Domestic Financial Development and International Financial Integration

Transcription

1 Domestic Financial Development and International Financial Integration Philip R. Lane, IIIS-TCD WBI Paris Seminar Capital Flows, Monetary Policy and Current Issues in International Finance April 2007

2 Introduction Two-way interaction between domestic financial development (DFD) and international financial integration (IFI) DFD and IFI: complementary versus substitution effects Policies in relation to domestic financial sector influential in determining scale and composition of international capital flows In other direction, foreign investors are pivotal in shaping evolution of domestic financial sector Review key conceptual issues Case studies: (a) China/India; (b) Central and Eastern Europe 2

3 DFD and IFI: Connections DFD: pooling of domestic savings DFD: creation of domestic financial assets (bank loans; stock market; bond market; derivatives), to enable activation of investment projects Domestic financial intermediaries play central role in IFI (banks, institutional investors, mutual funds) Domestic securities markets a key attractor for global investors In turn, IFI alters scale and nature of domestic financial system and domestic financial markets 3

4 Domestic Financial Policies Banking system Stock market Bond market FDI Capital account restrictions on outflows and inflows Exchange rate regime Restrictions on domestic institutional investors Level playing field between domestic and foreign investors? Regulation/Stability issues 4

5 The Policy Trilemma Pick 2 of 3: monetary independence; fixed exchange rate; international capital mobility Trilemma a key constraint in determining domestic financial policies and the level of IFI Other major factor: financial stability 5

6 DFD and IFI: Complements In general, natural symbiosis between DFD and IFI DFD key in maximising gains from IFI Example: Productivity impact of FDI (Alfaro et al, JIE) Domestic financial sector the natural gatekeeper to channel external funds to best domestic uses Foreign expertise helpful in raising efficiency of domestic financial institutions and markets 6

7 DFD and IFI: Risks Poor domestic regulation and incentive structure can mean that IFI serves to magnify existing distortions, leading to excessive credit creation and a financial crisis Key role of domestic regulatory policies 7

8 Financial Globalisation: Macro Impact The Traditional View Financial Globalization More efficient international allocation of capital Capital deepening International risk-sharing GDP growth Consumption volatility The traditional view focuses on the importance of channels through which capital flows could directly increase GDP growth and reduce consumption volatility. A Different Perspective Traditional Channels Financial Globalization Potential Collateral Benefits: Financial market development Institutional development Better governance Macroeconomic discipline GDP / TFP growth Consumption volatility 8

9 Threshold Conditions Financial Globalization X Above Thresholds Threshold Conditions Financial market development Institutional Quality, Governance Macroeconomic policies Trade integration GDP / TFP growth Risks of Crises Below Thresholds GDP / TFP growth? Risks of Crises Financial globalization leads to better macroeconomic outcomes when certain threshold conditions are met. This generates a deep tension as many of the threshold conditions are also on the list of collateral benefits. 9

10 The International Financial Integration of China and India Philip R. Lane, IIIS-TCD and CEPR Sergio Schmukler, World Bank

11 Introduction Motivation a. China and India have increasing share of world GDP and world trade. b. China and India have also become important players in the international financial system. Goal of the paper Assess how the increasing economic prominence of China and India is reshaping the international financial system. 11

12 Analysis Basic stylized facts on level and composition of international financial integration (IFI) of China and India Relate IFI to policies and developments in domestic financial sectors Implications Impact on the international financial system Medium-term evolution of the IFI of China/India 12

13 Variables of interest: IFI Gross holdings of foreign assets and foreign liabilities The equity-debt mix in international balance sheets Net foreign asset positions Variables of interest: Domestic factors Financial liberalization and exchange rate/monetary policies Evolution of the financial sector Impact of financial reform on savings and investment 13

14 IFI: Net Foreign Assets India Latin America G7 China East Asia Eastern Europe 14

15 IFI: Net Foreign Assets, X-sectionX 100 NFA to GDP India China GDP per capita, PPP 15

16 IFI: Gross Positions (IFI) IFI: Gross Positions (IFI) G7 East Asia Eastern Europe Latin America China India

17 2.0% 1.8% 1.6% 1.4% 1.2% 1.0% 0.8% 0.6% 0.4% 0.2% 0.0% % 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% IFI vs. IRI (Financial vs. Real) China India GDP Share Trade Share IFI Share

