had emerged, particularly related to the explosive growth of derivatives worldwide. Derivatives, at their simplest, allowtwo parties to agree on a future price for a given asset, for example, a purchase of foreign exchange. Derivative contracts have become increasingly important in developing economies as instruments for firms and others to hedge risk and for international hedge funds and investment banks to speculate. Large parts of these derivative markets are not regulated, nor have existing regulations fully incorporated the risks that derivatives pose in situations of stress, when they can add to systemic risk.
During booms,developing countries thatmarkets view as success stories are almost inevitably drawn into a capital flows boom, inducing private-sector deficits and risky balance sheets (Ffrench-Davis 2001). For example, when Mexico joined both the North American Free Trade Agreement (NAFTA) and the Organisation for Economic Co-operation and Development (OECD) in the 1990s and was seen as a ‘‘successful reformer,’’ it initially attracted huge inflows of capital. Even countries with weak macroeconomic fundamentals, such as low current account deficits,may be drawn into the boom, however, and all countries, again with some independence from their fundamentals, will suffer sudden stops of capital flows. There is also widespread evidence that ample private capital flows encourage expansionary macroeconomic policies during booms, such as excessive growth of government spending. Ample private capital flows encourage expansionary responses by individuals (who consume more) and companies (which invest more), as well as by macroeconomic authorities. When capital inflows fall sharply or turn into outflows, consumers, companies, and governments in developing countries have to reduce their spending.Thus unstable external financing distorts incentives that both private agents and authorities face throughout the business cycle, inducing a procyclical behavior of economic agents andmacroeconomic policies (Kaminsky et al. 2004).
Although procyclicality is inherent in capital markets, domestic financial and capital account liberalization in the developing world, as well as technological developments, such as very rapid communications, have accentuated its effects. A lag in developing adequate prudential regulation and supervision frameworks increases the risks associated with financial liberalization.
The costs of such financial volatility in the developing world in terms of economic growth are high. There is now significant evidence that capital flows have not encouraged growth and rather have increased growth volatility in emerging economies (Prasad et al. 2003). Whatever the efficiency gains from financial market integration, they seem compensated by the negative effects of growth volatility. During and after financial crises, major falls in output, employment, and investment have occurred (Eichengreen 2004).Volatility in financialmarkets is partly transmitted to developing countries through public-sector accounts, especially through effects of the availability of financing on government spending, and of interest rates on public sector debt service payments. In commodity-dependent developing countries, links between availability of financing and commodity prices reinforce the effects on public sector accounts. The most important effects of capital account fluctuations are on private spending and balance sheets. Capital account cycles, their domestic financial multipliers, and their reflection in asset prices (such as stock markets and property prices) became an important determinant of growth volatility.
Different types of capital flows show different volatility patterns. The higher volatility of short-term capital indicates that reliance on such financing is highly risky (Rodrik and Velasco 2000), whereas the smaller volatility of foreign direct investment (FDI) vis-a-vis all forms of financial flows is considered safer. FDIalso can bring valuablebenefits related totechnology transfers and access tomanagement expertise and toforeignmarkets.Useofriskmanagementtechniques by multinationals, via derivatives, may make FDI in critical moments as volatile as traditional financial flows, however (Griffith-Jones and Dodd 2006).
Countercyclical Prudential Regulation and Supervision
Managing countercyclical policies for developing countries in the current globalized financial world is no easy task. For this, it is essential that international cooperation in the macroeconomic policy area be designed to overcome incentives and constraints. This means that the first role of international financial institutions, from the point of view of developing countries, is to mitigate the procyclical effects of financial markets and open policy space for countercyclical macroeconomic policies, that is, policies that can attenuate the economic cycle, for example, by expanding government spendingwhen the economy is slowing down so as to accelerate recovery and by contracting government spending in boom times, to avoid overheating of the economy.This can be achieved partly by smoothing out boom-bust cycles at the source through regulation.
One of the major problems seems to be the focus of prudential regulation onmicroeconomic risks and the tendency to underestimate risks that have a clear macroeconomic origin (see BIS 2001, chap. 7). For example, in times of rapid economic growth, a portfolio of bank loans may seem very safe; when the economy slows down or goes into recession, however, that same portfolio of bank loans may become highly problematic.This dimension of changing risk through time is not usually sufficiently perceived by individual banks or even by bank regulators. The basic problem in this regard is the inability of individual financial intermediaries to internalize collective risks assumed during boom periods.
Moreover, traditional regulatory tools, including both Basel I and Basel II international standards for bank regulation on capital adequacy, have a procyclical bias. The basic problem is a system in which loan-loss provisions are tied to loan default or to short-term expectations of future loan losses. Precautionary signals may be ineffective in hampering excessive risk-taking during booms, when expectations of loan losses are low, effectively underestimating risks and the counterpart provisions for loan losses. The sharp increase in loan delinquencies during crises reduces financial institutions’ capital and, hence, their lending capacity, potentially triggering a credit squeeze; this would reinforce the downswing in economic activity and asset prices and, thus, the quality of the portfolios of financial intermediaries.
Given the central role all of these processes play in the business cycles of developing countries, and the important influence of banking regulation on credit availability in themodern economy, the crucial issue is to introduce a countercyclical element into prudential regulation and supervision. The major innovation is the Spanish system of forward-looking provisions, introduced in 2000 and later adopted by Portugal and Uruguay. According to this system, provisions are made when loans are disbursed based on the expected (‘‘latent’’) losses; such latent risks are estimated on the basis of a full business cycle.
