Financial Stability in Emerging Markets

Description
The rapid increase in global liquidity and the large-scale net capital flows to emerging countries have raised serious concerns about adverse effects on the recipient countries; these include the danger of overheating, exchange rate appreciation pressures, inflationary pressure on consumer and asset prices, and risks to financial stability.

Financial Stability
in Emerging Markets
Dealing with Global Liquidity
Ulrich Volz (ed.)

Financial Stability in Emerging Markets
Dealing with Global Liquidity

Ulrich Volz (ed.)

Bonn 2012
The German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) is one of
the leading research institutions and think tanks for global development and international
development policy world-wide. This has been attested in January 2012 by the ranking of the
Global “Go-To Think Tanks” Report: once again, DIE ranked among the Top Five in the category
of “Top International Development Think Tanks“. DIE builds bridges between theory and practice
and works within international research networks. The key to DIE’s success is its institutional
independence, which is guaranteed by the Institute’s founding statute. Since its founding in 1964,
the institute has based its work on the interplay between Research, Consulting and Training.

The Institute’s Postgraduate Training Programme is concentrated on courses dedicated to
development-related themes and issues bound up with shaping the process of globalisation as well
as with improving trainee communicative and social skills. The cornerstone of the Postgraduate
Training Programme – field research carried out by small interdisciplinary groups in a developing
country – serves to provide trainees with an opportunity to gain practical experience with what
they have learned by participating in concrete consulting-oriented research projects. Once they
have completed the Postgraduate Training Programme, the graduates find career opportunities
with development organisations in Germany and abroad.

partner countries of Germany’s international cooperation the participation in the Global
Governance School. The highly qualified participants from Brazil, China, Egypt, India, Indonesia,
Mexico, Pakistan, and South Africa work in governments, ministries, universities, policy-
orientated Think Tanks or research institutions. The Training and Dialogue Programme of the
Global Governance School is the practice- and research-oriented component of the Managing
Global Governance-Programme, implemented jointly by the German Development Institute and
GIZ. This unique exchange and learning opportunity supports the creation of a sustainable,
equitable, and effective global governance architecture.

The German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) is headed
by Prof. Dr. Dirk Messner (Director). At present, the Institute has a staff of 100, more than two
thirds of whom are researchers.

Ulrich Volz is Senior Researcher at the German Development Institute / Deutsches Institut für
Entwicklungspolitik (DIE) and Visiting Professor at Peking University’s School of Economics.

© Deutsches Institut für Entwicklungspolitik gGmbH
Tulpenfeld 6, 53113 Bonn
+49 (0)228 94927-0
+49 (0)228 94927-130
www.die-gdi.de
www.facebook.com/DIE.Bonn

E-mail: [email protected]
E-mail: [email protected]

In

addition

to

the

Postgraduate

Training

Programme,

the

German

Development

Institute

/
Deutsches Institut für Entwicklungspolitik (DIE) offers Young Professionals from selected
Abstract
The rapid increase in global liquidity and the large-scale net capital flows to emerging
countries have raised serious concerns about adverse effects on the recipient countries;
these include the danger of overheating, exchange rate appreciation pressures, inflationary
pressure on consumer and asset prices, and risks to financial stability. The historical
experience of many emerging countries highlights the risk of a rapid reversal of capital
flows, followed by a possible financial and currency crisis. There have also been concerns
about the inflationary consequences of excessive global liquidity for commodity prices,
including those of agricultural commodities. Against this backdrop, this volume comprises
contributions by internationally renowned experts from academia and international
organisations who discuss the spillover effects of expansionary monetary policies in
advanced countries on emerging economies, and the risks that excessive global liquidity
and abundant capital flows to emerging economies entail for macroeconomic and financial
stability in these countries. They also discuss policy options for reining in these risks,
ranging from capital account management and prudential policies in source and recipient
countries to an enhanced monitoring of global capital flows.

Contents
Introduction 1
Ulrich Volz
Global rebalancing with financial stability: possible, feasible, or unlikely? 8
Menzie D. Chinn
US quantitative easing: spillover effects on emerging economies 12
Feng Zhu
The comovement of international capital flows:
evidence from a dynamic factor model 19
Marcel Förster / Markus Jorra / Peter Tillmann
Global liquidity and commodity prices 23
Ulrich Volz
Foreign banks and financial stability: lessons from the Great Recession 27
Ralph de Haas
Emerging market economies after the crisis: trapped by global liquidity? 35
Anton Korinek
Capital account management: the Indian experience and its lessons 40
Y. Venugopal Reddy
Avoiding capital flight to developing countries: a counter-cyclical approach 44
Stephany Griffith Jones / Kevin P. Gallagher
What role for the FSB? 50
Jo Marie Griesgraber
International capital flows and institutional investors 55
Bernd Braasch
Global liquidity and the Brazilian economy 60
Renato Baumann
AMRO’s role in regional economic surveillance and promoting regional economic
and financial stability 65
Akkharaphol Chabchitrchaidol
Authors 70

Abbreviations
ADRs American depositary receipts
AMRO ASEAN+3 Macroeconomic Research Office
APF Asset Purchase Facility
ASEAN+3 Association of Southeast Asian Nations (Brunei, Cambodia, Indonesia, Laos, Myanmar,
Malaysia, Philippines, Singapore, Thailand, Vietnam) plus China, Japan, South Korea
BIS Bank for International Settlements
BRIC Brazil, Russia, India, China
BRICS Brazil, Russia, India, China, South Africa
CRB Commodity Research Bureau
CFM Capital Flow Management
CMIM Chiang Mai Initiative Multilateralisation
CGFS Committee on the Global Financial System
CPI Consumer Price Inflation
EBRD European Bank for Reconstruction and Development
ECB European Central Bank
EMDEs Emerging Markets and Developing Economies
EM Emerging markets
EMEs Emerging market economies
ESRB European Systemic Risk Board
FAO Food and Agriculture Organization of the United Nations
FDI Foreign direct investment
FSB Financial Stability Board
G20 Group of Twenty (Argentina, Australia, Brazil, Canada, China, European Union, France,
Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa,
South Korea, Turkey, United Kingdom, United States)
GDP Gross domestic product
GVAR Global Vector Autoregression
IIF Institute of International Finance
IMF International Monetary Fund
IOSCO International Organization of Securities Commissions
LSAP Large-Scale Asset Purchase
MBS Mortgage Backed Securities
MEP Maturity Extension Program
OECD Organization for Economic Co-operation and Development
OTC Over-the-counter
SMEs Small- and medium sized enterprises
SMP Securities Markets Programme
SSBs Standard Setting Bodies
UNCTAD United Nations Conference on Trade and Development

US United States
USD United States dollar
VAR Vector Autoregression

Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 1
Introduction
Ulrich Volz
The world economy has been in a state of fragility since the outbreak of the global
financial crisis in September 2008. While most emerging countries navigated the crisis
with relative success and staged strong recoveries in 2009, many advanced countries are
still struggling with recession or tremors in their banking systems. Since 2010, the
European sovereign debt crisis has not only caused jitters in the global financial markets
but has also sparked worries about contagious effects around the world, increasing the
volatility of international capital flows.
The central banks of all major advanced economies responded to the global financial crisis
and the ensuing recession with unprecedented monetary expansion by lowering interest
rates to historically low levels and pursuing unconventional monetary policies, such as
large asset-buying programmes. As shown in Figure 1, both the Federal Reserve System
and the Eurosystem have seen remarkable expansions of their balance sheets since
September 2008. The extremely accommodative monetary policies in the major advanced
countries have caused a surge in global liquidity. Moreover, the resulting large interest
rate differentials have incited carry trades and capital flows into emerging economies with
higher risk-adjusted rates of return. Capital flows to emerging countries have been further
reinforced by rather bleak growth prospects in advanced countries. The monetary
expansion in Europe and the United States (US) caused Brazil’s president Dilma Rousseff
in March 2012 to voice her concerns about the resulting “monetary tsunami” that was
making its way to emerging economies.
Figure 2 shows that prior to the global financial crisis net private capital flows to emerging
countries rose from USD 149 billion in 2002 to an all-time high of USD 1,244 billion in
2007. This upward trend in net private capital flows to emerging countries was reversed in
2008: net inflows were halved to USD 619 billion as financial institutions in advanced
countries scrambled to liquidate assets, even profitable ones in emerging markets,
wherever they could in the face of the liquidity crunch on the US and European markets.
The result was a global credit crunch in the last quarter of 2008 and first quarter of 2009
that was felt in emerging countries as well. Even though the US was the epicentre of the
crisis, the global flight to safety into US Treasury bills, along with a reversal of carry
trades, led to large capital inflows into the US during the crisis and caused a strong
appreciation of the US dollar (McCauley / McGuire 2009). By 2010, however, net flows
to emerging countries had again reached an impressive USD 1,040 billion. In 2011, net
flows to emerging markets ebbed to an estimated USD 910 billion as the European
sovereign debt and banking crisis increased funding difficulties among European banks.
The need for liquid assets and the introduction of new European Union capital
requirements caused European banks to cut back their international exposure and sell
assets in emerging markets at the end of 2011.
1
The Institute of International Finance
projects net private capital inflows of USD 746 billion to emerging economies in 2012 and

1 The European Banking Authority requires major European banks to increase their core capital to 9%
of risk-weighted assets by mid-2012.
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
2 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
Figure 1: Total assets of the Eurosystem and the Federal Reserve System (in USD millions)

Source: Compiled by the author based on data from the ECB and the Federal Reserve.

Figure 2: Net private capital inflows to emerging markets (in USD millions)

Note: The 2011 figure is estimated (e); figures for 2012 and 2013 are forecasts (f). Net private capital inflows to
emerging markets (EM) represent flows of capital (both equity and debt) from foreign private sector investors
and lenders. “Net” means that foreign investors’ withdrawals of capital are subtracted. Outward investments
by EM residents (“capital outflows”) are not taken into account here. Net inflows to EM from official sector
sources are also excluded. The sample includes a geographically diverse group of the 30 largest EM countries,
i.e. those which account for the vast majority of global capital flows to EM.
Source: Compiled by the author based on data from IIF (2011, 2012).
1,300,000
2,000,000
2,300,000
3,000,000
3,300,000
4,000,000
LurosysLem
lederal 8eserve SysLem
0
300,000
1,000,000
1,300,000
2
0
0
2
W
3
1
2
0
0
3
W
0
8
2
0
0
3
W
1
7
2
0
0
3
W
2
6
2
0
0
3
W
3
3
2
0
0
3
W
4
4
2
0
0
4
W
0
1
2
0
0
4
W
1
0
2
0
0
4
W
1
9
2
0
0
4
W
2
8
2
0
0
4
W
3
7
2
0
0
4
W
4
6
2
0
0
3
W
0
2
2
0
0
3
W
1
1
2
0
0
3
W
2
0
2
0
0
3
W
2
9
2
0
0
3
W
3
8
2
0
0
3
W
4
7
2
0
0
6
W
0
4
2
0
0
6
W
1
3
2
0
0
6
W
2
2
2
0
0
6
W
3
1
2
0
0
6
W
4
0
2
0
0
6
W
4
9
2
0
0
7
W
0
6
2
0
0
7
W
1
3
2
0
0
7
W
2
4
2
0
0
7
W
3
3
2
0
0
7
W
4
2
2
0
0
7
W
3
1
2
0
0
8
W
0
8
2
0
0
8
W
1
7
2
0
0
8
W
2
6
2
0
0
8
W
3
3
2
0
0
8
W
4
4
2
0
0
9
W
0
1
2
0
0
9
W
1
0
2
0
0
9
W
1
9
2
0
0
9
W
2
8
2
0
0
9
W
3
7
2
0
0
9
W
4
6
2
0
1
0
W
0
2
2
0
1
0
W
1
1
2
0
1
0
W
2
0
2
0
1
0
W
2
9
2
0
1
0
W
3
8
2
0
1
0
W
4
7
2
0
1
1
W
0
4
2
0
1
1
W
1
3
2
0
1
1
W
2
2
2
0
1
1
W
3
1
2
0
1
1
W
4
0
2
0
1
1
W
4
9
2
0
1
2
W
0
6
600,000
800,000
1,000,000
1,200,000
1,400,000
0
200,000
400,000
600,000
1993 1996 1997 1998 1999 2000 2001 2002 2003 2004 2003 2006 2007 2008 2009 2010 2011e 2012f 2013f
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 3
USD 893 billion in 2013. Compared with historical standards, these are enormous sums
that emerging economies will have to absorb.
The rapid increase in global liquidity and the large-scale net capital flows to emerging
countries have raised serious concerns, not least in the recipient countries, about adverse
effects; these include the danger of overheating, exchange rate appreciation pressures,
inflationary pressure on consumer and asset prices, and risks to financial stability. The
historical experience of many emerging countries, not least during the global financial crisis,
highlights the risk of a rapid reversal of capital flows, followed by a possible financial and
currency crisis. There have also been concerns about the inflationary consequences of
excessive global liquidity for commodity prices, including those of agricultural commodities.
Against this backdrop, the contributions in this volume discuss the spillover effects of
expansionary monetary policies in advanced countries on emerging economies, and the risks
that excessive global liquidity and abundant capital flows to emerging economies entail for
macroeconomic and financial stability in these countries. Several chapters also discuss policy
options for reining in these risks, ranging from capital account management and prudential
policies in source and recipient countries to an enhanced monitoring of global capital flows.
Menzie Chinn evaluates the prospects for rebalancing the global economy, the
implications of the current two-speed global recovery, and policy options in both
advanced and emerging economies. In the advanced countries, Chinn urges a looser
monetary policy to help deleveraging. The macroeconomic difficulties confronting the
advanced economies will ensure continued capital flows to the emerging markets. To deal
with these, Chinn believes that emerging market policymakers should first resort to
macroeconomic measures, including countercyclical fiscal policy and an abstention from
heavy foreign exchange intervention against exchange rate appreciation; this would also
facilitate macroeconomic rebalancing.
Feng Zhu presents empirical evidence concerning the cross-border effects of the Federal
Reserve’s quantitative easing policy. He shows that the Fed’s asset purchase programmes
had a broad, immediate, and sizeable impact on global financial markets. In the early
stage, with the global economy slipping into a major slowdown, these balance sheet
policies may have contributed to global financial stability and aided the recovery of
emerging economies by strengthening trade credit and supporting demand. But as many
emerging economies have returned to solid growth, Zhu highlights that such measures
may also have increased the risk of overheating, high inflation, and volatile capital flows.
In particular, fears of disruptive capital inflows and currency appreciation pressures may
dissuade emerging market central banks from raising policy rates. Zhu cautions that
further extraordinary monetary stimulus packages in advanced countries may create
difficult challenges for emerging market central banks.
Marcel Förster, Markus Jorra and Peter Tillmann investigate the importance of common
components among international capital flows with different destinations. They apply a
dynamic factor model in order to gauge the extent to which international capital flows are
correlated on a global level, and they identify global and regional factors in flows from a
large set of industrial and emerging economies. Their results suggest that the global factor
is common to capital flow cycles on the whole, but that a large degree of heterogeneity
among countries can be attributed to either regional or country-specific determinants. In
other words, their findings suggest that capital flows to emerging economies are not only
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
4 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
(or primarily) driven by global “push” factors, but that country- and region-specific “pull”
factors also play an important role. Hence they stress the importance of domestic policies
in emerging countries; these policies, they believe, can have a considerable impact on
capital flows and can also limit such adverse consequences of capital inflows as asset
price booms and real appreciation of the domestic currency.
Ulrich Volz discusses the relation between global liquidity and commodity prices.
Cointegration analysis indicates a positive long-term relation between global liquidity and
the development of commodity prices over the last three decades, a relationship that was
driven by global liquidity. That is, food and commodity price inflation were apparently
driven by monetary expansion in the world’s major economies. Volz highlights the
dilemma that arises when the central banks of all major advanced economies
simultaneously engage in expansionary monetary policies as a means of stabilising their
respective economies and financial sectors: the resulting global liquidity shock feeds
commodity and food price inflation. While he regards expansionary monetary policies as
indispensable in times of severe economic and financial crisis, Volz urges policymakers to
think of the negative side-effects and to consider stricter regulation of commodity markets,
especially agricultural commodity markets, in order to avoid driving up prices through a
further flow of liquidity into these markets.
Ralph de Haas scrutinises the role of foreign banks in emerging markets and the impact
of these banks on financial stability. Based on his analysis of the Great Recession, he
draws two policy lessons: First, the crisis underlined the importance of funding
structures for banking stability. In particular, it became clear that excessive wholesale
funding can expose banks to periods of illiquidity in wholesale markets. To reduce their
vulnerabilities, foreign and domestic banks should therefore focus more on local
funding. This requires the development of a local-currency deposit base and local-
currency bond markets, each of which would reduce the need for banks to borrow and
lend in foreign exchange. Second, the recent crisis underscored the risk that
multinational banks may pass on shocks from home to their host countries and the
magnitude of these effects if foreign bank affiliates are of local systemic importance. De
Haas therefore demands improvements in the supervisory framework for multinational
banking groups in order to ensure better coordination, cooperation, and information
exchange among supervisors, thus preventing a recurrence of the shock spillovers seen
during the recent crisis.
Anton Korinek makes the welfare-theoretic case for regulating capital flows based on the
notion that such flows impose externalities on the recipient countries. Just as
environmental pollution produces externalities that reduce societal well-being if
unregulated, capital inflows to emerging markets produce externalities that make such
economies more prone to financial instability and crises. As Korinek explains, different
forms of capital inflows result in different probabilities of future capital outflows and
different payoff characteristics in the event of a crisis; this in turn leads to different
externalities. Optimised macroprudential policy should aim precisely at offsetting these
externalities. He illustrates this with a sample evaluation of the magnitude of
externalities created by various types of capital inflows to Indonesia. He also points out
that policy measures for regulating capital inflows should be regularly adjusted to meet
changes in the financial vulnerability of the respective economy. Since the externalities
of foreign capital rise during booms, when leverage increases and financial imbalances
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 5
build up, and new capital inflows create smaller externalities after a crisis has occurred
and economies have de-leveraged, optimal capital flow regulation should therefore be
strongly procyclical.
Y. V. Reddy, who served as Governor of the Reserve Bank of India between 2003 and 2008,
reviews the Indian experience with capital account management over the past two decades.
He highlights the importance of integrating management of the capital account with other
policies – especially fiscal management, regulation of the financial sector, and monetary
policy – and points out that capital account management should be treated as an essential
component of countercyclical policies at all times, even when recourse to it is taken as a
purely temporary measure. In Reddy’s view, capital account management should involve
both pricing and administrative measures and aim at managing inflows as well as outflows.
Since the nature of capital flows and the complexity of operations of financial intermediaries
keep changing, there should be sufficient flexibility for modifying the various measures and
altering their relative priorities. Reddy emphasises that the critical part of capital account
management relates to the financial sector and that therefore the most important instrument
of capital account management should be regulation of the financial sector.
Stephany Griffith Jones and Kevin Gallagher put forward a counter-cyclical approach for
avoiding capital flight from advanced to developing and emerging countries. In particular,
they propose that macroprudential regulatory measures in recipient countries be coupled
with actions by advanced countries to discourage capital outflows and risk-taking on the
part of their economies while encouraging productive use of capital within their own
economies. The prime aim of regulating cross-border capital flows in both recipient and
source countries is to reduce systemic build-ups of risk in both, thus reducing the risk of
future crises. The US above all should establish prudent capital regulations or levy taxes
on the outflow of speculative capital. Measures to discourage short-term outflows would
encourage the liquidity created by the Fed to stay in the US and be used for promoting
productive investment. Griffith-Jones and Gallagher hence emphasise that managing
excessive capital outflows from developed countries, especially from the US, would
constitute a clear win-win situation by benefiting both the US economy and developing
economies which are being harmed by excessive short-term inflows.
Jo Marie Griesgraber scrutinises the role of the Financial Stability Board (FSB) and its
recommendations regarding emerging markets and developing economies. While she
praises the merits of many of the FSB’s recommendations regarding the regulation and
surveillance of banks and non-bank financial institutions, the management of exchange
rates, and an increased reliance on domestic currency loans, she criticises the FSB’s
failure to address the basic vulnerability of emerging and developing economies to the
volatile global financial system. She compares the FSB’s recommendations to “tinker toys
holding back a tsunami, unable to withstand the storms when foreign markets for exports
dry up, domestic capital flees, and commodity prices sky-rocket or collapse”. Griesgraber
points out that emerging markets and developing economies have a strong stake in the
stability of the global financial system but only scant opportunity to participate in the
design of that system’s management and re-regulation. Especially the poorest developing
countries are more often than not excluded from decision-making processes that will
shape the future of their financial markets. She calls for the FSB, as well as the Standard
Setting Bodies, to become more inclusive, transparent, and accountable.
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
6 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
Bernd Braasch highlights the benefits of extended global monitoring of international
capital flows. Global monitoring should focus on all aspects that contribute to a better
assessment of the stability of the financial system as a whole. This requires a better
understanding of how the main global players and drivers of international capital flows
behave and how that behaviour changes the structures of financial markets. He calls for a
more thorough analysis of the role and behaviour of institutional investors. In his view,
this should become a major component of the monitoring of global capital flows. Braasch
argues that a better understanding of international investors and their portfolio strategies
and rebalancing activities will enable financial authorities to better identify the sources of
capital flow volatility, contagion, and spillovers as well as the areas of vulnerability in
macroeconomically sound countries. This would help policymakers to design better
responses to external shocks and changes in international crisis transmission channels. It
would also enhance the effectiveness of early warning systems and help improve
regulatory frameworks.
Renato Baumann describes the effects of volatile international capital flows on the
Brazilian economy. Besides contributing to an inflation of asset prices, with hints of an
asset bubble, the large capital inflows to Brazil also contributed to an overvaluation of the
exchange rate. This in turn had a clear effect on the export sector, with export performance
becoming increasingly dependent on agribusiness while the share of manufactures
declined. Even though the European crisis caused foreign portfolio investment in Brazil to
fall by about 40% in 2011, Baumann sees the Brazilian economy in a comfortable and
stable macroeconomic position with relatively low levels of net public debt, a relatively
small current account deficit, and foreign exchange reserves exceeding total external debt.
Last but not least, Akkharaphol Chabchitrchaidol discusses the role of regional
macroeconomic surveillance and monitoring in coping with the current macroeconomic
challenges of the East Asian region. Since the Asian financial crisis, the ASEAN+3
countries have made considerable progress in terms of regional financial cooperation.
2
The
Chiang Mai Initiative, which was launched in 2000 as a network of bilateral central bank
swaps, was expanded and transformed into a multilateral arrangement among all
ASEAN+3 member countries (as well as Hong Kong, SAR) in 2010. This new
arrangement, the Chiang Mai Initiative Multilateralisation (CMIM), was complemented in
April 2011 by the ASEAN+3 Macroeconomic Research Office (AMRO). AMRO’s role is
to function as a surveillance mechanism that keeps track of the economic and financial
soundness of members, to make policy recommendations, and to continue monitoring
once CMIM funds are disbursed. In view of increasing uncertainty and volatility in the
East Asian region in 2012, Chabchitrchaidol highlights the growing importance of timely
and effective region-wide surveillance as a means of assessing effects and remedies in
individual economies. Given policy risks both within and beyond the control of individual
countries, or potential system-wide shocks such as currency wars, beggar-thy-neighbour
policies, or unforeseen tail events, cooperation will be crucial as we go forward to avoid
lose-lose outcomes which may otherwise prevail.