18 160% 140% 120% 100% 80% 60% 40% 20% 0% IFI: Foreign Assets Reserve and Non-Reserve Assets to GDP China India East Asia Eastern Europe Latin America G7 Reserve Assets Non-Reserve Assets

19 IFI: Foreign Liabilities Debt and Equity Liabilities to GDP 140% 120% 100% 80% 60% 40% 20% 0% China India East Asia Eastern Europe Latin America G7 Debt Liabilities Equity Liabilities 19

20 IFI by Component 1 Japan 2 China 3 Taiwan 4 Korea 5 India 6 Hong Kong 7 Russia 8 Singapore 9 United States 10 Malaysia Others Top Reserve Asset Holders 3.3% 6.0% 16.0% 21.7% Top Portfolio Equity Liability Holders 1 United States 2 Luxembourg 3 UK 4 Japan 5 Ireland 6 France 7 Switzerland 8 Germany 9 Netherlands 10 Canada 22 India 24 China Others 34.9% 0% 10% 20% 30% 40% 0.6% 0.6% 14.3% 20.6% 20.1% 0% 5% 10% 15% 20% 25% 1 United States 2 UK 3 Germany 4 France 5 Japan 6 Luxembourg 7 Netherlands 8 Switzerland 9 Italy 10 Ireland 23 China 49 India Others 1 United States 2 Luxembourg 3 France 4 UK 5 Germany 6 Netherlands 7 China 8 Belgium 9 Hong Kong 10 Spain 36 India Others Top Non-Reserve Asset Holders 0.6% 0.1% 8.6% Top FDI Liablity Holders 18.5% 14.3% 22.7% 0% 5% 10% 15% 20% 25% 0.4% 4.1% 7.8% 22.0% 0% 10% 20% 30% 31.7% 1 United States 2 UK 3 Germany 4 France 5 Italy 6 Japan 7 Netherlands 8 Spain 9 Ireland 10 Belgium 22 China 32 India Others Top Debt Liability Holders 0.6% 0.3% 21.5% 17.0% 0% 5% 10% 15% 20% 25% 20

21 Composition and Asymmetries, Assets/Liabilities Table 1a Composition of Foreign Assets and Liabilities, 2004 China India Assets Liabilities Assets Liabilities Portfolio Equity FDI Private Debt Reserves Total

22 Composition and Asymmetries, Assets/Liabilities Table 1b Asymmetries in the International Balance Sheet, 2004 China India Net Portfolio Equity Net FDI Net Equity Net Private Debt Reserves Net Debt

23 Main Stylized Facts on IFI of China and India Three facts on: Size, composition, and net terms Fact 1: Size Pivotal role in the international financial system, owning about 20 percent of global official reserves. Small global share of privately-held external assets and liabilities. Small financial participation relative to real participation Exceptions: FDI into China (about 4% of world FDI), aside from reserve assets (China #1; India #6) 23

24 Main Stylized Facts on IFI of China and India Fact 2: Composition IFI highly asymmetric, long debt, short equity. Asset side: hold low-return foreign reserves. Liability side: owe higher yield instruments. Negative net equity positions FDI in China Portfolio equity for India Net private debt also important in India 24

25 Main Stylized Facts on IFI of China and India Fact 3: Net terms Neoclassical models predict these countries to be net borrowers in the international financial system. However, both China and India have reversed their large net debtor positions. China: net creditor (8% of GDP) India: net debtor (-11% of GDP) Both small in terms of global imbalances 25

26 Main Stylized Facts on IFI of China and India Financial policies essential to explain these patterns of IFI; will likely keep shaping them over the following years. 26

27 Domestic Financial Sector and IFI IFI closely linked to nature of domestic financial system/policies. Relevant policies 1. Capital account and exchange rate regimes 2. Development of domestic financial system Debt; equity Banks; capital markets 3. Financial system and savings/investment balance Important to understand background in each country. Beyond simple financial development indicators. 27

