Source countries must act on portfolio-flow surges

The growth in institutional investments, which are associated with increasing voltility, demands the imposition of regulatory requirements on the investment funds not only in the host but also the source country. Such regulation, contends Chilean economist, Stephany Griffith-Jones, would serve both to protect retail investors in the source country and to ensure a more stable supply of capital to the target emerging-market economies.

by Chakravarthi Raghavan

GENEVA: The growing role of foreign portfolio investment as a channel for international capital flows and the surges of such capital flows to developing countries have posed major challenges to the economic authorities of these countries, and regulatory processes are needed in the host and source countries, according to Chilean economist Ms Stephany Griffith- Jones.

In a paper at a seminar at the Hague last November, which has also been published in Forum on Debt and Development (FONDAD)'s publication, "The Policy Challenges of Global Financial Integration," Griffith-Jones, who is Senior Fellow at the Sussex Institute of Development Studies, argues that the speed of such capital movements, in and out of a country, is associated with global institutional investors (mutual funds, pension funds and so on), and that the flows are mainly driven by liquidity and short-term performance considerations.

These capital surges have also coincided with a period of liberalization of financial markets, are almost completely unregulated in the source countries and need to be tackled through regulations in the source countries, including through measures such as varying prudential liquid reserve provisions, tailored to country-risk and creditworthiness factors, according to Griffith-Jones.

However, according to Andrew Cornford, a senior Economic Advisor at UNCTAD specializing in such matters, this would require the introduction of supervisory procedures for mutual funds analogous to those used for banks, and would pose some additional regulatory and jurisdictional problems in view of the differences in the way mutual funds and banks function, and the fact that mutual funds may be managed by banks.

The increased flows of securities investments from industrialized countries to emerging markets, Griffith-Jones points out, have been made possible by a number of developments, a critical one being the marked change in investment patterns in the national markets of major industrialized countries in the 1980s.

Institutionalization of savings

The so-called institutionalization of savings - that is, choice of pooled funds held by pension funds, insurance companies, mutual funds and investment trusts as repositories for the majority of savings - has increased the share of funds invested in securities and enhanced the role of institutional investors.

And as the assets of these investors expanded, their diversification strategies increasingly resulted in an expansion of cross-border investments - more so after the removal of exchange controls by all industrialized countries in the 1980s, and their adopting capital account convertibility in the early 1990s.

And the shift towards portfolio investments in emerging markets became possible when many developing countries began relaxing exchange controls and opened their capital accounts - thus increasing opportunities for cross-border investments by residents of all countries.

Another critical development contributing to this has been the worldwide wave of privatizations.

And over the last two decades, the US has been both a major recipient of and a source for international capital flows. The US experience with surges of foreign investments in the 1980s created problems similar to, but with less severe impact on the domestic economy than those experienced by the emerging-market countries in the 1990s: an overvalued currency, rising current account deficits, and a boom in consumption and massive increase in domestic debt - with the aggregate debt of the US borrowing sectors (government, households and business) more than doubling in the period 1983 to 1990 - from $5.4 trilion to $10.9 trillion.

And just as the explosion of debt in the US would not have been possible without sizeable increases in net capital inflows, sizeable increases in capital outflows from the US in the early 1990s, particularly of portfolio flows to developing countries, would not have occurred if the US institutional investors had not played a dominant role in channelling such funds.

And the major sources for foreign portfolio investments in developing countries were the predominantly US-based emerging- market mutual funds which led the surge in investment in emerging-market equities. US pension funds followed, investing through mutual funds and on their own account.

Such surges of capital flows pose two major sets of challenges to the economic authorities of the developing countries, and important policy dilemmas with regard to macroeconomic management of large inflows - since such surges lead to currency overvaluation and excessive expansion of domestic money supply. They also pose the risk of a sharp reversal should conditions in the country or the international environment change - as illustrated dramatically by the Mexican peso crisis.

Regulating short-term flows

Preliminary studies indicate a hierarchy of volatility - with securitized flows more volatile than medium-term bank loans. The speed of inflows and outflows is facilitated by technological developments. And the speed with which such capital moves in and out of countries seems also to be related to the growing importance of global institutional investors. This, coupled with the fact that this growth has taken place during a period of liberalization of financial markets, has implied that flows originating from these global institutional investors are almost completely unregulated in their source country, particularly with regard to market risks.

After the Mexican crisis, Griffith-Jones notes, the Bank for International Settlements (BIS) noted in 1995 that it was widely agreed "that prudence in liberalizing capital inflows implies that short-term operations should not be free until the soundness of the domestic financial system is assured."

