[SOUND]. [MUSIC] Now we'll speak about consequences of unrestricted capital movement in the world economy, and how economic policies of emerging market economies must adjust to this new global environment. This free capital mobility has several consequences for all economies, but perhaps the most important are for emerging market economies. First, capital mobility changed the philosophies and principles of balance of payment management. Then also capital mobility changes condition in which monetary policy is conducted. And that is a big question, based on these two examples, what policy instruments still remain in the hands of national government? In both cases, but also in other cases. Let's start from balance of payment analysis. The traditional assumption behind such analysis is that the balance of payments and international investment position, they are a concept based on residence. And capital, there is increased assumptions, usually not openly articulated that capital has its fixed residence, domicile, which is not easy to change. So the consequence is that individual country gross national investment must be ultimately financed by out of this country gross national saving. Even if inter-temporal balance of payments and balances are accepted for such a period of time. And this is on microeconomic levels. This is echo of the, some call it, home country bias, as elaborated in the famous Martin Feldstein-Horioka research of 1980. And what are implications of such traditional assumptions? Net capital inflow leads to accumulation of country's external liabilities. And here usually analysts do not distinguish between foreign direct investment and various debt instrument and credits, et cetera. Everything is external liability. And it's according to the previous assumptions. Those external external liabilities cannot grow indefinitely. They must repay it at some point. And the higher they are, the more vulnerable country's external position is. But we live in a bit different world than the world we used to live in 1960s, 70s, or even 1980s. And when I mention Feldstein-Horioka research, we showed that there is this home bias of capital. Probably it was effect of the international financial regime at that time, that most countries follow capital control and was very needed global financial integration. So, as the results in periodical research demonstrated that there is home bias, but we live now in different world. And we live in a definitely, in the world of unrestricted international capital mobility. And major sources of capital do not have country of origin, they may change the whole domicile. And private investors seek the highest rate of return disregarding country borders. And some countries to better business and investment climate may offer higher rates of return than others for a long period of time. So now classical gross assumptions and that is convergence of the right of return do not necessarily must apply. At least for short-term to medium periods of time. And the next question is, can countries in practice influence the size and direction of capital flows? Let's think how it can be done. The most obvious source that many people speak about, there are capital controls. But they are never like in case of members of European Union, where it is prohibited and it has doubtful effectiveness in many other cases. When certain threshold of capital account liberalization is achieved, the remaining restriction can be very easily converted. Monetary policy has basically no impact under hard peg on capital flows and may have limited impact under flexible exchange rate. But introducing exchange rate uncertainty and exchange rate risk. Fiscal policy in macro sense has some impact but sometimes there is in some sense pervasive because if you run a fiscal deterioration in a short term it may bring more capital inflow in order to finance the government debt. But still, improvement in fiscal policy, decreasing fiscal deficit may bring some improvement in current accounts, other things being equal. At least for certain period of time. Fiscal incentives in the sense of micro economy, micro fiscal policy tools may have some impact. I mean various kinds of tax instruments, tax exemption, etc. But more in the respect of structure of capital flows than volume, overall volume. The same counts as micro-prudential regulation, financial sector. They may have some impact on the composition of flows, but rather not on the overall volume. And finally, there is now popular idea of macro-prudential regulation, something between monetary policy and micro-prudential regulation. And here very much depends on what one has in mind. There are different interpretations and basically we still are in not very much trapped toward a scheme system. Many countries are at state of experimenting with various macro-prudential policy tools. What are the consequences of modified assumptions? Those which are related to the world of unrestricted capital movement. One of these consequence is that country may become net capital exporter or net capital importer for a long period of time. We know, for example, situation of oil countries, which do not very often, do not have opportunity to rationally absorb, or related to that. So they become capital exporters. Another hint, countries which, especially many emerging market economies, become capital importers because they are attractive as potential growth center but domestic savings are not sufficient. And the expected rate of return determines the direction of capital movement. When capital outflows happen, this rates not only to capital, which inflowed earlier, so, not the residence money, which flew into country, but when situation worsen, there're going out. It also affects residents and there is many examples from financial crisis episodes, especially emerging markets, that residents are leaving first. But in spite of all this new phenomena, we must remember that capital accounting balances still matter as long as country has its own currency. And there is exchange rate risk. So we cannot say that they don't matter. And other traditional approach in the world of restricted capital mobility. This way of primary impact came from domestic factors of competitiveness, trade policy, exchange rate policy. The influenced trade and current account balances, and then these balances trigger capital flows when country around deficit had to look for source of financing, when it ran surplus it had to think how, how invest the surplus internationally. But in the work of free capital mobility, very often the reverse causality. These are net capital flows, which have exogenous character, and current account balance which must adapt to changes in capital account through changes in the real exchange rate. And here we have two interesting regional exemplifications of how it works. The first graph demonstrates Central Eastern Europe, and the upper, solid line is, net capital flows. And the bottom dotted line, it's current account balance. And we see that when capital flows intensified, especially in decade of 2000 prior to global financial crisis. The current account deficits wided because they had to adapt to capital inflows. Then we saw capital outflow, or sudden stop of capital flows after 2008, 2009 crisis. And current accounts had to adjust. Sometimes it was very dramatic and painful process, but then capital flows started to increase again, and again current account became, started to deepen. And the second region where is quite similar situation, there is Latin America, Caribbean was also current account balance follows very much changes in capital flow, so net capital inflows. And how this interact current account with capital account. First where we think about policy consequences. National macroeconomic policy has limited control over current account balance, and real exchange rate, even if it controls nominal exchange rate, but then is the problem of inflation differences. So, we found that this relevant to the size of current account deficit of countries has its own currency monetary policy. It may arise concerns under certain circumstances on the market, but it has limited policy impact on this variable. This leads us to the frequent criteria of assessment of various analysts who use some kind of styles like, for example, deficit which exceed 4% of GDP current account deficit of 5% of GDP, signs of weaknesses of country, vulnerability of country has current account surplus. It's sign of good health, while we have sometimes quite opposite situation where sometimes we have situation of current account surplus is demonstration of the fact that a country has problems with investment climate, and capital prefers to go out of this country, while current account deficit is very often evidence that countries are attractive for foreign investors. So this was about current account balance, and then you circumstances. Now let's say if you answer, how capital mobility influenced national monetary policies. First observation is that money supply becomes largely exogenous as a result of capital flows. And this happens even under the free floating exchange rate and inflation targeting. Even this regime, which many people consider as most sovereign monetary policy regime, under this regime monetary is limited room of maneuver. Why? Because interest rate decision must take into account international financial market trades who have limited opportunity to lean against the wind. And also there are limits of currency, economic and political limits of currency appreciation and depreciation. As the result of interest rate policy decision. And on the other hand, decisions of major central banks, especially United States Federal Reserve system, goes far beyond their formal jurisdiction. So, basically, they shape not only macroeconomic environment in home countries but also in the entire world. And as we observed during last several years, they sometimes cause serious volatility in capital markets or export inflation or deflation to other countries. And other central banks in countries which are not the centers of monetary policies must follow decision of these major players. For them this is dealing with external shocks producing decision. But they are not random shocks. They are the result of monetary policy decision, but of those major central banks. [NOISE] [MUSIC]
