Global Capital Flows: Raising the Returns and Reducing the Risks
June 17, 1997
Managing Director of the International Monetary Fund
at the World Affairs Council of Los Angeles
California, June 17, 1997
Thank you, ladies and gentlemen.
When historians write the economic history of the late twentieth century, no doubt they will have a lot to say about the surge of private capital into "emerging markets." Private flows to developing and transition economies reached a record high of $235 billion last year--five times the level in 1990. Indeed, not since the opening decade of this century have private capital inflows been such a significant source of financing for developing countries. Why is the world putting so much capital into emerging markets? Is it a good thing? And if so, what can be done to see that the trend continues? As you might imagine, the IMF, with its mandate to oversee the smooth functioning of the international monetary system, has some views on these questions, which I am delighted to share with you.
First of all, why such large flows now? Certainly, the development of the private capital markets over the last 15 years or so has had a lot to do with it. In particular, the removal of restrictions on overseas investment by institutional investors, the elimination of capital controls in developing countries, and, of course, technological advances in telecommunications have all contributed to the unprecedented mobility of private capital today. Low interest rates in the advanced countries and a desire for greater portfolio diversification have also led institutional investors to search out new markets.
But equally important is what has been going on in developing and transition countries themselves. In recent years, many of these countries have established good track records of sound macroeconomic management, including prudent fiscal and monetary policies and low inflation. Many countries have also undertaken various structural reforms--such as removing trade barriers, streamlining investment procedures, and liberalizing their own financial markets--that have made their economies much more attractive to investors. Meanwhile, countries such as Argentina, Mexico, and many formerly centrally planned economies have embarked upon ambitious privatization programs, offering investors a wider range of investment opportunities. I can say--not too immodestly, I hope--that the IMF has played an important role in this process through its policy advice to member countries, its lending programs, and its technical assistance efforts.
As you may have guessed, we at the IMF consider the flows to emerging market economies a very positive development. The benefits for recipient countries and investors are clear. The countries are able to achieve higher levels of investment, faster economic growth, and rising standards of living. Moreover, to the extent that these flows are in the form of non-debt-creating foreign direct investment, countries are receiving larger transfers of technology and business skills, with less risk of ballooning debt-service payments. For investors, the new opportunities in emerging markets have increased the returns on saving and provided an important avenue for portfolio diversification.
Less well appreciated, perhaps, are the substantial benefits for the international economy. Investment in emerging markets, where the return on capital is often higher than elsewhere in the world, helps promote a more efficient allocation of resources and faster growth worldwide. Moreover, as emerging market economies develop, they are taking an increasing share of imports from advanced countries and trading more extensively among themselves. Thus, they have become a source of dynamism in the global economy that can help sustain world growth when economic conditions in the advanced countries are weak. This is indeed what occurred in 1991-93, when the sustained growth in a number of emerging market economies helped cushion the impact of successive recessions in industrial countries.
I would also observe that the competition for private capital flows is a powerful incentive for recipient countries to follow prudent policies and undertake new reforms to improve their domestic investment climate. In this respect, the private capital markets are helping to foster a "virtuous circle" of economic reform, investment and growth. This augurs well for the health and dynamism of the global economy in the years ahead.
For all of the reasons I just mentioned, the potential returns on private flows to emerging markets are high. But what of the risks? As the world saw in Mexico, the presence of large capital inflows requires greater vigilance and foresight on the part of economic policymakers in recipient countries, since policy mistakes can lead to a sudden loss of market confidence and trigger capital outflows, with potentially devastating consequences for other countries.
In addition, as several Asian and Eastern European countries have seen more recently, large capital inflows can also complicate domestic economic management. In particular, strong inflows can put unwelcome upward pressure on the exchange rate and constrain the operation of monetary policy. Unless properly sterilized, these inflows also tend to fuel domestic demand and inflation, but simply raising interest rates may only attract more inflows. In some countries, strains have also been felt in labor and real estate markets. While fiscal tightening and structural reforms are a key part of the policy prescription, they take time to produce results. Meanwhile, the strong growth in domestic demand associated with the inflows often leads to a widening of the current account deficit.
