Domestic Financial Development and International Domestic Financial Development and International Financial IntegrationFinancial Integration
Philip R. Lane, IIIS-TCDWBI Paris Seminar
Capital Flows, Monetary Policy and Current Issues in International Finance
April 2007
2
Introduction
• Two-way interaction between domestic financial development (DFD) and international financial integration (IFI)
• DFD and IFI: complementary versus substitution effects• Policies in relation to domestic financial sector influential in
determining scale and composition of international capital flows• In other direction, foreign investors are pivotal in shaping
evolution of domestic financial sector• Review key conceptual issues• Case studies: (a) China/India; (b) Central and Eastern Europe
3
DFD and IFI: Connections
• DFD: pooling of domestic savings• DFD: creation of domestic financial assets (bank loans; stock
market; bond market; derivatives), to enable activation of investment projects
• Domestic financial intermediaries play central role in IFI (banks, institutional investors, mutual funds)
• Domestic securities markets a key attractor for global investors• In turn, IFI alters scale and nature of domestic financial system
and domestic financial markets
4
Domestic Financial Policies
• Banking system• Stock market• Bond market• FDI• Capital account restrictions on outflows and inflows• Exchange rate regime• Restrictions on domestic institutional investors• Level playing field between domestic and foreign investors?• Regulation/Stability issues
5
The Policy Trilemma
• Pick 2 of 3: monetary independence; fixed exchange rate; international capital mobility
• Trilemma a key constraint in determining domestic financial policies and the level of IFI
• Other major factor: financial stability
6
DFD and IFI: Complements
• In general, natural symbiosis between DFD and IFI• DFD key in maximising gains from IFI• Example: Productivity impact of FDI (Alfaro et al, JIE)• Domestic financial sector the natural ‘gatekeeper’ to channel
external funds to best domestic uses• Foreign expertise helpful in raising efficiency of domestic
financial institutions and markets
7
DFD and IFI: Risks
• Poor domestic regulation and incentive structure can mean that IFI serves to magnify existing distortions, leading to excessivecredit creation and a financial crisis
• Key role of domestic regulatory policies
8
Financial Globalization
More efficient international allocation of capital
Capital deepening
International risk-sharing
The Traditional View
GDP growth
Consumption volatility
Potential Collateral Benefits: Financial market
developmentInstitutional development
Better governanceMacroeconomic discipline
A Different Perspective
The traditional view focuses on the importance of channels through which capital flows could directly increase GDP growth and reduce consumption volatility.
GDP / TFP growth
Consumption volatility
Financial Globalization
Traditional Channels
Financial Globalisation: Macro Impact
9
Threshold Conditions
Financial Globalization
Threshold ConditionsFinancial market development
Institutional Quality, GovernanceMacroeconomic policies
Trade integration
GDP / TFP growth
Risks of Crises
GDP / TFP growth
Risks of Crises
X
Above Thresholds
Below Thresholds ?
Financial globalization leads to better macroeconomic outcomes when certain threshold conditions are met. This generates a deep tension as many of the threshold conditions are also on the list of collateral benefits.
The International Financial IntegrationThe International Financial Integrationof China and Indiaof China and India
Philip R. Lane, IIIS-TCD and CEPRSergio Schmukler, World Bank
11
IntroductionIntroduction
• Motivation a. China and India have increasing share of world GDP and
world trade.b. China and India have also become important players in the
international financial system.
• Goal of the paper Assess how the increasing economic prominence of China and India is reshaping the international financial system.
