Remarks by Timothy Lane
Deputy Governor of the Bank of Canada
Centre for International Governance Innovation (CIGI)
16 November 2016
Waterloo, Ontario
Follow the Money: A Canadian
Perspective on Financial Globalization
Introduction
Thank you for inviting me to speak to you today. The movement of goods,
services, people and money across international borders has always been
controversial and seems to be becoming more so by the day. In this context,
Canada needs to be fully engaged in the global dialogue. As a medium-sized
country, we can only have an impact on this dialogue by bringing new ideas and
careful analysis to the table. This is where the Centre for International
Governance Innovation's contribution continues to be particularly vital.
Today, I would like to focus on one aspect of globalization: international capital
mobility.
I'll start by opening up some basic questions associated with capital mobility and
trends in capital flows over the past few decades. I'll discuss the
then review key
benefits and challenges of being open to capital flows and the policy tools that
are being deployed by some countries to manage them. Finally, I'll
take you
Canada's
through experience and the factors that have enabled us to conduct an
effective monetary policy in the face of free capital mobility.
Capital Flows: Servant or Master?
It is striking how perceptions of international capital mobility differ across
countries.
In Canada, we take our ability to move funds across our borders for granted.
Canadian investors hold US equities. Snowbirds open US bank accounts and run
up bills on US credit cards. Canadian banks fund themselves in New York.
Canadian companies borrow and issue shares in US markets. And our
governments sell bonds to foreign central banks and other foreign investors.
There are, of course, certain types of transactions that are periodically a source
of controversy-notably, foreign investment in Canadian real estate and certain
foreign acquisitions of Canadian companies. But for the vast bulk of the capital
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of us don't give
flowing across our borders, in both directions, most it a second
thought.
To draw the bigger picture: capital flows in and out of Canada in response to
broader economic trends. At the present time, Canada is going through a
complex adjustment to lower prices for oil and other commodities in the face of
persistently weak demand for our non-commodity exports. We have had to rely
on domestic demand to keep our economy growing. In that context, Canada as a
whole is spending more than it earns from the rest of the world-a current
account deficit. Capital is flowing into Canada, in various forms, to finance that
deficit. The inflows are accommodating the needed economic adjustments that
are taking place.
The experience of many emerging-market and developing countries has been
quite different. Many of these countries have, at some time, faced the economic
devastation of capital account crises, when sudden halts in foreign capital, often
accompanied by capital flight by domestic residents, forces the economy through
wrenching adjustments. In such episodes, capital flows take on a life of their own:
they become a driver, rather than an enabler, of economic decisions. They can
raise significant concerns for both economic and financial stability.
In many of these countries, capital flows are seen as driven mainly by external
forces, in particular, the monetary policies of the major advanced economies. In
the eight years since the global financial crisis, ultra-low interest rates and
unconventional monetary policy in the United States, the euro area and Japan
have created incentives to search for yield, which have led to large surges of
foreign investment in many emerging-market economies (EMEs). There are
concerns that these flows are not sustainable-that when monetary policies in
the advanced economies return to normal, the flows could reverse in a disruptive
way, particularly for those EMEs with weaker domestic fundamentals. We had a
hint of that with the "taper tantrum"
in 2013.1 In the same vein, over the past
week, market interest rates and capital flows worldwide have shifted sharply,
along with changing perceptions of the direction of the economic policies of the
United States.
Financial globalization raises another question: Can a central bank still conduct
an effective monetary policy to fit its own circumstances and objectives?
has given rise to a "global financial cycle" through
International capital mobility
which asset prices, longer-term interest rates and capital flows in many countries
tend to move together. But long-term interest rates and asset prices are key
transmission channels through which monetary policy affects the national
economy. If these channels are compromised, policy could become less
effective.
In Canada, we have been living with an open capital account for several
decades. But our flexible exchange rate gives us room to conduct an effective
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monetary policy that is consistent with domestic conditions and promotes the
economic and financial welfare of Canadians. In many other countries, however,
there are legitimate concerns that their monetary policies may be overwhelmed
by the global financial cycle. In this light, some have even argued that capital
controls are a precondition for monetary policy independence.
