Speech

Managing Capital Flows: Challenges in Leaner Times

May 5, 2017

Introduction

Welcome to this conference on “Managing Capital Flows: Challenges for Developing Economies.”

I would like to thank Finance Minister Mutati for his warm welcome.

Thanks to all of you for joining us today for the third capital flows conference that the IMF has organized since 2011. A lot has changed since our last gathering in Mauritius in 2015. That was a moment when developing countries were benefiting from the commodities boom and investments were flowing. That situation presented one set of challenges for managing capital flows.

Now the global backdrop is entirely different—and that means a very different set of capital flow challenges. The world economy is gaining momentum again, but sub-Saharan Africa still faces its slowest growth in 20 years. Commodities exporters are feeling the pinch of low commodities prices, which remain far below the levels of 2015.

The result is that investors have found the risk profile of many developing countries to be daunting. The immediate policy challenge is no longer how best to accommodate surges, or just rising capital flows. It is how to prevent outflows—or even to get capital to return.

I think you understand exactly what I am talking about. Many of the ministers and governors who have joined us are grappling with the ramifications of this reversal of flows. So, in the time I have today I’d like to address these policy challenges within the context of our broader discussion of managing capital flows.

We should not lose sight of the bigger picture: that global booms and busts will recur. But right now, the immediate issue is how to manage the much leaner environment for capital flows. I hope my perspectives can help spark today’s discussion.

Let me start with a few numbers that illustrate what the developing countries are facing. Then I will offer some perspectives on capital flows and growth, before coming back to the policy challenges that sub-Saharan Africa faces.

With the drop in global commodity prices, growth in developing countries slowed from six percent in 2014 to just 3.6 percent in 2016. Our latest Regional Economic Outlook for sub-Saharan Africa sees growth momentum in the region remaining fragile and subdued, partly because of insufficient policy adjustment in some of the region’s largest economies.

Net capital flows to the developing world declined 34 percent from 2014 to 2016. Non-FDI flows plummeted 70 percent, with commodity producers feeling the effects the most.

In both 2014 and 2015, issuance of Eurobonds by sub-Saharan Africa—excluding South Africa—hit a record of nearly 7 billion dollars, with 10 countries going to market. Last year only 750 million dollars of bonds were issued—all of it by Ghana. The prospects for this year look slightly better, with one issuance so far and a few others looking to go to market. But this is a far cry from where we just two years ago.

One key point: External financing conditions for some countries have eased somewhat since last year in line with the relaxation of global financial conditions. But borrowing costs remain higher for sub-Saharan African economies than other developing countries. That’s because investors remain more focused on policies and fundamentals since the commodities slump began. Needless to say, an unexpected shift in Fed policy could have a significant impact.

Growth and Capital Flows

I will return to the situation in Africa in a moment, but allow me to take a moment to explore some perspectives on economic growth and capital flows.

Research has not reached strong conclusions about the impact of capital flows on economic growth. This reflects some well-known difficulties identifying the effects, which depend on thresholds related to the quality of economic and political institutions, and the level of financial development.

That said, our latest World Economic Outlook shows that a one percentage point increase in the ratio of capital flows to GDP raises medium-term growth by two-tenths of a percentage point.

Growth effects depend on the nature of the flows themselves: the benefits tend to be more evident when foreign capital brings more than just financing. This means the technologies and know-how that may, but do not always, accompany flows. The benefits are also likely to accrue strongly when developing countries make the most of available external finance—for example, when it finances productive infrastructure.

There are other benefits: financial openness may promote financial development, and, indeed, financial inclusion. It may facilitate risk sharing and more efficiency in the global allocation of capital. These benefits are part and parcel of why countries seek further integration in global capital markets.

IMF advice on managing capital flows

Of course, capital account openness is a mixed blessing. Allow me to take a moment to run through some of the challenges that capital flows present, and how the IMF and its membership believe it may be appropriate to respond.

As I have been saying, managing a large volume of capital inflows is not the issue of the day. But lessons about how to do this remain salient, for the reasons I mentioned already. Indeed, our research and experience strongly suggest that effectively managing the inflow phase of the capital flow cycle is the best protection against difficulties, or even a full-blown crisis during the bust phase.

