Cross-border financial flows:

Sustainable macroeconomic policies needed to reap benefits

by Gamini Warushamana

The world has become more integrated, not just through trade, but through steadily rising cross border financial flows and accumulation of large and rising foreign assets and liabilities, said the Deputy Governor of the Central Bank, Chandra Premarathne, at the inauguration of a training program on 'Cross border financial flows and related issues' organised by the Centre for Banking Studies for the officers of the Bangladesh Bank.

Following are excerpts of her speech:

Chandra Premarathne

Cross border financial flows can take the form of portfolio investments in bonds or equities, FDI, in enterprises or loans between residents between different countries. Generally the level of total cross border financial flows indicates the intensity of financial linkage or financial integration between different countries.

For three decades the globalisation of finance appeared to be an unstoppable trend as the world economy become more tightly integrated. New technology and access to new markets propelled cross-border capital flows to unprecedented heights.

Global foreign assets and liabilities grew six-fold between 1980 and 2007, from around 60% of world GDP to more than 360% of world GDP. Over the same period gross global financial flows grew from 6% of world GDP in 1980 to 36% of world GDP.

But the financial crisis brought that era of rapid growth to a halt. During the global financial crisis global cross border investment as measured by global asset and liability, financial flows plunged from 35% of world GDP in 2007 to less than 5% of world GDP in 2008. It is important to note that the financial crisis has only temporarily halted the process of increasing financial integration but it was observed that in the past few years cross-border investment has steadily been increasing and recovering.

Benefits

Global cross border investment is beneficial to both the investing and recipient economies and in the long run the benefits can be sizeable. First, cross-border holdings of assets and liabilities allow economies to share the risk associated with their individual domestic business cycles.

Improved risk sharing in turn enhances the ability of countries to specialise in their most productive sectors that leading to increase economic efficiency. Second, international financial flows are essential to direct global capital to the areas where it can be used most productively.

Third, capital should flow from economies where it yields a relatively smaller marginal return to economies where the marginal productivity of capital is higher. Fourth, cross-border finances allow economies to expand investment and production beyond the constraints imposed by domestic savings helping the recipient to raise its rate of economic growth and improve its living standards.

Finally, cross-border financing may associate with transfer of knowledge and technology and have a beneficial impact on the efficiency of the domestic banking system by increasing the depth and breadth of domestic financial markets.

Challenges and risks

Despite these beneficial effects imbalanced and unmanaged financial flows can pose considerable challenges and significant risks for domestic economies. Excessively prolonged and large net financial inflows can have undesirable macroeconomic effects, including rapid monitory expansion and inflationary pressure and can thus inflate asset prices and fuel credit growth raising the risk of boom and bust cycles.

Therefore, balanced and sustainable macroeconomic policies are needed to reap the benefits of cross-border financing which are conducive to the long-term growth of the economy. At the same time to address any systemic risk or contagion effects of the financial integration, adherence to macro prudential measures is essential.

Having experienced the adverse repercussions of integrated financial markets, Central Bank and the regulatory authorities around the world are now more focused on defending their local financial market from the adverse effects of cross border flows through sound macroeconomic policies and strong regulatory and governance framework.

Sri Lankan experience

If we look at the Sri Lankan experience, Sri Lanka is moving towards $ 100 billion economy by 2016 with $400 per capita income. The savings investment gap is around 4%. Our strategy mainly focuses on improving productivity through technological advancement and attracting high level of cross border financial flows.

Sri Lanka has introduced far reaching measures to liberalise and develop financial markets through relaxation of exchange control regulations, widening the range of financial instruments offered, increasing the efficiency and accessibility of commercial banks and strengthening institutional and legal framework.

These measures specially encouraged the foreign corporate sector to invest in the Sri Lankan capital market. Meanwhile, Sri Lanka has placed great emphasis on promoting the corporate bond market by introducing several measures to enhance capital flows.

In 2012 banks tapped the international market and borrowed more than $ 1 billion. In 2012, for the first time, a state bank issued bonds in international markets, at an attractive rate.

Sri Lanka has adopted a cautious approach to counter downside risks associated with cross border financial flows such as reversal of capital flows, vulnerabilities due to build up of foreign liabilities in corporate balance sheets, appreciation of domestic currency eroding external sector competitiveness.

Mandatory corporate governance directions were issued in 2007 to the banks to enhance their governance structure and conduct the banking business in a responsible and accountable manner.

The integrated risk management framework has been set up in the banks to mitigate risks arising from foreign borrowers.

Meanwhile, banks were required to enhance their minimum capital on a staggered basis to improve their soundness and stability and thereby increasing borrowing capacity.

Banks are required to maintain their capital adequacy ratio against risk weighted assets at 10% minimum which is above the Basel requirement of 8%.

Banks are required to maintain a liquid asset ratio of 20% at a minimum to be resilient and to go for more foreign borrowings from the international market. Directions on risk management relating to foreign exchange business of commercial banks were issued to standardise and strengthen foreign exchange risk management systems in the banks.

To promote greater harmonisation with international regulatory standards, the Central Bank is taking measures to implement Basel III capital and liquidity standards on a staggered basis. The Central Bank is developing macro-prudential approaches to regulation which would pre-emptively address any systemic risks and contagion risks to the financial system.