Managing capital flows

1. Managing capital flows Thorvaldur Gylfason IMF Institute/Center for Excellence in Finance, Slovenia Course on Macroeconomic Management and Financial Sector Issues Ljubljana, Slovenia September 21–29, 2011

2. Outline • Costs and benefits • Conceptual framework • Anatomy of aid flows • Aid, exchange rates, and growth • History, context, and recent trends • Causes and effects of capital flows • Financial crises • Capital controls • Liberalization of capital flows

3. 1 Capital flows: costs and benefits • Definition • International capital movements refer to flows of financial claims between lenders and borrowers • Lenders give money to borrowers to be used now in exchange for IOUs or ownership shares entitling them to interest and dividends later • International trade in capital allows for • Specialization, like trade in commodities • Intertemporaltrade in goods and services between countries • International diversification of risk Significant benefits, but there are costs as well

4. Goods and Capital • The case for free trade in goods and services applies also to capital • Trade in capital helps countries to specialize according to comparative advantage, exploiteconomies of scale, and promote competition • Exporting equity in domestic firms not only earns foreign exchange, but also secures access to capital, ideas, know-how, technology • But financial capital is volatile

5. Symmetry between Goods and Capital The balance of payments R = X – Z + F where DR= change in foreign reserves X= exports of goods and services Z= imports of goods and services F= FX – FZ = net exports of capital • Foreign direct investment (net) • Portfolio investment (net) • Foreign borrowing, net of amortization X includes aid

6. Capital flows: for what? • Facilitate borrowing abroad to smooth consumption over time • Dampen business cycles • Reduce vulnerability to domestic economic disturbances • Increase risk-adjusted rates of return • Encourage saving, investment, and economic growth

7. Capital inflows resemble natural resource booms • Sudden inflows of capital, e.g., following capital account liberalization, impact economy like natural resource booms • Currency appreciates • Volatility • Public expenditure expands • Immunization becomes necessary • Stabilization • Capital controls

8. 2 Capital flows: conceptual framework Emerging countries save a little Saving Real interest rate Investment Loanable funds

9. Capital flows: conceptual framework Industrial countries save a lot Real interest rate Saving Investment Loanable funds

10. Capital flows: conceptual framework Emerging countries Industrial countries Financial globalization encourages investment in emerging countries and saving in industrial countries Saving Lending Real interest rate Real interest rate Saving Borrowing Investment Investment Loanable funds Loanable funds

11. development aid: definition • Unrequited transfers from donor to country designed to promote the economic and social development of the recipient • Excluding commercial deals and military aid • Concessional loans and grants included, by tradition • Grant element ≥ 25% 3

12. development aid: definition • Development aid can be • Public (ODA) or private • Bilateral (from one country to another) or multilateral (from international organizations) • Program, project, technical assistance • Linked to purchase of goods and services from donor country, or in kind • Conditional in nature • IMF conditionality, good governance

13. Motivation: Why aid? • Moral duty • Neocolonialism • Humanitarian intervention • Public good • National (e.g., education and health care) • International • Social justice to promote world unity • UN aid commitment of 0.7% of GDP • World-wide redistribution • Increased inequality word-wide • Marshall Plan after World War II • 1.5% of US GDP for four years vs. 0.2% today • But this Think tank in Nairobi disagrees, see www.irenkenya.com

14. Motivation: Why aid? • Objectives • Individuals in donor countries vs. governments in recipient countries • Who should receive the aid? • Today’s poor vs. tomorrow’s poor • Aid for consumption vs. investment • Conflicts • Beneficiaries’ needs • Donors’ interests

15. Past Trends • Aid is a recent phenomenon • Four major periods since 1950 • 1950s: Fast growth (US, France, UK) • 1960s: Stabilization and new donors • Japan, Germany, Canada, Australia • 1970s: Rapid growth in aid again due to oil shocks, recession, cold war • 1980s: Stagnation, aid fatigue, new methods, new thinking

16. Past Trends: 1950s • Rapid growth of development aid • US provided 50% of total ODA • To countries ranging from Greece to South Korea along the frontier of the “Sino-Soviet bloc” • France provided 30% • To former colonies, mainly in West Africa • UK provided 10% • To Commonwealth countries

17. Past Trends: 1960s • Stabilization of aid from traditional donors and emergence of new donors • US contribution decreased considerably after the Kennedy presidency (1961-63) • The French contribution decreased starting from the early 1960s • New donors included Japan, Germany, Canada, and Australia

