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D Mihaljek EIZ Nov 2008

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					The financial stability implications of increased
capital flows for emerging market economies

Dubravko Mihaljek
Bank for International Settlements




Presentation at the Economics Institute Zagreb
Zagreb, 11 November 2008



The views expressed are those of the author and not necessarily those of the BIS.




                                                                                    1
Outline


1. Data description
2. Recent trends in capital flows to/from EMEs
3. Financial stability implications of increased capital flows
    – Focus on bank-intermediated capital inflows and CEE
    – Policy responses
    – Financial stability implications of debt portfolio outflows




                                                                 2
Data description

   Focus (mostly) on private capital flows
   Gross vs. net flows
    •   Gross flows: to study financial integration, financial stability
        issues; composition of flows important for macroeconomic
        management
    •   Net flows: key for macroeconomic (demand) management
   Sample
    •   Mostly 2001-2006
    •   Some comparisons with 1990s
    •   3 EM regions: Asia and Latin America, CEE (Baltics, central
        Europe, SEE)


                                                                           3
Data description (2)

 Data sources
    •       BoP data (IMF, International Financial Statistics)
    •       BIS: locational and consolidated statistics


 Look at average of countries in the region, and regional
   totals:
                      n


   1 KFin            KF         i

      Y vs.         i 1
                        n

                      Y
   n i 1 i
                             i
                      i 1


                                                                 4
                     Recent trends – gross inflows

                    All emerging markets                                           Asia
16                                                              16

                 Gross inflows          Gross outflows
12                                                              12


                                                                8
8

                                                                4
4

                                                                0
0
     1990          1994          1998        2002        2006
                                                                -4
-4                                                                   1990   1994   1998   2002   2006


            % of GDP, regional totals
10
                                                                22
                                                                                                 5
8
                     Recent trends – gross inflows (2)

                         Latin America                             Central and eastern Europe
10
                                                       22

8
                                                       16
6

                                                       10
4


                                                       4
2


0                                                      -2
     1990         1994          1998     2002   2006        1990     1994     1998      2002    2006



            % of GDP, regional totals


                                                                                                6
Recent trends: regional distribution

Share in gross inflows of private capital to EMEs, %

                               1995                    2006

CEE                              11                     26

Asia                             51                     47

Latin America                    29                     12

Other EMEs                       9                      19



                                                              7
Gross inflows and outflows for CEE

            Inflows                                                          Outflows




% of GDP, unweighted country average; except net flows (regional average).
                                                                                        8
Net flows to CEE - latest data

               Net private capital flows to CEE - Oct. 2008 WEO
                                  % of GDP, regional total
12
                                  9.5
10
         8.2
                                                               7.8                      7.5
 8
                                  5.8
         3.1
 6                                                             4.0                       3.5
         0.7
 4                                                             0.5                       0.6

 2       4.4                      4.1
                                                               3.3                       3.4

 0                                -0.4

 -2
        2006                     2007                          2008                     2009

       Direct investment, net   Private portfolio flows, net     Other private capital flows, net


                                                                                                    9
Recent trends – breakdown of gross inflows




                                             10
Recent trends – breakdown of gross outflows




                                              11
          Portfolio outflows
          - mostly for purchases of foreign debt securities
          - mostly from China (70% of Asian total, $140 bn. from 2002-06)
          - “private” sector probably includes SOCBs




                                                                      12
% of gross outflows
 Two main developments from FS perspective:
 (a) “other” investment inflows; (b) portfolio outflows

 “Other” investment: flows to banks and to other sectors non-
 financial corporations, NBFIs, households

             Gross inflows of other investment                                Gross outflows of other investment
80                                                                80


60                                                                60


40                                                                40


20                                                                20


 0                                                                 0


-20                                                               -20
      Trade credit        Loans     Currency and       Other            Trade credit         Loans     Currency and   Other assets
                                      deposits      liabilities                                          deposits
              EME total     Asia   Latin America   CEE                           EME total     Asia   Latin America   CEE

 % of gross inflows/gross outflows of “other investment”; unweighted country average for 2004-06.                             13
    Other investment flows increased very strongly in CEE