12
• Analysis – Basic stylized facts on level and composition of international
financial integration (IFI) of China and India– Relate IFI to policies and developments in domestic
financial sectors– Implications
• Impact on the international financial system• Medium-term evolution of the IFI of China/India
13
• Variables of interest: IFI– Gross holdings of foreign assets and foreign liabilities– The equity-debt mix in international balance sheets– Net foreign asset positions
• Variables of interest: Domestic factors– Financial liberalization and exchange rate/monetary policies– Evolution of the financial sector– Impact of financial reform on savings and investment
14
-0.6
-0.5
-0.4
-0.3
-0.2
-0.1
0
0.1
1985 1987 1989 1991 1993 1995 1997 1999 2001 2003
-0.6
-0.5
-0.4
-0.3
-0.2
-0.1
0
0.1
1985 1987 1989 1991 1993 1995 1997 1999 2001 2003
-0.6
-0.5
-0.4
-0.3
-0.2
-0.1
0
0.1
1985 1987 1989 1991 1993 1995 1997 1999 2001 2003
IFI: Net Foreign AssetsIFI: Net Foreign Assets
G7
East Asia
Eastern Europe
Latin America
China
India
15
IFI: Net Foreign Assets, XIFI: Net Foreign Assets, X--sectionsection
-150
-100
-50
0
50
100
6 6.5 7 7.5 8 8.5 9 9.5 10 10.5
GDP per capita, PPP
NFA
to G
DP India
China
16
0.0
0.5
1.0
1.5
2.0
2.5
3.0
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
0.0
0.5
1.0
1.5
2.0
2.5
3.0
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
0.00.5
1.01.52.0
2.53.0
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
IFI: Gross Positions (IFI)IFI: Gross Positions (IFI)
G7
East Asia
Eastern Europe
Latin America ChinaIndia
17
0.0%0.2%0.4%0.6%0.8%1.0%1.2%1.4%1.6%1.8%2.0%
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
GDP Share Trade Share IFI Share
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
IFI vs. IRI (Financial vs. Real)IFI vs. IRI (Financial vs. Real)China
India
18
IFI: Foreign AssetsIFI: Foreign Assets
Reserve and Non-Reserve Assets to GDP
0%20%40%60%80%
100%120%140%160%
1991
1994
1999
2004
1991
1994
1999
2004
1991
1994
1999
2004
1991
1994
1999
2004
1991
1994
1999
2004
1991
1994
1999
2004
China India East Asia Eastern Europe Latin America G7
Reserve Assets Non-Reserve Assets
19
IFI: Foreign LiabilitiesIFI: Foreign Liabilities
Debt and Equity Liabilities to GDP
0%20%40%60%80%
100%120%140%
1991
1994
1999
2004
1991
1994
1999
2004
1991
1994
1999
2004
1991
1994
1999
2004
1991
1994
1999
2004
1991
1994
1999
2004
China India East Asia Eastern Europe Latin America G7
Debt Liabilities Equity Liabilities
20
IFI by ComponentIFI by Component
Top Debt Liability Holders
Top Reserve Asset Holders Top Non-Reserve Asset Holders
Top Portfolio Equity Liability Holders Top FDI Liablity Holders
16.0%21.7%
6.0%
3.3%
34.9%
0% 10% 20% 30% 40%
Others10 Malaysia
9 United States8 Singapore
7 Russia6 Hong Kong
5 India4 Korea
3 Taiwan2 China1 Japan
22.7%
8.6%14.3%
18.5%
0.1%0.6%
0% 5% 10% 15% 20% 25%
Others49 India
23 China10 Ireland
9 Italy8 Switzerland7 Netherlands
6 Luxembourg5 Japan
4 France3 Germany
2 UK1 United States
20.6%14.3%
0.6%0.6%
20.1%
0% 5% 10% 15% 20% 25%
Others24 China22 India
10 Canada9 Netherlands
8 Germany7 Switzerland
6 France5 Ireland4 Japan
3 UK2 Luxembourg
1 United States
31.7%
7.8%22.0%
0.4%
4.1%
0% 10% 20% 30%
Others36 India
10 Spain9 Hong Kong
8 Belgium7 China
6 Netherlands5 Germany
4 UK3 France
2 Luxembourg1 United States
0.3%0.6%
17.0%21.5%
0% 5% 10% 15% 20% 25%
Others32 India
22 China10 Belgium
9 Ireland8 Spain
7 Netherlands6 Japan
5 Italy4 France
3 Germany2 UK
1 United States
21
Composition and Asymmetries, Assets/LiabilitiesComposition and Asymmetries, Assets/Liabilities
Portfolio Equity 0.3 3.4 0.1 9.6FDI 2.2 30.1 1.4 6.7Private Debt 15.6 13.9 2.7 17.9Reserves 37.3 19.2Total 55.4 47.4 23.4 34.3
Table 1a
China India
Composition of Foreign Assets and Liabilities, 2004
Assets Liabilities Assets Liabilities
22
Composition and Asymmetries, Assets/LiabilitiesComposition and Asymmetries, Assets/Liabilities
Net Portfolio Equity -3.1 -9.5Net FDI -27.9 -5.3Net Equity -31.0 -14.8Net Private Debt 1.8 -15.3Reserves 37.3 19.2Net Debt 39.0 3.9
Table 1bAsymmetries in the International Balance Sheet, 2004
China India
23
Main Stylized Facts on IFI of China and IndiaMain Stylized Facts on IFI of China and India• Three facts on: Size, composition, and net terms
• Fact 1: Size – Pivotal role in the international financial system, owning
about 20 percent of global official reserves.– Small global share of privately-held external assets and
liabilities.– Small financial participation relative to real participation– Exceptions:
• FDI into China (about 4% of world FDI), aside from reserve assets (China #1; India #6)
24
Main Stylized Facts on IFI of China and IndiaMain Stylized Facts on IFI of China and India• Fact 2: Composition
– IFI highly asymmetric, “long debt, short equity.”– Asset side: hold low-return foreign reserves. – Liability side: owe higher yield instruments. – Negative net equity positions
• FDI in China• Portfolio equity for India• Net private debt also important in India
25
Main Stylized Facts on IFI of China and IndiaMain Stylized Facts on IFI of China and India• Fact 3: Net terms
– Neoclassical models predict these countries to be net borrowers in the international financial system.
