Regulation of Capital Flows

2.1 Capital Flows: Internalizing the Externality through Regulation

Issues pertaining to the regulation of capital flows in the international system have been controversial, especially since the 1997–1998 Asian crisis. Up to that point, liberalization of the capital account was thought to be consistent with free-market logic that was dominant in the 1990s. Open capital markets would allow investment to flow to countries where the return was highest, and therefore where it would be the most productive, just as open markets for goods and services allowed for greater efficiency based on comparative advantage. This logic would suggest that developing countries would have the most to gain from open capital flows: after all, they tended to be capital scarce and, therefore, would receive the most investment, leading to gains in output, efficiency, and productivity.

The problem with this approach is that it ignores the externalities associated with international capital flows. These externalities render finance different from international trade, as articulately argued by Bhagwati (2004). International capital flows are a function of many different variables, not merely rates of return. And footloose (short-term) capital inflows into a country can rapidly transform into capital outflows, which under certain conditions could leave the financial system in ruins. Such a reversal was evident in the case of the Asian crisis of 1997–1998. The liberalization of domestic financial institutions beginning in the late 1980s freed up banks and non-bank financial institutions to expand activities locally and internationally. The large current account deficits that accumulated over this period were increasingly financed by short-term capital inflows (rather than long-term flows, such as foreign direct investment (FDI), particularly short-term bank loans. The resulting “double-mismatch” (i.e., maturity and currency mismatches) rendered the region vulnerable to external shocks and contagion.³

Thus, capital flows carry with them the potential for financial systemic risk—i.e., a negative externality. Such an externality does not exist in the context of FDI or trade. In fact, some have characterized the complications as being akin to economic problems associated with pollution (“financial pollution”⁴). In the general theory of second best, this would suggest a theoretical role for government in regulating capital flows.⁵

Kawai and Takagi (2008) identified three types of risks in the event that large capital inflows that are not managed properly. First, poorly managed large inflows can increase macroeconomic risk as they lead to a boom in domestic credit and real exchange rate appreciation. Second, they can produce potential financial instability through the “double-mismatch” phenomenon noted above, as well as leading to asset bubbles. And third, there is a potential for capital-flow reversal (or “financial pollution” effect). Kawai and Lamberte (2008) suggested that dealing with these problems is not easy, but they note that regional approaches to managing capital flows have considerable potential, in particular through greater regional exchange rate coordination, financial market surveillance and integration, and regulatory and supervisory capacity building, perhaps under the auspices of an AFSD.⁶ The AFSD was proposed by Asian Development Bank (ADB) President Haruhiko Kuroda in September 2008; it would include finance ministry and central bank officials, financial regulators and supervisors, and market participants, and could develop an early warning system to ameliorate surveillance of the region's financial markets. The AFSD is discussed at length in Section V.

The Asian experience of this period has reaffirmed that the capital-flow cycle so apparent in the crises of Latin American countries could actually be generalized. This has led to greater skepticism and, certainly, reluctance to embrace open capital markets. Indeed, even Singapore, which has one of the most advanced financial systems in the world, put its foot down when the US insisted on its never using capital controls in negotiations leading to the Singapore-US Free Trade Agreement (Naya and Plummer 2005). In fact, there has been little activity in terms of imposition of capital controls in Asia since the vast majority of the Malaysian capital controls expired one year after their imposition on 1September 1998.⁷ No doubt, this is due to the fact that since the 1997 Asian crisis, the region has generated significant current account surpluses and, hence, the region's economies have become a significant net creditor to the global system. But it is no longer taboo to consider using controls if and when it may be necessary in the future.

Tables 1 and 2 compare the degree of openness of developing East Asian economies relative to other developed and developing regions based on a new database developed by the IMF (Abiad, Detragiache, and Tressel 2008). This database includes financial reforms covering 91 countries over the period 1973–2005. The results are interesting: while developed countries obviously score top marks, East Asian economies are rather middle-of-the-road in terms of their financial liberalization programs. For example, relative to Latin American countries they score lower markets for every financial reform component except the securities market (Table 2 [ PDF 81.4KB | 1 page ]). However, it is also true that East Asian regimes are more stable in terms of back-tracking: they had less frequent “large reversals” in financial-sector-related policies than did Latin America and Africa, receiving a score that is one-half the full-sample average (Table 1 [ PDF 81.4KB | 1 page ]). They also displayed greater reforms in this area than did any other region (including the advanced economies) save the transitional economies, which created an entirely new financial system over this period.

