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Capital Flows in an Interconnected World, Speech by Rodrigo de Rato, Managing Director of the International Monetary Fund
July 28, 2007
As Prepared for Delivery
1. Thank you very much. Let me begin by thanking the Bank of Thailand for hosting this meeting, and especially Khun Tarisa for her warm welcome to all of us and for her kind words in introducing me. Khun Tarisa combines great experience in central banking with great expertise in financial markets, and these qualities are reflected in the excellent paper which the Bank of Thailand has prepared for this meeting. The main focus of the paper is on the risks from capital inflows, and what central banks can do to manage and reduce these risks. In commenting on this, let me begin with two observations.
2. First, Asia is not just experiencing very large capital inflows, but also very large capital outflows. You know this well: you see it every day in the information on banks and markets that comes to your desks. But the implication of this is that you are not in the same world as your predecessors in the early and mid-1990s, when private capital inflows were much greater than private capital outflows.
3. Second, you are not alone. The greatly increased capital flows into and out of SEACEN countries are part of a worldwide phenomenon of financial globalization. All around the world, home country bias has declined and institutions and individuals are more willing and more able to hold assets outside their own country. Financial globalization, measured by the sum of gross external assets and liabilities as a share of GDP, has increased threefold since the mid-1970s, and has accelerated since the mid-1990s. By 2004, the average sum of external assets and liabilities was more than 100 percent of GDP in low-income countries, more than 1½ times GDP in middle-income countries, and more than 5½ times GDP in high-income countries.
4. Financial globalization has been associated with a wide range of benefits, including to businesses and citizens in Asia. It has given businesses access to a much broader market for savings and has lowered their cost of capital. Higher foreign direct investment has the potential to accelerate technology transfer, improve productivity, and provide greater employment opportunities. And increasingly—returning to my first point—financial globalization is giving Asia's savers access to a wider pool of investments, and the opportunity to diversify risks across borders. In addition, financial globalization can play a catalytic role in encouraging development of capital markets and financial sectors, improving the quality of institutions, and promoting the adoption of stronger macroeconomic frameworks. Financial globalization can have many benefits, and policies directed to it should be careful to preserve these benefits.
5. Of course, financial globalization also has risks, for investors and for the countries in which they invest. Over the last few months I have on several occasions cautioned about some of these risks: stemming from global imbalances and from increased protectionist sentiment; from carry trades across various currencies; and from the lack of information about the exposure of financial institutions, including hedge funds, in the U.S. sub-prime mortgage market. My aim in drawing attention to these risks is not to predict disruption in global financial markets, but to forestall it. By taking timely action, governments and regulatory authorities in industrial countries can protect their investors and markets. And countries which are the recipients of large capital inflows can protect their economies from the consequences of market disruptions.
6. Let me now talk about some actions that emerging market countries can take to reduce the risks coming from large private capital inflows, including the risks that these will be subject to a sudden stop, and be followed by capital outflows.
7. The first priority remains good macroeconomic policies, and especially exchange rate flexibility. Many Asian countries have already allowed their exchange rates to float quite freely, and have benefited from the experience. Permitting exchange rate flexibility has enabled several countries in the region to conduct monetary policy with more freedom, and helped them bring inflation under control. Indeed, monetary policy and exchange rate flexibility are important elements for sustaining growth in the long run. And these economies have flourished: recent economic performance suggests that the warnings of some exporters about loss of competitiveness due to exchange rate appreciation are exaggerated. On the other hand, resisting appreciation can lead to rising inflationary pressures if inflows are not fully sterilized, fiscal costs if sterilization is substantial, and economic distortions in either case.
8. There is a place in managing capital inflows for intervention, especially where inflows of capital appear to be a short-term surge rather than a long-term trend. I will not go into detail on when and how this is best done, though this is an area that the Fund will be working on, some of which will be made public in our next Regional Economic Outlook. But I do want to make it clear that the Fund recognizes that intervention can be an appropriate tool of macroeconomic management. Indeed, the role that intervention can play in reducing volatility in exchange markets, including disruptive short-term movements in the exchange rate of its currency, was emphasized in the recent revision of the Fund's Decision on Bilateral Surveillance over Members' Policies. The new Decision emphasizes the importance of giving due consideration to domestic circumstances in assessing exchange rate policies.
9. Another approach that can be useful in reducing exchange market pressures and offsetting inflows is to be more liberal on capital outflows. Many countries in the region are taking this approach with promising results. Korea's Pension Fund Association raised its allocation to foreign assets in 2005, and Korea has also liberalized private capital outflows, leading to higher equity outflows. Malaysia increased its limit on holdings of foreign assets by some institutional investors and investment trusts from 10 percent to 30 percent in 2005 and again to 50 percent this year. And the Bank of Thailand announced earlier this month that it was also considering measures to encourage capital outflows.
10. Side by side with such liberalization should come domestic financial market development. A strong financial sector cannot eliminate the problems of capital inflows, but it can certainly mitigate them. The Fund has recently completed a study on what countries need to do to reap the benefits of financial globalization. A key finding is that the benefits are much more likely to be realized if the financial frameworks of countries receiving flows are strong. The more solid the foundation of the financial sector, and the better it is able to spread risks, the less countries have to be concerned about capital inflows. This makes the work that many of you are doing on financial sectors, both nationally and in your efforts to promote greater regional financial integration, very important. It also means that the work that SEACEN members, the Fund, and the World Bank do together through Financial Sector Assessment Programs is very significant. Other factors that have helped countries to get the most out of financial globalization are familiar ones: stronger institutions, sound macroeconomic policies, and more open trade systems. These are all areas on which most SEACEN countries score very strongly.