18. Past Trends: 1970s • Rapid growth in aid from industrial countries in response to the needs of developing countries due to • Oil shocks • Severe drought in Africa • The donor governments promised to deliver 0.7% of GNI in ODA at the UN General Assembly in 1970 • The deadline for reaching that target was the mid-1970s

19. Past Trends: 1980s and 1990s • Stagnation of development assistance • Donor fatigue? • Private investor fatigue?

20. Donor fatigue?

21. Private investor fatigue?

22. Who are the donors? • United States: largest donor in volume, but low in relation to GDP • US aid amounts to 0.2% of GDP • Japan: second-largest donor in volume • Nordic countries, Netherlands • Major donors to multilateral programs • Sole countries whose assistance accounts for 0.7% of GDP • EU: leading multilateral donor

23. Who are the donors? • Even if targets and agendas have been set, year after year, almost all rich nations have constantly failed to reach their agreed obligations of the 0.7% target • Instead of 0.7% of GNI, the amount of aid has been around 0.4% (on average), some $100 billion short

24. Geographical distribution of aid (%) • Sub-Saharan Africa and Asia have received the most aid, the former a rising amount over time • Aid to Sub-Saharan Africa is high in relation to GDP • For the 44 countries in the IMF’s Africa Department, net official transfers are as follows: < 5% of GDP: 14 countries 6%-16% of GDP: 24 countries > 20% of GDP: 6 countries

25. 4 Macroeconomics of Aid • The recent increase in aid flows toward developing countries (particularly Africa) poses crucial questions for both recipient countries and donors • What is the role of aid? • What is the macroeconomic impact of aid? • Is the impact of aid necessarily positive, or could aid have adverse consequences? • Recall: Influx of aid is just another type of capital inflow

26. Macroeconomics of Aid • Aid fills gap between investment needs and saving and, if well managed, can increase growth • Poor countries often have low savings and low export receipts and limited investment capacity and slow growth • Aid is intended to free developing nations from poverty traps • E.g., capital stock declines if saving does not keep up with depreciation

27. Aid and Investment To understand the link between aid and investment, consider Resource Constraint Identity by rearranging the National Income Identity: Y = C + I + G + X – Z I = (Y – T – C) + (T – G) + (Z – X) In words, investment is financed by the sum of private saving, public saving, and foreign saving • This is where aid enters the picture Aid is treated as part of government saving which increases domestic resources to finance investment. Sg Sp Sf

28. Aid and Investment Rearrange again: Y + Z = E + X where E is expenditure E = C + I + G Total supply from domestic and foreign sources Y+Z equals total demand E+X Aid increases recipient’s ability to import: Z rises with increased X, incl. TR Aid is treated as part of government saving which increases domestic resources to finance investment.

29. aid and growth • Poor countries are trapped by poverty • Driving forces of growth (saving, technological innovation, accumulation of human capital) are weakened by poverty • Countries become stuck in poverty traps • Aid enables poor countries to free themselves of poverty by enabling them to cross the necessary thresholds to launch growth through • Saving • Technology • Human capital

30. Aid and Poverty • Is it feasible to lift all above a dollar a day? • How much would it cost to eradicate extreme poverty? Let’s do the arithmetic (Sachs) • Number of people with less than a dollar a day is 1.1 billion • Their average income is 77 cents a day, they need 1.08 dollars (don´t ask) • Difference amounts to 31 cents a day, or 113 dollars per year • Total cost is 124 billion dollars per year, or 0.6% of GNP in industrial countries • Less than they promised! – and didn’t deliver

31. Empirical Studies of Aid • Several empirical studies have assessed the impact of aid on growth, saving, and investment • The results are somewhat inconclusive • Most studies have shown that aid has no significant statistical impact on growth, saving, or investment • However, aid has positive impact on growth when countries pursue “sound policies” • Burnside and Dollar (2000)

32. aid and growth r = rank correlation • Foreign aid has sometimes been compared to natural resource discoveries • Aid and growth are inversely related across countries • Cause and effect • 156 countries,1960-2000 r = -0.36 Other people’s money

33. Does aid work?The current debate • No robust relationship between aid and growth • Aid works in “countries with good policies” • Aid works if measured correctly • Distinction between fast impact aid (infrastructure projects) and slow impact aid (education) • Infrastructure: High financial returns • Education and health: High social returns

