Managing Capital Flows: Key Issues

Determinants of Capital Flows

The surge in capital flows to emerging market economies in the past 20 years or so is a reflection of the rapid expansion and integration of international capital markets that had been driven by economic policy and structural changes, and technological factors. The latter refer to revolutionary advances in handling of information and telecommunications and the emergence of increasingly sophisticated financial engineering. These factors have increased the speed and complexity of capital account transactions. Meanwhile, economic policy and structural changes from the standpoint of developing economies can be categorized into two broad groups: those that are country-specific, or “pull” factors; and those that are external to the country and beyond its control, or “push” factors.

One set of “pull” factors were policies that improved the relations of heavily indebted countries with external creditors. A key element was the role of debt-equity swaps in increasing the expected rate of return on domestic investment projects, thereby encouraging FDI (Calvo et al., 1994). Successful price stabilization programs that were accompanied by improved fiscal policy fundamentals and greater macroeconomic stability were also major pull factors. Lastly, institutional reforms such as the liberalization of the capital account played a significant role in attracting capital flows. Indeed, the right to repatriate dividends and capital may have been the most important factor in the surge of foreign equity flows to emerging market economies (Taylor and Sarno, 1997).

Among the prominent “push” factors were the decline in international interest rates and economic recessions in industrialized countries. These factors reduced profit opportunities in world financial centers and drove international capital to emerging market economies. Another type of push factor was in the mode of contagion effects.

Large shifts in capital flows to one or two large countries in a region may have generated externalities for the smaller neighboring countries (Calvo et al., 1996).

In terms of actual policy adjustments, regulatory changes in the US and Europe made it easier for foreign firms to place their equity and bonds under more attractive conditions to investors. This facilitated the trend towards international portfolio diversification. Meanwhile, competition and rising labor costs in industrialized countries, along with falling transport and communications costs, induced firms to seek opportunities to increase efficiency and returns by producing abroad (Rana, 1998). The realignment of major currencies contributed to this process. The result has been a progressive globalization of production and the growth of FDI flows.

A crucial debate has been on the relative importance of “pull” and “push” factors in the evolution of capital flows. If “pull” factors were the primary determinants of capital flows into emerging market economies, this would support the optimistic view that the sustainability of these flows is to a large extent a function of domestic policies under the control of developing countries. On the other hand, if the surge in capital flows was mostly a result of “push” factors, particularly interest rate movements, this would support the view that the capital flows are highly volatile because they are subject to factors beyond the control of policymakers (Fernandez-Arias, 1996).

The empirical evidence has generally been mixed. Some analysts argue that the weight of the evidence favors the push view—that falling US interest rates have played a dominant role in driving capital flows to developing countries (Fernandez-Arias and Montiel, 1996). Other studies have shown that country specific factors—e.g. the domestic credit rating and black market exchange premium—have been as important in influencing capital flows, particularly portfolio flows (Taylor and Sarno, 1997). The primacy of “pull” factors, however, can be questioned on several counts. Although it is true that not all countries have been recipients of the new inflows, it is also true that flows have not been restricted to countries with well-established track records of macroeconomic and structural adjustment. Second, country creditworthiness depends not only on domestic factors but also on the international interest rate. Third, the significant role of contagion in the 1997 Asian financial crisis points to the relative strength of “push” factors.

Knowledge of the determinants of capital flows has profound implications in terms of appropriate policy responses. In this context, the overriding objective of economic managers is to maximize the benefits of capital flows and minimize their costs.

Advantages of Greater Capital Mobility

Greater capital mobility is generally viewed to be advantageous to the process of economic development. Capital flows to emerging market economies have eased the domestic savings constraint, which in turn has increased investment, thereby boosting economic growth. To the extent that real returns to marginal investment are lower in capital-rich countries than those in capital-scarce countries, the movement of capital from developed economies to emerging market economies improves the efficiency of world resource allocation (Devlin, Ffrench-Davis and Griffith-Jones, 1995).

Instead of raising the investment rate indirectly by providing more resources, capital flows may do so directly in the form of FDI. This type of inflow usually brings a range of dynamic benefits such as technology, improved management practices and greater access to international markets.

The availability of international capital also provides an economy the ability to smooth expenditures especially in the advent of adverse exogenous shocks. Meanwhile, an open capital account for both developed and emerging market economies allows for greater portfolio diversification and better management of risk on the part of investors. This is one of the more common arguments at the microeconomic level for capital account liberalization (Devlin et al., 1995).

Drawbacks of Greater Capital Mobility

The Asian financial crisis was a painful reminder of the risks associated with more open capital accounts. Foreign capital flows may cause imbalances that threaten macroeconomic stability. This situation becomes likely if the absorptive capacity of the economy falls below the level of the capital inflows. Such a disparity arises because of policy arbitrage, where capital flows are attracted by the sound fundamentals of an economy causing financial markets to allocate too much or too little capital to some recipients at a given moment (Guitian, 1998).

If an economy has a flexible exchange rate regime, capital inflows will lead to an appreciation of the nominal and real exchange rates. This will have an adverse impact on the competitiveness of exports and import-substituting industries and result in a deterioration of the current account balance. The resource allocation effects of a real exchange rate appreciation may also spawn asset price bubbles and rapid credit expansion that could jeopardize the stability of the financial system.