Under this system, provisions build up during economic expansions and are drawn on during downturns. Moreover, many regulatory practices aimed at correcting risky practices shift underlying risks to nonfinancial agents (e.g., companies). This is why capital account regulations aimed at avoiding inadequate maturity structure of borrowing in external markets by all domestic agents, and at avoiding currency mismatches in the portfolios of those agents operating in nontradable sectors, may be the best available option (Ocampo 2003). Also, as long as there is no international central bank that could provide unconditional official liquidity in times of crisis, international rules should continue to provide room for the use of capital account regulation by developing countries.
More broadly, the Basel II Accord to regulate banks internationally has a number of problems that require attention: it is complex where it should be simple; it is implicitly procyclical when it should be explicitly countercyclical; and although it is supposed to more accurately align regulatory capital with the risks that banks face, in the case of lending to developing countries it ignores the proven benefits of diversification. In particular, by failing to take account of the benefits of international diversification of portfolios, capital requirements for loans to developing countries will be significantly higher than is justified on the basis of the actual risks attached to such lending.There are thus fears that Basel II creates the risk of a sharp reduction in bank lending to developing countries, particularly during crises (thus enhancing the stop-go pattern of such lending).
One clear way in which Basel II could be improved to reduce these problems would be to introduce the benefits of diversification.One of themajor benefits of investing in developing and emerging economies is their relatively low correlation with mature markets. This has been tested empirically using a wide variety of financial, market, and macro variables. Different simulations that compared estimated losses of portfolios that were diversified across both developed and developing countries with the losses of portfolios in developed countries only indicate that the former were from 19 to 23 percent lower (Griffith-Jones, Segoviano, and Spratt 2002). If risks are measured precisely, this should be reflected in lower capital requirements.
An additional positive effect of taking account of the benefits ofdiversification is that thismakes capital requirements far less procyclical than otherwise. Indeed, if the benefits of diversification are incorporated, simulations showthat the variance over time of capital requirementswill be significantlysmaller than if they are not.
Adequate Official Liquidity for Crises
At the country level, central banks have acted for many decades as lenders of last resort, providing liquidity automatically to prevent financial crises and avoid their deepening when they occur. Equivalent international mechanisms are still at an embryonic stage, with International Monetary Fund (IMF) arrangements, as of 2007, providing credit only with policy conditions attached and not automatically (Ocampo 2003). Despite some moderation in this area in the early 2000s, the general trend in IMF financing was toward increased conditionality, even in the face of external shocks, including those that involve financial contagion. Enhanced provision of emergency financing at the international level in response to external shocks is essential to lowering unnecessary reduction of economic growth or recession within a country and to avoiding the spread of crises to other countries.
Between the 1980s and the early 2000s, capital account liberalization and large capital account volatility greatly increased the need for official liquidity to deal with large reversals in capital flows. There is increasing consensus that many of the crises in emerging markets in the late 1990s and early 2000s have been triggered by self-fulfilling liquidity runs (Hausmann and Velasco 2004). Indeed, capital outflows could be provoked by many factors not related to countries’ policies. The enhanced provision of emergency financing in the face of capital account crises is thus important not only to manage crises when they occur but to prevent such crises and to avert contagion (Cordella and Yeyati 2005; Griffith- Jones and Ocampo 2003).
To address this obvious need, the IMF has made efforts to improve its lending policy during capital account crises. In 1997, the Supplemental Reserve Facility was established.
The evidence that even countries with good macroeconomic fundamentals might be subject to sudden stops of external financing also gave broad support to the idea that a precautionary financial arrangement, closer to the lender-of-last-resort functions of central banks, had to be added to existing IMF facilities. In 1999 the IMF introduced the Contingent Credit Line (CCL). The facility was never used andwas discontinued inNovember 2003. Contrary towhatwas desired, the potential use of the CCL was seen as an announcement of vulnerability that could harm confidence.
After the expiration of the CCL, the IMF explored other ways to achieve its basic objectives. A move in that direction was proposed by the managing director of the IMF and approved by the International Monetary and Financial Committee in April 2006. Interestingly, as the IMF recognized, by offering instant liquidity, a well-designed facility of this sort ‘‘would place a ceiling on rollover costs thus avoiding debt crises triggered by unsustainable refinancing rates, much in the same way as central banks operate in their role of lenders of last resort’’ (IMF 2005). Approval of such a facility within the IMF, however, seems difficult to achieve.
Volatility and contagion in international financial markets increased the incidence of financial crises and growth volatility in the developing world, and reduced policy space to adopt countercyclical macroeconomic policies. Therefore, amajor task of a development-friendly international financial architecture is tomitigate procyclical effects of capital flows and open a debate about countercyclical macroeconomic policies in the developing world. To achieve these objectives, a series of useful policy instruments can be developed, including explicit introduction of countercyclical criteria in the design of prudential regulatory frameworks; designingmarketmechanisms that better distribute the risk faced by developing countries throughout the business cycle; and better provision of countercyclical official liquidity to deal with external shocks. Such measures would make capital flows better support development. See also asymmetric information; balance sheet approach/ effects; banking crisis; capital controls; capital flight; capital mobility; contagion; convertibility; currency crisis; financial crisis; financial liberalization; global imbalances; hot money and sudden stops; international financial architecture; International Monetary Fund (IMF); International Monetary Fund conditionality; international reserves; Latin American debt crisis; lender of last resort; twin deficits