Capital Flow Reversals Research Articles

Which Capital Flow Surge Methods Are Better at Predicting Reversals and Sudden Stops?: Balancing Type 1 and Type 2 Errors

AbstractCapital flow surges have become a major source of concern as they have been often followed by disruptive reversals and sudden stops. We introduce F-score methodology which evaluates how well particular capital flow surge method can predict reversals and sudden stops. F-scores consider both type 1 and type 2 errors and provide policy makers a framework to weigh economic costs of false negative and false positive signals. We construct and compare a large number of commonly used surge identification approaches, including several machine-learning methods, to investigate which types of formulations best help explain which surges are more likely to be reversed. While considerable literature has investigated the determinants of capital flow reversals and sudden stops with surges being included as one of the independent variables, so far little research attention has been focused directly on attempting to determine the likelihood that particular surge will result in reversals or sudden stops. This is the most important question for policies toward capital inflows since the optimal responses to capital flow surges would be quite different depending on whether the flows are likely to be reversed or not. Unfortunately, theory does not offer a clear guide to identifying surges other than that they are unusually large inflows. We emphasize that appropriate evaluation should involve not only precision in predicting reversals but also accuracy in not giving false alarms by predicting reversals that do not occur. In other words, attention needs to be paid to both type 1 and type 2 errors.

Capital flow reversals and currency crises: Do capital flow types matter?

AbstractWe analyze how reversals of several types of capital flows impact currency crises in emerging market and developing economies. Estimates of logit models show that reversals of (equity and debt) portfolio flows significantly increase the likelihood of currency crises in emerging market economies. In developing economies, reversals of portfolio debt flows and banking flows have a significant positive impact on currency crises. Finally, our results suggest that countries with mature financial systems and fixed exchange rate regimes are less likely to experience a currency crisis after a capital flow shock. The mediating role of capital account liberalization varies by country type.

Capital Flow Reversals and Currency Crises: Do Capital Flow Types Matter?

Capital Flow Reversals and Currency Crises: Do Capital Flow Types Matter?

Cost of foreign reserve accumulation in emerging market and developing economies

PurposeThis paper aims to obtain a recent estimate of the cost of precautionary foreign reserve accumulation that emerging market and developing economies (EMDEs) had to endure to protect themselves against the risks of financial globalization. In addition, the study estimates the cost of excess reserves in emerging market economies (EMEs) using various reserve adequacy indicators that reflect potential sources of foreign exchange drains and vulnerability in EMEs' balance of payments.Design/methodology/approachThis paper begins by explaining the accumulation of foreign reserves in EMDEs as a self-protection strategy against the risks of financial globalization. Next, it sheds light on the different types of economic costs of foreign reserve accumulation. Finally, it estimates the cost of foreign reserve accumulation in EMEs during the period (1990–2018) and in EMDEs during the period (1990–2015) due to data availability.FindingsResults indicate that the cost of accumulating foreign reserves as a self-protection strategy in EMDEs and EMEs' was huge compared to their development financing needs. Applying various reserve adequacy measures demonstrates that many of the EMEs were holding inadequate precautionary reserves in 2018. Actually, this reflects the significant increase in external short term debt that many of the EMEs have witnessed since the eruption of the global financial crisis (2008). Thus increasing reserves in EMEs with weak reserve buffers and higher external debt is critical as they are more vulnerable to external shocks and capital flow reversals. Also given the estimated huge costs of accumulating foreign reserves, EMDEs should accompany it by other complementary self-protection policies and liquidity management policies to free up resources for productive investment.Originality/valueThe study contributes to the literature by estimating the cost of precautionary foreign reserve accumulation imposed on EMDEs during an extended period of time that covers a decade after the onset of the global financial crisis. Also to the authors' knowledge, this is the first study that estimates the cost of excess reserves in EMEs using various reserve adequacy indicators including the International Monetary Fund (IMF) assessing reserve adequacy (ARA) approach.

