Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 3 Monetary Policy In An Open Economy

Globalisation and Monetary Policy

The 1990s have been marked by a further pickup in domestic as well as external liberalisation in a number of EMEs. Expansion in volume of world trade has continued to exceed the growth in world output. Even as world output growth decelerated from 3.3 per cent during the 1980s to 3.1 per cent during the 1990s, growth in volume of world trade in goods and services accelerated from 4.5 per cent to 6.4 per cent over the same period. Thus, between 1980 and 2003, while world output has doubled, world trade has trebled. Global trade openness has increased substantially. After showing some stagnation during the 1980s, trade openness - measured as the ratio of global exports of goods and services to world output - jumped from 19 per cent in 1990 to 25 per cent in 2003. Apart from continuing trade liberalisation during the 1990s, the higher order of expansion in international trade can be attributed to three factors:

1. falling costs of trade;

2. productivity growth in tradable goods sector; and,

3. increasing income per head.

As a country's income rises, consumer spending shifts away from basic food and clothing towards manufacturing goods which offers scope for product differentiation, diversification and international trade. Quantitative analysis suggests that the fall in relative prices of tradable goods (relative to non-tradables) and the fall in tariffs are the key explanatory factors leading to increased trade. For a sample of 10 developed economies, these two factors alone explain nearly 65 per cent of the increase in the ratio of imports to total final expenditure. While increased trade is beneficial to an economy, evidence suggests that trade flows can also be quite volatile and economies may be required to make substantial adjustments in their current accounts.

While trade flows continue to be an important source of global transmission of shocks, a fundamental change that has taken place in recent years is the movements in capital flows. In the aftermath of the World War II, efforts to liberalise international trade in goods made significant progress from multilateral negotiations through various rounds of discussions under the General Agreement on Tariffs and Trade and subsequently, under the World Trade Organisation. Liberalisation of trade in services has, in particular, received a focus in the recent decades. In contrast the post-War period till the early 1970s was largely characterised by capital controls. This was, in turn, the outcome of the fixed but adjustable exchange rate systems under the Bretton Woods system. With the collapse of this system in the early 1970s, flexible exchange rates permitted countries to start liberalising their capital accounts. Initially, advanced economies opened up their capital accounts and in the 1990s, a number of emerging economies opened up their capital accounts. At the same time, it may be noted that while trade liberalisation is generally viewed to be welfare improving, a similar unanimity does not prevail in the case of capital account liberalisation.

Reflecting this progressive opening up of capital accounts, capital flows to EMEs increased significantly during the 1990s. As a consequence, it is capital flows that now influence exchange rate movements significantly as against trade deficits and economic growth, which were important in the earlier days. The latter do matter, but only over a period of time. Capital flows, on the other hand, have become the primary determinants of exchange rate movements on a day-today basis. Second, unlike trade flows, capital flows in "gross" terms which affect the exchange rate can be several times higher than "net" flows on any day. These are also much more sensitive to what everybody else is saying or doing than is the case with foreign trade or economic growth. Therefore, herding becomes unavoidable. Thus, the analysis of capital flows and their behaviour - the volatility on account of the boom-bust pattern - becomes important for the conduct of monetary policy.

The nature of capital flows to EMEs has undergone significant shifts in the post-World War II period. In the period till the 1980s, capital flows were mainly in the form of aid flows and these were relatively stable. With external and financial liberalisation, net capital flows to developing economies have increased rapidly. This step-up was entirely on account of private capital flows, which increased from fairly low levels - about US $ 15 billion per annum - during the 1980s to a peak of almost US $ 166 billion by mid-1990s before dipping sharply in the aftermath of the East Asian crisis and a recovery in the subsequent period. The defining characteristic of private capital flows is their volatility. Monetary authorities thus need to understand the nature of these capital flows so as to make a distinction between enduring and volatile components of capital flows. Within private capital flows, direct investment inflows are relatively stable while portfolio and debt flows are highly volatile. Even with the sharp reversals, net private capital flows averaged US $ 122 billion per annum during the 1990s, eight times of that recorded during the 1980s.

