Managing portfolio flows.

Author:Weller, Christian E.

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...

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