Volatile Capital Flows Research Articles

Financial Turmoil and Choice of Exchange Rate Regime

Financial turmoil is becoming a fact of life in Latin America. The 1990s have been characterized by enormous volatility in the magnitude and cost of capital flows. The correlation of capital swings across disparate countries suggests that the quality of emerging market policies in addition to global factors have been the main actors in this drama. Therefore, the blame for financial turmoil has moved away from inappropriate domestic policies. Instead, the paradigm has shifted to one of determining which policies ¾ domestic or international¾ are most effective in taming the destabilizing effects of inherently volatile capital flows.

Foreign Institutional Investor (Fii) Flows

Worldwide there has been a long debate both in academic and policy circles with regard to the Foreign Institutional Investor (FII) flows, mainly due to their volatility and pro-cyclicality, and consequent adverse impact on the monetary and macro-economic management. Contemporaneous with the global debate, the issue has surfaced and resurfaced in India also in tune with the magnitude of the flows both in upswing and downswing. India has seen massive flows and sudden stops and reversals. The present article is an attempt to analyze the underlying issues and put forth some policy options. Indian approach to capital flows, especially, FII flows, has stood the test of time. The Indian authorities, with a combination of sound macroeconomic policies, prudent debt management, exchange rate flexibility, effective management of the capital account, accumulation of appropriate levels of reserves as self-insurance and development of resilient domestic financial markets, have provided a sustainable response to the large and volatile capital flows.

Strengthening the International Monetary System - Taking Stock and Looking Ahead

The current IMS has survived for over forty years, underpinning strong growth in GDP and in the international exchange of goods and capital, one of its core objectives. As a result, interdependence among the world’s economies has grown dramatically, making the existence of a sound system ever more important. At the same time, the system has exhibited many symptoms of instability—frequent crises, persistent current account imbalances and exchange rate misalignments, volatile capital flows and currencies, and unprecedentedly large reserve accumulation. These symptoms have come to a head since the 2008 crisis and brought renewed international momentum to the idea of attempting to reform the IMS. Yet the debate so far suggests little consensus on the underlying problems, let alone on the solutions. This paper identifies four root causes to these problems: inadequate global adjustment mechanisms to prevent inconsistent or imprudent policies among systemic countries; lack a comprehensive oversight framework for growing cross-border capital flows, covering both source and recipient countries; inadequate systemic liquidity provision mechanisms; and structural challenges in the supply of safe assets.

Challenges and Developments in the Financial Systems of the Southeast Asian Economies

This paper discusses the economies and financial systems of Southeast Asia (SEA) and focuses on challenges and developments in the region. Despite the diversity of SEA economies and some important exceptions, most of them are relatively small but growing strongly. Financial deepening differs among SEA economies. Yet in general, equity markets have grown rapidly and bond markets slowly. The main vulnerabilities of the SEA economies stem from volatile capital flows as well as from decreases in export demand. As a result of national and regional policy responses to the Asian Crisis of 1997/98, the soundness of banking systems has improved, and frameworks to deal with foreign currency liquidity problems and to develop bond markets have been established. Due to these efforts, SEA economies have shown considerable resilience during the current global financial and economic crisis. In some economies, macro-prudential measures may have contributed to this resilience. Capital flows during the current crisis have reminded regional authorities of the risks inherent in these flows. Remaining issues for policy makers to consider are the risks presented by the expanding business activities of banks in the capital and real estate markets, and increasing the participation of SMEs and households in the financial system. JEL Classification: F30, F32, F55, G01, G15, G18, G28, N45 Keywords: Southeast Asia, capital flows, financial crises, financial development, international bond markets

Measuring and explaining the volatility of capital flows to emerging countries

This paper analyzes the determinants of the volatility of the various types of capital inflows into emerging countries. After calculating a proxy of the volatility of FDI, portfolio and bank inflows, we use a panel data model to study their relationship with a broad set of explanatory variables. Our results highlight the difficulties policy-makers face in stabilizing capital flows. Thus, we show that since 2000 global factors beyond the control of emerging economies have become increasingly significant relative to country-specific drivers. However, we identify some domestic macroeconomic and financial factors that appear to reduce the volatility of certain capital flows without increasing that of others.