28 Capital Account and Exchange Rate Regime Capital controls as development policy (exports), to control domestic monetary/financial variables, and to avoid crises. Controls to the KA shape type of financial integration Types of flows; Volume (less, more via round-tripping). Exchange rate target leads to reserve accumulation. 28

29 Capital Account and Exchange Rate Regime Policy trilemma Exchange rate target creates trade-off between monetary policy flexibility and capital account openness. Greater exchange rate flexibility Would allow China and India to combine monetary policy autonomy with capital account openness. Would also change composition of flows less reserve accumulation, less speculative inflows. Capital account restrictions increasingly porous by-product of increased trade and financial volumes. 29

30 Capital Account and Exchange Rate Regime Foreign Exchange Reserves / GDP 40% 35% 30% 25% 20% 15% 10% 5% 0% China India East Asia Eastern Europe Latin America G7 M1 / GDP 80% 70% 60% 50% 40% 30% 20% 10% 0% China India East Asia Eastern Europe Latin America G

31 Capital Account and Exchange Rate Regime Table 2a Sources of FDI Liabilities China India World World Hong Kong SAR 45.0 Mauritius 35.6 United States 8.9 United States 16.5 Japan 8.7 Japan 6.9 Taiwan POC 7.4 Netherlands 6.9 British Virgin Islands 6.9 UK 6.6 Korea 4.8 Germany 4.4 Singapore 4.8 Singapore 3.1 United Kingdom 2.3 France 2.7 Germany 1.8 Korea 2.2 France 1.3 Switzerland 2.0 Other 8.2 Other

32 Capital Account and Exchange Rate Regime Table 2b Sources of Portfolio Liabilities China India Equity Debt Equity Debt World World Hong Kong SAR Mauritius United States United States Europe Europe Japan Singapore Singapore Japan Rest of the World Rest of the World

33 Domestic Financial System: Debt Aversion to liberal regime vis-à-vis debt borrowing, especially in foreign currency (typically from abroad ). East Asia crisis; Indian crisis of Chinese banking sector NPL overhang; focus of major banks on lending to SOEs; high (inefficient) lending. Party explains high reliance on firm internal financing. India Large public deficits financed by domestic banks holding government bonds interest rate exposure. Both countries: corporate bond markets under-developed. 33

34 Domestic Financial System: Debt Credit / GDP 180% 160% 140% 120% 100% 80% 60% 40% 20% 0% China India East Asia Eastern Europe Latin America G7 Deposits / GDP 180% 160% 140% 120% 100% 80% 60% 40% 20% 0% China India East Asia Eastern Europe Latin America G

35 Domestic Financial System: Debt Private Bond Market Capitalization / GDP 50% 40% 30% 20% 10% 0% China India East Asia Eastern Europe Latin America G7 Public Bond Market Capitalization / GDP 70% 60% 50% 40% 30% 20% 10% 0% China India East Asia Eastern Europe Latin America G7 Central Government Debt / GDP 70% 60% 50% 40% 30% 20% 10% 0% China India East Asia Eastern Europe Latin America G

36 Domestic Financial System: Equity China Pro-FDI policies, but overhang in equity market despite apparently reasonable indicators. India Success in attracting portfolio equity inflows but relatively less FDI inflows. Financial development By-pass motivation for FDI fades, but deep local capital markets can promote FDI. Both countries Liberalizing outward FDI; Also outward portfolio equity flows but requires advances in domestic intermediation (banks; institutional investors). 36

37 Domestic Financial System: Equity Number of Firms Listed 2,500 2,000 1,500 1, China India East Asia Eastern Europe Latin America G7 Market Capitalization / GDP 140% 120% 100% 80% 60% 40% 20% 0% China India East Asia Eastern Europe Latin America G7 Turnover Ratio China India East Asia Eastern Europe Latin America G7 37

38 Financial Reform and Savings/Investment Balance Financial under-development leads to high savings relative to investment. Industrial structure (heavy industry vs. services) also related to savings. Corporate governance also related to savings. China s high savings driven by corporate sector (Kuijs) 38