Financial Development, Financial Openness and Economic Growth in Nigeria

This study examined the impact of financial development and financial openness on economic growth in Nigeria between 1981 and 2019. This was done through the use of the Auto-Regressive Distributed Lag (ARDL) model. In doing this, the ratio of credit to the private sector to the GDP and broad money to narrow money were used as measures of financial development and financial openness respectively. The study found that financial development has a positive and insignificant impact on economic growth in Nigeria in the long and short-run. The study also found that financial openness has a negative and insignificant impact on economic growth in Nigeria in the long-run. The results of the study further revealed that simultaneous existence of financial development and financial openness has an insignificant but positive impact on economic growth in Nigeria in the long-run. Based on the findings, the study recommended that the CBN should increase its efforts towards the regulation and supervision of the financial sector to reduce the incidence of financial distress. The study also recommended that efforts to develop the mortgage and insurance sector and the capital market should be intensified through regulatory improvements, improvements in the instruments in use in the market as well as public enlightenment programs to increase awareness of the potentials of the mortgage, insurance and capital markets. The final recommendation made by the study is that more restrictions should be placed on the inflow of capital in and out of the country to guard against sudden capital flow reversals.

Endogenous corporate leverage response to a safer macro environment: The case of foreign exchange reserve accumulation

A country may adopt policy measures such as raising its foreign exchange reserves to better prepare for sudden reversal of international capital flows or currency attacks, which in principle should reduce financial vulnerability for its firms and the entire economy, but the beneficial effect of such policies may be partially offset by endogenous firms' decisions to take on more risks. We present a robust but previously undocumented relationship between corporate leverage and country-level foreign exchange reserve holdings. For 6610 non-financial firms in 23 emerging markets from 2000 to 2006, we show that more foreign reserve accumulation leads to higher corporate leverage. The effect is significantly greater in sectors that are intrinsically more sensitive to uncertainty. We go from correlation to causality via a two-prong instrumental variable strategy: simultaneously (1) instrumenting FX reserves by global commodity price movement, and (2) examining leverage of firms outside the commodity-sensitive sectors.

How fiscal rules can reduce sovereign debt default risk

The economic literature has been forceful on the role of fiscal institutions in attenuating economic fluctuations. In particular, the implementation of fiscal rules has gained importance in the toolkit of macroeconomic stabilization policies. This paper studies the effect of fiscal rule implementation on sovereign default risk and on the probability of capital flow reversals for a large sample of countries including both developed and emerging market economies. Results indicate that fiscal rules are beneficial for macroeconomic stability, as they significantly reduce both sovereign risk and the probability of a sudden stop in countries that implement them. These results, which are robust to various empirical specifications, have important policy implications specially for countries that have relaxed their fiscal rules in response to the Covid-19 pandemic.

The impact of capital flow reversal shocks in South Africa: a stock- and-flow-consistent analysis

ABSTRACT South Africa has a very well-developed financial sector and high reliance on capital flows. The country saw large capital outflows as the Covid-19 crisis developed, accompanied by a large depreciation of the rand and spikes in bold yields. We employ a stock- and flow-consistent model to study the impact of capital flow reversal shocks on the South African economy. The model includes a richer representation of institutional balance sheets than existing models. The financial sectors behaviour in the model draws on the theoretical frameworks, which highlight the relationship between bank capital, the risk-taking behaviour of the financial sector, lending spreads and economic activity. We specify a dynamic adjustment model of household expectations with properties that differ from the way in which expectations are formed in either stock- and flow-consistent or (DSGE) models. Household expectations resemble bounded rationality. The financial accelerator mechanism operates through the balance sheets of all institutions in the economy. We find that a reversal in capital flows can affect the domestic economy through its impact on domestic liquidity, on the risk-taking behaviour of the financial sector, and on the demand for assets.

