benefits and risks from financial liberalisation - world...

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Benefits and risks from financial liberalisation

Marcel Fratzscher

European Central Bank

World Bank – BMZ – GIZ Workshop "Managing Risk for Development" in preparation for the World Development Report 2014

Berlin, 12-13 December 2012

The views expressed here are those of the author and do not necessarily reflect those of the ECB.

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Three main points

• Aggregate stability key for development

• Dilemma: fostering development creates risks • Common trade-off: reducing risk vs. managing risk

• Point #1: Financial liberalisation good for growth • but needs to be managed and sequenced well

• Point #2: Poor public institutions as single most important source of risk for stable finance • Win-win: strong institutions both reduce aggregate risk and

manage/transfer risk

• Risk sharing highest with openness and good institutions

• Point #3: Financial protectionism major risk today, need for policy coordination

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Real per capita GDP growth (in %)

-5.0

0.0

5.0

10.0

-10 -8 -6 -4 -2 0 2 4 6 8 10

grow th +/- 1 std.dev.

growth accelerates after liberalisation of capital account

1. Financial liberalisation is good for growth ...

Source: Bussiere, M. and M. Fratzscher, 2008. “Financial openness and growth: short-run gain, long-run pain?, Review of International Economics 16(1), 69–95.

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... but also volatility in finance and growth rises Portfolio inflows to GDP ratio (in %)

-5.0

0.0

5.0

10.0

-10 -8 -6 -4 -2 0 2 4 6 8 10

portfolio inf low s/GDP +/- 1 std.dev.

highly volatile and diverse portfolio flows after liberalisation of capital account

Source: Bussiere, M. and M. Fratzscher, 2008. “Financial openness and growth: short-run gain, long-run pain?, Review of International Economics 16(1), 69–95.

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The role of sequencing

Countries that liberalised their domestic financial sectors first benefited more from liberalisation through higher growth

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2. How to deal with risks of sudden stops and capital flow volatility?

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Push versus pull: Drivers of capital flows

• Most of EMDCs capital flows during 2008-09 crisis explained by push factors, but post-crisis by pull factors (esp. Asia, LatAm)

Push factors Pull factors % of total capital flows explained by factors

Pre-crisis Crisis Post-crisis Pre-crisis Crisis Post-crisis

ALL countries 65.4 72.8 45.0 34.6 27.2 55.0

EM Asia 48.3 84.9 18.1 51.7 15.1 81.9 EM Europe 86.6 93.2 80.3 13.4 6.8 19.7 Latin America 48.8 150.0 36.9 51.2 -50.0 63.1 Africa/Middle East 109.3 104.4 54.8 -9.3 -4.4 45.2 Advanced Europe 90.8 23.2 84.2 9.2 76.8 15.8 Other advanced 76.1 80.5 58.8 23.9 19.5 41.2

Source: Fratzscher, M. , 2012. “Capital Flows, Push versus Pull Factors and the Global Financial Crisis,” NBER-Sloan project on the Global Financial Crisis, Journal of International Economics.

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Sudden stop in 2008-09 crisis strongly linked to poor institutions

510

1520

25co

untry

risk

-3 -2 -1 0 1

4050

6070

8090

qual

ity o

f ins

titut

ions

-3 -2 -1 0 1

050

100

150

200

finan

cial

ope

nnes

s

-3 -2 -1 0 1

-30

-20

-10

010

20cu

rren

t acc

ount

-GD

P ra

tio

-3 -2 -1 0 1

Source: Fratzscher, M. , 2012. “Capital Flows, Push versus Pull Factors and the Global Financial Crisis,” NBER-Sloan project on the Global Financial Crisis, Journal of International Economics.

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3. Managing risks: Risk sharing – openness and institutions

• Risk sharing across countries

• Smoothing private consumption by de-linking consumption from output

Unilateral Version:

test β=0

Bilateral Version:

test γ=1

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Link of sudden stops to risk & institutions

Source: Fratzscher, M. and J. Imbs, 2009. Risk sharing, finance and institutions in international portfolios, Journal of Financial Economics 94: 428–447, December 2009.

