Business   

Intriguing pattern of global capital flows

Any attempt to address the current problems will require a forum broader than the G7/G8 and wielding political clout

The relatively new phenomenon of mounting U.S. current account deficit on one side and investments by developing countries in U.S. bonds that have been financing the deficit on the other could have important implications in the near and medium term for the global financial system. Lawrence Summers, President of Harvard University (and former Secretary of the Treasury in the Clinton administration) dealt with this "capital flows paradox" and the question of its sustainability in the L. K. Jha Memorial Lecture delivered by him recently in Mumbai at the invitation of the Reserve Bank of India.

The following are excerpts from Prof. Summer's lecture.

THE MOST surprising development in the international financial system over the last half a dozen years is the large flow of capital from the world's most successful emerging markets to the traditional industrial countries, and the associated enormous buildup of reserves in the developing world. To my knowledge it was neither predictable nor predicted and the implications are large and have not yet fully been thought through.

Capital flows paradox

Three aspects of global financial flows stand out as being without precedent:

First, the net flow of capital is substantially from developing countries and emerging markets towards the industrialised world and principally the United States as the world's greatest power is the world's greatest borrower. It is apparent that the United States is an overwhelming absorber of global savings while the rest of the world is a supplier of global savings. While the combined current account surpluses of Japan and the non-European industrialised countries represents about 35 per cent of U.S. net international borrowing, the remainder is financed overwhelmingly by emerging markets and oil exporting countries.

Second, the buildup in U.S. net foreign debt is substantially mirrored in reserve accumulation by emerging markets. While claims flow in many directions, it is noteworthy that a large fraction of the buildup in foreign claims is represented by reserve accumulation. These reserves have grown from half a trillion dollars in 1999 to over two trillion dollars today. As the accompanying Table demonstrates, they are distributed quite broadly around the world.

Third, expected real returns on these reserves are very low. Assuming constant real exchange rates, reserves will earn the expected real return on primarily dollar and secondarily euro fixed income assets. Indexed bond yields or comparisons of interest rates and forecasted inflation rates would make 2 per cent a somewhat optimistic estimate of expected real returns in international terms. If real exchange rates in emerging markets are likely to appreciate then domestic returns will be even lower and more risky.

These three elements — flow of capital from emerging markets to industrial countries, huge accumulation of reserves, and expected negative returns on reserves — constitute what might be called the capital flows paradox in the current world financial system.

While borrowing and consuming is functional for the United States and reserve accumulating and exporting is perhaps functional for many other countries, the sustainability and the desirability of the capital flows paradox seems to me to require careful thought. Let me turn first to the American situation.

The American current account deficit is unprecedented in its economic history or that of other major economic powers. Today it is running at a rate approaching 7 per cent of GDP. Barring some discontinuity, most knowledgeable observers expect it to increase.

There is one striking fact about the global economy that belies a dominantly American explanation for the pattern of global capital flows: real interest rates globally are low not high. Whether one looks at index bond yields, measures of nominal interest rates relative to ongoing inflation, or yields on most assets, especially real estate or credit spreads, capital market pricing points to the supply of global capital tending to outstrip demand rather than vice versa. If the dominant impulse explaining global events was declining U.S. savings, one would expect abnormally high real interest rates, as with the twin deficits in the 1980s, not abnormally low real interest rates. America's consumption growth in substantial excess of income growth has been matched by substantial export led growth in the rest of the world.

The net surplus of emerging Asia led by China exceeds the combined surplus of Europe and Japan. And given the magnitude and attractiveness of investment opportunities in emerging Asia it would be natural for it to run a current account deficit. This suggests that the primary source of global demand to offset any likely increases in United States savings should come from the Asian consumer. India is a positive example here. It is noteworthy that consumption represents close to two thirds of GDP in India, and significantly under one half in China.

In addition to the benefits for the global system that a domestic demand led strategy would bring, a less export oriented strategy would also contribute to ultimate financial stability.

Opportunity cost

The rest of the world is probably not in a position to make large contributions to the global adjustment process. Healthier policy environments in Latin America and Africa would reduce capital flight, tend to increase private capital flows and lead to somewhat larger investment driven current account deficits. Given the current euphoria reflected in emerging market spreads, it would be a mistake for policy makers to cheer this process along too rapidly.