2 ASEAN+3 consists of the ten member countries of the Association of Southeast Asian Nations
(Brunei, Cambodia, Indonesia, Laos, Myanmar, Malaysia, Philippines, Singapore, Thailand, and
Vietnam) plus China, Japan, and South Korea.
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 7
I believe the contributions in this publication provide valuable insights into the current
challenges emanating from global liquidity for macroeconomic and financial stability in
the world economy, and emerging countries in particular. They provide different
perspectives and offer original policy recommendations for dealing with the challenges
posed by excessive global liquidity and volatile international capital flows. I hope they
will contribute to a better understanding of the current challenges and formulating
appropriate policy responses.
Bibliography
IIF (Institute of International Finance) (2011): 2011 January capital flows to emerging market economies,
24 January; online:http://iif.com/download.php?id=AQBTHjdXj4g=
– (2012): 2012 January capital flows to emerging market economies, 24 January; online:http://iif.com/
emr/resources+1670.php
McCauley, R. N. / P. McGuire (2009): Dollar appreciation in 2008: safe haven, carry trades, dollar shortage
and overhedging, in: BIS Quarterly Review January, Basel: Bank for International Settlements,
December; online:http://www.bis.org/publ/qtrpdf/r_qt0912i.htm

Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
8 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
Global rebalancing with financial stability: possible, feasible, or unlikely?
Menzie D. Chinn
In this chapter I will address three key questions facing policymakers: First, what are the
prospects for global rebalancing? Second, how is the two-speed global recovery evolving?
And third, what can policy accomplish?
Imbalances: past, present and future
The prospects for rebalancing are assessed here from the following perspective: the global
economy was unbalanced before the financial crisis of 2008, with current account
surpluses in China and the oil exporting countries matched by deficits primarily in the
United States (US). While imbalances shrank during the period 2007–09, during the
ensuing Great Recession, we can now see surpluses and deficits again expanding.
The source of these imbalances has been the topic of an extensive and heated debate that is
far too complicated to recount here. I would argue that while intertemporal consumption
smoothing and the dearth of profitable investment projects in East Asia are partly to blame, I
think that the existence of distortions in domestic financial markets in the United States
attracted excess savings from the rest of the world.
3
The abdication of regulation on the part
of the Bush Administration, aided and abetted by the anti-regulatory ethos of the Greenspan
Fed, ensured that the capital inflows that came with the current account deficit would
manifest themselves in the form of a massive boom. The resulting bust in consumption led
to a short-term improvement in the current account as imports fell faster than exports.
With the resumption of growth, there were hopes that global rebalancing would occur, that
is, that demand in China and East Asia would reorient itself away from exports and
towards domestic consumption while US aggregate demand would shift towards tradable
goods. It was never clear that the first part of the equation would occur, and it’s certainly
clear that the second part is not occurring with sufficient rapidity to make an impact over
the next couple of years.
At this juncture, I think it is useful to recount what our models can tell us. In work with
Barry Eichengreen and Hiro Ito, we have highlighted the fact that given projected growth
rates, and the historical norms that have governed the behaviour of current account
balances over the medium term, a persistence of current account balances can be predicted
(cf. Chinn / Eichengreen / Ito 2011). On the other hand, it is also true that our models have
done a poor job of predicting the level of current account balances for key countries like
the US and China, especially during the 2006–08 period. That is, while budget balances
explain some of the deterioration in the US current account, and the lack of both financial
and institutional development explain some of the surpluses of China, movements of these
factors do not enable us to track external developments in these economies.
In our forensic analysis, we found that the extent of misprediction during the 2006–08
period was well explained by housing price appreciation and private bond market growth
during the preceding 5-year period. In addition, increasing leverage in the household

3 See Chinn and Frieden (2011) for this position.
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 9
sector was clearly associated in a subset of countries with a deterioration in current
account imbalances. The unfolding of those trends – particularly in the United States, but
also in the United Kingdom – may very well result in greater current account convergence
than we predict with our statistical model.
For China, since our model is unable to capture the behaviour of Chinese surpluses during
the 2000s, I’m particularly loathe to make predictions based solely on our statistical
model. Suffice it to say that to date we have not seen evidence that the rapid internal
rebalancing of China’s spending patterns is having an effect on substantial shrinkage in
Chinese current account balances.
The two-speed recovery, accentuated
The foregoing analysis was based on medium term-trends and a statistical analysis of
current account balances over the medium term. However, to reach the medium term, one
must first make it through the short term, and this is where the prospects look particularly
unfavourable.
The two-speed recovery – fast growth in the emerging markets coupled with a halting
recovery in the advanced countries – has become almost a cliché. That being said, recent
events, including the rapidly escalating level of uncertainty, coupled with an observable
slowdown in GDP growth in advanced countries (and Europe in particular) have served to
accentuate this situation. To the extent that US growth slows or goes negative, that would
certainly effect a short-term decrease in the US current account deficit. However, a
downturn would definitely complicate rebalancing in the advanced countries, including
structural adjustments of labour and pension policies, as well as fiscal consolidation in the
United States.
Would the emerging market economies escape from a shock to advanced economies?
There is a widely held view that the developing world has “decoupled” from the advanced
economies. I think it is important to distinguish between secular and cyclical decoupling.
While trend growth in the emerging markets seem to have split away from trends in
advanced economies, it is not clear that the same is true for the business cycle. In
particular, considering the extent to which trade flows collapsed during the 2008–09
global recession, I think it would be foolhardy to assert that emerging market growth
would be largely unaffected.
What can policy do?
There are several policy sets that we can consider. While it is always good to consider the
scope of policy coordination, I will organise my discussion with the assumption that the
policies are undertaken largely in an independent fashion.
For the sake of argument, I will concede to the political constraints that largely take
further expansionary fiscal policy off the table in the advanced economies. However, I do
retain hope that the current levels of fiscal stimulus will be somewhat maintained.
In the advanced countries, a looser monetary policy is urgently needed. Attempts to reduce
the debt burden in the U.S. – to deleverage – have not had much impact. Although private
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
10 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
sector debt seems to be declining as a share of income, much of the decline is the result of
defaults rather than an actual paying down of private debt. We are in fact less than
halfway through the deleveraging process, which typically takes six to seven years. Only
if nominal GDP grows more rapidly than nominal debt will the debt burden shrink, and we
have not yet started that process. Additional measures are urgently needed if we are not to
suffer through stagnant growth for years – if not relapse into recession.
Ken Rogoff, the well-known proponent of conservative central banking, has recently
suggested “trying to achieve some modest deleveraging through moderate inflation of,
say, 4 to 6 per cent for several years” (Rogoff 2011).
How might a modest increase in inflation in this period of economic slack and a modest
depreciation, be accomplished? Although the Fed has adopted an explicit inflation target, I
believe that, given the exigent conditions facing the US economy, the Fed should adopt a
flexible inflation target, one that conditions the target inflation rate on the rate of
unemployment. Jeffry Frieden and I have laid out such an argument (Chinn / Frieden
2012), following the proposal by the Chicago Fed’s Charles Evans (2011) to keep the Fed
funds rate near zero, and augmenting this with other quantitative measures, so long as
unemployment remains above 7% or inflation stays below 3%. Clearly, the Fed is close to
hitting its inflation target, but it is certainly nowhere close to reaching anything close to its
output target. Conditioning the inflation target on the unemployment rate means that
inflationary expectations will remain anchored.
In Europe, the problem is definitely more complicated, given the fragmented nature of the
policy authorities, fiscal and monetary. However, it is clear that here too, the current
approach of country-by-country rescheduling of debt is not in and of itself sufficient to
address the problems of the debtor countries. A clear commitment, such as that proposed
by Frieden and myself, to faster euro-area inflation would make a solution easier to the
extent that real wage adjustment would be facilitated. Of course, this measure should
enhance, not replace, aggressive measures to reschedule sovereign debt in the crisis
countries and recapitalise European banks.
The macroeconomic difficulties confronting the advanced economies ensure continued
capital flows to the emerging markets. There, policymakers have responded with a
mixture of conventional macro policies, less conventional capital controls, and prudential
regulations.
The use of capital controls and prudential regulations in managing recent capital flows to
the emerging markets merits some discussion. I think that the use of these measures
should not be rejected out of hand. However, I think that the efficacy of such measures has
yet to be demonstrated fully, although there is some evidence that controls on inflows may
be useful.
4

Until such time as we have a more solid grasp of the efficacy of such measures, it seems
that the first resort should be to the macroeconomic measures we know will work. These
include countercyclical fiscal policy and abstention from heavy foreign exchange

4 See Ostry et al. (2011); Habermeier / Kokenyne / Baba (2011).
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 11
intervention against exchange rate appreciation.
5
Prudential regulation on the other hand is
a good idea on other grounds, including enhancing domestic financial stability.
This policy prescription, I think, is relevant for some emerging market economies,
particularly in East Asia, where more rapid currency appreciation would help prevent
overheating while re-allocating much-needed aggregate demand to the advanced
economies. Here, China’s policy choices are of key importance. While more rapid
appreciation of the Chinese currency would not be in and of itself sufficient to achieve
global rebalancing, it would be the fastest- working measure and would facilitate
adjustment toward a more domestically-oriented growth paradigm. The remaining East
Asian currencies would also be likely to follow China’s lead, thereby facilitating
adjustment for the region as a whole.
Bibliography
Chinn, M. D. / B. J. Eichengreen / H. Ito (2011): A forensic analysis of global imbalances, Cambridge,
Mass.: National Bureau of Economic Research (NBER Working Paper 17513)
Chinn, M. D. / J. Frieden (2011): Lost decades, New York: W. W. Norton
– (2012): How to save the global economy: whip up inflation:now, Foreign Policy January/February; online:http://www.foreignpolicy.com/articles/2012/01/03/5_whip_up_inflation_now
Evans, C. (2011): The Fed’s dual mandate responsibilities: maintaining credibility during a time of immense
economic challenges: speech at the Michigan Economic Dinner, Michigan Council on Economic
Education, Detroit, MI, 17 October; online:

ages/publications/
speeches/ 2011/10_17_11_mcee.cfm
Habermeier, K. F. / A. Kokenyne / C. Baba (2011): The effectiveness of capital controls and prudential
policies in managing large inflows, Washington, DC: International Monetary Fund (Staff Discussion
Note 11/14)
IMF (International Monetary Fund) (2007): World economic outlook, Washington, DC
Ostry, J. / A. R. Ghosh / K. F. Habermeier / L. Laeven / M. Chamon / M. S. Qureshi / A. Kokenyne (2011):
Managing capital inflows: what tools to use?, Washington, DC: International Monetary Fund (Staff
Discussion Note 11/06)
Rogoff, K. (2011): The bullets yet to be fired to stop the crisis, in: Financial Times 8 Aug. 2011

5 See Chapter 3 on “Managing Large Capital Inflows” in the IMF’s World Economic Outlook of
October 2007 (IMF 2007). The chapter concludes that resisting capital appreciation by use of
sterilised intervention does not typically work in the face of sustained capital inflows. Moreover, post-
inflow growth is typically lower as a consequence of such measures.
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
12 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
US quantitative easing: spillover effects on emerging economies
!

Feng Zhu
The 2007–2009 global financial crisis and the ensuing recession have significantly
changed the environment in which central banks perceive and implement monetary policy.
As policy rates were lowered rapidly to close to zero, policymakers lost their traditional
lever for influencing longer-term rates by changing interest rates at the very short end.
Bernanke and Reinhart (2004) suggest three policy options in this situation: first, shape
public expectations about the future path of the policy rate; second, increase the size of the
central bank balance sheet beyond the level needed to keep the policy rate at zero; and
third, change the composition of the balance sheet in order to affect the relative supply of
securities held by the public.
Several central banks in the major advanced economies have implemented such
policies, known as quantitative easing. Asset purchase programmes focusing on
longer-dated government bonds have been established with the aim of lowering
interest rates, reviving credit flows, and stimulating economic activity. Consequently,
the balance sheets of the US Federal Reserve, the Bank of England, and the European
Central Bank have all recorded a sharp expansion in the second half of 2008
(Figure 1). In addition, the balance sheets of the Federal Reserve and the Bank of
England have become dominated by holdings of government bonds with maturities of
five years and above.
Figure 1: Central bank balance sheet size and maturity
1

Federal Reserve Bank of England Eurosystem

Notes: (1) In billions of units of national currency. For the Bank of England and the Federal Reserve,
breakdown by remaining maturity; for the Eurosystem, breakdown of outstanding repo operations by original
maturity. (2): Includes agency debt securities, MBS and US Treasuries held outright; face value. (3): Holdings
of the Asset Purchase Facility; proceeds. APF transactions are undertaken by the Bank of England Asset
Purchase Facility Fund Limited. The accounts of the Fund are not consolidated with those of the Bank. The
Fund is financed by loans from the Bank, which appear on the Bank’s balance sheet as an asset. (4): Includes
holdings of sterling commercial paper, secured commercial paper and corporate bonds financed by the issue of
treasury bills and the Debt Management Office’s cash management and by the creation of central bank
reserves. (5): Securities held under the Securities Markets Programme (SMP).
Source: Compiled by the author based on data from Datastream and national data.

! The views expressed in this article are those of the author and do not necessarily reflect those of the
Bank for International Settlements. This paper is based on Chen et al. (2011).
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 13
Recent US asset purchase programmes
The role of central bank balance sheet policies has changed over time as the advanced
economies went through different phases of the financial and economic cycle. Initially
such policies focused on providing ample liquidity to stabilise financial markets and shore
up confidence. These included various term facilities set up by the Federal Reserve and
also currency swaps agreed upon among central banks. As the crisis subsided, balance
sheet policies placed greater emphasis on lowering borrowing costs and easing credit
conditions for the private sector so as to promote growth and employment. Asset purchase
programmes became more prominent along with central bank commitments to maintain
very low interest rates for an extended period of time.
The Federal Reserve has been among the most active central banks in implementing
balance sheet policies. Its recent quantitative easing measures include:
• The Large-Scale Asset Purchase (LSAP) programme, announced in November 2008,
for purchasing up to USD 600 billion in agency mortgage-backed securities and
agency debt. From March 2009 to March 2010, the Federal Reserve committed to buy
an additional USD 850 billion of such securities and USD 300 billion of longer-dated
Treasury bonds (LSAP1);
• LSAP2, announced in November 2010, for a further purchases of USD 600 billion in
longer-term Treasury securities until mid-2011;
• The Maturity Extension Program (MEP), announced in September 2011, for
extending the average maturity of the Federal Reserve’s portfolio of Treasury
securities by 25 months to about 100 months by the end of 2012.
6
To do so, the
Federal Reserve plans to exchange USD 400 billion of Treasuries with residual
maturities of 3 months to 3 years for those with 6–30 years of residual maturity.
Using an event study methodology with 1- and 2-day event windows, Meaning and Zhu
(2011, 2012a) have measured financial market responses to the major announcements of
the US asset purchase programmes based on cumulative changes in a number of key
financial indicators. The announcements had an immediate and significant impact on US
sovereign bond yields across the maturity range during LSAP1. The announcement effects
were much less pronounced for later programmes. In addition, the impact also affected
assets other than purchased sovereign bonds. For example, LSAP1 announcements led to
sizeable reductions in corporate bond yields and prompted significant depreciations in the
nominal effective exchange rates of the US dollar (7.7% in two days) during LSAP1.
International spillover effects of central bank asset purchases
Do the balance sheet measures recently adopted by the Federal Reserve have significant
international spillover effects? If so, are such effects beneficial or detrimental? The
answers are not straightforward. In a world of highly integrated finance and trade, leakage
from domestic policy is unavoidable, although the size of such leakage to the emerging
economies may differ across countries depending on the strength of cross-border
transmission channels.

6 Meaning and Zhu (2012a, 2012b) examined the impact of changes in the size and maturity structure of
the Federal Reserve’s Treasury securities holdings on US Treasury bond yields and found that the
MEP can have a sizeable impact provided that there is no large-scale intervention by the Treasury.
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
14 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
One view is that central bank asset purchases, combined with a very loose monetary
policy stance in both advanced and emerging economies, may further increase the already
abundant global liquidity. This creates tensions for some emerging economies concerned
with overheating, inflation and potential financial stability risks. In addition, extraordinary
monetary stimulus on top of persistent interest rate and growth rate differentials can lead
to large and volatile capital flows. Such flows may exert strong upward pressure on
exchange rates, credit growth, and asset prices in the recipient countries.
Channels of international transmission
There are several cross-border transmission channels through which central bank balance
sheet policies may operate. First, there is a global portfolio rebalancing channel, since
foreign and domestic assets can be imperfect substitutes for each other. For instance, US
Treasury securities are often perceived as a safe asset and are widely held by global
investors. As quantitative easing lowers US long-term bond yields, investors are likely to
adjust their portfolios to include more emerging market assets of similar maturity and risk
characteristics, boosting asset prices and reducing interest rates in the emerging economies.
Second, through an exchange rate channel, quantitative easing can exert strong appreciation
pressures on emerging market currencies against the major international reserve currencies.
This affects both trade and capital flows. US quantitative easing can also boost exports from
emerging economies through easier trade financing and increased spending.
Third, a global liquidity channel operates through bank lending and asset prices. Because
the global capital market is highly integrated, large-scale asset purchases and commitment
to very low policy rates for an extended period of time in one economy boosts global
liquidity. Low interest rates and abundant liquidity create incentives for credit expansion,
encouraging banks and investors in both advanced and emerging economies to take on
greater risks. In addition, large and persistent interest rate differentials can spur carry
trades and capital flows into emerging economies which provide higher risk-adjusted rates
of return (Figure 2). These forces can lead to significant inflationary pressures on
consumer and asset prices.
Figure 2: US capital outflows
1

Total outflows
1
Outflows to emerging Asia
1, 2

Outflows to Central and South
America
1, 2

Notes: (1) In billions of US dollars. The figure for 2011 is based on the first two quarters (annualised). (2): US-
owned private assets vis-à-vis emerging Asia / Central and South America.
Source: Compiled by the author based on data from the IMF’s International Financial Statistics and the
US Bureau of Economic Analysis.
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 15
Evidence of international spillovers
The Federal Reserve’s asset purchase programmes have had a broad, immediate, and
sizeable impact on global financial markets.
7
Recent data indicate that, although total US
capital outflows have not been exceptional since the start of the LSAP programme in
November 2008, bank lending to emerging Asia and Latin America and flows into those
regions’ debt securities have increased sharply since 2010 (Figure 2
Figure 3: Financial market impact of US LSAP programme
1

10-year government bonds yield
2

Exchange rate
5

Equity price
6

Notes: (1): Cumulative percentage change two days after the Large Scale Asset Purchase programme
announcement dates. (2): In basis points. (3): Announcements made on 25 Nov 2008, 1 Dec 2008, 16 Dec
2008, 28 Jan 2009, 18 Mar 2009, 29 Apr 2009, 24 Jun 2009, 12 Aug 2009, 23 Sep 2009 and 4 Nov 2009. (4):
Announcements made on 10 Aug 2010, 27 Aug 2010, 21 Sep 2010, 12 Oct 2010, 15 Oct 2010 and 3 Nov 2010.
(5): A positive change indicates appreciation against the US dollar; in %. (6): In %.
Source: Compiled by the author based on data from Bloomberg and national data.

