Managing Portfolio Flows
Weller, Christian E., Chaurushiya, Radha, Journal of Economic Issues
Capital account liberalization has been praised as a vehicle for faster growth and rising living standards but also criticized for raising financial instability in emerging economies. Capital account liberalization benefits the financial sector directly through more competition and innovation, lowering the costs of capital and facilitating investment for the nonfinancial sector. Since this should contribute to faster growth and since the incomes of the poor tend to rise with growth, proponents of liberalization conclude that it would help alleviate poverty. However, increased capital mobility has also frequently proved to be destabilizing. Moreover, the benefits of more capital mobility have often been unevenly distributed. Subsequently, poverty reduction has been hampered with unequal growth and growing instabilities. Several institutions may foster more stable growth in developing economies. They include better civil liberties, public support for indigenous banking systems, and progressive taxation coupled with effective tax collection.
Portfolio Flows as Development Tools
Since the early 1990s, many countries have liberalized their capital accounts, followed by booming capital inflows. In 1990, capital movements into these countries netted about $29 billion, which quickly ballooned to a peak of $197 billion in 1996. Portfolio flows turned from a net outflow of $1.8 billion in 1990 to a net inflow of $86 billion in 1996 (IMF 2004). After the mid 1990s, however, capital flows to developing economies began to taper due to a spate of financial crises. Although portfolio flows to developing countries rose again at the end of the 1990s, they have remained, on net, negative since 2001.
The largest recipients of portfolio flows during the last thirty years have been Latin American countries (IMF 2001). The IMF attributed these flows to larger fiscal deficits. Similarly, Asian countries, especially China, have heavily purchased the increasing issues of U.S. treasuries, resulting in an outflow of capital from developing countries to the USA.
Economies can theoretically benefit from more capital mobility. Financial markets could allocate capital to the most efficient uses. Because of large capital constraints, the marginal rate of return to new investments in emerging economies should be greater than in countries with less capital rationing, all else equal. By raising capital mobility, growth should receive a boost.
It is also argued that good macro policies can reduce inherent macroeconomic risks and thereby raise the risk-adjusted rate of return. Thus, capital flows may encourage good macroeconomic policies in the countries that are looking to receive foreign capital. This can prove to be a double-edged sword since this disciplining device also constrains government's ability to conduct countercyclical policies (Blecker 1999).
Portfolio flows may support growth initially. For instance, Levine 1997 shows that increased cross-border portfolio flows in emerging economies help to build capital markets and that capital market developments are linked to growth. Furthermore, the IMF (2001) has concluded that more capital flows can raise investment possibilities, create technology spill-overs, and deepen domestic capital markets. The IMF estimates that greater liberalization is associated with economic growth that is 0.5 percent higher annually. However, Ayhan Kose et al. (2004) concluded in a comprehensive review of the empirical literature that it is difficult to establish causality between financial integration and growth.
The link between capital markets and growth is made over long periods and tends to ignore increasing macroeconomic fluctuations that occur in the mean time. For instance, Christian Weller (2001) established a systematic connection between increased portfolio flows and the incidence of financial crises.
Capital account liberalization can promote poverty reduction because it can foster growth, which is typically equal over the long term (Dollar and Kraay 2001; Weller and Hersh 2004). Also, if greater capital mobility can promote better macroeconomic management and governance, emerging economies should become more stable. Since the poor have less insurance than the rich against the fall-out from crises, more stability should disproportionately benefit the poor.
Typically, only a small section of the credit market will gain access to the additional liquidity from portfolio flows. For instance, only large domestic corporations and the government will have access to the local capital markets. Similarly, international bank credit will likely only be extended to large borrowers that meet specific criteria, for example, minimum size. However, if reductions in financial constraints are limited to specific sectors, greater capital mobility will contribute to income inequality.
Capital account liberalization can come with benefits, but also at the potential cost of rising instabilities (table 1). While private investment and credit markets appear to be larger with greater portfolio inflows, countries also amass reserves as protection against crisis in the face of greater capital inflows. There seems to be little evidence that portfolio inflows are systematically linked to improvements in the distribution of income as the share of income is virtually the same in Latin America, Asia, and Africa with or without large inflows of portfolio investment.
Policy makers need to reduce the adverse effects, while maintaining the potential benefits of capital flows. Hence, they can limit capital flows through capital controls-minimum stay requirements, international transaction taxes, and outright prohibitions-or manage portfolio flows domestically, while reducing the need for more capital through more domestic saving.