Many of our points will resonate with the policy makers in this room. For example, when flows accrue mostly to the public sector, a key challenge is ensuring that the capital is used productively. In addition, public debt needs to remain sustainable.

Beyond ensuring the sustainability of public finances, the main macroeconomic concerns relate to avoiding overvaluation of the currency and overheating of the economy. Macroeconomic policies are the appropriate tools to manage these risks. Capital flow measures can be deployed in support of—but not as a substitute for—adjustment in macroeconomic policies.

Maintaining financial stability is another key challenge. The issue here is to avoid fragile external liabilities, especially excessive reliance on short-term carry-trade flows and foreign currency exposure of unhedged domestic balance sheets. This involves the judicious application of macro-prudential measures to limit systemic risks. To the extent that capital flows are the source of such risks, both capital flow and macroprudential measures may be required.

With this view in mind, let’s take a closer look at the challenges that Africa faces by dividing the region into commodity exporters and diversified exporters.

Commodity Producers and Capital Flows

The commodity producers are the ones really feeling the pain, with the oil producers hardest hit.

Current account deficits are rising, and so is public debt—in many cases because governments have not responded in the right way to the downturn. The disappearance of capital inflows is bringing pressure to bear on reserves, while exchange rates in several countries remain misaligned relative to fundamentals. But governments fear that action on exchange rates could cause inflation to rise sharply, and hit weak and unhedged balance sheets.

Investors will be very hesitant about returning without the needed policy adjustments. Too many governments have relied on stop-gap measures like central bank financing and accumulating arrears. While some have implemented fiscal adjustment, lost revenue has not been replaced.

What is needed is an appropriate mix of fiscal and monetary measures. For the hardest-hit countries, deep adjustment is in order.

This means growth-friendly fiscal consolidation, with targeted spending cuts and serious efforts to mobilize more domestic revenue. This needs to be combined with steps to protect the most vulnerable members of society.

Where possible, governments need to pursue greater exchange rate flexibility and the reduction of exchange rate restrictions. Additional delays could inflict even more economic damage.

In the long run, the commodities downturn should give resource-intensive countries every reason to diversify. We recognize this may be difficult when domestic resources are so constrained and investment flows scarce. But it is important to continue in this direction by focusing on infrastructure development and improved business climates that can unleash the potential for private sector-led growth and diversification.

The Challenge Facing Diversified Exporters

The picture is brighter for the countries with diversified exports. They have maintained higher growth rates and continue to attract capital inflows—although with fewer borrowing options now that the Eurobond market has become so limited.

Still, vulnerabilities are starting to emerge in some of these countries. Many maintained high budget deficits as governments sought to address social and infrastructure gaps as growth rose. Consequently, public debt has mounted and borrowing costs have increased.

Those vulnerabilities need to be addressed from a position of strength. While the expansionary fiscal stance so far has been appropriate, now is the time to shift toward gradual fiscal consolidation and greater fiscal transparency. Higher revenue mobilization—combined with sound public financial management—is essential. And as I said earlier, with market-based capital flows almost exclusively going to the public sector, sound assessment and implementation of infrastructure projects is essential—as is a firm awareness of debt sustainability.

These are points worth emphasizing for both diversified and commodity exporters.

The fact remains that developing countries—no matter how solid their policy profile—are extremely vulnerable to fluctuations in global risk appetite. This was underlined by the Fund’s latest Global Financial Stability Report. It showed that global financial conditions tend to account for a larger proportion of the variability in financial conditions in emerging and developing economies.

Conclusion

That is where many developing countries stand. They can weather the storm by strengthening their policies and containing the vulnerabilities. For the hardest-hit countries, the priority should be to re-establish macroeconomic stability to be able to regain access to capital flows. This is crucial if they are to tap their tremendous economic potential.

At the same time, developing countries should not lose sight of the overall importance of preparing for the next cycle. Containing imbalances during the boom phase—especially with respect to currency values and credit expansion— will limit the damage inflicted by sudden stops or slowing inflows. At the end of the day, it is essential for countries to be perceived as attractive and safe destinations for investment. Strong macro-financial management at all stages is essential.

I look forward to our conversations today. Thank you.