The Future of International Capital Flows

Abstract

The experience of the past decade has demonstrated the challenges that international capital flows can pose for financial stability. The build-up of global imbalances (large net capital flows) was one of the preconditions for the recent financial crisis. Increased interconnectedness between countries’ financial sectors (large gross capital flows) created channels through which the initial shock could spread around the world. In these respects, the scale and volatility of international capital flows were crucial determinants of the depth and breadth of the crisis which followed Lehman Brothers’ demise.These dramatic events demonstrate that it is incumbent upon policymakers to develop strategies to deal with these risks in the future. But however great the challenges policymakers may have faced in the most recent episode, these are set to become even greater in the future as large emerging market economies (EMEs) increasingly integrate into the global financial system.This paper elaborates on the simulations of Haldane (2010), with the aim of constructing some illustrative thought experiments to describe some potential trajectories for G20 countries’ capital flows and external balance sheets over the next 40 years. Some key results from our simulations are as follows:The overall size of external balance sheets relative to GDP across the entire G20 increases from a ratio of around 1.3 to 2.2; The distribution of external assets shifts to emerging markets. By 2050, more than 40% of all external assets are held by the BRICs, up from the current 10%; Non-G7 annual capital outflows are simulated to be more than twice the size of G7 outflows by 2050; Global current account imbalances (the sum of deficits and surpluses) rise from around 4% of world GDP to around 8% at their peak.These simulations focus on two fundamental drivers of capital flows — GDP convergence and demographics. Plainly, other factors which we do not explicitly model — such as financial development, changes in investor preference, exchange rate policies and the development of social safety nets — will also be important in the years to come. Notwithstanding these caveats, it seems reasonable to envisage a future world in which the financial integration of EMEs is accompanied by a substantial rise in international capital flows relative to world GDP.Developments in the size and volatility of global capital flows are linked to UK financial stability both directly and indirectly. Direct links operate via the United Kingdom’s very large gross external balance sheet position, in turn a function of its role as a global financial centre. A more indirect set of channels operate via the International Monetary and Financial System (IMFS), and in particular, through interactions between global capital flows and various frictions that inhibit orderly adjustments to imbalances across countries.The key challenge for policymakers is to mitigate the potential financial stability risks associated with much larger future international capital flows while simultaneously preserving the key benefits that financial globalisation has to offer. The increase in capital flows will have implications for many policy issues, including, but not limited to: the elimination of data gaps; policies which limit the build-up of balance sheet mismatches; the Basel III international capital and liquidity standards; macroprudential policies; the use of capital controls; and reforms to the international monetary and financial system. This is clearly a challenging task, not least because the global nature of the problem will demand a co-ordinated policy response. But while policy co-ordination will be a crucial element of any first-best policy response, individual countries may also be able to introduce unilateral measures to mitigate their vulnerability to large and volatile capital flows — including through macroprudential measures. Although the policy challenge is considerable, the experience of the recent crisis shows that the stakes are already high. But if — as the simulations presented in this paper suggest — global capital flows grow to dwarf those experienced in the lead-up to the 2007–08 crisis, the stakes will become higher still.