A new approach to capital flows: Theory and evidence

This paper examines how an open economy determines its financial openness and deals with volatile capital flows when deciding to utilize them for output growth. We find that higher economic instability is an inevitable price paid for faster growth if a country permits wider openness without reversing its financial vulnerability. We prove that the country can leave its capital market wider open to achieve higher growth and lower instability if its financial system has been strengthened substantially. We show why some financially advanced countries request reluctant developing countries to liberalize their immature markets and how the conflict of interest between the two parties is formulated. The paper also presents a large sample of cross-country experiences with tradeoffs between growth and instability, with the observed evidence supporting our theoretical predictions.

Globalism Ascendant, Regionalism Stagnant: Japan’s Response to the Global Financial Crisis

AbstractJapan’s response to the global financial crisis has emphasized global initiatives and downplayed the regional agenda, in sharp contrast with its approach to the Asian financial crisis. This rebalancing in Japan’s economic diplomacy reflects the greater political space that it has enjoyed at the global level since its long-held views on the benefits of flexible International Monetary Fund (IMF) lending practices and controls on volatile capital flows became mainstream. Meanwhile, at the regional level Japan faces stiff competition from China in shaping the regional integration agenda and unchartered territory in coleading a multilateral Chiang Mai Initiative. Despite its enhanced profile, Japan’s new globalism is uneven: it has made a very significant financial contribution to expand the IMF’s resources and to restore trade financing; but Japan has not played a major role in the debate surrounding the most pressing issues of a future financial architecture, such as tackling global imbalances and promoting foreign exchange-rate cooperation. Japan’s muted voice, despite its large financial commitments, reflects its difficult adaptation to the G20 summitry process, as well as political volatility at home, which prevents it from developing measures to deal with the global downturn.

International Mutual Funds, Capital Flow Volatility, and Contagion-A Survey

Gaining a better understanding of the behavior of international investors is key for informing the debate about the optimal response to capital flows and about reforms to the international financial architecture. In this context, recent research on the behavior of international mutual funds at the micro level has expanded our knowledge about the drivers of portfolio flows and the mechanisms behind the transmission of financial shocks across countries. This paper provides a brief survey of this literature, with a focus on the empirical evidence for emerging markets. Overall, the behavior of international mutual funds is complex and overly simplistic characterizations are misleading. However, there is broad-based evidence for momentum trading among funds. Moreover, funds tend to avoid opaque markets and assets, and this behavior becomes more pronounced during volatile times. Portfolio rebalancing mechanisms are clearly important in explaining contagion patterns, even in the absence of common macroeconomic fundamentals. From a surveillance point of view, this implies that monitoring the exposures of large investors at a micro level is crucial to assess vulnerabilities.

International Mutual Funds, Capital Flow Volatility, and Contagion - A Survey

Gaining a better understanding of the behavior of international investors is key for informing the debate about the optimal response to capital flows and about reforms to the international financial architecture. In this context, recent research on the behavior of international mutual funds at the micro level has expanded our knowledge about the drivers of portfolio flows and the mechanisms behind the transmission of financial shocks across countries. This paper provides a brief survey of this literature, with a focus on the empirical evidence for emerging markets. Overall, the behavior of international mutual funds is complex and overly simplistic characterizations are misleading. However, there is broad-based evidence for momentum trading among funds. Moreover, funds tend to avoid opaque markets and assets, and this behavior becomes more pronounced during volatile times. Portfolio rebalancing mechanisms are clearly important in explaining contagion patterns, even in the absence of common macroeconomic fundamentals. From a surveillance point of view, this implies that monitoring the exposures of large investors at a micro level is crucial to assess vulnerabilities.

Can Capital Account Liberalization Lessen Capital Volatility in a Country with 'Original Sin'?