39 Financial Reform and Savings/Investment Balance Financial and other reforms might reduce savings. Development of consumer credit would allow households to finance purchase of durables. Other reforms (improved social insurance, provision of health, and education services) would also affect savings. Improved corporate governance and private participation might lead to reduction in corporate savings. Decline in corporate saving also facilitated by development of domestic bond markets and increased focus by banks on private sector firms. 39

40 Financial Reform and Savings/Investment Balance Financial reform might also switch level and composition of investment. Level: Less by SOEs, more by private sector. Composition: Better investments. On net, possible negative effect on savings/investment balance. 40

41 China and India as a Destination for External Capital China and India not that large destinations, except FDI to China. Do not appear to have crowded out investment elsewhere. Diversion? Direct and indirect channels To expect: More balanced structure of capital flows. Relative rise in debt and portfolio equity (China), as opposed to FDI; debt and FDI (India), as opposed to portfolio equity. Role of proxy markets Bilateral composition Depends on currency policies; regional integration. 41

42 China and India as International Investors Important only as holders of international reserves. Part of development strategy (undervalue exchange rate) with global consequences. Lower interest rates, deficit financing, lower inflation. Costly to accumulate reserves and perpetuate strategy. Greater balance in outflows. Reduction in reserves; Pick up in outward debt, FDI, and portfolio equity flows. Reallocation of external portfolios Might be good for other emerging markets. Regional focus? Depends on integration and currency policies. Transition: Redeployment of reserves 42

43 Global Imbalances: Net Foreign Asset Positions Is current configuration stable or just a temporary phenomenon? Historical examples CA deficits of Korea and Singapore averaged 5.0 percent and 14.4 percent respectively during Feasible after crises of the 1990s? Not great example to the contrary. Scenario Reforms and capital account openness: lower savings rates, investment inflow CA deficits (2-5%/year Dollar-Kraay). China and India substantial net debtors in the medium-term (or higher world interest rates). Transition of deficits to a possible long-run creditor position 43

44 Global Risks Transition to financially liberalized regime Evidence on financial integration and (short-run) volatility/ crises/bumpiness Crises and political stability Learning to be open - but many lessons learnt? Robustness of banking sector key China: efficiency of banking sector India: fiscal policy Rest of world: transition from current low interest rate environment 44

45 Conclusions Large holders of international reserves, but smaller than perceived in many other areas (except FDI for China). However, IFI of China and India might be near a turning point. Domestic financial reform and KA liberalization will lead to a restructuring of balance sheets, affecting stylized facts. Significant implications for global system, mostly for Asia. 45

46 Conclusions Future gross positions More investment opportunities to domestic and foreign residents. Accumulation of external assets and liabilities by the private sectors in these countries expected to grow. Restructuring of inward and outward portfolios. Diminution in the asymmetries in external liabilities, with a greater dispersion of holding/inflows (FDI, equity, and debt). On the assets side, acquisition of non-reserve foreign assets should see a marked increase. Together with the projected increase in their shares in world GDP, China and India are set to become major international investing nations. 46

47 Conclusions Future net balances Much uncertainty and debate. Emergence of significant medium-term current account deficits in both countries with financial development (other things equal). Part of the development process. CA deficits and a deceleration in reserve accumulation: Substantial shift in the roles of China and India in the global distribution of external imbalances. 47

48 Conclusions: Key Factors to Monitor 1. Exchange rate policy, in light of the sustained appreciation pressure. Appreciation may be resisted in the short run by further reserve accumulation, but increasingly costly and conflicting. 2. A sharp correction in the dollar may act as an external trigger for a switch to greater exchange rate flexibility. Concerns may change the currency composition of reserves, affecting interest rates and possibly exchange rates. 3. How fast these countries substitute reserve holdings for other assets abroad. Might start to happen under favorable scenario. 4. Fully-fledged liberalization of capital controls remains unlikely in the short-medium term, but more liberalization to come. Which form? How soon? How fast? 48

49 Capital flows to Emerging Europe Philip R. Lane IIIS, Trinity College Dublin Gian Maria Milesi-Ferretti International Monetary Fund