– However, both China and India have reversed their large net debtor positions.
– China: net creditor (8% of GDP) – India: net debtor (-11% of GDP) – Both small in terms of global imbalances
26
Main Stylized Facts on IFI of China and IndiaMain Stylized Facts on IFI of China and India• Financial policies essential
– to explain these patterns of IFI; – will likely keep shaping them over the following years.
27
Domestic Financial Sector and IFIDomestic Financial Sector and IFI• IFI closely linked to nature of domestic financial
system/policies.
• Relevant policies1. Capital account and exchange rate regimes2. Development of domestic financial system
– Debt; equity– Banks; capital markets
3. Financial system and savings/investment balance
• Important to understand background in each country.– Beyond simple financial development indicators.
28
Capital Account and Exchange Rate RegimeCapital Account and Exchange Rate Regime• Capital controls as development policy (exports), to control
domestic monetary/financial variables, and to avoid crises.• Controls to the KA shape type of financial integration
– Types of flows; – Volume (less, more via round-tripping).
• Exchange rate target leads to reserve accumulation.
29
Capital Account and Exchange Rate RegimeCapital Account and Exchange Rate Regime• Policy trilemma
– Exchange rate target creates trade-off between monetary policy flexibility and capital account openness.
– Greater exchange rate flexibility • Would allow China and India to combine monetary policy
autonomy with capital account openness.• Would also change composition of flows – less reserve
accumulation, less speculative inflows.• Capital account restrictions increasingly porous – by-product of
increased trade and financial volumes.
30
Capital Account and Exchange Rate RegimeCapital Account and Exchange Rate RegimeForeign Exchange Reserves / GDP
M1 / GDP
0%
5%
10%
15%
20%
25%
30%
35%
40%
China India East Asia Eastern Europe Latin America G7
0%10%20%30%40%50%60%70%80%
China India East Asia Eastern Europe Latin America G7
1991 1994 1999 2004
31
Capital Account and Exchange Rate RegimeCapital Account and Exchange Rate Regime
World 100.0 World 100.0Hong Kong SAR 45.0 Mauritius 35.6United States 8.9 United States 16.5Japan 8.7 Japan 6.9Taiwan POC 7.4 Netherlands 6.9British Virgin Islands 6.9 UK 6.6Korea 4.8 Germany 4.4Singapore 4.8 Singapore 3.1United Kingdom 2.3 France 2.7Germany 1.8 Korea 2.2France 1.3 Switzerland 2.0Other 8.2 Other 13.2
Table 2aSources of FDI Liabilities
China India
32
Capital Account and Exchange Rate RegimeCapital Account and Exchange Rate Regime
World 100.0 100.0 World 100.0 100.0Hong Kong SAR 34.3 36.7 Mauritius 31.5 27.8United States 28.6 16.3 United States 41.2 13.4Europe 15 24.7 20.4 Europe 15 24.1 22.8Japan 4.6 10.3 Singapore 0.4 16.6Singapore 3.9 10.3 Japan 0.2 11.9Rest of the World 4.0 5.9 Rest of the World 2.6 7.6
Table 2bSources of Portfolio Liabilities
China IndiaEquity Debt Equity Debt
33
Domestic Financial System: DebtDomestic Financial System: Debt• Aversion to liberal regime vis-à-vis debt borrowing, especially in
foreign currency (typically from abroad ).– East Asia crisis; Indian crisis of 1991.
