## _pdp07 - Section 1 and Section 2 ## Source details **Canonical URL:** [_pdp07 - Section 1 and Section 2](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/pdp/2005/_pdp07.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/pdp/2005/_pdp07.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/pdp/2005/_pdp07.pdf.json) --- ### Abstract and purpose - Policy Discussion Paper: PDP/05/7. - © 2005 International Monetary Fund; prepared October 2005. - Authors: Eswar S. Prasad and Raghuram G. Rajan. - JEL Classification Numbers: F3, F4, G1. - Keywords: Capital inflows, foreign exchange reserves, closed-end mutual fund, international portfolio diversification. - Purpose: Develop a proposal for a controlled approach to capital account liberalization for economies experiencing large capital inflows by securitizing a portion of inflows through closed-end mutual funds. ### Key problem statement - Large non-FDI capital inflows into economies with closed capital accounts or underdeveloped financial markets create macroeconomic pressures (exchange rate appreciation, inflationary liquidity) and fiscal costs through sterilization. - Full capital account convertibility can be risky when underlying fragilities exist (huge fiscal deficits, banking sector non-performing loans, opaque corporate/financial sectors) because unrestricted outflows can precipitate crises. - Governments face a trade-off: retain controls and bear sterilization costs and domestic distortions, or liberalize and risk destabilizing outflows. ### Main proposal (mechanics) - Central bank accumulates necessary reserves for precautionary purposes and determines the amount of outflows it is willing to permit. - License private fund management companies to start closed-end foreign asset funds with initial assets totaling the permitted amount. - Fund investors: domestic residents purchase fund shares denominated in domestic currency. - Central bank sells the fund foreign currency at the prevailing market exchange rate in exchange for the domestic currency raised by the fund. - Fund activity: invest the foreign currency in foreign financial assets (e.g., stocks and bonds). - Timing and scale: periodically (e.g., every quarter) new funds can be licensed or existing funds augmented based on desired external investment levels tied to inflows. ### Expected benefits and policy objectives - Eliminates fiscal sterilization costs by securitizing reserves and taking them off the central bank’s balance sheet. - Central bank retains control over both timing and quantity of capital outflows by deciding the timing, number, and size of licensed funds. - Provides domestic investors with international portfolio diversification and broader investment opportunities. - Stimulates development of domestic securities markets and fund management capacity (international investment skills). - Limits downside risk if appropriately structured; provides a calibrated safety valve that can mitigate pressures for exchange rate appreciation and give governments breathing room to undertake structural reforms. - Insulates government balance sheet relative to direct government-held foreign asset schemes because a private intermediary separates investors from the government. ### Analytical considerations and conditions for success - If the fund holds the same mix of foreign government securities as central bank reserves and passes returns through to shareholders, fund shares should trade at net asset value (NAV), implying no net cost to investors. - Factors that can cause deviation from NAV: - Management discretion and investor trust or mistrust in fund management leading to premium or discount. - Domestic demand for diversification could create premiums, especially in countries with fragile financial systems. - Perceived expropriation risk or expectations of government bailouts can alter attractiveness. - Concerns about currency appreciation or a step revaluation if exchange rate is fixed and undervalued; less so with flexible exchange rates. - Legal and institutional safeguards required: - Clear separation between government and fund management companies. - Legal arrangements to minimize expropriation risk and avoid implicit government guarantees. - Government role limited to determining the quantum of external investment allowed and routine oversight (no guarantees of returns). ### Comparison with alternative approaches - Alternatives include: allowing pension funds/institutional investors to invest abroad; government investing abroad and issuing foreign-currency-denominated securities to domestic investors; qualified domestic institutional investor schemes. - Advantages of the proposed closed-end fund securitization: - Smaller risks to government balance sheet versus government-held reserves. - Broader diversification benefits to individual investors compared with institutional-only schemes. - Ability to control timing and pace of outflows, unlike many institutional investor schemes that primarily set ceilings. - Greater potential to stimulate domestic securities market development and managerial skill buildup. - Limitations of alternatives: - Government-held