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

1

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.

2

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

3

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)

4

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

i i

i

Y

KF

n 1

1 vs.

n

ii

n

ii

Y

KF

1

1

5

Recent trends – gross inflows

% of GDP, regional totals

All emerging markets

-4

0

4

8

12

16

1990 1994 1998 2002 2006

Gross inflows Gross outflows

Asia

-4

0

4

8

12

16

1990 1994 1998 2002 2006

Latin America

0

2

4

6

8

10

1990 1994 1998 2002 2006

Central and eastern Europe

-2

4

10

16

22

1990 1994 1998 2002 2006

6

Recent trends – gross inflows (2)

% of GDP, regional totals

Latin America

0

2

4

6

8

10

1990 1994 1998 2002 2006

Central and eastern Europe

-2

4

10

16

22

1990 1994 1998 2002 2006

7

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

8

Gross inflows and outflows for CEE

% of GDP, unweighted country average; except net flows (regional average).

Inflows Outflows

9

Net flows to CEE - latest data

Net private capital flows to CEE - Oct. 2008 WEO% of GDP, regional total

4.4 4.13.3 3.4

0.7

-0.4

0.5 0.6

3.15.8

4.0 3.5

-2

0

2

4

6

8

10

12

2006 2007 2008 2009

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

8.2

9.5

7.8 7.5

10

Recent trends – breakdown of gross inflows

11

Recent trends – breakdown of gross outflows

12

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

% of gross outflows

13

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

% of gross inflows/gross outflows of “other investment”; unweighted country average for 2004-06.

Gross inflows of other investment

-20

0

20

40

60

80

Trade credit Loans Currency anddeposits

Otherliabilities

EME total Asia Latin America CEE

Gross outflows of other investment

-20

0

20

40

60

80

Trade credit Loans Currency anddeposits

Other assets

EME total Asia Latin America CEE

14

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


Latin America3

Vis-à-vis all sectors 263 233 350 13.9 15.1 11.1


Central and eastern Europe4

Vis-à-vis all sectors 82 118 579 12.1 16.5 32.4


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.

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The increase was most pronounced in the past three yearsCross-border claims of BIS reporting banks

vis-à-vis emerging marketsChanges 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

-0.7

-0.2

0.0

-0.8

0.1

1.7

0.0

-0.5

-0.9

-0.5-0.2

1.5

0.7

1.4

0.7

1.2

2.9

3.4

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

2002 2003 2004 2005 2006 2007

AsiaLatin AmericaCEE

Vis-à-vis non-the bank private sector

-0.4-0.2

0.2 0.10.3

1.01.2

-0.8

-1.6 -1.6

0.5

0.10.4 0.4 0.3

1.2

3.0

1.5

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

2002 2003 2004 2005 2006 2007

Source: BIS, Locational Banking Statistics; IMF, World Economic Outlook.

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Cross-border loans account for a large share of domestic credit in CEE

Cross-border and domestic bank creditin emerging market economies

As a percentage of total bank credit

Sources: IMF; national data; BIS locational banking statistics.

13 1532

2239 37

87 8568

7861 63

0

25

50

75

100

2002 2007 2002 2007 2002 2007

Asia Latin America CEE

Cross-border loans Domestic bank credit

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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

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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

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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)

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Return on equity for banks in major home and host countries, 2005

Host countries ROE

(%) Major home countries

ROE (%)

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

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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

22


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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 dollars29

22

15

10 8

0

0 -1 -2-4

6

-19

-30

-20

-10

0

10

20

30

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

2002 2006 2008:Q1

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

-160

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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

In billions of US dollars

27

18 18 1714

74 4 3

6155

-1

-30

-10

10

30

50

70

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

2002 2006 2008:Q1

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.

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Private sector deposits

As a percentage of total liabilities1

7469

64 63 6258

42

5952 52 49

25 24

12

48 4640

36 34 32 32

2216 13

57

4338

0

20

40

60

80

100

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 RU1 Total private sector deposits; domestic banking system, end-period levels (for 2008, May).Source: IMF, International Financial Statistics.

2002

2008

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Ratio of total loans to total deposits1

1.9

0.9 0.8 0.8 0.8 0.8

0.5

2.4

1.7

0.90.8 0.8 0.7 0.6

2.6

2.11.9

1.4 1.4 1.31.1 1.1 1.0

0.8

1.5

1.1

0.8

0.0

1.0

2.0

3.0

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.

2002

2008

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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

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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

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Funding sources of EME banks are poorly diversified

Domestic money market instruments and bonds1

As a percentage of total liabilities2825

12

40 0 0

128 8

1

0

10

20

30

CL CO ZA MY MX BR RO KR CN VE PE

Money market instruments Domestic bonds issued bybanks

2002 2008

1 End-period levels (for 2008, May), domestic banking system.Source: IMF, International Financial Statistics.

Bank borrowing from other domestic financial institutions1

As a percentage of total liabilities

3 31 1 0 0

21

9

64

0

5

10

15

20

25

CO CN BR ZA TH MX CL MY ID TR

2002 2008

1 Liabilities to other domestic banking institutions and non-bank f inancial institutions; end-period levels.Source: IMF, International Financial Statistics.

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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

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3. Home-host supervisory cooperation (cont’d)

– Subsidiaries vs. branches

– MOUs, supervisory colleges, joint supervision

– Resolution of cross-border bank failures

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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

Documents

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