Financial Liberalization

GNI vs. GDI GNI GDI Gross National Income Gross Domestic Income = income earned by domestic residents. = income created within national borders. GNI = GDI +NFI (GNP = GDP+NFI) Net Factor Income [NFI] is income earned on overseas work or investments minus income generated domestically but paid to foreigners.

Compare Macau and the Philippines GDP or GNI Macau produces a lot of profits paid to overseas owners of casinos. Philippines workers earn a lot of income overseas. Which is larger Philippines’ GDP or Philippines GNI? Does Macau have greater GDP or GNI?

1. Trade balance refers to net export (export less import) of goods 1. Current Account represents the net sum of trade in goods and services, primary income and secondary income: NX +NFI. a. Net Exports 1. Trade balance refers to net export (export less import) of goods 2. Net Services, defined as the net export (export less import) of services. b. + c. Net Factor Income b. Primary Income comprises compensation of employees (wages, salary) and investment income c. Secondary Income refers to donation or grant paid to or received from nonresidents Meta Data

Balance of Payments Table

Capital Account, Financial Account, Capital Account: transfer of ownership of fixed asset, and debt forgiveness), and acquisition and disposal of non-financial assets (tangible: land; intangibles: patents, trademarks) Financial Account: refers to net flows of financial transactions between residents and nonresidents, reflecting changes of ownership over financial assets and liabilities Capital and Financial Account measure net inflows

Current account is (net) domestic non-central bank actors acquiring foreign currency selling goods or services. Capital & Financial Account is (net) foreign actors selling foreign currency to acquire domestic currency. Reserve Assets is (net) acquisition by central bank of foreign currency

Accounting Net Capital Inflows = (Capital & Financial Account - Reserve Assets ) Accounting Net Capital Outflows Should equal Current Account. If you earn more funds selling goods overseas, you can acqure overseas assets. Theory: Current Account + Net Inflows = 0 Accounting: Uncounted Inflows = Net Inflows – Current Account

What if economy does not have enough capital inflows to support its current account deficit? Net Capital Outflows Not enough buyers for domestic currency goods Too many buyers for foreign currency assets Current Account

Two Possibilities Floating Exchange Rates – Changes in the exchange rate equalize forex market. Pegged Exchange Rate – Changes in reserve assets equalize forex market.

Not enough demand for domestic currency causes exchange rate to depreciate. Net Capital Outflows Current Account Net Capital Outflows Current Account Falling price of currency makes domestic goods & financial assets more competitive

Central bank must use forex reserves to buy domestic currency to absorb pressure on its value. Net Capital Outflows Current Account Net Capital Outflows

Hot Money What if economy receives a surge in inflows? Current Account Net Capital Outflows Hot Money

Floating exchange rates Excess demand for domestic currency causes exchange rate to appreciate? Current Account Net Capital Outflows Current Account Net Capital Outflows Floating exchange rates

Central bank purchases inflows and increases reserves Net Capital Outflows Current Account Net Capital Outflows

Types of Capital Flows Direct Investment reflects the lasting interests of nonresidents of an economy in a resident entity. A direct investor may invest in equity capital, lending to affiliates, or reinvested earnings. Portfolio Investment refers to transaction that involves buying and selling of equity securities, debt securities in form of bonds, notes, money market instruments Other Investment includes loans, trade credits, deposits as well as other account receivables and payables

Gross Flows vs. Net Flows Balance of Payments Table

II. The debate over financial globalization Broad agreement (among economists at least) that trade liberalization is beneficial and leads to faster growth → Free trade in good and services makes countries better off In contrast, much controversy over whether the liberalization of international financial flows is desirable → Free trade in financial assets may not make countries better off

Capital Controls Stock Market: Limits on foreigners holdings of shares, possibly in certain sectors. Financial Institutions: Limits on businesses of foreign banks, insurance co’s. Restrictions on Direct Investors – Requirements of Domestic Partners http://www.imf.org/external/pubs/ft/fandd/2010/09/dataspot.htm

Liberalization and Economic Growth Capital Deepening: Absent capital mobility, national investment must be financed with national savings. In low savings countries, investment may be slow. Allocative Efficiency: Capital mobility allows seeking out the highest rate of return. Investment can go to locations where it has the highest productivity. Technology Transfer: Foreign investors may bring along techniques of production.

Empirical Evidence: Economic Growth Link Kose, Prasad, Rogoff, and Wei: 2006: “it remains difficult to find robust evidence that financial integration systematically increases growth.” summary of 40 studies. .

Sudden Stops International hot money (short-term lending) is subject to herding behavior from international financial market. Rapid inflows and rapid outflows. When capital inflows stop, either those can be replaced with forex reserves, or domestic borrowers will face bankruptcy. Domestic firms can no longer finance investment Demand, GDP, and employment fall. Devaluation of currency. Link

Financial Crises Sudden Stops: Foreign investors herding behavior and short-termism lead them to move in and out of countries rapidly. “The greatest concern I have is that capital account convertibility would leave economic policy in a typical ‘emerging market’ hostage to the whims and fancies of two dozens or so thirty-something country analysts in London, Frankfurt, and New York. ” Dani Rodrik, 1998

Reaping the Benefits of Financial Globalization Empirical evidence shows that the benefits of opening capital account are mixed. But there are several factors which have been shown to allow countries with open capital accounts to: Increase risk-sharing ; Increase economic growth; Reduce the likelihood of crises.

Keys to Benefiting from Globalization Financial sector development. Well-regulated domestic financial markets Institutional Quality. Low corruption, high transparency, good corporate governance. Sound Macroeconomic Policies. Low deficits and price stability. Trade Integration. High degree of trade openness. http://www.imf.org/external/pubs/ft/fandd/2007/03/kose.htm

How to Liberalize During the early 1990’s, some authors argued in favor of a “big bang” approach to capital account liberalization. Since mid-1990’s, taking empirical evidence in mind, IMF has adopted a more moderate approach referred to as sequencing or ‘integrated approach’

Integrated Approach capital account liberalization is best undertaken against a background of sound and sustainable macroeconomic policies; domestic financial reform should be complemented by prudential regulation and supervision, and financial restructuring policies; liberalization of capital flows by instruments and/or sectors should be sequenced to take into account concomitant risks—in general, long-term and non-debt creating flows (especially FDI) should be liberalized before short-term and debt-creating flows; Link

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Imbalances