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Financial Liberalization. 1. Current Account represents the net sum of trade in goods and services, primary income and secondary income: NX +NFI. a. Net Exports 1. Trade balance refers to net export (export less import) of goods
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1. Current Account represents the net sum of trade in goods and services, primary income and secondary income: NX +NFI. a. Net Exports 1. Trade balance refers to net export (export less import) of goods 2. Net Services, defined as the net export (export less import) of services. b. + c. Net Factor Income b. Primary Income comprises compensation of employees (wages, salary) and investment income c. Secondary Income refers to donation or grant paid to or received from nonresidents Meta Data
Capital Account, Financial Account, • Capital Account: transfer of ownership of fixed asset, and debt forgiveness), and acquisition and disposal of non-financial assets (tangible: land; intangibles: patents, trademarks) • Financial Account: refers to net flows of financial transactions between residents and nonresidents, reflecting changes of ownership over financial assets and liabilities • Capital and Financial Account measure net inflows
Current account is (net) domestic non-central bank actors acquiring foreign currency selling goods or services. • Capital & Financial Account is (net) foreign actors selling foreign currency to acquire domestic currency. • Reserve Assets is (net) acquisition by central bank of foreign currency
Accounting • Net Capital Inflows = (Capital & Financial Account - Reserve Assets ) • Theory Net Capital Outflows Should equal Current Account. If you earn more funds selling goods overseas, you can acqure overseas assets. • Theory: Current Account + Net Inflows = 0 • Accounting: Uncounted Inflows = Net Inflows – Current Account
What if economy does not have enough capital inflows to support its current account deficit? Net Capital Outflows Not enough buyers for domestic currency goods Too many buyers for foreign currency assets Current Account
Two Possibilities • Floating Exchange Rates – Changes in the exchange rate equalize forex market. • Pegged Exchange Rate – Changes in reserve assets equalize forex market.
Not enough demand for domestic currency causes exchange rate to depreciate. Net Capital Outflows Current Account Net Capital Outflows Current Account Falling price of currency makes domestic goods & financial assets more competitive
Central bank must use forex reserves to buy domestic currency to absorb pressure on its value. Net Capital Outflows Current Account Net Capital Outflows
What if economy receives a surge in inflows? Hot Money Current Account Net Capital Outflows
Excess demand for domestic currency causes exchange rate to appreciate? Current Account Net Capital Outflows Current Account Net Capital Outflows Floating exchange rates
Central bank purchases inflows and increases reserves Net Capital Outflows Current Account Net Capital Outflows
II. The debate over financial globalization • Broad agreement (among economists at least) that trade liberalization is beneficial and leads to faster growth → Free trade in good and services makes countries better off • In contrast, much controversy over whether the liberalization of international financial flows is desirable → Free trade in financial assets may not make countries better off
Capital Controls • Zero-Interest Reserve Requirements: Thailand (2006, 2009) • Tobin Tax: Tax on currency transactions • Administrative Controls http://www.imf.org/external/pubs/ft/fandd/2010/09/dataspot.htm
…and recovered from the crisis somewhat • Financial integration has been fastest in developed economies. • But emerging markets financial flows have also been substantial. http://www.imf.org/external/pubs/ft/weo/2011/01/pdf/c4.pdf
Reaping the Benefits of Financial Globalization Empirical evidence shows that the benefits of opening capital account are mixed. • But there are several factors which have been shown to allow countries with open capital accounts to: • Increase consumption risk-sharing and; • Increase economic growth and; • Reduce the likelihood of crises.
Keys to Benefiting from Globalization • Financial sector development. Well-regulated domestic financial markets • Institutional Quality. Low corruption, high transparency, good corporate governance. • Sound Macroeconomic Policies. Low deficits and price stability. • Trade Integration. High degree of trade openness. http://www.imf.org/external/pubs/ft/fandd/2007/03/kose.htm
How to Liberalize • During the early 1990’s, some authors argued in favor of a “big bang” approach to capital account liberalization. • Since mid-1990’s, taking empirical evidence in mind, IMF has adopted a more moderate approach referred to as sequencing or ‘integrated approach’
Integrated Approach • capital account liberalization is best undertaken against a background of sound and sustainable macroeconomic policies; • domestic financial reform should be complemented by prudential regulation and supervision, and financial restructuring policies; • liberalization of capital flows by instruments and/or sectors should be sequenced to take into account concomitant risks—in general, long-term and non-debt creating flows (especially FDI) should be liberalized before short-term and debt-creating flows; Link
