Capital Flows, Financial Markets and Banking Crises

Chia-Ying Chang

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781315469393
• Edition: 1
• Topic: Economics
• Subtopic: Economic Theory
• Index: Economics

The increasing capital flows in the emerging markets and developed countries have raised various concerns worldwide. One main concern is the impact of the sharp decline of capital flows – so-called sudden stops – on financial markets and the stability of banking systems and the economy. The sudden stops and banking crises have been identified as the two main features of most financial crises, including the recent Asian Financial Crisis and Global Financial Crisis. However, how capital flows and banking crises are connected still remains unanswered.

Most current studies on capital flows are empirical work, which faces various challenges. The challenges include how data has been collected and measured in each country and how sensitive the results are to the data and the adopted methodologies. Moreover, the links between capital flows and banking systems have been neglected. This book helps provide some insight into the challenges faced by empirical studies and the lessons of the recent crises. The book develops theoretical analysis to deepen our understanding on how capital flows, banking systems and financial markets are linked with each other and provides constructive policy implications by overcoming the empirical challenges.

1 Introduction

Globalization has reduced the distances between countries and has sped up the integration of capital markets. In response to capital market integration, countries have started liberalizing/deregulating financial markets. Both the liberalization and deregulation have led to rapid growth in capital flows across countries. The growth of capital flows changes not only the volumes and the frequencies of flows but also their nature and the composition, which could then affect the fundamentals of an economy and have raised many concerns. Thus, the issues related to capital flows have attracted broad attention and discussion, especially in emerging markets.

Capital flows

An increase in capital flows, on one hand, could integrate capital markets across countries and reduce the frictions of financial markets. On the other hand, the associated contagion effects, also called spill-over effects, could shake the stability of the banking system and the financial markets and hence expose the economy to international credit risks and ultimately lead the economy to overseas-originated financial crises. While enjoying the benefits brought by increasing capital flows, the countries, especially emerging economies, are motivated to manage increasing capital flows to prevent contagion effects as well as overseas-originated crises. Amongst all management on capital flows, capital controls are the most popular and controversial policies. Their effectiveness as well as their pros and cons have been under debate for several decades since the 1970s. The results of the debates are inconclusive. The inconclusive results from this debate and the mixed results from decades of research also reflect in reality that while some countries move from free flows to capital controls, other countries move from capital controls to free flows through the liberalization of capital controls and/or accounts.

In general, capital controls were adopted widely before the 1970s but were removed gradually to promote free flows after the 1970s. Controls became popular and were implemented once again in the 1990s. During 1990–1997, prior to the Asian Financial Crisis, the implemented capital controls were mainly on inflows [Edwards (2009a, 2009b), Johnson et al (2007)], such as in Thailand, Malaysia, Philippines, Indonesia, Czech Republic, Colombia and Brazil. Different from these countries, Spain was one of few which implemented controls on outflows. After the crisis in 1997, countries such as Thailand, Malaysia and Brazil added controls on outflows, in addition to their existing inflow controls. Although not affected by the Asian Financial Crisis, Argentina has joined the club to implement inflow controls.

It has been more than four decades since the 1970s, when controls were adopted broadly. Today, countries hold different views on promoting and opposing controls. While opposing each other’s view on capital controls, some countries are in fact switching between implementing and liberalizing controls. The switch back and forth between implementation and liberalization of capital controls increases the challenges researchers face in analysing capital flows, especially when conducting empirical studies. As one may know, it takes time for specific policies and the removal of policies to have impacts on the economy. When and how these impacts take place and how long the effects last depend on economic conditions, which vary across countries and across time. Thus, the frequency of switching between implementation and liberalization of capital controls makes it more difficult to analyse the impacts of capital controls and the removal of capital controls, especially for empirical studies. This may explain why despite the continuous development in the methodology of research on capital flows, several key issues surrounding capital flows remain unanswered, while new and more complex issues concerning capital flows keep arising. By summarizing the issues, old and new, one can easily find that most issues are related to the linkages between capital flows, the stability of banking/financial systems and the associated crises, the effectiveness of capital controls and macroeconomic variables such as output and growth.