7 Chen, Filardo, He and Zhu (2011) provide a detailed analysis of the global financial impact of the
announcements of asset purchases by central banks in the advanced economies.
).
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
16 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
Based on an event study with a two-day window, Chen et al. (2011) found a significant
impact in terms of cumulative global financial market responses to the major
announcements by the Federal Reserve of its asset purchase programmes (Figure 3). First,
LSAP1 announcements had the greatest impact on sovereign bond yields, reducing the 10-
year yields by an average of over 80 basis points across emerging Asia and Latin America.
Notably the announcements had a greater impact on yields in many emerging economies
than in the United States itself. For example, the announcements lowered the 10-year
yields by over 100 basis points in Indonesia, Brazil, Mexico and Thailand. LSAP1
announcements reduced corporate bond yields by over 50 basis points in Latin America
and in other advanced economies. Indeed portfolio rebalancing appeared to be a powerful
channel of cross-border transmission.
Second, LSAP1 announcements provided strong support to global stock markets, boosting
equity prices by over 10% in the emerging markets (
rose by about 20% in Thailand, Hong Kong and India, and by between 10–17% in
Malaysia, Singapore, Mexico, Brazil, the Philippines, Indonesia and Chile. LSAP1 helped
rebuild confidence and stabilise emerging financial markets.
Third, emerging market exchange rates tended to strengthen following LSAP1
announcements. The Korean won, Brazilian real, Chilean peso and Indonesian rupiah
appreciated by between 10–15% against the US dollar.
The results also suggest much smaller market reactions to LSAP2 and MEP than those to
LSAP1. Part of the reduced influence reflects the different sizes of LSAP1, LSAP2 and
MEP. In addition, the “novelty” or surprise factor associated with LSAP1 might have
waned over time as markets became better acquainted with quantitative easing, and “more
of the same” failed to evoke market reactions of similar magnitude.
Chen et al. (2011) examined the cross-country macroeconomic impact of US quantitative
easing with a global vector autoregressive (VAR) model, using the US term spread
between the 10-year Treasury bond yield and the 3-month bill rate as an indicator of post-
crisis monetary policy. They found that large-scale purchases of longer-dated domestic
assets shrink the US term spread, which in turn influences pricing in global financial
markets.
Model estimates indicate that a 23-basis-point reduction in US term spread (one standard
deviation of US term spread shocks) leads to an almost 2% increase in currency
appreciation pressure on the Brazilian real over 12 months (Figure 4). The term spread
shock increases domestic credit in Indonesia by almost 3% and has an even greater impact
on equity prices. The impact differs across countries, e.g. the impact on Korea is smaller.
The spillover effects can be perceived as beneficial or harmful in different circumstances.
In the early stage, with the global economy slipping into a major slowdown, balance sheet
policies might have contributed to global financial stability and helped emerging
economies recover by strengthening trade credit and supporting demand. But as many
emerging economies returned to solid growth, such measures might have increased the
risks of overheating, high inflation and volatile capital flows there. Moreover, fears of
disruptive capital inflows and currency appreciation pressures tend to dissuade emerging
market central banks from raising policy rates.
Figure

). In particular, equity prices 3
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 17
Figure 4: International impact of US monetary easing
1

Forex exchange
2
Domestic credit
2
Equity prices
2

Notes: (1): Estimates are from a global vector autoregressive (GVAR) model based on data from January 1996
to 2010 December. The impulse responses are not significantly different from the GVAR estimates for the
sample period ending in December 2006, suggesting the international transmission mechanism might have
largely stayed in place following the global financial crisis. (2): In %.
Source: Chen et al. (2011).
Conclusion
Recent quantitative easing measures by the Federal Reserve significantly reduced yields of
longer-term government bonds and raised the prices of other financial assets in both advanced
and emerging economies. Such changes may be accompanied by increased financial
stability risks in emerging markets arising from cheap money and large and rising global
liquidity. A sharp balance sheet expansion due to the Federal Reserve’s asset purchases, if it
persists, may affect inflation expectations globally. Furthermore, it can be difficult for
central banks to time correctly their unwinding of large asset holdings given uncertainties
in assessing current economic prospects. The government, with large fiscal deficits to
finance, may not welcome central bank sales of government bonds. The impact of such
sales on global markets and the risks of large and sudden reversals of capital inflows to the
emerging economies are also hard to evaluate.
Given these caveats, any gains from further quantitative easing have to be weighed against
possible costs and risks, taking into account their likely externalities. Diverging growth
prospects in the advanced and emerging economies suggest that the multi-speed recovery
may persist, and further extraordinary monetary stimulus could represent a challenge for
many emerging economies.
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
18 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
Bibliography
Bernanke, B. / V. Reinhart (2004): Conducting monetary policy at very low short-term interest rates, in:
American Economic Review 94 (2), 85–90
Chen, Q. / A. Filardo / D. He / F. Zhu (2011): International spillovers of central bank balance sheet policies,
Basel: Bank for International Settlements and Hong Kong: Hong Kong Institute of Monetary Research,
mimeo
Meaning, J. / F. Zhu (2011): The impact of recent central bank asset purchase programmes, in: BIS
Quarterly Review December, 73–83
– (2012a): The impact of central bank asset purchase programmes: a quantitative evaluation, Basel: Bank for
International Settlements, mimeo
– (2012b): The impact of Federal Reserve asset purchase programmes: another twist, in: BIS Quarterly
Review, March, 23–30

Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 19
The comovement of international capital flows: evidence from a dynamic factor model
Marcel Förster, Markus Jorra and Peter Tillmann
Introduction
The recent financial crisis in the United States and other advanced economies was
accompanied by strong swings in global capital flows. Capital flows to emerging countries
received particular attention and reappeared on the agenda of international financial
diplomacy. In emerging Asia, for example, economies experienced sharp increases in net
inflows in response to tensions in the capital markets of advanced economies in 2007 and
early 2008, followed by net outflows immediately after the failure of Lehman Brothers in
September 2008 and massive inflows again thereafter.
The extent to which capital flows to different countries are linked, i.e. the degree of
comovement of capital flows, is a key question for policy makers. Put differently, the
appropriate policy response to capital inflows depends on the driving forces behind capital
flows. If investors carefully discriminate between countries, thus sending funds as a
response to the recipient countries’ fundamentals such as growth prospects or as a
response to returns differentials with respect to advanced economies, capital is said to be
driven by pull factors. If, however, investors treat emerging countries similarly,
irrespective of domestic fundamentals, thus responding mostly to global developments
such as abundant liquidity, financial stress or weak growth prospects in mature economies,
capital flows are said to be driven by push factors. Moreover, in the past a crisis in one
country has often been contagious, leading to “sudden stops” of capital inflows or even
withdrawals in neighbouring or even remote countries.
Although domestic economic policies may naturally influence pull factors, such policies
have by definition no impact on the nature and the strength of push factors. The
Economist (2011) recently argued that flows “may have less to do with [the receiving
countries’] long-term prospects than with temporary factors such as unusually loose rich-
world monetary policy, over which they have no control.” Therefore, it is important to
gauge the extent to which flows are correlated on a global level. This chapter seeks to shed
light on the degree of comovement of capital flows and discusses results from a dynamic
factor model suitable for disentangling flows for a large set of countries into global, flow-
related, and regional factors.
The role of global factors in driving capital flows is an unresolved issue. Milesi-Ferretti and
Tille (2011) have shown that the retrenchment of capital flows at the peak of the financial
crisis at the end of 2008 was highly heterogeneous across time, across types of flows, and
across geographic regions. Forbes and Warnock (2011), in contrast, attribute an important role
to global factors, a somewhat less important role to contagion, and a less prominent role to
domestic pull factors. While most of the existing studies focus on capital flows with a
quarterly frequency, the recent study by Fratzscher (2011) is based on portfolio flow data at
daily, weekly and monthly frequency. Fratzscher shows that idiosyncratic pull factors
originating in emerging market economies dominated during the recovery from the global
crisis. In a study prepared for the World Economic Outlook, the IMF (2011) addresses this
issue. Estimates of time dummies and regional dummies in a simple panel of capital flows
suggest that a common factor plays a minor role for capital flows.
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
20 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
Evidence from a factor model
To assess the importance of the common components among different types and
destinations of capital flows, we estimate a dynamic factor model for a large set of
industrial and emerging economies. The full empirical specification as well as the
complete set of results can be found in Förster, Jorra and Tillmann (2012). Here we briefly
present some selected findings.
In a simple factor model the comovement of observables is captured by a small set of
factors linked to all variables. This approach has been successfully applied to answer
diverse research questions using various national macroeconomic data sets, where
movements of the common factors typically explain a large fraction of the variables’
variances. The basic assumptions of the simple model, however, appear less convincing
in an international setting. Here, regional developments which affect only a subset of
economies and series are likely to be at least as important as global factors. We therefore
use the Dynamic Hierarchical Factor Model introduced by Moench and Ng (2011) and
refined by Moench, Ng and Potter (2011) to address these issues. The model allows us to
disentangle capital inflows into a global factor, a factor for each type of capital inflow,
and a regional factor affecting groups of countries. Factors affecting all countries, i.e.
the global factor as well as the type-specific factors, could be interpreted as push factors.
The remaining dynamics can then be attributed to regional and idiosyncratic
determinants, i.e. pull factors. By doing this we can separate country-specific and
regional-specific variations that would otherwise be spuriously subsumed by the
estimated global factor. As a result, we can analyse whether global effects, such as
surges in portfolio or foreign direct investment, or group-specific characteristics such as
regional investment booms in Eastern Europe, or even the contagious nature of the
Asian crisis are the driving forces behind a country’s capital inflows.
Following recent research that highlights the reduced information content of net capital
flows (Forbes / Warnock 2011; Broner et al. 2011), our focus is on gross inflows measured
in percent of GDP. We further differentiate between portfolio, foreign direct investment
and other flows using quarterly data from the IMF’s International Financial Statistics.
8

After excluding major financial centres we end up with a sample of 47 countries with data
from 1994Q1 to 2010Q4. Our sample period thus covers the Asian crisis, the debt crises in
Latin America and Russia, and the recent global financial crisis.
We construct seasonally adjusted capital-flow-to-GDP series which are generally judged
stationary according to standard univariate and panel unit root tests. Following the World
Bank’s classification we then group the country-specific data into four geographical
blocks: Asia, Emerging Europe, Latin America, and industrialised countries.
9
For a given
type of capital inflow the dynamic factor model estimates a separate block factor for each
of these country groups.

8 Given the limited data coverage for emerging economies we augment our data set by adding
information from a few national sources.
9 The World Bank’s geographical classification is simplified by merging the “South Asia” and “East
Asia & Pacific” block into one block (Asia). Furthermore, Israel and South Africa are allocated to the
Emerging Europe and Asia block, respectively.
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 21
-
2
-
1
.
5
-
1
-
.
5
0
.
5
1
1
.
5
-
3
0
-
2
0
-
1
0
0
1
0
2
0
1995-Q1 2000-Q1 2005-Q1 2010-Q1
Asia Emerging Europe
Industrial Latin America
Global Factor
left axis: average regional captial inflows in % of GDP (deviation from mean)
right axis: global factor
Figure 1: Capital inflows – regional averages and the global factor

Source: Förster / Jorra / Tillmann (2012).
A first impression of regional differences with respect to the role of the global factor can be
obtained from Figure 1, which shows region-specific average capital inflows along with our
estimate of the global factor. As a first key finding, the global factor extracted from the large
set of countries closely reflects capital flows to industrial countries and transition economies
in Eastern Europe. Flows to emerging Asia or Latin America, in turn, appear only loosely
connected to conditions reflected by the global factor. The financial crises in Asia, Russia
and Brazil are associated with only a small decline in the global factor.
As a second result, the factor decomposition reveals the impact of the recent financial
crisis on international capital flows. At the peak of the crisis the connection between the
global factor and all flow series intensifies, suggesting that the pattern of comovement
changes substantially during severe crises. Towards the very end of the sample, flows to
emerging Europe became disconnected from the global factor, while Latin America shows
a much stronger link to the global factor than before the crisis. To summarise, the results
do not support the notion of capital inflows being predominantly pushed into emerging
economies by global conditions. Deteriorating global economic conditions might,
however, increase the probability of a sudden stop in capital flows.
10

Conclusions
Our preliminary results suggest that the global factor does a good job of tracking overall
capital flow cycles, but leaves a large degree of heterogeneity attributable to either
regional or country-specific determinants. This suggests that domestic policy has

10 For all other findings including variance decompositions, results for different types of capital inflows,
and many robustness checks the reader is referred to Förster, Jorra and Tillmann (2012).
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
22 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
considerable room to affect capital flows and, if this is deemed appropriate, also to limit
the consequences of capital inflows such as asset price booms and a real appreciation of
domestic currencies.
11
Recently, capital controls have often been seen as the ultima ratio
in a situation in which a country receives massive capital inflows driven by global
determinants over which domestic policy has no control. Our results suggest that this is
less often the case than previously thought. Thus, the primary responsibility for dealing
with large and volatile capital flows remains with domestic policymakers.
Bibliography
Broner, F. / T. Didier / A. Erce / S. L. Schmukler (2011): Gross capital flows, Washington, DC: World Bank
(Policy Research Working Paper 5768)
Förster, M. / M. Jorra / P. Tillmann (2012): The dynamics of international capital flows: results from a
dynamic hierarchical factor model, Giessen: Justus-Liebig-University Giessen, mimeo
Forbes, K. J. / F. E. Warnock (2011): Capital flow waves: surges, stops, flights and retrenchment,
Cambridge, Mass.: National Bureau of Economic Research (NBER Working Paper 17351)
Fratzscher, M. (2011): Capital flows, push versus pull factors and the global financial crisis, Frankfurt am
Main: European Central Bank (ECB Working Paper 1364)
IMF (International Monetary Fund) (2011): International capital flows: reliable or fickle?, Chapter 4 of
World economic outlook, April, Washington, DC
Milesi-Ferretti, G. M. / C. Tille (2011): The great retrenchment: international capital flows during the global
financial crisis, in: Economic Policy 26 (66), 290–346
Moench, E. / S. Ng (2011): A hierarchical factor analysis of U.S. housing market dynamics, in: The
Econometrics Journal 14 (1), C1–C24
Moench, E. / S. Ng / S. Potter (2011): Dynamic hierarchical factor models, New York: Columbia University,
mimeo
Pradhan, M. / R. Balakrishnan / R. Baqir / G. Heenan / S. Nowak / C. Oner / S. Panth (2011): Policy
responses to capital flows in emerging markets, Washington, DC: International Monetary Fund (IMF
Staff Discussion Note 11/10)
The Economist (2011): The reformation, 9 Apr., 76

11 See Pradhan et al. (2011) for a thoughtful discussion of the appropriate policy responses.
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 23
Global liquidity and commodity prices
Ulrich Volz
Introduction
The prices of most commodities – including food and other agricultural commodities –
floated around the same level between 1980 and 2000 but underwent a sharp upturn
thereafter (Figure 1). Prices peaked in 2008, plunged during the global financial crisis,
and started a strong rebound at the beginning of 2009. As pointed out in the report that
the G20 Study Group on Commodities presented at the Cannes Summit in November
2011, “[t]hese commodity price movements present important policy challenges world-
wide” (G20 2011, 5). In particular, increases in the prices (and price volatility) of food
and other agricultural commodities can have dire consequences for the world’s poorest
people.
12
Agricultural commodity price developments have therefore stirred an
intensive public and policy debate and have motivated a flurry of academic research on
the dynamics which drive food price inflation and volatility and the most appropriate
policy responses.
13

There have been two major approaches to explaining recent price developments in
commodity markets. The first explanation centres on supply and demand factors.
According to Trostle (2008), Krugman (2008), Irwin, Sanders and Merrin (2009),
Hamilton (2009), Kilian (2009), and others, the rapid growth of emerging market
economies, not least China and the other BRICS, increased world demand for all kinds of
commodities including food and oil and led to fast price increases until mid-2008.
14
Prices
crashed when demand contracted sharply with the outbreak of the global financial crisis.
Other researchers, in contrast, point to a growing presence of financial investors in
commodity-related markets and a resulting “financialisation” of global commodity
markets (e.g., Tang / Xiong 2010; Gilbert 2010; UNCTAD 2011) as the underlying reason
behind these price developments. According to this explanation, an increasingly important
role of commodities as an asset class for investors has led to large flows of investment into
commodity markets, especially into index investments and other commodity derivatives,
and has contributed to growing trading volumes in commodity futures markets. This has
led to a synchronised boom-and-bust of seemingly unrelated commodity prices, driving
commodity prices “away from levels justified by market fundamentals, with negative
effects both on producers and consumers” (UNCTAD 2011, vii).

12 Food price increases and volatility affect poor people in different ways (cf. Braun / Tadesse 2012).
Most importantly, they affect real income and increase income instability. The magnitude of these
effects depends on the share of income derived from agriculture and the share of food expenditure in a
household’s budget.
13 See von Braun and Tadesse (2012) and FAO et al. (2011) for an overview of the problems associated
with food price inflation and volatility, and for policy recommendations.
14 In addition to growing demand from emerging economies, supply and demand factors that are
frequently cited as contributing to price increases in agricultural commodities and a sharp downward
trend in world aggregate stocks include slower growth in production due to low investment or adverse
weather conditions, growing demand for biofuels, rising energy prices that increase the costs of
agricultural production, and protective policies adopted by exporting and importing countries. See, for
instance, Trostle (2008).
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
24 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
Figure 1: Development of commodity and food prices, 1980–2011

Note: CRB: CRB Spot Index (broad index comprising metals, textiles and fibres, fats and oils); CP_food: CRB
Foodstuffs (hogs, steers, lard, butter, soybean oil, cocoa, corn, Kansas City wheat, Minneapolis wheat, sugar);
CP_livestock: CRB Livestock and Products (hides, hogs, lard, steers, tallow); CP_RI: CRB Raw Industrials
(hides, tallow, copper scrap, lead scrap, steel scrap, zinc, tin, burlap, cotton, print cloth, wool tops, rosin, rubber).
Source: Compiled by the author based on data from the Commodity Research Bureau / Thomson Reuters.
Is “global liquidity” to blame?
In a recent paper with Ansgar Belke and Ingo Bordon (Belke / Bordon / Volz 2012), we
investigated the effects of “global liquidity” – casually defined as the liquidity created by
the world’s major central banks – on food and commodity prices. Using different
measures of global liquidity and various indices of commodity and food prices for the
period 1980–2011, we analysed the interactions between global liquidity and commodity
and food prices on a global level. For our empirical analysis we used a global cointegrated
vector-autoregressive model.
In our analysis we included liquidity and output measures for a group of major advanced
and emerging economies, representing approximately 80% of world GDP in 2011 and
presumably a considerably larger share of the global financial markets. We also took into
account the nominal effective exchange rate of the US dollar to allow for dollar valuation
effects, and included export data of emerging and developing economies to the rest of the
world as proxies for demand-driven development of commodity and food prices. In order
to understand the interactions between monetary aggregates, interest rates, inflation, and
food and commodity prices on a global level, we mainly focused on long-run equilibrium
relations.
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 25
Our results provide insight into the links between monetary policy and commodity and
food price inflation. We found support for the hypothesis that there is a positive long-term
relationship between global liquidity and the development of food and commodity prices.
The latter adjust significantly to the cointegrating relationship and exhibit a long-term co-
movement with liquidity on an international level. Global liquidity, in contrast, does not
adjust; rather it “drives” the relationship.
In other words, over the three decades that we observed, food and commodity price
inflation were apparently driven by monetary expansion in the world’s major economies.
Our results can be seen as supporting the view of a “financialisation of commodities” in
which food and commodity prices are impacted to a large extent by flows of (portfolio)
investment into commodity markets with an eye to returns, and not merely by demand
from the real economy. Our findings corroborate research by Gilbert (2010, 420), among
others, who concludes that “index futures investment was the principal channel through
which monetary and financial activity have affected food prices over recent years”.
While we are not forecasting food and commodity price developments in our paper, the
analysis suggests that further price hikes may be in store given current expansionary
monetary conditions in Europe and the United States.
Policy options
Our findings highlight the dilemma that arises when the central banks of all major
advanced economies engage simultaneously in expansionary monetary policies as a means
of stabilising the respective economies and financial sectors, causing a large global
liquidity shock that feeds commodity and food price inflation. While such expansionary
monetary policies may be necessary to respond to financial crises, economic contraction,
high unemployment and deflationary tendencies, our analysis suggests that there may be
pronounced negative side-effects in terms of commodity and food price increases.
From a policy perspective, what should be done? Whilst expansionary monetary policies are
indispensable at times of severe economic and financial crisis, policymakers should take into
account the negative side-effects and consider stricter regulation of commodity markets,
especially agricultural commodity markets, in order to prevent a further flow of liquidity into
these markets. In spite of differing views on the role of speculation in driving commodity
prices, a broad consensus exists regarding the need to improve information and transparency
in commodity futures markets, particularly in over-the-counter (OTC) markets (see e.g. FAO
et al. 2011). Building on this consensus, regulatory authorities should swiftly implement the
“Principles for the regulation and supervision of commodity derivatives markets” (IOSCO
2011) prepared by the IOSCO Task Force on Commodity Futures Markets at the request of
the G20 leaders at the Seoul Summit in November 2010.
Building on and going beyond the International Organization of Securities Commissions
(IOSCO) principles, several concrete measures should be considered to enhance
transparency and improve the functioning of commodity markets – and curtail the flow of
liquidity into these markets:
15
(i) registration of all OTC derivative trades in a trade
repository; (ii) imposition of appropriate position limits on individual market participants

15 See also the recommendations in UNCTAD (2011) and FAO et al (2011).
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
26 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
in order to restrain the engagement of non-commercial investors in commodity markets;
(iii) regulation of high volume and frequency trading in commodity markets, and (iv)
introduction of a marginal transaction tax for all transactions in commodity markets. Such
measures, if introduced in all major markets, would discourage non-commercial
participants such as commodity index funds, swap dealers, and money managers who have
no involvement in the physical commodity trade (in contrast to commercial participants
such as farmers, traders and processors) from “excessive” speculation in commodity
markets. These regulatory provisions could be adjusted over time, to allow for changing
market conditions and new insights into their effectiveness and to limit potential
unintended side-effects.
Bibliography
Belke, A. / I. Bordon / U. Volz (2012): Effects of global liquidity on commodity and food prices, Berlin:
German Institute for Economic Research (DIW Discussion Paper 1199)
Braun, J. von / G. Tadesse (2012): Global food price volatility and spikes: an overview of costs, causes, and
solutions, Bonn: University of Bonn (ZEF Discussion Paper 161); online:http://www.zef.de/fileadmin
/media/news/1a7f_zef_dp_161.pdf
FAO / IFAD / IMF / OECD / UNCTAD / WFP / World Bank / WTO / IFPRI / UN HLTF (2011): Price
volatility in food and agricultural markets: policy responses, Policy report including contributions by
FAO, IFAD, IMF,OECD, UNCTAD, WFP, the World Bank, the WTO, IFPRI and the UN HLTF, 2
June; online:http://www.oecd.org/dataoecd/40/34/48152638.pdf
G20 (2011): Report of the G20 Study Group on Commodities under the chairmanship of Mr. Hiroshi
Nakaso, November; online:http://www.banque-france.fr/fileadmin/user_upload/banque_de_france/
Economie_et_Statistiques/Tendances_Regionales__ne_pas_ecraser_/mois_impairs/Study_group_report
final.pdf
Gilbert, C. L. (2010): How to understand high food prices, in: Journal of Agricultural Economics 61 (2),
398–425
Hamilton, J. (2009): Causes and consequences of the oil shock of 2007–2008, Brookings Papers on
Economic Activity Spring, 215–261
IMF (International Monetary Fund) (2011): World economic outlook, September, Washington, DC
IOSCO (International Organization of Securities Commissions) (2011): Principles for the regulation and
supervision of commodity derivatives markets: final report, Madrid; online:http://www.iosco.org/
library/ pubdocs/pdf/IOSCOPD358.pdf
Irwin, S. H. / D. R. Sanders / R. P. Merrin (2009): Devil or angel? The role of speculation in the recent
commodity price boom (and bust), in: Journal of Agricultural and Applied Economics 41 (2), 377–391
Kilian, L. (2009): Not all oil price shocks are alike: disentangling demand and supply shocks in the crude oil
market, in: American Economic Review 99 (3), 1053–1069
Krugman, P. R. (2008): Fuels on the hill, New York Times, 27 June; online:http://www.nytimes.com/
2008/06/ 27/opinion/27krugman.html
Tang, K. / W. Xiong (2010): Index investment and financialization of commodities, Cambridge, Mass.:
National Bureau of Economic Research (NBER Working Paper 16385)
Trostle, R. (2008): Global agricultural supply and demand: factors contributing to the recent increase in food
commodity prices, Washington, DC: United States Department of Agriculture (Economic Research
Service Outlook Report WRS-0801); online:http://www.ers.usda.gov/Publications/WRS0801/
WRS0801.pdf
UNCTAD (United Nations Conference on Trade and Development) (2011): Price formation in financialized
commodity markets: the role of information, New York, Geneva

Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 27
Foreign banks and financial stability: lessons from the Great Recession
Ralph De Haas
Introduction
The rapid process of financial globalisation over the past three decades has resulted in
high levels of foreign direct investment in banking sectors across the world (Figure 1).
Spanish and Portuguese banks have developed a stronghold in Latin America on the back
of cultural and trade links between this region and the Iberian Peninsula. Nigerian and
South African banks have created pan-African banks, while various European banks
operate African affiliates as well. In New Zealand, most banking assets are currently
owned by foreign, mainly Australian banks.
Yet banking integration has perhaps advanced the most between Western and Eastern
Europe. After the fall of the Berlin Wall, Western European banks bought former state
banks and opened new affiliates, both branches and subsidiaries, across Emerging Europe.
Banks with saturated home markets were attracted to the region due to its scope for further
financial deepening at high margins. Policy makers stimulated banking integration
because of the presumed positive impact on both the efficiency and stability of local
banking sectors. Figure 1 shows that, as a result, in many Eastern European countries
between 67% and 100% of all banking assets are now in foreign hands.
Figure 1: Foreign banks around the world

Note: Foreign-bank assets are shown as a percentage of total banking assets.
Source: Compiled by the author based on data from Claessens and Van Horen (2012) and EBRD.
What are the economic implications of this dominant role for foreign banks? To
answer this question, we first briefly review the pre-crisis academic literature on
foreign bank entry into emerging markets. We then discuss new empirical evidence
that emerged after the 2008–09 financial crisis as well as the implications of this
evidence for economic policy.
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
28 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
Pros and cons of foreign banks in emerging markets
Academic and policy discussions about the economic impact of foreign banks on
emerging markets typically focus on three topics: changes in the quantity, the efficiency,
and the stability of financial intermediation. We discuss these in turn.
Foreign bank entry and the quantity of financial intermediation
Foreign bank entry into emerging markets can help unlock access to foreign savings,
increase investments, and speed up economic convergence. Although less capital tends to
flow from rich to poor countries than theory would predict, Emerging Europe is one of the
few regions where the Lucas paradox does not apply. Facilitated by the presence of
foreign banks, the transition region has been quite successful in accessing foreign savings,
using these to fund local business opportunities, and moving more quickly towards
Western European living standards than would otherwise have been possible.
16

Foreign bank entry and the efficiency of financial intermediation
Foreign banks may not only expand the amount of available savings, they may also
transform savings more efficiently into investments. In emerging markets, foreign banks
often introduce superior lending technologies and marketing know-how, developed for
domestic use, at low marginal cost (Grubel 1977).
17
Evidence suggests that Emerging
Europe, where commercial banks were still largely absent at the start of the 1990s, has
reaped substantial efficiency gains due to foreign entry.
18
Foreign banks are not only
efficient themselves but also generate positive spillovers to domestic banks (which for
instance copy risk management methodologies).
An important issue is whether this higher efficiency comes at the cost of a narrower client
base. Foreign banks may simply be more efficient because they cherry-pick the best
customers and leave more difficult clients – such as opaque small- and medium sized
enterprises (SMEs) – to domestic banks. Domestic lenders may be better positioned to
collect and use “soft” information about opaque clients (Berger / Udell 1995) whereas
foreign banks rely more on standardised lending technologies. Some evidence
consequently indicates that foreign banks are associated with a relative decline in SME
lending (Detragiache / Tressel / Gupta 2008; Gormley 2010; Beck / Martinez Peria 2010).
Nevertheless, foreign banks increasingly apply technologies that use hard information,
such as credit scoring, to lend to SMEs without the need to develop long-term lending
relationships. Some recent studies therefore find that foreign banks may increase SME
lending in the medium term as they adopt new lending technologies (De la Torre /
Martinez Peria / Schmukler 2010). For Emerging Europe, the evidence also suggests that
foreign bank entry has not led to a reduced availability of small business lending (De Haas /
Ferreira / Taci 2006; De Haas / Naaborg 2006; Giannetti / Ongena 2008).

16 See EBRD (2009, Chapter 3) and Gill / Raiser (2012, Chapter 3) for empirical evidence.
17 In developed countries, foreign banks are generally less efficient than domestic banks as the
advantages of incumbent banks tend to dominate those of new entrants (Claessens / Demirgüç-Kunt /
Huizinga 2001).
18 See for instance Bonin, Hasan and Wachtel (2005), Fries and Taci (2005), and Havrylchyk and Jurzyk
(2011).
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 29
Foreign bank entry and the stability of financial intermediation
Even if foreign bank entry is associated with more (and more efficiently delivered) credit,
this advantage may be partly offset if that lending is highly volatile and contributes to
economic instability. The empirical evidence on this issue focuses on three impacts that
banking integration can have on financial stability in host countries.
First, there is abundant evidence that foreign banks have a stabilising effect on aggregate
lending during local bouts of financial turmoil.
19
Compared to stand-alone domestic
banks, foreign bank subsidiaries tend to have access to supportive parent banks that
provide liquidity and capital if and when needed. De Haas and Van Lelyveld (2006)
confirm such a stabilising role for Emerging Europe, and De Haas and Van Lelyveld
(2010) for a broader set of countries.
Second, foreign bank entry may expose a country to foreign shocks. Because parent banks
reallocate capital across borders (Morgan / Rime / Strahan 2004), capital may be
withdrawn from country A when it is needed in country B. Peek and Rosengren (1997,
2000a) show how the drop in Japanese stock prices starting in 1990, combined with
binding capital requirements, led Japanese bank branches in the United States to reduce
credit. Van Rijckeghem and Weder (2001) find that banks that are exposed to a financial
shock in either their home country or another country reduce credit in their (other) host
countries. Schnabl (2012) shows how the 1998 Russian crisis spilled over to Peru, as
banks – including foreign-owned ones – saw their foreign funding dry up and had to cut
back lending.
While foreign bank subsidiaries can transmit foreign shocks, lending by such local brick-
and-mortar affiliates is still considerably less volatile than cross-border lending by foreign
banks (García Herrero / Martinez Peria 2007). Peek and Rosengren (2000) find for Latin
America that cross-border lending did in some cases diminish during economic
slowdowns, whereas local lending by foreign banks was much more stable. Similarly, De
Haas and Van Lelyveld (2004) find that reductions in cross-border credit to Emerging
Europe have generally been met by increased lending by foreign bank subsidiaries, either
because new subsidiaries were established or because the lending of existing affiliates
increased.
Third, foreign bank ownership may also affect the sensitivity of the aggregate credit
supply to the business cycle. Because multinational banks trade off lending opportunities
across countries, foreign bank subsidiaries tend to be more sensitive to the local business
cycle than domestic banks (Barajas / Steiner 2002; Morgan / Strahan 2004). However, if
the population of foreign banks in a country is sufficiently diverse in terms of home
countries, this diversity may make aggregate lending more stable. In line with this, Arena,
Reinhart and Vázquez (2007) argue on the basis of a dataset comprising 20 emerging
markets that the presence of foreign banks has contributed somewhat to overall bank
lending stability in these countries.

19 See Dages, Goldberg, and Kinney (2000); Crystal, Dages, and Goldberg (2002); Peek and Rosengren
(2000b); Goldberg (2001); Martinez Peria, Powell, and Vladkova Hollar (2002); and Cull and
Martinez Peria (2007).
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
30 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
To sum up, the empirical evidence available before the 2008–09 crisis suggests the
following:
(1) Foreign banks improve credit availability in emerging markets and make the delivery of
credit more efficient. At least in the short term, small firms may benefit less from this.
(2) Foreign bank entry may exacerbate business and credit cycles, in particular if parent
banks are mostly from the same home country or region.
(3) Foreign bank entry reduces the economic impact of local financial crises.
(4) Foreign bank entry increases the vulnerability of a country to foreign shocks.
New evidence from the Great Recession
The Lehman Brothers bankruptcy on 15 September 2008 triggered a flurry of research into
how multinational banks transmitted this unexpected shock across borders. Many of these
banks were either directly exposed to the sub-prime market or indirectly affected by the
US dollar illiquidity. It became more difficult for parent banks to support their foreign
subsidiary networks with capital and liquidity, and this had knock-on effects for Emerging
Europe.
Popov and Udell (2012) show how Western banks with relatively little capital and high
financial losses propagated the crisis by reducing the credit supply of their Eastern
European subsidiaries. Opaque firms with few tangible assets were affected the most. In
line with this, De Haas, Korniyenko, Loukoianova and Pivovarsky (2012) find that foreign
bank subsidiaries in Emerging Europe reduced lending earlier and faster than domestic
banks.
20
Yet foreign banks that took part in the “Vienna Initiative” were somewhat more
stable lenders.
21

The stabilizing effect of the Vienna Initiative is confirmed by Cetorelli and Goldberg
(2011a) on the basis of aggregate data from the Bank for International Settlements. They
find that multinational banks transmitted the crisis to emerging markets via a reduction in
cross-border lending
22
and local subsidiary lending. Importantly, stand-alone domestic
banks – many of which had borrowed heavily on the international syndicated loan and
bond markets before the crisis – were forced to contract credit as well. Ongena, Peydró-
Alcalde and Van Horen (2012) also stress the funding heterogeneity among domestic
banks in Emerging Europe. Wholesale-funded domestic banks were much less stable than
domestic banks that relied on deposit funding. Similarly, Rocholl, Puri and Steffen (2011)
show how German Landesbanken with US sub-prime exposures reduced retail credit more
than unaffected banks. This was especially true for domestic banks that relied on
wholesale rather than deposit funding.

20 Barba Navaretti et al. (2010) argue that multinational banks were a stabilising force as they displayed
a stable loan-to-deposit ratio. Their analysis is limited to the years 2007–08, while much of the credit
crunch took place in 2008–09.
21 The Vienna Initiative was established towards the end of 2008 as a public-private coordination
mechanism to guarantee macroeconomic stability in Emerging Europe. Various multinational banks
signed country-specific commitment letters in which they pledged to maintain exposures and to
provide subsidiaries with adequate funding.
22 See De Haas and Van Horen (2011, 2012) for evidence on the rapid decline in cross-border lending
during the 2008-09 crisis, in particular by distant and relatively inexperienced international lenders.
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 31
Outside Europe, multinational banks also contributed to crisis transmission. De Haas and
Van Lelyveld (2011) analyse an international sample of banks and find that during the
recent crisis multinational bank subsidiaries had to curtail credit growth about twice as
much as stand-alone domestic banks. The latter relied more on deposits and were better
positioned to continue to lend. Subsidiaries of parent banks that used more wholesale
funding had to reduce credit the most. Cetorelli and Goldberg (2011b) find that US banks
with a high pre-crisis exposure to asset-backed commercial papers became more
constrained when off-balance sheet commitments became on-balance sheet commitments.
This affected foreign affiliates as funds were reallocated towards the parent, although this
effect was mitigated for large “core” affiliates. Finally, Kamil and Rai (2010) show that
crisis transmission to Latin America was less severe in countries where foreign banks
were lending through subsidiaries rather than across borders. Subsidiaries that had mostly
funded themselves locally and to a lesser extent through international wholesale markets
or through their parent banks were particularly stable credit sources.
Policy lessons from the Great Recession
When we compare the pre-crisis evidence on the impact of foreign bank entry on financial
stability with more recent findings, two lessons stand out.
First, the crisis underlined the importance of funding structures for banking stability. In
particular, it has become clear that an excessive use of wholesale funding exposes banks to
bouts of illiquidity in wholesale markets. Before the crisis, policy makers and academics
had focused instead on the potentially adverse effects of depositor runs, largely ignoring
the risks in the increasingly important wholesale markets.
The recent crisis also made it clear that funding structures matter for both foreign and
domestic banks. While foreign banks had easy access to parent bank and wholesale
funding, many domestic banks were increasingly able to access international wholesale
markets as well. When the crisis struck, it was these domestic banks that felt the pinch the
most and turned out to be the weakest links. They almost immediately lost access to cross-
border borrowing and had no recourse to a supportive group structure.
Important funding differences came to the fore among foreign bank subsidiaries as well.
The Latin American experience has shown that deep financial integration through a large-
scale presence of foreign banks may go hand in hand with financial stability if sufficient
local deposit and wholesale funding is available. Some (but not all) multinational bank
subsidiaries in Emerging Europe may have to adjust their funding model in this direction.
These subsidiaries will increasingly have to stand on their own financial feet by raising
local customer deposits and topping these up with wholesale funding if and when
required. This will be easier for and more relevant to subsidiaries that target retail rather
than corporate clients.
To make an increased focus on local funding a realistic option, some countries have more
work to do in terms of developing credible macroeconomic frameworks – including
flexible exchange rate regimes and inflation targeting – that facilitate the development of
local-currency bond markets (see Zettelmeyer / Nagy / Jeffrey 2010). Such frameworks
have helped Latin America to de-dollarise and subsequently create a more stable form of
financial integration. Adherence to credible macroeconomic policies will also help foster a
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
32 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
local-currency deposit base and reduce the need for banks, both foreign and domestic, to
borrow and lend in foreign exchange (Brown / De Haas 2012).
Second, while the Japanese experience of the 1990’s had already shown (or perhaps
forewarned) that multinational banks may pass on shocks from home to host countries,
what remained underappreciated until recently is how large these effects can be if foreign
bank affiliates are of local systemic importance. Nowhere has this been more evident than
in Emerging Europe where in many countries one or several of the top 3 banks are in
foreign hands. It was this combination of foreign ownership and systemic importance that
threatened financial stability in the region and necessitated the ad hoc establishment of the
Vienna Initiative. It also highlighted the inadequacies in the supervisory framework for
multinational banking groups.
Better coordination, cooperation, and information-exchange between supervisors are not
only necessary to prevent shock spillovers, but also because the alternative – forcing
banks to cut up their subsidiary networks into strings of completely independent banks –
may be costly. Such fully “ring-fenced” subsidiaries are costly to the bank groups
themselves, because the sum of ring-fenced pools of capital will be larger than the current
group capital as banks can no longer exploit the benefits of international diversification.
There may be costs at the macroeconomic level too as banks can no longer use their
internal capital market to raise funding where it is cheapest and must allocate it to the
most worthy investment projects.
Ideally, one would therefore like to move towards an integrated supervisory regime that
would still allow banks to operate multinational networks through which capital and
liquidity can be allocated according to their most productive uses. Prudential limits on
subsidiaries’ foreign funding (i.e. partial “ring-fencing”) may then cushion the cross-
border transmission of future financial shocks. At a minimum, such supervisory
“integration” could take the form of more harmonisation and the creation of a level
playing field, strengthening the colleges of supervisors on multinational banks, as well as
setting up (ex ante and binding) burden-sharing agreements (Goodhart / Schoenmaker
2009). The most far-reaching solution would entail the creation of a pan-European
supervisor for large groups. Whatever option is chosen, forced subsidiarisation through
full ring-fencing may be second-best and may reflect the inability of national supervisors
to reach a satisfactory level of cross-border cooperation and burden-sharing.
Bibliography
Arena, M. / C. Reinhart / F. Vázquez (2007): The lending channel in emerging economies: are foreign banks
different?, Washington, DC: International Monetary Fund (IMF Working Paper 07)
Barajas, A. / R. Steiner (2002): Credit stagnation in Latin America, Washington, DC: International Monetary
Fund (IMF Working Paper 53)
Barba Navaretti, G. / G. Calzolari / A.F. Pozzolo / M. Levi (2010): Multinational banking in Europe:
financial stability and regulatory implications: lessons from the Financial Crisis, in: Economic Policy
25, 703–753
Beck, T. / M. S. Martinez Peria (2010): Foreign bank participation and outreach: evidence from Mexico, in:
Journal of Financial Intermediation 19 (1), 52–73
Berger, A. N. / G. F. Udell (1995): Relationship lending and lines of credit in small business finance, in:
Journal of Business, 68, 351–382
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 33
Bonin, J. P. / I. Hasan / P. Wachtel (2005): Bank performance, efficiency and ownership in transition
economies, in: Journal of Banking & Finance 29 (1), 31–53
Brown, M. / R. de Haas (2012): Foreign currency lending in Emerging Europe: bank-level evidence, in:
Economic Policy 27(69), 59–98
Cetorelli, N. / L. Goldberg (2011a): Global banks and international shock transmission: evidence from the
crisis, in: IMF Economic Review 59 (1), 41–76
– (2011b): Liquidity management of U.S. global banks: internal capital markets in the Great Recession, New
York: Federal Reserve Bank of New York (FRBNY Staff Report 511)
Claessens, S. / A. Demirgüç-Kunt / H. Huizinga (2001): How does foreign entry affect domestic banking
markets?, in: Journal of Banking & Finance 25 (5), 891–911
Claessens, S. / N. van Horen (2012): Foreign banks: trends, impact and financial stability”, Washington, DC:
International Monetary Fund (IMF Working Paper 12/10)
Crystal, J. S. / B. G. Dages / L. S. Goldberg (2002): Has foreign bank entry led to sounder banks in Latin
America?, in: Current Issues in Economics and Finance 8 (1), 1–6
Cull, R. / M. S. Martinez Peria (2007): Foreign bank participation and crises in developing countries,
Washington, DC: World Bank (World Bank Policy Research Working Paper 4128)
Dages, B. G. / L. S. Goldberg / D. Kinney (2000): Foreign and domestic bank participation in emerging
markets: lessons from Mexico and Argentina, in: Federal Reserve Bank of New York Economic Policy
Review September, 17–36
De la Torre, A. / M. S. Martínez Pería / S. L. Schmukler (2010): Bank involvement with SMEs: beyond
relationship lending, in: Journal of Banking & Finance 34 (9), 2280–2293
Detragiache, E. / T. Tressel / P. Gupta (2008): Foreign banks in poor countries: theory and evidence, in:
Journal of Finance 63 (5), 2123–2160
EBRD (European Bank for Reconstruction and Development) (2009): Transition report 2009, London
Fries, S. / A. Taci (2005): Cost efficiency of banks in transition: evidence from 289 banks in 15 post-
communist countries, in: Journal of Banking & Finance 29 (1), 55–81
García Herrero, A. / M. S. Martínez Pería (2007): The mix of international banks’ foreign claims:
determinants and implications, in: Journal of Banking and Finance 31 (6), 1613–1631
Giannetti, M. / S. R. G. Ongena (2008): Lending by example: direct and indirect effects of foreign banks in
emerging markets, in: Journal of International Economics 86 (1), 167–180
Gill, I. / M. Raiser (2012): Golden growth: restoring the luster of the European economic model,
Washington, DC: World Bank
Goldberg, L. S. (2001): When is U.S. bank lending to emerging markets volatile?, Cambridge, Mass.:
National Bureau of Economic Research (NBER Working Paper 8209)
Goodhart, C. / D. Schoenmaker (2009): Fiscal burden sharing in cross-border banking crises, in: Inter-
national Journal of Central Banking 5 (1), 141–165
Gormley, T. A. (2010): The impact of foreign bank entry in emerging markets: evidence from India, in:
Journal of Financial Intermediation 19 (1), 26–51
Grubel, H. G. (1977): A theory of multinational banking, in: Banca Nazionale del Lavoro Quarterly Review
123 (December), 349–363
Haas, R. de / D. Ferreira / A. Taci (2010): What determines the composition of banks' loan portfolios?
Evidence from transition countries, in: Journal of Banking & Finance 34 (2), 388–398
Haas, R. de / Y. Korniyenko / E. Loukoianova / A. Pivovarsky (2012): Foreign banks and the Vienna
Initiative: turning sinners into saints?, London: European Bank for Reconstruction and Development,
mimeo
Haas, R. de / I. Naaborg (2006): Foreign banks in transition countries: to whom do they lend and how are
they financed?, Financial Markets, Institutions & Instruments 15 (4), 159–199
Haas, R. de / N. van Horen (2011): Running for the exit? International banks and crisis transmission,
London: European Bank for Reconstruction and Development (EBRD Working Paper 124)
– (2012): International shock transmission after the Lehman Brothers collapse: evidence from syndicated
lending, American Economic Review, Papers and Proceedings, May, forthcoming
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
34 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
Haas, R. de / I. van Lelyveld (2004): Foreign bank penetration and private sector credit in Central and
Eastern Europe, in: Journal of Emerging Market Finance 3 (2), 125–151
– (2006): Foreign banks and credit stability in Central and Eastern Europe: a panel data analysis, in: Journal
of Banking & Finance 30 (7), 1927–1952
– (2010): Internal capital markets and lending by multinational bank subsidiaries, in: Journal of Financial
Intermediation 19 (1), 1–25
– (2011): Multinational banks and the global financial crisis: weathering the perfect storm, London:
European Bank for Reconstruction and Development (EBRD Working Paper 135)
Havrylchyk, O. / E. Jurzyk (2011): Inherited or earned? Performance of foreign banks in Central and Eastern
Europe, in: Journal of Banking & Finance 35 (5), 1291–1302
Kamil, H. / K. Rai (2012): The global credit crunch and foreign banks’ lending to emerging markets: why
did Latin America fare better?, Washington, DC: International Monetary Fund (IMF Working Paper
10/102)
Martinez Peria, S. / A. Powell / I. Vladkova Hollar (2002): Banking on foreigners: the behavior of
international bank lending to Latin America, 1985–2000, Washington, DC: World Bank (World Bank
Working Paper 2893)
Morgan, D. / B. Rime / P. E. Strahan (2004): Bank integration and state business volatility, in: Quarterly
Journal of Economics 119 (4), 1555–85
Morgan, D. / P. E. Strahan (2004): Foreign bank entry and business volatility: evidence from U.S. states and
other countries, in: L. A. Ahumada / J. R. Fuentes (eds.), Banking market structure and monetary
policy, Santiago: Central Bank of Chile, 241–269
Ongena, S. / J. L. Peydro Alcalde / N. van Horen (2011): Shocks abroad, pain at home? Bank-firm level
evidence on financial contagion during the 2007–2009 crisis, s. l., mimeo
Peek, J. / E. S. Rosengren (1997): The international transmission of financial shocks: the case of Japan, in:
American Economic Review 87 (4), 495–505
– (2000a): Implications of the globalization of the banking sector: the Latin American experience, in: New
England Economic Review September/October, 45–63
– (2000b): Collateral damage: effects of the Japanese bank crisis on the United States, in: American
Economic Review 90 (1), 30–45
Popov, A. / G. Udell (2012): Cross-border banking and the international transmission of financial distress
during the crisis of 2007-2008, in: Journal of International Economics, forthcoming
Rijckeghem, C. van / B. Weder (2001): Sources of contagion: finance or trade?, in: Journal of International
Economics 54 (2), 293–308
Rocholl, J. / M. Puri / S. Steffen (2011): Global retail lending in the aftermath of the US financial crisis:
distinguishing between supply and demand effects, in: Journal of Financial Economics 100 (3), 556–
578
Schnabl, P. (2012): Financial globalization and the transmission of bank liquidity shocks: evidence from an
emerging market, in: Journal of Finance, forthcoming
Zettelmeyer, J. / P. M. Nagy / S. Jeffrey (2010): Addressing private sector currency mismatches in emerging
Europe, in: M. Kawai / E. Prasad (eds.), Financial market regulation and reforms in emerging markets,
Washington, DC: Brookings Institution Press

Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 35
Emerging market economies after the crisis: trapped by global liquidity?
!