Over the last three decades the volatility in international capital flows has shown an increasing trend in both emerging economies and advanced countries. This study investigates how capital account liberalization affects capital flow volatility using 34 country panel data. Overall, we find that the level of financial openness increases capital volatility. However, after we divide our panel data based on whether or not a country can borrow abroad in its own currency, namely 'original sin', the effect of financial openness appears differently in each group. While in original sin free groups capital openness has no significant effect on capital volatility, it increases the volatility significantly in original sin groups. Also when the sample is limited to countries which established good quality in their institutions, the difference remains between the two groups. It means that the different effects of capital openness on the volatility should be attributed to differences in international status of currencies rather than in institutional quality. This finding suggests that emerging economies whose currencies are not internationalized should be more cautious of capital account liberalization.

Role Reversal in Global Finance

I document that emerging markets have cast off their original sin--their external liabilities are no longer dominated by foreign-currency debt and have instead shifted sharply towards direct investment and portfolio equity. Their external assets are increasingly concentrated in foreign exchange reserves held in advanced economy government bonds. Given the enormous and rising public debt burdens of reserve currency economies, this means that the long-term risk on emerging markets' external balance sheets is shifting to the asset side. However, emerging markets continue to look for more insurance against balance of payments crises, even as self-insurance through reserve accumulation itself becomes riskier. I discuss a possible mechanism for global liquidity insurance that would meet emerging markets' demand for insurance with fewer domestic policy distortions while facilitating a quicker adjustment of global imbalances. I also argue that emerging markets have become less dependent on foreign finance and more resilient to capital flow volatility. The main risk that increasing financial openness poses for these economies is that capital flows exacerbate vulnerabilities arising from weak domestic policies and institutions.

Growth with Moderation and Uncertainty

With heightened uncertainties and moderating global and Western European growth and oil prices, and volatile capital flows, Russia is likely to grow by 4.2 percent in 2010, followed by 4.5 percent in 2011 and 3.5 percent in 2012 as domestic demand expands in line with gradual improvements in the labor and credit markets. Unemployment situation is likely to get worse before it gets better later in 2011. Fiscal risks have risen with likely expenditure pressures and downside risks to oil. While there is huge diversity across regions in the patterns of labor market recovery, smaller regions with a larger share of SMEs, better investment climate, more FDI, and stronger financial sector presence tend to show a more robust recovery.

A Sensible Policy Tool for Pareto Improvement: Capital Controls

This article analyses the fact that managed capital flows under capital controls are superior to free capital flows with market distortions and exposes the empirical invalidity of the orthodox theory, which has become a prevailing ideology but with misleading policy implications. We reformulate the issue of international capital flows by taking into account their inherent volatility and disruptive effects. This article finds that capital freedom may benefit capital-exporting countries at the expense of capital-importing countries due to the financial risk of volatile capital flows. We prove that, as a Pareto improvement policy tool, capital controls, if carefully chosen and properly managed, can make both parties better off by reducing the instability of those flows. It is shown that the source of this Pareto improvement lies in the favourably changed composition of capital flows (more of foreign direct investment (FDI) and less of speculative hot money) under interventions. Thus capital controls should be kept into perspective and cannot be weakened further in developing countries such as China.

Excessive Volatility in Capital Flows: A Pigouvian Taxation Approach

This paper analyzes prudential controls on capital flows to emerging markets from the perspective of a Pigouvian tax that addresses externalities associated with the deleveraging cycle. It presents a model in which restricting capital inflows during boom times reduces the potential outflows during busts. This mitigates the feedback effects of deleveraging episodes, when tightening financial constraints on borrowers and collapsing prices for collateral assets have mutually reinforcing effects. In our model, capital controls reduce macroeconomic volatility and increase standard measures of consumer welfare.

