1. 1 The financial stability implications of increased capital flows for emerging market economies Dubravko Mihaljek Bank for International Settlements Presentation at the Economics Institute Zagreb Zagreb, 11 November 2008 The views expressed are those of the author and not necessarily those of the BIS.

2. 2 Outline 1. Data description 2. Recent trends in capital flows to/from EMEs 3. Financial stability implications of increased capital flows –Focus on bank-intermediated capital inflows and CEE –Policy responses –Financial stability implications of debt portfolio outflows

3. 3 Data description Focus (mostly) on private capital flows Gross vs. net flows Gross flows: to study financial integration, financial stability issues; composition of flows important for macroeconomic management Net flows: key for macroeconomic (demand) management Sample Mostly 2001-2006 Some comparisons with 1990s 3 EM regions: Asia and Latin America, CEE (Baltics, central Europe, SEE)

4. 4 Data description (2) Data sources BoP data (IMF, International Financial Statistics) BIS: locational and consolidated statistics Look at average of countries in the region, and regional totals:

5. 5 Recent trends – gross inflows % of GDP, regional totals

6. 6 Recent trends – gross inflows (2) % of GDP, regional totals

7. 7 Recent trends: regional distribution Share in gross inflows of private capital to EMEs, % 19952006 CEE1126 Asia5147 Latin America2912 Other EMEs919

8. 8 Gross inflows and outflows for CEE % of GDP, unweighted country average; except net flows (regional average). InflowsOutflows

9. 9 Net flows to CEE - latest data

10. 10 Recent trends – breakdown of gross inflows

11. 11 Recent trends – breakdown of gross outflows

12. 12 Portfolio outflows - mostly for purchases of foreign debt securities - mostly from China (70% of Asian total, $140 bn. from 2002-06) - “private” sector probably includes SOCBs % of gross outflows

13. 13 Two main developments from FS perspective: (a) “other” investment inflows; (b) portfolio outflows “Other” investment: flows to banks and to other sectors non- financial corporations, NBFIs, households % of gross inflows/gross outflows of “other investment”; unweighted country average for 2004-06.

14. 14 Other investment flows increased very strongly in CEE

15. 15 The increase was most pronounced in the past three years Cross-border claims of BIS reporting banks vis-à-vis emerging markets Changes in amounts outstanding at end-period, as a percentage of GDP Cumulative increase in CEE since 2005: 7.5% of GDP 5.7% of GDP Source: BIS, Locational Banking Statistics; IMF, World Economic Outlook.

16. 16 Cross-border loans account for a large share of domestic credit in CEE Cross-border and domestic bank credit in emerging market economies As a percentage of total bank credit Sources: IMF; national data; BIS locational banking statistics.

17. 17 Financial stability implications of cross-border loans In the past, “pure” cross-border loans Latin America in 1980s  debt crisis Asia in 1990s  1997/98 crisis Now parent banks  loans to subsidiaries in EMEs “Pure” cross-border loans mainly to large corporations from EMEs

18. 18 Financial stability implications of cross-border loans (2) Parent banks  loans to subsidiaries Most pronounced in CEE and Mexico, where banking systems are 80-95% foreign-owned In CEE, cross-border loans are convergence flows – economic, financial, institutional integration with EU, which is different from Asia in the 1990s Cross-border loans were taking place in financially repressed banking systems in Latin America in the 1980s and Asia in the 1990s; banking systems in CEE are competitive and open Cross-border loans were financing import-substituting development in Latin America, not the case in CEE

19. 19 Financial stability implications of cross-border loans (3) Risk of a solvency crisis smaller Parent banks large, well-capitalised, well supervised, focus on traditional commercial banking, did not invest in subprime/structured products But the risk to sustainability of cross-border flows still large Underestimation of credit risk during credit boom High targets for ROE (to exploit franchise value)

20. 20 Financial stability implications of cross-border loans (4)

21. 21 Financial stability implications of cross-border loans (5) Risk of regional contagion Parent banks pursue similar strategies across regions (eg, lending to households) Transmission of shocks from home countries (eg, via funding in wholesale markets) Asymmetry of host country vs. parent bank exposures Other channels: short maturity of cross-border loans, concentration of foreign creditors, common creditors across region

22. 22 Financial stability implications of cross-border loans (5)

23. 23 Risks at the current juncture: sudden stop/reversal of bank intermediated flows

24. 24 Risks at the current juncture: sudden stop/reversal of bank intermediated flows (2)

25. 25 Risks at the current juncture: sudden stop/reversal of bank intermediated flows (3)

26. 26 Risks at the current juncture: sudden stop/reversal of bank intermediated flows (4)

27. 27 Policy responses – how to deal with these risks? 1. Macroeconomic policies Allow greater exchange rate flexibility – trade-off between the consequences of ER appreciation and sterilisation Reduce policy rates – trade-off between the consequences of capital inflows and domestic objectives (inflation target, domestic credit growth) May have limited room for manoeuvre on ER, IR Relax controls on capital outflows – eg, for institutional portfolio investors Fiscal tightening – best approach; should focus on expenditure restraint

28. 28 Policy responses (2) 2. Macroprudential and microprudential responses Tighten oversight of banks’ management of credit risk (to make sure banks hold sufficient capital) Improve quality of creditor information (accurate company financial reports, credit registry for households, tighter debt/income & debt service/ income ratios, etc) Diversify sources of bank funding Temporary capital controls

29. 29 Policy responses (3) Funding sources of EME banks are poorly diversified

30. 30 Policy responses (4) 3. Home-host supervisory cooperation –International scope of banking institutions vs. national scope of regulation and supervision –Conflict between macroeconomic and financial stability concerns in small economies hosting large international banks –Divided responsibilities for financial stability and financial sector supervision within home and host countries

31. 31 Policy responses (5) 3. Home-host supervisory cooperation (cont’d) –Subsidiaries vs. branches –MOUs, supervisory colleges, joint supervision –Resolution of cross-border bank failures

32. 32 Are there any financial stability implications of EME investments in foreign portfolio capital? Redirecting FX inflows helps macroeconomic policy (no need to deal with impact of capital inflows) But is it good investment? Interest rate differential vis-à-vis US Assets denominated in depreciating currency (USD) If investments are made by SWFs, additional issues: Protectionist backlash SWFs might not be subject to supervisory oversight in their home jurisdictions