Anton Korinek
Four years after the global financial crisis of 2008–09, the advanced economies of the
United States, Europe and Japan are still in a liquidity trap, where zero nominal interest
rates are insufficient to raise output to its potential level. Central bankers have provided
ample liquidity to their ailing economies through various forms of monetary easing.
Although the target of these actions has been domestic, their effects are felt worldwide.
Global investors have used part of the additional liquidity to invest abroad, leading to
massive capital flows to emerging market economies, thus driving up exchange rates and
inflating asset prices.
Policymakers in the affected economies have justifiably been worried about the
consequences: as Reinhart and Reinhart (2008) have pointed out, massive capital inflows
are all too often followed by severe crashes that impose enormous social costs.
Furthermore, policymakers felt that if they followed the standard prescriptions for cooling
down their overheating economies – i.e. cutting government spending or raising domestic
interest rates – they would make themselves even more attractive to global investors and
risk a further increase in capital inflows. In short, they felt “trapped by global liquidity”.
A growing chorus of academics, perhaps most famously reflected in Stiglitz (2002), has
argued that emerging economies should therefore impose regulations on international
capital flows. Country after country, from Brazil to Indonesia, Korea, Peru, Taiwan and
Thailand, has followed their advice in recent years. In a notable reversal of earlier policies,
the International Monetary Fund (IMF) has given its blessing to capital controls under
certain circumstances (see Ostry et al. 2010).
Externalities of capital flows
Korinek (2010b) makes the welfare-theoretic case for regulating capital flows based on
the notion that such flows impose externalities on the recipient countries. Just as
environmental pollution produces externalities that reduce societal well-being if
unregulated, capital inflows to emerging markets produce externalities that make such
economies more prone to financial instability and crises. By implication policymakers can
make everybody better off (i.e. achieve a Pareto-improvement) by regulating and
discouraging the use of risky forms of external finance, in particular foreign currency-
denominated debts.
Risky forms of capital inflows create externalities because individual borrowers find it
best to ignore the effects of their financing decisions on aggregate financial stability. They
take the risk of financial crisis in their economy as a given and do not recognise that their
individual actions contribute to this risk. In a way they face a “prisoners’ dilemma” – if
they could all agree to use less risky financing instruments and less external finance

! This article is partially based on Korinek (2010a, b, 2011b, 2012). For background papers please visithttp://www.korinek.com
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
36 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
overall, the economy as a whole would become more stable and everybody would be
better off. This creates a natural role for policy intervention.
Mechanism of financial crises
The economic rationale for capital flow regulations derives from a specific market
imperfection that plays a crucial role during emerging market financial crises: international
investors typically demand explicit or implicit collateral when providing finance. However,
the value of most of a country’s collateral depends on exchange rates: it rises in good times
when exchange rates appreciate; it declines in bad times when exchange rates depreciate but
when access to finance is most needed. When an emerging economy is hit by an adverse
economic shock, its exchange rate depreciates, the value of its domestic collateral declines,
and international investors become reluctant to roll over their debts. The resulting capital
outflows depreciate the exchange rate even further and trigger an adverse feedback cycle of
declining collateral values, capital outflows, and falling exchange rates (see Figure 1).
Figure 1: Feedback loops during emerging market crises

Source: Compiled by the author.
This financial feedback loop, sometimes referred to as Fisherian debt deflation or simply
as the deleveraging cycle, can amplify economic shocks so that a relatively small initial
shock leads to large declines in exchange rates, borrowing capacity, and economic activity
coupled with large capital outflows. As shown in Korinek (2010b), rational private agents
do not internalise their contribution to such feedback loops and therefore impose
externalities on the rest of the economy.
Magnitude of externalities
This theory of externalities based on financial vulnerabilities provides a clear framework
for how to determine the optimum magnitude of policy measures. The reason why capital
inflows expose an economy to financial fragility is that they may reverse precisely when
the economy is experiencing financial difficulty and trigger the described feedback loops.
Different forms of capital inflows result in different probabilities of future capital outflows
and different payoff characteristics in the event of a crisis; this in turn leads to different
externalities. Optimal macroprudential policy should aim precisely at offsetting these
externalities.
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 37
If an emerging economy takes on dollar debts and subsequently experiences a financial
crisis, the exchange rate depreciates and the domestic value of the debt increases sharply,
implying that dollar debt imposes a large negative externality. Consumer price inflation
(CPI)-indexed debt protects borrowers against the risk of exchange rate fluctuations,
imposing smaller externalities. Local currency debts and portfolio investments play an
insurance role, since both the value of the local currency and equity markets tend to go
down during crises. Finally, non-financial foreign direct investment (FDI) often stays in the
country when a financial crisis hits; in those instances it does not impose any externalities.
Figure 2 reports a sample estimation of the annual magnitude of externalities created by
various types of capital inflow to Indonesia (see Korinek (2010b) for a detailed description
of the analytical method employed). For each type of capital flow, the blue bar to the left
represents the average magnitude of externalities over the past two decades, whereas the
red bar on the right captures the externalities imposed during the 1997–98 financial crisis.
Figure 2: Feedback loops during emerging market crises

Source: Korinek (2010b).
Dollar debt, for example, imposed a long-run average externality of 1.54% annually on the
Indonesian economy over the past two decades. However, during the East Asian crisis of
1997–98, the externality reached 30.70%, justifying a tax of equal magnitude on the eve of
the crisis. More generally, optimal policy measures on capital inflows should be regularly
adjusted for changes in the financial vulnerability of the economy (see Jeanne / Korinek,
2010). The externalities of foreign capital rise during booms, when leverage increases and
financial imbalances build up. After a crisis has occurred and economies have de-levered,
new capital inflows create smaller externalities, justifying a zero tax in bad times when a
country seeks to attract more capital. Optimal capital flow regulation should therefore be
strongly procyclical. For dollar debt, a tax between 0% and 30%, with an average of 1.5%,
can be justified for the case of Indonesia.

Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
38 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
International spillover effects of capital controls
When one emerging economy imposes capital controls, capital is naturally diverted to
other countries, as documented e.g. by Forbes et al. (2011) and Lambert, Ramos-Tallada
and Rebillard (2011). The economic mechanism for this is simple: if a country such as
Brazil imposes a new tax on capital inflows, then Brazil’s demand for capital declines. But
given the lower demand, the world interest rate must fall to re-equilibrate the market: at a
lower world interest rate, worldwide investors will find it less enticing to save, i.e. supply
is lower, and other countries find it more attractive to borrow, i.e. demand is higher.
As discussed in Korinek (2012), the decline in the world interest rate is the natural
mechanism through which the market re-equilibrates demand and supply and is necessary
to clear markets. Technically speaking, we may call the decline in the world interest rate a
pecuniary externality, but we know from the first welfare theorem that pecuniary
externalities do not matter for Pareto efficiency in a well-functioning and relatively
complete market, such as the world market for capital. In short, the diversion of capital
from Brazil to other countries is the efficient response of the market system to the new
balance of supply and demand for capital.
Since the described spillover effects of capital controls are Pareto efficient, it follows that it
is neither necessary nor desirable to control them. In fact, welfare would be reduced if the
world interest rate was not allowed to adjust in response to capital controls, and if capital
was not allowed to seek its next-best destination. The pecuniary externalities arising from
optimal capital controls should therefore not be subjected to international oversight.
However, in many instances, the recipients of the capital flows diverted from Brazil are
themselves emerging economies that struggle with a flood of capital inflows. This has led
to concerns that Brazilian capital controls may have “bubble-thy-neighbour” effects on
other countries, as expressed e.g. in Forbes et al. (2011). In response to an increase in
Brazilian capital controls, the supply of capital to Brazil’s neighbours increases and the
interest rate at which they can borrow declines.
Arms race of capital controls
If Brazil’s neighbours also suffer from the described financial stability externalities, then
this increased supply is a mixed blessing: it reduces the interest rate that countries pay on
their loans, but it also increases the danger of financial instability and the associated
externalities. However, as Korinek (2012) describes, they can simply respond to this
higher danger by imposing or raising capital controls of their own.
The result may look like an arms race, but is actually the efficient equilibrating process (or
tatonnement process) of the market: in response to Brazilian controls, capital flows are
diverted and generate greater externalities in neighbouring countries, e.g. Peru. As a result, it
may be best for Peru to impose capital controls, which in turn pushes some of the capital
back to Brazil. This may lead to yet higher capital controls in Brazil, and so forth. The end
result is that each country converges to its optimal level of capital flows and capital controls.
The findings so far are based on the premise that countries are able to effectively
implement capital controls – if policymakers faced externalities but did not have the
policy tools to address them, then the resulting equilibrium would be inefficient.
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 39
Korinek (2012) studies a number of situations in which the effectiveness of capital
controls can be increased via concerted action among source and destination countries.
First, if capital controls are costly and the marginal cost increases in accordance with the
magnitude of the controls, for example because they create ever-greater incentives for
circumvention, then it may be desirable to share the burden of regulation between source
and destination country. Secondly, if source countries are better able to distinguish
between risky and safe forms of capital flows than destination countries, for example
because authorities in the source country have regulatory control over the banks from
which the flows originate, then it is of course desirable to involve source country
authorities in the regulatory process.
Involving the authorities of the source countries may be desirable for an additional reason:
when policymakers impose taxes on capital flows, they collect tax revenue. By the same
token, when policymakers impose quantity restrictions on capital flows, the agents who
are subject to the restrictions earn an implicit rent. If capital flows are partially restricted
by regulators in source countries, they are the ones who can collect the tax revenue.
Bibliography
Forbes, K. / M. Fratzscher / T. Kostka / R. Straub (2011): Bubble thy neighbor: direct and spillover effects
of capital controls, Cambridge, Mass.: MIT, mimeo
Jeanne, O. / A. Korinek (2010): Managing credit booms and busts: a Pigouvian taxation perspective,
London: Centre for Economic Policy Research (CEPR Discussion Paper 8015)
Korinek, A. (2010a): Regulating capital flows to emerging markets: an externality view, College Park, Md.:
University of Maryland, mimeo,
– (2010b): Regulating capital flows to emerging markets: design and implementation issues, VoxEU; online:http://www.voxeu.org/index.php?q=node/5953
– (2011a): Hot money and serial financial crises, in: IMF Economic Review 59 (2), 306–339
– (2011b): The new economics of prudential capital controls, in: IMF Economic Review 59 (3), 523–561
– (2012): Capital controls and currency wars, College Park, Md.: University of Maryland, mimeo
Lambert, F. / J. Ramos-Tallada / C. Rebillard (2011): Capital controls and spillover effects: evidence from
Latin-American countries, Paris: Banque de France (Working Paper 357)
Ostry, J. / A. R. Ghosh / K. F. Habermeier / M. Chamon / M. S. Qureshi / D. B. S. Reinhardt (2010): Capital
inflows: the role of controls?, Washington, DC: International Monetary Fund (Staff Position Note
10/04)
Reinhart, C. M. / V. Reinhart (2008): Capital flow bonanzas: an encompassing view of the past and present,
London: Centre for Economic Policy Research (CEPR Discussion Paper 6996)
Stiglitz, J. E. (2002): Globalization and its discontents, New York, London: W.W. Norton

Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
40 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
Capital account management: the Indian experience and its lessons
Y. Venugopal Reddy
Until 1992, India had tight control over its capital and current accounts. As part of the
reforms that were implemented following the 1991 currency crisis, a new regime of external
sector management was adopted. This was based on the report of a high-level committee
concerning the balance of payments. The major features of the regime involved (a) a full
liberalisation of the current account; (b) restricting the current account deficit to a
sustainable level, assessed through the level of normal capital flows (initially placed at 2%
of Gross Domestic Product [GDP]); and (c) an active management of the capital account.
The regime also involved efforts to build up foreign exchange reserves to an appropriate
level, taking into account not only import needs but also overall payment obligations in
the short-term. In managing the capital account, priority was given to non-debt inflows
over debt inflows. With respect to debt, short-term debt was not permitted except for
trade-related purposes. The possibility of capital account transactions being undertaken in
the guise of current account transactions was noted. Hence, appropriate safeguards were
provided. These included repatriation and surrender requirements for export earnings, and
reasonable monetary limits on automatic access to current account transactions in services.
These measures were followed up with appropriate legislative changes to strengthen the
framework. In particular, India’s Foreign Exchange Control and Regulation Act was
replaced by the Foreign Exchange Management Act. At that time, when this framework
was put in place, the idea was to ensure a non-disruptive movement of India’s economy to
greater integration with the rest of the world economy, as considered appropriate. In this
regard, while the appropriateness of immediate current account convertibility was
recognised, the approach to capital account liberalisation was somewhat ambivalent. The
law assured full current account convertibility as a rule, with scope for exceptions, and
empowered the Reserve Bank of India to manage the country’s capital account with the
approval of government.
In 1997, there was a widespread feeling that full capital account convertibility should be a
natural corollary of the reform process undertaken in 1991–1992. However, there were
apprehensions about the possible risks of sudden and full capital account convertibility,
and the need to undertake capital account liberalisation in accordance with progress in
fiscal consolidation, the level of foreign exchange reserves, and reforms in the banking
system, especially with regard to the problem of too high a level of non-performing assets.
A committee appointed to recommend measures for capital account convertibility
presented a set of preconditions for full convertibility and a road map to that goal.
With the onset of the Asian financial crisis of 1997–1998, extensive use was made of
administrative measures regarding financial flows into the capital account. Intervention in
the foreign exchange markets was undertaken by the Reserve Bank through public sector
commercial banks. Due to the imposition of harsh economic sanctions by the US
government in May 1998 (a response to India’s detonation of nuclear devices), special
mechanisms were considered for obtaining capital flows from non-resident Indians
through the issuance of bonds. In brief, the range of instruments for managing volatility in
financial markets, in particular foreign exchange markets, increased.
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 41
In 2003 there was some apprehensiveness that excessive capital inflows might destabilise
the Indian economy. In order to counter this, several steps were taken which included
tightening the limits on external commercial borrowing by corporations and the rules for
approval of this. In any case, there was no outstanding sovereign debt in foreign currency,
except through bilateral or multi-lateral aid institutions. There were strict limits on the
holding of sovereign debt by non-residents. During this period, the approach to capital
account management included a formal distinction between households, corporations and
the financial sector regarding the pace and extent of liberalisation of the capital account.
Prudential regulations and regulations on capital transactions over the financial sector
were liberalised in a very cautious manner. There was greater liberalisation (though with
some limits on overseas exposure in connection with the net worth of a corporation) for
operations of resident real sector corporations, particularly regarding the acquisition of
equity in the form of foreign direct outward investment by Indian corporations. This
process enabled a large number of Indian corporations to make acquisitions outside the
country, and thus relieved the pressure caused by capital inflows into the economy. The
limited cross-border operations of non-financial firms were considered more stable than
those undertaken by the financial sector. The restrictions on foreign exchange transactions
of individual households were liberalised, but the mobilisation of household savings for
purposes of capital account transactions by financial intermediaries was restricted.
In view of the size and volatility of the capital inflows that were anticipated during 2004,
and the possible cost of intervention in the foreign exchange markets, an innovative
“market stabilisation scheme” was introduced. Basically, this scheme is a substitute for
bond issues by the central bank for sterilisation with government bonds. This scheme
permitted what would normally have been a quasi-fiscal burden of sterilisation operations
to be more transparent and to be reflected in the government budget. This also promoted a
careful assessment of the costs and benefits of capital account management by the
government. The bonds issued are no different from treasury bonds, except that a specified
amount for sterilisation is transparently frozen and not utilised by the government. These
operations were reversed, however, when the global financial crisis struck in 2008. The
pace of liberalisation of the capital account was also coordinated with the countercyclical
policies that were undertaken both by monetary policy and in regulation of the financial
sector. In undertaking these measures, the inadequacies of interest rates and fiscal tools by
themselves in countering volatility were recognised. Furthermore the objective was to
avoid commitment to a predetermined level of the exchange rate, but rather to moderate
excessive volatility. What “excess volatility” means has never been defined, but over time
larger movements in exchange rate were tolerated. Thus the boundaries between volatility
and flexibility were not rigidly defined. The major criticism of this system has been that the
scheme compromises the independence of the central bank. However, the position taken by
the Reserve Bank has been that this compromise in favour of coordination was essential in
order to manage the “trilemma”, the impossibility of having a fixed exchange rate, a fully
liberalised capital account, and an independent monetary policy at the same time.
By 2006, pressure mounted on the Reserve Bank to liberalise the country’s capital account
further, and hence another committee was appointed. This committee recommended
further relaxation of capital account management, but the framework of 2003 remained in
place. In conformity with the global fascination for accelerated growth in the financial
sector, the Indian government appointed a committee to suggest measures for making
Mumbai a regional international financial centre; and another committee to make
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
42 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
recommendations on comprehensive reforms in the financial and external sectors. The two
reports, which were submitted in 2008, remain largely unimplemented today.
With the onset of the global financial crisis in 2008, instruments of external borrowing,
including short-term debt, were used to increase capital inflows. Similarly, the ceiling on
interest rates offered by commercial banks for deposits from non-residents, both in foreign
currency and in domestic currency, was raised. Permissions for external commercial
borrowing were issued more liberally. Financial intermediaries were able to revise foreign
currency resources more liberally. These measures, supplemented by interventions in the
foreign exchange market by the Reserve Bank and the reversal of operations under the
“market stabilisation scheme”, helped moderate volatility in the exchange rate in Indian
markets, despite the huge impact of the global financial crisis on global liquidity.
Lessons of the Indian experience
On the basis of the Indian experience with capital account management, the following
lessons may be drawn, recognising that these lessons may not be of universal validity:
First, it is necessary to integrate management of the capital account with other policies,
especially fiscal management, regulation of the financial sector, and monetary policy. In
2006, the Reserve Bank mooted serious consideration of a tax on transactions in the
financial sector, but this did not find favour with government. It is possible to maintain
that such supplementary policies might have moderated the cost of sterilisation.
Second, capital account management should be treated as an essential component of
countercyclical policies. For example, the Indian real estate bubble was moderated
through regulation of the financial sector, but the government remained reluctant to
impose adequate restrictions regarding capital inflows. This impacted to some extent on
asset quality, in spite of the limited exposure of banks, when the correction took place in
2008–2009.
Third, management of the capital account cannot be divorced from developments in
foreign exchange markets as well as developments in the current account.
Fourth, it is necessary to ensure that there is full commitment on the part of public policy-
makers both at the level of the government and the central bank to manage the capital
account actively and to ensure the credibility and effectiveness of such a policy. This
policy commitment is essential to resisting the inherent tendency of market participants to
counter such actions. Many market participants tend to gain from excess volatility until a
collapse is feared and at that stage, there may be an appeal from them for policy
intervention in one form or another.
Fifth, capital account management may involve both price and administrative measures,
and these measures should not be confined to managing inflows, but should also include
the management of outflows whenever appropriate.
Sixth, it is necessary to recognise that in developing countries the capacity of the central
bank to intervene at the time of a currency depreciation is limited by constraints in the
availability of foreign exchange reserves. The central bank has a greater capacity to
intervene at times of appreciation, since purchases are made with its own currency, over
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 43
which there are no supply constraints. Hence, any policy involving a reduction in volatility
must exercise the necessary caution in the strategies adopted in both cases. Further, in the
face of limitations on effective management of depreciation, there is an enhanced need to
moderate excessive appreciating pressures in order to avoid possible over-shooting and
disruptive corrections.
Seventh, the nature of capital flows and the complexity of the operations of financial
intermediaries keep changing, and hence there should be sufficient flexibility for
modifying these measures and altering the relative priorities among them.
Eighth, it should be clear that capital account management is a tool that is necessary at all
times, even when recourse to it is taken as a purely temporary measure. Furthermore, the
perception that the central bank is credibly committed to avoiding excess volatility has an
influence on the expectations and actions of market participants. In fact, treating capital
account management as a temporary measure would imply that recourse to the former is
itself a sign of recognition of a problem.
Ninth, the critical part of management of the capital account relates to the financial sector,
where the stability of financial institutions and the exchange rate are closely intertwined.
Hence, the most important instrument of capital account management should of necessity
be regulation of the financial sector. In this regard, the operations of financial institutions
which concentrate on cross-border transactions require special monitoring and intense
regulation. Their operations have a tendency to overtly and covertly undermine efforts
aimed at capital account management. Global financial conglomerates are particularly
prone to operations of a cross-border nature, which undermine capital account
management. Furthermore, the unhedged foreign currency exposures of non-financial
corporations need to be monitored by the financial intermediaries, and the regulators need
to be cognizant of this in view of the possible impact of the exchange rate on the portfolios
of financial intermediaries.
Finally, any set of measures involving the capital account would require discrimination
based on residential status or on the currency of denomination in contracts, and often on
the basis of both. The limitations on effective capital account management are set by a
country’s legal framework and the space available for public policy at the national level,
taking into account the relevant bilateral, regional or multilateral treaty obligations that the
country has entered into.

Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
44 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
Avoiding capital flight to developing countries: a counter-cyclical approach
!

Stephany Griffith-Jones and Kevin P. Gallagher
Introduction
Developing countries have in recent years again become the destination for speculative
capital flows, with inflows reaching pre-crisis levels. Many of these nations are deploying
prudential capital regulations to stem these inflows. Macroprudential regulatory measures in
recipient countries could be coupled with action by advanced countries in order to
discourage capital outflows and risk-taking from their economies, so as to encourage the
productive use of capital within their own economies; such measures would also avoid
excessive exchange rate strengthening in developing economies, both supporting their own
growth and helping to avoid possible future crises within these developing economies.
Indeed, one important aim of regulating cross-border capital flows in both recipient and
source countries is the reduction of systemic risk build-up in both, thus reducing the risk
of future crises. We argue therefore that such measures for managing excessive capital
outflows from developed countries, especially from the US, could be a clear win-win, as
they would benefit both the US and the developing economies. The only ones to lose
would possibly be financial institutions, with regard to short-term profits; however, we
have seen the disastrous results of defining economic policies solely to maximise profits
for the financial industry, whilst neglecting their impact on systemic financial and
macroeconomic stability and on the real economy.
Capital flows in the wake of the crisis
As nations across Asia and Latin America still have a long way to go in terms of income
growth, foreign investment is welcomed by them. The problem is that the sheer volume
and composition of these flows implies that a large part of them are short-term and volatile
in character and do not go into productive investment. Furthermore, massive inflows of
short-term capital have been causing asset bubbles and currency appreciation in
developing countries, making macroeconomic policy difficult and increasing the risk of
future crises; appreciation of exchange rates also discourages exports and import
substitution by national production.
Short-term capital inflows have been flocking to the developing world largely through
carry trade and other mechanisms, usually using derivatives. Since the crisis began,
interest rates have been very low in the US and other industrialised nations. There is clear
evidence over the last thirty years that there is a broad correspondence between periods of
accommodative monetary policy in advanced economies and capital flows to emerging
market economies, as well as the reverse, with each monetary tightening producing capital
flow reversals and often crises in emerging countries.

! We would like to thank Amar Bhattacharya, Leonardo Burlamaqui, Gerry Epstein, Rakesh Mohan,
José Antonio Ocampo and particularly Shari Spiegel, as well as other participants of a workshop on
“Managing capital flows for long-run development”, convened by Boston University and the Initiative
for Policy Dialogue at Columbia University in Boston in September 2011, for their valuable comments
and suggestions. Responsibility for any mistakes is our own.
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 45
In the recent period, increased US liquidity and low interest rates have prompted US
financial institutions to decrease their risk-taking in the US, thus leading to little or no
creation of credit, which is the main transmission channel of monetary expansion to
domestic economic activity. This has, however, increased risk-taking abroad,
channelling it to nations with higher interest rates with an eye to rapid returns and better
growth prospects in the medium term. Speculative short-term flows push up the value of
emerging market currencies and create asset bubbles. It is for this reason that the US was
criticised at the G20 meeting in Seoul in late 2010. For example, Brazil, with high
interest rates, had seen an appreciation of over 40%, due in part to the carry trade, and
was most vocal in Seoul. But this is a problem in many emerging and even low-income
developing countries which, like Uganda, experience excessive short-term inflows
during long periods.
In contrast, emerging markets again experienced a “flight” to safety away from their
economies from September to December 2011 when the Eurozone began to jitter " once
again reversing much of the flows of the previous year and accentuating volatility.
Prudential regulations in developing countries
Emerging and developing economies have a “new” set of options which several are pursuing
now to stem the tide. One of them is to engage in prudential capital account management by
taxing, putting unremunerated reserve requirements, or discouraging excessive capital inflows
by other means. Taken as a whole, these measures are not a panacea, but they do help to
provide greater monetary policy autonomy to these countries; this is essential, since their
growth rates are high, and it is essential for them to avoid not only inflation in goods and
services, but also asset price bubbles and overvalued exchange rates.
Many nations such as Brazil, China, Argentina, Taiwan, Thailand, South Korea, Peru, and
Indonesia have put in place various forms of capital account regulations to limit excessive
inflows. Such controls have been recently sanctioned by the International Monetary Fund
(IMF) – a very significant shift. However, the support by the IMF for capital account
regulations has some limitations.
Indeed, capital account management measures follow a mountain of economic evidence
gathered in academia and by the international financial institutions, most notably the
National Bureau of Economic Research in the US, the IMF, the United Nations, and the
Asian Development Bank, indicating that capital account management by developing
countries is a useful tool of policy when accompanied by broadly prudent macro-economic
policies. In February of 2010, IMF economists published a staff position note entitled
“Capital inflows: the role of controls”, empirically showing that capital controls not only
work but were “associated with avoiding some of the worst growth outcomes” (Ostry et al
2010, 13) of the current economic crisis. The paper concludes that the “use of capital
controls – in addition to both prudential and macroeconomic policy – is justified as part of
the policy toolkit” (Ostry et al. 2010, 5).
That IMF report singles out measures such as taxes on short-term debt (like Brazil’s) or
requirements whereby inflows of short-term debt need to be accompanied by an
unremunerated deposit to be placed in the central bank for a certain period of time (as
practiced in the past by nations such as Chile, Colombia, and Thailand). The goal of these
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
46 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
measures – which are often turned on when capital flows start to overheat and turned off
when such flows cool – is to prevent massive inflows of hot money that can appreciate the
exchange rate and threaten the macroeconomic stability of a nation.
The IMF’s findings came at an appropriate time. In the wake of the US Federal Reserve’s
quantitative easing and other measures to loosen monetary policy, the carry trade had
again started bringing speculative capital to developing countries, with the risk of
disrupting their recovery from the crisis (even though, as mentioned before, there have
been episodes in late 2011 of brief reversals of such flows). As José Antonio Ocampo
(2011, 5) writes “monetary expansion may be largely ineffective in industrial countries but
can generate large externalities on emerging markets”.
To make the proper deployment of capital account management effective however, at least
four obstacles need to be overcome. First, after a while investors tend to creatively evade
prudential capital management through derivatives and other instruments. Second, US
trade and investment agreements make capital controls difficult to implement. Third,
speculative capital can still wreak havoc because hot money blazes past countries that
successfully deploy controls to reach nations that do not. Fourth, the massive scale of
capital flows from source countries may overwhelm relatively small countries even though
they use capital account management of their inflows.
Brazil started imposing a tax on hot money inflows back in 2009 and has been fine tuning
it ever since, not only because of the volume of flows but also because the regulations
were being evaded. Some investors have loop-holed controls by disguising short-term
capital as foreign direct investment, or through currency swaps and other derivatives, or
by purchasing American depositary receipts (ADRs).
ADRs are issued by US banks and allow investors to buy shares of firms outside the US –
enabling investors to purchase Brazilian shares in New York and thereby skirt controls in
Brazil. In a step in the right direction, Brazil moved to put a 1.5% tax on ADRs to stem
speculative circumvention of the controls. Thus, a Brazilian bank or investor that deposits
shares with foreign banks will be charged the tax. Most recently (mid-2011), Brazil has
started taxing net foreign exchange derivative positions above a certain level " an
interesting measure, as it may help curb excessive pressure on the national currency to
become too strong while helping to avoid evasion of other capital account management
measures. It would be helpful for emerging economies to exchange their experiences
regarding capital flow regulation and evasion of the controls and to analyse which
measures have had better economic outcomes.
Secondly, since 2003, US trade and investment treaties have made prudential management
of capital accounts by developing country trading partners difficult if not impossible by
mandating the free flow of capital to and from a country, regardless of that country’s level
of development – for instance, in trade deals with Chile, Peru, and Singapore. (Singapore
and Chile initially resisted these measures, but ultimately agreed to the treaties.) Pending deals
with Colombia and South Korea would also ban prudential capital controls. Other higher-
income countries and trade partners – such as Canada and Japan – grant countries the right to
use the macroeconomic tool, or at least grant exemptions to prevent or mitigate crises.
The third problem is that capital will simply flow past nations that successfully deploy
controls to nations that do not, implying negative externalities for the latter. Some
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 47
economists, such as former IMF economist Arvind Subramanian, propose full-fledged
coordinated capital controls among all emerging market economies to circumvent the
problem. This idea may have some merit, but of course not all emerging markets will
agree to coordinate. We propose attacking the problem at its source, that is, in the
countries where the flows originate.
The fourth, and serious, problem is that if interest differentials are important, the incentive
for investors to come into emerging economies is very strong, and the scale of capital
account management required by the emerging country to resist them is very large; this is
particularly the case because global capital markets are so large and so mobile, and can
thus overwhelm the financial markets of relatively small emerging and developing
economies. Again complementary measures in the source countries would help tackle the
issue. Although the measures proposed below are aimed primarily at the US, which is
currently the main source of carry trade, such measures would be even more effective if
coordinated with other advanced countries that are sources of short-term capital outflows
or risk-taking.
Regulate the carry trade in the United States
As pointed out, actions taken by developing and emerging economies regarding their
capital accounts may not be enough to stem the massive wall of money coming towards
them at times. Therefore it may be desirable to complement these measures with actions
by the countries where the capital is coming from, especially the US. Given that most of
the carry trade effect in the near future will come from the US, US authorities could start
regulating the outflow of capital due to the carry trade. As pointed out, though the scale
may be greater now, there have been several previous episodes where very loose US
monetary policy contributed to surges in capital flows to developing economies, episodes
that mostly ended in tears. As far back as 1998 D’Arista and Griffith-Jones (2008) argued
for measures such as unremunerated reserve requirements to discourage excessively large
portfolio outflows from source countries.
At present, the US could introduce measures to discourage excessive carry trade flows
from that country to the rest of the world, and especially the developing countries. This
could be done, for example, by taxing such flows on the spot market; furthermore, foreign
exchange derivatives that mimic spot transactions could have higher margin requirements
to discourage them. Alternatively, such foreign exchange derivatives could also be taxed
at a level equivalent to the tax on foreign exchange spot transactions, on the notional value
of that derivative, such as non-deliverable forwards. Interesting lessons could be drawn,
for example, from the recent experience of Brazil in taxing foreign exchange derivatives,
which also seems to show the feasibility of such taxes. There are two routes through
which US monetary easing is transmitted abroad: (a) the money and credit supply channel,
which implies higher capital outflows and less credit creation in the US and (b) the
derivatives channel, whereby the fixed risk budget of US banks or hedge funds is allocated
more towards risk-taking with emerging economies and less towards risk-taking in the US.
The proposal sketched above would attempt to curb both routes when and if desirable, that
is when both excessive capital and risk-taking go abroad.
Such an approach would benefit the US economy, since the purpose of monetary easing is
precisely to encourage increased lending and risk-taking in the US, and not for funds to be
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
48 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
channelled abroad. It would benefit emerging countries, whose economies are being
harmed by excessive short-term inflows that could cause future crises. It would thus be a
big win-win situation for the world economy.
The results of the US Congressional elections unfortunately make it difficult for the US
government to pursue the first-best policy to keep its economy recovering: further fiscal
expansion, for a time. As Keynes taught us, and as we have seen during numerous crises,
private investment and consumption will not recover on their own (due both to over-
leveraging and lack of confidence) without the stimulus of aggregate demand, which only
governments can give in these particular circumstances. Once a recovery is on track, fiscal
policy needs to contract in order to avoid both overheating and excessive public debt.
The Fed has already brought the short-term interest rate to zero, that is, Ben Bernanke, to
his credit, has ventured into the emergency toolkit. The Fed chairman should be applauded
for his willingness to think past convention. As one of the last policy-makers in developed
countries with significant economic power, he is an important voice for expansionary
economic policy.
On its own, however, a looser US monetary policy seems not to be enough to restore the
US economy to growth; supportive fiscal policy would be highly desirable, as would other
measures to stimulate aggregate demand. Furthermore, easy monetary policy may
contribute to a further overheating of asset prices and exchange rates in the emerging
economies; this could not only complicate macroeconomic management for them now but
also increase the risk of future crises.
To ensure that looser monetary policy helps the US economy grow, institutional
mechanisms and a broader framework need to be found in order to channel the additional
liquidity created by the Fed as credit into the real economy. The key is to expand credit to
small and medium-sized enterprises, starved for funds as they are at present, and to
finance large investments in infrastructure, including those required to generate clean
energy and energy conservation. Institutional innovations may be necessary to achieve
this, such as the creation of an Infrastructure Fund, possibly with the addition of special
institutions dedicated to lending to small and medium enterprises. Indeed, in the US, the
Federal Reserve could, for example, possibly use some of the liquidity it creates to
purchase bonds of a US Infrastructure Fund or Bank; this would both provide credit to a
key sector for future development and lead to an increase in aggregate investment and
demand.
Internationally, if the US were to dig into the emergency toolbox again, it could impose
prudent capital regulations or taxation on the outflow of speculative capital from the US
via mechanisms such as the carry trade. As discussed above, this might help to avoid
future crises which would harm not only the emerging countries but also the US and the
world economy. Taxation may have some important advantages. Firstly, taxes are more
difficult to avoid or evade, since they involve not merely authorities like the Federal
Reserve but also the Internal Revenue Service, whose enforcement mechanisms are
possibly stronger.
23
Secondly, such taxation could generate some additional revenue for a
US Government with a large budget deficit, surely an attractive feature. However, the tax

23 We thank Nelson Barbosa for this point relating to the Brazilian experience.
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 49
would need some ex-ante flexibility on rates so that it could be modified according to the
level of outflows and derivative positions. Complementary to introducing measures like
new taxes to discourage outflows of capital or increased risk-taking abroad, it seems
clearly desirable – in the US and elsewhere – to reduce existing tax biases (i.e. tax
loopholes) which favour such flows; indeed, this could be a first step to discourage
excessive short-term outflows.
Measures to discourage short-term outflows would make it easier to keep the liquidity
created by the Fed within the US and improve the chances of going toward productive
investment.
Road to the G20
Re-orienting capital flows for productive development and resulting growth should be a key
priority as world leaders prepare for the next G20 meetings. Prudential capital account
regulations, deployed in both the industrialised and developing worlds, should be examined
as one instrument to achieve this aim. Coordination between developed and developing
countries on this issue would be desirable; an advantage here is the fact that the aims of both
developed and developing countries often coincide. However, it does not seem desirable for
such coordination to be imposed multilaterally, since no institution at present seems to have
the governance needed to be trusted as appropriately representing the collective interests of
all countries. Nevertheless, the IMF could continue to be a useful forum for exchanging
experiences of capital account management (by both developed and developing countries)
and possibly providing a useful, voluntary forum for informal coordination " at least in
cases where all countries involved desire such a role to be played.
To rectify some of the problems related to capital flows, industrialised nations (especially
the US) should consider regulating the carry trade and providing safeguards in their trade
treaties in order to allow developing nations to deploy prudential regulation. Developing
countries should also impose prudential regulations. The Financial Stability Board, or
another relevant body, as well as national regulatory authorities, should play a watchdog
role regarding those who evade these regulations.
Bibliography
D’Arista, J. / S. Griffith-Jones (1998): The boom of portfolio flows to emerging markets and its regulatory
implications, in: A. Montes / A. Nasution / S. Griffith-Jones (eds.), Short term capital flows and
economic crises, Helsinki: World Institute for Development Economics Research, 52–69
Mohan, R. (2011): Capital account management: is a new consensus emerging?, in: K. Gallagher / J. A.
Ocampo / S. Griffith-Jones (eds.), Managing capital flows for long-run development, Boston, Mass.:
Boston University (Pardee Center for the Study of the Longer-Run Future)
Ocampo, J. A. (2011): The case for and experience with capital account regulations paper presented at the
conference on managing the capital account and regulating the financial sector: a developing country
perspective, organised by the Ford Foundation, Initiative for Policy Dialogue at Columbia University
and UN-DESA, Rio de Janeiro, 23–24 August; online:http://policydialogue.org/files/events/
Capital_Account_Regulations_JAO.pdf
Ostry, J. / A. R. Ghosh / K. F. Habermeier / M. Chamon / M. S. Qureshi / D. B. S. Reinhardt (2010): Capital
inflows: the role of controls?, Washington, DC: International Monetary Fund (Staff Position Note
10/04)

Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
50 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
What role for the FSB?
Jo Marie Griesgraber
The appearance of large quantities of global liquidity coincided with the end of the
Bretton Woods agreement in the 1970s, when Eurodollars, money without a country,
were free to seek the highest returns. This phenomenon could only expand when
computers enabled currencies to move with the speed of light, and the ideology of
neoliberalism ordained that this was the best desirable goal. Secrecy jurisdictions in the
Caribbean, New York and London ensured that all this could happen without the
nuisance of taxes.
24
The financial crisis beginning in 2007 was not the first financial
disaster created in the so-called “advanced economies” to swamp the developing world,
but it is the current and continuing disaster that peoples and governments of the world
have yet to master (Rodrik 2011).
In this context, developing countries are instructed to develop sophisticated regulations
and competencies for dealing with the onslaught of financial flows – whether into the
country or out of the country. They are also warned that they must stay abreast of
rapidly changing financial innovations.
How do developing countries, especially the poorest, train and retain skilled financial
professionals when their first priorities are food, clean water and sanitation, primary and
secondary education, preventive and restorative health care, roads, electricity, and
communication? Why must scarce resources be diverted to gaining an understanding of
complex financial instruments instead of meeting basic human needs? The hard answer
to these questions is “They must”, because the situation will be worse unless floods of
liquidity are managed in order to slow them down and thereby reduce the loss of jobs,
livelihoods, and resources.
What options are available for developing countries to deal with global financial flows?
The best options – capital controls, regulations in the sending countries, and the
transparency of banking, taxes, corporate profits and losses – could be realised in the
medium term. Campaigners throughout Europe, the US, and parts of the global South are
insisting on an automatic exchange of information between countries on all earning and
taxes; the disclosure of the beneficial owners of all corporations, trusts, foundations
registered in any secrecy jurisdiction (e.g., London, Switzerland, Delaware, the Cayman
Islands); ending transfer mispricing and the practice of hiding gains in low tax
jurisdictions and posting losses in high tax jurisdictions; and reversing trade agreements
that require host countries to offer all benefits and present no barriers to foreign
financial services.
The immediate options for Emerging Markets and Developing Economies (EMDEs)
involve national level regulations, transparency, and coordination as presented in
Financial Stability Issues in Emerging Market and Developing Economies, a recent
paper submitted to the G20 Finance Ministers by the World Bank, the International
Monetary Fund (IMF), and the Financial Stability Board (FSB) (hereafter, the FSB

24 See Chwieroth (2010) and Shaxson (2011).
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 51
paper).
25
The paper identifies financial issues and makes corresponding recommend-
dations regarding EMDEs, notably recommendations relating to the regulation and
surveillance of banks and non-bank financial institutions (both large and small),
management of exchange rates, and increased reliance on domestic currency loans.
Regarding banks, the FSB paper reflects the influence of Louis Kasekende and Victor
Murinde – the former was one of the paper’s authors – on the need for low-income and
other developing countries to exercise caution in incorporating recommendations of the
Basel Committee on Banking Supervision aimed at reining in the largest banks in
advanced economies.
26
EMDE domestic banks have frequently rushed to implement the
Basel agreements, resulting in unnecessary domestic credit restrictions. They raised
reserve requirements to levels in excess of their needs, thereby limiting the resources
available to lend to the local economy and leaving them capable only of lending to the
national government.
International banks with branches and/or subsidiaries in EMDEs are charged to share
information on the financial well-being of the overall institutions and include host
country managers in oversight committees and any international supervisory colleges.
Non-bank financial institutions within the EMDEs tend to be small in absolute size but
significant within the local economy. These include micro-financial institutions,
cooperatives, and mutual funds. Micro-finance is highlighted for its overall lack of
regulations. With investments coming from outside the country, often in hard currency,
the cost of loans becomes subject to international currency rates, and repayment must
also be in values equivalent to hard currency. Large foreign banks, attracted by the high
interest rates and the high rates of repayments, are among the investors in micro-finance.
The FSB paper encourages local regulators to have domestic banks and non-bank
financial institutions use domestic currency in their operations, thereby enabling greater
local control over interest rates and reducing unexpected cross border flows and
currency exchange fluctuations.
It acknowledges that exchange rate policies are one tool over which EMDE governments
have some control, hence the recommendation to increase the use of local currency by
local banks and non-bank financial institutions alike. Another tool for expanding
reliance on and increasing the legitimacy of domestic currency is the expansion of
domestic capital markets. If capital is available from local sources, the difficulties of
repaying international debts are reduced. Domestic capital is also expected to involve
longer-term investments in the real economy. In contrast, a flood of hard currency into