Capital controls have their limits. They cannot substitute for sound policies, no single measure can always be effective everywhere, targeted controls leave sufficient room to be circumvented, and the choice of controls is determined by a country's administrative capacity (Ariyoshi et al. 2000). Further, Michael Klein and Giovanni Olivei (1999) have found that developed countries with open capital accounts were also more likely to grow faster from 1986 to 1995 than countries with closed capital accounts, and Hali Edison et al. (2002) concluded that fewer capital controls, among other things, might be associated with faster growth. Faster growth in the short run appears to come at the expense of greater instability. Also, capital controls do nothing to alleviate domestic financial constraints. Furthermore, some capital controls can raise funds but not eliminate the destabilizing force of rapid swings in portfolio flows, such as Tobin taxes (Kitano 2004; Ariyoshi et al. 2000). Hence, to stabilize emerging economies and to lower finance constraints, countries need to consider supplemental policies.
Stabilization can come from strong domestic institutions that can mitigate, if not fully eliminate, growing instability accompanying portfolio flows. Specifically, effective bank level management and sound official supervision should strengthen the stability of emerging financial sectors and market discipline (Barth et al. 2002). Also, sound financial regulation that would result in more asset diversification, more balanced financial structures, and better enforcement of contracts and regulations can help to raise financial stability as risk exposure of banks is limited.
Furthermore, civil liberties and worker rights can create an economy that is less conducive to speculative investments. Better worker rights result in higher productivity growth in the formal economic sector, thus leading to faster growth. Child labor, forced labor, labor market discrimination, and legislation barring unionization or collective bargaining all inhibit productivity growth (Aidt and Tzannatos 2003). In addition, improved worker rights and better civil liberties tend to result in a more equitable income distribution. These benefits tend to be spread beyond the formal labor market just as civil liberties tend to give rise to more redistributive policies and more public investment. As the benefits of faster growth are more evenly distributed, local demand is stronger and more stable (Aidt and Tzannatos 2003). Additionally, Alberto Alesina and Dani Rodrik (1994) pointed out that more equal income distribution is, in and of itself, correlated strongly with improved economic performance. Worker rights, then, help spark a virtuous circle of equality and economic growth. Stronger demand means that supply and growth increase in tandem, rather than supply outpacing demand, thus diminishing default risk and the chance of a crisis. Weller and Laura Singleton (2004) showed that political freedom is an important determinant of financial stability. The evidence also shows that the severity of crises, if they occurred, was muted in countries with better worker rights and civil liberties. After the Asian currency crisis of 1997-98, South Korea fared relatively well in its recovery, while Indonesia fared particularly poorly. Rodrik (1999) and Nora Lustig (2000) found that institutions promoting democratic rights, rule of law, and social safety nets are an important factor in enabling nations to rebound more quickly from economic shocks. Lustig similarly argued that the existence of decent social safety nets is an important crisis-recovery policy a nation can adopt.
In addition to stabilization measures, policymakers should focus on increasing national saving. One way would be to strengthen indigenous financial institutions. Although emerging financial systems have seen the market share of foreign institutions rise, most of the benefits from this development have been concentrated among clients who were already well served, such as multinational corporations, large domestic corporations, and high net worth individuals. At the same time, financial constraints for other markets may actually increase because domestic banks reduce their lending activities to these markets to improve their own costs. To counter this trend, public support could be granted to local banks, where banking services are currently scarce. Public support can come in the form of tax free status, for example, credit unions in the USA; public ownership and thus public guarantees for loans, for example, public savings banks in Germany; or office space for postal savings unions, for example, postal savings unions in Japan (Scher 2001).
Among open countries, larger domestic banking systems seem to go along with fewer capital inflows and vice versa. Among all open emerging economies, in those with large domestic bank ownerships, portfolio inflows totalled 0.6 percent of GDP. In those with small domestic banking systems, portfolio flows totalled 1.0 percent of GDP (table 2). The size of portfolio inflows varies particularly sharply in Asia, the Middle East, and the transition economies of Central Asia and Central Europe. At the same time, the figures also indicate that countries with larger shares of the domestic banking system in the hands of domestic banks tend to have more equitable income distributions (table 2). In all emerging economies with domestic banks holding credit below the median credit market share when portfolio flows exist, the share of income of the bottom 20 percent of households is 4.9 percent, while it is 5.6 percent in countries with domestic banking shares above the median. The difference in income distribution holds for all regions, for which data are available. Thus, there is some evidence that a greater emphasis on developing domestic financial institutions may contribute to fewer portfolio flows and fewer chances of disruptive capital movements and a more equitable income distribution at the same time.
