Appendix I. Factors Motivating Capital Inflows, Their Implications,and Policy Responses
Appendix II. Experiences of Israel and Poland with Capital Account Liberalization
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International Monetary Fund, the National Bank of Poland, the Bank of Israel, and formerly the Czech National Bank, respectively. Comments from Martins Bitans, Nada Choueiri, Costas Christou, Martin Cihak, Karl Driessen, Robert Feldman, Lorenzo Giorgianni, Gavin Gray, Robert Hagemann, Daniel Hardy, Alexander Hoffmaister, Han Herderschee, Wes McGrew, Andre Meier, Ashoka Mody, David Moore, Ceyla Pazarbasioglu, Stanislav Polak, Piotr Szpunar, Chris Towe, Rachel van Elkan, Andrew Tiffin, and Dalia Treigiene, and able research assistance from Yulia Makarova and Nada Oulidi are greatly appreciated.
Bulgaria, Croatia, the Czech Republic, Estonia, Hungary, Israel, Latvia, Lithuania, Poland, Romania, and Turkey.
See Ariyoshi and others (2000) and the literature cited therein for a description of these experiences.
In the early 2000s, the share of other investments (including, e.g., a significant fall in the short term assets of commercial banks abroad), as well as purchases of domestic bonds by nonresidents were also non-negligible.
There were no net inflows through the banking system in Bulgaria in 2005, largely as a result of the credit limits that were introduced early that year.
In the Czech Republic, Hungary, Poland, and Romania, the liberalization of capital flows was a key commitment in the context of EU accession and OECD membership.
See Kapteyn, Keller, and McGettigan (2005). Some issuers, merely issued the YTL bonds and onlent the proceeds in Turkey for projects—a natural currency hedge. Issuing YTL bonds, other private foreign issuers used the proceeds to buy (higher yielding) domestic public debt instruments as a currency hedge, thereby prompting capital inflows. This type of hedging is associated with international investors who may have appetite for exposure to the YTL and the higher local rates in Turkey but may face restrictions (e.g., to invest only in investment grade credit), or simply shy away from the transaction costs of buying Turkish paper directly. For these investors, a foreign bank may issue a 5 or 10 year bond denominated in YTL and demand or buy a similar bond issued by the Turkish Treasury to cover the YTL liability this creates on the balance sheet.
Foreign banks hold an average of 80 percent of domestic banking system assets, except in Turkey, where the share of foreign-controlled banks continues to be small (about ¼ of total assets).
FDI into the banking and financial sectors in Croatia and Poland and functioning of branches of foreign banks in the Czech Republic brought increased efficiency and managerial skills, and contributed to the development of interbank FX and bank-client markets, thereby providing an important stabilizing element for managing FX risks (e.g., during the currency crisis). In the Baltic’s, subsidiaries of foreign banks have benefited from knowledge transfer as foreign parent banks have enforced credit management techniques on their subsidiaries similar to those in their home institutions (see e.g., Adahl, 2002, and Schipke, and others, 2004).
In fact, there has been a significant deterioration in banks’ net foreign asset positions since the early 2000s (see Hilbers, Ötker-Robe, Pazarbasioglu, and Johnsen, 2005).
The real growth of banking sector credit ranged from 16-45 percent in the Baltic’s, Bulgaria, Croatia, Hungary, and Romania during 2002–2005, with a significant FX component, ranging from 40–80 percent of total loans (Enoch and Ötker-Robe, 2007). In Turkey, there has been a significant increase in consumer loans in recent years and banks are exposed to indirect FX risks through their customers.
In Latvia, several foreign controlled banks have been seeking to expand and maintain market share, leading them to lower lending standards (IMF, 2006). In Lithuania, the riskiness of bank exposure to the household sector have been aggravated by several factors, including the softening of credit standards (Ramanauskas, 2007). High growth rates of some types of loans, strong competition and loosening of credit standards induced the authorities to increase close monitoring of the appropriateness of risk evaluation by banks (Bank of Lithuania, Financial Stability Review, 2005) and encourage banks for more prudent risk management and strengthen capital buffers during 2005–06 (IMF, 2007).
