Janet L Yellen: Reaping the full benefits of financial openness
Speech by Mrs Janet L Yellen, Vice Chair of the Board of Governors of the Federal Reserve
System, at the Bank of Finland 200th Anniversary Conference, Helsinki, 6 May 2011.
* * *
I am indebted to Board staff members Brian Doyle, Steven Kamin, and Nathan Sheets for their assistance in
preparing these remarks.
Thank you. I usually begin my remarks by stating that my views are my own and do not
necessarily reflect those of anyone else on the Federal Open Market Committee (FOMC).
However, in this case, I would like to extend best wishes to the Bank of Finland on its 200th
anniversary not only from myself but also on behalf of Chairman Bernanke, of the rest of the
FOMC, and of the entire Federal Reserve System. All of us have enjoyed many years of
fruitful contact with the Bank of Finland, and we hope to continue to do so for many more to
come. Okay, disclaimer back on.
The subject of this session, "Finance and Growth," is aptly chosen, as the severity of the
recent global financial crisis has prompted a reappraisal of conventional thinking regarding
the role of the financial system in our economies. Because one of the distinguishing features
of the crisis was its global reach, this reappraisal should address, among other issues, the
benefits of global capital mobility and the extent to which countries should open their financial
markets to the rest of the world. Does increased financial openness result in stronger
economic growth and improved economic performance more generally? Indeed, even well
before the current crisis, a number of economists had begun to question the near-consensus
view in favor of unrestricted financial openness. And, more recently, a number of publications
from economists at the International Monetary Fund (IMF) have suggested circumstances
when capital controls might be appropriate.1 As a practical matter, during the ongoing
recovery from the crisis, some emerging market economies have attracted considerable
capital inflows, raising concerns about potential overheating and leading authorities in a
number of countries to impose capital controls in an attempt to manage these flows.
As I will discuss today, these issues are complicated, but I continue to believe that open
capital markets offer significant benefits in terms of greater efficiency and improved
standards of living, and that they represent a long-run goal to which policymakers should
remain committed. That said, recent experience suggests that reaping the full benefits of
capital mobility requires prerequisites, including a sound legal and institutional infrastructure,
solid prudential supervision and regulation, and appropriate incentives for risk management
by domestic financial institutions. Suffice it to say that the achievement of these objectives
takes time. In the interim, countries may need to employ a variety of tools to effectively
manage capital flows. Such tools may include macroeconomic policies, exchange rate
flexibility, liberalization of capital outflows, and, perhaps in some particularly challenging
instances, constraints on capital inflows. Nevertheless, while successfully managing sizable
capital inflows may require a range of policy responses, the need to make these responses is
not cause to abandon the pursuit of financial openness as an objective over the longer term.
The case for financial openness
To start off, the arguments in favor of countries being open to financial flows are compelling.
First, countries that open their markets to capital flows can be expected to reap stronger
economic growth. Indeed, the economic history of a number of small, open advanced
economies, such as Australia, Canada, and New Zealand, points to a notable role for foreign
capital, especially from the United Kingdom and the United States.2 And the United States
was itself aided by foreign capital at an early stage of its development.3 That the advanced
economies have achieved high standards of living, while at the same time embracing
financial openness, suggests that such openness is likely to bring long-term benefits for other
countries as well.
Free capital markets support economic growth by allowing resources to move across borders
to their most productive uses. These flows should expand the opportunities for savers and, in
the savings-rich countries, likely raise the return on domestic savings. Capital inflows can
lower the cost of capital to firms in capital-scarce countries, raising investment. The result is
more investment, more productive investment, and faster economic growth than would have
occurred in the absence of such capital flows. And these flows do not merely represent the
wherewithal to finance investments - they potentially are accompanied by positive spillovers
from technological transfer and the adoption of managerial and organizational best practices.
Second, opening up domestic financial markets to the rest of the world subjects domestic
financial institutions to foreign competition. Increased competition should make domestic
financial institutions more efficient as well as more transparent and better governed.
