Policy Responses to Capital Flows

IMF News, October 11, 2018

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Bibliographic details

• Authors: Tobias Adrian
• Published: October 11, 2018

Overview

• Speech by Tobias Adrian, IMF, LIII Meeting of Governors of Latin America, Spain and the Philippines at the IMF-World Bank Annual Meetings in Bali, Indonesia, October 11, 2018.
• Theme: trade-offs and policy mix for managing capital inflows to maximize benefits (financial depth, inclusion, stronger GDP growth) while limiting systemic risk from excessive credit expansions and reversals.

Capital inflows and credit expansions — empirical findings

• Financial globalization led to a dramatic increase in global capital flows to emerging-market and developing countries (EMDCs) since the early 2000s; notable reversals occurred in 2008 (GFC, 2007 to 2009) and in 2013 (the “taper tantrum”).
• EMDCs’ cross-border liabilities more than tripled since 2000.
• Drivers of cross-border liabilities buildup: rise in flows from banks to non-banks, and from non-banks to non-banks.
• Persistence: aggregate capital flows declined post-GFC due to a decline in bank flows among advanced economies, but capital flows to EMDCs remained more persistent (bank flows in Asia; bond portfolio flows in Latin America).
• Channels linking inflows to credit and systemic risk:
  • Exchange rate appreciation and asset price increases raise collateral values, boost borrower demand for credit, and reduce perceived lender default risk.
  • Non-core funding channel:
  • Capital inflows ease borrowing constraints for local banks, enabling increased domestic credit.
  • Rapid domestic credit growth can outpace deposit growth, pushing banks to source wholesale funding abroad, “pulling in” further cross-border funding.
• Empirical correlations:
  • Positive correlation between capital flows and credit for both emerging and advanced open economies; correlation tighter for gross flows than for net flows.
  • In countries with high credit-to-GDP gaps, cross-border credit growth has been particularly high since the GFC; low credit-to-GDP gap countries saw moderate cross-border credit growth over the past 10 years.
  • Composition matters: strongest relationships between non-FDI flows (particularly gross debt flows) and credit booms; increases in domestic credit are associated with significant increases in “other investment flows” (mainly cross-border bank credit).
• Cross-border credit growth in EMs over the last five years is associated with increasing domestic vulnerabilities; most vulnerable countries are characterized by high credit-to-GDP gaps coupled with high external borrowing.
• Spillovers from U.S. monetary policy:
  • Cecchetti et al. (2018) find prolonged U.S. monetary easing fuels rising financial sector leverage in other countries; international spillovers play a larger role in leverage buildup than domestic easing.
  • Countries’ resilience to tighter global financial conditions depends on limiting macro-financial imbalances and strengthening buffers during the “low-for-long” era.

Policy frameworks and preconditions

• “Baseline” countries equipped to absorb shocks typically have:
  • (i) a fully flexible exchange rate;
  • (ii) an open capital account;
  • (iii) a credible and effective monetary policy framework such as inflation targeting;
  • (iv) a resilient financial sector.
• Preconditions for shock absorbers to work effectively:
  • Well-developed and transparent financial markets, including deep hedging markets.
  • Strong micro- and macroprudential supervisory and legal frameworks.
  • Adequate information for calibrating macroprudential instruments.
  • Data and policy transparency.
• Evidence on transparency: Brandao-Marques, Gelos, Melgar (2018) find that more transparent government policies and better corporate disclosure significantly reduce EM assets’ sensitivity to global shocks (study uses daily data for 62 stock and bond markets, 1992–2017).

Macroprudential measures (MPM) — objectives and effectiveness

• Three interlocking objectives:

1. Increase resilience to aggregate shocks by building buffers to maintain credit provision under adverse conditions. 2. Contain buildup of systemic vulnerabilities by reducing procyclical feedback between asset prices and credit and containing unsustainable leverage and volatile funding. 3. Control structural vulnerabilities from interlinkages that can make institutions “too important to fail.”

• Tool guidance by vulnerability type:
  • Broad-based banking-system tools: countercyclical capital buffers, leverage ratios.
  • Household-sector vulnerabilities: sectoral capital requirements (risk weights), loan-to-value (LTV) ratios, debt-service-to-income (DSTI) ratios.
  • Corporate-sector vulnerabilities (corporate leverage, CRE lending, FX lending): targeted corporate sectoral tools, sectoral capital requirements, exposure caps.
  • Liquidity and currency risks: liquid asset ratios, stable funding requirements, limits on FX open positions.
  • Structural contagion risks: capital and liquidity surcharges for systemically important institutions; measures to control interlinkages in funding and derivatives markets.
• Empirical evidence (panel of 62 advanced and emerging economies, quarterly 2000Q1–2016Q4):
  • Appreciation of the local exchange rate against the dollar is associated with expansion in the credit gap; effect strongest for non-G7 financially open economies.
  • Macroprudential policy attenuates the exchange rate → credit gap relationship: tighter macroprudential policy slows credit gap increases and flattens the exchange-rate-to-credit relationship.
  • Strongest attenuation from borrower-based tools (LTV, DSTI); also present for some institution-based tools, notably liquidity requirements.
• Survey and cross-country usage:
  • IMF’s New Macroprudential Survey: liquidity and FX tools most commonly used overall, including in Latin America; household-sector tools (LTV, DSTI) are the second-most-commonly used globally but less common in the Western Hemisphere (~25% of countries) than in Asia, Europe, and the Middle East (~50% of countries).
  • Tighter capital requirements on household exposures are common across regions, including the Western Hemisphere.
  • Corporate-sector measures less common; additional capital requirements and caps on FX lending are among the more frequent measures.
• Lessons from country experience:
  • Portfolio approach: combine LTV, DSTI, amortization requirements to address housing risks and avoid circumvention.
  • Introduce “speed limits” allowing a fraction of banks’ exposures outside limits to reduce efficiency costs.
  • Act early—“Taking out insurance when financial conditions are easy is cheap.”

