Chair:

Benu Schneider, ODI.
Speakers:

Anh-Nga Tran-Nguyen, UNCTAD.

Avinash Persaud, State Street Bank.

Private capital flows: Stable or not?
Anh-Nga Tran-Nguyen

1. Ms Tran-Nguyen argued that with globalisation, the international financial system has become private sector-driven. The nature of private capital flows has changed in the 1990s, with foreign direct investment (FDI) and foreign private investment (FPI) playing a more important role than syndicated bank lending. Widespread removal of barriers to foreign investment, falling transportation and communication costs have allowed trans-national corporations (TNCs) to globalise their production across countries. FPI, another important component of last decade's private capital flows, is increasingly channelled to emerging markets by institutional investors. Together, TNCs and institutional investors control increasingly large amounts of assets that they can move around globally in search of high profits. The predominant role of the private investors in the allocation of financial and productive assets is now a permanent feature of the world economy.

2. According to Ms Tran-Nguyen, the result of these developments have been:

(i) The distribution of international resources has become more unequal. While a small number of emerging market economies have access to private sources of finance, the majority of developing countries have to rely mainly on dwindling aid money.

(ii) Countries have lost much of their policy autonomy. Macroeconomic policies (e.g. interest rate policy) are increasingly dictated by international financial markets. TNC's resource flows influence local markets and policies.

(iii) Financial markets have become more competitive, both on the lending and the borrowing side.

(iv) Volatility is an inherent feature of the international financial system. Massive inflows of private capital into emerging markets are frequently followed by sudden reversals. Crises ensue, e.g. Mexican 1994, Asian 1997, Russian 1998. Recent crises have tended to be shorter compared to the debt crisis in the 1980s, due to the higher share of FDI and portfolio equity flows, which are more stable than bank lending, and equity tends to flow back into the crisis-countries while asset prices are low. However, there is also a systemic threat in portfolio investment if investors, such as hedge funds, are highly leveraged and rely on bank loans to finance their investments.

3. Ms Tran-Nguyen stated that this situation has brought a number of challenges for developing countries, namely:

(i) How to achieve a more equal distribution of resources among countries and expand the reach of FDI to more low-income countries?

(ii) How to maximise the development impact of private flows, and FDI in particular?

(iii) How to reduce the volatility of private flows?

4. The Report of the Secretary-General on Financing for Development contains a number of recommendations, which Ms Tran-Nguyen believes address these challenges:

(i) The expansion of private resource flows to lower-income countries will need a more pro-active approach to public/private partnership to facilitate the flow of information about investment opportunities, to invest in basic infrastructure, and to reduce the initial cost entailed by pioneering investment in poor countries.

(ii) Provision of information about investment opportunities in their own markets by developing countries; financial and fiscal support to outward investors, insurance schemes, etc

(iii) The encouragement of the transfer and dissemination of technology (the developmental impact) of FDI, the generation of employment, etc, while minimising the negative effects that can be associated with FDI (anti-competitive practices, erosion of tax-base, etc)

5. Ms Tran-Nguyen concluded with some policy recommendations for addressing the volatility of private flows:

(i) In order to reduce the risks of external shocks, developing countries' governments need to strengthen their regulatory and institutional framework, put in place prudential and supervisory regulations together with enforcement rules (adoption of international standards in relation to bank supervision and regulation, information disclosure and transparency, accounting and auditing practices, insolvency codes). However, developing countries may find it difficult to comply with these requirements and may need a special and different treatment. Moreover, source countries should share responsibility in ensuring financial stability (e.g. via effective co-ordination of macroeconomic policies of major capital exporting countries) and in channelling more resources to those countries which are most marginalised.

(ii) Governments should also be as selective in the types of capital flows they want to attract, and integrate policies on capital flows and foreign investment within national development strategies.

(iii) Liquidity needs to be managed actively in recipient economies. Governments should retain the right to apply disincentives or controls on capital flows, particularly short-term flows, in times of capital surges or during severe crises.

(iv) Credit rating agencies play a critical role in channelling information, which forms the basis of investors' decisions regarding where to invest and the pricing of their investments. Concerns have been raised about the pro-cyclicality and contagion sensitivity of sovereign ratings by credit rating agencies. The Secretary-General Report encourages credit rating agencies to rate sovereign risk according to criteria that are as objective and transparent as possible. Borrowing developing and transition economies are also encouraged to give priority to the development of reliable local systems of credit information.

(v) At the international level, the reforming of multilateral institutions is still an open debate.

Are foreign direct investment flows really less volatile than portfolio and bank flows?
Avinash Persaud

6. Avinash Persaud's presentation focused on the growing importance of equity flows and the characteristics of equity flows versus bond flows.

