Bank of England - Capital Flows

Relationship between capital flows and exchange rates
Ole Rummel CCBS, Bank of England

10 August 2010
ole.rummel@bankofengland.co.uk Exchange rates, foreign reserves management and financial stability, stability, 1010-13 August 2010 Bank of England
The Bank of England does not accept any liability for misleading or inaccurate information or omissions in the information provided.
Outline
Todays presentation Recent trends in capital flows to emerging countries The nature of capital flows Benefits and drawbacks of capital flows Capital flows and exchange rates Capital flows and exchange-rate regimes Dealing with capital flows Summary
ole.rummel@bankofengland.co.uk Exchange rates, foreign reserves management and financial stability, stability, 1010-13 August 2010 Bank of England 2 The Bank of England does not accept any liability for misleading or inaccurate information or omissions in the information provided.
International capital flows (1)

Recent trends in capital flows to emerging countries
ole.rummel@bankofengland.co.uk Exchange rates, foreign reserves management and financial stability, stability, 1010-13 August 2010
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Determinants of capital flows (1)

Push factors Positive:
low-interest rate environment; compression of spreads; and search for yield
Negative:
output sensitivity of emerging market countries to growth slowdowns in advanced economies; correlation in risk premia across markets; and international finance multiplier: redemption calls, margin calls, funding of positions
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Pull factors Positive:
high emerging-market growth prospects; commodity boom; and financial reform
Negative:
historical reputation; trend volatility in fundamentals; fiscal procyclicality; and fragility of external funding mechanism: foreigncurrency debt
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The nature of capital flows (1)

There are different types of capital flows Capital inflows occur when domestic or foreign agents purchase domestic assets with foreign assets Standard international classifications split capital flows into the following three broad categories:
foreign direct investment (FDI) occurs when a nonresident acquires a stake of at least 10% in a domestic enterprise; portfolio investment includes purchases of securities and equity shareholdings; and other capital flows include non-tradable instruments
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Gross international capital flows
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Foreign direct investment (FDI) As the most stable form of capital, FDI is generally assumed to be a stabilising factor during episodes of financial crises in emerging market countries Underlying this view is the notion that FDI is driven by positive longer-term sentiment about the recipient country and, to the extent that it entails physical investment in plant and equipment (and thus a transfer of technology), is more difficult to reverse than other capital flows
ole.rummel@bankofengland.co.uk Exchange rates, foreign reserves management and financial stability, stability, 1010-13 August 2010 Bank of England 8

Some types of capital flows are riskier than others
High degree of risk sharing
Portfolio equity
Foreign direct investment
No risk sharing
Short-term debt
Long-term debt (bonds)
Transitory
Permanent
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Remittances (1)
Definition and nature of remittances Remittances are defined as transfers from international migrants to family members in their country of origin Remittances tend to be a stable, and often countercyclical, source of foreign-exchange earnings But at a macroeconomic level large and sustained remittance flows may lead to (equilibrium) real exchange rate appreciation, with adverse consequences for exports
Remittances (2)
Scale of remittances
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Remittances (3)
Macroeconomic consequences of remittances Given the large size of aggregate remittance flows, they can be expected to have significant macroeconomic effects on the economies that receive them The empirical evidence suggests that:
remittances are positively correlated with real (equilibrium) exchange rate appreciation (hence, there is some evidence of Dutch disease effects (on long-run growth) in remittancereceiving countries (Chami et al. (2008))
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Capital flows and returns Capital inflows occur when investors perceive that the (risk-adjusted) domestic rate of return in the recipient country has risen relative to the international rate of return - capital flows are an early signal that perceptions of domestic economic conditions have changed relative to those abroad Are unfettered capital flows a benign phenomenon and do all financial flows result from rational investment, borrowing and lending decisions?

