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«Role Reversal in Global Finance Eswar S. Prasad I. Introduction The global financial crisis has sparked a reconsideration of the role of unfettered ...»

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Role Reversal in Global Finance

Eswar S. Prasad

I. Introduction

The global financial crisis has sparked a reconsideration of the role

of unfettered capital flows in the new international economic order.

Far from fulfilling their promises of boosting growth and helping

to diversify risk, capital flows are now seen by some as a destructive

force, causing crises that take down countries and scorch innocent

bystanders in their wake. Yet, despite all the opprobrium directed at

them, capital flows are resurgent. Many emerging markets in fact face the problem of plenty as their strong growth prospects fuel surges of inflows and create pressures on domestic inflation, asset prices, and exchange rates.

In this paper, I first evaluate recent trends in global financial integration and examine whether the financial crisis has halted or reversed this process. Next, I examine the evolution of the structures of external balance sheets of the major advanced and emerging market economies and evaluate the implications for capital flows and vulnerability to external shocks. Third, I offer a proposal for global insurance that may help emerging markets obviate the domestic and collective costs of self-insurance through reserve accumulation. Fourth, 340 Eswar S. Prasad I review the changing complexion of risks that capital account openness poses for emerging markets.1

The main points of the paper are as follows:

1. The financial crisis represented only a brief pause in the process of global financial integration. External balance sheets are expanding rapidly for virtually all major economies. Rising gross external asset and liability positions imply greater financial integration but also higher capital flow volatility due to currency fluctuations, portfolio rebalancing, and greater exposure to other external shocks.

This may increase emerging markets’ demand for insurance against capital flow volatility and balance of payments crises.

2. In the past, foreign currency-denominated external debt dominated the external liabilities of emerging markets. That has now shifted, with foreign direct investment (FDI) and portfolio equity accounting for the majority of liabilities. Even external debt issued by these countries is increasingly denominated in their own currencies. This structure of liabilities is consistent with the objective of sharing risk across countries, with foreign investors bearing capital as well as currency risk on such investment. Emerging markets have thus accumulated enough good karma to cast off their “original sin.”2 By contrast, portfolio debt and bank loans together constitute the major share of the external liabilities of advanced economies.

3. The asset positions of emerging market external balance sheets (not just for China) are becoming increasingly dominated by foreign exchange reserves, mostly held in government bonds issued by the four major reserve currency areas (the United States, euro area, Japan, the United Kingdom). The recent global financial crisis has if anything accentuated the incentives for accumulating reserves for self-insurance purposes, thereby ensuring that the foreign demand for these advanced economy government bonds remains strong.

4. The level of public debt in the major reserve currency economies is high and rising, imposing an enormous burden on these economies and constraining their macroeconomic policy responses to shocks.

A substantial fraction of the global increase in central government debt over the next five years is likely to be accounted for by Role Reversal in Global Finance 341 advanced economies, especially the United States and Japan. As the safety of the sovereign bonds of advanced economies comes into question, the risk on emerging market balance sheets has now shifted mostly to the asset side. These countries may be forced to rethink the notion that advanced economy sovereign assets are “safe” assets, although they are certainly highly liquid.

5. Self-insurance through accumulation of ostensibly safe assets is becoming increasingly costly for emerging markets. Reserve accumulation involves intervention in foreign exchange markets and sterilization to mitigate the inflationary consequences thereof.

The costs of conducting sterilized interventions are likely to rise in tandem with the rising differentials between the interest rates of emerging and advanced economies. Moreover, the high debt levels of advanced economies will crowd out private investment in those economies and could lower their productivity growth relative to emerging markets. This suggests that emerging market currencies are eventually going to appreciate against those of the advanced economies, which in turn implies a significant wealth transfer (in nominal domestic currency terms) in the future from the former group of countries to the latter.

6. Emerging market economies need a simple insurance mechanism that is characterized by ex-ante rather than ex-post conditionality in terms of a country’s macroeconomic policies, does not involve the stigma associated with the IMF, and involves an unconditional payout at the time of a balance of payments crisis. To minimize moral hazard, the mechanism should offer insurance against liquidity risk rather than solvency risk. I offer a proposal that satisfies these criteria.

7. For emerging markets, the major risks from capital inflows are now less about balance of payments crises arising from dependence on foreign capital than about capital inflows accentuating domestic policy conundrums. For instance, foreign capital inflows add fuel to domestic credit expansions, a factor that made some emerging markets vulnerable to the aftershocks of the recent crisis. New risks from capital account openness are related to existing sources of domestic instability—rising inequality in wealth and in opportunities 342 Eswar S. Prasad for diversification and sharing risk. Capital inflows and the resulting pressure for currency appreciations also have distributional implications as they exacerbate inflation, which disproportionately hurts the poor, and adversely affect the growth of industrial employment. For most emerging markets the right solution to these problems lies in establishing a richer set of financial markets to better absorb capital inflows and manage volatility, broadening access to the formal financial system (financial inclusion), and improving the quality of domestic institutions and governance.

II. Financial Globalization In the lead up to and right after the global financial crisis of 2008much of the discussion about global capital flows was centered on global macroeconomic imbalances and the uphill flows of capital from emerging markets to advanced economies. To this day, there is a raging debate about whether or not these current account imbalances were an “equilibrium” phenomenon and how much they contributed to precipitating the financial crisis. Chart 1 shows that capital continues to flow uphill, although China and the United States now seem to be the key drivers of this phenomenon.3 While the ebbs and flows of current account balances have garnered much of the attention, in the background global financial integration has continued unabated.

