Bolstering the Surveillance of Regional Capital Flows

1. Bolstering the Surveillance of Regional Capital Flows Some out-of-the-box ideas By Huzaime Hamid, Malaysia For NEAT Working Group on Intra-regional Exchange Rate Stability and Prevention of Financial Crisis in East Asia, Tokyo, Japan 30 June, 2006

2. Definitions: • Oxford / Reader’s Digest Complete Wordfinder: “…close observation, esp. of a suspected person, syn. Watch, scrutiny, reconnaissance….” • IMF: • “One of the core responsibilities of IMF is to maintain a dialogue with its • member countries on the national and international repercussions of their • economic and financial policies.This process of monitoring and consultation • is normally referred to as “surveillance”, though there is nothing clandestine • about it. Indeed, the consultation process has become increasingly open to • public scrutiny in recent years.” (2003) 3. ADB: “….assist the developing member countries of ADB – both individually and collectively – to harness the full benefits of global financial integration and international capital flows while at the same time minimizing any disruptive effects.” (2003) Source: IMF and ADB Perspectives on Regional Surveillance in East Asia, Brouwer

3. Frameworks for the APT Surveillance Process • Manila Framework (November 1997 – 2004) – to create a framework for regional cooperation to enhance the prospects for financial stability. It established a mechanism for regional surveillance, complementary to IMF’s global surveillance. • APT Finance Ministers’ Meeting – for Finance Ministers to discuss financial and currency issues in East Asia. • Informal APT and Central Bank Deputies Meeting (Informal AFDM+3) – for mutual surveillance and exchange of views on macroeconomic and structural problems. ADB supported. • APEC Finance Ministers’ Meeting – to discuss economic issues related to macroeconomics and capital flow issues. • ASEM Finance Ministers’ Meeting – to strengthen linkages between Asia and Europe and to progress further economic and financial cooperation. • EMEAP Governors’ Meeting – to strengthen cooperative organization between central banks and monetary authorities in East Asia and the Pacific. • Cont’d….

4. …cont’d7. SEACEN Experts’ Group on Capital Flows – to develop regional framework for information sharing on capital flows & to draw up implementable proposals to enhance the management of capital flows.8. ASEAN Surveillance Process – organized around the ASEAN Surveillance Coordination Unit. Prime objectives are to strengthen cooperation by (i) exchanging information and discussing economic & financial developments among members, (ii) providing a peer review and early warning system to enhance regional macroeconomic and financial systems stability, (iii) highlighting possible policy options & encouraging early actions to prevent a crisis, (iv) monitoring & discussing global financial and economic developments, its regional impact and any necessary actions thereto.9. ADB REMU – facilitate integration of member ADB countries into global economy so they can harness benefits at minimal costs. Supports surveillance process through studies on regional integration & monetary and financial cooperation.10. ADB ARIC – started as a (crisis) recovery center but now provides information on economic and social developments, financial & corporate restructuring initiatives, and structural reforms.Source: Report Summary of Studies on “Economic Surveillance and Policy Dialogue in East Asia”, IIMA, 2005

5. Four main risks for foreign investors: • Debt maturity mismatch risk • Currency mismatch risk • Capital structure mismatch risk (constant coupon payments in declining • FX value & cashflow stress periods) • Solvency risk (Liabilities > Assets) • Source: IMF Balance Sheet Approach to Financial Crisis Prevention & • Resolution, Hofer, 2002

6. Key IMF Surveillance & Crisis Prevention Measures • Financial sector assessment programme – assesses a country’s financial system) • Country surveillance (under Article IV consultations) – annual review of the • country as a whole • Regional surveillance – assessment of monetary unions (e.g. EU, ECCU, WACU, • EACU) • Multilateral surveillance – through World Economic Outlook and Global Financial • Stability Report • Reports on the Observance of Standards and Codes – mainly on best practices on • fiscal policy • Special Data Dissemination Standards – national economic indicators • Debt Sustainability Analysis – tests on the serviceability of national debt • under shock • Balance Sheet Approach – Vulnerability assessment due to currency or maturity • mismatches • Technical Assistant and Regional Institutes – Assistance and education on • systems relevant to economic and monetary policy • Source: IMF Balance Sheet Approach to Financial Crisis Prevention & • Resolution, Hofer, 2002

7. IMF Special Data Dissemination Standards (‘SDDS’) covers: • National accounts, nominal, real & associated standards – quarterly • Production indices – monthly & quarterly • Labor markets – quarterly • Prices indices – monthly • General government/public sector operations (special framework provided) – annually • Central government operations – monthly • Central government debt – quarterly • Analytical accounts of the banking sector (specially framework provided) – monthly • Analytical accounts of the Central Bank – monthly; weekly encouraged • Interest rates – daily • Stock market movements – daily • Balance of payments data (special framework provided) – quarterly • International reserves and foreign currency liquidity – monthly; weekly encouraged • Merchandise trade figures – monthly • International investment positions – annually; quarterly encouraged • Exchange rates – daily • External debt – quarterly • Socio-economic indicators – annually • Source: IMF website 9/6/2006

8. Key weaknesses of the IMF SDDS appear to be: • Infrequency – capital flows happen daily. • Daily capital flows from one country to another not well captured, rather a • static picture of account balances is taken • The amount of foreign capital and ownership structure within a nation, • especially the flighty sort, appears to not be captured specifically either. • The set appears to be more a test of a country’s credit-worthiness rather • than its temporal experience with capital flows.