Financial openness may also provide impetus for institutional reform within countries. Such
reforms might include a better legal system to enforce contracts and other property rights,
better accounting and disclosure standards as domestic firms compete for foreign funds, and
improved prudential supervision as domestic regulators observe the risk-management
practices of foreign financial institutions. In addition, some observers argue that greater
financial openness may even yield better macroeconomic policy, as countries are subject to
the discipline of outside capital markets.
Third, being more open to the rest of the world - both to financial flows and to trade - may
help countries better absorb economic shocks by allowing temporary current account
surpluses and deficits. For example, a spending boom that leads the economy to overheat
could induce a rise in the country's currency and a decline in exports, restoring more normal
conditions and avoiding an undesirable rise in inflation. Any impediments to the free
operation of international capital markets, including their role in setting exchange rates, can
hamper this rebalancing of demand across countries.
Finally, openness also improves welfare by allowing countries greater scope to share risk.
Although financial openness may or may not reduce the volatility of an economy's output,
risk-averse consumers should benefit by diversifying their portfolios across countries and
thus insuring themselves against the shocks hitting their own particular economy. During
domestic recessions, lower income from domestic assets may be offset by higher income
from abroad, thereby reducing consumption volatility, as long as the shocks hitting the
domestic and foreign economies are not too similar.
Some practical challenges
Despite the strong case for financial openness, countries have faced some practical
challenges in the pursuit of this objective. In particular, capital flows can be volatile, and
many countries have struggled with the adverse effects of this volatility on the domestic
economy. Access to foreign capital may also exacerbate domestic financial distortions, such
as maturity mismatches or agency problems, by channeling funds into the domestic system
that would not have otherwise been available. A related matter is that the domestic financial
system may simply not have the capacity to effectively intermediate large volumes of inflows.
For example, if financial supervision is not sufficient to ward off such problems, short-term
lending from abroad (so-called hot money) can result in maturity mismatches, which can
bankrupt domestic institutions in the event of sharp and sudden outflows. Unhedged
borrowing in foreign currencies creates an additional mismatch, where a sharp currency
depreciation can dramatically boost debt burdens, push borrowers into insolvency, and, in a
vicious circle, induce further curtailment of finance from abroad. Heavily managed exchange
rate regimes may also provide incentives for such mismatches to arise. In addition, increased
financial openness may increase countries' exposure to the risk of contagion and spillovers
from financial shocks elsewhere in the global economy.
Many of these vulnerabilities have been manifest in the emerging market crises of the past
several decades. For example, in the lead-up to the 1997-98 Asian crisis, domestic financial
intermediation failed to prudently allocate capital, and these deficiencies were amplified by
large amounts of external borrowing in foreign currencies, encouraged by heavily managed
exchange rate regimes. As such deficiencies came to light, exchange rates collapsed,
resulting in large balance sheet losses. Foreign investors lost confidence in much of the
region, precipitating capital flight, the spread of the crisis to additional countries, and a sharp
downturn in activity in these economies.
Consistent with the broad set of practical challenges posed by capital flows that I have just
highlighted, the empirical literature on the connection between openness and growth
contains a wide range of findings. For example, work using firm-level data finds notable
positive effects, while other papers that draw on cross-country data find little or no effect.4 In
addition, there is limited evidence of any decline in consumption volatility due to increased
financial openness. More generally, capital has been observed to flow from capital-poor
emerging market economies to capital-rich advanced economies over the past decade, a
finding that appears to undermine one of the central rationales for free capital mobility.
These empirical results notwithstanding, it may be that benefits exist but are difficult to
identify in empirical research due to methodological difficulties in measuring financial
openness, issues of endogeneity, and the coincidence of greater openness with other types
of reform. But the failure of the empirical literature to identify clear gains from financial
openness likely also reflects that countries have struggled to effectively manage sizable
flows of capital.
