Domestic capital, rather than foreign capital, flight is the bigger issue for most EM now

A country with a small domestic capital base has little choice but to borrow from ‘strangers’ (Wynne Godley’s sectoral balances approach) and thus be subject to foreign capital flight whenever (foreign) interest rates rise and/or the external BoP situation worsen considerably. The inevitability of this outcome, of course, leads to the boom and bust scenario we have been so used to in EM in the past. Monitoring US economic business cycles and local external debt statistics, current and capital account balances, FX reserves, etc., becomes essential for forecasting local currency value.

However, as the EM middle class has progressively grown for the last two decades, so has the domestic capital base, and so has the importance of monitoring what the locals are doing with respect to their savings and investments. There is, therefore, also the case of domestic capital flight, which is much more difficult to quantify as its causes are much more subjective.

EM countries have responded to this development by gradually shifting to borrowing in their local currency. Thus, the ratio of local debt to external debt in EM has risen. In many cases, however, the growth of local government bond instruments has not been fast enough for the growth of the domestic capital base. Traditionally, locals have invested in real estate and some equities. If local financial markets remain underdeveloped relative to the growth of the domestic capital base, with fewer domestic investment options available, there is a bigger incentive for capital to search other investments in foreign currencies.

In addition, the larger the domestic capital base, the bigger the risk of domestic capital ‘flight’ if locals start fearing that a currency depreciation is forthcoming. In this case, money does not need to necessarily leave the country; all it takes is to be deposited in foreign currency in the domestic banking system, thus not directly available for local currency lending. For example, the level of dollarization in both Argentina and Turkey is quite high (more than 50% of all deposits are foreign currency denominated).

Finally, some locals can decide not only to convert their savings/investments in foreign currency for the reasons above but also to take them out of the country. This can happen if they also fear ‘currency appropriation’, i.e. they believe the local institutional framework is inadequate to protect their assets. For example, in 2004 Argentina decided to pay local foreign currency deposits in pesos at an exchange rate which had nothing to do with reality. There have been also many occasions where governments have re-possessed real assets (real estate or productive assets, like factories, resources, etc.).

So, a growing domestic capital base combined with an underdeveloped institutional (financial, legislative) infrastructure increases massively the risk of domestic capital flight. For a lot of EM countries currently, the case can be made that domestic capital flight is a bigger issue than foreign capital flight at the moment. How to monitor this is not that obvious though. The IMF measures reserve adequacy ratios taking into account domestic money supply, imports, external debt and other external liabilities.

The case of China and Russia

In a wonderful blog post, Brad Setser addresses the issue of how much FX reserves a country needs using this IMF framework. I do agree with his reasoning that, applied broadly, this measure tends to overstate the FX reserve adequacy ratio in some BoP surplus countries and understate it in others (large external debt borrowers). However, I do not think it is that straightforward. For example, China falls in this unique category where, despite running a BoP surplus there is a bigger risk of domestic, rather than of foreign capital, flight and the IMF measure rightly implies so.

China also has the largest single country FX reserves position. In addition, it has very little public foreign debt (though it does have a lot of corporate foreign debt). By these measures, it does look like China has more than enough of FX reserves. However, China also has a very large and growing domestic capital base, an underdeveloped financial markets infrastructure (few domestic investment options) and untested institutional framework, which are the main ingredients for a potential domestic capital flight. Indeed, we saw the risk of capital flight in 2016 when, despite of the capital controls, a lot of money found its way out of the country for the reasons mentioned above.

It will be a big test for China once it lifts its capital controls. Obviously, the level of FX reserves is extremely inadequate to keep the Yuan stable if even a small portion of the domestic capital base decides to convert to USDs. In fact, if other EM countries are an example, the prospects are not bright.

Russia experienced massive capital flight between 2006 and 2015 despite boasting higher CA surplus, higher FX reserves to GDP and lower foreign debt to GDP than China’s now. These good economic numbers were irrelevant to stop locals from converting their domestic deposits into foreign ones in the face of an untrustworthy domestic institutional framework. And despite more than seemingly adequate FX reserves, the RUB depreciated as a result.

Conclusion

So, is the IMF overstating the adequacy of FX reserves for BoP surplus countries but with large domestic deposits? It depends on people’s perception of how trustworthy the domestic institutional framework is (and what, therefore, the prospects for the currency are) and what domestic investment options are available. On the other hand, is the IMF understating the importance of bigger FX reserves for countries with large external deficits? It depends on people’s view on how high foreign interest rates could rise.

It is much more difficult to quantify the risk of domestic capital flight, and once it starts, it is also much more difficult to reverse it. On the other hand, one could say that the risk of foreign capital flight is not only smaller now, because developed markets terminal rates have been steadily declining, but also the recipe for reversing it is also more obvious – raise domestic interest rates to offset the rise in developed markets interest rates. I therefore think it is better to lean on the side of caution and allow for larger FX reserves relative to the domestic banking system for those EMs with a weaker (and untested, i.e. capital controls about to come off) institutional frameworks.

A much more efficient solution, obviously, would be to develop the domestic financial infrastructure, something which China has indeed been doing in the last few years.