## 1. Gross Capital Flows into and from Main External Asset Holders ## Source details **Canonical URL:** [1. Gross Capital Flows into and from Main External Asset Holders](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2011/_101311.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2011/_101311.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2011/_101311.pdf.json) --- ### Introduction and key messages - Global crisis beginning in 2007 and its international propagation in 2008 illustrate extensive cross-border linkages in capital flows and that the stability of the global financial system can be considered a global public good. - G20 survey: the vast majority of authorities either were unaware or unable to quantify the impact on capital flows of their own policies. - Important milestones and Fund actions: - December 2010: IMF Executive Board observed there are no universal "rules of the road" for capital flows and saw merit in developing a coherent Fund view on capital flows. - April 2011: Board endorsed a first building block—a possible framework for managing capital inflows—and noted the need for a comprehensive and balanced approach. - IMFC has identified further work on a comprehensive, flexible and balanced approach for the management of capital flows as a priority. - Communiqué of the 24th Meeting of the IMFC, September 24, 2011, is referenced. - This paper adds a building block focusing on multilateral aspects of policies affecting capital flows, emphasizing: - Prudential regulation and supervision in advanced economies. - Monetary policy of large advanced economies. - Multilateral dimension of capital flow management measures (CFMs) adopted by recipient countries. ### Stylized facts—reconsidered in light of the crisis - Scope and definitions: - "Capital flows" = sum of foreign direct investment, portfolio, and other investment flows. - "Gross flows" = either the outflow (asset) or inflows (liability) sides of these transactions. - Key stylized facts: - Stylized fact 1: Intra-advanced economy gross flows embed potential systemic risks—gross flows primarily originate from and flow into advanced economies, producing small net positions but large underlying exposures (Figure 1, 1980–2010). - Stylized fact 2: Global SIFIs bear directly on the riskiness of capital flows—few systemic advanced economies account for the bulk of gross global capital flows and host many global systemically important financial institutions (G-SIFIs) and global capital markets (Table 1). Portfolio and other investment are the most volatile components; banks account for the bulk of other investment. - Stylized fact 3: Volume and volatility of EME capital flows are on upward trends—flows to EMEs have expanded over time and empirical links to global liquidity are noted. ### Global liquidity, global banks, and transmission channels (Box 1) - Global liquidity indicator: sums "core" (deposit) and "non-core" (nondeposit or shadow banking) liabilities for the Euro Area, Japan, the United Kingdom, and the United States. - Historical patterns: - End of the 1990s: the two components were roughly equal. - Pre-crisis: shadow banking (non-core liabilities) grew rapidly, coinciding with expansion in gross cross-border flows, especially portfolio and other investment. - Mechanisms and empirical findings: - Global banks collect liquid funding globally (large amounts from money market mutual funds) and lend globally (including to banks in EMEs) based on global asset allocation strategies. - Cross-border lending volume is a function of banks' capital, interest rate differentials, and leverage; leverage (and liquidity) depend on regulatory and supervisory parameters. - Empirical work: higher global liquidity is correlated with higher global equity prices and other macro-financial outcomes; global liquidity impacts capital flows. - Implication: G-SIFIs and global liquidity are important channels for multilateral transmission of advanced-economy monetary and prudential policies. ### Policy conclusions and emphasis on multilateral effects - Main message: National policymakers should pay more attention to multilateral effects of their policies, especially prudential policies. - Macroeconomic policies can be primary drivers of capital flows, but prudential policies shape the riskiness of those flows. - Prudential policy is most in flux (including macroprudential reforms) and reforms could better take multilateral transmission into account. - Monetary policy of large advanced economies: - Evidence is textured: monetary policy appears to have a direct impact on flows, but indirect effects via global demand and growth can partially offset direct impacts. - Case for explicitly addressing multilateral effects through monetary policy is less clear-cut. - CFMs adopted by recipients: - Recent CFMs have produced mixed cross-border transmission and their unilateral effectiveness is modest to date. - Organizational framing: multilateral aspects discussed in Sections III–V; extension of possible CFM framework in Section VI; issues for discussion in Section VII. ### Volatility and drivers of EME capital flows - Gross inflows into EMEs have become more volatile (Figure 3); more volatile components of cross-border flows have been trending up recently. - Global (push) factors account for a large share of variation in flows to EMEs. - Empirical analysis: lower world interest rates and higher global GDP growth are associated with higher probability of a capital inflow surge in EMEs; greater uncertainty in international markets significantly reduces this likelihood. - Influence of advanced-economy monetary policy on world interest rates implies significant effects on flows to EMEs. - Recent pattern: surge of inflows to EMEs since crisis peak reversed recently. - Scale and persistence: - Net EME capital flows remain large relative to the size of their economies and markets (bottom-right panel of Figure 1); temporary halts can adversely impact macroeconomic stability. - Global liquidity growth appears to affect GDP, credit growth, and asset prices in EMEs. - To forestall effects from large inflows (exchange rates, asset prices, credit growth), some EMEs have turned to CFMs; CFMs could become more widely used. - Capital inflows trending upwards in EMEs (Figure 4) may reflect permanent increase in demand for EME assets (declines in home bias, limited growth potential in advanced economies). - Limits in absorption capacity of many EME financial sectors raise stability concerns. - Continued upward trend in flows to EMEs may strengthen transmission of advanced-economy policies that affect capital flows. ### Transmission channels of regulatory and supervisory policies to capital-flow risk - Foreign exchange liquidity risk channel: - Dependence on short-term U.S. dollar and in some cases euro financing created cross-border maturity transformation exposures. - Cutoff of U.S. MMMF funding and reliance of foreign affiliates on head-office financing transmitted the late-2008 global liquidity shock to recipient countries. - Cross-border counterparty risk channel: - Complex financial linkages generated counterparty risk not fully understood by market participants and authorities (example: reliance on AIGFP). - U.S. MMMFs withdrew funding from European bank counterparties amid viability concerns, freezing cross-border linkages and flows. - Cross-border mortgage market risk channel: - Exposure of