In contrasting the Canadian experience with that of EMEs, we could conclude
that capital flows are a good servant but a bad master. Being open to global
capital flows is beneficial when it serves residents by creating a wider range of
opportunities to save, invest and borrow. But it is harmful if it becomes a
and curtails the country's freedom to chart
controlling influence on the economy
its own course. So how can a country learn to live with capital flows, to reap the
benefits while insulating its economy from their effects and maintaining its policy
independence?
Overview of the Trends
start with
Before I talk about recent trends, let's some basics-what we mean
when we talk about gross and net capital flows.
Gross private inflows refer to net purchases of domestic assets by foreign
residents. They are defined as the sum of foreign direct investment, portfolio
inflows, derivatives inflows and other investment inflows (which include trade
credit and bank lending). (Gross outflows are the reverse, net purchases of
foreign assets by domestic residents.)
Gross flows, then, measure the extent and form of cross-border investment. They
include foreign direct investment (FDI)-say, an American company buying a
Canadian gold mine; portfolio flows-such as a Hungarian investor buying
Ontario government bonds; and other flows-for example, a Canadian pension
fund carrying out derivatives transactions in London.2
The net capital flow is the sum of these gross inflows and outflows and any
the country's
change in official reserves. This is a key macroeconomic variable: it
a country's
is the mirror image of current account balance, the difference
between domestic savings and investment. Indeed, a net capital inflow is the way
in which a current account deficit is financed.
Now, let me turn to the global trends.
For much of the past decade and a half, advanced countries ran current account
deficits and received funding from emerging-market and developing countries
(Chart 1). This seems odd, since rapidly growing emerging economies surely
had vast needs for investment-creating opportunities to earn much higher yields
than those offered by investments in advanced countries. This counterintuitive
flow of funds corresponds to large differences in national savings. In particular,
while Chinese households and firms save a lot, those in the United States do not.
These differences in savings rates, in turn, reflect a combination of factors,
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including the different stages of development of these countries' financial
systems.3
Chart 1: Poorer countries lent to richer ones for most of the past 15 years
Current account balances
US$ billions
800
400
0
-400
-800
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Emerging and developing economies Advanced economies
Sources: International Monetary Fund, World Economic Outlook, and Haver Analytics Last observation: 2015
Over the same period, we saw a massive expansion in gross flows, a testament
to rapidly increasing global financial integration. This process has been anything
but smooth. Global gross flows more than tripled in the early 2000s, from just
over US$3 trillion in 2000 to close to US$12 trillion in 2007 (Chart 2). The flows
fell sharply in 2008-09 during the global financial crisis, recovered somewhat in
2010 and remain well below pre-2008 highs.
Chart 2: World gross capital flows peaked in 2007
US$ billions
Four-quarter rolling sum
15000
12000
9000
6000
3000
0
-3000
Sources: International Monetary Fund Balance of Payments Statistics and Haver Analytics Last observation: 2015Q4
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The composition of gross capital inflows also shifted considerably over this
period (Chart 3). FDI has been the most stable form of capital flows, since it
tends to be driven by longer-term corporate decisions. Portfolio flows are easier
to liquidate than FDI and thus are often more volatile. Other flows, mainly
banking flows, have been the most volatile of all. Bank lending is procyclical,
rising in good times and falling in bad times. This is not only because banks
respond to the attractiveness of lending opportunities, which are themselves
procyclical, but also because they typically lever up to increase lending during
booms and de-leverage during downswings.4 After the global financial crisis,
global bank lending dropped off sharply, since banks needed to repair their
balance sheets and comply with more-stringent regulatory capital requirements.
So how does Canada fit in?