Borrowing Agreement with the Czech National Bank

The last comprehensive discussion of reform of the international monetary system (IMS)—the set of official arrangements that regulate key dimensions of balance of payments—international reserves, exchange rates, current payments, and capital flows—was held nearly four decades ago. In light of repeated and costly international financial crises since then, it is timely to review the structure of the IMS to assess how it can be strengthened and made more resilient. At issue is the confluence of, on one side, an unprecedented build-up in global current account imbalances and volatile cross border capital flows, accompanied by a sharp build-up of international reserves, and on the other side, the concentration of those reserves in a few reserve currencies facing new challenges in maintaining fiscal and financial stability. As pre-crisis trends appear set to resume, this tension calls for examining their broader implications for the stability and efficiency of the current system. While the paper views the problems of the IMS through this prism in the tension between high reserve demand and narrow reserve supply, it also inevitably touches on all the components of the IMS—exchange rate arrangements, capital flows, and the global adjustment process. It should also be seen in the broader context of the Fund’s recent work on IMS stability, which started with a paper focused on exchange rate arrangements last summer and will continue in coming months with another on capital flows.

Excessive Volatility in Capital Flows: A Pigouvian Taxation Approach

This paper analyzes prudential controls on capital flows to emerging markets from the perspective of a Pigouvian tax that addresses externalities associated with the deleveraging cycle. It presents a model in which restricting capital inflows during boom times reduces the potential outflows during busts. This mitigates the feedback effects of deleveraging episodes, when tightening financial constraints on borrowers and collapsing prices for collateral assets have mutually reinforcing effects. In our model, capital controls reduce macroeconomic volatility and increase standard measures of consumer welfare.

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.

Intermediäre und Standards in der Immobilienwirtschaft

Intermediaries and standards in the real estate industry. The aim of the paper at hand is to examine the significance of the integration of financial and real estate markets for urban property markets. It is argued that the integration of both markets has increased the volatility of urban property markets and in particular of the office market of financial cities as London and Frankfurt am Main. International property consultants play a key role in it as knowledge brokers. Through their global office networks they produce and offer information about the outlook of investment possibilities, i.e. urban property markets. In that sense they channel capital which contributes to increased volatility of capital flows into and out of the built environment. Thus, the liberalisation and globalisation of the financial markets as well as modern investment products transformed the urban real estate markets to a great extent.

Government size and openness revisited: the case of financial globalization

SUMMARYThe volatility of international capital flows to emerging markets has been well documented. Financial globalization may not in general fulfill its theoretical role as a risk sharing mechanism in financially underdeveloped economies, and hence may provide an impetus for compensating government spending. Comparative studies of the public sector have provided evidence of a robust positive association between government size and openness of the economy to trade flows. This paper extends the existing literature by investigating the relationship between government size and financial openness for 87 developing and developed countries between 1976 and 2003. The analysis reveals a positive relationship between exposure to international capital flows and government size. Furthermore, interacting capital flows with income levels shows that richer open economies tend to have smaller government size. These findings are consistent with the hypothesis that benefits of financial integration, in terms of improved risk‐sharing and consumption smoothing, accrue only beyond a certain minimum level of financial development.

Foreign capital flows into India: Compositions, regulations, issues and policy options

Existing studies reveals that the huge surge in international capital flows since early 1990s has created unprecedented opportunities for the developing countries like India to achieve accelerated economic growth. International financial institutions routinely advise developing countries to adopt policy regimes that encourage capital inflows. Since the introduction of the reform process in the early 1990s, India has witnessed a significant increase in capital inflows. The size of net capital inflows to India increased from US $ 7.1 billion in 1990-91 to US $ 108.0 billion in 2007-08. Today, India has one of the highest net capital inflows among the EMEs of Asia. Capital inflows, however, not an unmitigated blessing. The main danger posed by large and volatile capital inflows is that they may destabilize macroeconomic management. As evident, the intensified pressures due to large and volatile capital flows in India in the recent period in an atmosphere of global uncertainties has posed new challenges for monetary and exchange rate management. The present paper elaborates on various aspects of the capital inflows to India and their policy implications. Key words: Capital inflows, policy, exchange rate, India.