Empirically, as theory would suggest, the economic desirability of capital controls has been a source of controversy. Edison et al. (2002) offers a comprehensive survey of the literature on the economic effects of capital account liberalization, as well as undertaking their own empirical investigation. They came up with several salient conclusions: (i) while developed countries have largely liberalized their capital accounts and there has been a movement in this direction for some developing countries, the majority of developing countries continue to retain significant capital controls; (ii) the empirical literature addressing the issue of capital account liberalization and economic performance is agnostic—that is, there is mixed evidence that capital account liberalization promotes long-term economic growth; (iii) however, their own regression results suggest a positive relationship for East Asian economies and developed countries. Klein (2005) concluded that the ultimate effect of capital account liberalization on economic growth is a positive function of institutional development.

I suggest that the Klein (2005) results are intuitive. But “institutional development” is certainly an elusive term. The US and the United Kingdom arguably had in place what were deemed the most developed financial institutions in the world. Yet, the global economic crisis financial earthquake began with them. If developing financial institutions means moving to the frontier defined by the developed countries, it must be shown that the “best practices” are truly best. Clearly this was not the case in certain aspects of the Anglo-American approach. In this paper, I endeavor to identify means to ensure the creation of a new set of “best practices” within the framework of a more effective regulatory and monitoring system.

2.2 Dealing with the New Finance: Hedge Funds and Regulatory Complications

The financial scandals that emerged in the late 1990s and through the 2001 crisis, of which Enron Corporation was the most notorious case, to no small degree stemmed from off-balance-sheet transactions. These transactions distorted the balance sheets of firms and created problems of transparency (and, sometimes, outright fraud). Included in these transactions were a number of vehicles, including stock options, that were difficult to measure and, hence, were not included as costs to the firm in public reports. Stock options had an important economic role to play; they were designed to bring the goals of management in line with that of stockholders, and thereby address the traditional “principal-agent” problem. Nevertheless, they also had the effect of distorting incentives of management to focus on short-run profits and stock price at the expense of the long-run interests of the firm. Enron manipulated mark-to-market accounting rules and used special purpose entities to effect favorable stock price movements. Enron's price, for example, reached US$90 per share in mid-2000 but fell to US$0.10 by October 2001. While it was famous for its highly-complex and modern approach to risk management, these “cutting edge” practices turned out to be disastrous to the firm, which had used derivatives extensively as well as employed special purpose entities. Its questionable practices should have been picked up by its auditor, famed accounting firm Arthur Andersen, but the latter received hefty auditing and consulting fees from Enron, creating a massive conflict of interest.⁸

The Enron scandal is indicative of how methods deemed “best practices” today could, in fact, be anything but. The complicated nature of finance that has emerged over the past quarter century, including complex derivatives—that few market participants understand completely—and other forms of financial engineering, has made regulating the financial sector increasingly difficult. Sarbanes-Oxley legislation in the US was, perhaps, sufficient to help prevent scandals of the Enron type appearing in the future; it was even criticized by some as being overly-strict. Nevertheless, it did not prevent the emergence of another set of fundamental problems that ultimately revealed themselves with the subprime crisis and, of course, the global economic crisis.

Sophisticated risk-management strategies and complex derivatives often give the impression of effective hedging, stability, and competence when, in fact, they can generate risk exposure significantly beyond expectations, with the potential for catastrophic consequences. When the markets are doing well, such strategies appear to be ingenious.

And if everyone is profiting, there is no reason to look too deep at potential problems.⁹ It is during downturns that the house of cards reveals itself. The MBS and CDS, after all, would pose no systemic risk during an economic expansion. But the housing-market bubble in the US and in other OECD countries was widely anticipated as the instigator of the next recession, and when prices did fall, so did the financial system.

