Capital Flow Reversals Research Articles

The Enormous Loans of the Deutsche Bundesbank to Distressed European Countries’ Central Banks

As of October 2011, in the context of the TARGET2 payment system, the Bundesbank had accumulated a total claim of 465 billions € on the rest of the Eurosystem, that is on the other National Central Banks of the euro zone and the ECB. The growing claims of the Bundesbank and, to a lesser extent, the National Central Banks of Luxembourg, the Netherlands and Finland, are the counterpart of growing liabilities of the distressed peripheral countries of the euro area. Since the beginning of these crises the rising claims of the Bundesbank correspond to rising liabilities of the National Central Banks of Ireland, Greece and Portugal, and recently Italy and Spain.The central bank of the Eurozone is in fact a set of several institutions known as the Eurosystem. It is composed of the European Central Bank and all the 17 National Central Banks of the member countries. Cross border payments between banks of different countries of the euro area are conducted through a system known as TARGET2. Through this payments system banks can transfer to each other claims on the National Central Banks, known as “central bank money” or “reserves”. Through TARGET2, each cross border transaction between countries belonging to the Euro area gives rise to a gross claim of a National Central Bank on another National Central Bank. Indeed the National Central Bank of the country of the “paying” bank needs to borrow claims on the National Central Bank of the country of the “receiving” bank, in order to transfer these claims to this bank. The National Central Bank of the country of the “paying” bank has thus to borrow reserves from the National Central Bank of the country of the “receiving” bank, before transferring the property of these reserves to this “receiving” bank At the end of each day, the claims or liabilities of National Central Banks on or to each other are netted and replaced by a net claim or a net liability of each National Central Bank on or to the Eurosystem. These daily net claims or liabilities are added to the cumulated TARGET2 balances of each National Central Bank built up since the launch of the euro. Until 2007, the current account deficits of the peripheral countries of the Euro area were compensated by net capital inflows. Since 2008 however, the banks of Germany and other core countries are reluctant to lend to the banks of the peripheral countries, which also experience huge capital outflows. the growing imbalances of TARGET2 accounts are caused by a sustained reversal of capital flows. Net capital outflows now add to the structural imbalance of the current account of peripheral countries, due to a lack of competitiveness. the balance of payments imbalances of the distressed countries benefit from a kind of monetary funding by the Bundesbank.If the euro zone broke up, the Deutsche Bundesbank could incur enormous losses on its TARGET2 related claims on the Eurosystem. In such a scenario, the Bundesbank should be recapitalized by the German government, at the expense of the German taxpayer. Even without a breakup of EMU, the Bundesbank should bear 30% of the potential losses of the distressed countries’ National Central Banks loans to their banks which lack good quality assets to provide as collateral.

Do Countries Falsify Economic Data Strategically? Some Evidence That They Might

Using Benford's law, we find evidence supporting the hypothesis that countries at times misreport their economic data strategically. We group countries with similar economic conditions and find that for countries with fixed exchange rate regimes, high negative net foreign asset positions, negative current account balances, or more vulnerable to capital flow reversals, we reject the first-digit law for the balance-of-payments data. This corroborates the intuition of a simple economic model. The main results do not seem to be driven by countries in sub-Saharan Africa or those with low institutional quality ratings.

Responding to the global financial crisis: Vietnamese exchange rate policy, 2008–2009

The paper presents an analysis of exchange rate policy in Vietnam during 2008–2009. In early 2008, the country faced a sudden reversal of capital flows as signs of developing domestic vulnerabilities became evident. The downward pressure on the dong then intensified with the onset of the global financial crisis in the fall. In these environments, the Vietnamese authorities responded with various exchange rate policy measures. The paper documents a shift in Vietnam's de facto exchange rate regime, from a basket peg to a simple US dollar peg, when the domestic vulnerabilities became compounded by the evolving global crisis. The authorities utilized additional measures to relieve pressure on the parallel exchange rate. An event study methodology finds little evidence of systematic effectiveness for these policy actions; any effectiveness was short-lived. A close examination of individual actions suggests that the impact of foreign exchange market intervention appeared more consistent than any other type of measure and most effective when combined with other measures.

Capital Flow Reversal and Foreign Exchange Crisis in Korea: Supply-side Approach to the Foreign Exchange Crisis

Capital Flow Reversal and Foreign Exchange Crisis in Korea: Supply-side Approach to the Foreign Exchange Crisis

Balance of Payments

The world economy, led by the buoyant economic activity in emerging economies, is gradually recovering from the crisis. The risks however remain, as advanced economies face large fiscal deficit, high public debt and unemployment levels and tepid aggregate demand, leading to subdued growth. The sovereign debt crisis in the peripheral euro-zone countries is contributing to the uncertainty. At the same time, large capital flows to emerging economies, rising oil and agricultural prices are fueling inflationary pressures that may affect the nascent global recovery. In the backdrop of these developments, the Indian economy continues to exhibit resilience, moving steadily towards the pre-crisis growth path. The current account deficit, however, has widened due to robust import demand and lower invisibles surplus. These are being largely financed by the relatively higher capital flows, leading to moderate accretion in reserves. There are, however, challenges that include volatile nature of foreign institutional investment that is characterized by surge and reversal of capital flows, deceleration in foreign direct investment and the risk of further slowdown in advanced economies that may affect exports and strain balance of payments.