Notably, a separate literature that considers the link between domestic financial development
and growth finds somewhat stronger evidence for such a relationship.5 This research finds
that countries with stronger domestic financial systems grow faster, partly because firms are
better able to access financing from sources besides their own retained earnings.6 This
finding suggests that the benefits of greater financial openness among countries may be
larger than has been identified to date.
Managing capital inflows
Despite the practical challenges associated with managing capital inflows, we should be
careful not to conclude that limiting capital mobility is a first-best policy outcome. The recent
financial crisis certainly highlighted the fact that financial markets are prone to speculative
excesses and behavior that may exacerbate systemic risk. But, as central bankers and
supervisors, we must remain humble about our ability to preempt market forces in ways that
predictably enhance welfare.
An alternative to limiting capital mobility is for countries to rely on more-standard policy tools
as an initial line of defense against the challenges posed by capital flows. For example, the
effects of undesired capital movements prompted by variations in the business cycle can be
addressed directly with the mix of fiscal and monetary policies. Countries facing overheating,
with strong capital flows being attracted by rising interest rates, may consider a tighter fiscal
policy to reduce both the extent of overheating and the related strength of capital inflows.
And some countries facing strong capital inflows may help alleviate pressures by lifting
controls on capital outflows. Exchange rate flexibility can also play a crucial role in helping
modulate the effects of capital flows, as exchange rates appreciate in response to an inflow
(or depreciate in the face of outflows), thereby contributing to external balance and damping
further such flows by altering asset valuations. Increased exchange rate flexibility should also
discourage excessive currency mismatches, as market participants better gauge the risks of
future currency movements. Notably, in some cases, volatile capital flows have been a
symptom of deeper distortions within the recipient country, and addressing these distortions
has required a shift in the underlying mix of the country's policies.
Past experience also highlights that attempts to limit financial openness are themselves
imperfect. Clearly, capital controls can influence capital flows if applied with enough force.
But how effective are they and at what cost? The Chilean controls on capital inflows during
the 1990s are often cited as an example of an approach that other countries might use. But
studies of these controls, including by staff members at the Central Bank of Chile itself,
suggest that the success of the Chilean controls was mixed. The controls did shift the
composition of flows away from assets with shorter maturities, but the effects on the volume
of flows and the exchange rate - two key goals of the controls - are less clear.7 Some
evidence also suggests that the controls harmed small firms in Chile by reducing the
availability of financing and raising interest rates.8
In addition, the incentives to circumvent capital controls are powerful when the returns that
these flows might reap are large. In the extreme, controls can lead to rent-seeking behavior
or, worse, result in corruption among public officials.9 Controls can also result in unintended
distortions in prices in other financial markets or in goods prices as investors use those
markets to try to move funds into or out of a country. Moreover, global capital flows have
increased dramatically in recent decades. Although these substantial flows are the very
reason that many countries wish to impose capital controls, the size of the flows - as well as
the sophistication of investors who might seek to circumvent controls - means that countries
that avoid opening up may face higher and higher costs in trying to control them.
Finally, capital controls have global implications, as restricting financial openness can
impede current account adjustment and thus hinder the world economy from reaching a
more balanced equilibrium. Indeed, as I have noted in an earlier speech, the current
international monetary system is a mixture of economies, some with open capital accounts
and flexible exchange rates, and others with managed exchange rates, more-restricted
capital mobility, and more-limited monetary policy independence. Many of these latter
economies also have current account surpluses, in part because authorities have been able
to resist currency appreciation, and thus inhibit external adjustment, for prolonged periods.
This feature of the international system inhibits the process of global rebalancing and could
restrain the current recovery.
