Hard Talk: Should We Better Regulate Capital Flows to Prevent another Crisis?

By José Antonio Ocampo and Alberto Bernal

In the wake of the financial crisis, should governments take policy steps to shield themselves from global contagion and meltdown? José Antonio Ocampo and Alberto Bernal square off in AQ's Winter 2009 issue.

YES: Enhanced Regulation Will Keep Speculators at Bay

Latin America is all too familiar with financial volatility. The policy tools developed by Latin American central bankers and economic policymakers in response to previous crises will therefore serve them well today. But those tools still need to be improved.

The boom-bust tendency of liberalized financial and capital markets has again been evident in recent months. One aspect of these cycles is the “appetite for risk” that characterizes financial booms. The accumulation of risk later leads to financial meltdowns and to a “flight to quality,” in which investments in risky assets leave. A second is the tendency of both booms and busts to spread (“contagion”). A third is the tendency of the cycle to be particularly strong for markets that are considered higher risk by investors, such as developing-country markets.

In sum, financial markets are pro-cyclical, especially in developing countries. This means that, in terms of GDP, exchange rates and stock markets, these countries are much more likely to be victims of financial volatility and contagion.

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Since the 1970s, Latin America has known three cycles of this sort. In short order, they have been a boom of external financing in the 1970s, followed by the debt crisis and lost decade of the 1980s; a new boom in 1990–1997, followed by a sharp reduction in net flows after the Asian and Russian crises of 1997–1998, which led to a new recession; and a new boom in financing since 2003 that probably ended in mid-2008.

This history points to two major lessons. First, financial liberalization must be accompanied by more effective regulation and supervision. Second, policies should be put in place to manage the strong pro-cyclicality of capital flows to the developing countries. On both counts, Latin America is better prepared this time, but is it certainly not immune.

Due to better regulation, largely introduced following past financial collapses, our domestic banking systems are in better shape than during previous crises. Also, and ironically, the fact that certain market segments are less well developed in most Latin American countries than in the industrial world has also served as a source of protection.

Nevertheless, in the debate over the current crisis and the regulatory deficiencies that led to it, subsequent reforms must lead to enhanced regulation around the following principles.

Regulation should have a strong counter-cyclical focus. This is essential to address the basic problem of pro-cyclicality that characterizes financial markets. This principle, however, is still neither widely accepted nor applied. Spain provides a good model. In 2000, it introduced a mechanism that forces banks to accumulate more provisions against loan losses (or reserves) during booms. Other analyses suggest that increasing capital requirements during periods of fast credit growth can have the same effect. In any case, a central feature of banking regulatory reform should be to require banks to maintain a set level of reserves both during booms and downturns.

A second principle is that regulation should be comprehensive; meaning that it should be applied to all financial transactions, whoever makes them. The major losses in derivative markets in Brazil and Mexico during the recent crisis underscore the need for strong regulation in this area, so far ignored by regulatory authorities. Regulations on securitization should also be strengthened. More generally, banking and security regulations should be made consistent to avoid security markets from becoming a source of destabilization, as happened in the United States.

A third principle is that currency mismatches should be avoided or at least strongly penalized. Bank lending and debt contracts should only be made in the currencies in which deposits are made (and in which customers earn revenue). In other words, loans to persons who earn pesos should be denominated in pesos. The ultimate goal of such a policy should be the eradication of financial sector dollarization—an area in which countries like Peru, Bolivia and Uruguay have made advances in recent years, and others, like Brazil, Chile and Colombia always avoided.

Managing capital account booms and their boom-and-bust effects is another issue. Central banks in developing countries can address this by accumulating excessive capital inflows as foreign-exchange reserves during booms. The best analogy is for central banks in developing countries to serve as dams that accumulate excessive foreign exchange liquidity during booms and supply foreign exchange during the drought that follows.

Fortunately, most Latin American central banks followed this and it has already proven useful in managing the recent turmoil. Argentina, Brazil, Peru, and, to a lesser extent, Colombia, are cases in point. Chile also accumulated large foreign exchange assets, though mostly in its copper stabilization funds. The large foreign exchange reserves should allow central banks to apply a counter-cyclical monetary policy over the next few months and years to reduce interest rates to manage the growth slowdown or recession.

The accumulation of foreign exchange reserves therefore provides effective room to maneuver, but it is also costly. It forces central banks to sell the government bonds they hold or to issue their own bonds to offset (or sterilize) the accumulation of foreign exchange. The downside is that these bonds generally carry higher interest rates than what central banks earn on the reserves and therefore generate losses for central banks.

Also, from a national government’s perspective, the long-term costs of external financing are higher than the interest earned on reserves. For that reason, it makes sense to regulate capital flows, particularly during boom years.

How could this be done? One way is to prohibit external capital from being invested in certain domestic assets. Purchases by foreign institutional investors of government bonds issued in domestic currency could be restricted or even prohibited. This can be considered a case of “currency mismatch,” an area in which strong regulations should be introduced.

A second method involves putting in place capital controls establishing minimum stay periods for investments. This is normal practice in the private sector. Mutual and many other private funds require that investors pay a penalty for keeping funds less than a minimum period. One way to do this is to establish a uniform reserve requirement on capital inflows as a way to increase the costs of short-term investments. The practice was applied by Chile and Colombia in the 1990s, and by Argentina and Colombia more recently.