Capital Flow Measures (CFMs) and CFM/MPMs

• IMF Institutional View (adopted 2012) recommends:
  • Treat capital flows primarily through macroeconomic policies supported by sound supervision, regulation, and strong institutions.
  • In certain circumstances, CFMs can be useful to support macroeconomic adjustment and safeguard financial stability.
  • CFMs should not substitute for warranted macroeconomic adjustment.
• CFMs may be useful during inflow surges when:
  • (i) room for macroeconomic policy adjustment is limited;
  • (ii) appropriate policies need time to take effect; and/or
  • (iii) inflows contribute to systemic financial risks.
• Measures that are both CFMs and MPMs (CFM/MPMs) fall under both frameworks.
• Empirical findings (Nier, Olafsson, Rollinson):
  • Increases in the credit gap lead to increases in non-core funding (“other investment flows”); restricting such flows can break the link and help avoid increases in systemic risk from volatile funding structures.
  • Effect is present for temporary tightening of capital account restrictions (“gates”) and stronger for the existing stock or “wall” of longstanding capital account restrictions.
• Western Hemisphere experience (IMF Taxonomy of CFMs since November 2012):
  • Most countries in the region have not introduced new CFMs or adjusted existing measures recently.
  • Apart from crisis measures in Argentina, only eight CFMs were introduced or adjusted over the near six-year period, mostly using specific reserve requirements or taxes.

Foreign Exchange Intervention (FXI)

• FX intervention is a common response to capital inflows, including in economies with flexible exchange rates.
• Motivations:
  • Financial stability: address substantial unhedged currency mismatches on private sector balance sheets.
  • “Lean against the wind” to prevent short-term pressures from moving the exchange rate away from longer-term equilibrium.
  • Build foreign currency reserves.
  • Macroeconomic considerations: reduce exchange rate volatility’s impact on inflation or growth.
• Latin America experience (key findings from forthcoming book):
  • FX intervention plays a larger role in highly dollarized economies (e.g., Peru), consistent with financial stability motives.
  • Derivatives intervention (vs. spot) used to address hedging needs and preserve FX reserves.
  • Rules-based intervention improved transparency in some countries, avoiding perceptions of targeting a level of the exchange rate (Colombia, Mexico).
  • Clear communication and transparency around interventions are key to preserving monetary policy credibility.
• Usage patterns:
  • FX intervention is widely used in Latin America; frequency varies across countries.
  • Many countries accumulated reserves while leaning against sustained inflows and deployed reserves during depreciation pressures.
  • Recent examples of FX intervention in spot and derivatives markets include Argentina, Indonesia, Brazil, India, and Turkey.

Recent capital flow developments and projections (as of 2018)

• Portfolio flows to emerging markets have fallen sharply but remained positive year-to-date (2018); decline driven mainly by retail flows (turned negative during Q2–Q3 2018 selloff); institutional inflows estimated to have declined but remained positive; debt portfolio flows particularly affected after strong inflows in 2017.
• U.S. monetary policy normalization: markets revised expectations upward for the path of U.S. interest rates, pricing in additional policy rate hikes; balance sheet contraction pace set to accelerate, “reaching its maximum in the current quarter, the fourth quarter of 2018.”
• Estimated cumulative impact of U.S. normalization on portfolio flows to EMs:
  • Estimated cumulative decline in net non-resident portfolio equity and debt flows through the end of 2019 is about $80 billion, with much of the additional impact expected in 2019 due to the Fed’s balance sheet reduction.
• Market differentiation and contagion risks:
  • Widening of spreads on hard-currency sovereign bonds more pronounced in lower-rated issuers.
  • Greater dispersion in exchange-rate volatility across EMs; limited evidence of contagion so far, but contagion risk could rise if global risk appetite weakens.
• EMs’ policy responses to recent pressures:
  • Interest rate hikes and FX interventions were commonly used.
  • Argentina and Turkey raised policy rates sharply.
  • Countries already tightening (including Indonesia, Mexico, the Philippines) hiked rates by more than markets had expected.
  • FX interventions executed in spot markets (Argentina, Indonesia) and via derivatives (Argentina, Brazil, India, Turkey).

Policy recommendations and conclusions

• Core advice:
  • Use exchange rate flexibility as a key shock absorber.
  • Appropriate macroeconomic policies should be the core response.
  • Complementary tools: macroprudential policies to contain systemic risk and FX interventions when warranted.
  • Policy rate hikes should counter inflationary pressure from currency depreciation and market pressures from outflows.
  • FX interventions can prevent disorderly market conditions if reserves are adequate.
  • CFMs can be implemented in certain situations but should be:
  • temporary,
  • transparent,
  • part of a broader policy response,
  • not substitutes for needed macroeconomic adjustment.
• No one-size-fits-all solution; policy mix choices depend on:
  • type of capital inflows;
  • type of financial and macroeconomic vulnerabilities;
  • monetary policy framework and credibility;
  • institutional capacity.

Source: "Policy Responses to Capital Flows" — Tobias Adrian, IMF; speech delivered October 11, 2018.

References

• Tobias Adrian
• Argentina and the IMF
• Indonesia and the IMF
• United Kingdom and the IMF
• Speeches
• PRESS CENTER
• https://www.elibrary-areaer.imf.org/Macroprudential/Pages/Home.aspx
• Adrian, 2017
• https://www.imf.org/en/home