The risks associated with large capital inflows are all the greater when domestic banking systems and supervision are weak, since a rapid expansion of domestic credit may lead to poor lending decisions and undermine the quality of loan portfolios. The problem is worse still if countries have liberalized and/or privatized their financial systems without having ensured that banks and their supervisors can cope in the new environment. In these circumstances, banks often assume more credit, exchange rate, interest rate and other market risks than is prudent. Policymakers are then reluctant to tighten policies when they should, for fear of intensifying banking sector problems.
Risks arise when these factors come together. When large current account deficits financed by ample inflows suddenly seem too high, when banking fragilities are suddenly perceived as vulnerabilities, market sentiment can turn. And then there is the risk of spillover effects. If markets start to lose confidence in one country, they may become more skeptical about others that they believe share similar characteristics, even in other regions. And while the market generally makes reasonable assessments of countries' policies and prospects, its judgment on these fundamentals sometimes seems capricious: money flows in when policies are less than desirable, only to flow out again on a bandwagon of changed investor sentiment.
Time is too short tonight for me to tell you the detailed story of what happened in Mexico at the end of 1994 and how we had to take unprecedented steps to contain the crisis, re-orient domestic policies, and set the stage for Mexico's eventual economic recovery and return to the international capital markets. Suffice it to say that the Mexican crisis prompted in-depth reflection about what could be done to reduce the risks associated with large private inflows to emerging markets.
In the first instance, Mexico focused attention on the importance of countries' maintaining sound domestic macroeconomic policies that will attract and retain the market's confidence. It also brought home the critical importance of establishing solid domestic institutions--especially independent central banks and strong domestic banking systems--that can accommodate tighter fiscal and monetary conditions as the need arises. Likewise, Mexico highlighted the usefulness of structural reforms such as trade liberalization, privatization, and the establishment of transparent regulatory systems, in creating a more favorable investment climate and, thus, increasing the likelihood that capital inflows would be used for productive, long-term investment. Finally, Mexico pointed to the importance of providing the market with accurate, comprehensive, and up-to-date information on economic policies and performance so as to avoid market "surprises" and the sudden shifts in market sentiment that may follow.
I am pleased to report that a number of countries have absorbed these lessons and are acting upon them. Many countries throughout the world have taken important initial steps to strengthen their financial systems. And in Asia, especially, a number of countries have taken appropriate steps to tighten policies and avoid overheating their economies. Indeed, the recent slowdown in Asia should be seen as an appropriate correction following two years of very rapid growth. China, in particular, appears to have achieved a "soft landing," while maintaining very large capital inflows. India has kept inflation and current account deficits at manageable levels, while markedly raising its rate of economic growth and--gradually--opening up to foreign equity capital.
Malaysia is a good example of a country where the authorities are well aware of the challenges of managing the pressures that result from high growth and of maintaining a sound financial system amid substantial capital flows and a booming property market. Of course, the life of policymakers is always easier when one starts, as Malaysia does, with a long history of low inflation and an outward-oriented economy. But significant further progress has been made in dealing with new challenges. Over the last year, output growth has moderated to a more sustainable rate, and inflation has remained low. The current account deficit--which is primarily the result of strong investment spending--has narrowed substantially. The increase in the fiscal surplus targeted for this year is expected to make an important contribution toward consolidating these achievements. The Malaysian authorities have also emphasized maintaining high standards of bank soundness. Non-performing loan ratios of financial institutions have fallen markedly in recent years; risk-weighted capital ratios are above Basle recommendations; and steps have been taken to restrain lending for the property and stock markets. In an effort to increase the flow of comprehensive, up-to-date, and reliable information to markets, Malaysia was also among the first to subscribe to the Fund's Special Data Dissemination Standard--an initiative I will come to in a moment. Of course, as the Governor of the Central Bank of Malaysia, Ahmad Don, said recently, "Despite this positive outlook, there is no room for complacency. Given rapidly changing market conditions, there is a need to remain ever vigilant." That is true in all countries. And it is the kind of attitude that fully justifies the confidence of the markets on the positive prospects of countries persevering in such endeavors.