Regulation on banking, securities and on cross-border flows should be discussed in an integrated way. Since cross-border flows are the source of strong boom-bust cycles in developing countries, they simply cannot be ignored. Latin America has lost much in the past from financial volatility. It must use its entire armory to shield itself from current and future global financial turmoil.

José Antonio Ocampo is professor of professional practice in international and public affairs at Columbia University and has served as UN under-secretary-general for economic and social affairs.

NO: Leaders Should Resist the Temptation to Meddle

Shielding countries from the free flow of capital and financial innovation will dampen economic and social development. Among other things, regulation tends to diminish the liquidity of local markets. For example, the comparatively less regulated equity markets in Mexico average a daily trading volume of around $500 million, compared to only $20 million in Argentina, where regulation is very strict. The lack of stock trading intensity implies that companies have less capacity to issue stocks, and hence are hindered from raising capital under more convenient terms.

Capital market liberalization in Brazil fueled 63 new initial public offerings (IPOs) during 2007, totaling some $30.4 billion. Thanks to financial liberalization, the average daily trading volume of the Bovespa (Brazil’s stock exchange) increased to $4 billion that year. Without such level of liquidity, there would have not been room for this flourishing of IPOs.

A more relevant concern is the perennial housing deficit plaguing the region, and the speed with which Latin American countries can address it. If governments overreact to the current market turmoil in a way that discourages financial innovation, there would be a deceleration in housing construction. The housing deficit cannot be addressed unless governments endorse widespread securitization of assets (e.g. the issuance of mortgage-backed securities) and support the continued growth of private-sector pension savings. Without private-sector pension funds, there will be no buyer of last resort for these securities.

The most important challenge to national leaders in forthcoming years is staying abreast of changes in the world financial markets. In fairness, this financial crisis, the most dramatic since the Great Depression, caught most people unaware. As Alan Greenspan argued to members of the U.S. Congress last year, this degree of crisis was a “one percent probability event.” And just as people have not stopped flying because of the one percent probability of a plane crash, people did not and should not have hedged massively against the one percent probability of a financial crash.

I have two strong convictions. First, the world financial structure will increasingly limit the capacity of the financial sector to generate high profits. Leverage will definitely be more constrained in the future. (Leverage relates to the number of times that an investor can increase the nominal size of a position based on a set amount of capital.) In my view, less leverage will mean lower salaries on Wall Street, and hence the brightest minds could decide to move on.

Second, investors and dealers will be less willing to participate in over-the-counter transactions. For example, there is no evolved “clearing house” for credit default swaps (CDSs) or for collateralized debt obligations (CDOs), just as there is for more traditional financial instruments such as bonds, options and futures. CDSs and CDOs are bilateral contracts, tailor-made for each case. Creating government-monitored clearinghouses for illiquid assets will diminish the interest of banks and investors to buy and sell these tailor-made structured products because contracts will likely standardize. This development will constrain the speed of financial innovation as well.

It’s important to underline that the credit default swap market does not yet exist in Latin America. The risk here is that these contracts may not be allowed to evolve in the region because of what happened in the United States. The problem is that credit default swaps today are what foreign-exchange-forward contracts were ten years ago. Currency forwards have allowed many corporations in Latin America to hedge their exposure to movements in world currencies. The capacity to hedge has been a positive social development because it reduces the volatility of the revenues of exporters. The lower the volatility of revenues, the lower the need for layoffs when the currency moves. In the future, credit default swaps will help Latin American corporations to contract debt at a lower spread. That development will also help boost employment.

The same goes for mortgage securitization. A lot of people will likely argue that the securitization of mortgages should be controlled or banned because of what happened in the U.S. If that happens, it will slow the market’s ability to deal with the region’s housing deficit. Also, the people that tend to argue that mortgage-backed securities should be outlawed tend to criticize private-pension funds, supporting the re-nationalization of those savings.

But this is bad reasoning. Such funds are the natural buyers of these mortgage-backed securities. In Colombia, since the creation of the fully funded pension system in the early 1990s, the value of pension savings has increased from zero to around $32 billion or 17 percent of GDP, in 2008. Some of those resources are invested in mortgage-backed securities and other securities supporting infrastructure investment projects. Most of the Colombian Peso $3.9 trillion ($1.7 billion) in mortgage-backed securities that have been issued by the Titularizadora Colombiana (Securitization of Colombia) have been bought by pension funds. In addition, $7 billion is invested in Colombian stocks, some of which invest and deal in housing projects. The fact that pension funds hold those stocks and all those securities implies that more employment has been created and that more houses have been built in the country. On top of that, the fact that Colombian pension funds hold around $10 billion in government debt (or about 25 percent of the total local debt portfolio) has allowed Colombia to invest more in housing and infrastructure and to have a working yield curve.

A liquid local interest rate curve (that permits investors to move money at ease) allows a government to finance itself at lower rates and permits productive investments (because, for example, the markets can estimate the risk of a corporate bond). That said, as the case of Argentina demonstrates, the efficient development of private-sector pension funds requires governments to provide room for financial professionals to diversify portfolios, and therefore hedge against violent downturns. Therefore, capital-market liberalization is also a key ingredient in the successful development of local capital markets.

The pro-regulation lobby will likely win this argument in both the developed world and in the developing world-—which is a shame. I hope at least that regulation will be tempered with caution. In the rush to respond to popular belief that the system has failed, we may suffocate innovation and kill the capacity of many of the region’s poor to finally overcome the poverty trap.

Alberto Bernal is head of EM Macroeconomic Strategy at Bulltick Capital Markets.