Controlled Capital Account Liberalization Eswar Prasad & Raghuram Rajan IMF

Plan of Talk Reserve accumulation—how much, why, and cost-benefit issues Reserve accumulation—how much, why, and cost-benefit issues Approaches to sterilization Approaches to sterilization Other approaches to dealing with inflows Other approaches to dealing with inflows The Prasad-Rajan proposal The Prasad-Rajan proposal The proposal in the broader context of new literature on financial globalization The proposal in the broader context of new literature on financial globalization China and India as illustrations China and India as illustrations

Why the Build-up of Reserves? Capital flows to emerging markets Capital flows to emerging markets Speculative inflows Speculative inflows Current account surpluses Current account surpluses Oil revenues Oil revenues

Benefits of Reserve Accumulation Reduced vulnerability to crises Reduced vulnerability to crises Mitigates real exchange rate appreciation Mitigates real exchange rate appreciation Lowers external borrowing costs Lowers external borrowing costs

Costs of Reserve Accumulation Complications for macroeconomic management Complications for macroeconomic management Adjustment may come through inflation Adjustment may come through inflation Opportunity cost of holding reserves Opportunity cost of holding reserves Quasi-fiscal costs of sterilization Quasi-fiscal costs of sterilization Domestic policy distortions Domestic policy distortions

Sterilization: Instruments/Methods Repos, open market operations Repos, open market operations Central Bank securities Central Bank securities Fx swaps Fx swaps Government deposits at the Central Bank Government deposits at the Central Bank Reserve requirements Reserve requirements

What Are Countries Doing with Reserves? Actions and Proposals U.S. bonds (Treasury and Agency) U.S. bonds (Treasury and Agency) Other industrial country treasury paper Other industrial country treasury paper Bank recapitalization (China) Bank recapitalization (China) Infrastructure investment (India) Infrastructure investment (India) Korea Investment Corporation Korea Investment Corporation

Improving Risk-Return Profile of Reserves Diversify into non-U.S. $ denominated instruments, gold Diversify into non-U.S. $ denominated instruments, gold Regional pooling of reserves—e.g., Asian Investment Corporation (Genberg et al.) Regional pooling of reserves—e.g., Asian Investment Corporation (Genberg et al.) Invest reserves in broader range of instruments including foreign equities Invest reserves in broader range of instruments including foreign equities Asset management by IMF and World Bank (Summers) Asset management by IMF and World Bank (Summers)

Other Policy Actions Tighter controls on inflows Tighter controls on inflows Liberalization of outflows: Liberalization of outflows: Firms (retain fx earnings, borrow in fx)Firms (retain fx earnings, borrow in fx) HouseholdsHouseholds Institutional investors (QDII)Institutional investors (QDII)

Is There a Way to Do Better? How to Achieve Multiple Objectives? Get benefits of inflowsGet benefits of inflows Reduce costs of sterilization and fx exposure of Central BanksReduce costs of sterilization and fx exposure of Central Banks Lower risks of capital account liberalizationLower risks of capital account liberalization The Prasad-Rajan Proposal

Reserves $ Central Bank Inflows Liquidity $ RMB CB Bills RMB

Central Bank Inflows $ RMB Liquidity $ RMB Closed-end Mutual Fund Investments $ Shares RMB Financial Market Development Sterilization Controlled Outflows: Quantity + Timing International Portfolio Diversification

Other Benefits Provides breathing room for some macroeconomic reforms (fx flexibility) Provides breathing room for some macroeconomic reforms (fx flexibility) Fx risk taken off Central Bank’s balance sheet Fx risk taken off Central Bank’s balance sheet Securitizing inflows may facilitate reduction in external borrowing costs Securitizing inflows may facilitate reduction in external borrowing costs Could complement other approaches such as QDII Could complement other approaches such as QDII

Potential Concerns Could delay more fundamental reforms Could delay more fundamental reforms Governance problems Governance problems Multiple exchange rates Multiple exchange rates Rents to mutual funds if excess demand for securities Rents to mutual funds if excess demand for securities Fx risk transferred to households Fx risk transferred to households No demand for securities if expectation of currency appreciation No demand for securities if expectation of currency appreciation

The Macroeconomic Implications Of Financial Globalization: A Reappraisal And Synthesis Ayhan Kose, Eswar Prasad, Kenneth Rogoff, Shang-Jin Wei The Proposal in a Broader Context

Financial Globalization More efficient international allocation of capital Capital deepening The Traditional View International risk sharing GDP growth Csmn. volatility

Financial Globalization Financial market development Institutions, governance Macroeconomic discipline Competition A Different Perspective Collateral Benefits GDP growth Csmn. volatility

Factors that Influence Outcomes of Financial Integration: Threshold Effects Financial Sector Development Financial Sector Development Institutions, Governance Institutions, Governance Macro Policies Macro Policies Trade Openness Trade Openness Exchange Rate Regime Exchange Rate Regime

TENSION !! Financial integration helps developing countries to improve their financial markets, enhance governance, impose discipline on macro policies, break power of interest groups that block reforms, etc. Financial integration helps developing countries to improve their financial markets, enhance governance, impose discipline on macro policies, break power of interest groups that block reforms, etc. But, in the absence of a basic pre-existing level of these supporting conditions, financial integration can wreak havoc But, in the absence of a basic pre-existing level of these supporting conditions, financial integration can wreak havoc

What’s a Country to Do? Trade integration to begin with; but often results in de facto financial integration. Works okay, but not ideal substitute Trade integration to begin with; but often results in de facto financial integration. Works okay, but not ideal substitute Collateral benefits perspective can guide country-specific sequencing of capital account opening Collateral benefits perspective can guide country-specific sequencing of capital account opening Controlled capital account liberalization if experiencing inflows, external circumstances favorable Controlled capital account liberalization if experiencing inflows, external circumstances favorable