Dissecting the Effect of Credit Supply on Trade: Evidence from Matched Credit-Export Data

We estimate the elasticity of exports to credit using matched customs and rm-level bank credit data from Peru. To account for non-credit determinants of exports, we compare changes in exports of the same product and to the same destination by firms borrowing from banks differentially affected by capital flow reversals during the 2008 financial crisis. A 10% decline in credit reduces by 2.3% the intensive margin of exports, by 3.6% the number of firms that continue supplying a product- destination, but has no effect on the entry margin. Overall,credit shortages explain 15% of the Peruvian exports decline during the crisis.

Capital flows to emerging economies: Minsky in the tropics

Capital inflows to emerging economies have a significant exogenous component, they are very large when scaled to the size of the domestic financial sectors of recipients and they have large real macroeconomic effects. They also sow the seeds for the ensuing sudden stops, or capital flow reversals, observed in financial crises in emerging markets. This paper tests the implications of applying the Kindleberger--Minsky model of financial crises to capital account reversals in emerging economies, or sudden stops as they have been called in the recent literature. It uses a panel-probit framework with heterogeneous unobserved country effects. The most important variables that account for sudden stops are preceding capital surges, the share of flows other than foreign direct investment, the size of the current account deficit, contagion from sudden stops in other emerging markets and the ratio of external debt to exports. The main policy conclusion is that emerging economies need specific policies to deal with capital surges. In addition, macroeconomic policies geared toward preserving sustainable macroeconomic balance may be necessary to avoid sudden stops but they are clearly insufficient. Copyright The Author 2010. Published by Oxford University Press on behalf of the Cambridge Political Economy Society. All rights reserved., Oxford University Press.

The Fund's Role Regarding Cross-Border Capital Flows

Global capital flows have multiplied many times over in recent years, mainly between advanced economies but increasingly also to emerging markets, reflecting the general reduction in regulatory and informational barriers. Thus, with international asset positions now dwarfing output, global portfolio allocations and reallocations have profound effects on the world economy, as demonstrated by recent boombust episodes of both global reach (e.g., the transmission of the 2001 IT shock and the 2008 mortgage market shock from the United States) and regional significance (in Asia, Latin America, and Central and Eastern Europe). Such cycles and reversals in cross-border capital flows should not be surprising, given that these flows - more so than domestic ones - imply crossing informational barriers, currency and macroeconomic risks, and regulatory regimes.

Are Net FDI Flows and Reversals of Capital Flows a Result of Output Growth?

Abstract Literature notes many factors as affecting capital flows, but the effects of these flows over the recipient economies and the overall effect over growth are highly debatable. This study claims that although capital flows may be required for the increase in output, other forces are causing this growth and creating the demand for capital. We construct a model in which growth requires both decisions of firms regarding training of managers in order to expand, representing the absorption capacity of the firms, and capital for the firms’ expansion. The model shows that in early stages of development when output is low, capital inflows are increasing with an increase in the output, but are not the cause for the output growth. However, when output is higher, an increase in the output is associated with financial outflows since the local savings are increasing by more than the local demand for capital. Although we cannot empirically test the model, we use cross-country regressions to show that capital flows are in-line with the predictions of the model and manage to explain half of the variations in net FDI flows per capita using the stage of development. Many policies regarding capital flows may be, therefore, irrelevant.

Bankruptcy costs, liability dollarization, and vulnerability to sudden stops

Countries with intermediate levels of institutional quality suffer larger output contractions following sudden stops of capital inflows than less developed nations. However, countries with strong institutions seldom experience significant falls in output after capital flow reversals. We reconcile these two observations using a calibrated DSGE model that extends the financial accelerator framework developed in Bernanke, Gertler and Gilchrist (1999). The model captures financial market institutional quality with creditors' ability to recover assets from bankrupt firms. Bankruptcy costs affect vulnerability to sudden stops directly but also indirectly by affecting the degree of liability dollarization. Simulations reveal an inverted U-shaped relationship between bankruptcy costs and the output loss following sudden stops.