    External positions of BIS reporting banks vis-à-vis emerging market countries
                                                                 Amount outstanding
                                                   USD billions                        Per cent of GDP
                                           1998       2002         2007        1998         2002         2007
Emerging markets1
  Vis-à-vis all sectors                   1,017         865       2,290         19.3         14.6         17.3
  Vis-à-vis non-bank private sector         366         354         914          6.9          6.0          6.9
Asia2
  Vis-à-vis all sectors                     574         442       1,068         26.6         14.7         16.9
  Vis-à-vis non-bank private sector         105          87         270          4.9          2.9          4.3
Latin America3
  Vis-à-vis all sectors                     263         233         350         13.9         15.1         11.1
  Vis-à-vis non-bank private sector         170         156         213          9.0         10.1          6.8
Central and eastern Europe4
  Vis-à-vis all sectors                      82         118         579         12.1         16.5         32.4
  Vis-à-vis non-bank private sector          44          70         289          6.5          9.8         16.2

Assets of BIS reporting banks vis-à-vis individual emerging market countries; end of period. Totals for positions
in US dollars; simple averages for positions as a percentage of GDP.
Sources: IMF; BIS locational banking statistics.
                                                                                                                    14
                     The increase was most pronounced in the past three years
                                  Cross-border claims of BIS reporting banks
                                         vis-à-vis emerging markets
                      Changes in amounts outstanding at end-period, as a percentage of GDP

                                           Cumulative increase in CEE since 2005:
                                  7.5% of GDP                                 5.7% of GDP
                                  Vis-à-vis banks                                                         Vis-à-vis non-the bank private sector
 4.0                                                                                        4.0
                                                                                      3.4
                 Asia
                                                                                                                                                                   3.0
 3.0             Latin America                                      2.9
                                                                                            3.0
                 CEE

 2.0                                                                      1.7               2.0
                                                                                1.5                                                                                              1.5
                            1.4                                                                       1.2
                                                        1.2                                                                                         1.2
                                                                                                                                                                         1.0
 1.0           0.7                          0.7                                             1.0
                                                                                                            0.4          0.4                                 0.5
                                                                                                                               0.2      0.3               0.3
                                   0.0                        0.1                                                                             0.1                              0.1
         0.0
 0.0                                                                                        0.0
                     -0.2                                       -0.2                                              -0.2
                                                     -0.5                                          -0.4
                         -0.5
 -1.0 -0.7                                        -0.8                                      -1.0                     -0.8
                                         -0.9

                                                                                                                                     -1.6       -1.6
 -2.0                                                                                       -2.0
        2002           2003         2004           2005        2006        2007                      2002           2003         2004          2005        2006            2007


Source: BIS, Locational Banking Statistics; IMF, World Economic Outlook.
                                                                                                                                                                                       15
 Cross-border loans account for a large share of domestic credit in CEE
                                    Cross-border and domestic bank credit
                                        in emerging market economies
                                       As a percentage of total bank credit

  100


   75
                                                    68                             61           63
                                  85                                 78
               87
   50


   25
                                                    32                             39           37
                                  15                                 22
               13
     0
              2002              2007               2002             2007          2002         2007

                       Asia                            Latin America                     CEE

                                       Cross-border loans         Domestic bank credit


Sources: IMF; national data; BIS locational banking statistics.
                                                                                                      16
Financial stability implications of cross-border loans

 In the past, “pure” cross-border loans
    • Latin America in 1980s  debt crisis
    • Asia in 1990s  1997/98 crisis


 Now parent banks  loans to subsidiaries in EMEs


 “Pure” cross-border loans mainly to large corporations
   from EMEs




                                                           17
Financial stability implications of cross-border loans (2)

 Parent banks  loans to subsidiaries
   • Most pronounced in CEE and Mexico, where banking
     systems are 80-95% foreign-owned
   • In CEE, cross-border loans are convergence flows –
     economic, financial, institutional integration with EU, which
     is different from Asia in the 1990s
   • Cross-border loans were taking place in financially
     repressed banking systems in Latin America in the 1980s
     and Asia in the 1990s; banking systems in CEE are
     competitive and open
   • Cross-border loans were financing import-substituting
     development in Latin America, not the case in CEE
                                                                18
Financial stability implications of cross-border loans (3)

