1. Lecture 12: Benefits of International Financial Integration e.g., for emerging markets Capital Flows to Developing Countries An international debt cycle. Reasons for flows to emerging markets in the 1990s & 2000s. Pros and Cons of Open Financial Markets Advantages The theory of intertemporal optimization Other advantages Disadvantages of financial integration Procyclical capital inflows Periodic crises

2. 1 st boom 3 rd boom (carry trade / BRICs) 2 nd boom (emerging markets) start stop (international debt crisis) stop (Asia crisis) Three booms in capital flows to developing countries (recycling petro-dollars) ITF220 Prof.J.Frankel

3. Causes of renewed capital flows to emerging market countries in early 1990s “Pull” factors (domestic): Economic reforms 1. Econ. Liberalization => pro-market environment 2. Privatization => assets for sale 3. Monetary stabilization => higher returns 4. Removal of capital controls => open to inflows “Push” factors (external): Global financial environment 1.More of Northern portfolios in mutual funds 2.Low rates of return in the North Cross-border factors 1.Brady Plan lifted debt overhang of 1980s 2.New vehicles: country funds, ADRs, etc. 3.Moral hazard from earlier bailouts?

4. Developing Countries Used Capital Inflows to Finance CA Deficits in 1976-1982 & 1990-97; but not 2003-07. IMF 1 st boom (recycling petro-dollars) start stop (international debt crisis) stop (Asia crisis) 2 nd boom (emerging markets) 3 rd boom (carry trade & BRICs)

5. ITF220 Prof.J.Frankel In 2003-07 boom, many countries used the inflows to build up forex reserves, rather than to finance Current Account deficits (as in 1990s) international debt crisis Asia crisis 2 nd boom 3 rd boom

6. ITF220 Prof.J.Frankel Advantages of financial opening For a successfully-developing country, with high return to domestic capital, investment can be financed more cheaply by borrowing from abroad than out of domestic saving alone. Investors in richer countries can earn a higher return on their saving by investing in the emerging market than they could domestically. Everyone benefits from the opportunity to diversify away risks and smooth disturbances.

7. ITF220 Prof.J.Frankel Further advantages of financial opening in emerging-market countries Letting foreign financial institutions into the country improves the efficiency of domestic financial markets. It subjects over-regulated and potentially-inefficient domestic institutions –to the harsh discipline of competition and –to the demonstration effect of examples to emulate. Governments face the discipline of the international capital markets in the event they make policy mistakes. (“Golden straitjacket” – Tom Friedman )

8. ITF220 Prof.J.Frankel Welfare gains from open capital markets 1.Even without intertemporal reallocation of output, consumers better off (borrowing from abroad to smooth consumption). 2.In addition, firms can borrow abroad to finance investment WTP, C, F & J, 2007

9. ITF220 Prof.J.Frankel THE INTERTEMPORAL-OPTIMIZATION THEORY OF THE CURRENT ACCOUNT, AND WELFARE GAINS FROM INTERNATIONAL BORROWING Source: Caves, Frankel & Jones (2007) Chapter 21.5, World Trade & Payments, 10 th ed. => domestic residents borrow from abroad, so that they can consume more in Period 0. Assume interest rates in the outside world are closer to 0 than they were at home (the slope of the line is closer to -1.0). Welfare is higher at point B. 1. Financial opening with fixed output ● ●

10. ITF220 Prof.J.Frankel THE INTERTEMPORAL-OPTIMIZATION THEORY OF THE CURRENT ACCOUNT, AND WELFARE GAINS FROM INTERNATIONAL BORROWING, continued Source: Caves, Frankel & Jones (2007) Chapter 21.5, World Trade &Payments. Shift production from Period 0 to 1, and yet consume more in Period 0, thanks to foreign capital flows. Assume interest rates in the outside world are closer to 0 than they were at home. Welfare is higher at point C. 2. Financial opening with elastic output ● ● ●

11. ITF220 Prof.J.Frankel CAPITAL ACCOUNT LIBERALIZATION: THEORY, EVIDENCE, AND SPECULATION Peter Henry http://www.nber.org/papers/w12698 Effect when countries open their stock markets to foreign investors on cost of equity capital to domestic firms. Liberalization occurs in “Year 0.” Cost of capital falls.

12. ITF220 Prof.J.Frankel CAPITAL ACCOUNT LIBERALIZATION: THEORY, EVIDENCE, AND SPECULATION Peter Blair Henry http://www.nber.org/papers/w12698 Effect when countries open their stock markets to foreign investors on investment. Rate of capital formation rises.

13. ITF220 Prof.J.Frankel Does this theory ever work in practice? Norway discovered North Sea oil in 1970s. It temporarily ran a large CA deficit, to finance investment (while the oil fields were being developed) & to finance consumption (as was rational, since Norwegians knew they would be richer in the future). } } Subsequently, Norway ran big CA surpluses.

14. ITF220 Prof.J.Frankel Indications that financial markets do not always work so well in practice Crises => Financial markets work imperfectly  the 1982 international debt crisis;  1992-93 crisis in the European ERM;  1994-95 Mexico;  1997East Asia; 1998 Russia; 2000 Turkey; 2001 Argentina  2007-09 global financial crisis; 2008 Iceland, Latvia…; 2010 Greece. It is difficult to argue that investors punish countries when and only when governments follow bad policies:  Large inflows often give way suddenly to large outflows, with little news appearing in between to explain the change in sentiment.  Second, contagion sometimes spreads to where fundamentals are strong.  Recessions hitting emerging markets in such crises have been so big, that the system does not seem to be working optimally.

15. ITF220 Prof.J.Frankel Indications that financial markets do not always work well (continued) More generally, capital flows have:  not on average gone from rich (high K/L) to poor (low K/L) countries – The “Lucas paradox;”  often been procyclical, rather than countercyclical.

16. Appendix 1: More on opening equity markets to foreign investment. ITF220 Prof.J.Frankel

17. CAPITAL ACCOUNT LIBERALIZATION: THEORY, EVIDENCE, AND SPECULATION Peter Blair Henry Working Paper 12698 http://www.nber.org/papers/w12698 Effect when countries open their stock markets to foreign investors on growth.

18. ITF220 Prof.J.Frankel In the early 1990s, portfolio investment dominated. This time (2003-07) Foreign Direct Investment (FDI) was bigger. Source: IMF WEO, 2007 Appendix 2: More on the EM boom starting in 2003

19. ITF220 Prof.J.Frankel This time, China and India shared in the inflows. Source: IMF WEO, 2007 But capital inflows financed only reserve accumulation, not current account deficits.

20. ITF220 Prof.J.Frankel Source: IMF WEO, 2007 Even Latin America ran CA surpluses and added to reserves!

21. ITF220 Prof.J.Frankel Source: IMF WEO, 2007 Central/Eastern Europe is the one emerging markets group that ran worrisome current account deficits, esp. Hungary, Ukraine, Latvia...