Briefing | Jamaica must manage capital flows

WHY IS AN UNDERSTANDING OF CAPITAL FLOWS NECESSARY?

Capital flow refers to the movement of money in and out of a country for the purpose of investment, trade, commerce and production. Developing countries with the correct capital flow legislation/environment can expand and diversify their portfolios arising from increased capital inflows to their advantage.

However, if capital inflows are too excessive they can become unsustainable in the long run if these flows are not managed properly by the receiving country. There are also difficulties in dealing with short-term capital inflows that are a direct result of high domestic interest rates, especially when the country's macroeconomic policy is one in which the exchange rate is inflexible.

WHAT ARE THE MAJOR CAPITAL FLOW CONCERNS?

The major concerns that arise from rapid increases in Net Capital Inflow (NKI) can be grouped into four main categories (see Aizenman and Pasricha 2013).

1. Concerns about overheating. NKIs to emerging markets are often procyclical, increasing when the economies are booming and retreating when the economies are slowing. Surging capital inflows in periods of high economic growth can therefore lead to overheating concerns by further boosting growth, domestic credit expansion and inflationary pressures.

2. Concerns about foreign exchange valuation. NKI surges can lead to overvaluation of the exchange rate, thus hurting export competitiveness.

3. Concerns about financial stability. NKI surges can exacerbate asset price booms in real estate or financial markets and aggregate balance-sheet exposures, thus giving rise to financial stability concerns.

4. Concerns about macroeconomic volatility. The booms and busts in non-residents' inflow can be an independent source of macroeconomic volatility and can exacerbate existing cycles.

WHAT ABOUT THE MANAGEMENT OF THESE CAPITAL FLOWS?

The failure to properly manage capital flows can jeopardise a country's internal as well as its external stability. According to Sarwono (2014), a 'surge of capital inflows can pose a range of policy challenges, including macroeconomic risks through excessive credit expansion, an overheating economy and an overvalued real exchange rate'. Sarwono also highlight that exchange rate flexibility is important to managing capital flows. It can serve as a shock absorber that will lessen the cost of overheating and dampen the pressure on other asset prices. Free capital movements recommended by the International Monetary Fund (IMF) facilitate more efficient allocation of global savings, helping to channel resources to their most productive uses, thereby increasing growth and welfare.

WHY IS THIS RELEVANT TO JAMAICA?

Results from Chapter 6 of my book "Developing Sustainable Balance of Payments in Small Countries: Lesson from Macro Economic Deadlock in Jamaica" indicate that maintaining an optimal balance of payment path depends on the sustainability of the capital flows to the island. There are several factors that influence the sustainability capital flows that must be analysed in the Jamaican situation. We employ three sets of control variables: macroeconomic control variables, financial control variables and institutional control variables. Macroeconomic control variables include real interest rate, real effective exchange rate, and the degree of economic openness. Financial control variables include financial deepness, the ratio of private credit by banks and other deposit-taking institutions over GDP, financial development, the ratio of the value of total shares traded to average real market capitalisation and financial account openness. Institutional control variables include index of corruption, political stability and law and order.

WHAT ARE THE RESULTS FROM OUR ANALYSIS?

The level of corruption in Jamaica has a huge negative impact on the flow of foreign capital, which is of economic significance though not statistically significant, due to large standard deviation. As expected, political stability and law and order have positive impacts on the level ofcapital flows. Meanwhile, an increase in real interest rate, increase in crude oil prices and a depreciation of the local currency have negative impacts on capital flows. The most significant drivers of the capital account are openness, domestic-credit-to-GDP ratio and lagged values of the capital-account to-GDP ratio.

WHAT ABOUT THE IMPACT OF SHOCKS?

Shock to the level of openness causes the optimal capital requirements to increase in the first period, subsequently decreasing in the second period as the effect meanders and disappearing to zero after the seventh period. Similarly, a one unit standard deviation increase in the level of domestic credit to GDP causes the level of capital required to increase in the first period, subsequently falling after the fourth period with the effect gradually disappearing to zero after the tenth period. Finally, a one standard deviation positive shock to the level of capital requirements in the first period causes a gradual fall in capital requirements consistently afterwards per annum. The effect disappears at around the eighth period.

- Dr Andre Haughton is a lecturer in the Department of Economics on the Mona campus of the University of the West Indies. Follow him on Twitter @DrAndreHaughton; or email editorial@gleanerjm.com.