International Financial Liberalization, Capital Flows, and Exchange Rate Regimes: An Introduction

1. International Financial Liberalization, Capital Flows, and Exchange Rate Regimes: An Introduction Written by: Francisco Rivera-Batiz and Luis Rivera-Batiz Presented by: Christina Boyd

2. Purpose of Paper • Recent major financial crises in emerging markets included: • 1994/95 Mexican peso crisis • 1997/98 East Asian crisis • 1998 Russian crisis • 1999 Brazilian crisis

3. Purpose of Paper Cont… • These crisis raised serious concerns about the consequences of an increasingly globalized capital market. • Mundell argues that such concerns are misplaced since the blame for the crises must be placed on the failure of current international monetary arrangements.

4. Purpose of Paper Cont… • Rivera-Batiz and Rivera-Batiz looked at: • Alternative exchange rate regimes. • Private and official capital flows to developing countries. • Whether international financial liberalization is a boost or a hindrance to development.

5. Pegged Exchange Rates • Pegged exchange rates characterized the external payments regimes of the crisis countries. • According to Mundell, pegged rates create policy conflicts that cause destabilizing capital flows and eventually lead to currency and financial crises.

6. Pegged Exchange Rates Cont… • Under pegged rates, central banks intervene in the foreign exchange market to peg currency values, but they still keep independent monetary policies which may be inconsistent with the long-run stability of the pegged currency values. • Therefore, the problem is the policy inconsistency.

7. Dollarization • Dollarization occurs when residents of a country extensively use foreign currency alongside or instead of the domestic currency.

8. Dollarization Cont… • Benefits of dollarization: • Countries gain by the greater liquidity allowed by the adoption of the dollar, a major world currency. • Countries import the stability and credibility of American monetary policy.

9. Dollarization Cont… • Costs of dollarization: • Countries transfer their seigniorage, which is the difference between the value of money and the cost of its production, to the United States. • Countries lose economic sovereignty since the U.S. wouldn’t adjust its inflation rate to take into account the policy interests of dollarized countries.

10. Currency Board • A currency board combines three elements: • A fixed exchange rate between a country's currency and an “anchor currency.” • Automatic convertibility at a fixed rate. • A long-term commitment to the system, often made explicit in the central bank law.

11. Performance of Alternative Exchange Rate Regimes • An examination of the comparative performance of alternative exchange rate regimes suggests that countries adopting currency boards have grown faster and inflated less on average than countries adopting other regimes, particularly adjustable pegs.

12. Performance of Alternative Exchange Rate Regimes Cont… • However, in “Discipline, Signaling, and Currency Boards,” by Oliva, Rivera-Batiz and Sy, the currency regime choice should be undertaken carefully because there is no single regime that is best for all circumstances.

13. Private and Official Capital Flows to Developing Countries • “International Capital Mobility in Emerging Markets: New Evidence from Daily Data,” by Kumhof examines the extent to which financial integration broke down during the East Asian crisis in 1997/98. • To test this, he studied deviations from covered-interest parity.

14. Private and Official Capital Flows to Developing Countries Cont… • The covered-interest parity hypothesis asserts that assets that are similar except for the country of issue and the currency of denomination should yield the same covered returns. • Therefore, the interest differential between money market assets denominated in two different currencies should be equal to the forward premia or discount between the two currencies.

15. Private and Official Capital Flows to Developing Countries Cont… • The degree of financial integration in emerging markets was measured by the extent to which covered interbank differentials differ from zero. • As predicted by the theory, covered interest differentials in Indonesia, Thailand, and Mexico were close to zero and displayed low volatility before the currency crisis, and increased dramatically during the crisis.

16. Private and Official Capital Flows to Developing Countries Cont… • The breakdown of covered interest parity in East Asia during the crisis can be attributed to temporary capital controls, capital market imperfections, and large bank default risk.

17. Private and Official Capital Flows to Developing Countries Cont… • “Foreign Aid and the Business Cycle,” by Pallage and Robe focuses on a different type of financial flow – foreign aid – which constitutes a major source of external finance for many developing countries.

18. Private and Official Capital Flows to Developing Countries Cont… • Foreign aid is granted in order to finance growth and increase the standard of living rather than as insurance against cyclical instabilities. • Pallage and Robe find that developing countries’ foreign aid receipts have been procyclical rather than countercyclical.

19. Private and Official Capital Flows to Developing Countries Cont… • Therefore, in times of recession, developing countries find themselves facing high interest rates, limitations in the access to capital markets, and receiving less foreign aid. • On average, the volatility of aid receipts is twice as much as the highly volatile recipient country output.

20. Private and Official Capital Flows to Developing Countries Cont… • The high procyclicality and volatility of foreign aid raise key questions about the impact of foreign aid on economic development, because they make it difficult for a developing country to smooth out the fluctuations in domestic consumption.

21. Is International Financial Liberalization a Boost or a Hinderance to Development • Has increased financial integration contributed to the increase in banking crises in emerging markets? • “Bank Fragility and International Capital Mobility,” by Detragiache, shows that full integration – which occurs when domestic banks, and domestic investors in general, are able to participate abroad freely – reduces the probability of bank runs.

22. Is International Financial Liberalization a Boost or a Hinderance to Development Cont… • Under full integration, with banks having the same access to foreign markets as the investor, the asymmetry collapses and international financial liberalization is welfare-increasing. • Therefore, a key policy implication is that speeding up the process of liberalization toward full integration can reduce the probability of a crisis.

23. Is International Financial Liberalization a Boost or a Hinderance to Development Cont… • “International Financial Liberalization and Economic Growth,” by Levine, states that “international financial integration can promote economic development by encouraging improvements in the domestic financial system, with positive ramifications for long-run productivity growth.”

24. Is International Financial Liberalization a Boost or a Hinderance to Development Cont… • Levine’s analysis rests on evidence of two linkages: • International financial liberalization increases the efficiency of the domestic financial system. • The increased efficiency of domestic financial systems exerts a heavy impact on economic growth by boosting total factor productivity in the economy.

25. Is International Financial Liberalization a Boost or a Hinderance to Development Cont… • “Foreign Portfolio Investments, Financial Liberalization, and Economic Development,” by Errunza, presents evidence indicating that liberalization has profound effects on the cost of capital and the type of financing.

26. Is International Financial Liberalization a Boost or a Hinderance to Development Cont… • However, Errunza states that although the evidence that foreign portfolio investments provide benefits to emerging markets is strong, the adequate preconditions must be in place to ensure such benefits. • Prudent regulatory measures, adequate informational infrastructure, and market-oriented reforms must precede liberalization if a country is to maximize the potential gains from liberalization and minimize its costs.

27. Is International Financial Liberalization a Boost or a Hinderance to Development Cont… • “International Financial Liberalization, Corruption, and Economic Growth,” by Rivera-Batiz, examines the nature of capital flight and its implications regarding the liberalization of international financial transactions.

28. Is International Financial Liberalization a Boost or a Hinderance to Development Cont… • Rivera-Batiz finds that this policy initiative can result in an increase or a decrease in the economy’s long-run growth. • If the level of corruption in the economy is sufficiently low, the capital account liberalization will serve as a boost to the country’s growth, with foreign capital flowing into the economy and stimulating innovation and growth. The opposite is true if the level of corruption in the economy is sufficiently high.

29. Conclusions • International financial liberalization can help an economy grow if: • The right exchange rate regime is implemented. • The policy followed by the country is consistent over time. • Prudent regulatory measures, adequate informational infrastructure, and market-oriented reforms are made prior to the liberalization.

30. Any Questions???