Understanding the Crisis in Emerging Europe

Despite the large output declines suffered by emerging Europe in 2008-09, a major currency and banking crisis was avoided. This paper argues that European economic and political integration was a mitigating factor in this. Cross-border banking groups, in particular, seem to have forestalled a sharp reversal in capital flows. Cross-country variations in output decline can be explained by a small set of macroeconomic vulnerabilities.

ECONOMIC CRISES IN TURKEY: A COMPARATIVE ANALYSIS OF FAILURES IN 1994, 2001 AND 2008-9

The currency and banking crises which the Turkish economy faced in the last sixteen years are generally attributed to financial and fiscal fragilities, typical of developing countries with liberalised capital accounts. Although the sudden stops and reversals in capital flows seem to be the common factor underlying crises of that kind, the three cases analysed in the text took place at different international and domestic conjunctures and were unfolded in different policy environments. In the international context, the volume, composition and degree of volatility of capital flows made a major impact on the severity and evolution of the crises. In the context of the national economy, not only diverse exchange rate arrangements and demand management policies, but also the changing emphases on institutional issues put their imprint on the actual course of events. The paper starts with definitions, explanations and stylised facts about currency and banking crises. It later goes into exploring the behaviour of the relevant indicators (i.e. those related to balance of payments, finance and public sector accounts) in Turkey over the pre-crisis, crisis and post-crisis periods in each of the crises concerned. The possibility of using some of these indicators as advance warning signals is also discussed. The last three crises in the Turkish economy were not simply the outcomes of policy mistakes committed by Turkey alone, but were also highly influenced by systemic features of the world economy working under neoliberal principles. The fact that the Turkish governments since the capital account liberalisation have been either unable or unwilling to monitor the transmission mechanisms of international shocks into the domestic economy suggests that currency and banking crises in Turkey are likely to recur over the medium term.

Determinants of International Bank Lending from the Developed World to East Asia

The reversal of capital flows from the banking sector, rather than portfolio equity investment, has long been considered a main reason for the severity of the East Asian financial crisis of the late 1990s. This study analyzes the factors behind the boom and bust of bank lending, focusing on loans from private banks in seven Organization for Economic Cooperation and Development countries to nine East Asian economies during the 1990–2004 period. The findings suggest that political instability and weaknesses in legal, judicial, and bureaucratic systems help explain the continued stagnation in lending after the financial crisis. Thus, institutional reforms are critical for East Asia to successfully compete for international bank financing.

Economic Survey 2008-09: India's External Sector

The year 2008-09 was marked by adverse developments in the external sector of the economy, particularly during the second half of the year, reflecting the impact of global financial crisis on emerging market economies including India. Emerging economies were affected in varying degrees depending upon the extent of openness and the dependence on capital flows as the external environment deteriorated on account of slowdown in global demand, reversal of capital flows and reduced access to external sources of finance in the face of adverse global credit market conditions.

The Fiscal Response to the Global Crisis

India's banks had no direct exposure to the subprime mortgage assets. Yet India was affected by the global financial crisis as its economy has significantly integrated with the global economy in the recent past in terms of the globalization of trade and financial integration. The global crisis resulted in a reversal of capital flows to India and a slump in the demand for its exports. This caused a deceleration in growth and the policy response was a fiscal and monetary stimulus that resulted in the fiscal deficit being the highest since 1993–94, the revenue deficit that is the largest ever in India's history, and an aggressive reduction in monetary policy rates. The massive government borrowing programme has resulted in a hardening of the yield on government securities which adversely affects aggregate output. As financial markets have factored in a lack of commitment to fiscal correction, the intentions of the fiscal stimulus have been impeded. The fiscal stimulus lacks sustainability, states Errol D'Souza.

Fiscal Responsibility and Economic Efficiency: A Functional Approach

In both developed and developing countries, there are basically two main sources of economic instability: exogenous shocks and inappropriate policies. Exogenous shock (terms-of-trade shocks, natural disasters and capital flow reversals) can throw an economy into disequilibrium and therefore require compensatory action. On the other hand, a disequilibrium can be self-induced by poor economic macroeconomic management such as an excessively loose fiscal stance. Therefore, economic crisis are often the result of external shocks and poor management. While the worlds of agriculture are vast, varied and rapidly changing, with the right policies and supportive investments at local, national and global levels, today’s agriculture offers new opportunities to hundreds of millions of rural poor to move out of poverty. Similarly, the construction industry is an essential contributor to the process of development. Roads, dams, irrigation works, schools, houses, hospitals, factories and other construction works are the physical foundations on which development efforts and improved living standards are established. This paper there argued that an efficient and functional fiscal policy can have a direct impact on the poor through the distributional implications of tax policy as well as public spending. However, the genuine reformer is distinguished by courage which is that signal that separates the genuine reformer (undertaking transition) from the weak government (hoping to disguise itself).