European banks to derivatives based on U.S. mortgages was underappreciated by European supervisors. - Swedish and Austrian parent banks’ exposure to real estate risk via affiliates in the Baltics and Eastern Europe exemplifies this channel. - Cross-border credit concentration risk channel: - Overseas loans of Swedish and Austrian foreign affiliates were concentrated regionally and large relative to recipient countries, producing systemic stress and feedback to source countries. - Indirect exchange rate risk channel: - Affiliates funded in dollars or euros and lent in that currency to local-currency earners, exposing recipient countries to downward pressure on local exchange rates when funding dried up. - Home supervisors of foreign affiliates did not fully appreciate this cross-border risk. ### Shortcomings revealed by the crisis - Supervisors often failed to grasp risks outside the regulatory perimeter, especially shadow banking (AIGFP, OTC derivatives, off-balance sheet conduits). - Circumvention of banking regulations via parent-bank direct lending or unregulated affiliates in host countries. - Absence of overarching macroprudential framework left authorities without responsibility for system-wide financial stability. - Policies that safeguard domestic stability also help mitigate cross-border risks; better advanced-economy regulation and supervision consistent with international standards would have made capital flows safer. ### Specific policy recommendations on regulation and supervision (Box 2) - Regulatory perimeter: extend to cover any institution, market, or product that is systemically important—especially those involved in shadow banking—to reduce cross-country regulatory arbitrage. - Information gaps: collect and monitor data on risk exposures of major G-SIFIs (including banks and shadow banking entities: SPVs, MMMFs, MBS issuers), their inter-linkages across borders and markets, and concentration in OTC derivatives markets. - Regulation of OTC derivative markets: increase reporting of transactions and positions; register OTC derivative dealers; apply prudential requirements for OTC derivative risk exposures; clear standardized contracts through CCPs; trade on organized platforms or exchanges. - Macroprudential policies of source countries: develop new frameworks to limit pro-cyclicality and mitigate sudden surges and stops of capital flows. - Micro-prudential policies: limit risks via limits on large exposures and on direct and indirect exposure to foreign exchange risk. - Cross-border supervisor coordination: improve communication and coordination, including joint inspections of consolidated groups and nonconsolidated subsidiaries. - Supervisory capacity: enhance resources for supervisors to deal with cross-border complexities. - Cross-border resolution and burden sharing arrangements: establish arrangements to stabilize market expectations on failure-handling and manage aftermath of serious stress. ### Present context and need for continued reform - Crisis left many advanced economies with financial systems facing ongoing strains amid challenging macroeconomic settings. - Global growth slowed by high public and private debt and leverage left after the crisis, creating need for credible fiscal consolidation timetables and, in some cases, lack of fiscal space for additional expansionary policies (Fiscal Monitor, September 2011). - Orderly private balance sheet deleveraging is needed in many countries (WEO, September 2011). - Banks in several advanced economies still need to build adequate capital buffers amid higher sovereign risk and slow growth (GFSR, September 2011). - Financial spreads have widened and leverage has increased; Euro Area crisis contributed to sharply lower bank equity and signs of stress in money markets led to resumption or expansion of liquidity support by major central banks. ### Low interest rates and search for yield; risks of destabilizing capital flows (paragraphs 29) - Large advanced-economy central banks maintain policy interest rates at historically low levels and inject large amounts of liquidity. - Continued dependence of many large European banks on short-term financing from U.S. MMMFs exposes them to further liquidity squeezes. - Signs that shadow banking may be expanding again. - Destabilizing episodes possible: - Further withdrawal of funding of banks by U.S. MMMFs. - A sudden stop of flows to EMEs. - Potential consequences: slowing the global recovery and possibly another round of cross-border contagion. - Need for more effective regulatory and supervisory policies; reforms underway will influence riskiness of capital flows. - Market participant observations: - Pension funds and insurance companies with fixed liabilities face pressure; many public pension funds target returns "7.5 percent to 10 percent". - Views on QE effects mixed; some consider QE had considerable effects on capital inflows to Korea, Indonesia, India, and the Philippines. - Many market participants skeptical of QE's effectiveness in supporting growth. - Regulatory arbitrage risks highlighted (Box 3): - Examples include potential divergence between Basel III and CRD4; variation in RWAs; differing liquidity requirement implementation (LCR, NSFR); treatment of DTAs; divergent derivatives and margin requirements across jurisdictions; CFTC/SEC minimum CCP capital US$50 million; Volcker Rule implications. ### Market participant views on CFMs and policies affecting capital flows (Box 4) - Investing in EME assets viewed as a structural trend accelerated after the crisis. - Market participants see significant regulatory arbitrage in areas including the Volcker Rule, EU compensation rules, and U.S. derivatives separation. - Low interest rate and easy liquidity environment widely viewed as pushing investors toward riskier assets. - CFMs: - Market participants view capital controls as of secondary importance and did not express strong views about multilateral transmission of CFMs. - Dominant view: capital controls and macroprudential measures have not induced lasting depreciation pressures but have affected arbitrage spreads and composition of flows. - CFMs disadvantage investors via reduced arbitrage and higher funding costs; some CFMs can be circumvented, especially by real-money investors. - Announcement of capital controls may present opportunities for long-term real-money investors if announcement effects depress local markets and currencies. ### Impact of advanced economy monetary policy on capital flows (Section IV) - Monetary policy in major advanced economies affects cross-border capital flows by changing interest rate differentials and by shaping deep asset and money markets that generate and channel liquidity globally. - U.S. monetary policy emphasized given the size of U.S. institutions and markets. - Empirical findings: - U.S. interest rates explain a sizable share of variation in flows to EMEs, particularly bond flows. - Economies with greater financial exposure to the United States are more sensitive to changes in U.S. interest rates (WEO, April 2011, Chapter 4). - Equity and bond portfolio flows of real money investors are driven by growth prospects and country and global risk; interest rate differentials do not play a significant role for these investors (September 2011 GFSR). - Quantitative Easing (QE) effects since 2009: - QE shifted policy toward purchases of long-term public bonds after policy rates reached