In Poland, the non-responsiveness of the partly reformed banking sector and segmented financial markets limited the transmission of policy rates to market rates in the late 1990s. Given the ineffectiveness of the traditional instruments, the NBP, in an unusual operation in late 1997, attracted deposits directly from the household sector to force banks to raise deposit and lending rates. Similarly in Croatia, sterilization efforts were undermined by the lack of effective monetary instruments. Since even very high interest rates on central bank bills failed to attract demand from the banks, the Croatian National Bank (HNB) temporarily used (until end-1996) “obligatory HNB bills” that were remunerated at a rate higher than deposit rates but slightly lower than those on voluntary HNB bills. The high euroization of the economy continues to undermine the HNB’s sterilization efforts at present.
Greater flexibility was afforded, for example, by gradually widening exchange rate bands in the Czech Republic (1996), Hungary (2001), Israel (until 1997), and Poland (1995–99), and by a switch to floating exchange rates in the Czech Republic and Israel (in 1997), Poland (in 2000), and Romania (in 2004).
Fiscal policy in general remained prudent in these countries, as the main tool for stabilization and to reduce external imbalances (Arvai, 2005, Lattemae, 2007, Lewis, 2005, and Kattai and Lewis, 2004), although there have been limits to the feasibility of maintaining fiscal surpluses for sustained periods of time (IMF Country Reports, various issues).
Chilean-type inflow controls in Croatia (1998), including a deposit requirement for short-term foreign credits, and limits on banks’ short-term open positions with nonresidents in the Czech Republic (1995). In the latter, the measure had only a limited effect in extending the maturity of the inflows as it was circumvented. In Croatia, they were effective in reducing the share of short-term inflows, but the controls on longer term financial credits and deposits were lifted in late 1998 after a market turmoil, making it difficult to assess their overall impact.
The literature on effectiveness of such measures on net inflows is inconclusive, however, given the potentially positive impact of such measures on market confidence in stimulating further inflows.
For instance, in the earlier (1994–96) period of inflows to the Czech Republic, the pegged regime was weakened by monetary expansion, failure to prevent overheating, and large current account deficits. During the subsequent inflow episode in 2001–02 under IT, the currency appreciated markedly in nominal terms, and a prolonged stagnation was followed by worsening exports and an undershooting of inflation targets in 2003–04.
Israel’s experience is informative in this regard. The Bank of Israel (BoI) adopted a “crawling fan” regime and a non-intervention policy from mid-1997, in response to the pressures generated by attempting to simultaneously target inflation and the exchange rate. Under the fan, the band width was asymmetrically widened on the more depreciated limit, while the more appreciated limit had been under attack; this approach raised the actual and potential variability of the exchange rate, and taking advantage of high domestic interest rates was no longer a virtual one-way bet. The BoI was able to stop intervention until the formal elimination of the band. The regime not only helped increase the perception of two-way exchange rate risks and led to a fall in the private sector’s net foreign liabilities, but also helped the market learn to cope with exchange rate uncertainty, contributing to the development of FX hedging markets (Ötker-Robe and Vávra, 2007).
For example, Romania was facing competitiveness concerns related to large capital inflows in 2004–05, which created some reluctance to allow rapid pace of exchange rate appreciation and raised policy tensions.
The appreciation of the koruna associated with capital inflows in the 2000s resulted in prolonged undershooting of inflation targets, despite efforts to limit the inflows and their implications for the targets. This was particularly true for the 2001–02 episode in which government induced FDI (e.g. privatization and government bond issuance) and other inflows replaced the “capacity building FDIs” (e.g., greenfield investment) of the late 1990s, and agreement was made on converting governmental FX proceeds in the central bank. While the nominal appreciation eventually came to an end (following a series of interest rate cuts, supported with interventions), the real appreciation had prolonged effects on economic activity and the external balance that kept inflation low until 2004 (see the CNB Inflation Reports, various issues).
In Israel, experience with sterilized intervention was unfavorable because it raised questions on commitment to the inflation target, while also leading to large quasi fiscal costs and undermining the BoI’s capital. In Romania, the NBR intervened, at times significantly from mid to September 2005 on concerns about the sustained appreciation pressure and its implications for the current account. With insufficient support from fiscal and incomes policies the policy mix undermined the credibility of commitment to the inflation target.
During EU accession Hungary took a cautious approach to liberalization: controls were maintained on certain capital transactions, including on lending to nonresidents in domestic currency and derivative transactions, thereby helping limit speculation against the currency (Arvai, 2005). Romania postponed liberalization of certain capital transactions under its EU accession commitments, including restrictions on nonresident purchases of government securities and other controls on short-term capital until 2005. Poland and Israel deferred further liberalization of inflows and remaining capital account transactions at times of strong inflows.