V. Effects of the Inflows
- Robert Kahn, Adam Bennett, María Carkovic S., and Susan Schadler
- Published Date:
- September 1993
The financial and macroeconomic developments during the inflow periods differed considerably among the six countries. This reflected not only the varying causes of and responses to the inflows, but also differences in other aspects of the economies: initial conditions; policies not directly related to the inflows; and political, regional, and demographic developments that affected expectations. This section reviews the most direct effects of the surges in capital inflows and policy responses in four areas: interest rates and asset prices; reserves and money; inflation and the real exchange rate; and domestic activity.
Interest Rates and Asset Prices
Surges in capital inflows should ease domestic money market conditions and lower domestic interest rates. This is true almost regardless of the causes of the inflows, although when changes in real domestic economic policies have been an important cause, credit demand from residents without access to international markets may be strong enough to push interest rates up. Also, of course, aggressive sterilization as a policy response would limit any drop in interest rates.
It has been seen that in each of the six countries, except Thailand, real short-term interest rates rose just prior to or coincidentally with the initial surge in inflows (Chart 3). To what extent did the ensuing capital inflows reverse these increases? Three broad patterns were evident.
First, in Chile, Colombia, Mexico, and Spain, real interest rates dropped. In Chile, Colombia, and Spain the easing of sterilization one year into the inflow episode resulted in a return of real interest rates to approximately the level during the two to three years preceding the surge in inflows. In Mexico, a sizable drop in real interest rates also occurred, but to a level above the pre-inflow period.8 Second, in Egypt, the large initial increase in real interest rates was not reversed. This reflected several factors: the recentness and short duration of the surge in inflows; the short period elapsed since adjustment policies were implemented; and the persistence of sterilization. Third, real interest rates in Thailand were quite stable throughout the inflow period. This is consistent with the proposition that a tightening of credit conditions played a negligible role in inflows.
These experiences confirm that, barring aggressive sterilization or exceptionally strong domestic credit demand, inflows tend to push domestic interest rates down rather quickly. Moreover, the sharp ebb of inflows as interest rates fell in Chile and Colombia suggests that aggressive sterilization, which helped hold up domestic interest rates, had contributed to the inflows. That inflows were still sizable in these two countries, and even grew in Mexico and Spain as real interest rates fell, suggests, however, the causes for the inflows beyond tight credit market conditions were important.
In most of the countries under review, financial markets remain relatively simple in structure so that bond markets are thin. There are, however, sizable equity markets, which provide an indication of financial developments outside the short-term money market. Here again experiences vary (Chart 5). In Chile, Colombia, and Mexico, there was a break in the trend of real equity prices at the beginning of the inflow episode. In Spain and Thailand, the inflow period saw more modest changes in equity prices. This pattern is puzzling. In theory, the countries where changes in structural and fiscal policies were greatest should have experienced the largest increases in equity prices. The marked divergence from this pattern may reflect differences in the depth of these markets or in starting positions. The countries with the largest increases were those that had been most affected by the debt crisis, which may have affected initial price earnings ratios.
Chart 5.Local Currency Indices of Stock Market Prices1
Source: International Financial Corporation, Emerging Stocks data base; and International Monetary Fund, International Financial Statistics.
1 Period t is the first year of the surge in capital inflows, the timing of which is indicated in parentheses after country name. The indices have been deflated by seasonally adjusted consumer prices.
Reserves and Money
How surges in inflows affect money growth depends on the causes of the inflows. When a tightening of domestic credit market conditions—and therefore residents’ excess demand for money—is an important cause, money growth should not change significantly from recent rates. Rather, inflows should cause a shift in the backing of money from domestic assets toward foreign assets. However, when other causes dominate, inflows represent an increase in the supply of money.9 In these cases, inflows can be expected to push up the growth of domestic money unless or until an offsetting increase in the current account deficit occurs.
In fact, contrary to the fears of policymakers, surges in capital inflows did not, in general, produce concomitant increases in money growth (Table 5). More often than not, the growth of the aggregates, as well as the velocity of aggregates, remained broadly stable or fell. This pattern suggests relatively restrictive monetary conditions, particularly in the countries where disinflation and a reversal of currency substitution were occurring. Surprisingly, however, a quickening of the shift from currency to broad money occurred only in Mexico and Thailand. This is unexpected because these were the two countries where short-term interest rates fell or remained stable, while they rose in the other countries, at least at the outset of the surge.
