Mark Carney is beginning to approach the end of his Governorship at the Bank of England – he will stand down in under six months, at the end of January next year. And whether because of this, or because he is looking at wider horizons for his next post, some of his speeches recently have ranged far beyond the UK and the British economy.
One such was a little-noticed speech he gave a couple of months ago, at the 2019 Institute of International Finance Spring Membership Meeting in Tokyo. It carried the slightly quirky title “Pull, push, pipes: sustainable capital flows for a new world order”; one recognises the hand of the Bank’s chief economist, Andy Haldane, in the choice of words, but behind the semi-jocular title there was a very serious speech, which anyone interested in the health of the international financial system would do well to study.
International capital flows, in other words cross border investment, are essential to the world’s financial system. On the most basic level they are the counterpart to current account flows – a country that is running a current account deficit (ie, importing more than it exports) will by definition need to import capital to pay for it. That import of capital can be financed for a short time by selling assets, but that is not sustainable for most countries for long and the main component of the capital account is foreign direct investment, in other words foreigners lending money.
Beyond that, capital flows are the main way in which emerging market economies (EMEs) finance the investment they need to develop and grow. A closed economy, ie one that whether for political, ideological or economic reasons tries to finance necessary investment from within its own resources, will always find that those resources are too limited to generate significant growth – this was the one of main reasons for the economic stagnation of the Comecon countries in the decades of Soviet control. Put simply, a poor and backward economy struggles to generate the money it needs to escape its poverty.
So, most countries, and almost all developing ones, need international investment. This is the Pull in the speech’s title. The Push is equally simple and equally important: citizens in rich countries need an outlet for their surplus funds, a home for their savings where they can put them to use. And while investment in home markets can be lower risk, overseas markets offer the investor both diversification and also often greater returns. As growth and investment returns in the developed world slow, the returns in the developing world look ever more attractive to ageing first world populations and their need to save for their retirement.
And the Pipe? The Pipe is the world’s financial system, the arrangements whereby an investor from Country A can buy assets in Country B efficiently, easily and with some certainty that their investment will be protected by the rule of law.
In recent years all three components of the Pipe have improved. Investing in a foreign market is more efficient than before, with interconnected banking systems and enhanced flows of financial information. It is easier too, as countries reduce their barriers to capital flows and more and more markets are open to international investors. And in much of the developing world, the rule of property law has improved to the point where foreign investors no longer fear that they will be summarily expropriated at the slightest sign of capital problems.
And in theory, this should all be for the good. Foreign capital inflows should support growth through greater allocative efficiency, better risk sharing and increased technology transfer. And for the international investor, this higher growth should generate greater returns.
But in reality, financial openness has proved a double-edged sword. The Bank’s research shows that while the typical EME receiving higher capital inflows will indeed, all other things being equal, grow faster than its peers, this is only if those flows remain unperturbed. And as soon as there is any volatility in or interruption to the flows, the typical EME with higher capital flow volatility will grow markedly more slowly.
Worse, the downside for a country experiencing volatile flows (in or out) is an order of magnitude more than the upside from the flows in the first place. As the speech observes, time and again waves of investment into EMEs are sharply withdrawn with damaging consequences. And more generally, the greater an EME country’s financial openness, the greater their vulnerability to foreign shocks.
Not surprisingly, many in the developing world have sought to defend themselves against this volatility. One way is by direct capital controls, but these are seen these days as too absolute a measure, cutting off beneficial capital flows as well as harmful ones. A second method is the accumulation of foreign exchange reserves, as a pool of capital to act as a buffer when investors try to leave. And this has been happening – the developing world’s FX reserves are as high as they have ever been. But this is an expensive and wasteful policy for countries whose main characteristic is that they are short of capital in the first place, and it also contributes to the global savings glut which is pushing down rates of return across all assets.
A third way, much preferred by the experts at the IMF, is for EMEs to “run a tight ship”, or in central banking parlance a credible monetary and fiscal regime with low inflation, sustainable government budgets and strong banking regulations. But this is easier said than done – not many developed economies manage it consistently! Moreover, even those EME countries that do run themselves well are not thereby safe; indeed if anything they become the poster-boys of the world economy and attract even more hot money inflows.
As Carney summed it up near the end of his speech, “The power and growth of international capital is such that EMEs have to run hard to stand still”. It is a depressing conclusion for anyone trying to run an emerging economy: if global capital flows and assets looking for investment homes continue to grow faster than the global economy, then the possibility of disruptive capital flows will also grow, and with it the risk that they are large enough to overwhelm even well run economies.
It is at this point that the speech takes a surprising turn, as Carney states bluntly that as well as EMEs having a responsibility to manage their economies well, the developed economies of the rich West also have responsibilities. Carney emphasises that well-run global capital markets are beneficial to all, and he states that “policy makers [in the creditor economies] also have a responsibility to manage risks in these global public goods”.
In our view this is not said often enough or loudly enough. As Carney implies, creditors too have obligations, and they should not be able to just cut and run at the first sign of trouble and expect to be kept whole while everyone else suffers. But getting creditors to understand this is very difficult; the mantra “creditors good, debtors bad” is deeply entrenched.
Carney concludes: “We are all responsible for addressing the fault lines in the global financial system and its safety net. In doing so we will reduce the volatility of capital flows, increase the sustainability of cross-border investment, and meet the great challenges of our age”. If those that run the global financial system, and particularly the creditor nations who benefit so much from the willingness of others to provide a home for their surpluses, do not pay heed to this, they risk killing the international capital market, the goose that lays the golden eggs of global growth.
 Not least in Germany, which runs an enormous current account surplus and compounds it with a fiscal (budget) surplus, both of which are highly deflationary for neighbouring economies. But anyone seeking to debate with Germany whether their twin surpluses and their refusal to open the spending taps in case they imperil their balanced budget might be factors contributing to Europe’s economic malaise is met not by reasoned argument, nor even by flat denial, but simply by blank incomprehension. The idea that creditors are “the good guys” is extremely difficult to shift!