The future of international capital flows

William Speller, Gregory Thwaites, 21 December 2011

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The experience of the past decade has demonstrated the challenges that international capital flows can pose for financial stability. Between 2002 and 2007, annual gross international capital flows rose from 5% to 17% of world GDP, and the network of cross-country financial linkages became increasingly complex (Hoggarth et al. 2010). Net international capital flows also rose sharply over this period, with global current-account imbalances (the sum of global deficits and surpluses) doubling from 3% to 6% of world GDP. The build-up of global imbalances was one of the preconditions for the recent financial crisis. And the increased interconnectedness between countries’ financial sectors associated with large gross flows created channels through which the initial shock could spread around the world.

As remarkable as the pre-crisis growth in international capital flows was, the collapse post-Lehman was yet more dramatic. Gross global cross-border capital flows plummeted to less than 1% of world GDP in 2008, with severe implications for both advanced economies – especially those with large, open financial sectors – and many emerging-market economies that had hitherto accessed funding from abroad. In these respects, the scale and volatility of international capital flows were crucial determinants of the depth and breadth of the crisis which followed Lehman Brothers’ demise.

These dramatic events bring home just how essential it is for policymakers to develop strategies to deal with these risks in future. Yet, however great the challenges policymakers may have faced in the most recent episode because of the size and volatility of capital flows, these are set to become even greater in the future as large emerging-market economies increasingly integrate into the global financial system. Whereas the immediate challenge for policymakers today is to prevent – or to have policies to deal with – the risk of a sharp cross-border deleveraging of gross capital flows, the medium-term risk is the opposite – having policies to deal with much larger inflows. But just how large might gross external balance sheets, gross capital flows, and the imbalances in net positions become in the years to come?

To get a sense of this, in a recent Bank of England Financial Stability Paper together with Michelle Wright (Speller et al. 2011), we elaborate on the simulations of Haldane’s (2010) speech titled “Global imbalances in retrospect and prospect”. Our aim is to construct some illustrative thought experiments to describe some potential trajectories for G20 countries’ capital flows and external balance sheets over the next 40 years, based on some key drivers of capital flows.

Based on some assumptions that extrapolate from historical relationships, the scenarios suggest the following outcomes are plausible:

  • The overall size of external balance sheets relative to GDP of the G20 countries in aggregate increases from a ratio of around 1.3 to 2.2.
  • The distribution of external assets shifts to emerging markets. By 2050, more than 40% of all external assets are held by the BRICs (Brazil, Russia, India, and China), up from the current 10% (Figures 1 and 2).
  • Non-G7 annual capital outflows are simulated to be more than twice the size of G7 outflows by 2050. By this time, India and China would represent almost half of all annual gross capital outflows.
  • India’s national saving rate – already high – increases from 38% to 50% in 2050. In Germany, France, the UK, and the US, the saving rate is below 10% in 2050 (Figure 3).
  • Global current-account imbalances (the sum of deficits and surpluses) rise from around 4% of world GDP to around 8% at their peak (Figure 4).

Figure 1. Share of G20 total gross external assets, by country group(a)

Sources: Updated and extended version of the External Wealth of Nations Mark II database developed by Lane and Milesi-Ferretti (2007), IMF, US Census Bureau, Penn World Tables and Bank calculations.
Note: (a) Data for China are only available from 1981. Data for Russia are only available from 1993.

Figure 2. Share of G20 total gross external assets, by country

Sources: Updated and extended version of the External Wealth of Nations Mark II database developed by Lane and Milesi-Ferretti (2007), IMF, US Census Bureau, Penn World Tables and Bank calculations.

Figure 3. Saving rates by country(a)

Sources: Updated and extended version of the External Wealth of Nations Mark II database developed by Lane and Milesi-Ferretti (2007), IMF, US Census Bureau, Penn World Tables and Bank calculations.
Note
: (a) Gross national saving as a percentage of nominal GDP.

Figure 4. Global imbalances (current accounts in percent of world GDP)

Sources: Updated and extended version of the External Wealth of Nations Mark II database developed by Lane and Milesi-Ferretti (2007), IMF, US Census Bureau, Penn World Tables and Bank calculations.

These simulations focus on two fundamental drivers of capital flows – GDP convergence and demographics. Plainly, other factors which we do not explicitly model – such as financial development, changes in investor preferences and the degree of ‘home bias’, exchange-rate policies and the development of social safety nets – will also be important in the years to come. Notwithstanding these caveats, it seems reasonable to envisage a future world in which the financial integration of emerging-market economies is accompanied by a substantial rise in international capital flows relative to world GDP.

Developments in the size and volatility of global capital flows are linked to UK financial stability both directly and indirectly. Direct links operate via the UK’s very large gross external balance sheet position, in turn a function of its role as a global financial centre. A more indirect set of channels operate via the International Monetary and Financial System (IMFS) and, in particular, through interactions between global capital flows and various frictions that inhibit orderly adjustments to imbalances across countries.

The key challenge for policymakers is to mitigate the potential financial stability risks associated with much larger future international capital flows while simultaneously preserving the key benefits that financial globalisation has to offer. The increase in capital flows will have implications for many policy issues, including, but not limited to: The elimination of data gaps; policies which limit the build-up of balance sheet mismatches by currency, maturity and type of asset; the Basel III international capital and liquidity standards; macroprudential policies; the use of capital controls; and reforms to the IMFS. (In another Bank of England study, Bush et al. (2011) underscore the importance of, and outline some options for, the latter).

This is clearly a challenging task, not least because the global nature of the problem will demand a coordinated policy response. But while policy coordination will be a crucial element of any first-best policy response, individual countries may also be able to introduce unilateral measures to mitigate their vulnerability to large and volatile capital flows – including through macroprudential measures. Although the policy challenge is considerable, the experience of the recent crisis shows that the stakes are already high. But if – as the simulations presented in this paper suggest – global capital flows grow to dwarf those experienced in the lead-up to the 2007-8 crisis, the stakes will become higher still.

Authors note: The views expressed in this column are those of the authors

References

Haldane, A (2010), “Global imbalances in retrospect and prospect”, Speech at the Bank of England.

Hoggarth, G, L Mahadeva, and J Martin (2010), “Understanding international bank capital flows during the recent financial crisis”, Bank of England Financial Stability Paper No. 8.

Bush, O, K Farrant, and M Wright (2011), “Reform of the International Monetary and Financial System”, Bank of England Financial Stability Paper No. 13.

Speller, W, G Thwaites, and M Wright (2011), “The future of international capital flows”, Bank of England Financial Stability Paper No. 12.
 

Topics: Global crisis, International finance, Monetary policy
Tags: international capital flows

Economist in the International Finance Division of the Financial Stability directorate, Bank of England

On leave from the Bank of England at the London School of Economics