Amir Hadžiomeragić Sarajevo, 6 June 2014 CBBH and SESOX high level seminar South East Europe in an Environment of Volatile Capital Flows Amir Hadžiomeragić Sarajevo, 6 June 2014

Capital flows to emerging markets: „Master or servant Capital flows to emerging markets: „Master or servant?“„Benefactor or menace?“ Unprecedented volume of capital flows to emerging countries in the last 20 years Very intensive discussion on impact of capital flows and capital account liberalization Two strands of opinions on benefits of removing capital barriers and enabling free capital movement how to measure direct and indirect benefits and contribution to growth? ...And very uniform view about threats and possible negative aspects of capital inflows

Negative impact of capital inflows can be classified into three major categories Macroeconomic imbalances Financial stability problems „Sudden stop“ or reversals

Macroeconomic imbalances: Excessive expansion of aggregate demand („overheating“) resulting with boom-bust growth Exchange rate misalignment – real appreciation and loss of international competetivness Widening current account Increase in asset prices („bubbles“) Inflationary pressure Loss of monetary control

Financial stability problems from cross-border banking flows Very rapid credit expansion Underestimation of the build-up in credit risk Deterioration of loan portfolio quality Sharp slowdown or reversal in bank-intermediated capital flows Risk of financial contagion from other economies and regions

Macroeconomic performance and capital flows 2006 2007 2008 2009 2010 2011 2012 Total Capital Flows (net, in % GDP) Official/gov‘t 11% (0%) 13% (0,3%) (0,6%) 4% (3,0%) 5% (2%) 8% (2%) 7% (3%) Real growth 5.7% 6.0% 5.6% -2.7% 0.8% 1.0% -1.2% Current account deficit (in % GDP) -7.4% -10.2% -15.9% -6.5% -6.1% -9.7% -9.2% Sustainability of growth – prior to crises it was not questioned, but... Real growth very much dependant on net capital flows External disbalances also fueled with capital flows

Credit growth dependant on foreign capital flows in banking sector

Managing of capital flows for small open (transition) economy Very difficult challenge („living in bathtube next to the ocean“) Repeated episodes of large inflows and subsequent crises Increased demand for capital inflows due to disbalance between investment and saving ratios Global conditions are key factor driving capital inflows increased liquidity (lower global interest rates) risk appetite by investor, but also... Country-specific factors also play important role for the EU accession countries, lower risk premia associated with macroeconomic stabilization, EU-related structural reforms

Managing of capital flows for small open (transition) economy recipient economy has got very limited capacities to control and influence capital flows Mixed results with capital controls EU accession dictates capital account liberalization a need to have prudent economic policies in order to reap benefits from capital inflows and mitigate related risks

What makes economies more resilient to a surge in capital inflows? WEO (2013) concluded that more resiliant economies have: more flexible exchange rate lower government spending (counter-cyclical fiscal policy) inflation targeting (lower inflation) significantly better economic institutions

Counter-cyclical fiscal policy (Fiscal restraint) is not very likely  „When it rains, it pours" (Kaminsky et al.2004) Study on procyclicality and economic policies instead offsetting capital inflows, government often contribute with even higher expenditures in periods of economic growth and capital inflows

Did we repeat the same mistakes Did we repeat the same mistakes? Procyclical fiscal policy in Bosnia and Herzegovina during capital surge "good time" "bad time" 2006-2008 2009-2011 average real growth Amplitude Expenditure 10.65% -0.85% 11.50% Current expenditure minus interest payment 10.75% -0.95% 11.71% Expenditure on goods and services 8.24% -8.16% 16.40% Expenditure on wages and salaries 10.30% 1.43% 8.87% Note: positive amplitude signals procyclicality

Conclusion How to reap benefits from capital flows and reduce related risk? Financial integration and economic globalization will continue Need to be very cautious about magnitude and structure of capital flows to domestic economy Volatility is highly unpredictable and beyond of our control Sound macroeconomic policies and adequate prudential measures