50 Objective of paper Put trends in external capital flows and their composition in perspective (compare CEE with EU15, other emerging mkts) Provide simple calculations on sustainable future capital flows Draw implications for future trade surpluses 50

51 Road map Capital flows and external position: stylized facts ( ) Bilateral exposure Implications for medium-term factor flows 51

52 Capital flows Large! Initial liabilities very small (except Bul, Hun, Pol) Strong growth prospects Obsolete capital 52

53 External liabilities in 1994 were small Swaziland Net external position in 1994 (percent of GDP) NFA/GDP Latvia Slovak Republic Romania Namibia Paraguay Lithuania Estonia Russia Mauritius Iran Lebanon Colombia South Africa Guatemala El Salvador Macedonia Brazil Kazakhstan Fiji Poland Turkey Costa Rica Chile Bulgaria Egypt Thailand Morocco Jamaica Dominican Rep. Algeria Peru MalaysiaHungary Panama Czech Republic Venezuela, Rep. Bol. Uruguay Mexico Slovenia Argentina -80 Ecuador Jordan -100 Trinidad and Tobago Syria Tunisia Gabon GDP per capita 53

54 ...but MUCH larger at end Iran Algeria Mauritius Venezuela, Rep. Bol. Net external position (pct of GDP), Russia Malaysia Oman NFA/GDP South Africa Albania Guatemala Belarus Egypt Jordan Uruguay Paraguay Thailand Macedonia Romania Slovak Republic Czech Republic Colombia Lithuania Chile Turkey Gabon Mexico Bulgaria Costa Rica Brazil Peru Latvia Poland Kazakhstan Dominican Republic El Salvador Croatia Jamaica Argentina Trinidad and Tobago Slovenia Portugal Ecuador Tunisia Panama Lebanon Hungary Estonia GDP per capita 54

55 International financial integration is increasing EU Other emerging markets 100 CEE countries

56 ...with equity liabilities playing a more important role CEE countries Other em. mkts EU

57 ...and particularly so FDI CEE countries 35 Other em. mkts EU

58 50 40 CEE countries FX share Equity share Reserves play an important role among external assets, more so than elsewhere EU 15 Equity share FX share Other emerging and developing economies FX share Equity share

59 In most CEE countries net equity liabilities are larger than net debt 30 Czech Republic net debt (pct of GDP) Slovak Republic Bulgaria Romania Slovenia Estonia Lithuania -10 Poland Latvia -20 Hungary Croatia -30 net equity (pct of GDP)

60 Returns on external liabilities Returns on FDI are linked to economic performance (high when the economy does well, low otherwise) This implies better risk-sharing relative to foreign-currency debt......and can help productivity growth......but the price is a higher cost 60

61 Financial integration with the EU is particularly strong Sources of FDI (2002) EMU UK US DEN SWE SWI. CEEC Bulgaria Croatia Czech Republic Estonia Hungary Latvia Lithuania Poland Romania Slovakia Slovenia

62 Implications for future flows External liabilities cannot grow faster than GDP forever... Sustainable flows imply a stable ratio of net external liabilities to GDP... For example, with 8% nominal growth and liabilities of 50% of GDP, the CA balance would be -4% SS ca ( g +π ) NFA t t SS 62

63 Does this imply that large capital inflows can persist without any adjustment? Not quite. As liabilities accumulate, investment income payments to foreigners increase To keep the CA from deteriorating, the trade balance (broadly defined) must improve......because servicing external debt and FDI is costly 63

64 ...and the improvement must be large... Trade balance (average ) NFAstabilizing trade balance Implied current account balance (baseline) Bulgaria Czech Republic Slovak Republic Estonia Latvia Hungary Lithuania Poland

65 What can countries do? Strengthen export growth (and hope for recovery in the euro area!) Contain budget deficits (that contribute to widening current account imbalances) Be prepared for leaner times on global capital markets 65

66 Upside and downside risks Credible policies and integration with EU can lower spreads, implying more favorable debt dynamics... But there is limited scope for exchange rate correction to ease the trade balance adjustment, at least with current exchange rate regimes 66