7. Mr Persaud concluded that the recurrent suggestion that emerging markets should eschew portfolio flows and focus mainly on FDI flows because of the lower degree of volatility of the latter is not supported by his study. He argued that equity flows should be encouraged together with FDI flows. Bond flows, in contrast, represent the most volatile form of portfolio flows, behaving like bank-lending flows. This occurs because of the common interest of those investors in the conservation of their capital, which makes them pull out if, for example, they fear currency devaluations. Therefore, the benefit for developing countries of following the G7-IMF suggestion of deepening bond markets is highly questionable. On the other hand, equity investors are interested in the long-term evaluation of the enterprise they have invested in. Particularly in cases where investors own a slice of a real asset, especially if the asset is placed in the external sector of a foreign country (e.g. an Indonesian oil-well) earning revenues in hard currency, they are less prone to step suddenly out of their investment.

8. Rather than introducing convoluted changes to bond contracts, a more effective way of ensuring private sector participation and burden sharing would be to encourage the deepening of equity markets in emerging markets.

Mr Persaud's conclusions were based on the following analysis:

9. Globalisation during the last 10 years has been much stronger in terms of cross-border portfolio flows than in trade flows. In terms of GDP, the former is now six times higher than the latter.

10. Since the mid-nineties, the equity-bond ratio has risen considerably. Until less than a decade ago, the importance of equity and bond markets generally lay in the domestic and international respectively. This was also indicated by the 'bond-friendly' ECB-constitution, which was written in the mid-nineties and reflected the emphasis at that time on inflation targeting by an independent Central Bank rather than unemployment and growth.

Today, equity flows are higher than bond flows for the first time ever. The composition of international capital flows has changed. In terms of unhedged flows, bond-holders tend to hedge their position while equity holders do not. Today equity flows are twice the size of bond flows.

11. This has led to a change in the evaluation of markets from an emphasis on indicators and aggregates related to currencies in the emerging market world and their current accounts (the real yield etc.) to today's emphasis on equity valuation (e.g. the knowledge base of the economy; the depth and movement of the equity market etc.).

12. The other part of this 'process of equitization of capital flows' is M&A and FDI in general. If one looks at cumulative M&A, debt and equity flows from Europe into the US over the period Jan 1997 to Oct 2000 (source: State Street Bank), one would see a sharp rise in equity flows and M&A. The policy debate is about what flow is best for countries. In the hierarchy of the G7 and IMF, M&A comes first, debt second and equity last. As a result, deepening of bond markets in developing countries is advocated. However, for at least three reasons, the current policy debate is framed incorrectly:

(i) Rather than being in a position where they are able to choose between capital inflows, capital-poor developing countries have to take those flows that they are able to access. Therefore, the policy issue is about the optimal utilisation and management of the flows available.

(ii) Current studies usually lump equity and bond flows together in their analyses of portfolio flows, without taking into account the very different characteristics of these types of capital and the distinct behaviour of their holders.

(iii) The observation that M&A does not seem to be less volatile than equity portfolio flows leads to a departure from the consensus.

In general, M&A and FDI should be encouraged because they entail transfer in knowledge and technology. Nevertheless, other types of capital, such as equity portfolio flows, should not be discouraged. Moreover, the issue about the degree of volatility of cross-border capital flows is rather complex and often difficult to gauge. Retained earnings from FDI investment are usually a strongly volatile component of international capital flows as they are moved according to exchange rate expectations (e.g. South Africa, April 1998).

13. Mr Persaud presented the results of his analysis on capital flows from Europe into the US over the period January 1997 to October 2000. Daily portfolio flow data compiled by State Street bank and daily M&A data from other market sources were used.

Mr Persaud argued that in order to assess the inherent nature of different forms of capital flows, it is necessary to analyse cross border flows among developed countries with large, broad and deep financial markets. In contrast, the disparity in size, depth and features of emerging economies' markets renders an analysis of the inherent nature of capital flows impossible. Indeed, whereas some middle-income countries have very deep markets, other economies, particularly in Sub-Saharan Africa, either possess only extraordinarily thin markets or lack them altogether. Moreover, developing countries' peculiar and disparate characteristics would give a singular and peculiar picture of the underlying nature of capital flows. Therefore, according to Mr Persaud, the correct methodology is to extract sound information from the study of capital flows between developed markets, enabling the provision of valid advice to developing countries on how to make optimal use of capital flows with distinct features.

A comparison of portfolio equity flows from Europe into the US with portfolio debt flows over the period 1997-2000 (monthly data), showed that bond investors reacted more nervously to shocks originated in equity markets (e.g. NASDAQ collapse, April 1999) than equity investors themselves, who appeared to have responded more passively. Moreover, portfolio flows, both bonds and equity, were more volatile during 1999-2000 compared to 1997-1998.