lower bounds. - Event studies suggest QE1 and QE2 were associated with declines in foreign bond yields, with larger effect for QE1. - QE announcements associated with higher capital inflows to EME bond and equity funds (U.S. Spillover Report). - GFSR (April 2011) found little evidence that cross-border flows surged due to QE, though QE may have prompted asset reallocation into the most liquid EME markets. - Broader transmission: - Macro-model simulations: monetary policy tightening in large advanced economies that stabilizes domestic output reduces negative demand transmission to the rest of the world (WEO, April 2011, Chapter 1). - Several VAR and macro-model studies suggest QE boosted U.S. growth, narrowing growth differentials and slowing inflows to EMEs. - Exceptional liquidity provision by the ECB helped contain spillovers via reduced bank deleveraging. - Policy implications: - Complex multilateral transmission weakens case for major central banks to actively target multilateral effects in monetary policy, though feedback to domestic stability may justify consideration. - Fund will continue periodic assessment of multilateral effects through bilateral and multilateral surveillance. - Prudential policies and tools should be used, when possible, to offset negative cross-border effects of major advanced-economy monetary policy. - Fully effective regulatory and supervisory frameworks for large advanced economies (e.g., regarding G-SIFIs) could mitigate increases in riskiness of capital flows associated with expansionary monetary policy. - Multilateral surveillance, including traditional Fund products and Spillover Reports, can facilitate cross-border policy assessments. ### Capital Flow Management Measures (Section V) - Renewed interest in CFMs warrants greater attention to their multilateral implications. - CFMs encompass residency-based measures (capital controls) and non-residency-discriminatory measures designed to influence flows, including some macroprudential measures. - Fund stance: CFMs can be appropriate within a package of policy actions but cautions about domestic adverse effects if overused or misapplied. - Multilateral transmission channels: - CFMs to curb inflows can reduce asset prices and inflows at home and potentially divert flows to other countries with similar characteristics; anticipation of CFMs spreading could reduce flows and asset prices in neighboring countries. - Empirical evidence on multilateral effects: - Event studies show CFMs have both decreased and increased equity prices and flow quantities in other countries in the same region (Box 5). - Examples: - Brazil (2009–11): CFMs coincided with domestic stock price declines and real depreciation the day after events; equity returns in Mexico moved opposite, suggesting diversion from Brazil to Mexico. - Colombia’s URR in 2007 may have diverted flows to Chile; Thailand’s URR in 2006 may have diverted flows to Indonesia, Korea, Malaysia, and the Philippines. - Korea (June and November 2010): associated with increase in equity prices and appreciation of the won, complicating interpretation. - Flow-data analysis: some evidence of diversion from Brazil to Mexico and Peru; for Chile Brazil’s CFM announcements associated with lower flows; inconsistencies exist between return-based and flow-data results. - Limitations: equity fund flow data available only from 2008 and represent a small portion of total equity flows; event-study detection may miss longer-spreading effects. - Overall assessment: - Mixed multilateral transmission and modest unilateral effectiveness suggest CFMs have limited implications for overall riskiness of capital flows and global stability. - Empirical work suggests capital controls have little effect on overall flows and currency appreciation, though they may change composition temporarily; macroprudential measures may address financial stability concerns but not stem appreciation or slow inflows. - Market participants generally do not view CFMs as effective. - CFMs risk excluding desirable flows and face challenges identifying and targeting destabilizing flows; macroeconomic push and pull factors likely dominate flow behavior. - Risks of proliferation: - If CFMs proliferate amid insufficient regulatory and supervisory reform, countries may adopt progressively more restrictive capital controls, potentially leading to financial protectionism and reduced benefits of financial globalization. - Political pressures and imitation effects could spread CFMs even if unilateral effectiveness is limited, possibly causing foreign investors to pull back and reducing profitability and volume of capital flows. - Fund role: monitor global recourse to CFMs and advise on globally superior alternatives, including well-designed policies affecting capital flows from source countries. ### Conclusions and extension of the proposed framework (Section VI) - National policies can influence the riskiness of capital flows and contribute to instability domestically, regionally, or globally; crisis revealed cross-border feedback loops were not always internalized by policymakers. - Key conclusion: National policymakers should pay greater attention to multilateral transmission of their policies, especially regarding prudential frameworks. - Macroprudential frameworks should incorporate cross-border reciprocity elements and enhance monitoring and mitigation of risks associated with cross-border activities. - Roles of policies: both source and recipient country policies matter for reaping benefits of capital flows while limiting risks. - Highest priority: complete and fully implement national and international regulatory and supervisory reforms underway. - Framework extension: previously proposed framework needs extension to encompass multilateral aspects to provide clearer basis for international policy collaboration. - Fund role: deepen understanding of global drivers of capital flows and national policy impacts; continue bilateral and multilateral surveillance and facilitate policy coordination. - Box 6 — Additional framework elements covering multilateral aspects: - National policymakers of both source and recipient countries should take into account how their policies affect others. - National authorities should share information multilaterally on objectives and implementation of policies affecting capital flows. - National prudential authorities should be mindful of risks associated with cross-border activities and be prepared to take measures to address them. - Effects of capital flows on financial stability should be considered in macroprudential policy frameworks. - Capacity to identify and mitigate risks associated with capital flows—through regulated and non-regulated institutions—should be enhanced and cross-border responsiveness monitored. - Agreement on "reciprocity" in the application of macroprudential policies should be sought. - National authorities should complete and fully implement reforms of the international regulatory and supervisory architecture expeditiously and actively minimize scope for regulatory arbitrage. ### Issues for discussion (Section VII) - Do Directors agree that policies in source countries may impact the volume and riskiness of flows, and macroeconomic and financial stability in recipient countries? - Do Directors agree that global stability is a public good, and that better accounting for multilateral transmission of policies affecting capital flows would help all countries reap benefits while reducing risks? - Do Directors agree that completing and fully implementing national and international regulatory and supervisory reforms and developing new macroprudential frameworks would enhance national and global stability by better accounting for implications of capital flows? - Do Directors support extending the proposed framework to address multilateral aspects of policies affecting capital flows as an additional building block toward a comprehensive, flexible and balanced multilateral approach to management of capital flows? *Source: IMF staff estimates.