What does theory tell us? The theory (and empirics) of international capital market integration finds:
large benefits for industrial countries; and some benefits for developing countries, but also problems and vulnerabilities
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Benefits of capital flows (1)

Capital flows have undoubted benefits For recipient countries:
tap foreign savings; lower the cost of capital for borrowers; smooth consumption; help develop financial markets and institutions; and facilitate the transfer of technology and management expertise
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Benefits of capital flows (2)

Capital flows have undoubted benefits For source countries:
improve rates of return available to savers; and allow diversification of portfolios
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Drawbacks of capital flows (1)

Capital flows have potential risks Volatility and reversals of capital inflows (sudden stops) Vulnerability to external shocks (including through regional and international contagion) Limit effectiveness of domestic policy instruments Macroeconomic and financial crises Concerns about ability to absorb capital inflows

Capital flows may lead to higher volatility But capital inflows have also been associated with volatility in variables that central banks use as targets of monetary policy, such as monetary growth, inflation and the exchange rate Liberalisation of capital inflows may also reduce the scope for using interest rates to achieve domestic monetary policy objectives
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Reversals of capital flows International capital flows can also be very volatile in nature, with the tendency of reversing direction when there is the slightest hint of risk, whether it is in the conduct of macroeconomic policies or concerns over the fragility of the financial sector (sudden stops) Changes in the assessment of the economic situation in a country or a currency area can result in significant international shifts in capital, and not infrequently these shifts take place rapidly if it is financial capital that is involved
Sudden stops
Large reversals in capital flows
Mexico, 1993-95 Korea, 1996-97 Mexico, 1981-83 Thailand, 1996-97 Venezuela, 1987-90 Turkey, 1993-94 Venezuela, 1992-94 Argentina, 1988-89 Malaysia, 1986-89 Indonesia, 1984-85 Argentina, 1982-83 0 15% of GDP 11% of GDP 6% of GDP 10% of GDP 7% of GDP 10% of GDP 5% of GDP 4% of GDP 10 20 30 40 50 60 9% of GDP 18% of GDP 12% of GDP
USD billion
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depend on the nature of the flows Policymakers are generally concerned that capital flows are of a kind that are likely to exit an economy owing to a sudden change in sentiment The risks inherent in international capital flows are exacerbated when short-term capital flows are all attracted to the asset markets, which has led to asset bubbles
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Further problems of short-term capital flows Short-term capital inflows may also be associated with concerns over the fragility of the financial system Another circumstance in which economies receive short-term capital inflows is when investors take positions on the basis of expected exchange-rate developments
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Interim summary Capital inflows create important policy challenges because of their potential to generate:
overheating; loss of competitiveness; and increased vulnerability to crisis
Large capital inflows are of particular concern to countries with substantial current account deficits and to countries with inflexible exchange rate regimes (IMF (2007))

Episodes of large net private capital inflows
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Capital flows and asset prices (1)

Is there a relationship? It seems reasonable to suppose that there will be a number of correlations between capital flows, on the one hand, and other financial variables, on the other, including the exchange rate But short-term correlations between the exchange rate and capital flows cannot be simply interpreted as an automatic process of cause and effect
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Capital flows and the exchange rate For example, current exchange rates and exchangerate expectations as well as other factors are no doubt major determinants in the calculations of internationally-operating investors and are therefore reflected in the flows of capital Conversely, capital flows also affect the (expected) movements in exchange rates
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Capital flows and the exchange rate In the recent foreign-exchange microstructure literature, order flow is introduced as a possible determinant of exchange rate movements Capital flows associated with, e.g., rebalancing of portfolios, may initiate foreign-exchange order flows, which, in turn, induce exchange-rate movements A number of recent empirical studies have found significant effects of portfolio flows on (real) exchange rates