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"This crisis started in the developed world, … it will not be overcome through quantitative easing policies that have triggered … a monetary tsunami, have led to a currency war and have introduced new and perverse forms of protectionism in the world." President Rousseff of Brazil (2012, FT 29 March

2012)

4. The risk of financial protectionism

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Global financial stability: Externalities from crisis responses

• “Monetary tsunami” capital flows, global liquidity

• “Currency war”

• Financial “protectionism” – Capital controls and FX policies in EMEs as forms of

protectionism…

– …but also monetary policy and other policies of advanced economies?

Externalities – The Example of Brazil

* is significant at the 1% level, ** at the 5% level, *** at the 1% level

Log- Log- Log-difference difference difference

Control Brazil -0.028*** -0.275*** -0.028*** -0.276*** -0.027*** -0.271*** -0.028*** -0.276***(0.003) (0.061) (0.003) (0.062) (0.003) (0.061) (0.003) (0.062)

Control ExBrazil/Externality 0.002 0.017 -0.002 -0.017 -0.018* -0.343** 0.016 0.175(0.009) (0.187) (0.008) (0.308) (0.008) (0.139) (0.010) (0.232)

ω benchmark 0.847*** 0.975*** 0.847*** 0.975*** 0.845*** 0.975*** 0.845*** 0.974***(0.021) (0.043) (0.021) (0.043) (0.022) (0.044) (0.022) (0.043)

Region 0.012** 0.207***(0.005) (0.052)

Market Size 0.009 0.098 (0.014) (0.137)Dragon Play 0.025** 0.416**

(0.009) (0.194)Control Risk -0.018** -0.184**

(0.008) (0.070)

Macro Controls Y Y Y Y Y Y Y Y

Observations 1,086 1,086 1,086 1,086 1,086 1,086 1,086 1,086R-squared 0.702 0.555 0.702 0.555 0.704 0.558 0.703 0.556

First-difference

Log-difference

Region Market Size Dragon Play Control RiskFirst-

differenceFirst-

differenceFirst-

difference

Source: Forbes, Fratzscher, Kostka and Straub M. , 2012. “Bubble Thy Neighbor: Portfolio Effects and Externalities from Capital Controls,” NBER Working Paper No. 18052, May 2012.

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Findings on externalities of capital controls

• Externalities from capital controls substantial

– Risk of triggering competitive devaluations

– Raising incentives for others to implement capital controls

– Evidence for diversion of capital flows to neighbors and other EMEs

– Call for global coordination on capital flow management

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Policy levers – what pecking order to ensure that finance supports stability and development?

• Macroeconomic Monetary, fiscal, structural policies

• Prudential Macro- and microprudential

• Financial intermediation to reduce and hedge risks

– Financial market development, depth and sophistication

• Institutional quality and environment – “flight-to-safety” phenomenon makes capital flows to EMEs

often highly pro-cyclical and hence detrimental

– Link to quality of institutions and country risk

• Financial protectionism, capital controls and FX policy interventions

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Three main points

• Point #1: Financial liberalisation good for growth • but needs to be managed and sequenced well

• Point #2: Poor public institutions as single most important source of risk for stable finance • Strong institutions as insurance against sudden stops and

volatility

• Risk sharing (consumption smoothing) highest with openness and good institutions

• Point #3: Financial protectionism major risk today • Wrong lesson from the 2007-08 and 2010-12 crises

• Reflects a coordination failure – need for policy coordination at global level

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Appendix

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The intertemporal trade-off

Portfolio investment inflows lead to significantly higher growth in short-term and lower growth in long-term

may explain why evidence for overall positive growth effect is so weak in literature

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2. Rising risk of financial protectionism

1.4

1.45

1.5

1.55

1.6

1.65

Dis

pers

ion

capi

tal c

ontro

ls

-.6-.4

-.20

.2.4

Mea

n ca

pita

l con

trols

1985 1990 1995 2000 2005 2010

Mean capital controls Dispersion capital controls

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Two episodes with rising controls

05

1015

2025

1985 1990 1995 2000 2005 2010

Raise Reduce