* ### 1. Gross Capital Flows into and from Main External Asset Holders.........................................7 ### 1. Gross Capital Flows into and from Main External Asset Holders ### Introduction and key messages - The global crisis beginning in 2007 and its international propagation in 2008 illustrate extensive cross-border linkages in capital flows and that the stability of the global financial system can be considered a global public good. - A survey by the G20 found that the vast majority of authorities either were unaware or unable to quantify the impact on capital flows of their own policies. - Important milestones and Fund actions: - December 2010: IMF Executive Board observed there are no universal "rules of the road" for capital flows and saw merit in developing a coherent Fund view on capital flows. - April 2011: Board endorsed a first building block—a possible framework for managing capital inflows—and noted the need for a comprehensive and balanced approach. - IMFC has identified further work on a comprehensive, flexible and balanced approach for the management of capital flows as a priority. - Communiqué of the 24th Meeting of the IMFC, September 24, 2011, is referenced in the paper's context. - This paper adds a building block focusing on the multilateral aspects of policies affecting capital flows, with emphasis on: - Prudential regulation and supervision in advanced economies. - Monetary policy of large advanced economies. - Multilateral dimension of capital flow management measures (CFMs) adopted by recipient countries. ### Stylized facts—reconsidered in light of the crisis - Scope and definitions: - "Capital flows" refers to the sum of foreign direct investment, portfolio, and other investment flows. - "Gross flows" refer to either the outflow (asset) or inflows (liability) sides of these transactions. - Stylized fact 1: Intra-advanced economy gross flows embed potential systemic risks - Gross flows primarily originate from and flow into advanced economies, producing small net positions but large underlying exposures (see Figure 1, 1980–2010). - Risky gross flows can go both ways between advanced economies (example: European bank purchases of U.S. MBSs as inflows into the U.S.; U.S. MMMF financing of European banks as inflows into Europe). - Stylized fact 2: Global SIFIs bear directly on the riskiness of capital flows - A handful of systemic advanced economies account for the bulk of gross global capital flows and are home to many global systemically important financial institutions (G-SIFIs) and global capital markets (see Table 1). - The most volatile components of capital flows are portfolio and other investment; banks account for the bulk of other investment. - The pre-crisis G-SIFI business model relied heavily on global markets and short-term funding (including U.S. dollar funding), accumulated foreign assets (e.g., highly rated U.S. dollar securities), and used derivatives to manage exchange rate risks—leading to high leverage and vulnerability to global dollar liquidity risk. - When unable to roll over short-term U.S. dollar liabilities, G-SIFIs deleveraged rapidly by adjusting the asset side, amplifying systemic distress. - Stylized fact 3: The volume and volatility of EME capital flows are on upward trends (text preceding Box 1 and Figure references indicate expanding flows to EMEs over time; empirical links to global liquidity noted). ### Global liquidity, global banks, and transmission channels (Box 1) - Staff developed a global liquidity indicator that sums "core" (deposit) and "non-core" (nondeposit or shadow banking) liabilities for the Euro Area, Japan, the United Kingdom, and the United States. - Historical patterns: - At the end of the 1990s, the two components of global liquidity were roughly equal. - Pre-crisis, shadow banking (non-core liabilities) grew rapidly and became more important, coinciding with the expansion in gross cross-border flows, especially portfolio and other investment. - Mechanisms and empirical findings: - Global banks collect liquid funding globally (large amounts from money market mutual funds) and lend globally (including to banks in EMEs) based on global asset allocation strategies. - The overall volume of cross-border lending is a function of banks' capital, interest rate differentials, and leverage; leverage (and liquidity) depend on regulatory and supervisory parameters among other things. - Empirical work suggests higher global liquidity is correlated with higher global equity prices and other macro-financial outcomes, and that global liquidity impacts capital flows. - Implication: G-SIFIs and global liquidity are important channels for the multilateral transmission of large advanced-economy monetary and prudential policies. ### Policy conclusions and emphasis on multilateral effects - Main message: National policymakers should pay more attention to the multilateral effects of their policies, especially prudential policies. - Macroeconomic policies can be primary drivers of capital flows, but prudential policies shape the riskiness of those flows. - Prudential policy is also the area most in flux (including macroprudential reforms) and thus where reforms could better take multilateral transmission into account alongside domestic considerations. - Monetary policy of large advanced economies: - Evidence is textured: monetary policy appears to have a direct impact on flows, but indirect effects via global demand and growth can partially offset direct impacts. - The case for explicitly addressing multilateral effects through monetary policy is therefore less clear-cut. - Capital flows management measures (CFMs) adopted by recipients: - Recent CFMs have produced mixed cross-border transmission and their unilateral effectiveness is modest to date, suggesting limited multilateral implications at this juncture. - Organizational framing: - The paper discusses multilateral aspects in Sections III–V (regulation/supervision, monetary policy, CFMs) and extends a previously proposed possible framework for CFMs to address multilateral aspects in Section VI; issues for discussion appear in Section VII. *Source: _1. Gross Capital Flows into and from Main External Asset Holders (excerpts) from the provided IMF chapter/section content.