|Year Prior to Episode||Inflow Episode|
|Year 1||Year 2||Year 3||Year 4|
|Net foreign assets (NFA)2||245.0||442.4||207.7||260.9||…|
|Net domestic assets (NDA)2||–223.2||–114.3||–178.0||–230.5||…|
|Current account offset4||…||—||0.3||0.2||…|
|Egypt (1991/92, July–June)|
|Current account offset4||…||2.0||…||…||…|
|Current account offset4||…||1.1||0.8||0.7||0.8|
|Velocity (ALP)3, 6||1.1||1.0||1.0||1.0||1.0|
|Current account offset4||…||0.2||0.4||0.6||0.6|
|Current account offset4||…||0.6||0.4||0.6||0.7|
What were the influences that insulated growth rates of currency or base money and, by extension the broader aggregates, from the surges in inflows? In Mexico, Spain, and Thailand, the principal influence was a widening of the current account deficit. In these countries where changes in fiscal, structural, and external policies were relatively important causes of the inflows, some 60–80 percent of the cumulative inflows over 3–4 years was absorbed by the widening of the current account deficit.10 In Chile, Colombia, and Egypt, however, current account positions changed relatively little, and the insulation of money growth from the inflows reflected principally changes in domestic credit policies. Once again, causality is difficult to establish. The negligible effect of the inflows on money or current account positions may reflect a relatively important role of tighter domestic credit policies in attracting the inflows to these countries. Alternatively, the stability of money growth could be viewed as evidence that these countries’ relatively aggressive sterilization was successful in insulating the economy—particularly money growth and the current account—from the inflows.
In each country, official reserves rose, in terms of both U.S. dollars and months of imports (Table 6). The size of the increase, particularly relative to imports, was linked to the degree of sterilization and current account offset. In the relatively light sterilizers, where the current account offset was large (Mexico, Spain, and Thailand), the increase in reserves was not more than two months of imports; in Chile, Colombia, and Egypt, however, the increase ranged from four to seven months of imports. Possibly more relevant than the import cover of reserves was the degree to which official reserves provided a cushion against a reversal of the inflows. Table 6 shows, as a summary measure, the ratio of official reserves to the cumulated (over the surge period) flow of net foreign liabilities, excluding direct foreign investment (excluded on the grounds that it is less easily reversible than other forms of inflow). This measure ignores the size of the stock of debt at the beginning of the inflow episode (which, in the countries other than Spain and Thailand, was sizable) and focuses on countries’ vulnerability to a reversal of the inflows only. Although the ratio fell sharply during the inflow episode, it remained above one in most countries.
|Year 1||Year 2||Year 3||Year 4|
|Months of imports||7.8||11.2||12.4||12.6||…|
|Ratio to cumulative capital inflows2||…||2.5||2.4||1.7||…|
|Months of imports||7.5||11.7||11.3||…||…|
|Ratio to cumulative capital inflows3||…||3.3||2.2||…||…|
|Egypt (1991/92, July–June)||6.9||11.2||…||…||…|
|Months of imports||7.2||13.3||…||…||…|
|Ratio to cumulative capital inflows2||…||3.4||…||…||…|
|Months of imports||2.9||3.1||3.9||5.6||4.9|
|Ratio to cumulative capital inflows2||…||2.9||0.9||0.7||0.4|
|Months of imports||5.5||6.2||6.7||6.3||6.3|
|Ratio to cumulative capital inflows2||…||4.3||3.8||2.4||2.4|
|Months of imports||4.7||4.3||5.0||5.2||5.8|
|Ratio to cumulative capital inflows2||…||4.4||2.0||1.2||0.8|
Inflation and the Real Exchange Rate
The potential for inflows to push up inflation posed the greatest concern to policymakers, but, with the benefit of hindsight, was not realized (Chart 6). In Spain and Thailand, inflation edged up to around 5 percent, and in Egypt and Colombia it fell, albeit over a short inflow period to date. An initial acceleration in prices in Mexico and Chile was subsequently reversed. This description begs the question of whether inflation would have been lower had the surge in inflows not occurred. The higher-inflation countries were committed to lowering inflation, and, except in Chile, were not successful in achieving their targets. For these countries, it is reasonable to conclude that the inflows thwarted the policy objective.
The generally favorable outcome for inflation reflects both the limited impact of the inflows on the monetary aggregates and, in several countries, exchange rate adjustments. While not fully explaining the movement in inflation, actions to reduce the rate of depreciation or revalue (the timing of which is indicated by stars in Chart 6) in Chile, Colombia, and Mexico tended to coincide with reversals in, or a sharpening of the deceleration in, inflation. The nominal appreciation in Spain, which was more gradual, had a more continuously moderating effect on inflation.
Real effective exchange rates rose significantly—by more than 10 percent—in each country except Thailand (Chart 2). For the Latin American countries, this trend reflected nominal depreciations that were less than the inflation differential; in Egypt, the nominal exchange rate was held fixed despite large inflation differentials; and in Spain, the real change broadly followed the gradual nominal appreciation. Thailand was the only country that avoided a real appreciation over a prolonged period of large inflows. The stark conclusion is that the unusually large and quick fiscal adjustment, together with a history of low inflation, was critical in this development.