Financial Development, Financial Openness and Economic Growth in Nigeria

This study examined the impact of financial development and financial openness on economic growth in Nigeria between 1981 and 2019. This was done through the use of the Auto-Regressive Distributed Lag (ARDL) model. In doing this, the ratio of credit to the private sector to the GDP and broad money to narrow money were used as measures of financial development and financial openness respectively. The study found that financial development has a positive and insignificant impact on economic growth in Nigeria in the long and short-run. The study also found that financial openness has a negative and insignificant impact on economic growth in Nigeria in the long-run. The results of the study further revealed that simultaneous existence of financial development and financial openness has an insignificant but positive impact on economic growth in Nigeria in the long-run. Based on the findings, the study recommended that the CBN should increase its efforts towards the regulation and supervision of the financial sector to reduce the incidence of financial distress. The study also recommended that efforts to develop the mortgage and insurance sector and the capital market should be intensified through regulatory improvements, improvements in the instruments in use in the market as well as public enlightenment programs to increase awareness of the potentials of the mortgage, insurance and capital markets. The final recommendation made by the study is that more restrictions should be placed on the inflow of capital in and out of the country to guard against sudden capital flow reversals.

An Early Warning Signal (EWS) Model for Predicting Financial Crisis in Emerging African Economies

The devastating effects of the global financial crisis (GFC) have led to a renewed, global interest in the development of an early warning signal (EWS) model. The purpose of the EWS model is to alert policymakers and other stakeholders to the possibility of the occurrence of a crisis. This study estimates a EWS model for predicting the financial crisis in four emerging African economies using a multinomial logit model and a data set covering the period of January 1980 to December 2017. The result of the study suggests that emerging African economies are more likely to face financial crisis as debts continue to rise without a corresponding capacity to withstand capital flow reversal as well as excessive foreign exchange risk due to currency exposure. The result further indicates that rising debt exposure raises the likelihood of the economies remaining in a state of crisis. This result confirms the significance of a financial stability framework that addresses the issues confronting Africa’s emerging economies such as rising debt profile, liquidity and currency risk exposure.

Spatial fixes and switching crises in the times of COVID-19: implications for commodity-producing economies in Latin America

ABSTRACT The COVID-19 pandemic is exposing the vulnerabilities of Latin America’s commodity-producing countries and is exacerbating their structurally weak position in global financial capitalism. Due to a high dependency on incomes from commodity exports, a reliance on external finance, and the volatility of exchange rates, the economies of Bolivia, Brazil, Chile, Colombia, Ecuador, Mexico, and Peru are hit particularly hard by the COVID-19 crisis with projections for 2020 predicting economic contractions of up to 14 per cent. By looking through the theoretical prism of critical economic geography, this article argues that in addition to the health and direct economic consequences of the pandemic, these countries will experience so-called switching crises as a result of the constant geographical restructuring of capitalism. As capital had moved into Latin America’s commodity-producing economies to provide spatial fixes to global capitalism’s previous crises by displacing them geographically and temporarily, the fall in commodity prices and the sudden stop to and reversal of capital flows has caused additional burdens in the current crisis. With the resulting debt expansion, the remaining dependency on external finance, and the structural deficiencies in achieving economic diversification, the territorialisation of capitalism’s crisis tendencies in the COVID-19 crisis will disproportionately affect Latin America’s commodity-producing economies.

The Chair’s Summing Up Independent Evaluation Office - IMF advice on Capital Flows Executive Board Meeting 20/93 September 18, 2020

Executive Directors welcomed the report of the Independent Evaluation Office (IEO) on IMF Advice on Capital Flows. Directors appreciated the high quality of the report, and its thematic and background country studies. Directors welcomed the finding that the adoption of the Institutional View (IV), along with the development of other frameworks and additional tools, had represented a major advance in the Fund’s policy framework to provide systematic advice to member countries on the management of capital flows and capital account liberalization. Directors also noted the conclusion that, in its application, the Fund had generally followed the IV and other policy frameworks to ensure that the advice was consistent, tailored to country circumstances, and evenhanded across countries. Directors welcomed that capital flow management measures (CFMs) have generally not been used to substitute for warranted policy adjustments. Directors also welcomed the finding that most authorities broadly support the IV’s sequenced framework to capital account liberalization and appreciated the Fund’s specific advice in many cases, especially in the context of technical assistance. More recently, faced with the abrupt capital flow reversals during the COVID-19 crisis, Directors noted that emerging markets and developing economies generally followed a multi-pronged approach broadly consistent with the IV framework and made relatively little use of CFMs.