* ### 14. Gross inflows into EMEs have become more volatile (Figure 3). The more volatile ### 14. Gross inflows into EMEs have become more volatile (Figure 3). The more volatile ### Volatility and drivers of EME capital flows - Gross inflows into EMEs have become more volatile (Figure 3). The more volatile components of cross-border flows have been trending up recently (Background Paper, Policy Note II.A), influenced by global monetary and financial conditions. - Global (push) factors have accounted for a large share of the variation in capital flows to EMEs. - New empirical analysis indicates that lower world interest rates and higher global GDP growth are associated with a higher probability of a capital inflow surge in EMEs, whereas greater uncertainty in international markets significantly reduces this likelihood (Background Paper, Policy Note II.B). - The influence of monetary policy in major advanced economies on world interest rates suggests they may have significant effects on capital flows to EMEs. - The surge of capital inflows into EMEs since the peak of the crisis, attracted by brighter growth prospects and stronger fundamentals combined with low interest rates in advanced economies, has recently reversed. ### Scale, persistence, and potential impacts - Net EME capital flows remain large relative to the size of their economies and markets (bottom-right panel of Figure 1). Hence even a temporary halt in flows can adversely impact macroeconomic stability. - Global liquidity growth appears to affect GDP, credit growth, and asset prices in EMEs (Box reference in source). - To forestall potential effects from large inflows—including undue effects on exchange rates, asset prices and credit growth—some EMEs have again turned to CFMs to help deal with these pressures (Section V), and CFMs could become more widely used. - Capital inflows have been trending upwards in EMEs (Figure 4). This may reflect a permanent increase in the demand for EME assets, driven by declines in home bias and more limited growth potential in advanced economies. - Limits in the absorption capacity of many EME financial sectors call into question the stability implications of this trend. - A continued upward trend in flows to EMEs may generally strengthen the transmission of advanced economy policies that affect capital flows. ### Transmission channels of regulatory and supervisory policies to capital-flow risk - Foreign exchange liquidity risk channel - Dependence on short-term U.S. dollar and in some cases euro financing created cross-border maturity transformation exposures. - Cutoff of U.S. MMMF funding and reliance of foreign affiliates on head-office financing transferred the late-2008 global liquidity shock to recipient countries. - Exposure to drying up of global liquidity was not adequately appreciated by national financial authorities in source or recipient countries; many countries had to provide emergency liquidity. - Cross-border counterparty risk channel - Complex financial linkages generated cross-border counterparty risk not fully understood by market participants and authorities. - Reliance of G-SIFIs on mortgage default protection from AIG Financial Products (AIGFP) exposed them to counterparty risk when AIGFP could not meet obligations, prompting large-scale official liquidity support. - U.S. MMMFs withdrew funding from European bank counterparties amid viability concerns, freezing cross-border linkages and flows. - Cross-border mortgage market risk channel - Exposure of European banks to derivatives based on U.S. mortgages was underappreciated by European supervisors due in part to strong credit ratings and use of off-balance sheet conduits. - Exposure of Swedish and Austrian parent banks to real estate risk taken on by affiliates in the Baltics and Eastern Europe exemplifies this channel. - Cross-border credit concentration risk channel - Overseas loans of Swedish and Austrian foreign affiliates were concentrated regionally and large relative to recipient countries, producing systemic stress when losses occurred and feeding back to source countries. - Indirect exchange rate risk channel - Affiliates raised funding in dollars or euros and lent in that currency to local-currency earners, exposing recipient countries to downward pressure on local exchange rates when funding dried up. - Home supervisors of foreign affiliates did not fully appreciate this cross-border risk. ### Shortcomings revealed by the crisis - Supervisors often failed to grasp risks outside the regulatory perimeter, especially those related to shadow banking (e.g., AIGFP was essentially unregulated; OTC derivatives traded outside regulation; off-balance sheet conduits avoided regulation). - Circumvention of banking regulations occurred through parent-bank direct lending to corporations or by setting up unregulated affiliates in host countries. - The absence of an overarching macroprudential framework left national authorities and prudential regulators without responsibility for system-wide financial stability; cross-border linkages were more complex and largely outside the policy purview. - Policies that safeguard domestic stability also help mitigate cross-border risks; better advanced-economy regulation and supervision—consistent with international standards—would have made capital flows safer. ### Policy recommendations (Box 2: Specific Policy Recommendations on Regulation and Supervision) - Regulatory perimeter—Extend the perimeter to cover any institution, market, or product that is systemically important—especially those involved in shadow banking—to reduce cross-country regulatory arbitrage. - Information gaps—Collect and monitor data on risk exposures of major G-SIFIs (including banks and shadow banking entities: SPVs, MMMFs, MBS issuers), their inter-linkages across borders and markets, and concentration in OTC derivatives markets to help assess the riskiness of flows. - Regulation of OTC derivative markets—Increase reporting of derivative transactions and trading positions; register OTC derivative dealers; apply prudential requirements for OTC derivative risk exposures; clear standardized contracts through CCPs; and trade on organized platforms or exchanges to prevent market disruptions that lead to cross-border stress. - Macroprudential policies of source countries—Develop new macroprudential frameworks to limit pro-cyclicality and mitigate sudden surges and stops of capital flows. - Micro-prudential policies—Limit risks embedded in capital flows via limits on large exposures and limits on direct and indirect exposure to foreign exchange risk. - Cross-border supervisor coordination—Improve communication and coordination, such as joint inspections of consolidated financial groups and nonconsolidated subsidiaries, to reduce regulatory arbitrage and destabilizing cross-border risk shifts. - Supervisory capacity—Enhance resources to allow supervisors to deal with complexities of cross-border linkages. - Cross-border resolution and burden sharing arrangements—Establish arrangements to stabilize market expectations on failure-handling and to manage aftermath of serious stress. ### Present context and the need for continued reform - The crisis left many advanced economies with financial systems facing ongoing strains in a challenging macroeconomic setting. - Global growth is being slowed by high public and private debt and leverage left after the crisis, creating a pressing need for credible fiscal consolidation timetables and, in some cases, a lack of fiscal space for additional expansionary policies (Fiscal Monitor, September 2011). - Orderly private balance sheet deleveraging is needed in many countries (WEO, September 2011). - Banks in a number of advanced economies still need to build adequate capital buffers amid higher sovereign risk and slow growth (GFSR, September 2011). - In view of these uncertainties and their impact on the value of financial assets, financial spreads