foreign assets sold to private markets create a direct government-investor link and increase bailout pressure. - Qualified institutional schemes make timing control difficult, do not necessarily stimulate domestic securities markets, and may not match individual investors’ diversification needs. - Recommendation: alternative schemes can operate in parallel but do not substitute for the calibration and control benefits of the securitization approach. ### Risks and calibrations noted by the authors - Potential for liberalization to encourage greater inflows by making reversals easier; the proposed structure is designed to be calibrated so it cannot serve as a channel for reversal of speculative inflows. - Need for investor education and appropriate fund structure to ensure closed-end nature and understand limited redemption to prevent misuse as an outflow channel. - Importance of limiting government oversight to appropriate regulation without explicit guarantees to avoid moral hazard and fiscal exposure. ### Domestic investor behavior and fund design - Domestic retail investors may have a “home bias” and need time to develop confidence in foreign investments; poor domestic investment opportunities can be a spur. - Some domestic investors may need to be educated about the diversification benefits of investing abroad. - Domestic investors may be wary about investing in an indefinitely closed end fund because these tend to trade at a discount; this concern can be mitigated by setting a fixed life for the fund (say five years). - A fixed life allows: - the central bank to provide the fund with domestic currency to pay off investors at maturity, while letting the central bank take the fund’s foreign currency assets back into reserves at the end of the fund’s life as a safety net if the central bank underestimated its need for foreign reserves; - assets of earlier licensed funds to revert to the government, enabling the government to rebuild reserves at a measured pace; - the possibility for the government, if the need is more pressing, to borrow from foreign banks using the foreign assets of a yet-to-mature fund as collateral. - Caution: too many options that link government and funds reduce the necessary separation between government and the funds. ### Exchange rate appreciation and investor risk - Typical pressure: foreign investor inflows create pressure on an exchange rate to appreciate. - In flexible exchange rate regimes, appreciation pressures might dampen domestic demand for foreign-currency-denominated assets, but controlled liberalization could itself alleviate appreciation pressures. - In countries where deposits in fragile state-owned banks are the only viable domestic financial asset, there may be considerable interest in alternative investment opportunities including foreign bonds and equities. - Trade-offs: - Concerns about exposing domestic investors to additional exchange risk should be weighed against benefits of reduced investor risk concentration. - In many emerging market countries with relatively closed capital accounts, investor jobs and wealth are currently fully exposed to domestic economic fragilities; foreign assets can provide diversification benefits. - In emerging-market countries with volatile output growth, exchange rate risk involved in foreign assets would generally serve domestic investors’ diversification objectives well. - Special case—undervalued fixed exchange rate: - A significant step appreciation imposes considerable risk on domestic investors in foreign assets, who may hold the government responsible for their losses. - The proposal has a better chance of success if the exchange rate is flexible, or when fixed, is deemed to be close to equilibrium. - The proposal may alter perceptions of equilibrium and may have merit even where wider gaps otherwise exist. - Downside risk to the government of setting up the scheme is limited as long as adequate separation is maintained. - Shares in the fund could trade at a discount in secondary markets if investors’ cost-benefit evaluation changes after launch, but that would not have implications for government finances. ### Technical implementation issues and governance - Technical complexity concerns can be managed: - In closed capital account economies with limited domestic expertise to manage international investments, licensing foreign fund managers and setting up mechanisms to transfer their expertise to domestic funds over time is a solution. - Governance concerns are not obviously greater than those related to management of domestic mutual funds or financial institutions. - Rent capture risk: - Excess demand could generate rents for the fund, squandering potential government revenue; this could be addressed by auctioning the license to run the fund. - As amounts grow, more funds could participate, introducing competition. - Any license auction must be separated from the sale of foreign currency to a fund (which would take place at the prevailing market exchange rate) to avoid generating multiple exchange rate practices. ### Extension to existing reserves and interaction with fiscal