Referring to various measures taken by a range of countries (Chile, Colombia, Brazil, Indonesia, Malaysia, the Philippines and Thailand), Griffith-Jones notes that the IMF, World Bank and the BIS explicitly recognize that despite some limitations, measures taken by recipient governments to discourage short- term capital flows may play a positive role if they are part of a package of policy measures leading to sound macroeconomic fundamentals. "Therefore it has become fairly widely accepted that regulation by recipient countries of excessive surges of capital flows can be a desirable policy."

However, she adds, no complementary action by source countries has been taken to regulate potential volatile flows from them, even though such regulations would both protect their domestic investors and discourage excessive surges of potentially volatile capital flows to developing countries. She cites the views of several mainstream economists about asymmetry of information and market failures and which are in favour of governmental actions, and says that since moral hazard and adverse selection policies are endemic to all market situations, market failures are pervasive in the economy.

Hence, intervention by governments through taxes or regulation is potentially desirable in most sectors. But the practical information needed by governments to implement corrective measures may not be available or the cost of administering such measures may exceed the benefits.

Hence, in the view of the World Bank's Chief Economist Joseph Stiglitz, governments should focus attention and efforts on instances where large and important market failures may occur.

New regulatory strategies

And, adds Griffith-Jones, international capital markets are particularly prone to substantial market imperfections, given the serious degree of asymmetric information in these markets.

Referring to some of the measures taken in recipient countries, she notes that even countries like Chile and Colombia have on occasion found these measures insufficient to stem massive inflows.

Given the important shift in the channel of savings towards institutional investors, and the growing diversification of these investors into emerging markets, there is a case for new regulatory strategies in source countries to protect retail investors who put their savings in mutual funds and who are beneficiaries of pension funds.

In the past, it was thought that regulatory strategies for banks were very different from those appropriate for securities markets. While in developed countries, requirements for diversification are applicable to mutual funds, liquidity requirements, such as levels of cash reserves or for insurance coverage to promote confidence, are not. Nor is enough consideration given to the impact of national macroeconomic developments on securities markets. The effect of such factors, like "market risks", that is, national macroeconomic factors or international factors such as US interest rates, is particularly crucial for determining the evolution of securities markets in developing countries.

But the views on the appropriateness of certain soundness strategies for mutual funds are changing and the importance of "market risks" to institutional investors is increasingly stressed by securities regulators. Nevertheless, institutional investors continue to evaluate market risks in emerging markets poorly. But with institutional investors assuming a dominant role in financial markets, and the distinction between mutual funds and banks becoming less clear, strategies promoting public confidence in banks are being adapted to also cover mutual funds.

Referring to developments in this regard in the US, including provisions for the Federal Reserve to provide liquidity to such funds, and other developments like the "fund of funds" created on the Fidelity model, Griffith-Jones suggests that mutual funds should be required to have some portion of their cash reserves in the form of interest-bearing deposits in commercial banks as a prudential charge. This could constitute a first line of defence for access liquidity in the event of a significant market decline. Also, current key elements in regulation, namely risk-weighting, could be made applicable to mutual funds.

And while for emerging-market economies, the requirement of cash reserves on mutual-fund assets invested in them could increase their costs of raising foreign capital, it would be compensated for by the benefit of a more stable supply of funds at a more stable cost.

Additional regulation of mutual funds should, however, be symmetrical with regulation of other institutions, such as banks, and other potentially volatile flows such as short-term bank credits.


There should also be improved disclosure requirements for mutual funds, as proposed by the US Securities and Exchange Commission in its initial proposals for comments. But these proposals do not include what many investors and commentators seek, namely, disclosure by the funds, for example, of their ten largest holdings and discussions by the management of what affected a fund's performance in the past year.

However, according to Andrew Cornford, mandatory requirements of liquidity reserves for mutual funds, as suggested by Griffith-Jones, would represent a radical break with existing regulatory practices (and thus may run into opposition). The proposal also envisages variations in these reserve requirements in response to changes in a country's creditworthiness. This would require the introduction of supervisory procedures for mutual funds analogous to those used for setting reserves for banks with high external exposures. But in view of the differences between mutual funds and banks, and the fact that funds may be managed by banks, the suggestion that the liquidity reserves could be used to reduce competitive disparities between banks and mutual funds would pose additional problems. (Third World Economics No. 189, 16-31 July 1998)

Chakravarthi Raghavan is the Chief Editor of the South-North Development Monitor (SUNS) from which the above article first appeared.