The COVID-19 Pandemic: Conceptual Model for the Global Economic Impacts and Recovery

Since the outbreak at Wuhan in China, the contagious disease COVID-19 (SARS-Cov-2) pandemic is taking an unprecedented toll on global public health, economy, and livelihood issues. As the public health crisis is highly associated with economic affairs, it has grappled the global economy exponentially towards the dramatic downturn that pushed it into the worst recession after the great depression of the 1930s. The present review study aims to be summarized of the existing literature on the magnitude causes and effects of the COVID-19 pandemic on the people and business corporations and developed a conceptual model for the recovery of the world economy. The study revealed that people and business are suffering by vulnerable scenarios which have causes of effect on the existing economic indicators especially for microeconomic indicators such as jobless soaring, lowering income, higher health expenses, higher household expenses, low productivity, mental stress, lower consumption, social imbalance, the collapse of commodity prices, capital flow reversal, unemployment, fixed recurring expenses, the factory closed and heavy financial loses. However, for macro-economic indicators affected in the categories of the global financial crisis, global demand and supply shocks, volatile capital market, disruption in fiscal policy, disruption in monetary policy, severe unemployment problem, disruption in the aviation industry, disruption in international tourism and hospitality industry, disruption in global trade and commerce, disruption in the global supply chain, global public health emergency and global economic downturn. The present study concluded that the institutions have to play a major and mature role especially all government agencies as well as the non-government agencies by developing of right policies and laws and ensure of practices and coordination as well as increase awareness among the public and business accordingly. The study summarized strategic and policy guideline for the recovery of the global economy by strengthening the health care system, commodity market volatility fix-up, financial market restructuring, resumption of manufacturing and economic activity, special care for micro, small and medium scale enterprises, mitigate the unemployment problem, recovery package for tourism, hospitality and aviation sector, strengthening the global supply chain network, impacts on global immigration and remittance issues and develop sustainable development framework accordingly for recovery of the world economy.

Was a sudden stop at the origin of German hyperinflation?

Since the publication of Cagan's seminal contribution in 1956 and its further development by Sargent (1982) there has been a growing literature that seeks to explain German hyperinflation in terms of the monetary hypothesis. However, this article shows that the origins of this hyperinflation can be traced back to a sudden stop that occurred in the summer of 1922 at a time when expectations that the German economy would stabilise began to subside. The reversal of capital flows that took place in those months led in the short term to a dramatic depreciation of the mark, a significant increase in prices and a decline in output. This decline sparked bitter social conflict that fuelled a wage and price spiral. This spiral was accommodated by monetary authorities, leading in turn to explosive inflation.

The relationship between currency crises and capital flow reversals: An empirical examination

Large capital flow reversals and currency crises are an important feature of the global economy. They are often treated as being closely related and as typically occurring together. We investigate the relationship between them for a large set of emerging market economies using both event analysis and logit estimation. We find that more often than not the two types of events do not occur together. We find that this conclusion holds irrespective of the way in which currency crises and capital flow reversals are measured. We examine the circumstances under which we might expect them to occur together or separately and compare the behavior of a number of economic and financial variables prior to each type of event. While some conditions, such as rapid credit growth and economic overheating precede both currency crises and capital reversals, we also find important differences. Exchange rate behavior tends to be more important for currency crises than for capital flow reversals, while capital flow surges and financial conditions in the global economy are more important for capital flow reversals.