There is no doubt that the methodologies and datasets adopted are as important as their findings. As shown in the literature, the datasets adopted vary across studies. Depending on the definitions and measurements of the datasets, the results can be sensitive to both methodologies and datasets. Without the knowledge of the definitions and measurements adopted in all datasets used in all countries in empirical studies, it is difficult to provide insights on suitable datasets to be adopted when studying capital flows. Meanwhile, each methodology adopted to study capital flows has its own features and tends to drive specific results [Forbes (2012)]. In order to fit into specific methodologies, some studies may have treated and/or adjusted data. The treatments and the adjustments may have affected the results. The comments regarding suitable datasets and methodologies to be adopted will be left to the experts who have knowledge on various datasets and methodologies. The focus of the book will be to use the information adopted and the results obtained in the empirical studies to compare consistencies and inconsistencies in various topics and then use the theoretical analysis to identify possible factors which might be useful to explain why these inconsistencies in the empirical studies emerge. The introduction of each chapter is presented to draw information from empirical studies in order to develop the theoretical framework and address the related issues relevant to the chapter topic. The details underlying mapping of the theoretical and empirical analysis will be discussed in Chapter 7.

To understand the issues related to capital flows, we must return to the sources of flows, which are the capital accounts showing the components of flows. Capital accounts can be divided into four categories: (1) foreign direct investment (FDI); (2) foreign portfolio investment (FPI); (3) other investment; and (4) the reserve accounts held by the central banks. Among these, this book focuses on the first three categories. This is because the reserve accounts (the fourth category) has a different nature from the other three due to the role and the strategies of the central banks. Among the first three, FDI flows are often considered long-run (LR) flows and more stable, while both FPI flows and other investments are often considered short-run (SR) flows and more volatile. The nature of FDI LR flows and FPI SR flows are different from each other. Moreover, FDI and FPI flows serve different purposes and play different roles and hence have different impacts on the economy. Therefore, it is important to differentiate FDI flows from FPI flows and to incorporate their features while conducting analysis on capital flows, whether it is theoretical or empirical.

The limitation of specific datasets

Despite the importance of differentiating the types of flows in any analysis, the available datasets may not provide the differentiations between LR and SR flows. Moreover, some of the datasets provide only annual data, and some datasets provide only net flows. These datasets not only fail to differentiate the types of flows but also neglect the possibility of seasonal effects and have mixed the changes of flows to/from various industries. The empirical studies which employ these datasets may provide non-intuitive results without sensible explanations, increase unnecessary confusion in the current literature and/or make it more difficult to solve the puzzle and to move the current capital flows/controls debates forward.

Take the famous Feldstein-Horioka-puzzle as an example. Many research works have attempted to explain the puzzle. The puzzle states strong correlation between domestic saving and investment and implies low capital mobility and less perfect capital market, as assumed in the literature. Among the studies seeking to explain the puzzle, one main stream of research shows that the puzzle is for average LR capital but not for SR capital [Abbott and Vita (2003), Bai and Zhang (2010), Chang and Smith (2014), Coakley et al (1996), Sinn (1992)]. Another stream of research attributes specific country factors to the puzzle [Abbott and Vita (2003), Chen and Shen (2015), Corbin (2001)]. The specific country factors include home bias portfolio preferences [Feldstein (1983)], interest rate differential, currency premium [Corbin (2001)] and regime switching on capital controls [Abbott and Vita (2003), Chen and Shen (2015), Corbin (2001)]. By gathering the literature on the Feldstein-Horioka-puzzle, one can conclude that the key to solving the puzzle is not only to find ways to differentiate SR and LR capital flows but also to find the specific country factors, such as capital controls, which may drive specific results. The puzzle will not be solved and would become even more confusing when the empirical studies adopt specific datasets that do not have the qualities needed to assist in solving the puzzle.