Capital flows and the exchange rate Portfolio investment flows, foreign borrowing, aid and income flows are generally found to significantly affect the (real) exchange rate, while flows related to foreign direct investment were not found to influence the (real) exchange rate significantly (Brooks et al. (2001) and Bakardzhieva et al. (2010)) Remittances are found to have disparate effects on the real exchange rate
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Capital flows (1)

and exchange-rate regimes The exchange-rate regime plays an important role in enabling economies to take the maximum advantage of the increasing openness and depth of international capital markets
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Capital flows (2)

and exchange-rate regimes Under a fixed exchange rate system, capital inflows will in the absence of sterilisation potentially conflict with inflation goals Moreover, to the extent that a peg discourages hedging, there is a risk that agents build up unbalanced portfolios
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Dealing with capital flows (1)

The impossible trinity or policy trilemma A country can choose no more than two of the following three features of its policy regime:
(1) free capital mobility across borders; (2) a fixed exchange rate; and (3) an independent monetary policy
How should countries try and resolve this trilemma?
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The policy trilemma
Free capital flows
US
Hong Kong
Independent monetary policy
Fixed exchange rate China

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Approaches to the policy trilemma For the economically advanced nations that use the worlds three key currencies, the benefits of independent monetary policies and capital mobility greatly exceed whatever costs may result from a regime of flexible exchange rates
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Approaches to the policy trilemma Some might argue against allowing developing and emerging-market countries choosing to allow free capital mobility on the grounds that rapid reversals in international capital flows (sudden stops) have induced balance of payments crises and difficult domestic adjustments in the past
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Approaches to the policy trilemma If we agree that every country should set a goal of achieving at least some degree of capital mobility, then the trilemma for developing and other emerging-market countries boils down to the choice between:
flexible exchange rates (and the associated independence of monetary policy); and fixed exchange rates (which do not allow monetary independence)
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Capital flows (1)

and flexible exchange rates A degree of exchange-rate flexibility would raise the exchange-rate risk premium (driving a wedge between the interest-rate differential), helping to dampen interest-sensitive capital flows
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Capital flows (2)

and flexible exchange rates But problems of capital inflows do not vanish under flexible exchange-rate systems Persistent capital inflows put upward pressure on the exchange rate, potentially weakening competitiveness more rapidly than under a fixed regime, and widening external current account deficits Concerns about external sustainability could increase the vulnerability of the country to wide swings in capital inflows

How best to assess capital flows The management of the capital account involves a distinction not only between residents and nonresidents or between inflows and outflows, but also between individuals, corporates and financial intermediaries An appropriate policy response depends not only on an understanding of the underlying causes of capital flows, but also on the knowledge of their likely impact on the economy

What are the issues? Identification of the causes of inflows is very important in determining the appropriate policy response:
do they reflect domestic or external factors? are they temporary or persistent?
Other considerations include the stage of the business cycle, the fiscal policy situation and the quality of domestic financial markets
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Policy instruments
Assessing the effectiveness of policy instruments Policy instruments differ in their effectiveness An effective instrument must fulfil two properties:
it must be macro-relevant; and it must be independent
In general, the more macro-relevant a policy instrument is, the more difficult it is to use it to target specific economic problems
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Policy responses (1)

Allow greater exchange-rate flexibility (appreciation) Insulates the money supply Real appreciation through the exchange rate instead of the price level Reduces one-way bets and deters speculative flows But are risk management tools, such as hedging, available and affordable, particularly considering exchange rate volatility Could affect the competitiveness of exports

Intervene to prevent exchange-rate appreciation Creates domestic liquidity Sterilisation (e.g., open-market operations and reserves requirements) can incur quasi-fiscal costs, act as a tax on the financial sector and paradoxically attract further inflows Lower interest rateswhich could lead to overheating and a conflict with inflation targeting framework for monetary policy

Capital controls Aim is to drive a wedge between domestic and foreign interest rates to enable greater control over domestic monetary conditions when the exchange rate is managed Facilitate financial repression Tend to lose effectiveness over time as financial markets develop synthetic products or discover other ways to evade regulations