have widened and leverage has increased. - The Euro Area crisis has contributed to sharply lower bank equity while signs of stress in money markets have led to a resumption or expansion of liquidity support by major central banks. *Source: _101311 - 14. Gross inflows into EMEs have become more volatile (Figure 3). The more volatile* ### 29. Low interest rates seem to be leading to riskier behavior via the search for yield. ### 29. Low interest rates seem to be leading to riskier behavior via the search for yield. ### Low interest rates and search for yield - Large advanced economy central banks are maintaining policy interest rates at historically low levels and are injecting large amounts of liquidity. - The continued dependence of many large European banks on short-term financing from U.S. MMMFs exposes them to yet another liquidity squeeze. - There are signs that shadow banking may be expanding once again. ### Risk of destabilizing capital flows and contagion scenarios - A ratcheting up of financial sector stress could lead to destabilizing capital flows. - Continued low growth and risky behavior in individual advanced economies or regions could ultimately lead to a renewal of systemic financial stress. - Potential destabilizing capital flow episodes described: - Further withdrawal of funding of banks by U.S. MMMFs. - A sudden stop of flows to EMEs. - Consequences: - At minimum, slowing the global recovery. - Possibly another round of cross-border contagion. - Recent developments likely reflected such contagion. ### Need for more effective regulatory and supervisory policies - Stronger regulation and supervision are needed to limit financial stability risks and those transmitted via capital flows. - Regulatory and supervisory reforms take on special urgency in the current setting. - Reforms to the international regulatory and supervisory architecture now underway will influence the riskiness of capital flows. - Reforms aim to address shortcomings in national policies revealed by the crisis, while ensuring globally consistent rules and a level playing field. - Outcomes will have important consequences for EMEs and global stability, including risks posed by capital flows. - Substantial progress has been made on addressing systemic stability risks posed by G-SIFIs, but progress in other areas has been uneven (Background Paper, Policy Note II.C). ### Regulatory arbitrage risks (Box 3 highlights) - Slow progress with the global reform agenda may generate regulatory arbitrage opportunities and undermine global stability. - Linkages between European banks and U.S. markets that generated systemic risks during the crisis can be explained in large degree by regulatory arbitrage opportunities combined with strong competitive pressures and uneven market development. - Specific examples of regulatory arbitrage opportunities and divergent implementation risks: - Basel III / CRD4: - The draft legislation recently presented by the European Commission (CRD4) is in certain areas less prescriptive/ambitious than the Basel III framework; this could trigger a "race to the bottom" or shift risky activities to less well-regulated jurisdictions. - Risk weighted assets (RWAs): - Considerable variations in risk weights applied by banks, with concern over extremely low levels for mortgages in some jurisdictions. - Material discretion granted to banks by national regulators in determination of RWA may lead to significant understating of risks and inflate capital adequacy ratios. - Liquidity requirements: - Basel III is finalizing a short-term liquidity coverage ratio (LCR) and a long term net stable funding ratio (NSFR). - Substantially diverse implementation across jurisdictions could interact adversely with varying starting liquidity positions and national availability of liquid assets. - Deferred tax assets (DTAs): - DTAs are treated more generously under CRD4 in Europe compared to in the United States, allowing European institutions to carry a larger balance sheet for a given level of capital (excluding DTAs). - Carving out risky bank activities: - Dodd-Frank Act (Section 716) separation of derivatives in the United States will result in U.S. banks having two derivative books, likely higher collateral requirements, and potentially lower rates of return for a given capital base. - Financial markets: - Proposed U.S. margin requirements for uncleared OTC derivatives are more stringent than those proposed in other jurisdictions; forthcoming European Commission margin requirements under EMIR may also differ. - EMIR exempts official entities from full collateral and margin requirements, while U.S. regulations do not. - ISDA master agreements governed by either New York or English law could create incentive to book under English law to avoid Dodd-Frank Act. - The CFTC and SEC allow CCPs to operate with a minimum capital of only US$50 million, raising the possibility of a larger-than-optimal number of CCPs; the European minimum capital criterion is still under discussion and is expected to be much higher. - CFTC commodity limits under consideration could shift business away from the United States while not reducing global risks. - Supervisory perimeter: - Volcker Rule (Section 619 of the Dodd-Frank Act) will require large U.S. banks to offload proprietary trading and hedge fund business, reducing risky activities of banks but possibly shifting some activities outside the regulatory perimeter to jurisdictions with weaker regulations. ### Market participant views on policies affecting capital flows (Box 4 highlights) - Investing in EME assets is viewed as a structural trend accelerated following the crisis, supported by low returns and higher risks in advanced economies and high liquidity in some large EME markets. - Regulation and supervision: - Market participants see significant regulatory arbitrage in areas including the Volcker Rule, EU compensation rules, and separation of derivatives in the United States. - Differences in timing of OTC derivatives rule implementation between the United States and the EU could create regulatory arbitrage. - Lack of regulatory harmonization and disappointing progress could make global markets more unstable. - Monetary policy in advanced economies: - Low interest rate and easy liquidity environment is widely viewed as pushing investors to invest in more risky assets. - Pension funds and insurance companies with fixed liabilities are most under pressure; many are underfunded and cannot earn enough without taking on more risky assets. - A surprising number of pension funds, public ones in particular, have high fixed target returns "7.5 percent to 10 percent" that may be unsustainable in the current low interest rate environment, forcing them to hold more equities and alternative assets. - Views on the Federal Reserve's Quantitative Easing (QE) effects in Asia are mixed; some participants in Asia consider QE had considerable effects on significant capital inflows to Korea, Indonesia, India, and the Philippines. - Many market participants are skeptical as to the effectiveness of QE in supporting growth. - Capital Flow Management Measures (CFMs): - Market participants report that capital controls are of secondary importance and did not express views about multilateral transmission of CFMs. - Dominant view: capital controls and macroprudential measures have not induced lasting depreciation pressures, but have affected arbitrage