11. Of course, there is another approach to trying to reduce capital inflows, which is to impose direct limits or controls on capital inflows. I can understand why some countries have considered capital controls, given the difficult trade-offs between domestic and external objectives that countries sometimes face when capital inflows are large. And controls on capital inflows might succeed temporarily in reducing inflows and easing exchange market pressure.
12. However, they are unlikely to do so for very long, and they also have important disadvantages. They tend to set central banks and private financial institutions against each other. And since private institutions are generally imaginative and well resourced, they generally find ways around the restrictions, often very quickly. Indeed, recent studies conclude that capital controls rapidly become ineffective after their imposition. Capital controls can also create distortions in the behavior of firms and individuals, and when imposed on short-term flows they can cause particular problems for companies that cannot get long-term finance—usually small businesses and start-up firms.
13. Let me now shift focus to the issue of international cooperation. I recognize that some of the advice I have given may not be easy advice to follow, and that concerns about capital inflows—and especially about the risk of a sudden reversal of capital flows—remain. To protect themselves from this risk, some countries have built up reserves as a first line of defense against crises. Asian countries working together have also established mechanisms such as the Chiang Mai Initiative to give further support. The Fund is also considering how we can enhance our own efforts to reduce risks to our members. We are working on the design of a new instrument to support emerging markets that would provide a mechanism for countries to commit to sound policies, while making high-access financing available during adverse shocks. The risks of economic or financial market turbulence can also be reduced if there is good international cooperation on economic policies. Let me give some examples of ways in which multilateral efforts can help countries to maintain external stability and to make the work of central banks more manageable.
14. We have recently seen a good process of cooperation on the issue of global economic imbalances. This is an important issue for all countries, and it is particularly important for SEACEN members. Given their economies' heavy dependence on exports, they are vulnerable to a contraction in external demand that could accompany a disorderly unwinding of global imbalances. Concern about such a disorderly unwinding was one of the motivations behind the Fund's initiative of launching a Multilateral Consultation, bringing large economies together to discuss measures that would lead to a gradual reduction of imbalances, while sustaining strong global growth.
15. During our Spring Meetings a few months ago, the five major economies participating in the Multilateral Consultation—China, the euro area, Japan, Saudi Arabia, and the United States—jointly set out their policies in a document circulated to ministers representing the Fund's 185 members. The policy plans set out by the participants were concrete and mutually consistent, and they reflect ownership by the countries concerned. If implemented, they will reduce imbalances while sustaining growth.
16. One important issue in the Multilateral Consultation was China's exchange rate policy. Much of the focus of public discussion of this issue has been about the implications of China's exchange rate policy for major currency exchange rates and about the risk of a deterioration in trade relations between China and the United States. But China's exchange rate policies also have important effects on the trade volumes and exchange rates of its Asian trading partners. Greater exchange rate flexibility is not only in China's best interest , but would allow other Asian countries to appreciate with less concern about competitiveness. On the other hand, an intensification of trade restrictions on China would also have adverse effects on many other countries, including on other Asian countries that are tightly linked to China through global production chains. There is also the possibility of such protectionism spinning out of control with disastrous consequences for the global economy. The policies agreed in the Multilateral Consultation—which are all in the best interest of the participants—provide a road map to bring about a resolution of this issue and more generally to produce an orderly reduction in global imbalances. It is important for all countries that this path is taken.
17. Increased cooperation and consultation is also important in deepening our understanding of financial markets, and in taking steps to improve their functioning and reduce systemic risks. For example, measures to increase the transparency of hedge fund operations and to improve international monitoring of and cooperation on them would enable problems to quickly be identified and addressed. Similar considerations apply to other financial market issues.
18. International cooperation on macroeconomic policy, including exchange rate issues, and on financial sector issues is becoming more important for Asian countries as they become more important in the global economy and also more interconnected with the global economy. The increased significance of Asia in the world economy carries responsibilities with it. It is important not just for Asian countries but for the world that national policies promote Asia's development, rebalance growth in the region, and support multilateral solutions to global problems.
19. My final point is that the greater responsibilities of emerging market economies, including many of the SEACEN countries, should be matched by greater influence in global economic decision making, including in the Fund. Last year in Singapore, the Fund took a first step in increasing the representation of emerging market countries, including some Asian countries, and agreed on broad outlines for the next stage of reform. Now we need to translate the outlines agreed in Singapore into a concrete reform package that can command broad support.
20. Over the next three months, between now and the Fund's Annual Meetings, I hope to make progress on a new quota formula that is simple and transparent, consistent with the roles of quotas, and reflects members' relative positions in the global economy. I also hope to make progress on the broader parameters for the second round of ad hoc quota increases. When complete, the reform should result in higher shares for dynamic economies, many of which are emerging market economies, whose weight and role in the global economy have increased, while also protecting the voice of low-income countries. I have said many times that this is an issue that is vital for the Fund's legitimacy: I believe that it is also important that we act quickly.
21. An interconnected world needs cooperation between countries of the kind exemplified by SEACEN. It also needs strong international public institutions, and this is the foundation of our efforts to reform the IMF.
22. Thank you very much.
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