• Chinese banking sector– NPL overhang; focus of major banks on lending to SOEs;
high (inefficient) lending.– Party explains high reliance on firm internal financing.
• India– Large public deficits financed by domestic banks holding
government bonds – interest rate exposure.• Both countries: corporate bond markets under-developed.
34
Domestic Financial System: DebtDomestic Financial System: Debt
Deposits / GDP
Credit / GDP
0%20%40%60%80%
100%120%140%160%180%
China India East Asia EasternEurope
Latin America G7
0%20%40%60%80%
100%120%140%160%180%
China India East Asia Eastern Europe Latin America G7
1991 1994 1999 2004
35
Domestic Financial System: DebtDomestic Financial System: Debt
Central Government Debt / GDP
Private Bond Market Capitalization / GDP
Public Bond Market Capitalization / GDP
0%
10%
20%
30%
40%
50%
China India East Asia Eastern Europe Latin America G7
0%10%20%30%40%50%60%70%
China India East Asia Eastern Europe Latin America G7
0%
10%
20%
30%
40%
50%
60%
70%
China India East Asia Eastern Europe Latin America G7
1991 1994 1999 2004
36
Domestic Financial System: EquityDomestic Financial System: Equity• China
– Pro-FDI policies, but overhang in equity market despite apparently reasonable indicators.
• India– Success in attracting portfolio equity inflows but relatively
less FDI inflows.• Financial development
– “By-pass” motivation for FDI fades, but deep local capital markets can promote FDI.
• Both countries – Liberalizing outward FDI; – Also outward portfolio equity flows – but requires advances
in domestic intermediation (banks; institutional investors).
37
Domestic Financial System: EquityDomestic Financial System: Equity
Market Capitalization / GDP
Turnover Ratio
Number of Firms Listed
0
500
1,000
1,500
2,000
2,500
China India East Asia Eastern Europe Latin America G7
4413 5863 47302556
0%20%40%60%80%
100%120%140%
China India East Asia EasternEurope
Latin America G7
0
0.5
1
1.5
2
2.5
China India East Asia Eastern Europe Latin America G7
1991 1994 1999 2004
38
Financial Reform and Savings/Investment BalanceFinancial Reform and Savings/Investment Balance• Financial under-development leads to high savings relative to
investment.• Industrial structure (heavy industry vs. services) also related to
savings. • Corporate governance also related to savings.
– China’s high savings driven by corporate sector (Kuijs)
39
Financial Reform and Savings/Investment BalanceFinancial Reform and Savings/Investment Balance• Financial and other reforms might reduce savings.
– Development of consumer credit would allow households to finance purchase of durables.
– Other reforms (improved social insurance, provision of health, and education services) would also affect savings.
– Improved corporate governance and private participation might lead to reduction in corporate savings.
– Decline in corporate saving also facilitated by development of domestic bond markets and increased focus by banks on private sector firms.
40
Financial Reform and Savings/Investment BalanceFinancial Reform and Savings/Investment Balance• Financial reform might also switch level and composition of
investment.– Level: Less by SOEs, more by private sector.– Composition: Better investments.
• On net, possible negative effect on savings/investment balance.
41
China and India as a Destination for External CapitalChina and India as a Destination for External Capital• China and India not that large destinations, except FDI to China.• Do not appear to have crowded out investment elsewhere.
– Diversion? Direct and indirect channels• To expect: More balanced structure of capital flows.
– Relative rise in • debt and portfolio equity (China), as opposed to FDI; • debt and FDI (India), as opposed to portfolio equity.
• Role of “proxy” markets• Bilateral composition
– Depends on currency policies; regional integration.
42
China and India as International InvestorsChina and India as International Investors• Important only as holders of international reserves.
– Part of development strategy (undervalue exchange rate) with global consequences.
– Lower interest rates, deficit financing, lower inflation.• Costly to accumulate reserves and perpetuate strategy.• Greater balance in outflows.
– Reduction in reserves; – Pick up in outward debt, FDI, and portfolio equity flows.
• Reallocation of external portfolios– Might be good for other emerging markets.
• Regional focus? Depends on integration and currency policies.• Transition: Redeployment of reserves
43
Global Imbalances: Net Foreign Asset PositionsGlobal Imbalances: Net Foreign Asset Positions• Is current configuration stable or just a temporary phenomenon?• Historical examples
– CA deficits of Korea and Singapore averaged 5.0 percent and 14.4 percent respectively during 1970-1982.