policy - The proposal can be extended to an existing stock of a country’s reserves if authorities deem them excessive: - When a portion of the stock of the government’s sterilization instrument matures, the government would simply not roll that over. - To match additional liquidity generated, the government would allow the fund to sell shares in domestic currency for that amount and make the corresponding amount of foreign currency reserves available to the fund to purchase assets abroad. - There would be no change in domestic liquidity. - Determining the “adequate” level of reserves is complex, but some authorities view accumulated reserves as exceeding self-insurance requirements. - Application to windfall gains (e.g., positive terms of trade shocks such as oil price increases): - Rather than “using” reserves for social and infrastructure expenditures, it may be more transparent to finance such expenditures directly through the budget. - The proposal could work in conjunction with budget-financed expenditures by soaking up liquidity and generating revenue for the government budget through the auction of mutual fund licenses. - The demand for foreign investments is likely to come mostly from relatively wealthy households; auctioning licenses at a premium would procure revenues that could feed directly into the budget. ### Concluding observations and policy implications - The proposal facilitates controlled capital account liberalization in developing economies while mitigating many associated risks. - It is especially relevant for economies that have accumulated large stocks of reserves beyond levels essential for prudential purposes and are seeking ways to “use” reserves and manage further capital inflows. - Main attractions: - Satisfies pent-up demand for capital outflows arising from diversification motives in a manner the government can calibrate and control in the short term. - Gives domestic retail investors experience with international investments and allows for gradual learning-by-investing. - Allows domestic banks in weak financial systems breathing room to adjust as depositors gain alternative investment opportunities. - Prepares the ground for eventual fuller capital account liberalization. - Trade-off to monitor: - Greater ease of “sterilizing” inflows may reduce pressure to pursue full capital account convertibility and broader reforms such as greater exchange rate flexibility, but the proposal can make the path easier and deserves consideration. *Source: "Controlled Capital Account Liberalization: A Proposal", Eswar S. Prasad and Raghuram G. Rajan; IMF Policy Discussion Paper PDP/05/7 (October 2005).* ### Section 1 ### _pdp07 - Section 1 ### Abstract and purpose - Policy Discussion Paper: PDP/05/7. - © 2005 International Monetary Fund; prepared October 2005. - Authors: Eswar S. Prasad and Raghuram G. Rajan. - JEL Classification Numbers: F3, F4, G1. - Keywords: Capital inflows, foreign exchange reserves, closed-end mutual fund, international portfolio diversification. - Purpose: Develop a proposal for a controlled approach to capital account liberalization for economies experiencing large capital inflows by securitizing a portion of inflows through closed-end mutual funds. ### Key problem statement - Large non-FDI capital inflows into economies with closed capital accounts or underdeveloped financial markets create macroeconomic pressures (exchange rate appreciation, inflationary liquidity) and fiscal costs through sterilization. - Full capital account convertibility can be risky when underlying fragilities exist (huge fiscal deficits, banking sector non-performing loans, opaque corporate/financial sectors) because unrestricted outflows can precipitate crises. - Governments face a trade-off: retain controls and bear sterilization costs and domestic distortions, or liberalize and risk destabilizing outflows. ### Main proposal (mechanics) - Central bank accumulates necessary reserves for precautionary purposes and determines the amount of outflows it is willing to permit. - License private fund management companies to start closed-end foreign asset funds with initial assets totaling the permitted amount. - Fund investors: domestic residents purchase fund shares denominated in domestic currency. - Central bank sells the fund foreign currency at the prevailing market exchange rate in exchange for the domestic currency raised by the fund. - Fund activity: invest the foreign currency in foreign financial assets (e.g., stocks and bonds). - Timing and scale: periodically (e.g., every quarter) new funds can be licensed or existing funds augmented based on desired external investment levels tied to inflows. ### Expected benefits and policy objectives - Eliminates fiscal sterilization costs by securitizing reserves and taking them off the central bank’s balance sheet. - Central bank retains control over both timing and quantity of capital outflows by deciding the timing, number, and size of licensed funds. - Provides domestic investors with international portfolio diversification and broader investment opportunities. - Stimulates development of domestic securities markets