 Risk of a solvency crisis smaller
    • Parent banks large, well-capitalised, well supervised,
      focus on traditional commercial banking, did not invest
      in subprime/structured products


 But the risk to sustainability of cross-border flows still large
    • Underestimation of credit risk during credit boom
    • High targets for ROE (to exploit franchise value)




                                                                 19
Financial stability implications of cross-border loans (4)
                Return on equity for banks in major home and host countries, 2005
                               Host countries       ROE          Major home         ROE
                                                    (%)           countries         (%)
Asia                          Indonesia             24.0       Netherlands          16.0
                              Korea                 19.1       UK                   17.3
                              Malaysia              14.1       US                   17.7

Latin America                 Brazil                27.7       Spain                16.0
                              Chile                 17.3       UK                   17.3
                              Mexico                24.4       US                   17.7

Central Europe                Czech Republic        32.1       Austria              14.8
                              Hungary               27.0       Belgium              19.2
                              Poland                20.6       France               14.4
                              Slovakia              13.7       Germany              13.9
                              Slovenia              17.0       Italy                14.0
Baltic states                 Estonia               19.4       Denmark              18.9
                              Latvia                25.1       Sweden               20.7
                              Lithuania             16.0       Finland               9.4
South-eastern Europe          Bulgaria              21.4       Austria              14.8
                              Croatia               20.2       Greece               15.3
                              Romania               14.9       Italy                14.0
                              Turkey                17.8

                                                                                           20
Financial stability implications of cross-border loans (5)

 Risk of regional contagion
   • Parent banks pursue similar strategies across regions
     (eg, lending to households)
   • Transmission of shocks from home countries (eg, via
     funding in wholesale markets)
   • Asymmetry of host country vs. parent bank exposures
   • Other channels: short maturity of cross-border loans,
     concentration of foreign creditors, common creditors
     across region



                                                             21
Financial stability implications of cross-border loans (5)




                                                      22
Risks at the current juncture:
sudden stop/reversal of bank intermediated flows
                Net cross-border loans by BIS reporting banks to banks in EMEs1
                                              In billions of US dollars
          29
30
                  22                        2002           2006       2008:Q1
20
                          15
                                   10         8
10                                                                                              6
                                                       0
 0
                                                                  0    -1
                                                                                -2
                                                                                      -4
-10


-20
                                                                                                       -19

-30                                                                                                        -160

       RO      HU       LV      LT       EE       CZ        HR        BG    RS       PL    TR         ZA      RU

Cross-border loans to banks in EMEs, less deposits of EME banks in BIS reporting banks; end-period.
Source: BIS, locational banking statistics.

                                                                                                                   23
Risks at the current juncture:
sudden stop/reversal of bank intermediated flows (2)
            Net cross-border loans by BIS reporting banks to the non-bank sector
                                          in EMEs1
  70
                                            In billions of US dollars                        61
                                                                                                      55

  50                                        2002       2006       2008:Q1



  30        27
                     18       18       17
                                                14
                                                          7
  10                                                                 4     4        3

                                                                                                               -1
  -10



  -30
          PL       RO      HR       HU        CZ      BG        LT       LV      EE       RU       TR       ZA

Cross-border loans to the non-bank sector in EMEs, less deposits of the EME non-bank sector in BIS reporting banks; end-period.
Source: BIS, locational banking statistics.

                                                                                                                      24
                   Risks at the current juncture:
                   sudden stop/reversal of bank intermediated flows (3)

                                                             Private sector deposits
100                                                     As a percentage of total liabilities 1

    80   74                                                       2002
              69
                   64   63   62
                                  58         59                                                                                       57
    60                                            52    52   49     2008           48   46                                                  43
                                        42                                                    40
                                                                                                   36                                            38
    40                                                                                                  34   32   32
                                                                  25     24                                            22
    20                                                                                                                      16   13
                                                                              12


    0
         IN   TH   ID   PH CN MY KR AR BR CL PE CO MX VE HR RS BG RO PL CZ HU LT EE LV TR ZA RU
1
 Total private sector deposits; domestic banking system, end-period levels (for 2008, May).
Source: IMF, International Financial Statistics.