We have traditionally been a capital importer. Our current account balance-the
difference between how much we invest and how much we save-has typically
been in deficit to the tune of 2-3 per cent of GDP. We have depended on
external financing to fund this gap. In the early 2000s, strong foreign demand and
high commodity prices raised our national incomes, and we ran current account
surpluses for a number of years. During those years we exported capital to the
rest of the world (Chart 4). Since the global financial crisis, foreign demand has
been on a weaker track and commodity prices are lower. Our current account is
again in deficit and, once more, we are relying on capital imports from the rest of
the world.
Benefits and Challenges of Financial Globalization
As I've already mentioned, opening up an economy to capital flows brings both
benefits and challenges.
Benefits
The benefits of financial globalization are similar to those of free trade. Open
borders create opportunities for transactions that benefit both parties because of
their differences in endowments or preferences. For example, a country where a
large share of the population is of working age can benefit from being able to
As the country's
channel its savings to other countries-a net capital outflow.
population ages further and more of its citizens retire and start to draw on their
savings, foreign assets are liquidated, generating a capital inflow from the rest of
the world.
Cross-border investments, which give rise to gross capital flows, enable investors
Canada's pension funds
to diversify risk. have, for example, used international
opportunities to effectively provide more-secure retirement income for
Canadians.
FDI brings other benefits, since it bundles financing and know-how. This helps
residents of the investing country use these capabilities where they can be most
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productive and creates opportunities in the recipient country. Over the years,
Canada has benefited from sizable flows of FDI in both directions.
Chart 3: Banking flows are the most volatile capital flows
Per cent of group GDP, four-quarter moving average
%
30
20
10
0
-10
FDI direct inflows Portfolio inflows Other inflows
Derivative inflows Gross inflows
Source: IMF World Economic Outlook. IMF Balance of Payments Statistics, Haver Analytics and Bank of Canada calculations Last observation: 2015Q4
Chart 4: Canada's current account balance is once again in deficit
%
Per cent of GDP
3
2
1
0
-1
-2
-3
-4
-5
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Source: IMF World Economic Outlook Last observation: 2015
Being open to capital flows can also have collateral benefits. It can catalyze
competition, promote the development of the domestic financial system and
provide a force for better governance. For example, foreign financial institutions
can bring a healthy dose of competition, boosting the quality and bringing down
the cost of financial services. An open capital account can also lead to improved
corporate governance as companies bring their practices in line with what is
required to attract and retain foreign investors. In the same vein, some countries,
including Poland, the Philippines, Thailand and Malaysia, have used foreign
inflows as a tool to broaden their investor base and develop domestic equity and
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bond markets.5 To the extent that these forces are at work, they should
contribute to stronger productivity growth and higher living standards throughout
the economy.
While these potential benefits of capital mobility are real, they are hard to pin
down empirically. That is partly because they materialize over a longer time
period.
Challenges
At the same time, the challenges associated with financial openness are only too
easy to identify. Take the examples of Mexico and Thailand in the 1990s and of
Greece in the mid-2000s. The experiences of these countries taught that
financial flows from abroad can fuel macroeconomic and financial imbalances
that later unwind in a destructive way. A capital inflow surge can encourage
unsustainable spending by domestic households, companies and government;
this unsustainable spending is mirrored in a current account deficit. A sudden
stop in those inflows-particularly if accompanied by capital flight, where a
country's own residents move their assets
abroad-results in a crisis that forces
an abrupt contraction of domestic spending.6
Inflows of capital are often associated with a buildup of financial system
vulnerabilities, which can have important consequences for financial stability.
This is particularly the case where the domestic financial system is lacking the
ability to efficiently intermediate large gross flows.
To the extent that there are weaknesses in a country's financial system, opening
the capital account can feed those weaknesses and result in a larger buildup of
imbalances. These can include currency, maturity and liquidity mismatches: in
some instances, where liquid short-term banking flows denominated in foreign
currencies are used to finance longer-term domestic currency lending, you get all
three. Waves of foreign capital can also fuel credit booms, which are associated
with mounting leverage and deteriorating credit quality. When the flows reverse,
these vulnerabilities can amplify the effects on the domestic economy, in some
cases triggering a wave of bankruptcies.
