Changing patterns of capital flows

The decade following the Great Financial Crisis (GFC) of 2007–09 saw significant changes in the patterns of capital flows, especially in their composition. These changes reoriented rather than reduced concerns about the potentially adverse impacts of exceptionally large or volatile capital flows. In particular, extreme swings in non-resident inflows still pose a significant risk to macroeconomic and financial stability. This risk is particularly high for emerging market economies (EMEs), which tend to be more dependent on foreign capital and whose local financial systems are less resilient to shocks. The challenges posed by large swings in capital flows were highlighted again in the early stages of the Covid-19 crisis, when portfolio flows to EMEs reversed with unprecedented speed and magnitude. The crisis demonstrated the effectiveness of policy tools in managing the risks associated with extreme shifts in capital flows, but it also served as a reminder that both the toolkit and the framework for its application are still works in progress. Whereas the Committee on the Global Financial System's (CGFS) previous report on capital flows to EMEs, published in 2009, did not come to a definitive conclusion regarding the net benefits of capital account liberalisation, empirical evidence based on the richer data available today highlights these benefits more clearly. Capital inflows can have significant positive effects on real economic outcomes and financial development. However, the risks are also clearer, especially the adverse effects of sudden stops in capital inflows. These risks can be significant, and they are shaped by three sets of factors. First, they depend on the characteristics that "pull" capital flows towards recipient countries. Second, they depend on exogenous conditions that "push" capital flows to foreign markets. Third, they depend on the "pipes" through which capital is channelled, such as different types of financial intermediaries and the rules and practices they follow. Overall, there is a higher risk that resources will be misallocated when capital flows are driven by global financial conditions or channelled through a domestic financial system beset with financial frictions. The CGFS's 2009 report concluded that, at that time, a large number of EMEs already met the macroeconomic and financial system preconditions for fully realising the benefits of international capital mobility. This has since proved to be true. Improvements in EMEs' macroeconomic fundamentals and institutional frameworks have made investors more selective when assessing opportunities in EMEs. These improvements addressed structural weaknesses, leading investors to shift their focus towards cyclical factors such as economic growth. Supported by improved fundamentals, capital flows to EMEs have, on average, held up better than those to advanced economies (AEs) in the years since the GFC. Inflows to EMEs fluctuated around their pre-GFC levels, whereas flows to AEs remained far below their pre-GFC levels. That said, inflows to EMEs remained low in comparison with the size of their economies. China stood out as one of the few EMEs to see a substantial increase in inflows after the GFC. Even though EMEs have continued to catch up to AEs in terms of the development of their financial systems and policy frameworks, these structural improvements have not insulated them from sudden stops. The frequency of sudden stops in capital inflows to EMEs has not significantly declined since the GFC. Importantly, however, the improved resilience of EMEs has reduced the severity of the disruptions these sudden stops cause. For example, during the Covid-19 crisis, in contrast to previous periods of global stress, many EMEs had enough policy leeway to implement countercyclical policies to smooth the adjustment to the shock. Sudden stops are typically triggered by exogenous global shocks. Tightened monetary policy in major AEs stands out as a potential trigger, as seen during the 2013 "taper tantrum". Commodity price fluctuations played a role in the sudden stop episodes of 2015. Shifts in international investors' risk appetite are another possible trigger, as seen during the Covid-19 crisis. In general, global factors have played a significant role in driving capital inflows to EMEs. Against the backdrop of a prolonged period of low interest rates, there has been abundant global liquidity since the GFC, fuelling international investors' pursuit of yield. Shifts in risk appetite have also had an important influence on the ebb and flow of capital. Furthermore, due to China's growing weight in global activity, economic and policy developments in that country have increasingly shaped capital flow patterns, as demonstrated by the financial market fluctuations that followed the devaluation of the renminbi in 2015. Since the GFC, the pipes that channel capital flows to EMEs have changed significantly. An increasing share of foreign capital has been channelled through investment funds and other portfolio investors. Indeed, in many countries, portfolio investors have surpassed banks as the largest source of foreign credit. Other changes in these pipes include the international expansion of EME-based banks and investors, which has also broadened the role of public sector investors in international capital markets. Foreign direct investment (FDI), which has historically been the most stable and beneficial type of capital inflow, has also been more affected by financial and tax-related strategies than it had been in the past. These changes have altered the risks associated with capital inflows to EMEs. On the one hand, they helped diversify the investor base and develop local financial markets. This in turn enabled governments to borrow in their own currency rather than in foreign ones, thus reducing the currency mismatches that had exacerbated earlier crises in EMEs. On the other hand, the rising importance of portfolio investors exposed EMEs to new risks, or rather, "old risks in new clothes". Passive investment strategies and other practices in the asset management industry can give rise to herd behaviour and contagion, such as when changes to a bond or equity index trigger a rebalancing by the portfolio investors tracking the index. Also, unhedged investments can amplify feedback loops between exchange rates and asset prices, potentially resulting in destabilising dynamics. Other players, like rating agencies, have become an integral part of the global financial infrastructure, presenting their own new risks and benefits. More generally, the Covid-19 crisis increased attention on the potential systemic risks associated with non-bank financial intermediation and how to enhance its resilience. The CGFS's 2009 report concluded that the optimal response to large and volatile capital flows is a combination of macroeconomic and structural policies. It also concluded that there is no "one size fits all" regarding precisely how these polices are best combined – the best combination depends on the country and the context. This report reaffirms these conclusions and expands upon them to highlight that, even for EMEs with strong structural policies and sound fundamentals, there are circumstances in which additional policy tools, particularly macroprudential measures, occasional foreign exchange intervention and liquidity provision mechanisms, can help mitigate capital flow-related risks. Furthermore, the Covid-19 crisis underscored the critical role of international cooperation. The pipes that channel capital are interconnected and operate on a global scale. Therefore, policy actions that affect these pipes and the flows they channel have global implications. This highlights the importance of international dialogue about potential spillovers. It also confirms the need for a strong global financial safety net composed of a mix of tools suited to different shocks, including tools for alleviating short-term liquidity pressure as well as others designed to ease medium-term adjustment. It also highlights the need for clear international guidance on the appropriate use of various policy tools in managing extreme shifts in capital flows, taking into account their spillovers and other multilateral consequences. The first chapter of this report outlines trends in capital flows since the GFC, especially their composition and volatility. The second chapter examines the drivers of capital flows, distinguishing between what drives capital flows in normal times and what drives them during periods of extreme volatility. The third chapter analyses the benefits and risks of capital flows. The final chapter examines policy tools and lessons for managing risks, drawing on central banks' views of the effectiveness and potential side effects of various tools.