                                                                                                                                           25
                  Risks at the current juncture:
                  sudden stop/reversal of bank intermediated flows (4)

                                                     Ratio of total loans to total deposits1
3.0
                                                                                      2.6
                                              2.4
                                 2008
                                                                                            2.1
                                                                                                  1.9
2.0    1.9                       2002
                                                    1.7
                                                                                                        1.4 1.4 1.3                       1.5

                                                                                                                      1.1 1.1                   1.1
                                                                                                                              1.0
             0.9 0.8                                      0.9
1.0                  0.8 0.8 0.8                                0.8 0.8                                                             0.8                0.8
                                                                          0.7
                                                                                0.6
                                        0.5



0.0
      KR     TH   ID   MY   IN   CN     PH CO       CL VE MX BR           PE    AR LV       EE    LT    RO HU   BG HR    RS   PL    CZ    RU    ZA    TR
1
 Private sector loans divided by private sector deposits (end of period; for 2008, May), domestic banking system.
Source: IMF, International Financial Statistics.




                                                                                                                                                      26
Policy responses – how to deal with these risks?
1. Macroeconomic policies
   •   Allow greater exchange rate flexibility – trade-off
       between the consequences of ER appreciation and
       sterilisation
   •   Reduce policy rates – trade-off between the
       consequences of capital inflows and domestic
       objectives (inflation target, domestic credit growth)
   •   May have limited room for manoeuvre on ER, IR
   •   Relax controls on capital outflows – eg, for institutional
       portfolio investors
   •   Fiscal tightening – best approach; should focus on
       expenditure restraint
                                                                27
Policy responses (2)

2. Macroprudential and microprudential responses
   •   Tighten oversight of banks’ management of credit risk
       (to make sure banks hold sufficient capital)
   •   Improve quality of creditor information (accurate
       company financial reports, credit registry for
       households, tighter debt/income & debt service/
       income ratios, etc)
   •   Diversify sources of bank funding
   •   Temporary capital controls



                                                           28
                            Policy responses (3)
                            Funding sources of EME banks are poorly diversified

                        Domestic money market instruments and bonds1                                        Bank borrow ing from other dom estic
                                                                                                                    financial institutions 1
          28                       As a percentage of total liabilities
30                                                                                              25              As a percentage of total liabilities
                  25                                                                                   21
                                           2002      2008                                       20                            2002   2008
20
                            12                                            12                    15
                                                                                8    8
10
                                                                                                10           9
                                    4
                                                                                            1                       6
                                             0        0        0                                                          4
0                                                                                                5                               3    3
                                                                                                                                            1     1        0
         CL    CO         ZA     MY       MX       BR       RO       KR        CN   VE    PE                                                                   0
                                                                                                 0
                       Money market instruments                      Domestic bonds issued by         CO CN BR ZA TH MX CL MY                            ID   TR
                                                                              banks             1 Liabilities to other domestic banking institutions and non-bank
     1                                                                                          financial institutions; end-period levels.
      End-period levels (for 2008, May), domestic banking system.
     Source: IMF, International Financial Statistics.                                           Source: IMF, International Financial Statistics.




                                                                                                                                                      29
Policy responses (4)

3. Home-host supervisory cooperation
   – International scope of banking institutions vs. national
     scope of regulation and supervision
   – Conflict between macroeconomic and financial
     stability concerns in small economies hosting large
     international banks
   – Divided responsibilities for financial stability and
     financial sector supervision within home and host
     countries




                                                                30
Policy responses (5)

3. Home-host supervisory cooperation (cont’d)
   – Subsidiaries vs. branches
   – MOUs, supervisory colleges, joint supervision
   – Resolution of cross-border bank failures




                                                     31
Are there any financial stability implications of EME
investments in foreign portfolio capital?

 Redirecting FX inflows helps macroeconomic policy
  (no need to deal with impact of capital inflows)
 But is it good investment?
   • Interest rate differential vis-à-vis US
   • Assets denominated in depreciating currency (USD)
 If investments are made by SWFs, additional issues:
   • Protectionist backlash
   • SWFs might not be subject to supervisory oversight in
     their home jurisdictions


                                                             32

				
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