Global Capital Flows: Raising the Returns and Reducing the Risks

IMF News, June 17, 1997

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Published: June 17, 1997

Overview

Address by Michel Camdessus, Managing Director of the International Monetary Fund, at the World Affairs Council of Los Angeles, California, June 17, 1997.
Central question: Why is private capital surging into emerging markets, is it beneficial, and how can returns be raised while risks are reduced?
Key context: Private flows to developing and transition economies reached a record high of $235 billion last year--five times the level in 1990.

Drivers of large private capital flows

Removal of restrictions on overseas investment by institutional investors.
Elimination of capital controls in developing countries.
Technological advances in telecommunications increasing mobility of capital.
Low interest rates in advanced countries and the search for portfolio diversification.
Improved macroeconomic management and structural reforms in many developing and transition countries (prudent fiscal and monetary policies, low inflation, trade liberalization, streamlined investment procedures, financial liberalization, privatization).

Benefits (recipient countries, investors, and global economy)

Recipient countries:
- Higher levels of investment.
- Faster economic growth.
- Rising standards of living.
- Non-debt-creating foreign direct investment transfers technology and business skills with less risk of ballooning debt-service payments.
Investors:
- Increased returns on saving.
- Portfolio diversification opportunities.
Global economy:
- More efficient allocation of resources where returns on capital are higher.
- Emerging markets become important sources of demand, sustaining world growth during weak advanced-country conditions (example: cushioning effect in 1991-93).
- Competition for capital fosters a "virtuous circle" of reform, investment, and growth.

Risks and channels of vulnerability

Policy mistakes in recipient countries can trigger sudden loss of market confidence and capital outflows with spillover effects.
Strong inflows may:
- Put upward pressure on exchange rates.
- Constrain monetary policy.
- Fuel domestic demand and inflation if not sterilized.
- Widen current account deficits amid strong domestic demand.
- Create strains in labor and real estate markets.
Banking system weaknesses:
- Rapid credit expansion and poor lending decisions can undermine loan portfolio quality.
- Liberalization/privatization without adequate supervision increases bank exposure to credit, exchange rate, interest rate, and market risks.
- Policymakers may be reluctant to tighten policy for fear of exacerbating banking sector problems.
Market sentiment and contagion:
- Perceived vulnerabilities or high current account deficits can prompt abrupt reversals.
- Loss of confidence in one country can affect others perceived as similar, even across regions.
- Market judgments can be capricious—money can flow in despite weak policies, then flow out on changing sentiment.

Country experiences and lessons

Mexico (end-1994 crisis):
- Highlighted importance of sound macroeconomic policies, solid domestic institutions (independent central banks, strong banking systems), structural reforms, and timely, comprehensive information to markets.
Asia and Eastern Europe:
- Some countries tightened policies to avoid overheating; recent slowdown in Asia viewed as appropriate correction after very rapid growth.
China:
- Appeared to achieve a "soft landing" while maintaining very large capital inflows.
India:
- Kept inflation and current account deficits at manageable levels while markedly raising growth and gradually opening to foreign equity capital.
Malaysia:
- Output growth moderated to a more sustainable rate; inflation remained low.
- Current account deficit narrowed substantially; fiscal surplus increase targeted for the year expected to help consolidation.
- Improvements in bank soundness: non-performing loan ratios have fallen markedly; risk-weighted capital ratios are above Basle recommendations; steps taken to restrain lending for property and stock markets.
- Early adopter of the Fund's Special Data Dissemination Standard.

IMF role and policy priorities

IMF mandate and member expectations (181 members):
- Encourage sound economic and financial policies to attract private capital via policy advice, technical assistance, and financial support.
- Reduce the risk of sudden reversals of capital flows and their spillovers through emphasis on appropriate policies.
- Help manage crises when they occur to avoid outcomes detrimental to international prosperity.
- Provide a forum for members to discuss policy experiences, assess global developments, and defuse emerging problems.

Four priority issues highlighted:

1. Capital account liberalization

Current mandate focuses on eliminating "foreign exchange restrictions that hamper the growth of world trade"; more than three quarters of members (139 countries) have, for the most part, eliminated restrictions on current transactions.
Membership agreement to add an amendment to the charter to promote capital account liberalization and give the Fund appropriate oversight over restrictions on capital movements.
Emphasis: not to encourage premature removal of controls or forbid temporary use of controls in emergencies; promote liberalization consistent with sustainable macroeconomic policies, strong monetary and financial sectors, and lasting liberalization.

2. Soundness of domestic financial and banking systems

Next major crises likely to start with or be intensified by banking crises.
Emphasis on strengthening internal bank management, reinforcing market discipline, and improving bank regulation and supervision.
Support for internationally recognized "best practices" such as the Basle Committee's "Core Principles for Effective Banking Supervision."

3. Transparency

Higher premium on accurate, timely information about economic policies and performance to reduce market surprises.
Development and dissemination of standards on data coverage, frequency, timeliness, quality, integrity, and public availability.
Special Data Dissemination Standard: 42 advanced and emerging market economies have subscribed; of these, 7 have established "hyperlinks" to their actual economic data.

4. Integration and "good governance" for countries without market access

Countries face a choice: integrate into the international economy or risk marginalization and falling behind in growth and development (a major danger for Africa).
"Second generation" structural reforms required: simple, transparent regulatory systems; independent and professional judicial systems; government that makes cost-effective use of public resources.
IMF focus on governance aspects most closely related to macroeconomic surveillance, including increasing transparency of government accounts and encouraging reallocation from unproductive public expenditure toward health, education, and infrastructure.

IMF financing, quotas, and the case for strong Fund resources

IMF as a financial cooperative: members subscribe "quotas" paid partly in national currency and partly from reserves.
Quota subscriptions enable members to access temporary balance of payments financing by exchanging currencies among members.
For a member, subscribing to a quota increase is described as an exchange of assets, not a budgetary outlay; example cited: the United States considers quota subscription an exchange of assets and has in many years earned interest and realized exchange rate gains on its SDR-denominated position.
Membership was considering an increase in IMF quotas to ensure continued financial strength and credibility.

Source: Address by Michel Camdessus, Managing Director of the International Monetary Fund, World Affairs Council of Los Angeles, California, June 17, 1997.