All the governments and many observers expressed concern about the sustainability of changes in the real exchange rate. In principle, they were more likely to have been equilibrating if the inflows were linked to policy changes, such as structural reform and fiscal adjustment, that stimulated productivity and profitability in the traded goods sector; they were likely to be departures from equilibria when tight credit conditions with fixed exchange rate paths, lower foreign interest rates, or currency substitution were the more important causes of the inflows and exchange market pressures. Such qualitative statements, however, do not translate into concrete judgments about the degree of overshooting of the real exchange rate. Pragmatism therefore demands attention to two imperfect, yet observable indicators: changes in the relative profitability of producing traded goods domestically or abroad—commonly measured by relative unit labor costs; and the performance of the export sector. An equilibrating appreciation of the real exchange rate should reflect more an increase in final prices of nontraded goods than an increase in costs in the traded goods sector; thus measures of profitability in the traded goods sector, such as manufacturing unit labor costs, should increase less than relative consumer prices.11 Similarly, while large inflows may increase the demand for nontraded goods this does not preclude vigorous export growth in a growing economy. Indeed, if inflows are to feed long-term growth prospects, the profitability and vibrancy of exports must be strong.
What do these indicators say about the real appreciations in the countries under review? Relative unit labor costs in the manufacturing sector are available only for Mexico and Spain: they indicate a substantial loss of relative profitability, although less than the change in relative consumer price indices during the inflow period. However, even this may be an overstatement insofar as changes in the composition of production may hide quality changes. Export performance was more varied. Non-oil export volume growth rose or remained high in Chile, Spain, and, except for a brief period in 1992, Mexico, while it fell or remained low in Colombia and Egypt. These developments give greater reassurance about the sustainability of the real appreciations in Chile, Spain, and Mexico than in Colombia and Egypt.
Domestic Activity, Savings, and Investment
In Chile, Mexico, Spain, and Thailand, where fiscal adjustments and structural reform played a relatively large role in attracting the inflows, the surge was accompanied by an increase in output, albeit with some lag in Chile (Table 7). While other influences undoubtedly affected output growth, the surge in inflows both raised supply (through higher investment) and increased demand. In most countries, the acceleration in output was moderate; Thailand stands out with a 6–7 percentage point jump in growth. In Colombia and Egypt, output decelerated, albeit over a still short inflow episode. Several influences were at work: a deterioration in the terms of trade in each country and a large fiscal contraction in the first inflow year in Egypt.
|Year 1||Year 2||Year 3||Year 4|
|Real GDP growth (in percent)||7.7||10.0||2.1||6.0||10.4||…|
|Real GDP growth (in percent)||3.9||4.3||2.1||3.5||…||…|
|Egypt (1991/92, July–June)|
|Real GDP growth (in percent)||2.5||2.1||0.3||…||…||…|
|Real GDP growth (in percent)||–0.3||1.2||3.3||4.4||3.6||2.6|
|Real GDP growth (in percent)||2.6||3.8||5.6||5.2||4.8||3.6|
|Real GDP growth (in percent)||5.5||8.4||13.2||12.0||10.0||8.2|
In Mexico, Spain, and Thailand, where the immediate increase in growth was greatest, absorption outpaced output, and the current account deficit widened sharply. This response to the inflows, while often unnerving to policymakers, was at least to some degree equilibrating: it meant that the transfer implicit in the inflows had been effected and relieved pressure on domestic prices. Its implications for intertemporal balance of payments flows were less of a concern when rising investment was the dominant force, as it was in Spain, Thailand, and initially in Mexico. Thailand was particularly impressive in this regard: the investment ratio rose almost 15 percentage points above its average before the inflow episode. However, while it is tempting to disregard increases in the current account deficit matched by a strengthening of investment, at least two sources of concern remain: first, the likelihood of mismatches between the maturity structure of incoming capital (often bank deposits) and the gestation period of investments; and second, uncertainties about the foreign exchange earning potential of investments. The latter was the genesis of concern about real appreciation and its effect on the allocation of investment.
The widening of the current account deficit and the sustainability of the inflows were a serious concern when falling domestic savings were the cause. Among the three countries where the current account deficit rose, the evolution of savings ratios varied widely—from a large increase in Thailand to a moderate decline in Mexico. In principle, a surge in inflows, particularly after a period of low growth, should push up savings—through a bolstering of confidence, any cyclical improvement in fiscal revenues, and a pickup in growth, which might initially be perceived as feeding transitory income. The drop in savings in Mexico, which reflected a drop in private savings that more than offset an increase in public savings, is therefore a puzzle. Two explanations might be advanced. First, private savings may have responded to perceptions of increasing wealth as equity prices rose, government debt fell, and longer-term growth prospects improved. Second, the sizable real appreciation of the peso during the episode may have harbored an increase in labor’s share in value added; if labor’s marginal propensity to consume is above that of capital, this would tend to reduce savings.