Macroeconomic implications of public policies in the pandemic-borne crisis

Serbia and the world are facing the largest health-cum-financial crisis in the living memory. By utilizing the novel class of macroeconomic SIR models, we demonstrate that neither its origin nor its transmission is fully exogenous, but crucially depends on the complicated interaction of governments, firms and individuals? economic behavior. Hence, COVID-19 epidemics and provoked public health response exhibit profound economic and financial consequences that may well be mutually reinforcing. Paper dismisses neoliberal approach to pandemics, but also criticizes Serbian public policy as palliative and erroneously obsessed with amassing life-support machines. In fact, we argue that small open economies should focus on providing obligatory epidemiological gear and disinfectants to their population for public use while awaiting more effective medical treatment, especially after quarantines get called off. In terms of macroprudential policy and measures aimed at mitigating the economic crisis, even though reasonable at the onset, they would have to be fine-tuned and more sector specific as pandemics subsides. Instead of numerical guesswork with regards to the key macroeconomic stats, we inspected Serbian constellation in terms of likely growth trajectories without and with the second wave of contagion. From purely macroeconomic perspective, much depends upon the size and probability of capital flow reversals which so often additionally worsen the initial financial havoc. Thus, on top of conventional policy instruments, capital controls should play a greater role and must be deployed counter-intuitively to ongoing practice.

Structural asymmetries and financial imbalances in the Eurozone

Many southern European economies experience large capital inflows during periods of expansion that are followed by abrupt capital flow reversals when a recession hits. This paper studies the dynamics of cross-border flows between the North and South of Europe in a two-country DSGE model with incomplete international asset markets. Over the business cycle, the direction of capital flows between the two regions can be explained by a model in which common shocks have asymmetric effects on debtor and creditor economies. This mechanism explains why aggregate consumption is more volatile in the South than in the North and generates a higher welfare cost of business cycle fluctuations in the region that experiences procyclical net capital inflows. We also study the adjustment to asymmetric financial shocks.

Indonesia

The Indonesian economy performed well in 2018, despite external headwinds, including capital flow reversals. Growth stabilized above 5 percent and inflation eased to around 3 percent. A surge in imports and weak export growth contributed to a higher current account deficit. Growth is projected to remain stable over the medium term. Inflation is expected to remain within the target band and the current account deficit is expected to narrow gradually on lower imports. Risks are tilted to the downside and are mainly external. Reliance on portfolio inflows to finance the twin deficits leaves Indonesia vulnerable to capital flow reversals. President Joko Widodo has been re-elected for a second term and has committed to push ahead with economic reforms. Creating quality jobs for the young and growing population to harness Indonesia’s demographic dividend requires a stronger impetus to growth, which has been constrained by structural weaknesses, including low tax revenues, shallow financial markets, and labor and product market rigidities.

Sudden stops in a currency union – some lessons from the euro area

AbstractDuring the Great Financial Crisis several euro area Member States with current account deficits were subject to sharp reversals of private capital flows. We examine how the specific policy rules of the euro area's payments system TARGET2 affects the macroeconomic adjustments to sudden stops. We find that – in the short run – public capital flows in form of TARGET2 help euro area‐deficit countries to stabilize output, consumption, and investment after a sudden stop of private capital inflows. In the long run, however, euro area countries suffer under a prolonged economic recovery and accumulated large public debt as well as higher welfare losses relative to euro peggers.

Credit Cycle and Capital Buffers in Central America, Panama, and the Dominican Republic

Credit is key to support healthy and sustainable economic growth but excess aggregate credit growth can signal the build-up of imbalances and lead to systemic financial crisis. Hence, monitoring the credit cycle is key to identifying vulnerabilities, particularly in emerging markets, which tend to be more exposed to sudden external shocks and reversal in capital flows. We estimate the credit cycle in Central America, Panama, and the Dominican Republic and find that the creadit gap is a powerful predictor of systemic vulnerability in the region. We simulate the activation of the Basel III countercyclical capital buffers and discuss the macroprudential policy implications of the results, arguing that countercyclical macroprudential policies based on the credit gap could prove useful to enhance the resilience of the region's financial sector but the activation of macroprudential instruments should also be informed by the development of other macrofinancial variables and by expert judgment.