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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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There is little evidence that financial globalization has improved the quality of fiscal and monetary policies, but perhaps the real issue is about an alternative set of policies that creates broader financial access to the formal financial system, catalyzes better public and corporate governance, and provides a strong incentive for financial market development.26 Policy Complications The longer term perspectives discussed above are of little comfort to emerging market policymakers facing immediate pressures from capital inflows. Capital controls have been touted as a legitimate tool to deal with surges of inflows. Such inflows can certainly leave longlasting scars on a country’s tradable goods sector and export market shares if they result in persistent currency appreciations. There are many problems with capital controls, however. As trade expands, financial markets develop and become more sophisticated, and corporations and financial institutions increase their cross-border operations, the capital account becomes porous and capital controls are more easily circumvented, especially if the incentives such as crossborder interest differentials are strong enough. This makes capital controls largely ineffective in terms of controlling the overall volume of flows.27 What about selective capital controls—is it possible to use the hierarchy of capital flows to develop guidelines under which countries may intervene in foreign exchange markets or use targeted capital controls with the blessings of the international community?

The problem with this latter approach is that money tends to be quite fungible. Indeed, in countries with relatively well-developed financial markets, such fungibility is an even bigger issue and it has proven difficult to keep money from coming in (or leaving) through multiple channels. Moreover, most major emerging markets now Role Reversal in Global Finance 379 have relatively open capital accounts, especially in de facto terms, and trying to turn the clock back is unlikely to be effective and would just create policy uncertainty.

Determining when capital controls are legitimate requires fine judgments about the temporary versus persistent nature of flows, which is difficult in real time. The same is true of determining whether current account balances are being driven by transitory or permanent shocks, which makes it difficult to arrive at judgments about their appropriate level. Determining the appropriate level of current account balances will become even more complicated as current accounts become increasingly driven by valuation effects and earnings on countries’ external portfolios.

The IMF has proposed the creation of “rules of the road” to protect countries that have the right policies but get caught up in spillovers of global turmoil or in policy spillovers from large economies. To make progress on this requires clear benchmarks against which to evaluate current account balances and capital flows. Economic theory in its current form does not provide good benchmarks for evaluating the direction and patterns of capital flows, especially given various aspects of market incompleteness, information asymmetries, institutional weaknesses and other frictions. This will make it difficult to construct useful rules of the road that have general applicability.

This is an area where intensive academic research is sorely needed to generate better analytical frameworks, although it is still not clear if such rules are desirable or enforceable.

Rather than focus on evaluating the appropriateness and sustainability of current account balances and exchange rates, a more productive analytical approach might be to ask what market failures are leading to a pattern of capital flows that is not efficient and increases global risks. Unconstrained leverage is a problem that can be handled through regulatory tools. Other than that, many problems in terms of policy spillovers can be traced to weak macroeconomic frameworks among both the suppliers and recipients of capital. Dealing with the effects of one set of distortions by adding more distortions 380 Eswar S. Prasad in the form of capital controls and other ad hoc measures may ultimately prove counter-productive by exacerbating policy instability.

A better approach is to improve a range of other policies, from financial development and banking regulation to fiscal and monetary policies, so that capital flows in a more stable and efficient manner. For instance, broader and better-regulated financial markets can help emerging markets to absorb inflows and effectively intermediate them into productive rather than speculative activities.

It is also in the self-interest of emerging markets as a group to foster financial market development. This will allow them to invest more among themselves rather than finance fiscal profligacy in advanced economies. Advanced economies’ deeper and broader financial markets have made it easier for them to finance their deficits and allowed a number of them to avoid major reforms notwithstanding crises that they experienced. In the case of emerging markets, by contrast, financing constraints made significant policy reforms imperative when these economies were hit by crises.

One paradox is that in the short run emerging markets with better financial markets and good growth prospects may end up having to deal with a larger quantum of flows than those with underdeveloped financial markets that intrinsically limit foreign investment. There are few easy answers to these transitional risks.

VII. Concluding Remarks In this paper, I have documented dramatic shifts in the composition of emerging markets’ balance sheets. Their liabilities have come to be dominated by FDI and portfolio equity flows, while their assets are increasingly in the form of foreign exchange reserves. In tandem with the uphill flows of capital characterized in other studies, this implies a sharp role reversal between emerging markets and advanced economies. Emerging markets have not only become net exporters of capital to the advanced economies but have also substantially reduced the risk emanating from the structure of their external liabilities even as advanced economies’ external liabilities continue to be dominated by debt.

Role Reversal in Global Finance 381 At one level, financial globalization seems to be proceeding along the right track. Emerging markets are getting more capital in forms that promote international risk sharing and make them less vulnerable to sudden shifts in sentiment. Overall, their dependence on foreign capital is limited. As a group they have become net exporters of capital and even those countries like Brazil and India that have current account deficits have large stocks of reserves. Many of these countries have also adopted better monetary policy frameworks with flexible exchange rates, reducing the risk of currency crashes.

This picture is clouded by the fact that advanced economies have boxed themselves in with undisciplined fiscal policies that could erode their productivity and growth. Moreover, the external liabilities of these economies continue to be dominated by debt. Even though a large share of their external liabilities is denominated in their own currencies, leverage and weak regulation have proven to be a toxic combination in many advanced economies. In tandem with rising domestic and external sovereign debt, this makes them vulnerable to adverse shocks. It is high time for advanced economies to take the tonic of macroeconomic and structural reforms that they have for so long dispensed to the emerging markets.