– Feasible after crises of the 1990s?– Not great example to the contrary.
• Scenario – Reforms and capital account openness: lower savings rates,
investment inflow – CA deficits (2-5%/year – Dollar-Kraay).– China and India substantial net debtors in the medium-term
(or higher world interest rates). – Transition of deficits to a possible long-run creditor position
44
Global RisksGlobal Risks• Transition to financially liberalized regime
– Evidence on financial integration and (short-run) volatility/ crises/bumpiness
– Crises and political stability– “Learning to be open” - but many lessons learnt?– Robustness of banking sector key– China: efficiency of banking sector– India: fiscal policy– Rest of world: transition from current low interest rate
environment
45
ConclusionsConclusions
• Large holders of international reserves, but smaller than perceived in many other areas (except FDI for China).
• However, IFI of China and India might be near a turning point.– Domestic financial reform and KA liberalization will lead to a
restructuring of balance sheets, affecting stylized facts. – Significant implications for global system, mostly for Asia.
46
ConclusionsConclusions• Future gross positions
– More investment opportunities to domestic and foreign residents.
– Accumulation of external assets and liabilities by the private sectors in these countries expected to grow.
– Restructuring of inward and outward portfolios.– Diminution in the asymmetries in external liabilities, with a
greater dispersion of holding/inflows (FDI, equity, and debt).
– On the assets side, acquisition of non-reserve foreign assets should see a marked increase.
– Together with the projected increase in their shares in world GDP, China and India are set to become major international investing nations.
47
ConclusionsConclusions• Future net balances
– Much uncertainty and debate. – Emergence of significant medium-term current account
deficits in both countries with financial development (other things equal).• Part of the development process.
• CA deficits and a deceleration in reserve accumulation: – Substantial shift in the roles of China and India in the global
distribution of external imbalances.
48
Conclusions: Key Factors to MonitorConclusions: Key Factors to Monitor1. Exchange rate policy, in light of the sustained appreciation
pressure.– Appreciation may be resisted in the short run by further
reserve accumulation, but increasingly costly and conflicting. 2. A sharp correction in the dollar may act as an external trigger for
a switch to greater exchange rate flexibility. – Concerns may change the currency composition of reserves,
affecting interest rates and possibly exchange rates. 3. How fast these countries substitute reserve holdings for other
assets abroad. – Might start to happen under favorable scenario.
4. Fully-fledged liberalization of capital controls remains unlikely in the short-medium term, but more liberalization to come.– Which form? How soon? How fast?
Capital flows to Emerging Europe
Philip R. LaneIIIS, Trinity College Dublin
Gian Maria Milesi-FerrettiInternational Monetary Fund
50
Objective of paper
• Put trends in external capital flows and their composition in perspective (compare CEE with EU15, other emerging mkts)
• Provide simple calculations on ‘sustainable’ future capital flows• Draw implications for future trade surpluses
51
Road map
• Capital flows and external position: stylized facts (1995-2004)• Bilateral exposure• Implications for medium-term factor flows
52
Capital flows 1995-2004
• Large! – Initial liabilities very small (except Bul, Hun, Pol)– Strong growth prospects– Obsolete capital
53
External liabilities in 1994 were small...
Net external position in 1994 (percent of GDP)
Kazakhstan
Syria
MoroccoEgypt
Swaziland
Ecuador
Iran
Bulgaria
Paraguay
Guatemala
Algeria
Macedonia
Tunisia
Romania
Jordan
Russia
Dominican Rep.
Namibia
Peru
Thailand
FijiEl Salvador
Colombia
Latvia
Lithuania
Turkey
Estonia
South Africa
Mauritius
Slovak Republic
Jamaica
Poland
Malaysia
Brazil
Panama
Lebanon
Costa Rica
Hungary
Gabon
Chile
Czech Republic
Trinidad and Tobago
Venezuela, Rep. Bol.
Mexico
UruguayArgentina
Slovenia
-120
-100
-80
-60
-40
-20
0
20
1000 2000 3000 4000 5000 6000 7000 8000
GDP per capita
NFA
/GD
P
54
...but MUCH larger at end-2004
Net external position (pct of GDP), 2004
Slovenia
Portugal
Oman
Trinidad and Tobago
Argentina
Czech Republic
Mexico
Uruguay
Chile
HungaryEstonia
Poland
Croatia
Venezuela, Rep. Bol.
