Lecture 12: Benefits of International Financial Integration e.g., for emerging markets Capital Flows...

Lecture 12:Benefits of International Financial Integration

e.g., for emerging markets

• Capital Flows to Developing Countries• An international debt cycle.• Reasons for flows to emerging markets in the 1990s & 2000s.

• Pros and Cons of Open Financial Markets

• Advantages• The theory of intertemporal optimization• Other advantages

• Disadvantages of financial integration• Procyclical capital inflows• Periodic crises

1st boom

3rd boom (carry trade /

BRICs)2nd boom(emerging markets)

start

start

startstop

(international debt crisis)

stop (Asia crisis)

Three booms in capital flows to developing countries

(recycling petro-dollars)

ITF220 Prof.J.Frankel

Causes of renewed capital flows to emerging market countries in early 1990s

“Pull” factors (domestic): Economic reforms

1. Econ. Liberalization => pro-market environment2. Privatization => assets for sale3. Monetary stabilization => higher returns4. Removal of capital controls => open to inflows

“Push” factors (external): Global financial environment

1. More of Northern portfolios in mutual funds2. Low rates of return in the North

Cross-border factors

1. Brady Plan lifted debt overhang of 1980s2. New vehicles: country funds, ADRs, etc.3. Moral hazard from earlier bailouts?

Developing Countries Used Capital Inflows to Finance CA Deficits in 1976-1982 & 1990-97;

but not 2003-07.

IMF

1st boom(recycling

petro-dollars)

start

start

stop(internationaldebt crisis) stop

(Asiacrisis)

2nd boom(emerging markets)

3rd boom(carry trade & BRICs)


In 2003-07 boom, many countries used the inflowsto build up forex reserves, rather than

to finance Current Account deficits (as in 1990s)

Net Capital Flow

Change in Reserves

Current Account Balance

-4.00

-3.00

-2.00

-1.00

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

% o

f G

DP

in % of GDP(Low- and middle-income countries)

1980-2006international debt crisis

Asia crisis

2nd boom

3rd boom


Advantages of financial opening

• For a successfully-developing country, with high return to domestic capital, investment can be financed more cheaply by borrowing from abroad than out of domestic saving alone.

• Investors in richer countries can earn a higher return on their saving by investing in the emerging market than they could domestically.

• Everyone benefits from the opportunity to diversify away risks and smooth disturbances.


Further advantages of financial openingin emerging-market countries

• Letting foreign financial institutions into the country improves the efficiency of domestic financial markets. It subjects over-regulated and potentially-inefficient domestic institutions – to the harsh discipline of competition and – to the demonstration effect of examples to emulate.

• Governments face the discipline of the international capital markets in the event they make policy mistakes. (“Golden straitjacket” – Tom Friedman)


Welfare gains from open capital markets

1. Even without intertemporal reallocation of output, consumers better off (borrowing from abroad to smooth consumption).

2. In addition, firms can borrow abroad to finance investment

WTP, C, F & J, 2007


THE INTERTEMPORAL-OPTIMIZATION THEORY OF THE CURRENT ACCOUNT, AND WELFARE GAINS FROM INTERNATIONAL

BORROWING

Source: Caves, Frankel & Jones (2007) Chapter 21.5, World Trade & Payments, 10th ed.

=> domestic residents borrow from abroad, so that they can consume more in Period 0.

Assume interest rates in the outside world are closer to 0

than they were at home(the slope of the line

is closer to -1.0).

Welfare ishigher at

point B.

1. Financial opening with fixed output

●

●


THE INTERTEMPORAL-OPTIMIZATION THEORY OF THE CURRENT ACCOUNT, AND WELFARE GAINS FROM INTERNATIONAL BORROWING, continued

Source: Caves, Frankel & Jones (2007) Chapter 21.5, World Trade &Payments.

Shift production from Period 0 to 1,and yet consume more in Period 0,thanks to foreigncapital flows.

Assume interest rates in the outsideworld are closer to 0 than

they were at home.

Welfare is higher at point C.

2. Financial opening with elastic output

●

●

●


CAPITAL ACCOUNT LIBERALIZATION: THEORY, EVIDENCE, AND SPECULATION

Peter Henryhttp://www.nber.org/papers/w12698

Effect when countries open their stock markets to foreign investors on cost of equity capital to domestic firms . Liberalization occurs in “Year 0.”

Cost of capital falls.



Peter Blair Henryhttp://www.nber.org/papers/w12698

Effect when countries open their stock markets to foreign investors on investment.

Rate of capital formation rises.


Does this theory ever work in practice?

Norway discovered North Sea oil in 1970s.

It temporarily ran a large CA deficit,

• to finance investment (while the oil fields were being developed) &

• to finance consumption (as was rational, since Norwegians knew they would be richer in the future).

}

} Subsequently, Norway ran big CA surpluses.


Indications that financial marketsdo not always work so well in practice

• Crises => Financial markets work imperfectly the 1982 international debt crisis; 1992-93 crisis in the European ERM; 1994-95 Mexico; 1997East Asia; 1998 Russia; 2000 Turkey; 2001 Argentina 2007-09 global financial crisis; 2008 Iceland, Latvia…; 2010 Greece.

• It is difficult to argue that investors punish countries when and only when governments follow bad policies: Large inflows often give way suddenly to large outflows, with little

news appearing in between to explain the change in sentiment. Second, contagion sometimes spreads to where fundamentals are

strong. Recessions hitting emerging markets in such crises have been so big,

that the system does not seem to be working optimally.


Indications that financial marketsdo not always work well (continued)

• More generally, capital flows have:

not on average gone from rich (high K/L) to poor (low K/L) countries – The “Lucas paradox;”

often been procyclical, rather than countercyclical.

Appendix 1:

More on opening equity

markets to foreign investment.




Peter Blair HenryWorking Paper 12698

http://www.nber.org/papers/w12698

Effect when countries open their stock markets to foreign investors on growth.


In the early 1990s, portfolio investment

dominated.

This time (2003-07) Foreign Direct

Investment (FDI) was bigger.

Source: IMF WEO, 2007

Appendix 2:More on the EM boomstarting in 2003


This time, China and India shared in the inflows.


But capital inflows financed only reserve accumulation,not current account deficits.



Even Latin America ran CA surpluses and added to reserves!



Central/Eastern Europe is the one emerging markets group that ran worrisome current account deficits, esp. Hungary, Ukraine, Latvia...

Lecture 12: Benefits of International Financial Integration e.g., for emerging markets Capital Flows...

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