Capital controls Lead to administrative challenges and economic costs Could impede financial market development Generally asymmetric: more effective in restraining inflows than controlling outflows Recently used by countries to change the volume and maturity of capital inflows rather than prevent outflows (new results are presented in Binici et al. (2009))
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Capital control measures: some examples
tax measures to reduce net inflows and favour longer-term flows; non-remunerated reserves requirements (deposited at the central bank) on direct foreign borrowing; limits on offshore borrowing by domestic entities and nontrade related swap activity; limits on net open foreign exchange positions of banks; prohibit domestic residents from selling short-term money market instruments to foreigners; and Tobin tax on financial transactions
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Liberalisation of capital outflows Relax restrictions on foreign investment by residents (corporates and households) Relax restrictions on the repatriation of profits, interest and capital Accelerate external debt re-payment Relax exporters foreign-exchange surrender requirements Raise ceilings on tourism allowances for residents

Liberalisation of capital outflows: some examples Private outflows:
allowing domestic households more access to foreign assets; increasing limits on foreign assets of institutional investors; increased FDI investment to secure national resources; and increase overseas production capacity
Public outflows:
SWFs; and diversification of public pension portfolio
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Countercyclical fiscal policy Tighten fiscal stance, especially through reduction in public expenditure Pre-emptive tightening in the presence of volatile flows Advantages and disadvantages Need to consider timeliness and whether such a policy is consistent with domestic needs?
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Financial sector, trade and other structural reforms Longer-terms reforms to improve the flexibility of the economy Regulation of the financial system Trade policies
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Summary Factors determining policy responses include (Reinhart and Reinhart (2009)):
a countrys anti-inflation record; fiscal flexibility and the state of public finances; the openness of the economy; the health of the financial system; the regulatory and supervisory framework; and the size and liquidity of the domestic bond and other capital markets
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and exchange-rate appreciation What policies have been effective in containing upward pressure on the exchange rate?
greater real appreciation has been associated with stronger acceleration of CPI inflation, more sterilised intervention and rising government expenditure; countercyclical fiscal policy in the form of slower growth of government expenditure is associated with lower real appreciation; and tighter controls on capital do not appear to be associated with lower real appreciations
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Managing large capital inflows

Main lessons from IMF (2007) research Fiscal restraint during periods of large capital inflows can help limit real currency appreciation and foster better growth outcomes in the aftermath of such episodes Resisting nominal exchange rate appreciation through sterilised intervention is likely to be ineffective when the influx of capital is persistent Tightening capital controls does not appear to deliver better outcomes
Final thoughts
Capital flows and exchange-rate regimes Insufficiently flexible exchange-rate regimes have the potential to alter the pattern of capital flows and the price of financial assets The fact that official purchases of financial assets are determined by different factors than those influencing private investors suggests that we would probably see a somewhat different combination of capital flows, exchange rates and interest rates in the absence of official intervention
Summary (1)
The magnitude and gyrations of capital flows, rather than the trade deficit and economic growth, are becoming the primary determinant of exchange-rate movements on a day-to-day basis Identification of the causes of inflows is generally more important than analysis of its type, as it helps to determine the appropriate policy response
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Summary (2)
Capital flows are endogenous to economic development: once capital barriers are removed, a capital flow represents a change in expectations or relative returns available in the domestic economy compared with abroad In general, capital controls are found to have little impact on the total volume of capital inflows and thus on currency appreciation Controls on inflows, however, may alter the maturity structure and composition of inflows
Summary (3)
There is no one-size-fits-all way to deal with the impact of potentially destabilising short-term capital inflows but for both macroeconomic and macroprudential reasons, there may be circumstances in which capital controls are a legitimate component of the policy response to surges in capital inflows But supplementary (macroprudential) tools should not be seen as a substitute for sound macroeconomic policies, which are essential in limiting the consequences of volatile capital inflows
Selected further reading (1)

Bailey, A, Millard, S and Wells, S (2001), Capital flows and exchange rates, Bank of England Quarterly Bulletin, Autumn, pages 310-8. Binici, M, Hutchison, M and Schindler, M (2009), Controlling capital? Legal restrictions and the asset composition of international financial flows, IMF Working Paper WP/09/208. Brooks, R, Edison, H, Kumar, M and Slk, T (2001), Exchange rates and capital flows, IMF Working Paper WP/01/190.