and fund management capacity (international investment skills). - Limits downside risk if appropriately structured; provides a calibrated safety valve that can mitigate pressures for exchange rate appreciation and give governments breathing room to undertake structural reforms. - Insulates government balance sheet relative to direct government-held foreign asset schemes because a private intermediary separates investors from the government. ### Analytical considerations and conditions for success - If the fund holds the same mix of foreign government securities as central bank reserves and passes returns through to shareholders, fund shares should trade at net asset value (NAV), implying no net cost to investors. - Factors that can cause deviation from NAV: - Management discretion and investor trust or mistrust in fund management leading to premium or discount. - Domestic demand for diversification could create premiums, especially in countries with fragile financial systems. - Perceived expropriation risk or expectations of government bailouts can alter attractiveness. - Concerns about currency appreciation or a step revaluation if exchange rate is fixed and undervalued; less so with flexible exchange rates. - Legal and institutional safeguards required: - Clear separation between government and fund management companies. - Legal arrangements to minimize expropriation risk and avoid implicit government guarantees. - Government role limited to determining the quantum of external investment allowed and routine oversight (no guarantees of returns). ### Comparison with alternative approaches - Alternatives include: allowing pension funds/institutional investors to invest abroad; government investing abroad and issuing foreign-currency-denominated securities to domestic investors; qualified domestic institutional investor schemes. - Advantages of the proposed closed-end fund securitization: - Smaller risks to government balance sheet versus government-held reserves. - Broader diversification benefits to individual investors compared with institutional-only schemes. - Ability to control timing and pace of outflows, unlike many institutional investor schemes that primarily set ceilings. - Greater potential to stimulate domestic securities market development and managerial skill buildup. - Limitations of alternatives: - Government-held foreign assets sold to private markets create a direct government-investor link and increase bailout pressure. - Qualified institutional schemes make timing control difficult, do not necessarily stimulate domestic securities markets, and may not match individual investors’ diversification needs. - Recommendation: alternative schemes can operate in parallel but do not substitute for the calibration and control benefits of the securitization approach. ### Risks and calibrations noted by the authors - Potential for liberalization to encourage greater inflows by making reversals easier; the proposed structure is designed to be calibrated so it cannot serve as a channel for reversal of speculative inflows. - Need for investor education and appropriate fund structure to ensure closed-end nature and understand limited redemption to prevent misuse as an outflow channel. - Importance of limiting government oversight to appropriate regulation without explicit guarantees to avoid moral hazard and fiscal exposure. *Source: "Controlled Capital Account Liberalization: A Proposal", Eswar S. Prasad and Raghuram G. Rajan; IMF Policy Discussion Paper PDP/05/7 (October 2005).* ### Section 2 ### _pdp07 - Section 2 ### Domestic investor behavior and fund design - Domestic retail investors may have a “home bias” and need time to develop confidence in foreign investments; poor domestic investment opportunities can be a spur. - Some domestic investors may need to be educated about the diversification benefits of investing abroad. - Domestic investors may be wary about investing in an indefinitely closed end fund because these tend to trade at a discount; this concern can be mitigated by setting a fixed life for the fund (say five years). - A fixed life allows: - the central bank to provide the fund with domestic currency to pay off investors at maturity, while letting the central bank take the fund’s foreign currency assets back into reserves at the end of the fund’s life as a safety net if the central bank underestimated its need for foreign reserves; - assets of earlier licensed funds to revert to the government, enabling the government to rebuild reserves at a measured pace; - the possibility for the government, if the need is more pressing, to borrow from foreign banks using the foreign assets of a yet-to-mature fund as collateral. - Caution: too many options that link government and funds reduce the necessary separation between government and the funds. ### Exchange rate appreciation and investor risk - Typical pressure: foreign investor inflows create pressure on an exchange rate to appreciate. - In flexible exchange rate regimes, appreciation pressures might dampen domestic demand for foreign-currency-denominated assets, but controlled liberalization could itself