Clearly, the expansion of the private capital markets has increased the stakes for IMF member countries. What are the implications for the IMF?
Our 181 members are looking to the Fund to help enhance the stability of the global economic and financial system in the following ways:
- one, by encouraging countries to pursue the sound economic and financial policies
required to attract private capital and thereby expand opportunities for investment, trade, and
growth worldwide; we do this through our policy advice, our technical assistance,
and, when appropriate, our financial support.
- two, through this emphasis on appropriate policies, by reducing the risk of a sudden
reversal of capital flows and its potentially destabilizing spillover effects;
- three, when crises do occur--as undoubtedly they will--by helping to ensure that they
are dealt with in ways that are not detrimental to international prosperity; and
- four, by providing a forum in which members can discuss and learn from each
other's policy successes and failures, assess developments in the global economy and, to the
extent possible, defuse emerging problems before they become major crises.
The first point concerns capital account liberalization. The IMF's current mandate calls for it to help eliminate "foreign exchange restrictions that hamper the growth of world trade." It has taken more than fifty years, but we are well on our way to finishing the job: as of today, more than three quarters of our members (139 countries) have, for the most part, eliminated restrictions on current transactions.
But this is not enough. In order for countries to reap the full benefits of an open and liberal system of capital movements, they have to open their capital accounts. Up until now, the IMF's mandate in the areas of restrictions has been limited, essentially, to current transactions, not capital transactions. Now, there is agreement among the membership to add another chapter to our mandate--that is, an amendment to our charter specifically calling upon the IMF to promote capital account liberalization and giving the Fund appropriate oversight over restrictions on capital movements. We will be working on the provisions of this amendment in the coming months.
Needless to say, the point is not to encourage countries to remove capital controls prematurely, or to enjoin them from using capital controls on a temporary basis in emergencies. Rather, the emphasis will be on fostering the smooth operation of international capital markets, and encouraging countries to remove capital controls in a way that is consistent with sustainable macroeconomic policies, strong monetary and financial sectors, and lasting liberalization. This is good for recipient countries, good for investors, and good for the world economy.
This brings me to a second point, which is even more relevant in light of the first: the soundness of domestic financial systems in general, and of banking systems, in particular. As you may suspect, I am often asked where I think the next "Mexico" will occur. I do not know, but of this much, I am sure: the next Mexico will almost certainly start with a banking crisis or be intensified by one. In many countries, poor bank management, weak supervision, and unfavorable macroeconomic conditions have left the banking system in a perilous state. In these circumstances, a banking crisis is an accident waiting to happen. What can be done?
From our perspective, the main emphasis should be on strengthening internal bank management and reinforcing market discipline over banking practices. But there is also a clear need to improve bank regulation and supervision. Our policy dialogue with member countries now places greater emphasis on banking and financial sector problems. At the same time, however, having seen the state of banking systems around the world, the IMF has pointed to the need for a set of "best practices" in the financial area that are internationally recognized and applicable to countries at varying stages of development. We have also indicated our readiness to help disseminate these "best practices" through our policy discussions with member countries. I am happy to say that important steps are now being taken in this direction--such as the Basle Committee's "Core Principles for Effective Banking Supervision." We applaud these steps and hope to see more work in this direction.
The third point concerns transparency. Since market perceptions determine where capital will flow, there is now a much higher premium on accurate and timely information about country economic policies and performance. Besides, better information makes for better investment decisions and fewer market surprises. Thus, the IMF is actively encouraging all countries, but especially those tapping, or hoping to tap, international capital markets, to improve the economic and financial data they provide to the public. In particular, we have helped develop and disseminate a set of standards regarding the coverage, frequency, and timeliness of data; their quality and integrity; and their availability to the public. Countries subscribing to this Special Data Dissemination Standard agree to abide by its principles and to post information on their own specific data practices on an electronic bulletin board on the Internet maintained by the Fund. I am pleased to report that so far, 42 advanced and emerging market economies have subscribed to this Data Standard. Of these, 7 have established "hyperlinks" to their actual economic data, allowing users to access both the information on countries' statistical practices and the data itself, in one common format.