ORIGINAL SIN, DOLLARIZATION AND FEAR OF FLOATING

In this study, we examine fear of floating behaviors of central banks in countries which have encountered with original sin and dollarization problems at high level, and detect the relationship among original sin, dollarization and fear of floating for Turkish Economy at period of 1999–2007. Emerging market economies (EME) where floating exchange rate regimes are officially applied, original sin and dollarization cause to central banks actually intervene to exchange rate market. On the other hand, EME’s central banks which can not ignore foreign exchange denominated liability of economic agents, want to lessen dimension of huge fluctuations in exchange rate market by using foreign exchange reserves and interest rates and so these central banks act with fear of floating. By these reasons, although EMEs have applied floating exchange rate regimes, central banks can not perform monetary policy operations independent from capital flows. When these symptoms are being considered at the scope of Turkish Economy, we determine that UIG1 and dollarization indexes materialized at highest level during 1999-2007, UIG3 index and YIG indexes decreased respectively beginning from 2002 and 2004. Consequently, Turkish Economy has reflected considerable exposures to thepotential damages of huge fluctuations in exchange rate market which occur in balance sheet of residents at the end of sudden stop and/or reversal of capital flows. Therefore, although floating exchange rate regime has been applied since February 2001 crises, CBRT has intervened the exchange rate market actually. Movements of international rezerves/M2Y, RVER, RVEI indexes have proved that CBRT act with fear of floating. Nevertheless, to accumulate the foreign exchange reserves by CBRT in order to prevent the big fluctuations in exchange rate market imply floating with life jacket during 2002-2007 in Turkish Economy.

Chile: A Changed Jungle for the Latin American Tiger (a)

This case has been used since 2004 in Darden's first-year Global Economies and Markets MBA course in the module on exchange regimes and financial crises. In the early 1990s, in response to massive foreign capital inflows, the Chilean government restricted the flow of capital into the country in order to achieve a competitive and stable exchange rate and to control inflation. By the late 1990s, with the onset of the financial crises in emerging-market economies, investors began to pull their capital out of Chile and other emerging markets indiscriminately. This sudden reversal of capital flows was threatening to ignite a balance-of-payments crisis in Chile. The government must decide what to do. This case also contains information on the development experience of Chile, in particular, on the legacy of General Augusto Pinochet and the economic policies of the Chicago boys. This case may also be used with the B case, Chile: A Jungle for the Latin American Tiger (B) (UVA-BP-0462), which gives an update on the policies of the Chilean central bank up to 1999 and discusses the debate on the economic consequences of the policies. A teaching note (UVA-BP-0458TN) is available.An abridged version of this case exists: Chile: A Jungle for the Latin American Tiger (Abridged) (UVA-BP-0458). It focuses on the economic problems Chile faced from the early 1990s.

Chile: A Changed Jungle for the Latin American Tiger (Abridged)

This case has been used since 2004 in Darden's first-year Global Economies and Markets MBA course in the module on exchange regimes and financial crises.In the early 1990s, in response to massive foreign capital inflows, the Chilean government restricted the flow of capital into the country in order to achieve a competitive and stable exchange rate and to control inflation. By the late 1990s, with the onset of the financial crises in emerging-market economies, investors began to pull their capital out of Chile and other emerging markets indiscriminately. This sudden reversal of capital flows was threatening to ignite a balance-of-payments crisis in Chile. The government must decide what to do. This is an abridged version of the A case Chile: A Jungle for the Latin American Tiger (A) (UVA-BP-0461). The A case contains more detailed information on the development experience of Chile, in particular, on the legacy of General Augusto Pinochet and the economic policies of the Chicago boys. This case may also be used with the B case, Chile: A Jungle for the Latin American Tiger (B) (UVA-BP-0462), which gives an update on the policies of the Chilean central bank up to 1999 and discusses of the debate on the economic consequences of the policies. A teaching note (UVA-BP-0458TN) is available.

Determinants of the Banking Crises in the Turkish Economy

We constructed a monthly banking sector fragility index. According to this index, during the January 1987 – October 2004 period, the Turkish economy experienced three banking crises (in 1988, in 1994 and in 2001), two of which (in 1994 and in 2001) were twin crises. With risks at quite a high level, the banking sector was vulnerable to crises prior to all three events. A number of conclusions emerge from our probit estimations. Currency and banking crises are closely linked, and the twin crises have been the problem of the Turkish economy especially since 1990. The banking crises in Turkey in the aforementioned period were accompanied by sudden reversals in capital flows. A real depreciation of the Turkish Lira increases the likelihood of a banking crisis. An economic contraction reduces the value of the bank assets by making it difficult for the banks’ costumers to repay their credits, thus raising the likelihood of a banking crisis. The ratio of broad money to international reserves significantly affects the probability of a banking crisis, although this does not appear as a significant factor in the 2001 banking crisis.