(Following is the third of four reports based on papers presented at the 2013 Jackson Hole Economic Policy Symposium, hosted by the Federal Reserve Bank of Kansas City. The reports will be published as soon as the authors present their papers to the symposium.)
The sharp movement in emerging markets’ exchange rates in recent months is partly because the flow of money from investors’ portfolios have taken on the character of global liquidity, according to a paper delivered at the Jackson Hole symposium.
The rise of global banking has brought the world closer to being a single financial system, fueled by cross border liquidity that is created by private financial entities, such as major banks and investment funds, and central banks.
Traditionally, the direction of global capital flows was mainly driven by differences in expected returns and this in turn was based on a mix of growth and monetary policy expectations, according to Jean-Pierre Landau, former deputy governor of the Bank of France, in his paper “Global Liquidity: Public and Private.”
In the decade prior to the global financial crises, the flow of wholesale banking capital acted as the artery of global financial markets. A large part of cross-border funding took place between the head office and foreign offices of a bank – almost like an internal centralized funding model in which available funds are deployed globally through centralized allocation decisions.Portfolio flows used to be more stable, driven by economic fundamentals, and there is still a prominent view that growth perspectives are the main determinants behind the inflow of capital into emerging markets.
However, Landau finds that portfolio flows have become more volatile, with higher frequency and shorter cycles as compared with banking flows. This is in contrast with foreign direct investment that has been relatively stable.
Portfolio flows into emerging markets turned negative at the onset of the global financial crises, then surged in 2009 and 2010 as emerging market economies recovered and then dried up again in the second half of 2011 as Europe’s crises intensified and global risk aversion rose before picking up again as financial stress eased in Europe, improving investor sentiment.
“The flows seem to be driven more and more by global risk appetite and, to a lesser extent, interest rate differentials,” Landau said, referring to studies that show that the sensitivity of portfolio flows to policy rate differentials and to risk aversion appears to have increased during the post-crises period whereas in the pre-crises period growth differentials were relatively more important.
Part of this change may be due to the growing importance of open ended funds dedicated to emerging markets that allow investors to move in and out quickly, making it easier for retail and institutional investors to arbitrage between advanced and emerging countries risky assets.
With risky assets in emerging markets becoming more substitutable with those in advanced economies, it has amplified the spillover from monetary policy in advanced countries, he said.
Extraordinary low interest rates and unconventional monetary policy in advanced countries also means that risk appetite has played an even bigger role than usual in influencing the direction of private liquidity, magnifying global liquidity spillovers.
Although portfolio flows remain relatively modest compared with foreign direct investment and banking flows, Landau says these flows represent the “marginal investor, the one that instantly determines the market equilibrium and its price, with huge impact in times of stress when market liquidity dries up.”
The funds offer some liquidity to investors who want to redeem their money if they sense a crises.
“However, valuations may fluctuate and this can create or stimulate runs when risk perceptions shift,” said Landau, adding that the combination of risk sensitivity and a fairly “narrow exit” creates the conditions for such runs and provides a partial explanation for the sharp movement in emerging market exchange rates after the Federal Reserve in June said it was planning to wind down quantitative easing.
This heightened sense of sensitivity to risk perceptions will complicate the task of exiting from ultra-easy monetary policy, necessitating very close and constant dialogue and cooperation between central banks, said Landau, a deputy to the Group of Seven (G7) and Group of Twenty (G20).
“In the longer run, policy choices on global liquidity will determine the shape of global capital markets, as they will orient countries’ incentives in opening and deepening (on not) their financial systems,” said Landau.
Faced with increased volatility, Landau said some countries may decide to protect themselves from the capital flows and this could lead to a fragmentation of the international financial system.
“It may be natural that, after a period of opening and increase in gross asset positions, there would be some retrenchment, as signaled by the shift towards a more “local” model of banking in many countries and the acceptance of capital controls as part of overall macro prudential toolkit,” he said, adding:
“There may be no other choices in the short run as consequences of explosive dynamics of global liquidity are very apparent.”
In the long run, however, such a segmentation may be harmful as imbalances in savings, public debt and financial deepening can be better managed in an open financial environment, he adds.