So far, I have focused mainly on issues confronting countries that have access to global financial markets. What about those that don't? This brings me to the fourth point: in this era of global markets, countries face a rather stark choice: either to integrate themselves into the international economy or to become marginalized from it and thus fall farther and farther behind in terms of growth and development. This marginalization--which is a major danger for Africa today--is not only the source of much human misery, but a drag on world growth, and increasingly, a threat to peace.
Part of our mission at the Fund is to help countries make the right policy choices so that they can avoid these pitfalls. Traditionally, IMF assistance has focused on helping countries correct macroeconomic imbalances, reduce inflation, and undertake the key trade, labor, and market reforms needed to improve efficiency and expand production. Indeed, this is still our first order of business in all our member countries. But increasingly, we find that a much broader range of institutional reforms is needed if countries are to establish and maintain private sector confidence, and thereby lay the basis for sustained growth--call it the "second generation" of structural reform. These reforms include a simple, transparent regulatory system, an independent and professional judicial system, and a government that makes cost-effective use of public resources.
Every country that hopes to maintain market confidence must come to terms with these issues associated with "good governance." Our approach at the Fund is to focus on those aspects of "good governance" that are most closely related to our surveillance over macroeconomic policies, such as increasing the transparency of government accounts (an excellent means of controlling corruption!) and encouraging countries to reduce unproductive public expenditure in favor of investments in health, education, and basic infrastructure. I am sure that such orientations will be at the heart of the African initiative that the U.S. government intends to submit to the G7 on the occasion of the Denver summit this week.
You have heard now where the Fund is heading--toward freer capital movements, sounder financial systems, greater transparency, and a more encompassing view of policy reform--all with the goal of enhancing stability and growth in the global economy. What I have not yet made clear, perhaps, is what it takes to get there: and that is the financial support of its shareholders, especially its largest shareholder, the United States. Let me reassure you: I don't plan to pass the hat, at least not here. But I would like you to understand where the Fund gets the bulk of its resources, so that you will see just what a good deal the IMF is for your country, and indeed, all countries.
As you may know, the Fund is a financial cooperative. On joining the Fund, each member country subscribes a sum of money called its "quota," which it pays partly in national currency and partly out of reserves. When a member encounters a need for temporary balance of payments financing and "borrows" from the Fund, it exchanges a certain amount of its own national currency for an equivalent amount of currency of another Fund member in a strong balance of payments position. The borrowing country pays interest at a floating market rate on the amount of currency it is using, while the country whose currency is being used receives interest. When it comes time to "repay," the country exchanges the hard currency it is using for its own national currency.
For a country, rich or poor, subscribing to a quota increase is like putting your money in the bank--it does not reduce your net worth; it does not increase your budget deficit. The U.S., for example, considers its quota subscription an exchange of assets with the IMF, not a budgetary outlay. In fact, in many years, the U.S. has actually made money on its position in the Fund through the interest it receives on other countries' use of dollars, and the exchange rate gains it has realized on its SDR-denominated position.
The economic history of the world over the last fifty years is marked by many occasions when the United States exercised its leadership to help strengthen the world economy: in successive rounds of trade liberalization, in the resolution of the debt crisis, and in the economic transformation of Eastern Europe and the former Soviet Union, among other occasions. In doing these things, the United States has served the common good of the world. It has been able to accomplish all of this, and at relatively little cost to the U.S. Treasury, in large part because it could work through the IMF--and because the IMF, itself, has maintained its financial strength. Our membership is now considering an increase in IMF quotas, to ensure that the IMF continues to have the strength and the credibility to fulfill its functions. Americans are well known for their pragmatism, and I know that your government recognizes the IMF as a reliable messenger of sound policies and a strong supporter of reformers all around the world. Thus, I am confident that America will continue to recognize the benefits of a strong IMF, see what a miraculously good business it is, and give the IMF its wholehearted support.