382 Eswar S. Prasad Appendix A: Country List Advanced Economies (29): Australia, Austria, Belgium, Canada, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hong Kong, Iceland, Ireland, Israel, Italy, Japan, Korea, Netherlands, New Zealand, Portugal, Singapore, Slovak Republic, Slovenia, Spain, Sweden, Switzerland, United Kingdom, United States.

Emerging Markets (29): Argentina, Brazil, Bulgaria, Chile, China, Colombia, Hungary, India, Indonesia, Jordan, Kazakhstan, Kenya, Latvia, Lithuania, Malaysia, Mexico, Morocco, Nigeria, Pakistan, Peru, Philippines, Poland, Romania, Russia, Saudi Arabia, South Africa, Thailand, Turkey, Ukraine.

Role Reversal in Global Finance 383 Endnotes I use the IMF classification of advanced economies and emerging markets.

Countries with per capita income of over $15,000 in 2010 (at market exchange rates) are counted as advanced economies. The list changes only marginally when one uses purchasing power parity-adjusted exchange rates and an income threshold of about $18,000 in 2010 (Hungary and Poland would then be classified as advanced). The 58 economies—29 advanced and 29 emerging—included in the analysis sample account for about 90 percent of global GDP and are listed in the appendix. Switching economies like Hong Kong, Israel, Korea and Singapore to the emerging markets category only strengthens many of the empirical observations in this paper.

The term “original sin” was introduced by Eichengreen and Hausmann at the 1999 Jackson Hole Symposium. The term refers to the fact that, during the 1980s and 1990s, emerging markets’ capital inflows were mostly in the form of shortterm foreign currency-denominated external debt rather than more favorable forms of capital such as FDI or portfolio equity.

For a more detailed documentation of uphill capital flows and their implications, see Prasad, Rajan and Subramanian (2007). Gourinchas and Jeanne (2009) note that conventional theoretical models predict that countries with higher productivity growth should attract more foreign capital, but data on the allocation of foreign capital across developing countries show the opposite.

A standard data set used in this literature is the External Wealth of Nations database constructed by Lane and Milesi-Ferretti (LMF) (2007). Most of the major economies now report their international investment positions (IIP), although only for the last decade or so in many cases. I use official IIP data as the baseline source in this paper—this has an added advantage of helping me include 2010 data for many countries (the LMF dataset has been updated through 2009). I use LMF data for historical comparisons and for countries that do not provide IIP data.

Obstfeld (2010) alluded to some of these issues in his remarks at last year’s conference. Lane and Milesi-Ferretti (2008) analyze the factors that drive changes in countries’ gross external positions.

Forbes and Warnock (2011) analyze gross flows around crises and try to disentangle sudden stops or reversals of gross inflows (related to nonresident investors) from surges of gross outflows (by residents). They find that dynamics of gross inflows and outflows are driven by similar factors and that gross flows are more relevant than net flows for explaining currency crashes.

Currency fluctuations generate implicit wealth transfers due to currency valua

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world over the period 2007:Q4 to 2009:Q1. This was at the height of the financial crisis and could in part reflect valuation effects from the strengthening of the dollar during that period as money flooded into the Unites States in search of a safe haven.

Kose, Prasad and Terrones (2009) show that for emerging markets, FDI and portfolio equity liabilities improve international risk sharing outcomes. Debt liabilities have the opposite effect.

Based on BIS data, Burger, Warnock and Warnock (2010) report that in 2008 local currency denominated debt accounted for 85 percent of the outstanding stock of international bonds issued by emerging markets. The shares for different regions are as follows: Emerging Europe, 70 percent; Latin America, 72 percent; Asia, 95 percent. The International Finance Corp. reports that in 2008 local currency debt accounted for roughly 70 percent of emerging market debt.

The ironic phrase about nonappreciation is attributed to Edwin Truman.

Caballero, Farhi and Gourinchas (2008a, 2008b) argue that emerging markets’

search for safe assets precipitated global macroeconomic imbalances. Mendoza, Quadrini and Rios-Rull (2010) make a related point that the greater financial depth of advanced economies attracts large inflows.

I focus on central government securities as those are most relevant for reserve accumulation. Net debt is preferable for the purposes of my analysis as the remaining portion of gross debt is typically held domestically. The difference between gross and net public debt relates to intra-governmental holdings of debt. For instance, in the United States, Social Security trust fund surpluses are held in government securities. These count toward gross but not net public debt. For the subject of this paper—the reliance of national governments on foreign financing of their debt—net debt is a more suitable concept. In any event, using gross rather than net debt strengthens the patterns in the data that I discuss below and accentuates concerns about public debt levels of advanced economies. For more detailed data, including estimates of the burden of central government debt (debt per capita or per working-age person), see Prasad and Ding (2011) and www.ft.com/debtburden.

The reported debt levels of emerging markets should be interpreted with caution. In China, for instance, financial liabilities of provincial governments and contingent liabilities such as nonperforming assets held by the state-owned banking system imply a much higher value of government debt obligations than indicated by official statistics. Of course, as the recent crisis has shown, advanced economy governments arguably have similar implicit contingent liabilities if their big banks were to run aground or their public pension systems were to run out of money.

Cecchetti, Mohanty and Zampolli (2010) present sobering projections of advanced economies’ long-term debt levels under current policies in those countries.

A counter-argument is that the currency value is of little consequence as the

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