This morning, I want to offer some thoughts on private capital flows. These, rather than changes in macro policy, now domingate our business cycle.
The volatility of these flows are:
- making our balance sheets more difficult to manage; and
- it's changing: the types of products we offer; and our investment strategies.
These flows also create huge challenges for emerging markets.
Traditionally, economic cycles in OECD countries have been driven by corrections in macroeconomic policy.
Usually, this involved: adjusting short-term interest rates to control inflationary pressures, or it meant altering fiscal policy to help reduce current account imbalances and real exchange rate pressures.
But, the stabilization role of macro policy is changing. It's changing dramatically.
Why is this?
There are several reasons. Over the past decade, many OECD countries have extensively examined their governance structures, and the effectiveness of their policy institutions. Central Banks became more independent as a result. We've seen these moves supported by:
- greater fiscal responsibility; and
- better debt management policies.
In addition, two important deflationary factors make the outlook for price stability the best we have seen in many years.
These two factors are:
- the low costs of transmitting information; and
- the increase in productivity in emerging markets due to technology.
The cost of storing, sending and processing information is falling at a phenomenal rate.
Over the past 30 years, these costs declined each year by over 25%, and this has accelerated over the past 5 years.
We've never seen an important factor cost drop so rapidly for such a long period.
Take international phone calls, for example. These days, the biggest cost for long distance carriers is the cost of sending out the bill. The cost of storing and transferring information is now effectively zero.
A second powerful deflationary force is at work: it is the global transfer of information technology. Nowhere is this more true than in Western China. There, the transfer of these skill enhancing technologies is producing downward pressure on product prices internationally.
This deflationary impact should continue for several years, particularly, as these effects become more deeply rooted in eastern China and India; and as these countries increase their share of world trade.
The seeds of these swings lie in:Swings in private sector capital flows have become the primary driver of our business cycles.
- the disinflation; and
- financial sector deregulation of the 1980s.
As the 1990s progressed, inflation expectations became more deeply embedded at low levels. Investors looked for new ways to enhance yield. We saw EMU convergence trades. We also saw a lot of leveraged carry trades. These often involved emerging market currencies with fixed exchange rates.
Private capital flows to developing countries increased dramatically – by 5 times in the 6 years to 1997. In that year alone, they were 6 times the size of OECD government development aid.
When it came, the market re-rating of sovereign credit risk was both rapid and global. It began when the market reassessed roll over risk in the Czech Republic.
We know how quickly it spread to:
- East Asia;
- Russia; and
- Latin America
We saw a huge flight to quality – into the fixed income instruments of G7 countries.
The main driver in the last economic cycle was stock market flows –– especially into the high tech sector.
The downswing in this cycle was deep – mainly because collapsing equity prices were synchronized among the three major trading blocks.
Capital markets are becoming more volatile.
We see this in:
- swap spreads;
- credit spreads;
- emerging market FX;
- in equity markets; and
- also in some commodity markets
They are volatile for many reasons.
Capital markets are dominated by institutional investors. They invest long-term funds with a short-term perspective on risk and performance.
We live in a world of:
- mark-to-market accounting; and
- quarterly reporting standards.
Fund managers and proprietary traders often have little choice but to follow competitors into more risky trades.
At the same time, the volume of investment funds has increased rapidly.
Other factors are also at play. Privatization programs led to a global equity culture (although we haven't seen much sign of it over the last two years). And in order to attract savings from the rest of the world governments began removing capital controls.
Technology has changed our business so much.
70 years ago ––– on the day that Argentina defaulted in 1932, one prominent New York based investment banker (whose name shall go unmentioned) was in Buenos Aires at the time. He learned officially of Argentina's default, and cabled his head office to offload their Argentinean exposure. Over the next several hours, the firm liquidated its entire position before the news hit the rest of Wall Street the following day.
How times have changed.
Investors all around the world now have instantaneous access to the same information.
Price stability and volatile capital flows have important implications for all of us in the financial services sector. They have strong effects on relative prices and asset prices.