An analysis of the moments of distribution of monthly M&A, debt and equity flows over the same period between Europe and the USA, shows that M&A flows are more volatile than bond flows and the latter are more volatile than equity portfolio flows.

Discussion

14. Capacity building in poor and small economies for creating broader and deeper local stock markets.

Genuine capacity building is necessary and important. Although countries have been building up their stock markets during the 1990s, there is unfortunately a complete lack of liquidity in these markets. At the same time, investors' preference for liquidity has grown considerably, particularly since the crash of LTCM in 1998. Usually, investors display trend-chasing behaviour, leaving when prices start falling and entering while they are rising, but in 1999 overseas investors bailed out from smaller and illiquid emerging markets even when they were doing well (preference for liquidity). In the case of Chile, for example, one third of shares are quoted on the NYSE, while the domestic stock market is highly illiquid and unattractive to investors. A global stock market might emerge in ten years time.

15. How to capture equity flows?

One must ensure that larger local companies can compete in international markets because they are using international accounting standards, prudential controls and governance. Smaller companies cannot do that, so venture capital has to be encouraged, by involving banks in venture capital, with local companies being quoted in foreign markets rather than in the domestic market.

16. Why not an international institution as a credit rating agency?

A credit rating is the transmission of information about a borrower at a certain point in time. As a commercial rating is a private rating on private borrowers it would not be credible if performed by an international financial institution. Nonetheless, the IMF, for example, issues ratings on sovereign borrowers. Although the IMF criticises private agencies because their ratings tend to be procyclical, there is a tendency for convergence of this information. It would not be proper for the UN to intervene in rating-activities because they are private and have to be left to private markets. However, there is problem of oligopoly in the credit-rating market, with 3-4 agencies giving similar ratings. Emerging markets should establish their own credit rating information, which is credible enough to compete with the international rating agencies that provide additional information.

An opposing view presented was that although the credit rating market is essentially oligopolistic in nature, the entering of an 'institutional' rating agency would not break it up. Rather, it would be a case of natural monopoly, where investors want to use a rating agency which everyone else uses, reflecting the consistent view on that corporate credit or country credit. However, international institutions should get involved in credit ratings, since the markets always get ratings wrong. The core of the problem is not a lack of information (which does exist) but that financial markets are ineffective at predicting crises. The question should be why the market chooses to misinterpret or simply not consider certain information. It is here that a non-market institution could help in offering an objective view of credit rating. For example, what is known as 'crony-capitalism' today, was perceived positively as a 'stable political system' before the Asian crisis.

17. Bond market volatility and exchange rate policy.

In South Africa, bond-markets were particularly volatile and represented the main conduit for international contagion, as opposed to equity flows. Probably a structural change took place in South Africa around mid-1998, when the country was hit by a crisis through contagion from Indonesia and Russia. The government spent a considerable amount of foreign reserves in trying to defend the domestic currency but lack of success led to an abandonment of the policy of attempting to maintain a stable exchange rate. A stable exchange rate policy attracts bond flows, while equity investors prefer floating exchange rates, which stimulate competitiveness of enterprises in the host countries. Moreover, bonds are usually domestic currency-denominated assets, while equities of successful exporting businesses (even if not a commodity business) are a hard currency asset and thus more protected. The implication of this line of argument is the avoidance of a pegged or fixed exchange rate regime in the case of countries with large bond markets.

Suggestions were made on the suitability of intermediate exchange rate regimes in some countries.

18. Volatility seems to be over-rated as a problem.

This is especially true if the issue is seen in light of maximising quantities and if one can get the right sort of capital. If quantity rather than volatility is considered, one gets a different answer. The suggestion made was to work at a joint measure, using volatility and quantity.

19. Doubts about interpreting data for Europe into the USA for general conclusions.

Considering the period of the study presented by Mr Persaud, one would probably get different results by considering a longer period (e.g. 10 or 25 years). Further, the period from 1997 onwards, which was the time-span considered, represented a very special time for these two currency areas (US$-EURO).

Moreover, the composition of capital flows of emerging markets and developed countries differ, particularly with respect to equity/bond ratios. Therefore, even if it were true that equities are better than bonds, the choice would actually be between bond and FDI, and such a comparison might give a different answer. The weights on bond, equity and FDI flows would thus be very different in the case of emerging markets. In terms of portfolio theory, there is actually no element suggesting that emerging markets' portfolio flows follow a pattern similar to the flows analysed in Mr Persaud's study.

20. Analysis of composition of capital flows according to their functions.

In the discussion on composition of capital flows, it was felt that more emphasis is needed on the function of different capital flows in borrowing economies e.g. the consumption-smoothing feature of bank lending.