9. COURSE OF A FINANCIAL CRISIS- ECONOMY WITH SECTORAL BALANCE SHEET MISMATCHES (Source: Rosenberg, IMF) Exchange rate Depreciation Attempt to stabilize exchange rate Reversal of Capital flows Interest rate Increase Exchange Rate Shock Loss of confidence Rollover shock Interest Rate Shock Economy with mismatches Banks Government Corporations and Households Spillovers

10. To fully anticipate capital flows, surveillance needs to include: • Knowledge of amounts of flighty capital in a domestic system • Strategic asset allocation and country calls by fund allocators and strategists in • capital markets • Changes in fund benchmark indices • Changes in sovereign, foreign exchange, and major corporate debt issue ratings • Movements of capital across borders • Hedge fund positions on a regulated disclosure basis

11. Global assets under management (USD trillion as at end 2003): International Banking Assets 23.6 International Debt Securities 14.6 Insurance Companies 13.5 Pension Funds 15.0 Investment Companies 14.0 Hedge Funds 0.8 Other Institutional Investors 3.4 Total Funds under Management 84.9 Memo Item – OTC Notional Derivative Contracts 270.1 GRAND TOTAL 355.0 Or, some 44 times ASEAN+3 2004 GDP, and some 8.6 times the world’s 2004 GDP. MSCI World Index benchmark weight for APT 15.51% (as at 7 May 2006) Source: Exchange Rate Regimes and Global Imbalances, Sheng, 2006, BIS, IMF

12. Main Types of Global Flows: • World trade in goods & services in 2004 USD 11 trillion • FDI flows of USD 648 billion in 2004 • FPI flows of USD 4.2 trillion in 2004 (CPIS data for top 10) • Gross daily turnover of FX of USD 1.9 trillion in 2004 (BIS Triennial Survey 2004) • Derivatives trading of USD 5.7 trillion daily (BIS Triennial Survey 2004) • Source: Exchange Rate Regimes and Global Imbalances, Sheng, 2006

13. 2004 World Market Size USD Billion Total Reserves minus Gold (FT market proxy) 3,865.6 Stock Market Capitalization 37,168.4 Total Debt Securities 57,842.9 Commercial Bank Assets 57,315.8 Total Global Markets 156,192.7 Total Global Markets / World GDP 3.78x Total Portfolio Moneys / Total Global Markets 2.27x Source: IMF Global Financial Stability Report, 2006

14. Key quantitative capital flight trigger-points for fund managers (based on the • 1997 / 98 Asian Financial Crisis: • > 1.5% trade deficit / GDP • > 3% federal government budget deficit / GDP • > 100% banking system loans to deposits ratios • > 3 x debt to equity ratios of major corporations • > 20% per annum M2 growth • < 3 months import cover on FX reserves • Key qualitative capital flight trigger-points: • Domestic banking system and management thereof seen as weak • Presence of structured currency depreciation • “Excessive” property and asset prices, usually based on YoY price increases • “Large” amounts of short term debt to be redeemed in the near future • High corruption (proxied by Transparency International’s Corruption Index rating) • Key point is the risk tolerance of individual fund managers; however, • they will beat feet once the herd starts going the other way. It is a game • of perception and follow-the-crowd.

15. A typical re-weighting exercise Using the MSCI World Free Index (as at 7 May 2006) country weightings as a benchmark, A drop of 10% in say, the US market, necessitates a selling of non-US assets to re-weight Back to following the benchmark: Benchmark Portfolio Weights Portfolio % Portfolio Weights Weight %After 10% US dropTotal sell-offPost Adjustment (%) USA 45.08 40.57 N/A 45.08 Japan 10.98 11.50 1.15 10.98 Korea 1.31 1.37 0.14 1.31 Greater China 2.38 2.49 0.25 2.38 Singapore 0.37 0.39 0.04 0.37 Malaysia 0.20 0.21 0.02 0.20 Indonesia 0.12 0.13 0.01 0.12 Thailand 0.12 0.13 0.01 0.12 Philippines 0.03 0.03 0.00 0.03 Rest of World 39.41 41.27 4.13 39.41 For every USD1 bn invested this way, a 10% drop in the US market requires a sell-off of USD15.5 mn in APT markets to maintain a “benchmark-neutral” weighting. There are USD84.9 trillion worth of funds under management globally, not including the value of OTC contracts which could exacerbate the problem.

16. How quickly can it turn?

17. The next 10 weeks…..

18. Prevention is better than cure. A strong foundation helps calm capital markets. Knowledge is the key. Key Recommendations: 1. Capacity building in both institutions and human capital needs to be undertaken and/or intensified. Possible ambit – Informal AFDM+3, EMEAP Governor’s Meeting, SEACEN Experts’ Group on Capital Flows, ASP, and ADB’s ARIC. 2. Good “glocal” standards, codes, best practices, and transparency in operations needs to be put into place as confidence building measures. Possible ambit as above, including ADB’s REMU. 3. Financial and monetary governance needs further development and to be made more effective. Possible ambit of Informal AFDM+3, EMEAP Governor’s Meeting, and SEACEN Experts’ Group on Capital Flows. 4. The surveillance mechanisms currently in place needs to have its data re-examined; capital flows data especially that of portfolio capital, needs to be exchanged on a daily basis. This could be the start of an “early warning” system. Possible ambit of Informal AFDM+3, EMEAP Governor’s Meeting, SEACEN Experts’ Group on Capital Flows, ADB’s ARIC, ADB’s REMU, and ASP. 5. Hedge fund activity, derivatives markets, and private equity flows need proper monitoring and regulation. Such needs to be done on a global basis and should include, inter alia, banks, private equity houses, and especially, the OTC derivatives markets. Possible ambit of Informal AFDM+3, EMEAP Governor’s Meeting, SEACEN Experts’ Group on Capital Flows, ADB’s ARIC, ADB’s REMU, and ASP. 23/6/2006