International Finance: Managing Capital Flows and Financial Risks Joint CCER-World Bank Institute course July 16-20, Beijing, China

Capital Flow Volatility and Financial Risks: Overview Dr. Yan Wang, Senior Economist Managing Capital Flows and Financial Risks, a CCER-WBI joint course July 16-20, Beijing, China

3 Capital Flow Volatility & Financial Risks I. Rise and Fall of Capital Flows –Capital flow volatility –Implicit government guarantees –market failures –Volatility hurts growth and hurts the poor most II. New issues in managing risks –Fiscal risks and gov’t contingent liabilities –Derivatives and risks –“Value at Risk” –Early warning indicators –Short term flows and crises III. Policy options to manage financial risks – A spectrum of capital flow interventions – Chile: reserve requirements for short term inflows: pros and cons – Sound banking system and regulations: currency risk exposure and etc. – Competition and corporate governance crucial for market discipline –Summary

4 Global Integration and Capital Flow Volatility

5 The rise and fall of international capital flows: capital market flows are volatile Source: GDF 2000.

6 Capital Flow Volatility: FDI is More Stable Source: GDF, 1999

7 Large reversals in net private capital flows

8 Capital Flow Volatility is linked with Volatile Growth Relationship between economic growth variability and volatility in private foreign capital flows Source: Thomas et al “The Quality of Growth,” 2000.

Number of episodes SystemiccrisesSmallercrises Capital Flow Volatility is linked with Frequency in Systemic Banking Crises Frequent Banking Crisis

10 Banking Crises and aftermath are extremely costly for the real economy: unfair burden for the poor High Cost of Banking Crises

11 Growth Volatility hurts the poor most Source: Thomas et al “The Quality of Growth”, 2000.

12 Financial Deepening in the Domestic Economy can facilitate Economic Growth, however... Source:Thomas et al “The Quality of Growth,

13 Capital Account Openness is negatively related with GDP Growth Source: Thomas et al “The Quality of Growth,” 2000.

14 II. New Issues in managing risks: an overview of new topics in this course Financial and fiscal risks are linked Capital flow volatility may lead to a rising government contingent liabilities Derivatives may lead to heightened systemic risks (see Steinherr’s book) “Value at risk” method is important Early warning indicators of financial crises Short term debt should be controlled, regulated, and monitored, carefully.

15 Fiscal cost of banking crises, % of GDP

16 Derivatives may lead to heightened systemic risk: Markets have been growing rapidly,

17 Value at Risk (VAR) is an important tool to measure risk “The Daily Earning at Risk for our combined trading activities averaged approximately $15million…” –J.P. Morgan 1994 annual report VAR summarizes the expected maximum loss (or worst loss) over a target horizon (day/month) within a given confidence interval. It allows us to estimate company-wide risks in one number and compare across different companies/markets It is now widely used in firms and banks.

18 Value at Risk (VAR): for general distribution and an example Define W 0 as initial investment, R rate of return, then at the end of the day/month, W=W 0 (1+R). Denote the expected return as  and volatility of R as  ; and the lowest portfolio value at the given confidence level c as W*=W 0 (1+R*). VAR is defined as the dollar loss relative to the mean, Value at Risk (mean)=E(W)-W*= - W 0 (R*-  )(1) J.P. Morgan’s distribution of daily revenue in 1994: Mean revenue is $5.1m, n=254. Select c=95%, 254x5%=12.7. In the chart, we find the 5% of occurrences (15 obs) below -$9m. After interpolating, we find W*= -$9.6m The VAR of daily revenues, relative to the mean is VAR = E(W) – W*= $5.1m- (-$9.6m) = $14.7m (2) Absolute VAR=$9.6m

19 Short Term Capital Flows are Linked to Financial Fragility: Short term debt/reserve ratios peaked before crises Source: GDF, 1999

20 Short Term Debt /Reserve Ratios are good warning indicators of financial fragility: It peaked before the Peso crisis Source: GDF, 1999

21 Short-term Debt as percent of international reserves: a liquidity index

22 Short-term Debt as percent of international reserves: a good warning indicator

23 GDP growth and growth of short-term debt: Pro-cyclical to growth and exacerbate boom/bust

24 GDP growth and growth of short-term debt: Pro-cyclical to growth and exacerbate crises

25 III. Policy options to manage fiscal and financial risks A spectrum of capital flow interventions Chile: reserve requirements for short term inflows: pros and cons Prudential fiscal policy and disciplines Do not provide implicit guarantees Sound banking system and regulations: regulate foreign currency exposure Competition and corporate governance crucial for market discipline Summary

26 Policy Options: A Spectrum of Capital Flow Interventions 1. Financial Autarky 2. Quantity Controls (All Capital Inflows) 3. Tax/Non-Remunerated Reserve Requirement (All Capital Inflows) 4. Quantity Control on “Risky” Inflows 5. Tax on “Risky” Inflow 6. Remunerated Liquidity Requirements 7. Purchase Insurance (e.g:- Contingent Liquidity Facility) 8. Other Risk Management Techniques (Asset/Liability Management) 9. No Intervention Reduce Capital Inflows Change Inflow Composition Self-Insurance Risk Management 1st. Best World Nth. Best World Increasingly Severe Intervention: Reduction in Benefits of Foreign Capital & Reduction in Risks Source: Powell, On Liquidity Requirements, Capital Controls and Risk Management: Some Theoretical Considerations and Practice from the Argentine Banking Sector, 1999

27 Policy Options: Market Based Capital Control for Short Term Inflows in Chile Source: Schmidt-Hebbel & Hernandez, Capital Controls in Chile: Effective? Efficient? Endurable?, 1999

28 Chile and Malaysia: Two cases of Temporary Capital Controls for Short Term Inflows Source: GDF 1999

29 Chile: Short term capital inflows have been declining: URR is effective Source: GDF 1999

30 Malaysia: Short Term Capital Inflow declined temporarily Source: GDF 1999

31 Pros and cons of Chile’s URR Pros Provide more room for the use of independent monetary policy led to a fall in short term inflows, reducing Chile’s indebtedness changed the composition of capital inflows toward longer maturities, making Chile more resilient to shocks Cons did not affect the real exchange rate led to an inefficient allocation of resources led to higher short term interest rates, reducing investment and LT growth provided incentive for tax evasion.

32 Summary Information asymmetry and market imperfection prevail in financial markets--roles for government Capital flow is volatile in nature and volatility hurts the poor most--rationale for public policy Tight fiscal discipline good, guarantees are bad Sequencing in financial openness key Correcting incentives, building institutions and enforcing regulations crucial Market-based control on ST flows helps Early detection of problems is possible Decisive restructuring vital