However, as discussed earlier, credit markets in countries with fewer portfolio flows tend to be smaller than in countries with larger portfolio flows. There is some evidence, though, that the size of the nondomestic market share is not systematically linked to the size of the credit market share in general. For all emerging economies, the size of the credit market was on average 54.4 percent of GDP when the domestic credit market share was above the median for all emerging economies and 50.8 percent otherwise. In the Middle East and the transition economies, larger credit markets are associated with greater domestic ownership, while the opposite is true for Latin America and Asia. The difference is negligible in Africa (table 2).
In addition, the efficiency of the tax system could be enhanced. If a government can raise more revenues and do so in a more progressive manner, it has more resources available for public infrastructure investments and for a bigger social safety net, without restricting demand unnecessarily in the short run and building a foundation for faster growth in the future, for example, by investing in health and education.
The success in domestic savings mobilization through more efficient tax collection is a double-edged sword. If improved tax collection leads to a greater fiscal balance, foreign investors will be attracted to an emerging economy, thus possibly increasing portfolio inflows and financial instability. This seems indeed to be the case. Countries with larger fiscal balances appear to attract more portfolio flows and vice versa, with the exception of transition economies (table 2). The solution would be to use some of the additional revenue to enhance other domestic stabilizing institutions, such as local banks and civil liberties.
At the same time that tax collection is improved, the tax structure could be made more progressive. Many tax systems in industrializing countries are substantially less progressive than those in industrialized countries (Schmitt 2003). Increasing the progressivity could help to raise funds. In fact, countries with more progressive taxation indeed have higher revenue relative to GDP, 24.3 percent, than countries with less progressive taxation, 21.9 percent (table 2). The additional revenues that could be raised could surpass developing countries' expenditures on health and education (Schmitt 2003). Importantly, countries with more revenue relative to GDP tend to also have smaller deficits than countries with smaller tax revenues. Thus, the need to import foreign capital should be smaller in countries with more progressive taxation. Countries with more progressive taxation do in fact see smaller portfolio capital inflows than those with less progressive taxation--0.6 percent of GDP compared with 0.9 percent (table 2). That is, tax progressivity appears to breed stronger fiscal balances due to more fiscal revenues and the potential for more financial stability due to fewer portfolio capital inflows.
Developing economies have for the most part taken to the idea that opening their countries to international capital helps them to grow faster. With regard to liberalized capital flows, the record has been clear in showing that although there are indeed benefits to having access to foreign capital, there are also great costs. These costs are most acute when considering short-term portfolio flows, which can quickly be pulled out by foreign investors when they become skeptical about their investments in emerging markets, causing financial crises, crippling economic growth and hindering poverty reduction.
Some economies have played with the idea of returning to some form of capital controls to maintain greater stability in their financial systems. For long-term uses, the need for short-term stability may conflict with the more long-term need for additional capital. To address these potentially conflicting goals, policy makers should not consider capital controls in isolation. Instead, the use of capital controls should be considered carefully in conjunction with other policies to stabilize emerging economies and to mobilize additional savings.
Serious policy options should consider institutional improvements as a way to lower financial instability. Although some research indicates that institutional improvements cannot prevent a financial crisis, they can at least lower the probability of such an occurrence. Institutional reforms can focus on raising more domestic capital and ensuring more efficient allocation of it. Improved bank management and official supervision, sound financial regulation that encourages financial diversification, and implementation of stronger political freedoms, including workers' rights, could help allocate capital to more productive uses and distribute income more equitably. At the same time, improved tax collection and more progressive taxation and the development of local banking systems can help economies raise capital domestically, so that they do not have to depend as much on foreign capital to make necessary investments.
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Christian E. Weller is Senior Economist at the Center for American Progress, Washington, D.C. Radha Chaurushiya is a graduate student in the Graduate School of Business at the University of Chicago. This paper was presented at the annual meeting of the Association for Evolutionary Economics in Boston January 6-8, 2006.
