International Monetary Fund

1. International Monetary Fund Capital Flow Reversals Josh Felman IMF Research Department Philippine Economic Association November 15, 2013 The views expressed in this presentation are those of the author and do not necessarily represent those of the IMF or IMF policy.

2. Capital Flows to EMs (cumulative inflows since January 2010; billions of U.S. dollars) Emerging Asia Latin America Bernanke Taper Talk Bernanke Taper Talk Draghi’s Speech Draghi’s Speech Irish Crisis Irish Crisis Greek Crisis 1st ECB LTROs Greek Crisis 1st ECB LTROs Middle East and North Africa Other Emerging Markets Bernanke Taper Talk Bernanke Taper Talk Draghi’s Speech Draghi’s Speech Irish Crisis 1st ECB LTROs Irish Crisis Greek Crisis Greek Crisis 1st ECB LTROs Source: IMF, EPFR database. 1

3. Capital Flows and Output G-20 Emerging: Net Capital Inflows and Growth 13Q2 Sources: IMF, Balance of Payments Statistics; and IMF staff calculations. 2

4. Flows to Advanced Countries Australia: Domestic Portfolio Investments (percent of GDP) 13Q2 Sources: IMF, Balance of Payments Statistics; and IMF staff calculations. 3

5. 1994 Redux? G20 Emerging: Net Cumulative Inflows (percent of GDP) US: Change in 10-Year Government Bond Yield (percentage point) Gross Capital Flows (percent of GDP) Mexican Crisis Mexican Crisis Sources: IMF, World Economic Outlook; and Bloomberg, L.P. 1/ Mexican crisis; t = December 1993. 2/ Bernanke taper talk; t = April 2013. 4

6. Impact on EM’s Emerging Markets: MSCI (index; t=100) G-20 Emerging: Inflows, Credit, and Change in Reserves (percent of GDP) Emerging Economies: Real GDP Growth (percent) Mexican Crisis Sources: IMF, World Economic Outlook; and Bloomberg, L.P. 1/ Mexican crisis; t = December 1993. 2/ Bernanke taper talk; t = April 2013. 5

7. Textbook Model • Assumptions • Y = Y(E, i) • E= (1+i)/(1+i*)Ē • No domestic imbalances • No intervention • Then, i* increases • Policy response • Can maintain Y = `Y with right combination of i and E • 0< Δ i < Δ i* • Too easy 6

8. Capital Flows and Output • Nature of relationship • Correlation? • Causal? • If causal, mechanism? 7

9. Balance Sheet Effects? • Depreciation with fx debt stresses balance sheets • Policy implication: greater increase in i (compared to baseline). • But Δi increases burden of domestic debt • Key: how important is fx exposure? 8

10. Balance Sheet Effects? Mexico: Financial Indicators of the Corporate Sector (percent) 2013 Sources: Economatica; and IMF staff calculations. 9

11. Liquidity Effects? G20 Emerging: Gross Inflows and Credit Growth 13Q1 Sources: IMF, Balance of Payments Statistics; IMF, International Financial Statistics; and IMF staff calculations. 10

12. Liquidity Effects? • Are liquidity effects inevitable? • Not if exchange rate is freely floating • Not if cb intervenes and sterilizes • Effectively, cb purchases bonds foreigners are selling • Provides liquidity to institutions deprived of funding 11

13. Poorly Anchored Expectations? • Then, depreciation leads to inflation • Implication: increase in i, compared to baseline • Key: are expectations generally fragile? 12

14. Inflation Expectations Inflation Expectations, 5-year (percent) Sources: Consensus Forecasts; and IMF, World Economic Outlook. 1/ Data in Apr. 1996 for Russia and Turkey is from the May 1996 WEO. 13

15. Macro Vulnerabilities? • (initial conditions) Key EMs Under Pressure Today vs. 1997 Asian Financial Crisis EMs (percent) Sources: IMF, World Economic Outlook, April 2013. 1/ Indonesia, Korea, Thailand, Malaysia, and Philippines. Data shown for 1996. 2/ Brazil, Indonesia, India, Turkey, and South Africa. Data shown for 2012. 14

16. A New World • EM world has changed since the 1990s • Central banks target inflation • Exchange rates are largely floating • Macro stability has improved • Any reason left to fear outflows? 15

17. Back to Model • Assume: • Current account given in short run • No FX intervention • Then if foreigners sell, domestics must buy • Need different preferences 16

18. Distribution Effects • Possibility: • Foreign sales cause asset prices to fall • Financial accelerator goes in reverse, bankruptcies • But if asset prices determined by fundamentals (NPV of earnings), flows irrelevant • Further assume: • Prices detached from fundamentals • Or foreigners have lower discount rate • Then when foreigners sell to domestics, asset prices can fall 17

19. Capital Flows and Asset Prices Gross Inflows and Equity Prices Gross Inflows and Interest Rates Sources: IMF, Balance of Payments Statistics; IMF staff calculations; and Bloomberg, L.P. 18

20. Financial Disruptions • Foreign bank cuts funds to subsidiaries • Subsidiaries have firm-specific knowledge • Certain firms lose access to credit 19

21. Financial Disruptions Emerging Europe: External Positions of Western Banks vis-à-vis Emerging Europe (percent of GDP; adjusted for exchange rate changes; 2008Q3 change in flows) Sources: Bank for International Settlements, Locational Statistics; and IMF, World Economic Outlook. 20

22. Back to Monetary Policy • Conclusion • Capital outflows may have adverse effects • Policy options • Increase i • Fx intervention 21

23. Inflows and Intervention G-20 Emerging: Net Inflows to GDP and Reserves (percent) G-20 Emerging: Gross Inflows to GDP and Reserves (percent) Sources: IMF, Financial Flows Analytics; Haver Analytics; and IMF staff calculations. 1/ Based off of end year GDP. 22

24. FX Intervention • Should intervention policy be symmetric? • Reserves adequate • Can avoid attack by fixing quantities, not prices • Possible rule: sell x dollars for every 100 in outflows 23

25. Conclusion • Capital outflows a serious problem when • Fx debt exposures significant • Inflation expectations poorly anchored • Macro vulnerabilities • Conditions now less prevalent • But outflows may still affect asset prices, disrupt credit • Policy response can be very different. • Less need to increase i • More scope for depreciation • Can decumulate some reserves 24

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27. Capital Inflows Gross Inflows (percent of GDP) 13Q2 Sources: IMF, Financial Flows Analytics; and IMF staff calculations. 26

28. Monetary Policy Response Note: + means an increase in i or greater depreciation compared to the revised model case. 27

29. Capital Flows and Federal Funds Rate G-20 Emerging: Net Capital Inflows and Growth 13Q2 Sources: IMF, Balance of Payments Statistics; Bloomberg L.P.; and IMF staff calculations. 28

30. Risk Premium Shock? JP Morgan Emerging Bond Index Global Sovereign Spread (basis points) 9/18/2013 Source: Bloomberg L.P. 29

31. Sudden Stops Private Consumption Investment Gross Domestic Product Real Exchange Rate Asset Price Net Exports (percent of GDP) Source: IMF, World Economic Outlook. 30

32. Gross Flows Foreign Mutual Fund Domestic Bond Foreign Bond Dollars Dollars Domestic Mutual Fund 31

33. Balance Sheet Effects? External Debt (percent of GDP, debtor based) 2013 Source: IMF, World Economic Outlook. 32