Capital Flows: Too Much Of A Good Thing?

Includes: EWZ, FXF, FXI, INDA
by: QFinance

By Anthony Harrington

The damage that "hot money," i.e., surges of incoming capital, can wreak on the fiscal policies of a domestic economy has been proven time and again. Most countries want to attract capital to come to their domestic markets. What they don't want is to find that the capital comes in like a roaring flood, washing away all in its path.

Brazil suffered a good deal of that in the recent past as Western institutions and corporations, bored with low to no returns in advanced markets, went hunting their share of Brazil's surging growth. Its answer was to put up tax barriers to disincentivise external investors from pouring funds in willy nilly. Switzerland, in somewhat different circumstances, found the Swiss franc feted as a "safe haven" currency, and had to take dramatic steps to stop its currency from appreciating out of sight, killing its export and tourism businesses in the process. The Swiss Central Bank opted to peg the Swiss franc to the euro at a fixed rate, thus at least partially "spoiling" its safe haven status.

The scale of the ramping up in global capital flows over the last 10 years can be seen in a recent IMF study, entitled "The liberalization and management of capital flows". In the period from 1980 to 1999, global capital flows averaged less than 5% of global GDP. This ramped up through the boom period to 2007, to the point where these flows amounted to 20% of global GDP, "hot money" available to wash in and out of countries on the whim of the markets.

As the IMF says in its briefing paper, "there can be no presumption that full liberalization (of capital) is an appropriate goal for all countries at all times." A small, emerging country will not want rapacious investors descending on it, buying up its "crown jewels" and the bulk of its natural resources and fertile lands, and even a country as large as China has to watch the inflationary impact of huge inward flows of capital. It all comes down, the IMF says, to understanding the techniques and policies required to harness the benefits of capital mobility while addressing the implications of capital flow management. The point is to reap the benefits while curtailing the ills:

"Capital flow liberalization has been part of the development strategy in several countries, in recognition of the benefits that such flows can bring. At the same time, capital flows carry risks as they can be volatile and their size can be large relative to domestic markets... [so] an important policy challenge for policymakers is to develop a coherent approach to capital flows and the policies that affect them."

In November 2011, the G20 produced a statement: "Coherent conclusions for the management of capital flows", which provides a working consensus on the broad principles of a framework. The IMF paper points out too, that a number of international treaties, such as the EU's own founding document, and many bilateral and regional trade agreements, contain provisions that limit the extent to which countries can legally restrict capital flows.

While the pace of liberalization fell away somewhat during the crash of 2008, the general trend across the world, the IMF paper says, remains one of increasing openness to capital flows, with only specific types of flows being targeted for regulation. In general, foreign direct investment correlates well with growth, while debt financing (the influx of overseas money to fund domestic government bond issuance) has a much less clear cut relationship to GDP growth.

However, the fact that both China and India have managed to sustain rapid growth rates while maintaining relatively closed capital accounts shows that there are alternatives to full liberalization. That said, China in particular, has undoubtedly benefited from large inward FDI flows over several decades, with the result being marked improvements to China's managerial and technological expertise. One of the big risks in capital flows is that they can reverse suddenly if investors take fright, and the consequences of large amounts of money suddenly leaving an emerging economy can be catastrophic.