Thus, at most, capital controls should be seen as just one of many tools that can be used to
manage capital inflows, and one to be used only in particularly challenging situations. The
IMF work that I mentioned earlier concludes that capital controls may be appropriate in
conjunction with other policy tools as long as countries meet certain conditions. Foreign
currency reserves should already be adequate, and exchange rates should not be
undervalued. Controls should not be used as a substitute for necessary macroeconomic
policy adjustments; for example, if the economy is overheating, controls should only be used
along with a suitable monetary-fiscal policy mix. Moreover, controls should be lifted once
these prerequisites no longer apply.10
In addition, the IMF's work encourages countries to turn to macroprudential tools before
making use of capital controls. Although admittedly no bright line differentiates these two
types of policies, macroprudential tools generally are designed to enhance the resilience of
the financial system, a broader and more enduring objective than directly managing capital
flows. Operationally, macroprudential tools typically do not discriminate between residents
and nonresidents, nor differentiate by currency. Examples of such prudential policies would
include guidance on loan-to-value ratios, capital adequacy standards, and limits on net open
foreign exchange positions.11
Reaping the full benefits of financial openness
So where do we go from here? What needs to be done for countries to reap the full benefits
of financial openness? In my view, all countries must continue working toward improving the
resilience of their domestic financial systems to better take advantage of the potential gains
from free international financial flows. Policymakers should strive to mitigate financial
distortions by improving the regulation and supervision of financial markets and institutions,
encouraging market transparency, and setting rules to enhance corporate governance.
Effective microprudential policy frameworks should promote robust domestic financial
institutions that are able to suitably intermediate both domestic and foreign capital. Prudential
regulation should also be alert for risks from abroad, such as a buildup of liquidity risk,
foreign currency exposure, or, more generally, inadequate intermediation of foreign credit.
Indeed, some empirical studies find greater benefits from financial openness when domestic
financial markets are more developed and where institutions and markets are well
supervised.12
Granted, setting up an adequate financial policy framework takes significant time and
resources. Moreover, putting such a framework in place before liberalizing capital flows is not
a guarantee that countries will capture the full gains to financial openness without any
attendant stresses. Indeed, the recent crisis highlights that these efforts are ongoing for all
countries, including the United States. However, though effective regulation and supervision
are not a panacea, they doubtless increase the chance that economies will benefit from
financial innovation and openness.
The United States has taken an important step toward strengthening the institutional
underpinnings of its financial system with the Dodd-Frank Wall Street Reform and Consumer
Protection Act. The act will improve the monitoring of systemic risks, strengthen the
supervision of systemically important institutions, support an effective resolution mechanism
for large institutions, bring greater transparency to derivatives markets, and improve the
effectiveness of consumer financial protection regulation. The act gives the Federal Reserve
some new responsibilities. Among them are participating in the new Financial Stability
Oversight Council and developing enhanced prudential standards for systemic nonbank
financial firms and bank holding companies. We are working diligently to meet our new
responsibilities and to enhance our monitoring of emerging risks to the financial system.
Beyond strengthening our domestic prudential framework, we need to make further progress
in international cooperation on improving financial regulation and the international monetary
system. Central banks and regulatory agencies are working to design and implement a
stronger set of prudential requirements for large, internationally active banking firms. Last
year's agreement on the framework for Basel III was an important step, and the Federal
Reserve is committed to its timely adoption. Its requirements for more and higher-quality
capital and more-stringent liquidity buffers should increase the stability of the financial
system and reduce the probability of future crises. In addition, we need to continue to make
progress in setting rigorous international standards, clarifying the responsibilities of national
regulators of internationally diverse financial institutions, and preventing regulatory arbitrage.
We also need to continue to work toward an international monetary system characterized by
more-flexible exchange rates and independent monetary policies.
The case for increased financial openness is complicated, and one where many of us have
seen our views evolve. As I have already noted, the challenges to opening domestic financial
systems to international capital flows are real, and getting the appropriate policy frameworks
in place to permit the successful intermediation of these flows, while crucially important, is
likely to take time. But while we should be pragmatic about the tools we use to manage
capital flows, we should also keep in mind the long-term benefits that financial openness
promises.
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