It is striking to estimate the cost to developing countries of reserve holding that goes beyond what is necessary for financial stability. Even if we used a standard more rigorous than any that has been proposed and treated reserves in excess of twice short-term debt as unnecessary for insurance purposes, these reserves represent almost $1.5 trillion and are growing at several hundred billion dollars per year while earning what is likely to be a zero real return measured in domestic terms. This represents a substantial cost.

If the wealth tied up in reserves were invested either domestically in infrastructure or in a fully diversified long-term way in global capital markets, 6 per cent would not be an ambitious estimate of what could be earned. The resulting gain would be close to $100 billion a year. Aggregating the 10 leading holders of excess reserves, the opportunity cost of these reserves comes to 1.85 per cent of their combined GDP.

Scope for new approach

Any attempt to manage jointly any increase in U.S. savings and an offsetting increase in global demand from global sources will clearly require a forum broader than the G7/G8. So also will any global attempt to think through the implications of the massive reserve accumulation.

What should not be in doubt is the importance of creating a forum that structurally has political clout over the international institutions and at least some ability to influence domestic policy decisions of individuals countries. I would suggest three areas of focus in the next several years:

First and most importantly, the formulation of a global strategy for managing the U.S. current account deficit downwards without excessive risk to global growth.

Second, a new forum should look at the role and governance of the existing international financial institutions in the current environment.

Third, the group should take up the question of deploying the reserves of developing countries. There are of course the questions that are much discussed of the potential implications for the international financial system of shifts in the composition of currencies in which reserves are held. This is obviously a sensitive subject for everyone, but as long as the ex ante returns on dollar assets and euro assets are relatively close together it may not be a matter of welfare significance.

Of greater concern is the risk composition of the assets in which reserves are invested. When reserves were held at levels that represented self-insurance against possible financial crisis, the case for their investment in maximally liquid, maximally safe form was compelling. When reserves are far greater there would seem to be a case for more aggressive investment either in support of imports that have a high social return or in a much richer menu of international assets.

If India, for example, were to follow this course, the result would be extra returns that would amount to between 1 and 1.5 per cent of GDP each year. This figure, which dwarfs the seigniorage considerations that traditionally played so large a role in monetary theory, represents an amount greater than Indian public sector spends on health care each year. Annuitised and valued as a stock it is comparable to 40 per cent of the market value of all the traded stocks on the Bombay Exchange. And India is not an extraordinary case.

Reserves as a share of GDP are substantially larger in China, in Taiwan, in Russia, and in Thailand than in India.

In principle, decisions about reserve investment can be made domestically. But there are at least two important roles for international discussion and coordination.

There are important risks for any central bank that attempts to go in this direction. It is likely to reap much more disfavour in years when investments go badly than favour in years when investments go well.

And the opportunities for mischief in picking assets, in exercising control rights, in misvaluing assets are likely to be very large. Some form of legitimated international scrutiny and monitoring of central bank reserve investments could help to overcome these problems.

Perhaps it is time for the IMF and World Bank to think about how they can contribute to deploying the funds of major emerging markets rather than lending to major emerging markets.

More ambitious than simply providing surveillance and monitoring that would support most ambitious investments by emerging markets would be the creation of an international facility in which countries could invest their excess reserves without taking domestic political responsibility for the process of investment decision and ultimate result.

It is an irony of our times that the majority of the world's poorest people now live in countries with vast international financial reserves. The problem for these countries is not being supported in borrowing from abroad — and so it seems appropriate that some part of the focus of the international financial architecture moves towards the challenge of deploying their large reserves as effectively as possible. Just as India's remarkable development over the last fifteen years comes with both great opportunities and challenges, so too the dramatic changes in the pattern of global capital flows come with remarkable challenges and opportunities. I don't think any of us have the answers.

Printer friendly page  
Send this article to Friends by E-Mail

Stories in this Section

Intriguing pattern of global capital flows
Challenge of common regulations for non-banking finance companies
Restriction on bank deposits to qualify for 80 C relief
Search tools: new developments

Copyright © 2006, The Hindu. Republication or redissemination of the contents of this screen are expressly prohibited without the written consent of The Hindu