In a fixed-exchange rate regime, capital inflows lead to a real exchange rate appreciation via inflationary pressure brought about by the increase in money supply and domestic credit. However, a fixed-exchange rate regime is more vulnerable when there is a net capital outflow. Unless it has adequate foreign exchange reserves, the monetary authority would have to raise interest rates to protect the peg. The likely outcome would be an economic recession.

Many factors could also undermine the efficacy of the capital inflows. The host economy may experience a mere substitution of domestic savings by foreign savings, which would only facilitate a consumption boom. In order to avoid this situation, a relatively high saving rate must be attained in order to generate a trade surplus that will be used to service the foreign debt incurred. But even if this saving rate is attained, an insufficient amount of investment may be channeled to the tradable goods sector (most likely because of the appreciation of the real exchange rate), which would reduce the convertibility of the surplus to foreign currency needed to service the foreign debt. Some analysts have argued that even if capital inflows are channeled completely to investment, the resulting improvement in the growth rate is only short-term in nature unless it is accompanied by a significant improvement in the economy’s technology (Reisen, 1998).

Since capital account inflows inherently entail financial transactions, they are also susceptible to market imperfections associated with asymmetric information and moral hazard. These microeconomic distortions normally result in an inappropriate assessment of risk exposure and cause over-borrowing, making the financial system vulnerable to exogenous shocks. The problem becomes particularly acute when banks are the main intermediaries of capital flows. The situation is even more precarious in emerging markets where the risk-management practices of the private sector are underdeveloped, the capacity of regulators to supervise the financial sector are limited, and the financial markets are thin.

Another potential microeconomic distortion arises from the real sector where aspects such as imperfect competition, externalities or wage rigidity, may result in inappropriate private sector adjustment even if the financial sector is functioning well (Fernandez-Arias and Montiel, 1996). Such static distortions may lead to the choice of a wrong technology and access to foreign capital will magnify the problem (Calvo et al., 1994). Meanwhile, in the event of a sudden capital outflow, these distortions would induce exchange rate overshooting, making the economic adjustment more difficult.

Some Empirical Evidence

Despite the theoretical and intuitive arguments in favor of greater capital mobility, some studies have questioned the benefits of capital flows on empirical grounds. In one study, an indicator of capital account liberalization was included as an explanatory variable for economic growth (Rodrik, 1998). The conclusion reached was that the data provided no evidence that countries without capital controls have grown faster, invested more, or experienced lower inflation.

A more recent study used capital flows directly as an explanatory variable (Levine and Carkovic, 1999). The authors applied more sophisticated econometric techniques to account for simultaneity, country-specific effects and the inclusion of lagged dependent variables as regressors. The study found that the exogenous components of FDI flows and portfolio flows did not exert a positive influence on economic growth. The conclusion is consistent with microeconomic studies that generally suggest that FDI does not boost economic growth primarily because of the absence of evidence of positive spillovers running from foreign-owned to domestic-owned firms.

The study of Levine and Carkovic also looked at the effect of capital flows on productivity growth, which is an important determinant of the variation in long-term growth across economies. This data, too, did not show evidence of a link. However, a separate study by Levine (1999) presented evidence that the entry of foreign banks—a form of direct investment—enhanced the efficiency of the domestic financial system. Meanwhile, international portfolio equity flows were shown to have enhanced domestic stock market liquidity. Other studies have confirmed the positive effects of both financial system efficiency and stock market liquidity on productivity and economic growth. Hence, the study of Levine provided evidence of a transmission mechanism between foreign capital flows, on the one hand, and economic growth, on the other.

The study of Rodrik was criticized by Eichengreen (1998) as being biased. Variables that are negatively associated with growth but positively associated with the decision to open the capital account were inadvertently omitted. The study of Levine and Carkovic and the study of Levine indicate that the evidence on the impact of capital flows is generally mixed. Finally, it is widely accepted by economic analysts that the spectacular growth of several East Asian economies (e.g. Singapore and People’s Republic of China) was due in no small measure to FDI.

An analysis of the macroeconomic impact of capital flows can determine whether the aforementioned drawbacks have materialized. In one study, key economic variables for selected Asian and Latin American economies were monitored using data from 1988– 1994 (Calvo, Leiderman and Reinhart, 1996). Some stylized facts were documented from these observations. First, a substantial portion of the surge in capital inflows was channeled to accumulation of foreign exchange reserves. Second, in most countries the capital inflows were associated with widening current account deficits. Third, there was a rise in consumption spending, which was usually driven by rising imports of durable goods. Fourth, in almost all countries examined, there was rapid growth in the money supply both in nominal and real terms. Fifth, the surge in portfolio flows was accompanied by sharp increases in stock and real estate prices. Lastly, the evidence on the real exchange rate presents a mixed picture. The data indicate that real exchange rate appreciation was more prevalent in Latin America than in Asia.

The stylized facts suggest that the disadvantages associated with capital flows (e.g. increased consumption and real exchange rate appreciation) are likely outcomes. Given the potential benefits of capital flows, it is thus imperative for policymakers to adopt measures that minimize their costs. Strategies for capital flow management can be developed at the domestic, regional and international levels. Policy options that exist in the domestic front can further be classified into macroeconomic and microeconomic responses.

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