In theory, exchange rate flexibility should mitigate the risks associated with large
net capital inflows. This was framed by Robert Mundell as a trilemma: a country
cannot have an open capital account, a fixed exchange rate and an independent
monetary policy; but with a flexible exchange rate, it can use monetary policy to
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stabilize its economy in the presence of international capital flows.7 Consider the
case of a country experiencing capital inflows. Its currency would rise in value,
which-other things being equal-would have a negative effect on its net exports
and on economic activity more generally. The country's central bank, tasked with
stabilizing the economy, would typically respond with a lower policy interest rate.
The combination of a stronger currency and lower domestic interest rates would
make foreign investments in the country less attractive, thus attenuating the
capital inflows.
However, it doesn't always
work this way. Many countries do not allow their
currencies to adjust fully. Indeed, credit booms typically occur in countries with
fixed and managed exchange rate regimes.8
It is also possible that, even with a floating exchange rate, appreciations can
perversely encourage further capital inflows, exacerbating the problem. This
occurs through the
"risk-taking channel."9 If domestic borrowers have local
currency assets and foreign currency liabilities, an appreciation increases the
value of their domestic assets and makes their balance sheets look stronger.
This increase in perceived creditworthiness could lead to the provision of more
foreign currency loans as capital inflows through the banking sector increase.
In a similar vein, it has been argued that, even with a floating exchange rate, a
country's financial conditions depend
primarily on a global financial cycle, limiting
a central bank's ability to use monetary policy
independently to influence its
Mundell's
economy. One scholar thus argues that trilemma boils down to a
dilemma: "Independent monetary policies are possible if-and only if-the capital
via macroprudential policies."10
account is managed, directly or indirectly,
The most familiar examples of international capital flows enabling the buildup of
domestic economic and financial imbalances come from EMEs. But this is not
just a developing-country issue: think of the United States before 2008. The
distorted incentives and regulatory weaknesses in the US financial system during
that period are well known. In that context, the ability to borrow cheaply, at global
interest rates reflecting high savings rates in China and other EMEs, contributed
to a growing financial bubble. This pattern, and the ensuing financial crash in the
world's most
sophisticated financial system, had many elements that are familiar
from EMEs in the past.
To sum up, while there are known benefits to financial openness, a country can
reap those benefits only if it avoids some important pitfalls. If a country has major
distortions in its financial system, perhaps reflecting weaknesses in regulations,
opening the economy to capital flows may just feed those distortions. To turn this
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around: a country may need to achieve a certain level of financial system
soundness and standard of governance before it can fully reap the benefits of
capital mobility.
Based on this logic, a number of researchers have suggested that there is a
threshold: capital flows are beneficial only once a country has reached a certain
degree of institutional and financial sector development.11 Where those
conditions are lacking-say, when financial regulation is inadequate or property
rights are not fully protected-financial openness invites instability and, on the
whole, can be detrimental to economic growth.12 Above that threshold, capital
flows can provide broader benefits, which can support rising living standards.
The threshold suggests that countries may choose two distinct strategies. One is
to try to manage or control capital flows, or at least to cushion the economy and
financial system from their impact. The other approach is to try to achieve the
threshold. Of course, these strategies can be complementary if a country
effectively manages capital flows to buy time to strengthen its domestic system.
Capital Controls
The international view of capital controls has shifted over time. Most advanced
economies maintained pervasive restrictions on capital movements during the
period following the Second World War, but they opened their borders to capital
flows during the 1960s through to the early 1990s. Liberalization was generally
as irreversible: as one observer said, "You can't put the toothpaste back in
seen
the tube."13
While many developing countries maintained capital controls, the Washington
Consensus saw liberalization as the right destination-albeit with important
issues concerning pace and sequencing.14 In contrast-and based on extensive
international experience-capital control measures were viewed as distortionary
and ineffective.