Mixed results of liberalizations and controls

More mixed and confusing results in empirical studies are also found in the liberalization of capital accounts and the associated changes on output and growth. Some research finds that liberalization will promote growth, while others find that liberalization will harm growth. To be more specific, Eichengreen (2004, chapter 3) provides evidence showing that the positive effects of liberalization do not apply to most countries and that the robustness of the positive effect holds only for the post–1982 period and for high-income countries. For the countries with weak contract and law enforcement, the positive effect of liberalization cannot be found. Meanwhile, most views opposing liberalization are based on the contagion effects which may lead the countries to currency crises. There is no doubt that a sharp increase in capital flows would cause exchange rate fluctuations. However, moving from exchange rate fluctuations to currency crises is a very strong statement. One argument against this statement is that depending on changes in the direction of capital flows, an increase in capital flows may magnify (or offset) the size of movements on the exchange rate and hence worsen (improve) economic conditions caused by currency crises. Moreover, the volatility of the exchange rate does not depend on capital flows alone. The volatility of the exchange rate depends strongly on the country’s domestic fundamentals and its exposure to global risks, which would also determine how contagion effects would spread out to one country. In other words, the studies focusing on the effects of flows on currency crises can easily overstate/understate the impacts of flows on the exchange rate by failing to account for the influences of other macro factors which may not be related to capital flows. Hence, such studies miss the big picture of the real impacts of capital flows on the economy. Not to mention that for a fixed-exchange-rate regime, there is no room for exchange rate volatility, while for a flexible-exchange-rate regime, the existing theory that proves exchange rate indeterminacy has shown that the volatility of exchange rate is inevitable. To avoid the complications and confusion brought by the exchange rate, this book will focus on the impacts of capital flows on the banking system, the financial markets and macroeconomic variables in a real economy.

There are several reasons this book focuses on the linkages of capital flows/controls to the financial markets and the stability of banking systems as well as the possibility of banking crises. First, most capital flows, whether SR or LR, are through the banking systems of countries. Grittersova (2014) studies 18 advanced countries during 1960–2005 and shows that the financial liberalizations started in the 1990s have increased the role of banks and related financial institutions. Therefore, the changes of capital flows would affect banks’ assets and liabilities and the banks’ exposure to international credit defaults as well as other risks. Depending on bank governance, the changes of capital flows may affect the stability of banking systems. Second, the stability of banking systems is related to the possibility of bank runs and hence banking crises. To understand crises well, it is important to clarify the definition of crises. Banking crises, based on the definition of Allen and Gale (2007b, p 10), are defined as “financial distress that is severe enough to result in the erosion of most or all of the capital in the banking system”. Also in Allen and Gale (2007b, p 10), currency crises are defined as “a forced change in parity, abandonment of a pegged exchange rate or an international rescue”. Both banking crises and currency crises are classified as the two key features of financial crises [Tirole (2002), chapter 1]. Financial crises are defined as “a disturbance to financial markets, associated typically with falling asset prices and insolvency among debtors and intermediaries, which spread through the financial system, disrupting the market’s capacity to allocate capital”, according to Eichengreen and Portes (1987, page i). Regarding the frequency of the occurrence of banking crises, Tirole (2002, chapter 1) finds that banking crises have occurred more often in recent decades after the 1970s. Expanding to historical data, Eichengreen et al (2008) find that 50 per cent of financial crises have coincided with banking crises and only 2 per cent have coincided with currency crises. Focusing on the recent period after 1973, both Bordo et al (2001) and Allen and Gale (2007b, chapter 1) find that banking crises have occurred more frequently after 1973. Moreover, Tirole (2002, chapter 1) points out that starting in the 1970s, the crises have been related to bank failures which were not the case in the period prior to the 1970s when banking systems were highly regulated and banking activities were limited. In the 1970s, banking systems were deregulated jointly with financial liberalization as well as the liberalization of capital accounts/controls. Because the liberalization of capital accounts is defined as “easing the restrictions of capital flows across a country’s borders”, based on Kose and Prasad (IMF, 2012), it is also called the liberalization of capital controls in many studies.

The role change of the banking systems

While the deregulation of banking systems and financial liberalization have expanded banks’ activities, the liberalization of capital accounts/controls has led to the rapid growth of capital flows, which has, in turn, increased the role of banking systems and provided the banking system more opportunities to involve and to engage in new activities at an international level. The increasing activities involved by the banks have expanded the roles of banks to be not only a middleman and a portfolio manager but also to be a major player in the financial markets. As a major player, the banks would seek maximum profits. This implies that the traditional way to model banks as zero profit is no longer suitable for the modern economy. The policies which draw from the models with zero-profit banks must be revisited.