34. Impact of Aid on Growth and Investment • So, empirical evidence is mixed • Need to distinguish between different types of aid • Need to acknowledge diminishing returns to aid as well as limits to domestic absorptive capacity • Need to clarify interaction with governance and good policies • Special case: Post-conflict situations

35. Reasons for the Possible Ineffectiveness of Aid i • Aid may lead to corruption • Aid may be misused, by donors as well as recipients • Donors: Excessive administrative costs • Recipients: Mismanagement, expropriation • Aid may be badly distributed, sometimes for strategic reasons • Supporting government against political opposition

36. Reasons for the Possible Ineffectiveness of Aid ii • Aid increases public consumption, not public investment • Aid is procyclical • When it rains, it pours • Aid leads to “Dutch disease” • Labor-intensive and export industries contract relative to other industries in countries receiving high aid inflows • Dutch disease may undermine external sustainability

37. Reasons for the Possible Ineffectiveness of Aid iii • Aid volatility and unpredictability may undermine economic stability in recipient countries • Economic vs. social impact • Growth is perhaps not the best yardstick for the usefulness of aid • Long run vs. short run • E.g., increased saving reduces level of GDP in short run, but increases growth of GDP in long run (Paradox of Thrift)

38. Dutch disease See “Dutch Disease” in the New Palgrave Dictionary of Economics Online • Appreciation of currency in real terms, either through inflation or nominal appreciation, leads to a loss of export competitiveness • In 1960s, Netherlands discovered natural resources (gas deposits) • Currency appreciated • Exports of manufactures and services suffered, but not for long • Not unlike natural resource discoveries, aid inflows could trigger the Dutch Disease in receiving countries

39. Dutch disease • Foreign exchange is converted into local currency and used to buy domestic goods • Fixed exchange rate regime • Expansion of money supply leads to inflation and an appreciation of the domestic currency in real terms • Flexible exchange rate regime • Increase in the supply of foreign exchange leads to a nominal appreciation of the currency, so the real exchange rate also appreciates

40. Impact of aid on the Real Exchange Rate • Review theory of Dutch disease in simple demand and supply model

41. Balance of payments equilibrium Payments for imports of goods, services, and capital Imports Real exchange rate Earnings from exports of goods, services, and capital Equilibrium Exports Foreign exchange

42. Aid reduces exports Aid leads to appreciation, and thus reduces exports C B Imports Real exchange rate Exports plus aid A Exports Foreign exchange

43. Oil: same story Oil discovery leads to appreciation, and reduces nonoil exports C B Imports Real exchange rate Exports plus oil A Exports Foreign exchange

44. Oil: same story Composition of exports matters C B Imports Real exchange rate Exports plus oil A Exports Foreign exchange

45. The risk of Dutch disease • A large inflow of foreign aid -- like a natural resource discovery -- can trigger a bout of Dutch disease in countries receiving aid • A real appreciation reduces the competitiveness of exports and might thus undermine economic growth • Exports have played a pivotal role in the economic development of many countries • An accumulation of “know-how” often takes place in the export sector, which may confer positive externalities on the rest of the economy

46. Summary and Guidelines • From aid fatigue to new initiatives • Aid effectiveness is ambiguous • Positive results likely with better policies and governance • Five Primary Guidelines • Minimize risks of Dutch disease • Enhance growth – Always a good idea! • Assess the policy mix • Promote good governance and reduce corruption • Prepare an exit strategy

47. 5 Relevance and Context • Since 1945, trade in goods and services has been gradually liberalized (GATT, WTO) • Big exception: Agricultural commodities • Since 1980s, trade in capital has also been freed up • Capital inflows (i.e., foreign funds obtained by the domestic private and public sectors) have become a large source of financing for many emerging market economies

48. Evolution of capital flows A stylized view of capital mobility 1860-2000 Return toward financial integration First era of international financial integration Capital mobility Capital controls Source: Obstfeld & Taylor (2002), “Globalization and Capital Markets,” NBER WP 8846.

49. Net private Capital flows to emerging markets, 1980-2007 Source: IMF WEO, Oct. 2007, Chapter 3, Figure 3.1.

50. Concentration of Net Private Capital Flows to Selected Countries, 1990-2007 Source: IMF, World Economic Outlook database.