The role of capital controls is being reassessed in light of the experience of both
the crisis and the subsequent capital flow surges associated with the monetary
policies of the major advanced economies. In this context, capital controls are
often viewed as a type of macroprudential tool to limit the resulting buildup of
vulnerabilities. Used in combination with other macroprudential tools, it could give
monetary policy a freer hand in maintaining domestic macroeconomic and price
stability.
The reassessment is reflected in international discussions. In the autumn of
2011, G20 finance ministers and central bank governors drew up non-binding
"Coherent Conclusions for the Management of Capital Flows Drawing on Country
Experiences."
These conclusions accepted that capital controls could be
appropriate, provided they were temporary, targeted and transparent.15 This was
complemented by the development by the International Monetary Fund (IMF) of
an "institutional view" that characterizes the role of capital controls as part of the
macroeconomic policy tool kit.16
However, capital controls, like tariffs on trade, have spillovers to other countries.
This suggests a need for governance similar to that for trade restrictions. The
Organisation for Economic Co-operation and Development (OECD) countries
have entered into a legally binding agreement-the Code of Liberalisation of
Capital Movements-which is also open to adherence by non-OECD countries.
The G20 has established a working group on international financial architecture,
which is focusing on managing the risks stemming from capital flow volatility.
This group has highlighted a need for better data on the composition of capital
flows to better identify currency and maturity mismatches. It is also supporting
that draws lessons from countries'
analytic work experiences in capital flow
management. A broader goal is to complete the global financial safety net-the
set of financing arrangements available to countries faced with unexpected
reversals of capital inflows. For example, the group is exploring the scope for
contingent debt instruments such as GDP-linked bonds that would provide
insurance to countries that may be faced with adverse shocks.17 These
measures to strengthen the safety net should make it less necessary for
countries to resort to controls on capital outflows.
The emerging global consensus is that capital controls can be used under some
circumstances to mitigate the buildup of financial vulnerabilities. But they should
not be used to compensate for inconsistent or inappropriate macroeconomic
policies. Their effectiveness varies and typically diminishes over time. For
example, research at the Bank of Canada has found that capital control actions
have only a limited impact on net capital inflows, monetary policy autonomy or
the exchange rate.18
Finally, if controls are used to shore up an unsustainable exchange rate peg,
This is the classic bet"
they may exacerbate rather than stem volatility. "one-way
scenario: the strategy creates the expectation that the exchange rate will
eventually adjust, thereby inducing additional speculative capital flows.
Living with an Open Capital Account
To summarize the argument so far: capital controls are available as a tool to
cope with volatile capital flows-but they are, at most, a second-best tool. Over
the past 20 years or so, many EMEs have adopted a different approach: they
have taken action to prepare their financial systems and economies to cope with
the free movement of capital. They have put their fiscal deficits onto a
sustainable track, established credible frameworks for fiscal and monetary policy,
developed deeper and more-liquid domestic financial markets and stronger
financial systems, and tackled structural issues that impede growth. All of these
actions reduce their vulnerability to capital flows.
Canada's experience has been similar. Around the time of the
In some respects,
called the
Mexican peso crisis in the 1990s, our dollar was sometimes "northern
peso." Our exchange rate and borrowing costs were buffeted by changing market
perceptions of the financial strength of our governments and our banks.
That wake-up call caused us to put our house in order. In the wake of the failures
of some small financial institutions, Canadian policy-makers strengthened the
regulation of our financial system, taking the prudent, principles-based approach
that today underpins the soundness of the system. The federal government cut
the deficit and now has fiscal room to manoeuvre. And the Bank of Canada has
adopted a clear target for monetary policy and has established its credibility
around this target.
These actions have not completely insulated the Canadian financial system from
Canada's
the global financial cycle. market-determined interest rates are heavily
influenced by global term premiums-as examined in recent Bank of Canada
research.19 Despite that influence, however, the Bank of Canada retains the
ability to affect those interest rates and other aspects of financial conditions in
Canada.