alleviate appreciation pressures. - In countries where deposits in fragile state-owned banks are the only viable domestic financial asset, there may be considerable interest in alternative investment opportunities including foreign bonds and equities. - Trade-offs: - Concerns about exposing domestic investors to additional exchange risk should be weighed against benefits of reduced investor risk concentration. - In many emerging market countries with relatively closed capital accounts, investor jobs and wealth are currently fully exposed to domestic economic fragilities; foreign assets can provide diversification benefits. - In emerging-market countries with volatile output growth, exchange rate risk involved in foreign assets would generally serve domestic investors’ diversification objectives well. - Special case—undervalued fixed exchange rate: - A significant step appreciation imposes considerable risk on domestic investors in foreign assets, who may hold the government responsible for their losses. - The proposal has a better chance of success if the exchange rate is flexible, or when fixed, is deemed to be close to equilibrium. - The proposal may alter perceptions of equilibrium and may have merit even where wider gaps otherwise exist. - Downside risk to the government of setting up the scheme is limited as long as adequate separation is maintained. - Shares in the fund could trade at a discount in secondary markets if investors’ cost-benefit evaluation changes after launch, but that would not have implications for government finances. ### Technical implementation issues and governance - Technical complexity concerns can be managed: - In closed capital account economies with limited domestic expertise to manage international investments, licensing foreign fund managers and setting up mechanisms to transfer their expertise to domestic funds over time is a solution. - Governance concerns are not obviously greater than those related to management of domestic mutual funds or financial institutions. - Rent capture risk: - Excess demand could generate rents for the fund, squandering potential government revenue; this could be addressed by auctioning the license to run the fund. - As amounts grow, more funds could participate, introducing competition. - Any license auction must be separated from the sale of foreign currency to a fund (which would take place at the prevailing market exchange rate) to avoid generating multiple exchange rate practices. ### Extension to existing reserves and interaction with fiscal policy - The proposal can be extended to an existing stock of a country’s reserves if authorities deem them excessive: - When a portion of the stock of the government’s sterilization instrument matures, the government would simply not roll that over. - To match additional liquidity generated, the government would allow the fund to sell shares in domestic currency for that amount and make the corresponding amount of foreign currency reserves available to the fund to purchase assets abroad. - There would be no change in domestic liquidity. - Determining the “adequate” level of reserves is complex, but some authorities view accumulated reserves as exceeding self-insurance requirements. - Application to windfall gains (e.g., positive terms of trade shocks such as oil price increases): - Rather than “using” reserves for social and infrastructure expenditures, it may be more transparent to finance such expenditures directly through the budget. - The proposal could work in conjunction with budget-financed expenditures by soaking up liquidity and generating revenue for the government budget through the auction of mutual fund licenses. - The demand for foreign investments is likely to come mostly from relatively wealthy households; auctioning licenses at a premium would procure revenues that could feed directly into the budget. ### Concluding observations and policy implications - The proposal facilitates controlled capital account liberalization in developing economies while mitigating many associated risks. - It is especially relevant for economies that have accumulated large stocks of reserves beyond levels essential for prudential purposes and are seeking ways to “use” reserves and manage further capital inflows. - Main attractions: - Satisfies pent-up demand for capital outflows arising from diversification motives in a manner the government can calibrate and control in the short term. - Gives domestic retail investors experience with international investments and allows for gradual learning-by-investing. - Allows domestic banks in weak financial systems breathing room to adjust as depositors gain alternative investment opportunities. - Prepares the ground for eventual fuller capital account liberalization. - Trade-off to monitor: - Greater ease of “sterilizing” inflows may reduce pressure to pursue full capital account convertibility and broader reforms such as greater exchange rate flexibility, but the proposal can make the path easier and deserves consideration. *Source: _pdp07 - Section 2* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/pdp/2005/_pdp07.pdf_