Official flows on the other hand, at US $ 23 billion per annum during the 1990s were lower than that of US $ 26 billion per annum during the 1980s. Official flows were thus a fifth of private capital flows during the 1990s. Total capital flows to EMEs, therefore, moved in tandem with trends in private capital flows. While recent trends in private capital flows suggest an increase in financial integration, other indicators suggest that global financial markets are still not highly integrated. Correlation of national savings and national investment - the Feldstein-Horioka puzzle - remains very high, despite the significant opening up of global arkets. However, it needs to be stressed that absorption of capital flows has to be matched by an equivalent current account deficit. This deficit cannot be too high on a sustained basis and if it is so, it has to be turned into a surplus later on. In this backdrop, high correlation between savings-investment is surely not a puzzle. Another piece of evidence that international markets are not highly integrated emerges from the substantial 'home bias' in the composition of investment portfolios. The proportion of foreign investments in total investments is less than 10 per cent in the case of the US and only 15 per cent in the case of Germany. Thus, capital flows to EMEs may rise further if domestic savings-investment correlation weakens over time or if residents increase the holdings of foreign assets in their portfolios.

Another factor that can lead to a sustained rise in capital flows to emerging economies emanates from the evolving pattern of demographics and this could exacerbate the challenges to monetary policy formulation over the longer term (Mohan, 2004a). In general, economies pass through three stages of demographic transition:

1. high youth dependency (large proportion of population in the 0-14 years group),

2. rise in working age population (15-59 years) relative to youth dependency, and

3. rise in elderly dependency (60+ years) relative to working age population.

The second stage is regarded as the most productive from the point of view of secular growth since it is associated with the high rates of saving and work force growth relative to the other stages.

According to estimates made by IMF (2004), both savings and investment rates increase with an increase in the share of working age population. More importantly, the increase in the savings rate outpaces the increase in the investment rate and this increases the current account balance. An increase in the share of elderly population, on the other hand, has the reverse effect - both savings and investment rates decline, and the current account balance deteriorates as the decline in savings exceeds that in investment. These results confirm that demographic factors have a significant influence on current account balances through their effect on savings and investment.

Over the next half-century, the population of the world will age faster than during the past half-century as fertility rates decline and life expectancy rises. Developed regions like Europe, North America and Japan have been leading the process of population ageing and are likely to be deep into the third stage of demographic transition. Illustratively, according to estimates of IMF (2004), Japan's current account balance will deteriorate by around 2.5 per cent of its GDP between 2000 and 2050. These regions will switch to importing capital. On the other hand, high performers of East Asia and China are in the second stage of the demographic cycle. East Asia could increasingly become an important supplier of global savings up to 2025; however, rapid population ageing thereafter would reinforce rather than mitigate the inexorable decline of global saving. Increasingly, it would be the moderate and the low performers among the developing countries which would emerge as exporters of international capital. India is entering the second stage of demographic transition and over the next half-century, a significant increase in both saving rates and share of working age population is expected. The regional pattern of global population ageing is, thus, expected to get reflected in the magnitude and direction of international capital flows with implications for the conduct of monetary policy. While current global imbalances are more due to the US macroeconomic imbalances, the pattern of capital flows that may emerge from demographic transition is likely to be of a more enduring nature.

The behaviour of the capital flows during the 1990s reveals that these flows can increase rapidly but can be highly volatile. Surges in capital flows and the associated volatility have implications for the conduct of monetary, exchange rate and foreign exchange reserve policies. Emerging market economies, thus, need to be equipped to deal with such volatility in order to ensure monetary and financial stability. A striking feature of the last 3-4 years is the two-way movement of capital between EMEs and mature economies. Notwithstanding the recovery in capital flows, emerging market economies, as a group, have become net exporters of capital to the mature economies since 2000. Three key factors explain the recent movement in capital flows (IMF, 2004). First, EMEs have recorded current account surpluses. As against a deficit of US $ 65 billion per annum during the 1990s, the emerging economies recorded a surplus of US $ 149 billion during 2000-03. The emergence of surpluses reflected the adjustment process in response to the financial crisis in Asia and elsewhere. Countries that experienced crisis had to reduce domestic absorption and increase exports to generate a trade surplus. This process is quite visible in the East Asian countries which have seen a sharp turnaround in their current accounts - as high as 17.8 percentage points of GDP in case of Malaysia and 14.5 percentage points of GDP in case of Thailand.