Value-at-risk models within banks and non-bank financial institutions (like investment banks and hedge funds, discussed below), which had also become extremely sophisticated, failed as well. These models work out how much capital to set aside for risky assets. However, they tend to assume that the volatility of asset prices and correlations across prices are constant, when in fact they are not. An episode starring the Hunt brothers, at one time among the richest families in the US, may illustrate the point. The Hunt brothers began to accumulate silver in 1973 and by 1979 essentially cornered the market (with some associates), controlling 50% of global deliverable supply (Trumbore 1999).¹⁰ Silver prices had risen from US$1.95 per ounce in 1973 to a peak of US$54 per ounce in early 1980. When the price of silver collapsed later in 1980, this prompted the Hunts to sell holdings they had in the cattle market to meet margins in silver, thereby causing a precipitous drop in cattle prices as well. This underscores how two markets—silver and cattle—could seem completely independent in theory and recent data trends but in practice are linked by market participants in a largely unpredictable way. To create an effective value-at-risk model, therefore, would require knowledge that would be extremely expensive to obtain (if even available). Yet, mathematical precision in existing value-at-risk models produce a false sense of security. In addition, the potential exogenous shocks were generally assumed to be characterized by a normal distribution, which would suggest that major financial crises would happen extremely rarely, rather than every 10–20 years (as is the case recently).¹¹

This problem is especially present for hedge funds, which are highly-leveraged investment funds. When the Long-Term Capital Management (LTCM) hedge-fund—founded by two Nobel Prize winning economists—collapsed in 1998, systemic risk associated with highly-leveraged positions in these institutions became apparent. Nevertheless, regulation of this sector continued to be extremely mild after LTCM's demise, especially compared to banks and many other financial institutions. Highly-leveraged investment funds have been identified as major actors in the global economic crisis.

In a speech on 17 November 2004, Timothy Geithner, who was at the time President of the New York Federal Reserve Board and is currently the US Secretary of the Treasury, noted that:

Hedge funds combine the classic mix of factors that have been associated with institutions at the center of past instances of stress in financial markets. They can be highly leveraged and can be vulnerable to pressure to liquidate assets quickly if they sustain significant losses. They can be active in complex instruments, and assessing the risks in their exposures is formidably challenging. Additionally, they are not subject to the public disclosure or regulatory reporting requirements that apply to a range of other financial institutions. And they operate largely outside the framework of other requirements established by regulatory authorities to protect the stability of the financial system.

... systemic concerns have two dimensions. First is the possibility that the behavior of hedge funds in periods of market stress could amplify rather than mitigate the shock, induce larger moves in asset prices, or cause broader damage to the functioning of markets when it is most important they function well. Second is the possibility that the failure of a major hedge fund or group of funds could significantly damage the viability of a major financial institution, both through direct exposure to the fund and losses resulting from the impact on other market risks to which the institution is exposed.

These concerns existed before the events associated with Long-Term Capital Management (LTCM) in 1998, but that episode provided a powerful example of both sets of risks, and how the erosion of counterparty discipline can magnify those risks.

Our overall judgement is that the U.S. financial system today is significantly stronger than it was in 1998. It has proven to be quite strong in the face of a number of fairly substantial recent adverse events. And there is some evidence that hedge funds have helped contribute to this resilience, not just in the general contribution they provide by taking on risk, but as a source of liquidity in periods of increased stress and risk aversion in the rest of the financial system.

And yet, hedge funds – and financial leverage more generally – still present a source of potential risk to the financial system.

He does not, however, recommend direct regulation of the sector. He notes that prudential regulations (e.g., through capital or leverage requirements) were not on the horizon in the US, as investors in hedge funds had a strong interest in their being well-managed. He also suggests that, while greater disclosure might reduce systemic risk, he realized that this would pose challenges (given an obvious aversion to revealing investment strategies). Thus, he proposed means to improve risk management of potential exposures.

No doubt, he would take a different approach today. The systemic risks posed by hedge funds were obviously far greater than believed at the time. Risk management techniques suffered from many of the problems noted above. Moreover, the non-transparency of hedge funds—combined with other factors—made the Madoff scandal possible, for example.

The American International Group, Inc., (AIG) case highlights both examples of risk. AIG was rescued by the US government in mid-September 2008 in order to prevent its bankruptcy, which would have had severe—potentially catastrophic—consequences for the national and global economies. While AIG was the world's largest insurer, its financial products division caused its downfall. And as US Federal Reserve Board Governor Ben Bernanke noted, the company was being run exactly like a hedge fund (Torres and Son 2009). At the time of this writing, the company has required US$180 billion in US government financing. In an example of how hedge funds can make things worse, in March 2009, AIG reported a loss of US$7.8 billion due to short-selling of hegde funds of CDSs in which AIG had accumulated significant exposure.