spreads and composition of flows. - CFMs are disadvantageous to investors via reduced arbitrage and higher funding costs. - Some participants raised concerns about less visible CFMs (e.g., classifications of industries for which foreign investment is prohibited) increasing costs and risks of investing. - Announcement of capital controls may present opportunities for real-money long-term investors if announcement effects depress local markets and currencies. - Many participants noted that CFMs can be circumvented, especially by real-money investors. ### The policy message and recommendations - Macroeconomic policies may be the main driver of capital flows, but prudential policies influence their riskiness. - Evidence from the run up to the crisis shows shortcomings in regulation and supervision allowed banks and other market participants in advanced economies to take excessive cross-border risks that led to macrofinancial instability in recipient countries. - More effective regulatory and supervisory policies would help limit signs of systemic stress that are reappearing, including those transmitted via capital flows. - Completing and implementing national regulatory and supervisory reform agendas is especially urgent: - The same national regulatory and supervisory policies that foster domestic stability also support stable capital flows. - Upgrading national regulation and supervision frameworks to international standards would provide incentives to market participants to limit cross-border risks. - Bilateral and multilateral Fund surveillance, together with the Financial Stability Board (FSB) and other international bodies, can help ensure national reforms align with international standards. - Effective national macroprudential policy frameworks can complement and reinforce microprudential regulatory and supervisory policies: - Macroprudential policies aim at systemic financial stability and can shape incentives of markets and institutions and identify systemically important institutions outside the regulatory perimeter. - New macroprudential institutional arrangements should be completed and instruments further developed. - Close coordination between macroprudential and microprudential authorities, including sharing information and analysis on cross-border institutions and markets, would enhance policy effectiveness. - Macroprudential policies could be employed by source countries if risks from capital outflows bear on domestic stability. - Improved national prudential frameworks are "win-win": more effective supervision and development of macroprudential policies benefit both source and recipient countries and the global system. - Full reform of the international architecture would establish an overarching framework, reducing the riskiness of capital flows: - Significant progress has been made on G-SIFIs; more progress is needed in defining bank capital and setting up new liquidity rules. - Reforms must be effectively implemented at national and international levels; the Fund together with the FSB are working to help ensure reforms mitigate cross-border risks. - Cross-border coordination, including of macroprudential policies, and cross-border resolution of G-SIFIs would help mitigate the riskiness of capital flows: - The cross-country "jurisdictional reciprocity" of the Basel III counter-cyclical capital cushions is a positive step. - Reciprocity could be extended to use of macroprudential tools to limit capital flows aimed at circumventing domestic measures. - Developing cross-border coordination may take time as national frameworks are often in early stages; ensuring cooperation on resolution of G-SIFIs is paramount to avoid stress transmitted through capital flows. - The Fund could facilitate ongoing dialogue among macroprudential authorities to identify and mitigate cross-border risks. *Source: _101311 - 29. Low interest rates seem to be leading to riskier behavior via the search for yield.* ### 41. National regulatory and supervisory reforms, together with a new international ### 41. National regulatory and supervisory reforms, together with a new international architecture, would form a financial policy web that would enhance global stability and reduce the riskiness of capital flows ### IV. THE IMPACT OF ADVANCED ECONOMY MONETARY POLICY ON CAPITAL FLOWS - Monetary policy decisions in major advanced economies affect cross-border capital flows by changing interest rate differentials and by shaping deep asset and money markets that generate and channel liquidity globally. - U.S. monetary policy is emphasized given the size of U.S. financial institutions and markets; other large reserve currency issuers also matter. - Empirical findings: - U.S. interest rates explain a sizable share of the variation in flows to EMEs, particularly bond flows (Background Paper, Policy Note II.B). - Economies with greater financial exposure to the United States are more sensitive to changes in U.S. interest rates (WEO, April 2011, Chapter 4). - Equity and bond portfolio flows of real money investors are driven by growth prospects and country and global risk; interest rate differentials do not play a significant role for these investors (September 2011 GFSR). - Quantitative Easing (QE) effects since 2009: - QE by major central banks, especially the Federal Reserve, shifted policy toward purchases of long-term public bonds after policy rates reached lower bounds. - Event study analysis suggests QE1 and QE2 were associated with declines in foreign bond yields, with a notably larger effect for QE1.19 - QE announcements were associated with higher capital inflows to EME bond and equity funds (U.S. Spillover Report). - Market participants view the easy liquidity environment as pushing investors toward riskier assets (Box 4). - GFSR (April 2011) found little evidence that cross-border flows surged due to QE, though QE may have prompted asset reallocation into the most liquid EME markets. - Broader transmission considerations: - Macro-model simulations indicate that monetary policy tightening in large advanced economies that stabilizes domestic output reduces negative demand transmission to the rest of the world (WEO, April 2011, Chapter 1). - Several VAR and macro-model studies suggest QE boosted U.S. growth, narrowing growth differentials and slowing inflows to EMEs.20 - Exceptional liquidity provision by the ECB helped contain spillovers via reduced bank deleveraging. - In the absence of QE, a more severe downturn could have triggered a prolonged reversal of flows to EMEs. - Policy implications: - The complex multilateral transmission weakens the case for major central banks to actively target multilateral effects in monetary policy, though feedback effects to domestic stability may justify their consideration. - The Fund will continue periodic assessment of multilateral effects through bilateral and multilateral surveillance. - Prudential policies and tools should be used, when possible, to offset negative cross-border effects of major advanced economy monetary policy. - Fully effective regulatory and supervisory frameworks for large advanced economies (e.g., with respect to G-SIFIs) could mitigate increases in the riskiness of capital flows associated with expansionary monetary policy. - Multilateral surveillance, including traditional Fund products and Spillover Reports, can facilitate cross-border policy assessments. ### V. CAPITAL FLOW