One key element is the country risk premium. The currencies and assets of many
EMEs contain risk premiums that reflect their creditworthiness compared with
that of the United States. These risk premiums can be time-varying and
rise during periods and
correlated with the global financial cycle: they "risk-off"
they fall during periods.20 Canada's
"risk-on" credit risk premium has been
reduced to a very low level as a result of our strong economic and financial
fundamentals, which underlie our AAA credit rating (Chart 5). As a result, our
asset prices and interest rates are less affected by the global financial cycle.
of Canada's
Many large gross flows of capital tend to be offset by other flows-
contributing to our overall resilience. IMF research has shown that such offsetting
flows are characteristic of countries with sound policy, well-regulated institutions,
flexible exchange rates and open capital accounts-all of which are features of
Canada.21 In contrast, capital controls may reduce resilience by impeding such
offsetting flows.
favour is that
Another factor that works in Canada's (unlike many EMEs) it is able
to borrow in its own currency. This means that our national balance sheet does
not have an excessive currency mismatch. Where such mismatches are
important, exchange rate depreciations can be contractionary because the
balance-sheet effects of a weaker currency inflate the size of national liabilities,
overwhelming the expenditure-switching effects through the trade channel. In
contrast, a depreciation of the Canadian dollar tends to support the Canadian
economy. For example, the substantial depreciation of the Canadian dollar
during the past few years has helped to cushion the Canadian economy by
making our non-commodity exports more competitive. Being able to borrow in
one's own currency, in turn, is a benefit of having a strong track record of sound
macroeconomic and financial policies.
Chart 5: Canada's risk premium has been reduced to a very low level
Risk premium on 10-year government bond yields in Canada and the United States, monthly data
%
3
2
1
0
-1
Canadian Recession Canada United States
Sources: Bank of Canada and C.D. Howe Institute Last observation: October 2016
The credibility of Canada's monetary
policy framework, together with our floating
exchange rate, also gives us more room to respond to shocks that are likely to
have a differential impact on the Canadian economy than on the United States.22
For example, last year the Bank of Canada cut the policy interest rate twice, to
help cushion the Canadian economy from the collapse of oil prices. We were
confident that inflation expectations would remain well anchored despite the
depreciation of the Canadian dollar that was occurring.
The global financial cycle and policy actions by the Federal Reserve can have
important implications for Canada. These are, of course, factored into the Bank
of Canada's monetary policy decisions. As
a concrete (but still hypothetical)
example, suppose the Federal Reserve were to make an upward adjustment to
its policy rate. Such a tightening in US monetary policy would affect Canada
through two main financial channels. It leads to higher market interest rates
globally and thus in Canada (in a sense, a tightening effect for Canada). But it
also leads to a stronger US dollar, which increases the competitiveness of our
exports (in a sense, a stimulative effect for Canada). It is important to note that
the economic setting for such an interest rate move also needs to be taken into
Fed's
account: the rate move would likely be made in response to a
strengthening US economy, which is itself typically favourable for our exports.23
of the Fed's
The Bank of Canada would thus clearly need to take the net effects
move into account, alongside many other factors, in making Canadian monetary
policy. We could directly observe the effects on interest rates and exchange rates
prior to making a policy decision. And certainly, we would not consider the
implication of such a move by the Fed in any mechanical way.
The Bank of Canada's track
record-delivering low, stable and predictable
inflation for the past 25 years, in the face of many shocks affecting our
to Canada's ability to pursue an
economy-attests effective monetary policy in a
world of globalized capital flows. We are free to adjust our policy interest rate in
the context of Canadian economic conditions-and, in particular, do not need to
move in step with the Federal Reserve. And that policy rate is transmitted
effectively to stabilize the Canadian economy.
Conclusion
I began these remarks by noting that Canadians have learned to live with an
open capital account. That goes for policy-makers, too. While global
interconnections are a major factor in gauging the effects of our policies, they do
not circumscribe our ability to set our own course.
But the variety of international experience and our own past remind us that our
resilience has been hard won; that, even now, not all countries are ready to
benefit from financial globalization; and that we should be supportive of other
countries as they take actions to safeguard their own economic and financial
stability. A stable world is something from which we can all benefit.