Nevertheless, investment banks particularly in the US were arguably hit the worst in 2008. Famed investment bank Bear Sterns nearly collapsed and Lehman Brothers actually failed; others had to seek government help and reformed as “bank holding companies.”¹² In fact, with the global economic crisis came the virtual disappearance of the once-mighty US investment bank industry (to reappear later in 2009). While the specifics varied by firm, the industry's demise was generally characterized by the collapse in the prices of “structured securities” (soon to be called “toxic assets”), unhedged securitization positions, and the freezing-up of asset markets (Bank for International Settlements [BIS] 2009).

While officials would like to avoid stifling innovation through greater regulation, they are required to ensure stability of the financial system and the avoidance of systemic risk. Given the high leverage associated with hedge-fund-related investments, these non-bank financial institutions are particularly problematic. Greater monitoring of hedge funds and, perhaps, greater regulation will likely result due to the global economic crisis. International rules and regulatory best-practices, therefore, will likely be an important theme for discussion across international regulators in coming years. Monitoring became an important topic for the Financial Stability Forum (discussed in Section III); its Hedge Fund Working Group even launched a set of best-practices standards in January 2008. The Financial Stability Forum will certainly be more important for its successor, the Financial Stability Board, in the future.

2.3 The Credit-rating Agency Issue

As a final issue, the issue of credit-rating agencies should be considered; these entities have been much maligned, particularly in the current crisis. Credit rating agencies are essential to the smooth functioning of asset markets. As they are often used as a regulatory tool for supervisory bodies, regulators need to have sufficient criteria in order to rate credit-rating agencies. The Basle Committee on Banking Supervision suggests the following criteria: objectivity, transparency, credibility, international access, adequacy of resources, and recognition by a national regulatory supervisory authority (see, for example, ADB 1999). The main criticisms of credit-rating agencies during the Asian financial crisis related mainly to questions of transparency, particularly because the ratings that were given to the sovereign debt issued by the crisis-affected economies were seen in the region as exaggerated. In the current crisis, objectivity and transparency have both been called into question.

In theory, reliable credit-rating agencies become increasingly important for sovereign and corporate debt as asset markets develop. However, at the national level in developing Asia, there has not been a great deal of energy put into the development of national credit-rating agencies. Accomplishing this takes a good deal of time; the credit-rating-agency issue, though important, does not appear to be of the highest priority in the short run for most developing Asian economies. Even Singapore, for example, does not have any rating agencies; it requires that non-resident corporations issuing bonds in Singapore dollars obtain investment-grade ratings from two of the three most prestigious international credit-rating agencies (i.e., Standard & Poor's, Moody's, Fitch). For many years, Thailand only had the Thai Rating and Information Services (TRIS), but as of May 2001, a second agency emerged in the market, that is, Fitch-Thailand. The Philippines has three agencies but they are not very active in the sense that any corporate action is really being undertaken by only the top-tier firms that effectively do not require a rating.

Depending on the type, credit rating agencies do play an important role not only in addressing the traditional information asymmetries problem, but also in promoting transparency in the system and, if successful, bringing in a wide variety of firms to asset markets. Reputable credit rating agencies can also help in bringing foreign investor participation to the market.

The fallout from the global economic crisis suggests that the objectivity in the ratings of the major international credit-rating agencies is especially worrisome. Getting ratings from Moody's, Standard & Poor's, and Fitch is very expensive for clients, and lucrative for the agencies themselves. The conflict of interest problem is evident. Moreover, the ratings of “repackaged” financial assets—e.g., MBS—have been heavily criticized. For example, in the US, high-risk subprime mortgages were being sliced up and re-bundled into assets that were given high ratings. Obviously, this method proved to be disastrously improper.

Reforming credit rating agencies will be essential particularly as the 2004 Revised Framework on International Convergence of Capital Measurement and Capital Standards (“Basel II” accord) is implemented. External credit rating agencies will play a greater rule under Basel II in the risk-weighting of bank assets (Tarullo 2008). Improving these agencies—especially in correcting the conflict-of-interest problem but also in improving their ability to rate highly-complex assets—will need to be a priority in the post-global economic crisis architecture.

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