Bojan Marković: Desirable capital inflows in Serbia
Speech by Mr Bojan Marković, Vice-Governor of the National Bank of Serbia, to dealers at
the Bloomberg conference, Belgrade, 27 April 2010.
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Deliberating consequences and policies of capital inflows seems perhaps inappropriate
against the backdrop of recession and depreciation pressure on dinar. Yet, the situation may
change rapidly, as the recent experience of the emerging Europe attests. Just a year ago
Poland, Czech Republic and Romania were concerned about capital outflows and weakening
exchange rate - as was Serbia. Now there are increasing signs that capital starts flowing
again into the emerging Europe and these countries are finding it difficult to cope with the
consequences.
A similar turnaround in capital flows can happen in Serbia anytime soon too - we are not
doing worse than these countries as regards the macroeconomic performance or financial
system stability. One such trigger could be the planned issue of medium-term T-bonds that
are likely to attract much attention of international investors.
It is perhaps wise to use this occasion and review the thinking about capital flows from the
perspective of the National Bank of Serbia. We feel it is important for traders and other
players in the financial markets to understand the central bank's attitudes so that they could
anticipate our policies and feel comfortable in their activities.
Capital inflows are welcome! They have been a necessary backbone of our growth model,
helping the Serbian economy to realize its catch-up potential in the absence of domestic
savings. Before the crisis foreign savings financed most of our investments (the investment
share was 28% of GDP and domestic savings around 8%). Hand in hand went large
productivity gains and terms of trade improvements, which were mostly associated with
foreign direct investments (share in GDP of 7% was relatively high). Capital flows also
contributed to improving financial sector infrastructure, increasing the resilience of the
financial system to shocks, and allowing for a smoother and efficient allocation of resources.
However, by drawing on foreign savings capital inflows also allowed our consumers and
government keeping high consumption levels. Practically the entire Serbian income was
consumed in the period before the crisis. Such a model of growth was therefore socially
attractive, but economically unsustainable. The prospects of repaying the ballooning external
debts were dim against the backdrop of low competitiveness and exports of our economy.
And although the investment ratios looked high, even higher were necessary, especially
given that the investment structure did not support stronger growth in our competitiveness.
Regardless of their structure, capital inflows have complicated the life of a policy maker in
many ways. On a macroeconomic level, the reliance on foreign savings, especially when
channeled into consumption, manifested in large current account deficits. They reached as
much as 18% of GDP before the crisis and their long-term viability was rightly questioned.
The influx of capital into nascent financial markets with a low absorption capacity has led to
periods of sharp appreciation and contributed to unnecessary large exchange rate volatility.
Such appreciation spells - such as the one in 2006 - also encouraged excessive foreign
currency borrowing.
But these macroeconomic phenomena were not the major problems per se. After all,
exchange rate volatility is a key element of the Inflation Targeting regime, it prompts the
development of hedging instruments, and facilitates de-euroization of the financial system.
The moderate current account deficits could be partly just a flip side of high investment ratios
that are needed for our catch-up process. There is no doubt large capital inflows are needed
for growth to resume in the coming period. If the inflows are used wisely to increase the
productive capacity - and especially so in manufacturing, the current account deficits should
be self-corrective over long horizons, as many examples - also from the Eastern Europe -
attest. Investments in infrastructure are an example of how capital inflows can help increase
the productivity capacity and raise long-term growth prospects.
Before the crisis, the major problem with capital inflows in Serbia was the unbalanced risk
sharing and mismatches involved, potentially jeopardizing the stability of our financial
system. The catch-up potential is a long-term process requiring long-term financing. But a
part of the financing was short-term, requiring a regular roll-over. Furthermore, most of the
financing came in a foreign currency, while most revenues are denominated in the local
currency.
Unlike the popular wisdom, it is not a reckless risk behavior of foreign investors that put our
economy at risk - it is the lack of it.
The risks involved in the currency and maturity mismatches were not born by foreign
investors, but by domestic businesses and partly by households. They suffered the most,
when the capital flows dried up and the currency depreciated. Many blame the fragility of the
financial systems in emerging Europe on the "so called" speculation or carry traders. But who
was the most important carry trader in Serbia? A large number of households - not a shrewd
financier from London. And who bore most of the currency and maturity risk? Again domestic
entrepreneurs and partly households - not the foreign investors.
It is because of this unbalanced risk sharing that policy makers have to remain cautious
about capital inflows. Our macroeconomic and financial stability was put in danger during the
crisis not because we had been borrowing abroad to finance growth, but because foreign
investors did not carry adequate share of the risks involved in these activities. Those
businesses that were financed by foreign direct investment did not suffer so much from the
lack of financing during the crisis, nor did those who borrowed in dinars, when the currency
depreciated. In both these cases the foreign investors ventured into the future prospects of
our economy - hoping to enjoy benefits but also sharing the risks. Those foreign investors
who bought into dinar denominated financial instruments took the fair burden on their
shoulders, while those who had a stop-loss deposit with a local bank left the damage here.
This discussion gives a background for our thinking about capital inflows in the future. We
welcome all kinds of inflows, but as long as the financing risks involved rest fairly with the
investor and not only with the local economy. That of course favors long-term flows to
shortterm, because most investment projects require long-term financing. Foreign direct
investments or joint ventures are the most preferred examples here - also because they
bring other positive externalities in terms of know-how and technology. Such investors clearly
demonstrate their long-term commitment to the prospects of Serbian economy.
But we also encourage pure financial flows - even short-term, if they match the financing
needs. For many reasons explained earlier, they contribute to financial market development
and help risk diversification.
In particular, we are hoping the issue of dinar-denominated T-bonds will attract much
attention of foreign investors, and the program will be success, eventually allowing the
government to reduce the FX part of its debt. We are also hoping that higher volumes will
help spur secondary trading and develop a dinar yield curve for benchmarking of other
dinarbased instruments.
For all these reasons we encourage foreign investors' involvement in local currency T-bonds
- but we have clear preferences as regards specific forms of such an involvement. We prefer
the forms in which the foreign investors take most of the credit and FX risks, such as direct
purchases into buy&hold or trading portfolios. On the other hand, participation in T-bonds
through deposits and/or swaps with local banks is less welcome, because a substantial part
of the market, credit or FX risk remains with the local banking sector. An example of a least
favored involvement is a deposit with a local bank combined with a stop-loss that keeps all
the risks in the domestic financial system. Such involvements we would like to discourage.
As regards practical policy consequences, we believe that what is good for the stability of the
economy is also good for the market participants individually in the long term. We therefore
prefer corrective self-regulation to regulatory action. We understand that it may be difficult for
individual players to internalize all consequences for the entire financial system, but we are
here to provide enough guidance through speeches and regular discussions.
That being said, we stand ready to act swiftly, should we see that the imbalances from
unequal risk sharing accumulate in a way dangerous to the financial system. We have
enough tools for that purpose, including punitive reserve requirement and remuneration
policies, as well as prudential measures aimed at liquidity, capital or open positions.
In summarizing, by no means we would like to see lower volumes of capital inflows. We
would only prefer to see a different structure than in the past. Structure, in which foreign
investors adequately share the risks involved in investing into the local economy. This does
not imply only foreign direct investments and joint ventures - we also encourage pure
financial flows as long as the credit, maturity and FX risks are not left entirely with the
domestic financial system.
The upcoming dinar T-bonds issues are going to be a good occasion for a renewed foreign
investors' interest in the local financial market. We are hoping to see more trading, larger
volumes, more market development, and more risk taking. It will also be a good occasion to
test how the financial market players understand our preferences about risk needed for the
balance of our financial system.