Costa Rica
Latvia
Slovak RepublicLithuania
Panama
Lebanon
Mauritius
Malaysia
GabonBrazil
South Africa
Turkey
Jamaica
Dominican Republic
Thailand
Tunisia
Russia
Peru
El Salvador
RomaniaColombia
Algeria
Bulgaria
Jordan
Kazakhstan
Iran
Macedonia
GuatemalaEgyptBelarus
Albania
Ecuador
Paraguay
-120
-100
-80
-60
-40
-20
0
20
1000 2000 3000 4000 5000 6000 7000 8000 9000 10000 11000
GDP per capita
NFA
/GD
P
55
International financial integration is increasing...
CEE countries
EU 15
Other emerging markets
0
50
100
150
200
250
300
350
400
450
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
56
...with equity liabilities playing a more important role....
CEE countries
EU 15
Other em. mkts
10
15
20
25
30
35
40
45
50
55
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
57
...and particularly so FDI....
CEE countries
EU 15
Other em. mkts
10
15
20
25
30
35
40
45
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
58
Reserves play an important role among external assets,
more so than elsewhere
CEE countries
FX share
Equity share
0
10
20
30
40
50
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
EU 15
FX share
Equity share
0
10
20
30
40
50
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Other emerging and developing economies
FX share
Equity share
0
10
20
30
40
50
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
59
In most CEE countries net equity liabilities are larger than net debt
Bulgaria
Czech Republic
Slovak Republic
Estonia
Latvia
Hungary
Lithuania
Croatia
Slovenia
Poland
Romania
-40
-30
-20
-10
0
10
20
30
-100 -90 -80 -70 -60 -50 -40 -30 -20 -10 0
net equity (pct of GDP)
net d
ebt (
pct o
f GD
P)
60
Returns on external liabilities
• Returns on FDI are linked to economic performance (high when the economy does well, low otherwise)
• This implies better risk-sharing relative to foreign-currency debt...
• ...and can help productivity growth...• ...but the price is a higher cost
61
Financial integration with the EU is particularly strong
Sources of FDI (2002)
EMU UK US DEN SWE SWI. CEEC Bulgaria 87.0 5.3 5.7 1.0 1.0 Croatia 81.4 1.8 1.1 2.7 13.0 Czech Republic 82.3 5.3 4.3 1.0 1.9 4.4 0.9 Estonia 47.4 0.7 1.5 3.4 46.1 0.8 Hungary 79.2 7.3 8.1 0.7 2.3 1.5 1.0 Latvia 25.7 1.1 -0.6 15.7 44.6 13.5 Lithuania 23.5 0.5 2.8 34.7 24.5 14.0 Poland 73.1 7.4 9.3 2.9 3.8 3.1 0.3 Romania 89.4 1.3 7.7 0.4 1.1 Slovakia 83.5 8.6 0.7 1.4 5.8 Slovenia 95.5 1.6 0.0 3.0
62
Implications for future flows
• External liabilities cannot grow faster than GDP forever...• “Sustainable” flows imply a stable ratio of net external liabilities to
GDP....•• For example, with 8% nominal growth and liabilities of 50% of GDP,
the CA balance would be -4%
( )SS SSt tca g NFAπ≈ − +
63
Does this imply that large capital inflows can persist without any adjustment?
• Not quite. • As liabilities accumulate, investment income payments to
foreigners increase• To keep the CA from deteriorating, the trade balance
(broadly defined) must improve....• ...because servicing external debt and FDI is costly
64
...and the improvement must be large...
Trade balance
(average 2001-2004)
NFA-stabilizing
trade balance
Implied current account balance
(baseline)
Bulgaria -5.2 1.2 -3.9Czech Republic -1.3 1.3 -2.2Slovak Republic -3.6 1.3 -2.8Estonia -4.4 1.8 -8.4Latvia -8.1 0.8 -4.8Hungary -1.9 1.2 -6.3Lithuania -3.6 0.5 -3.4Poland -0.8 0.9 -3.4
65
What can countries do?
• Strengthen export growth (and hope for recovery in the euro area!)
• Contain budget deficits (that contribute to widening current account imbalances)
• Be prepared for leaner times on global capital markets
66
Upside and downside risks
• Credible policies and integration with EU can lower spreads, implying more favorable debt dynamics...
• But there is limited scope for exchange rate correction to ease the trade balance adjustment, at least with current exchange rate regimes
