Thinking about capital flows as a Big Fish Small Pond Problem

Andrew Haldane of Bank of England is in top form. He along with Lorenzo Bini Smaghi of ECB have emerged as the finds of the crisis amidst policymakers. Their speeches/papers are insightful and force you to think. You may not agree with Smaghi as he has strong pro-European ideas, but still takes you through issues with Europe which no one does.

There are few such problems with Haldane. His speeches have loads of data, graphs and ideas.

In his recent speech he says we need to think about this capital flows issue as Big Fish Small Pond Problem.

  • Big fish is developed econs which are looking to diversify their portfolios. The home bias (investors investing in home countries) has declined over the years
  • Small Pond is developing economies which are looking to deepen their financial markets but this would take time.
  • As big fish moves into small pond, ripples and bubbles are bound to be there. This is what is happening in developing economies which are trying to prevent these fallouts.

His paper looks at this BFSP issue:

This paper considers the BFSP problem. It plots the evolution of the international financial network over the past quarter-century. And, within that, it assesses recent shifts in portfolio choice by international investors which may have accentuated today’s BFSP problem (Section 2). More speculatively, it then considers potential future trends in portfolio choice and assesses their implications for tomorrow’s BFSP problem (Section 3).

If recent trends are continued, the BFSP problem may become more acute over time. In the race between capital market deepening in emerging markets and capital diversification in advanced economies, the latter may gain the upper hand (or foot). The BFSP problem during 2010 may have been the thin end of a sizable wedge. That, in turn, may intensify the debate on appropriate policy responses, such as the pace of capital liberalisation and the case for capital restrictions (Section 4)..

He explains this BFSP problem using global financial network showing nodes (shows absorptive capacity of economies) and linkages (capital distribution of adv economies). The exercise shows both capital deepening (by emerging econs) and integration (advanced economies). Today’s BFSP analysis shows:

Portfolio reallocation by the big fish has outpaced growth in the small pond of emerging capital markets. The upshot has been large and mounting financial ripples. These strengthening waves of capital inflows have, in turn, prompted some emerging countries to construct protective policy seawalls, such as capital flow restrictions and macro-prudential policies.

 

Countries which have used these policies are HK, China, Korea, Brazil, turkey and Indonesia (India is missed from the list as always).

What about tomorrow? Will this BFSP problem be smaller?  Not at all. Economic development in emerging will lead to financial deepening. And advanced economies further diversify lowering home biases further, BFSP problem only expected to intensify.

He does forward projections and says:

Having projected paths for home bias and market capitalisation among the G20 countries, the two can now be combined to give an illustrative general equilibrium projection of global flows of funds. This general equilibrium is a relatively complex one, for it involves the intersection of three forces in global finance:

  • First, the tendency towards increased diversification among advanced country investors. This causes more water to flow downhill – a capital flow substitution effect;
  • Second, the same trend among emerging economies but from a higher base. This would tend to push water uphill – a countervailing capital flow substitution effect; and
  • Third, a change in the composition of the global market portfolio as emerging economies account for a larger slice of the pie – a capital flow income effect.

By combining these three factors, we can form a proximate picture of the emerging pattern of global capital flows. These projections are based on the same restrictive set of modelling assumptions. Nonetheless, they provide a transparent window on possible emerging patterns. Are the forces of financial deepening in emerging capital markets sufficient to outpace the reduction in advanced country portfolio home bias, lessening the BFSP problem? Or does portfolio reallocation by advanced economies risk swamping embryonic emerging capital markets exacerbating this problem?

Further analysis shows, capital inflows to emerging much higher than outflows. This shows BFSP much larger in future:

Taken together, these projections do not suggest a dissipation of the BFSP problem. More likely, they suggest it could intensify, perhaps significantly, in the period ahead. If capital markets operated efficiently, these portfolio flows need not cause waves in emerging credit and asset markets. In practice, frictions in the functioning of these markets mean that asset market spillovers seem very likely to persist. In other words, the splashes from the big fish risk causing waves every bit as great, and potentially greater, than those seen recently.

This leads to reviewing policies which were snubbed earlier:

On this run of history, the global flow of funds could become an increasingly powerful generator of global financial instabilities. In that event, pressures could mount on policymakers to protect against the rising tide of capital flow-induced instability, including through capital restrictions and macro-prudential measures. Some of these measures, if not unthinkable, would have been frowned on as recently as a decade ago. When Malaysia imposed restrictions on capital movements in 1998, it was castigated by the international community. And when the Hong Kong authorities intervened in their stock market in the  same year, many international policymakers blew a raspberry.

What a difference a decade makes. What a difference a crisis in advanced economies makes. Ideological aversion to throwing grit in the wheels of international finance appears, if not to have disappeared, then to have moderated. Where once it was raspberries, today’s policymakers are blowing kisses. Capital restrictions and macro-prudential policies have entered the policy bloodstream, if not yet the mainstream. The debate today is how best to integrate such tools into established macroeconomic policy frameworks.

 

  Qs ahead:

  • Should capital restrictions be used by emerging markets as a last resort once conventional macroeconomic policies have been exhausted?
  • Are capital flow restrictions better conceived as a temporary or permanent measure?
  • Should differing rules of the game apply to different sources of capital inflow (foreign direct investment versus portfolio flows versus banking flows)?
  • What are the respective roles of capital restrictions and macro-prudential policy?
  • What are the respective roles of capital restrictions and financial market deepening as responses to the BFSP problem?
    Finally, what guideposts should be provided by the international community in tackling the BFSP
    problem?

Finally, some countries might get-off from this liberalisation game if benefits not there:

These are big public policy questions. They are by no means new ones. If the quantitative experiments presented here are even roughly right, these questions may assume a new urgency in the period ahead. The BFSP problem is real. It may be rising. The result would be growing waves of global financial exuberance, punctuated by crashing capital busts. This roller-coaster has the potential to leave some nation states feeling queasy. They may even wish to get off. What is at stake may be more than just the future stability of the international financial system.

Superb stuff..Helps you think through many problems via a simplified framework…..

Add BFSP to the many such shortforms which have emerged lately (TAF, TSLF, TBTF etc)

 

2 Responses to “Thinking about capital flows as a Big Fish Small Pond Problem”

  1. EPDM Coatings Says:

    I have lost many of my big fish, after that loss one pond expert told me that your pond is designed for small fish but you are keeping big fish in it for those fish you need little more depth and also little wide area.

  2. ecoloblue 30 awg Says:

    ecoloblue 30 awg…

    […]Thinking about capital flows as a Big Fish Small Pond Problem « Mostly Economics[…]…

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