MANAGEMENT MEASURES - Renewed interest in CFMs warrants greater attention to their multilateral implications.21 - CFMs overview: - CFMs encompass residency-based measures (capital controls) and non-residency-discriminatory measures designed to influence flows, including some macroprudential measures.21 - The Fund acknowledges CFMs can be appropriate within a package of policy actions but cautions about domestic adverse effects if overused or misapplied.22 - Multilateral transmission channels: - A CFM designed to curb inflows can reduce asset prices and inflows at home and potentially divert flows to other countries with similar characteristics. - Alternatively, anticipation of CFMs spreading could reduce flows and asset prices in neighboring countries. - Empirical evidence on multilateral effects: - Event studies of one-day market reactions indicate CFMs have both decreased and increased equity prices and flow quantities in other countries in the same region (Box 5; Background Paper, Policy Note II.E). - Examples from Box 5: - Brazil (2009–11): CFMs coincided with domestic stock price declines and real depreciation the day after events; equity returns in Mexico moved opposite on those dates, suggesting diversion of flows from Brazil to Mexico. - Colombia‘s URR in 2007 may have diverted flows to Chile; Thailand‘s URR in 2006 may have diverted flows to Indonesia, Korea, Malaysia, and the Philippines. - Korea (June and November 2010): associated with an increase in equity prices and appreciation of the won, making multilateral effects difficult to interpret. - Analysis using daily equity fund flow data shows some evidence of diversion from Brazil to Mexico and Peru, while for Chile Brazil‘s CFM announcements were associated with lower flows; these flow-data results are not entirely consistent with equity-return-based findings. - Limitations: flow data to equity funds available only from 2008 and represent a small portion of total equity flows; event-study detection of diversion may miss effects that spread over time or depend on surprises, severity, and investor understanding. - Overall assessment: - Mixed multilateral transmission and modest unilateral effectiveness suggest CFMs have limited implications for overall riskiness of capital flows and global stability. - Empirical work suggests: - Capital controls have little effect on overall flows and currency appreciation, though they may change composition of flows temporarily. - Macroprudential measures may address financial stability concerns but not stem appreciation or slow inflows.23 - Market participants generally do not view CFMs as effective (Box 4). - CFMs risk excluding desirable flows and face policy challenges in identifying and targeting destabilizing flows; macroeconomic push and pull factors likely dominate flow behavior (Background Paper, Policy Note II.B).24 - Risks of proliferation: - If CFMs proliferate amid insufficient regulatory and supervisory reform, countries may adopt progressively more restrictive capital controls, potentially leading to financial protectionism and reduced benefits of financial globalization.25 - Political pressures and imitation effects could spread CFMs even if unilateral effectiveness is limited, potentially causing foreign investors to pull back and reducing the profitability and volume of capital flows. - The Fund should monitor global recourse to CFMs and advise on globally superior alternatives, including well-designed policies affecting capital flows from source countries. ### VI. CONCLUSIONS AND EXTENSION OF THE PROPOSED FRAMEWORK - National policies can influence the riskiness of capital flows and contribute to instability domestically, regionally, or globally; the crisis revealed that cross-border feedback loops were not always internalized by policymakers. - Key conclusion: - National policymakers should pay greater attention to the multilateral transmission of their policies, especially regarding prudential frameworks. - Macroprudential frameworks should incorporate cross-border reciprocity elements and enhance monitoring and mitigation of risks associated with cross-border activities. - Roles of policies: - Both source and recipient country policies matter for reaping benefits of capital flows while limiting risks. - Highest priority should be given to completing and fully implementing national and international regulatory and supervisory reforms underway. - Framework extension: - The previously proposed framework (Box 1 of Recent Experiences in Managing Capital Inflows—Cross-Cutting Themes and Possible Policy Framework) needs to be extended to encompass multilateral aspects to provide a clearer basis for international policy collaboration. - The Fund has the mandate and tools to deepen understanding of global drivers of capital flows and national policy impacts and should continue bilateral and multilateral surveillance and facilitate policy coordination. - Over time, in consultation with others such as the FSB, more specific policy advice for managing capital flows may be developed; in the meantime, new framework elements covering multilateral aspects should be put forth to underpin consistent and evenhanded Fund advice in bilateral and multilateral contexts. - Box 6 — Additional framework elements covering multilateral aspects: - National policymakers of both source and recipient countries should take into account how their policies affect others. - National authorities should share information multilaterally on objectives and implementation of policies affecting capital flows. - National prudential authorities should be mindful of risks associated with cross-border activities of markets and institutions and be prepared to take measures to address them. - The effects of capital flows on financial stability should be considered in macroprudential policy frameworks. - The capacity to identify and mitigate risks associated with capital flows—through regulated and non-regulated financial institutions—should be enhanced and the responsiveness of cross-border activities to policies should be monitored. - Agreement on "reciprocity" in the application of macroprudential policies should be sought. - National authorities should complete and fully implement reforms of the international regulatory and supervisory architecture expeditiously and actively minimize the scope for regulatory arbitrage. ### VII. ISSUES FOR DISCUSSION - Do Directors agree that policies in countries at the source of capital flows may impact the volume and riskiness of flows, and macroeconomic and financial stability in recipient countries? - Do Directors agree that global stability is a public good, and that better accounting for multilateral transmission of policies affecting capital flows would help all countries reap benefits while reducing risks? - Do Directors agree that completing and fully implementing national and international regulatory and supervisory reforms and developing new macroprudential frameworks would enhance national and global stability by better accounting for implications of capital flows? - Do Directors support extending the proposed framework to address multilateral aspects of policies affecting capital flows as an additional building block toward a comprehensive, flexible and balanced multilateral approach to management of capital flows? *Source: IMF staff estimates.* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2011/_101311.pdf_