In a process that started in the mid-1980s and picked up pace over the past decade, advanced economies and emerging markets have substantially increased their integration into global financial markets.

This is evident from the rising gross positions of international assets and liabilities. Chart 2 shows that there has been a generalized increase in de facto financial openness, as measured by the ratio of the sum of gross stocks of external assets and liabilities to GDP.4 Among advanced economies, the median level of this ratio has more than doubled over the past decade. The increase is significant but smaller for emerging markets. By this criterion, advanced economies are much more integrated into global financial markets than the emerging market economies.

Role Reversal in Global Finance 343

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Notes: Financial openness is defined as the sum of gross external assets and gross external liabilities expressed as a ratio to nominal GDP, with all variables measured in current price U.S. dollars at market exchange rates. The median is the cross-sectional median calculated separately for each year for the relevant group of countries. The weighted mean is the ratio of the sum of external assets and liabilities for all countries in the group expressed as a ratio of the sum of nominal GDP for all countries in that group.

Source: Lane and Milesi-Ferretti (2010) Role Reversal in Global Finance 345 Table 1, which includes data for 2010, confirms that financial globalization increased sharply during 2000-07 and is on the rebound after the financial crisis. China and India were relatively closed in de facto terms in 2000 but have become much more open since then.

Other than Brazil and Russia, which experienced small dips, virtually every major economy—advanced or emerging—has a higher level of assets and liabilities relative to GDP in 2010 compared to 2007, indicating that the financial crisis did not reverse or stop rising global financial integration.

Rising gross external positions have important implications for growth, international risk sharing and financial stability. As gross stocks of external assets and liabilities grow in size, currency volatility will have a larger impact on fluctuations in external wealth and on current account balances.5 In particular, net factor income flows have already started playing an increasingly important role in driving current account fluctuations (rather than the trade balance, which used to dominate the current account for most countries). This has implications for evaluating appropriate/sustainable levels of current accounts.

Large gross positions imply far greater risks than those implied by net positions that may be small relative to the size of gross flows or stocks. Larger gross positions could mean greater volatility of capital flows due to external shocks as even modest portfolio rebalancing effects of international investors could lead to large fluctuations in net flows. Also, the level of net inflows may not be a good indicator of vulnerability if net flows are small relative to gross inflows and outflows. When an economy comes under pressure, gross inflows could stop and gross outflows could surge simultaneously, leading to a double blow in terms of net flows.6 Hence, countries may view rising gross positions as an incentive to accumulate more reserves to guard against externally-induced crises.

By the same token, large gross positions can provide better risk sharing, assuming that the currency, country and instrument composition of assets and liabilities is conducive to that. Given that countryspecific risks cannot be insured within a country, cross-border flows or wealth redistributions are the relevant channel for international 346 Eswar S. Prasad

–  –  –

Notes: Median refers to the cross-sectional median of the ratio across the countries in the group. The group ratio is the sum of external assets and liabilities for all countries in the group divided by the sum of their nominal GDPs.

For a few countries, data for 2009 were used when data for 2010 were not available and data for 2001 or 2002 were used when data for 2000 were not available. Euro area countries not included in the sample are Cyprus, Luxembourg, and Malta.

Sources: IMF’s International Financial Statistics and Lane-Milesi-Ferretti (2010). U.S., data for 2010 are from the Survey of Current Business, July 2011.

risk sharing. With large gross positions, even small currency fluctuations can generate large implied wealth transfers across countries, although the implications for risk sharing are not always positive.7 Typically, if a country faces a crisis such as a financial meltdown or pressures on its sovereign debt, its currency would depreciate, thereby automatically transferring some of the adjustment costs onto foreign holders of its liabilities. But this is true only if a country’s liabilities are denominated in the domestic currency. Liabilities denominated in foreign currencies could exacerbate the impact of adverse shocks that lead to currency depreciation as the value of such liabilities Role Reversal in Global Finance 347 would then rise in domestic currency terms. Domestic price dynamics combined with currency depreciation will then determine how the impact of adverse shocks is distributed among domestic agents and the foreign holders of a country’s liabilities. The magnitudes of these effects also depend on the shares of liabilities and assets that are fixed-income instruments versus those that have an equity component; the latter involve more sharing of risk between domestic and foreign investors.

While rising gross positions clearly have a major impact, a closer examination of the structure of external assets and liabilities is warranted as that structure has implications for the potential benefits of financial integration in terms of both growth and risk sharing.

III. Risk and the Structure of Country Balance Sheets I now turn to an examination of the international investment positions (IIP) of a set of major advanced and emerging market economies. The IIP is essentially a country’s balance sheet vis-à-vis the rest of the world. It provides an indication of a country’s gross external assets and liabilities as well as the composition of each side of the balance sheet.

Table 2 shows the latest IIP position for a key set of economies.

Among the advanced economies, the U.K. and the United States have significant net liabilities while Germany and Japan have net asset positions. For all of these advanced economies, the category “other investment”—which mainly covers bank loans—is an important share of liabilities. When one adds in portfolio debt—which is mainly corporate as well as government debt—it is clear that debt accounts for the majority of external liabilities.

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