Table 1. Economic Performance in Relation to Portfolio Investment Inflows Latin Total America Middle East PI inflows/GDP 1.1 1.1 1.2 Investment/GDP Total 20.8 20.1 22.3 Above median PI flows 23.9 21.9 21.1 Below median PI flows 21.5 20.6 20.8 Credit Total 34.7 35.9 44.3 Above median PI flows 50.8 46.3 78.9 Below median PI flows 42.4 39.7 77.3 Reserves/GDP Total 14.8 19.7 14.5 Above median PI flows 16.5 11.1 16.9 Below median PI flows 12.5 8.7 14.7 Income share of bottom 20% Total 5.8 4.1 5.6 Above median PI flows 5.5 4.1 5.6 Below median PI flows 4.9 3.9 6.7 Transition Asia Economies Africa PI inflows/GDP 1.0 0.6 -0.3 Investment/GDP Total 21.2 23.1 19.8 Above median PI flows 28.3 24.4 19.9 Below median PI flows 24.6 20.6 20.9 Credit Total 37.0 43.4 24.9 Above median PI flows 58.7 44.9 22.9 Below median PI flows 53.1 34.5 28.7 Reserves/GDP Total 13.9 11.7 10.5 Above median PI flows 23.5 14.8 25.5 Below median PI flows 16.8 12.2 15.3 Income share of bottom 20% Total 5.9 8.8 4.1 Above median PI flows 5.4 7.8 3.9 Below median PI flows 5.5 6.9 3.8 Notes: "PI" denotes portfolio investments. All figures are in per cent. All figures are weighted averages with the real dollar GDP for each region as the respective weight. Calculations for totals include all observations for emerging economies. For comparative analysis, only observations are considered when portfolio inflows are present. Median portfolio flows relative to GDP are calculated only for emerging economies. Authors' calculations are based on the IMF, International Financial Statistics, and the UNU/WIDER World Income Inequality Database. Where observations are missing, the share of income for the bottom 20% are calculated based on Dollar and Kraay 2001a. Table 2. Statistics on Domestic Saving Mobilization in Emerging Economies Latin Middle Total America East PI flows rel. to GDP with dom. credit 0.6 1.0 0.3 market share above median PI flows rel. to GDP with dom. credit 1.0 0.9 1.5 market share below median Inc. shares of bottom 20% with dom. 5.6 3.9 -- credit market share above median Inc. shares of bottom 20% with dom. 4.9 3.2 -- credit market share below median Credit rel. to GDP with dom. credit 54.4 36.6 96.3 market share above median Credit rel. to GDP with dom. credit 50.8 47.9 45.3 market share below median PI flows rel. to GDP if fiscal balance 0.5 0.4 0.7 is below median PI flows rel. to GDP if fiscal balance 0.7 0.6 1.3 is above median Tax collection rel. to GDP if top rate 21.9 17.9 31.0 below median Tax collection rel. to GDP if top rate 24.3 21.0 34.5 above median Fiscal balance rel. to GDP if tax -3.3 -3.0 -4.9 collection is below median Fiscal balance rel. to GDP if tax -2.4 -2.8 -4.4 collection is above median PI inflows rel. to GDP if top rate 0.9 0.7 1.9 below median PI inflows rel. to GDP if top rate 0.6 0.6 0.6 above median Transition Asia Economies Africa PI flows rel. to GDP with dom. credit 0.5 0.7 0.2 market share above median PI flows rel. to GDP with dom. credit 1.4 1.6 -0.2 market share below median Inc. shares of bottom 20% with dom. 5.8 7.9 5.1 credit market share above median Inc. shares of bottom 20% with dom. 4.9 7.9 3.8 credit market share below median Credit rel. to GDP with dom. credit 55.3 56.9 40.0 market share above median Credit rel. to GDP with dom. credit 74.2 38.5 41.9 market share below median PI flows rel. to GDP if fiscal balance 0.5 1.3 0.1 is below median PI flows rel. to GDP if fiscal balance 0.7 0.8 0.1 is above median Tax collection rel. to GDP if top rate 20.5 29.6 27.5 below median Tax collection rel. to GDP if top rate 18.8 36.2 24.4 above median Fiscal balance rel. to GDP if tax -2.9 -2.9 -5.0 collection is below median Fiscal balance rel. to GDP if tax 1.1 -1.8 -2.2 collection is above median PI inflows rel. to GDP if top rate 0.9 1.4 0.1 below median PI inflows rel. to GDP if top rate 0.8 1.0 0.1 above median Notes: All figures in percent. Authors' calculations based on data from the IMF, International Financial Statistics; IMF, Exchange Rate Arrangements and Restrictions; the Bank for International Settlements, International Financial Statistics, the UNU/WIDER World Income Inequality Database, Fraser Institute's 2005 Economic Freedom Data. Domestic credit is defined as total credit minus MNB credit relative to total credit. The median size of the domestic credit market is determined for all emerging economies that have portfolio inflows. Where observations are missing, the share of income for the bottom 20% are calculated based on Dollar and Kraay 2001a. Too few observations are available for the Middle East. Tax progressivity is determined by the top marginal tax rate.…
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Publication information: Article title: Managing Portfolio Flows. Contributors: Weller, Christian E. - Author, Chaurushiya, Radha - Author. Journal title: Journal of Economic Issues. Volume: 40. Issue: 2 Publication date: June 2006. Page number: 377+. © 1999 Association for Evolutionary Economics. COPYRIGHT 2006 Gale Group.