25 See FSB, IMF and World Bank (2011). The authors included some experts from emerging markets
and developing economies; this was appropriate given that the latter were the objects of study and
recommendations. The G20 summit in Pittsburgh established the FSB, bringing together national and
international regulators to promote systemic financial stability. The G20 group drives the FSB agenda;
in turn the FSB reports to the G20 Finance Ministers and Central Bankers. The Chair designates
working groups to develop consensus recommendations and present them to the Plenary. In its
biennial meetings, the Plenary accepts working group reports by consensus, with implementation
depending on national action. Final reports and full membership of the FSB are available on its
website (www.fsb.org). The small secretariat works from the Bank for International Settlements
offices in Basel, Switzerland.
26 See Kasekende, Bagyenda and Brownbridge (2011) and Murinde and Mlambo (2011).
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
52 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
or out of a country can cause wild gyrations in the exchange, inflation and interest rates.
Too much inflow of hard currency results in inflation and currency appreciation,
harming the export economy. When interest rates are raised to reduce inflation, they
reduce access to domestic credit and long-term investments in the real economy. Such
volatility motivates middle and upper class individuals to hold their wealth outside the
country, where it is less likely to lose its value. In short, when a wave of foreign
currency moves out, it can carry with it more funds than it originally carried in. The FSB
paper asks finance source countries to take steps to lessen the outflow.
The FSB paper further recommends floating bonds in local currency instead of
international currency. It also suggests the use of derivatives as protection against
currency rate volatility. In such instances, the EMDEs would again be using some of the
instruments that were central to the present financial crisis. With caution, these could be
useful.
Despite the merits of many of its recommendations, the FSB paper fails to address the
basic vulnerability of EMDEs to the volatile global financial non-system. The
recommendations are like tinker toys holding back a tsunami, unable to withstand the
storms when foreign markets for exports dry up, domestic capital flees, and commodity
prices sky-rocket or collapse as the EMDEs become more or less useful places for the
wealthy to park their capital.
The FSB paper does give a nod in the direction of other issues which may be relevant to
the EMDEs, but are addressed “in other G20/FSB workstreams [such as] the
management of sizeable and volatile capital flows; the design of policy measures to
address the risks arising from systemically important financial institutions; the
development of macro-prudential policy frameworks; the creation of effective resolution
tools and regimes for financial institutions; strengthening the oversight and regulation
of the shadow banking system; and reforming the functioning of over-the-counter
derivatives and commodities markets” (FSB / IMF / World Bank 2011, 3). The FSB
paper does encourage, in the case of resolutions or bankruptcies of financial institutions
in the home country, the sharing of information with host countries and their
participation in resolution committees. Strangely when recommending the use of over-
the-counter derivatives to expand and strengthen the use of local currencies, the FSB
paper remains silent regarding their regulation. Regrettably, none of these other
workstream papers benefit from the inclusion of non-G20 voices and perspectives.
EMDEs clearly have a strong stake on the global stage in the stability of the global
finance system, but they also have scant opportunity to participate in the design of that
system’s management and re-regulation. The era of the closed, self-sufficient state as an
option has ended. It is essential that EMDEs invest their best brains in participating in
the FSB, the Standard Setting Bodies (SSBs), and the IMF in order to ensure that
informed, respected voices articulate the likely impact of any proposed regulation on
countries and peoples least able to sustain the harm from financial crises.
Acting on the decision of the G20 in Toronto, the FSB recently created six regional
consultative groups: the Americas, Asia, the Commonwealth of Independent States,
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 53
Europe, the Middle East, and Sub-Saharan Africa.
27
Each is co-chaired by a G20
member and a non-G20 member, and is comprised of a “reasonable” number of
additional non-G20 countries to keep the size manageable, plus the private sector. The
G20 Co-Chair will present the findings to the biannual meetings of the full membership
of the FSB; the non-G20 Co-Chair will be present at the plenary as an observer. The
FSB website describes the meetings’ initial agendas in broad categories and identifies
countries which participate but not individuals. Clearly, the quality of these regional
consultative groups is of the essence (Lombardi 2011).
The 13 SSBs that also participate in the FSB generally await reform.
28
Some have
become more inclusive, expanding their membership to include the full 24 member
states of the FSB. All require much more transparency. And none has yet incorporated
principles of accountability.
Even with these reforms, the poorest EMDEs are usually absent from the room, and
hence, for all practical purposes, do not exist when decisions are made that will shape
the future of financial markets. This need not be the result of malice – it is simply that
those not in the room do not have a voice and can and do suffer from negative
“externalities”.
All these useful recommendations emanating from the FSB have yet to be implemented
on national levels. Further, they must be accompanied by the more fundamental changes
of generalised use of capital controls and financial transaction taxes to slow the flow of
global finance and put it at the service of the real economy.
29
Above all, financial
transactions must be exposed to the cleansing sunlight of transparency that can reduce
the torrents of illicit financial flows and open up secrecy jurisdictions.

27 The FSB Charter stipulates that the FSB “will consult widely amongst its Members and with other
stakeholders including private sector and non-member authorities. The consultation process will
include regional outreach activities to broaden the circle of countries engaged in the work to promote
international financial stability” (FSB 2009, Article 3).
28 According to the FSB website, the Standard Setting Bodies (SSBs) include the FSB itself, the IMF
and the World Bank, as well as the more usually recognized bodies: the Basel Committee on Banking
Supervision, the Committee on the Global Financial System, the Committee on Payment and
Settlement Systems, the Financial Action Task Force on Money Laundering, the International
Association of Deposit Insurers, the International Association of Insurance Supervisors, the
International Accounting Standards Board, the International Auditing and Assurance Standards Board,
the International Organisation of Securities Commissions, and the Organisation for Economic
Cooperation and Development.
29 See Stiglitz et al. (2006).
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
54 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
Bibliography
Chwieroth, J. M. (2010): Capital ideas: the IMF and the rise of financial liberalization, Princeton, NJ,
Oxford: Princeton University Press
FSB (Financial Stability Board) (2009): Financial Stability Board charta, Basel; online:http://www.financial
stabilityboard.org/publications/r_090925d.pdf
FSB (Financial Stability Board) / IMF (International Monetary Fund) / World Bank (2011): Financial
stability issues in emerging market and developing economies, Report to the G-20 Finance Ministers
and Central Bank Governors prepared by a task force of the Financial Stability Board and staff of the
International Monetary Fund and the World Bank, 20 October; online:http://siteresources.world
bank.org/EXTFINANCIALSECTOR/Resources/G20_Report_Financial_Stability_Issues_EMDEs.pdf
Kasekende, L. / J. Bagyenda / M. Brownbridge (2011): Basel III and the global reform of financial
regulation: how should Africa respond? A bank regulator’s perspective, 22 March; online: www.new-
rules.org
Lombardi, D. (2011): The governance of the financial stability board, 23 September, Washington, DC:
Brookings Institution
Murinde, V. / K. Mlambo (2011): Development-oriented financial regulation, May; online: www.new-
rules.org
Rodrik, D. (2011): The globalization paradox: democracy and the future of the world economy, New York:
W. W. Norton
Shaxson, N. (2011): Treasure islands: tax havens and the men who stole the world, London: Random House
Stiglitz, J. E. / J. A. Ocampo / S. Spiegel / R. French-Davis / D. Nayyar (2006): Stability with growth:
macroeconomics, liberalization, and development, Oxford, New York: Oxford University Press

Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 55
International capital flows and institutional investors
!

Bernd Braasch
Introduction
The financial crisis has clearly revealed that we need a deeper knowledge of the
underlying reasons for capital flows, their volatility, their rapidly changing compositions,
and in particular, the main drivers of capital flow. In this respect there is a broad
consensus among policy makers from advanced, emerging market economies (EMEs) and
developing countries alike. But how to achieve this is another matter owing to lack of
transparency, the increasing importance of shadow banking, and a lack of timely and
internationally comparable data. This chapter highlights the potential benefits of extended
global monitoring of international capital flows and calls for more thorough analysis of the
role and behaviour of institutional investors.
Portfolio strategies and capital flow volatility
Increases in capital flow volatility have been driven by the same factors which have
fuelled the ongoing process of financial globalisation, namely the institutionalisation of
savings, the marketisation of finance, the process of creating new financial instruments,
and the accompanying, increasing shift of financial risks to private households and firms.
This development has been enhanced by financial liberalisation and deregulation, as has
been described in myriad articles. Thus the influences of the so-called push and pull
factors as determinants of the volume and direction of international capital flows are also
well-known.
But relatively little attention has been paid to the real drivers of capital flows: those
institutions and investors that are moving markets with their cross-border investment
decisions and rebalancing activities. When looking for underlying reasons and stable
relationships between financial variables across borders, we have to monitor the main
actors and their strategies. To use the term “drivers” for interest rate differentials, spread
levels, growth differences etc. is in my view misleading. True, they may indeed build the
financial environment or, to continue this metaphor, the car, but its speed and direction is
determined by those who use the car, namely the international investors. Their portfolio
strategies and rebalancing activities can explain significant aspects of capital flow
volatility, contagion, spillovers and the vulnerabilities of macroeconomically sound
countries.
A deeper and ongoing monitoring of the behaviour of institutional investors as one pillar
in the monitoring of global capital flows can deliver significant progress. The portfolio
strategies of institutional investors and globally active banks build an important hinge
between the financial and the real sphere of the economy. Two points should be
highlighted in this context. Firstly, there is no doubt that portfolio decisions are
increasingly influencing fundamental variables and prices, which in turn are major driving

! The views expressed here are solely those of the author and should not be attributed to the Deutsche
Bundesbank.
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
56 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
forces for the whole economy of a country. But secondly, their decisions are not always
guided by fundamentals. The efficiency of portfolio strategies does not always correspond
with the needs of fundamental or macroeconomic efficiency.
Benefits of enhanced global monitoring
The main objective of monitoring global capital flows more closely is to enhance global
and national financial stability. Such global monitoring should focus on all aspects that
contribute to a better assessment of the stability of the financial system as a whole. This
includes a better understanding of how the main global players and drivers of international
capital flows behave and how that behaviour changes the structures of financial markets.
This would help policymakers design better responses to external shocks and changing
international crisis transmission channels (Braasch 2010). This applies not only to the
main objective – prevention of a new financial crisis of the dimension of the 2008 Global
Financial Crisis – but also with regard to improving the process of information gathering
and analysis in order to make progress towards more effective regulation on a global and
regional level.
The current financial crisis has underlined the importance of global monitoring, among
other things, because ongoing financial globalisation has enhanced the influence of global
financial factors for national financial markets. For example, the variance of EME spreads
is increasingly influenced by global factors such as global liquidity and institutional
investors’ risk appetite. Some empirical studies have drawn the conclusion that up to 50%
of spread variance in selected EMEs is influenced by these global factors (González
Rozada / Yeyati 2006).
This development not only casts light on the stronger dynamics of contagion but also on
spillover effects into the real economy. This produces another argument in favour of
enhanced global monitoring: the transmission of shocks from the financial sector into the
real sphere of the economy has become much broader and more complex. It is no
overstatement to say that the strong, unexpected worldwide synchronicity of the sharp
global decline in real activities after the Lehman shock was caused mainly by global
financial factors and that the latter are of increasing importance for national and global
business cycles. Global monitoring of international capital flows could therefore
significantly deepen our knowledge of the dynamically changing interdependencies
between the financial and the real sphere of the economy. This in turn would provide
valuable information for improving the integration of changing financial structures,
including prevalent assumptions about the behaviour of globally active banks and
institutional investors, into macroeconomic models.
A further lesson to be drawn from the financial crisis is that most financial (soundness)
indicators and early warning systems failed to send reliable early warnings of the build-up
of distortions or severe tensions in the financial system. Despite the fact that many
financial institutions raised warnings or issued critical assessments of the sustainability of
sector-specific developments, there were hardly any reliable indications of the dynamics
of potential contagion, the possible channels through which shocks could be transmitted,
and the weakness of complex financial structures. Global monitoring of international
flows could facilitate or support the required restructuring of early warning systems. A
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 57
better knowledge of investor strategies and rebalancing activities would complement or
support these efforts and enhance the effectiveness of early warning indicators.
Moreover, improved global monitoring could also support various vulnerability exercises.
The financial crisis has shown very clearly that even EMEs which have sound
macroeconomic conditions and have been successful in strengthening their regulatory
framework were nevertheless heavily affected by at least the first wave of the crisis.
Global financial factors, in particular the strategic behaviour of globally active banks and
institutional investors, can contribute significantly to explaining the vulnerabilities of
EMEs under the changed financial environment. The increasing importance of this
argument is underlined by a recent empirical study by Turner (2009), which has drawn the
conclusion that although macroeconomic stability is without a doubt an important factor,
macroeconomic factors during the global financial crisis were of no significance with
regard to sudden stops or the outflow of liquidity. In other words, macroeconomic factors
hardly made a difference. Other empirical studies, such as Didier, Love and Martinez
Peria (2010), concur that the main channel of transmission during the global crisis was
financial. Even when all the hurdles and restrictions of empirical studies are
acknowledged, the challenge is clear. An improved system of monitoring would deepen
our knowledge of the implications of a deeper integration of EME financial markets into
the world economy (CGFS 2009).
In addition, an improved global monitoring system would be instrumental for improving
regulatory frameworks. Greater transparency of international capital flows is a necessary
pre-condition for creating the most effective regulatory framework, targeted regulation,
and the best kind of regulatory measures. Last but not least, global monitoring could help
shorten the time lag between recognising a build-up of financial distortions, the emergence
of a financial crisis, and data needs.
“Optimal” assignment of roles
We must also evaluate an appropriate assignment of roles in monitoring capital flows and
global liquidity on a global, regional and national level. This is all the more necessary
against the background of the changing institutional environment, with recently created
institutions such as the European Systemic Risk Board (ESRB) or the ASEAN+3
Macroeconomic Research Office (AMRO), each of which issues its own assessments of
financial stability.
The main criterion for clarifying the assignment of roles is the question of which
institution has a comparative advantage. On a global level, the International Monetary
Fund (IMF) has a clear comparative advantage, in particular with regard to the monitoring
of financial structures, financial innovations, changing global transmission channels,
response patterns, and the vulnerabilities of countries. Considering the primacy of crisis
prevention, an improvement in surveillance, monitoring and deepened analysis are not
only significant elements of a New Financial Architecture but should also be the most
relevant elements of the IMF mandate in the longer term. It is important to have an
institution which focuses on the ongoing monitoring of changes in the financial
transmission channel. Monitoring might also have hidden potential for gaining better
insights into the most relevant changes in the financial transmission channel and
shortening the time lag between the first financial shock and targeted measures to contain
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
58 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
contagion and spillover effects. I share the growing view among economists that we will
never have a perfect model and all necessary prospective information needed to make
accurate assessments; nevertheless, the disparity between models and reality has currently
become too great.
The IMF should closely cooperate with the Bank for International Settlements (BIS),
using its extensive database and knowledge of global banking activities. It is important to
ensure an independent assessment, analysis and formulation of policy implications; this
might be primarily discussed and translated into action by the Financial Stability Board.
The IMF should also seek to intensify or build cooperation with regional bodies such as
the ESRB and the EU Commission in Europe, or AMRO in East Asia, to benefit from the
comparative advantages of regional institutions such as better knowledge of the respective
region or greater proximity to national regulatory authorities in the region (cf. McKay /
Volz / Wölfinger 2011).
Capital flow management – G20 recommendations, experiences and further challenges
The G20 countries discussed the challenge of Capital Flow Management (CFM) under the
French G20 Presidency in 2011 (cf. G20 Finance Ministers and Central Bank Governors,
2011). The significance of drawing “coherent conclusions from country experience”
should not be underestimated, since enhancing financial stability in the ongoing process of
financial globalisation is a long-term challenge. This is particularly true with regard to the
growth of global capital flows and its implications for financial stability.
At its core, the capital flow problem is not pre-dominantly a cyclical phenomenon or a
reflex response to the financial crisis and current conditions of excess global liquidity.
Institutional investors themselves emphasise that it would be an oversimplification to
blame accommodative monetary policies in advanced economies. Furthermore, they
acknowledge that the problems of capital flow volatility will not be overcome with a more
normal monetary stance in the US, Japan or on the part of European central banks.
To a considerable extent, strong and volatile capital flows are a long-term, structural
challenge and are part and parcel of the “New Normal”, a situation characterised by
globally acting investors and an increasing weight of EMEs in the world economy. The
dimension of this New Normal was reinforced by a recent study of the Bank of England
which forecasts that by 2050 more than 40% of all external assets will be held by the
BRIC countries, up from a current 10% (Speller / Thwaites / Wright 2011, 3).
From the perspective of a central bank, the main objectives of capital flow management
should be to enhance national and global financial stability, provide protection on the
fringes of monetary policy, strengthen the robustness of the financial system, and secure a
free flow of capital. Therefore it is worth emphasising that the G20’s “coherent
conclusions” also imply that macroeconomic stability should be the first line of defence,
since macroeconomic stability has proven to be the most effective way of dampening
capital flow volatility. A further set of measures should focus on enhancing the stability
and shock absorptive capabilities of financial systems by means of macroprudential
measures. And as a more medium,o-long-term strategy, countries should develop and
deepen their domestic financial markets, in particular bond markets. I fully agree with
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 59
colleagues at the Bank of England that the problem of “missing markets” is one of the
most important challenges ahead (cf. Bush / Farrant / Wright 2011).
According to the “coherent conclusions”, capital controls should be only temporary,
transparent, and targeted to dampen risks which might endanger financial stability. Capital
flow management measures should not delay necessary macroeconomic adjustment or try
to keep exchange rates at unsustainable levels. Germany’s experience with controls on
capital transactions in the 1960s and 1970s showed that these measures were unsuccessful
in stabilising exchange rates and safeguarding a primarily domestically oriented economic
policy against external influences. An ongoing convergence of approaches among
different countries could further help to dampen capital flow volatility.
Bibliography
Braasch, B. (2010): Financial market crisis and financial market channel, in: Intereconomics 45 (2), 96-105
Bush, O. / K. Farrant / M. Wright (2011): Reform of the international monetary and financial system,
London: Bank of England (Financial Stability Paper 13)
CGFS (Committee on the Global Financial System) (2009): Capital flows and emerging market economies,
Basel: (CGFS Paper 33)
Didier, T. / I. Love / M. S. Martinez Peria (2010): What explains stock markets’ vulnerability to the 2007-
2008 crisis?, Washington, DC: World Bank (World Bank Policy Research Working Paper 5224)
G20 Finance Ministers and Central Bank Governors (2011): G20 coherent conclusions for the management
of capital flows drawing on country experiences: Paper endorsed by G20 Finance Ministers and Central
Bank Governors, 15 October; online:http://www.mofa.go.jp/policy/economy/g20_summit/2011/pdfs
/annex05.pdf
González Rozada, M. / E. Levy Yeyati (2006): Global factors and emerging market spreads, Washington,
DC: Inter-American Development Bank (Research Department Working Paper 552)
McKay, J. / U. Volz / R. Wölfinger (2011): Regional financing arrangements and the stability of the inter-
national monetary system, in: Journal of Globalization and Development 2 (1), Article 1
Speller, W. / G. Thwaites / M. Wright (2011): The future of international capital flows, London: Bank of
England (Financial Stability Paper 12)
Turner, P. (2009): How local currency bond markets in EMEs weathered the financial crisis?: paper
presented at the 2nd International Workshop on Implementing G8 Action Plan “Lessons of the crisis
and progress made in developing local currency bond markets in EMEs and developing countries”,
Frankfurt am Main, 12–13 November; online:http://www.bundesbank.de/finanzsystemstabilitaet/fs_
dokumentation_konferenzen.en.php

Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
60 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
Global liquidity and the Brazilian economy
!