Countries affected by the crisis were also forced 'external deleveraging' i.e. a reduction in their external liabilities which also explains the pattern of capital outflows since 2001. This process which started in 1997 is still ongoing in some countries. Although non-crisis countries also exhibited some adjustment, the burden was mainly borne out by the crisis countries. The crisis-countries witnessed an average outflow of US $ 48.5 billion per annum during 2000-03 as compared with an average annual outflow of US $ 45.8 billion by non-crisis countries. The order of correction is better gauged when outflows are scaled by GDP; the outflows in the former group of countries at 2.8 per cent of their GDP were more than three-times of that recorded by non-crisis countries (0.9 per cent of GDP).

Second, global imbalances - large US current account deficit - also explain the reverse capital movements from EMEs. Third, the movements in capital flows reflect the accumulation of reserves to maintain a competitive exchange rate as well as self-insurance. Reflecting all these factors, foreign exchange reserves of the developing countries increased by US $ 1256 billion between December 1996 and June 2004. Concomitantly, net foreign assets have emerged as a key driver of reserve money.

The need for reserves as self-insurance emanates from the volatile nature of the capital flows. It also reflects weakness in the existing international financial architecture. Capital inflows can reverse quickly, leaving the country exposed to a liquidity crisis. In this context, the distinction between push and pull factors becomes important. While 'push' factors attribute capital flows to conditions in creditor countries, the 'pull' factors refer to conditions in debtor (recipient) countries. The former help explain the timing and magnitude of new capital inflows and the latter explain the geographic distribution of capital inflows. According to Calvo, Leiderman and Reinhart (1994), low US interest rates - hence, push factors - were dominant in explaining capital flows to Latin America in the early 1990s. Similarly, in the most recent episode of capital flows to the EMEs since early 2000, push factors appear to be playing a key role. According to estimates by Ferruci, Herzberg, Soussa and Taylor (2004), almost two-thirds of the compression in bond spreads between October 2002 and early 2004 can be attributed to push factors alone - in particular, the fall in the US short-term interest rates since 2001. This implies a need for caution by EMEs in borrowing too heavily during times of benign external financing environment, as a reversal in credit conditions is more often than not beyond the control of the borrower. Therefore, it would be more apposite if central banks attempt to hold these volatile flows into their reserves. The precautionary demand for reserves has increased, especially in the period after the Asian financial crisis. Aizenman, Lee and Rhee (2004) found that trade openness - the conventional explanatory variable - is no longer a significant factor in explaining international reserves after the crisis. In contrast, financial openness indicators and volatility of export receipts appear to be a significant factor in explaining the reserve accretion. Precautionary demand for reserves by EMEs apparently outweighs the costs associated with reserve build-up. The overall experience is that capital flows are characteristically volatile, both in terms of longer term waves and even more so in the short term. The longer term waves influence monetary policy thinking during each era, whereas the short term volatility has to be mitigated through day to day monetary policy operations. Monetary authorities, therefore, need to decide as to whether capital flows are durable or reversible. In case, flows are perceived to be reversible, authorities need to be prepared through building up foreign exchange reserves.

As the preceding analysis shows, monetary authorities are required to take cognisance of external developments on their domestic economy. In this context, one issue is: whether ex ante coordination of monetary policies would be useful? Obstfeld and Rogoff (2002) argue that, even in a world with significant economic integration, the welfare gains from international coordination are likely to be quantitatively small in comparison to gains from domestic stabilisation policy. Their result is, however, contingent upon the premise that domestic monetary policy rules will improve over time and that international markets will become complete over time. Clarida, Gali and Gertler (2002), on the other hand, argue there may be benefits from coordination. An ex post empirical assessment of monetary policy for 14 OECD countries suggests that monetary policy interdependence has increased. There is some evidence of increased business cycle synchronisation, at least for advanced economies.