Strong capital inflows into the U.S. helped to double U.S. productivity growth over the past 5 years. That was a major factor behind the strength of the dollar.
We have also seen how declines in stock prices and long-term interest rates have dramatically changed the funded status of pension plans internationally.
Pension Fund Managers around the World are currently revising their
- expected asset returns; and
- strategic asset allocations.
But what does all this mean for our businesses in the future?
Well, first, we're likely to see a greater range of hedging instruments. These may be linked to event risk, such as catastrophes and credit downgrades.
Second, we will see more customized structured investment products. Japanese investors have led the way in this area. These products are likely to become more important in Europe and the U.S., especially as investors look for ays to increase yield in a low inflation environment.
And third – research functions will change. In a world of price stability and volatile capital flows, analysts will generate the greatest value by:
- understanding how capital movements affect the business cycle; and
- understanding how policy makers are likely to react.
Fortunately, improvements in the quality and frequency of economic data are starting to pay off. We are starting to see higher quality credit analysis as a result.
It has been a pretty rough couple of weeks in the market and we may be starting to see signs of contagion from Argentina in the credit spreads for:
- Turkey; and
But, I believe that improved credit differentiation by analysts has been a major factor to date in containing the contagion effects of Argentina.
For developing countries, capital flows present enormous challenges.
The challenges are two-fold.
The 85 countries in the world with per capital incomes below US$500 don't receive significant private capital flows.
Our challenge is to provide them with:
- government aid – while, at the same time:
- strengthening their policies and institutions; and
- creating a climate that will attract domestic and foreign investment.
The tragedy – the tragedy is that many of these countries are desperately short of capital. Let me illustrate.
In doing so, I am drawing on one of the best publications prepared by the World Bank. It is called "Can Africa claim the 21st Century?". The statistics in this book are very distressing.
The 47 countries of Sub-Saharan Africa, including South Africa, have a population of over 650 million more than twice that of western Europe.
But their combined GDP is:
- less than that of the Netherlands and
- not much more than that of Belgium.
And if you look at the infrastructure for the whole continent, excluding South Africa, the amount of paved roads is much less than that of an Eastern European country like Poland.
Over the past five years, private capital flows to all of Africa and the Middle East have averaged around US$8 billion a year.
- US$60 billion in Latin America; and
- US$45 billion in Europe and Asia.
For countries such as China and Mexico who receive sizable capital flows our challenge is to help them manage their volatility. The link between capital outflows and poverty is only too clear.
Each new episode – be it Mexico, Brazil, Thailand, Korea, Russia, Turkey or Argentina, created millions of poor. Each country became dependent upon what turned out to be temporary flows. In order to help manage what they cannot control, developing countries are attempting to reduce their balance sheet risk.
Many Governments are:
- reducing their public ownership;
- they are strengthening their governance; and
- building the capacity of their institutions.
As for the World Bank Treasury, we are doing a great deal to help developing countries manage their balance sheet risk. We're making our loan products more valuable. We've built more flexible repayment terms and embedded options into our loans. We're also providing a lot of technical assistance with an experienced debt management team and, for 20 years, we've been assisting Central Banks in their reserves management.
Over the last two years, we've substantially increased our technical assistance in both these areas. We've also issued bonds in 18 emerging market currencies.
This gives investors the opportunity to take on the FX exposure, while also minimizing their credit risk.
It helps our borrowers by establishing benchmarks for domestic issuers, and it helps the government to develop its domestic bond market.
As you can see our business cycle is changing dramatically.
Life is becoming much more complex for us all.
Capital flows increasingly dominate our economic cycles, and understanding them is an enormous challenge for all of us.
It is changing the way we do business. It is changing:
- the types of products we offer and invest in
- and it is changing our research focus.
For the developing countries, these flows offer great opportunities but they also create enormous management challenges for them.
I hope from the examples that I have given you will realize just what a huge challenge this is for all of us.
Thank you very much.