Bakardzhieva, D, Ben Naceur, S and Kamar, B (2010), The impact of capital and foreign exchange flows on the competitiveness of developing countries, IMF Working Paper WP/10/154. Chami, R, Baraja, A, Cosimano, T, Fullenkamp, C, Gapen, M and Montiel, P (2008), Macroeconomic consequences of remittances, IMF Occasional Paper 259. Clements, B J and Kamil, H (2009), Are capital controls effective in the 21st century? The recent experience of Colombia, IMF Working Paper WP/09/30.

Deutsche Bundesbank (2002), Consequences of increasing capital flows for exchange rate policy observations and prospects worldwide, Monthly Report, June, pages 55-73. Glick, R and Hutchison, M (2008), Navigating the trilemma: capital flows and monetary policy in China, Federal Reserve Bank of San Francisco Working Paper 2008-32. Ghosh, A R, Ostry, J D and Tsangarides, C (2010), Exchange rate regimes and the stability of the international monetary system, IMF Occasional Paper 270.
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Hammond, G and Rummel, O (2005), Chief Economist Workshop April 2005: exchange rate regimes and capital flows, Bank of England Quarterly Bulletin, Summer, pages 202-10. Hoggarth, G and Sterne, G (1997), Capital flows: causes, consequences and policy responses, CCBS Handbooks in Central Banking no. 14. IMF (2007), Managing large capital inflows, Chapter 3 in the World Economic Outlook, October, pages 105-33.
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Lartey, E K K, Mandelman, F S and Acosta, P A (2008), Remittances, exchange rate regimes and the Dutch disease: a panel data analysis, Federal Reserve Bank of Atlanta Working Paper 2008-12. Ostry, J D, Ghosh, A R, Habermeier, K, Chamon, M, Qureshi, M S and Reinhardt, D B S (2010), Capital inflows: the role of controls, IMF Staff Position Note SPN/10/04. Reinhart, C M and Reinhart, V R (2008), Capital inflows and reserve accumulation: the recent evidence, NBER Working Paper No. 13842.

Bank of England - Capital Flows

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Relationship between capital flows and exchange rates

Ole Rummel CCBS, Bank of England

International capital flows (1)

Determinants of capital flows (1)

Determinants of capital flows (2)

The nature of capital flows (1)

International capital flows (2)

The nature of capital flows (2)

The nature of capital flows (3)

Foreign direct investment

Long-term debt (bonds)

Determinants of capital flows (3)

International capital flows (3)

Benefits of capital flows (1)

Benefits of capital flows (2)

Drawbacks of capital flows (1)

Drawbacks of capital flows (2)

Drawbacks of capital flows (3)

Drawbacks of capital flows (4)

Drawbacks of capital flows (5)

Drawbacks of capital flows (6)

Drawbacks of capital flows (7)

Capital flows and asset prices (1)

Capital flows and asset prices (2)

Capital flows and asset prices (3)

Capital flows and asset prices (4)

Capital flows (1)

Capital flows (2)

Dealing with capital flows (1)

How should countries try and resolve this trilemma?

Dealing with capital flows (2)

Independent monetary policy

Fixed exchange rate China

Dealing with capital flows (3)

Dealing with capital flows (4)

Dealing with capital flows (5)

Capital flows (1)

Capital flows (2)

Dealing with capital flows (6)

Dealing with capital flows (7)

Policy responses (1)

Policy responses (2)

Policy responses (3)

Policy responses (4)

Policy responses (5)

Policy responses (6)

Policy responses (7)

Policy responses (8)

Policy responses (9)

Policy responses (10)

Dealing with capital flows (8)

Managing large capital inflows

Selected further reading (1)

Selected further reading (2)

Selected further reading (3)

Selected further reading (4)

Selected further reading (5)

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