Vanessa da Costa Val (Professor at IE-UFU/Brazil and PhD student at Cedeplar/UFMG )

1. Capital Flight or Volatile Financial Flows: which one is the best indicator to measure Brazilian External Vulnerability Vanessa da Costa Val (Professor at IE-UFU/Brazil and PhD student at Cedeplar/UFMG) Gilberto Libânio (Professor at Cedeplar/UFMG) Presentation for the AHE Annual Conference 2009

2. Introduction • Importance of confidence in the global economy to the international capital flow movement. • The liquidity and dynamics of international financial markets determines the caractheristics and volume of these flows towards peripheral countries. • In Brazil, the financial liberalization associated with capital flight results in external vulnerability, high interest rate and public debt, and low economic growth. • The vulnerability depends on the weight of volatile capital flows in the Balance of payments.

3. Objectives • To Evaluate which indicator - capital flows volatility or capital flight measures - best reveals the resource reversal potential for Brazil and, then, the external vulnerability of this economy. - To measure the volatility of each sub-account of the Financial Account, detecting which flows have more influence on the vulnerability of this account. - To find out which capital flight measure is the best one for the Brazilian case.

4. Capital Flows Volatility: Motivation Analysis Monthly Financial Account – 1995 to 2008 (U$ Millions) Financial Sub-accounts of the Brazilian balance of payments - 1990 to 2008 (U$ Millions)

5. Data treatment and Time cut • Data resource: time series of the National Account System, displayed by the Central Bank of Brazil. • Data treatment: four groups of capital flows - 1) Direct Investment; 2) Portfolio Investment; 3) Derivatives; e 4) Other Investments. Each of these flows is again divided in further sub-accounts to show specific details. • GARCH Model(generalized autoregressive conditional heteroskedasticity model): instantaneous volatility in the series at specific moments of its trajectory. • Periodicity: monthly • Time cut: 1) between January 1995 and December 1998; 2) between January 1999 and August 2008.

6. Capital flows volatility: results for the first period Financial Account series volatility - 1995: 01 to 1998:12 (first level of openness of BoP)

7. Capital flows volatility: results for the first period Financial Account series volatility - 1995: 01 to 1998:12 (Second level of openness of BoP)

8. Capital flows volatility: results for the second period Financial Account series volatility - 1999: 01 to 2008: 08 (first level of openness of BoP)

9. Capital flows volatility: results for the second period Financial Account series volatility - 1999: 01 to 2008: 08 (second level of openness of BoP)

10. External Vulnerability showed by external debtors indicators Source: Central Bank of Brazil

11. Capital flows volatility: Results • High volatility of Direct Investments during the second period: historical record in July 2007. • High volatility in Other Brazilian Investments account in June 2007: large outflow/inflow of “currency and deposits”. • The high volatility of short run capital flows causes macroeconomics effects, such as interest rate trap and exchange rate valorization even when the crisis is not so deep. • The Subprime market crisis in USA in 2007 shows that capital flows volatility remains very high in the Brazilian economy.

12. Capital Flight • Definition: capital flight refers to the capital outflow not registered. • It is abnormal or illegal capital outflow. • This capital outflow usually occurs due to speculation movements. • Capital flight is related to uncertainty and to the risk of keeping certain domestic assets, that is, capital “flies” trying to avoid huge wealth losses.

13. Capital Flight: residual method • It measures capital flight indirectly: the residuals between officially registered resources and the use it funds. KFWB = CDET + NFI – CAD – CRES • CDET: net growth of external debt registered by Central Bank of Brazil (BCB). • NFI: Foreign Direct Investment + Portfolio Investment + Other Investments (IMF). • CAD: – (net current account) • CRES: international reserves variation (“RESERVE ASSETS: NET” of IMF).

14. Capital Flight: residual method Capital flight using residual method (US$ millions)

15. Capital Flight: residual method results • Capital flight peaks coincide with moments of international financial crisis or with some exogenous event, out of domestic control: in 1994’s 2nd quarter (Tequil Effect), 1998’s 4th quarter (Russian Crisis), and 2007’s 2nd quarter (positive international reserve variation). • During moments of crisis capital flight reaches a very significant percentage of GDP, as occurred in 1994 and 1998 in Mexico and Russia, respectively. It exceeded 50% of Brazil’s economic activity. • In periods of favorable international liquidity a reverse capital flight is observed.

16. Capital Flight: Hot Money method • Capital flight is represented by short term capital outflow. KFH = – SK (short term private capital flows) – EO (errors and omissions) • SK = SK1 + PORT. • Where SK1 = other assets from other investments; PORT = net Portfolio Investments; EO = net errors and omissions.

17. Capital Flight: Hot Money method Capital flight using Hot Money method (US$ millions)

18. Capital Flight: Misinvoicing trade method • Capital flight is represented by export under-invoicing and import over-invoicing. Export misinvoicing = (Xw / CIFFOB factor) - Xc Import misinvoicing = (Mc / CIFFOB factor) – Mw • Where: Xw = Brazil’s imports registered by the world on CIF basis; Xc = Exports registered by Brazil on FOB basis; Mc = Imports registered by Brazil on CIF basis; Mw = Exports to Brazil registered by the world on FOB basis; CIFFOB factor = CIF / FOB.

19. Capital Flight: Misinvoicing trade method Capital flight using Misinvoicing trade method (US$ millions)

20. Preliminary conclusions • External Events→ volatility of capital flows → Brazilian economic performance → reduce the scope of macroeconomic policy conduction. • High volatility → impacts on domestic variables (interest rate, exchange rate, public debt). • Increase of Minskyan behavior of International Financial System. • Most volatile capital flows: the ones of most reversal potential.

21. Preliminary conclusions • The changes in structures of international capital flow and of domestic economy are important to analyze capital flight in Brazil. • Capital flights are resulting from macroeconomic instability, the consequence of the financial liberalization process. • While financial flow volatility can indicate moments in which Brazil turns from receptor to emitter of international resources, capital flight can indicate the sensibility of capital flow towards Brazil when facing unstabilizing factors and external shocks.