from Follow the Money

Is the IMF heading toward irrelevance because of a revival in private capital flows?

September 20, 2005

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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My answer is no.

If the IMF is irrelevant (I don't think it is), it is not because private capital inflows to emerging markets have rebounded to pre-crisis (i.e. 1996/97) levels.  It is because emerging markets hold far more reserves now than they did then.

But let's get one thing straight.  Private capital inflows to developing countries right now are not financing "development" in emerging economies, at least not if "financing development" means "making up for a shortage of savings in emerging economies" or "allowing investment in excess of savings in emerging economies."  Right now, private capital inflows to emerging markets lead to higher reserves, and end up supporting the US Treasury market, the US agencies market, the mortgage-backed securities market, the German bund market and the UK gilt market.

The argument that private capital is once again financing "development" will be bandied about a lot this weekend.  It already showed up in a recent Bloomberg article, which argued: "Private capital markets are increasingly supplanting it [IMF] as the main source of credit for developing nations"

Of course, the IMF was never the main source of credit for developing nations.  Its role was (and is) to step in when private investors - both foreigners and a country's own residents -- suddenly decide they want to get out.   The IMF is not a substitute for private capital flows; it is a substitute for holding more reserves to cover sudden interruptions in private capital flows.   But let's set aside that point, and all the complexities associated with determining when the IMF should lend when private investors will not, and when it should not. 

Instead, I want to focus on the argument that private capital flows from investors in advanced (or industrial) economies have become a huge source of financing for development irritates me a bit.  Is it true?  I would say not really, at least not anymore.   Private investors were an important source of development financing back in 1996 or even 1997.  But not in 2005, even though private capital flows to emerging economies have revived.  At least not in aggregate. 

Why not?  Simple.  Almost all emerging economies now (Eastern Europe and Turkey are the exceptions) run current account surpluses, and thus save more than they invest.   They don't need foreign savings to finance their current levels of investment.  They would be adding to their reserves - i.e. financing the US and Europe - even without private capital inflows.  Don't get me wrong.  Private capital flows still bring important benefits.  Emerging economies clearly like the technology transfer and know-how that comes with FDI.  And offsetting flows from emerging economies to advanced economies and from advanced economies to emerging economies allow savers in both sets of countries to diversify their portfolios even if there are no net flows.

But most emerging economies don't need US and European savings to finance their current levels of investment.  At this point in time, more capital inflows to the emerging world simply means more reserves, and thus more support for the bond markets of industrial countries.  Think of China. 

Indeed, many emerging markets are every bit as scared of private markets as they are of the IMF - that is why every dollar in private flows ends up in their reserves.  Setting aside Turkey and Eastern Europe (countries that benefit from being part of Europe's broad sphere of influence), most emerging market economies are reluctant rely on private capital flows from abroad to finance ongoing current account deficits.

The IIF's data on the surge in private inflows to emerging markets -- "Private capital flows to 29 of the biggest developing countries will grow to a record $345 billion this year, up from $120 billion three years ago, the bankers' group forecasts" - is a bit misleading when taken out of context.   Inflows are up, and inflows matter, but so do outflows.  And right now, large private capital inflows to emerging markets are matched by even bigger capital outflows from emerging markets. 

Rather than using the IIF data, though, I want to use the IMF's data.  It is comparable, but a bit broader and more comprehensive.  And rather than 2005 forecasts, I will use 2004 data - not that much has changed, so the basic point still holds.

In 2004, private investors put $574 billion in emerging markets and developing countries.  That is a lot - it lots the previous peak of $516 billion in 1997.  Want to understand why emerging economies don't trust private markets to provide stable development financing in some sense?  $516 billion in 1997 fell to $136b in 1998.

But there is one key difference between 2004 and 1997.  In 2004, outflows from emerging economies totaled $941 billion.   That means emerging economies provided $367 billion in (net) financing to the rest of the world.  Compare that to 1997, when outflows from emerging economies were only $401 billion.  Inflows exceeded outflows by $115 billion, meaning the world provided $115 billion in (net) financing to emerging economies. 

That key shift in the pattern of capital flows is left out of this Bloomberg article.

The "outflows" data includes outflows from reserves.  Let's look at that data in more depth.  

  • In 1997, private capital outflows from emerging markets totaled $296b.  Private inflows were $516b.  The $220 b in (net) private inflows supported two things: a $105 billion increase in reserves, and an (aggregate) current account deficit of $115 billion.
  • In 2004, private capital outflows from emerging markets totaled $424 billion, v private inflows of $574 billion.   Net private inflows were $150 billion, not that much less than in 1997.   What did those inflows finance?  I would say $150 billion in reserves.   Total emerging market reserves increased by $517b.   $150b of that reserve increase was financed by capital inflows; $367 b by the current account surplus of emerging economies.  Data comes from table 1 of the statistical appendix of the IMF's global financial stability report.

The real story of the past few years, at least to my mind?   The fact that emerging market reserve accumulation has gone from $116 b in 2001 to $186 b in 2002 to 4365b in 2003 to $517b in 2004 ...  That -- I suspect -- has something to do with current low interest rates in the US and Europe.  I generally agree with Martin Wolf, but I thought he should have at least mentioned the "recycling" of private capital inflows back into industrial country bonds in his recent column.

The surge in emerging market reserves does pose some challenges for the IMF.  But this Bloomberg article still overstates the risk that IMF will find itself with nothing to do, even though the reporter saves the article by ending with a (useful) note of warning by Desmond Lachman. 

The resilience of emerging markets is not tested when global growth is strong, g3 interest rates are low and capital is flowing in.  It comes when growth slows, interest rates rise and capital starts flowing out.   Most emerging economies seem to have the reserves required to manage most sources of stress - indeed many in Asia have far more than they need.  But some of the IMF's biggest borrowers, namely Turkey and Brazil, are in somewhat different position.  The IMF will retain a role as a source of borrowed reserves for emerging economies.   Look at the IMF's financial statement.   Countries are paying the IMF back big time right now - but the IMF never committed more money than it did in 2002.  And 2002 is not that long ago.  Some things have changed.  But not everything.  Rumors of the IMF's death have been greatly exaggerated.  In April 2005, the IMF had more loans outstanding than it did in April 2001 (see section 2 of the appendix of the IMF's annual report; I love clearly love wonky appendixes ... ) ... 

The real challenge to the IMF does not come from the resurgence in private capital flows.  It comes from the fact that many emerging markets now have far more reserves than they know what to do with.  China will have about four times the financial fire power of the IMF by the end of the year.   Korea has about as much financial firepower as the IMF.   Should it want to do so, China has more than enough hard currency stashed away to lend Brazil $50 b - more than the IMF provided in 2002 - should Brazil need it.

Yet neither the IMF nor Korea nor China has anywhere near the fire power needed to manage a real crisis in the world's largest economy.  The IMF provided Turkey with a credit line of more than 10% of its pre-crisis GDP.  Anyone got $1.2 trillion for the USA? 

Those numbers obviously exaggerate to make a point.  I don't seriously think the US would need $1.2 trillion.  The USA is different from Turkey.   Dollar debt is much less of a problem if you can print dollars.  But it is pretty clear that the IMF is not really designed to help work through the risks created when its largest shareholder, and the world's largest economy, is the country most vulnerable to an interruption in private (or official) capital inflows. 

This IIE conference should be interesting.

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