Renato Baumann
Since the early 1980s, a liberalisation of financial markets world-wide has led to a process
that is commonly referred to as financial globalisation. More flexible rules were applied to
new financial agents, and new types of financial instruments were created, allowing the
emergence of large globally operating investment banks and the development of a shadow
financial sector, with financial firms that were not subject to the strict norms which were
traditionally mandatory for commercial banks. Moreover, international liquidity has
boomed since the beginning of the 1980s. The figures are quite impressive (cf. Palma
2011): between 1980 and 2007 the stock of global financial assets increased ninefold in
real terms, reaching USD 241 trillion, or 4.4 times the world output. From 1997 to 2007
the number of over-the-counter derivative contracts involving credit default swaps jumped
170-fold, with the amounts involved reaching 11 times the value of global output. At the
same time, between 1990 and 2007 the total number of hedge funds and funds of funds
grew from 610 to nearly 10 thousand, with assets of nearly USD 2 trillion.
Where have all these resources gone? In some countries – typically the East Asian
economies – the increased availability of international resources was used to complement
domestic savings in financing a high investment rate. Other countries, like several Latin
American economies, have absorbed a good deal of these resources while keeping their
investment rates relatively low, so that most of this additional liquidity was driven towards
consumption. This made them vulnerable when external financing dried up, leading to a
series of debt and currency crises in Latin America in the 1980s and 1990s. As the
sovereign debt crisis that erupted in Europe in 2010 has shown, several (mostly Southern)
European countries also used inflowing capital resources for debt-fuelled consumption or
non-productive investment.
The availability of a significant amount of fresh resources, coupled with increased degrees
of freedom in financial innovation and the mushrooming of new financial agents, have led
to a self-feeding process in which higher liquidity has fostered new businesses; the
resulting higher income has motivated higher prices of stocks and assets, and this has
stimulated yet other financial operations, in some cases mixing and disguising good and
bad credits. This process was given the “green light” by credit risk rating agencies, hence
being perceived as safe and sound, and involved additional agents, such as insurance
companies, to cope with the risks of credit default. At the same time, several multilateral
agencies recommended opening up capital accounts so that the countries could benefit
from this huge new wave of opportunities. With hindsight, the scenario comprised all the
required components for a huge financial bubble.
Problems started to emerge when the business cycle in the major economies lost its
dynamism and several agents started to experience difficulties in paying for their
operations. Thus in 2007 a set of difficulties showed up in the housing sector in the US,
but bigger surprises followed from the – until then unsuspected – degree of involvement
of the banking sectors in other countries in these operations. A second, even more

! Opinions here are my own and do not necessarily correspond to the position of the Institute of Applied
Economic Research or the Universidade de Brasília.
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 61
worrying set of surprises followed when it became clear that the payment difficulties were
not restricted to the private sector but also comprised the sovereign debt of a number of
Western European countries. 2010 is seen, therefore, as the starting point of a second,
more worrisome wave of the financial crisis.
Whereas Latin American countries experienced huge capital outflows during the global
financial crisis of 2008–09, international lending started to resume in 2010. As a response
to the global financial crisis, unprecedented amounts of liquidity were created by the
world’s major central banks. The surge in global liquidity led to large inflows of capital to
emerging countries, including those in Latin America. These capital flows gave rise to
harsh criticism, especially vis-à-vis the Federal Reserve, which was accused of using
expansionary monetary policy to force a devaluation of the US dollar and threatening
financial stability in emerging countries.
However, the turbulences in Europe have also started to affect capital flows to Latin
America, which according to recent World Bank data saw an estimated decline of 12.6%
in overall net capital inflows in 2011 (World Bank 2012). Portfolio inflows fell by an
estimated 60% in 2011. Foreign direct investment (FDI), which is less volatile than other
financial flows and accounts for a large proportion of financial flows to Latin America,
remained resilient
30
. But the 29% growth of net FDI inflows to the region in 2011 is still
markedly lower than the 43% growth in 2010.
The still unresolved situation in the euro area is likely to result in low output growth in the
coming years, as well as less availability of resources worldwide. This raises the question
of what could be the actual impact of this new situation for other regions, such as Latin
America, which has experienced a significant inflow of resources (USD 1.6 trillion) in the
period 1990–2010, according to Palma (2011).
As far as the relation with the euro area is concerned, several Latin American economies
have benefitted in recent years from the liquidity of the euro market, as well as from the
inflow of direct investment of European origin. In broader terms, there have been
significant gains stemming from the boom in commodities prices, as well as from the
increase in exports to Asia, particularly China.
This means that the present European problems might affect Latin America through (at
least) three channels: a reduction of credit lines (which might affect export credit), a
reduction of FDI flows, and fewer trade opportunities. The latter aspect is related not only
to direct Latin American-European trade, which might suffer from fewer imports by
European countries: a major concern is also the extent to which the overall fall in
European imports might affect the dynamism of the Chinese economy, a major importer
of Latin American products. The external equilibrium of several Latin American
economies depends in great part directly on their export performance to China.
Among the most obvious characteristics of the inflow of resources in the Brazilian
economy in recent years is a boom in FDI, reaching USD 69 billion in 2011 (an increase
of 32% over the previous year, corresponding to 2.7% of GDP) as well as the fact that
most of this investment is directed to the service sector, whose share in total inflow of FDI

30 Regional data have been largely influenced by Brazilian figures.
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
62 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
went up from 28% in 2010 to 46% in 2011. This is the counterpart of a number of factors,
among them the ample availability of international liquidity on the lookout for investable
projects, the lack of better investment opportunities in OECD economies, and specific
features of the Brazilian economy, namely the improvement in income of lower
population strata as well as the perspective of business opportunities related to deep-sea
oil production, the 2014 World Cup, and the 2016 Olympic games.
An inflow of such magnitude, when directed to non-tradable sectors, often affects asset
prices. As a matter of fact, the housing price index increased by 7.8% and 7.5% in 2010
and 2011 respectively, whereas the national wholesale price index varied only by 5.9%
and 6.5%. This took place parallel to a GDP increase of 7.5% in 2010 but only 2.9% in
2011. This clearly indicates an asset bubble.
Another effect of this massive inflow of resources is the overvaluation of the exchange
rate: between 2007 and 2010 it is estimated that the Brazilian real accumulated an
overvaluation of 18.5% against the US dollar and 16% against a basket of 13 other
currencies, according to FUNCEX (2011). This has had a clear effect on the export sector,
with export performance becoming increasingly dependent on agribusiness while the share
of manufactures drops. This in turn led Brazilian authorities to relate the lack of export
competitiveness to proactive exchange rate policies of other trade partners and to blame
the monetary authorities of OECD economies (the US in particular) for their lax monetary
policies.
The central aspect of the crisis, namely fiscal/financial disequilibrium, has affected foreign
portfolio investment. The net inflow of portfolio investment in Brazil came down from
USD 63 billion in 2010 to USD 25 billion in 2011 (BCB 2012). And even though Brazil
has adopted one of the highest interest rates in the world, foreign investment in
government bonds was more than halved, from USD 30 billion to USD 11 billion over the
same period. At the same time, profit remittances increased from USD 30 billion in 2010
to USD 38 billion in 2011, as subsidiaries had to provide resources to their headquarters.
In spite of these movements Brazil can count on a number of alternative policy
instruments hardly found elsewhere. The Brazilian economy presents a quite different
macroeconomic situation than that of economies in the euro area. Net public debt has gone
down from 60% of GDP in the early 2000s to 40% in 2011, much less than the more than
100% observed in several European countries.
In the external sector, total debt accounts for 12% of GDP but is surpassed by total foreign
currency reserves (14% of GDP). The current account deficit is thus only 2% of GDP,
well within the “acceptable margin”. This is in principle a rather comfortable situation.
Domestic credit has gone up from 22% of GDP in 2002 to 47% of GDP in 2011, with
three relevant associated characteristics. First, most of this increase results from credit
provided by public banks, an instrument that proved important in the 2008 crisis. Second,
since the adjustments of the financial sector back in 1995, the Brazilian banking system
has operated with more strict performance criteria than those required by the Basel
Agreements, making it less vulnerable. Third, this movement is parallel to an
improvement in income distribution and to the incorporation of low income strata into the
consumption market.
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 63
These features mean that a good deal of the recent growth of the Brazilian economy is
related to the dynamism of the domestic market. Yet some analysts are worried about the
investment rate being too low at only 18% of GDP since this may lead fairly soon to a
lack of productive capacity and hence inflationary pressure.
At the same time, however, as already said, a good deal of the comfortable situation in the
external accounts follows from the trade surpluses obtained in trade with China and with
other countries in the region. In this environment, what are the policy margins for coping
with an external liquidity crisis?
Brazilian authorities have a number of alternatives at hand: First, in case of a draught on
credit lines, a share of the country’s foreign currency reserves can be used to sustain
export financing (very much as in 2008). Secondly, a lack of liquidity can also be dealt
with by relaxing the compulsory deposit which banks must hold at the central bank
(ranging from 20% over savings deposits to 42% on deposits on checking accounts).
Thirdly, Brazil has attracted unprecedented amounts of FDI, and this provides foreign
exchange inflows that might help to compensate for eventual outflows motivated by an
external crisis. Fourthly, the low level of public debt provides room for fiscal
manoeuvring by the Brazilian government in case of a crisis. Stimulus to domestic
demand can and has been provided via tax reduction. Fifthly, as in 2008, public banks can
be used in order to channel credit into the productive sector. And last but not least, a more
expansionary monetary policy can be adopted by reducing the real interest rate, among
other possibilities.
The major concern relates to current Chinese demand for imports. A fall in Chinese
demand for commodities would not only negatively affect international prices, but would
actually impose a constraint on the Brazilian trade balance, given the relatively low
competitiveness of manufactured exports.
In the medium run, the margin for relying on consumption by the lowest income strata
looks increasingly narrow, and some re-designing of the macro policy will be needed, with
a much higher rate of investment. This will, of course, require a number of parallel
initiatives, comprising adjustment of the fiscal structure, improvement of the
infrastructure, and the supply of a better qualified labour force.
In summary, the present crisis in the euro area is bound to have negative spillover effects
in many other regions. Latin America as a whole is in a special situation in that this is a
crisis generated elsewhere " one which finds the region with a much better system of
macroeconomic administration than before, with improved conditions in terms of income
distribution and a more stable banking sector.
More specifically, the Brazilian economy can count on a number of policy instruments
that have proved to be quite important in previous liquidity crises. The major concern
refers to the trajectory of global trade: a significant slowdown of opportunities would find
the Brazilian economy heavily dependent on commodities for its trade balance and with
less ability to compete in other export sectors.

Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
64 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
Bibliography
BCB (Banco Central do Brazil) (2012): Nota do Setor Externo à Imprensa, 24 January, Brazlia; online:http://www.bcb.gov.br/?ECOIMPEXT
FUNCEX (Fundação Centro de Estudos do Comércio Exterior) (2011): Relatório de Câmbio e Contas
Externas 1 (3), Rio de Janeiro
Palma, J. G. (2011): How the full opening of the capital account to highly liquid financial markets led Latin
America to two and a half cycles of ‘mania, panic and crash’, Cambridge, Mass.: Cambridge University
(Cambridge Working Papers in Economics 1201, Faculty of Economics and the Department of Applied
Economics)
World Bank (2012): Global economic prospects: uncertainties and vulnerabilities, Washington, DC

Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 65
AMRO’s role in regional economic surveillance and promoting regional economic
and financial stability
!

Akkharaphol Chabchitrchaidol
Over the past few years, much debate has focused on the benefits of regional financial
cooperation, given that a global financial architecture in which the International Monetary
Fund (IMF) plays a central institutionalised role already exists. In Asia, developments in
this area have unfolded continuously since the 1997 Asian crisis, while recent events in
Europe have forced those countries to rethink their levels of cooperation and coordination
within the region. Each of these regional financial development processes has been aimed
particularly at helping that region to better tackle economic and financial crises, both by
individual countries and by the region as a whole. In East Asia, regional financial
cooperation was most visible in the setting up of the financial support facility known as
the Chiang Mai Initiative in 2000. In 2010 it was expanded and transformed as the Chiang
Mai Initiative Multilateralisation (CMIM) into a multilateral arrangement among all
ASEAN+3 member countries (as well as Hong Kong, SAR).
Regional arrangements for dealing with global liquidity: putting the cart before the
horse?
José Antonio Ocampo (2010) has broken down the concept of financial cooperation into
four basic components: macroeconomic policy dialogue, economic policy surveillance,
liquidity support during crisis, and exchange rate coordination. While recent troubles in
Europe have further dampened the already weak impetus for exchange rate coordination in
the East Asia region, financial cooperation in East Asia has remained steadfast in pursuing
and strengthening cooperation in the first three areas. This stems from an implicit
understanding that the basis for building confidence to tackle crises is twofold: having the
required funds available for financial support when needed, and having the right
information and policy-making support in place to establish confidence.
In the case of East Asia, finding funds for financial support during crises turned out to be
the simplest component of financial cooperation. This ease was no doubt a result of the
ample foreign currency reserve positions of most ASEAN+3 economies. As a result, the
CMIM’s founders went ahead and put their money on the table, first through a series of
bilateral swaps, followed by a multilateralisation agreement, all the while recognising that
setting up an institutionalised framework for managing CMIM funds would be a
challenging task that would require care, since it would determine how effective the
CMIM remains over the longer term. To prevent this challenge from delaying such a
setup, the CMIM was established in 2010 with a sole commitment: that of creating a
“CMIM Surveillance Unit” with responsibility for monitoring, assessing, and reporting on
the macroeconomic status and financial soundness of all CMIM parties and the possible
occurrence of macroeconomic and financial problems. The surveillance unit would also be
responsible for assisting in timely formulation of policy recommendations. Should the

! The views expressed in this article are the views of the author and do not necessarily reflect the views
or policies of AMRO.
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
66 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
CMIM be called upon for assistance, the unit would also be responsible for ensuring that
lending covenants were met.
The CMIM members recognised early on the difficulty in establishing overnight a credible
surveillance unit which could fulfil these functions. Since building a credible and
workable institutional structure from scratch would take substantial time and resources,
these functions were effectively “outsourced” to the world’s best-recognised provider of
such duties, namely the IMF. Explicitly linking disbursement of even part of the CMIM’s
resources to the IMF was a direct reflection of the CMIM’s lack of in-house mechanisms
for ensuring that loans would be repaid. The link with the IMF, in lieu of the region’s own
surveillance mechanisms, assured observers not only that the issue of moral hazard was
being taken seriously, but also that the CMIM was a viable institution which could assure
lenders that they would see their money again; it did so by ensuring that crisis-afflicted
borrowing countries took proper, remedial policy actions to ensure the repayment of loans,
much in the style of the IMF.
Filling the gap in regional financial cooperation
Behind the scenes, the CMIM members worked to set up what would eventually become
the groundwork for the CMIM’s institutional framework in the form of the ASEAN+3
Macroeconomic Research Office, or AMRO. In early 2009, the ASEAN+3 finance
ministers announced at a Special Meeting in Phuket that the regional surveillance
mechanism would need strengthening to be robust and credible enough to facilitate
prompt activation of the CMIM, specifically through the establishment of an independent
regional surveillance unit to promote objective economic monitoring. In their statement,
the finance ministers also explicitly conditioned a delinking of more than the current 20%
from the IMF until “[a]fter the above surveillance mechanism becomes fully effective in
its function” (ASEAN+3 Finance Ministers 2009).
The ultimate goal of AMRO, as mandated in the agreement for setting up the CMIM in
March 2010, was to create a surveillance mechanism that would keep track of the
economic and financial soundness of members, assist in making policy recommendations,
and continue monitoring after CMIM funds were disbursed. In order to circumvent the
administrative, bureaucratic, and legal hurdles of 14 economies which would be required
to set up AMRO as an international organisation, AMRO was established in April 2011
and registered in Singapore as a research office with the legal status of a Limited
Company. Setting up this temporary incarnation while the hurdles toward transformation
into an international organisation were being worked through would allow AMRO to
begin functioning immediately. Its quick setup from scratch is a testimony to the
ASEAN+3 members’ political determination to set up a working institutional framework
as soon as possible. It also reflects the dynamism and political will to achieve tangible
milestones in regional financial cooperation in times of urgency, rather than being mere
symbolism and watered-down resolve, as some critics have noted.
A unique role and place in regional surveillance
Although linkage with the IMF is in place to ensure efficiency of disbursement, CMIM
members have gone to great lengths to point out that AMRO does not aim to duplicate the
surveillance functions of the IMF. AMRO is expected to leverage its regional advantages
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 67
and capabilities in macroeconomic surveillance and monitoring, particularly its ability to
understand the idiosyncratic challenges facing countries in the region from a home-grown
perspective.
Two key features of AMRO’s regional surveillance are apparent. Firstly, AMRO plays a
unique role in the ASEAN+3 surveillance mechanism through its participation in the
ASEAN+3 Economic Review and Policy Dialogue process. This process, with its closed-
door meetings, provides ASEAN+3 countries with a platform for peer review, dialogue,
pressure, and cooperation. It allows a tightly-knit group of senior officials in the region to
search for and find ways of addressing the most pressing economic and financial issues,
both at the domestic and regional levels. Sharing experiences and enhancing the
understanding of other members’ problems and their responses to various issues have been
a basic part of these gatherings.
Secondly, AMRO’s own setup, with a staff of professionals from the region, ensures
greater understanding of the financial and fiscal constraints and prospects of the members.
AMRO can draw upon the benefits of being both small and in touch with the region
through its close contact with stakeholders and member authorities. This setup has placed
AMRO in a unique position, with close and direct access to the top economic policy-
makers in the region. In the past, these high-level meetings culminated in a finance
minister-level meeting which from 2012 onwards will be transformed into more
encompassing meetings between the finance ministers and central bank governors.
Beginning in 2011, AMRO has participated in these meetings as an advisor, consultant
and stakeholder. The greater sense of ownership by members of AMRO in the region also
helps to foster this special relationship between AMRO and the ASEAN+3 countries.
It is worth noting that a special relationship does not necessarily translate into a “cosy”
one. One of the most crucial aspects of AMRO’s surveillance is its independence from
authorities. From the start, AMRO was established as an independent entity with no
strings to any existing institution or any government office or ministry. AMRO’s core
team members are full-time staff that are independently sourced and not seconded from
member countries. While close collaboration with the IMF, Asian Development Bank, and
other international financial institutions is welcome, AMRO’s surveillance is conducted
independently of the surveillance work of other institutions.
Achieving effective surveillance
AMRO’s approach to regional surveillance is indeed different in many ways from the
IMF’s approach. Keeping in mind that one of the means of effective surveillance is
through collective pressure, AMRO’s approach is through peer pressure rather than public
pressure. AMRO’s discussions with authorities of member countries are limited to
confidential advisory services within the group, and do not consist in pointing out
potential problems to the public at large. In the current context, not publishing reports and
surveillance results can create benefits by permitting a more comprehensive exchange of
views and perspectives between the AMRO team and the members’ economic
policymakers and technocrats, thus preventing issues from becoming politicised. This
makes authorities more likely to be open to comments and criticisms. Furthermore, non-
publication does not imply a lack of transparency among the members, and does not
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
68 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
preclude or prevent AMRO from performing straightforward and frank assessments within
the confines of its own membership.
Members need to be comfortable with the surveillance unit; the surveillance unit in turn
needs to build trust and credibility and to engage with the authorities closely even in
normal times. Being a small, tightly-knit group makes it possible for AMRO to focus
surveillance on all members evenly at all times and to engage constructively with
authorities on an on-going basis. In this way, AMRO hopes to build trust over time. This
would be more difficult in larger institutions, where focused engagement with any
particular country tends to develop only when that country is in crisis.
Helping the region cope with macroeconomic challenges
AMRO was established to facilitate analysis of economic and financial conditions both
regionally and in individual economies. Its regional context and overview across the
membership helps illuminate the effect of external shocks on both the region and its
individual economies without obscuring variations in each country’s circumstances and
experiences.
As a regional institution, AMRO’s role is to take a region-wide view of risks and their
implications. For example, in analysing shocks, it is necessary to understand how they
affect our largest members, Japan and China (who together account for close to 80% of
the region’s GDP), and also to understand how developments in these two economies
affect other members. We need to recognise that these transmissions can be complex,
given interlinkages through trade and production, as well as through the banking and
financial channels within the region itself.
Where possible, AMRO needs to provide policy recommendations for national policies as
well as on how to take joint action on issues affecting the region as a whole. That is,
AMRO’s mission is to recommend cooperative action where needed, either with or
without calling upon the CMIM. In the latter case, AMRO needs to continue to build up
its capacities and to establish credibility for its own lending conditionality, independent of
IMF programmes, in order to assist in crisis resolution.
It is worth noting that both the members and the public in general should have realistic
expectations of what AMRO can achieve within a reasonable period of time. Discussions
over the past year have reflected high expectations for AMRO, not only in its core
function of conducting effective regional economic surveillance, but also in becoming a
strong, permanent CMIM secretariat that might eventually manage liquidity support to
member economies in times of turmoil. More ambitious plans are being discussed for
creating new instruments and increasing the pool of funds, all of which would remain
reliant on AMRO’s analyses, recommendations, and even management. The risk, then, is
of stretching AMRO’s resources too thinly before its capacity is ready.
Going forward: AMRO and regional financial cooperation
One important lesson that East Asia may have learned through the gradual process of
ever-tighter financial cooperation since the 1997 Asian crisis – a lesson reaffirmed in the
recent Euro-area crisis – is that financial cooperation, rather than coordination, is the way
Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) 69
forward. It may be unrealistic to discuss policy coordination until the basic surveillance
mechanisms and a culture of peer review and constructive criticism are more widely
accepted. Recent attempts in large international fora and their limited success in achieving
transnational policy coordination – as a means of bringing about global rebalancing, for
instance – further indicate that policy coordination is difficult to swallow for any country,
given the heterogeneous nature of international institutions and members.
In view of increasing uncertainty in the ASEAN+3 region in 2012, triggered among other
things by debt problems in Europe and the US, the increasing volatility these problems
bring to Asian markets, and the greater risk of shocks, timely and effective region-wide
surveillance is becoming increasingly important as a means of gauging effects and
remedies on individual economies. Given policy risks both within and beyond the control
of members, or potential system-wide shocks such as currency wars, beggar-thy-
neighbour policies, or unforeseen tail events, cooperation will be crucial as we go forward
to prevent us from ending up in lose-lose outcomes which may otherwise prevail. This
will depend upon successfully building strong institutions for providing the groundwork
for regional cooperation and managing and following through. Both by bringing such
issues to the table and coordinating cooperative outcomes, AMRO is in a unique regional
position to point out the risks and facilitate agreement on how to address such challenges.
It can help prevent the region from reaching an uncoordinated but destabilising
equilibrium where all parties are worse off.
Bibliography
ASEAN+3 Finance Ministers (2009): Action plan to restore economic and financial stability of the Asian
region, Joint media statement by ASEAN+3 Finance Ministers at the special AFMM+3 meeting in
Phuket, Thailand, 22 February; online:http://www.aseansec.org/22158.htm
Ocampo, J. A. (2010): The case for and experiences of regional monetary co-operation, in: U. Volz / A.
Caliari (eds.), Regional and global liquidity arrangements, Bonn: DIE (E-publication), 24–27

Financial stability in emerging markets: dealing with global liquidity Ulrich Volz (ed.)
70 German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)
Authors
Renato Baumann, Senior Fellow, Institute of Applied Economic Research, Brasilia &
Professor of Economics, Universidade de Brasília
Bernd Braasch, Director, Financial Stability Department, Deutsche Bundesbank,
Frankfurt am Main
Akkharaphol Chabchitrchaidol, Economist, ASEAN+3 Macroeconomic and Research
Office, Singapore
Menzie D. Chinn, Professor of Public Affairs and Economics, Robert M. La Follette
School of Public Affairs, University of Wisconsin, Madison
Ralph de Haas, Deputy Director of Research, Office of the Chief Economist, European
Bank for Reconstruction and Development, London
Marcel Förster, Research Assistant, Chair of Monetary Economics, Justus-Liebig-
University Giessen
Kevin P. Gallagher, Associate Professor of International Relations, Department of
International Relations, Boston University
Jo Marie Griesgraber, Executive Director, New Rules for Global Finance Coalition,
Washington, DC
Stephany Griffith Jones, Financial Markets Programme Director, Initiative for Policy
Dialogue at Columbia University, New York
Markus Jorra, Research Assistant, Chair of Monetary Economics, Justus-Liebig-
University Giessen
Anton Korinek, Assistant Professor of Economics, Department of Economics, University
of Maryland, College Park, MD
Y. Venugopal Reddy, Emeritus Professor of Economics, Department of Economics,
University of Hyderabad
Peter Tillmann, Professor of Monetary Economics, Justus-Liebig-University Giessen
Ulrich Volz, Senior Researcher, DIE, Bonn & Visiting Professor of Economics, School of
Economics, Peking University, Beijing
Feng Zhu, Economist, Monetary and Economic Department, Bank for International
Settlements, Basel

doc_387984842.pdf