When banks seek to maximize profits, on one hand, the profits of the banks may serve to finance liquidity shortfalls and reduce the probability of bank runs and banking crises. On the other hand, the goal to maximize profits may have the banks overlook/mismanage risks and expose themselves to various credit defaults and global risks. The exposure to global risks would make the banks more vulnerable and sensitive to the shocks and contagion effects and hence increase the probability of bank runs and banking crises. When capital flows are added to the analysis, it is not only the banking system but also the sectors to/from which the flows are injected/withdrawn that would be affected by the fluctuations of capital flows. How the fluctuations would benefit or damage the economy would depend on the directions of the flows, which may magnify or offset the contagion effects originated domestically and/or overseas. Therefore, it has become more important and urgent to understand better how the economy is affected by the deregulation of the banking system and the liberalization of capital flows if one wishes related policies implemented/liberalized to do a better job to stop the economy from bleeding or to divert the economy from crises instead of worsening the economy. This is why the analysis in this book will discuss the cases with and without capital flows as well as having a separate chapter (Chapter 5) to discuss bank governance.

The banking system without capital flows has its own inherent problems. As well, as documented by current banking literature, liquidity shortfalls are one of the key problems of the banking system. When the liquidity problems are not resolved in time, bank insolvency and bank runs are inevitable. The causes of liquidity shortfalls vary in different cases, situations and countries. The causes include the mismatch of maturity [Tirole (2002, chapter 2)] and the panic of creditors [Diamond and Dybvig (1983)], as well as risk-taking behaviours of the banks [Calomiris (2009)]. Note that the implicitly assumed zero-profit banks in the traditional literature have left the banks little space to absorb shocks and increased the possibility of bank runs. This assumption has been severely criticized. The bank runs would then interrupt the financial and other economic activities and drive the economy into crises and recessions. To prevent bank runs and their associated crises and recessions, central banks and international organizations, such as the International Monetary Fund (IMF), have provided short-term lending facilities to resolve the liquidity problems of banks. Despite various sources of liquidity provision, bank runs and banking crises continue to occur, as shown in the most recent crises. When more countries experience bank runs and banking crises which require liquidity provision to be in place, the promise of the IMF to provide lending has in turn threatened the financial positions of many central banks and the IMF. Does it mean that liquidity provision is insufficient in preventing banking crises? If so, what more can be done to prevent bank runs and crises? It is also one of the goals of the book to address these questions by modelling profit-maximizing banks to identify the circumstances in which liquidity provision would be effective or ineffective.

The format and the impacts of capital controls

To limit the exposure to global risks without restoring bank regulations, capital controls have been popularly adopted as macro-prudential policies. Capital controls aim to restrict flows and can be implemented in various ways and formats. However, the impacts of controls are not limited to flows but also to the sectors connecting to the flows. Unfortunately, the associated impacts on the connecting sectors by capital controls are not always desirable. Depending on the ways and formats of capital controls as well as economic conditions, capital controls would affect the economy through various channels. Therefore, it is important to be cautious when assessing the real impacts of capital controls by conducting analysis in various ways and tackling the issues from various angles to get a better picture of the real impacts of capital controls before implementing/liberalizing capital controls.

The effectiveness of capital controls

Depending on the goals one wishes to achieve, there are many definitions of the effectiveness of capital controls. In general, according to Edwards (2001, 2007a, 2007b), the goals of capital controls can be summarized as (1) restricting the volumes and compositions of flows, (2) gaining monetary autonomy and (3) reducing fluctuations and preventing crises. Empirically, the findings regarding the effectiveness of capital controls are mixed in several ways.

One example regards the effects of controls on capital flows. Forbes and Warnock (2012) find that capital controls have little association with foreign-driven capital flows. However, El-Shagi (2010) discovers that capital controls can restructure capital flows without distortion but does not specify whether the capital flows to be restructured by controls are limited to foreign- or domestic-driven flows. Without the specification of foreign-/domestic driven f...