GLOBAL FINANCE

Global competition for Global competition for attracting capital flowsattracting capital flows

September 2007 Michel Henry Bouchet

GLOBAL FINANCE

I- What drives global capital flows?

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Globalization’s impact? MisconceptionMisconception: capital should flow from rich countries to

poor ones, which have less capital and offer higher returns! By borrowing abroad, LDCs should be able to boost investment and the growth rate.

FactsFacts: capital is flowing « uphill » and the US current account deficit is financed by emerging countries’ purchase of US Treasury securities

Facts: LDCs have limited capacity to absorb foreign capital, due to underdeveloped financial systems. Dynamic growth boosts saving relative to investment, hence a current account surplus (China!).

Facts: US bond yields are 2% lower than they otherwise would be, thanks to the purchase of US securities by China and other EMCs. If these countries loose their appetite for US assets, bond yields could jump and the dollar plunge!

Source: IMF/Prasad-Rajan, 2006

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US Current account deficit in US$ billion

-900

-800

-700

-600

-500

-400

-300

-200

-100

0

1992 1994 1996 1998 2000 2002 2004 2006

-7% PBI US Treasury, IMF

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Global competition in financial markets

DEFICIT

SURPLUSSURPLUS

?

-$800 billion= $2200 million/day

?

?

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Who finances whom?Current account balances of OECD and EMCs

(billions of US$)

-800

-600

-400

-200

0

200

400

600

800

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

OECD

EMCs

Source: FMI/2006

Asian crisis

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Why do EMCs show such large CA surpluses and rising reserves?

1982 debt crisis + 1994 Tequila crisis + 1997 Asia crisis + 1998 Russian crisis + 2001

Argentina crisis Strong IMF-monitored adjustment + economic

and trade liberalization Devaluation + Boost in investment ratio= trade

and current account surpluses Improvement in debt indicators!

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Successful economic adjustment:Improvement in EMCs’ solvency ratios (drop in Debt/X %)

0

20

40

60

80

100

120

140

160

180

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Ratio

Source: FMI/2007

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SPREAD EMBI+ (1998 -2006)

0

200

400

600

800

1000

1200

1400

Dic

98  

Mar

99  

Jun9

9  

Sep

99  

Dic

99  

Mar

00  

Jun0

0  

Sep

00  

Dic

00  

Mar

01  

Jun0

1  

Sep

01  

Dic

01  

Mar

02  

Jun0

2  

Sep

02  

Dic

02  

Mar

03  

Jun0

3  

Sep

03  

Dic

03  

Mar

04  

Jun0

4  

Sep

04  

Dic

04  

Mar

05  

Jun0

5  

Sep

05  

Dic

05  

Mar

06  

EMBI+ Global EMBI+ Latinoamérica EMBI+ Perú EMBI+ México EMBI+ Chile

México consigue el Grado de Inversión

Embi+ Mexico

Current account surpluses + Global liquidity:Sharp drop in the cost of borrowing of EMCs

BCRP, Banco Central de Chile

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II- Global competition in financial markets

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Globalization Index = « Top 20 »

1. Singapore 2. Ireland 3. Switzerland 4. USA 5. Netherland 6. Canada 7. Denmark 8. Sweden 9. Austria 12. UK 18. France 19. Malaysia 20. Slovenia

26. Spain 34. Chile 42. Mexico 47. Argentina 51. Colombia 53. Peru 54. China 55. Venezuela 57. Brazil 61. India

ATKearney

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The 30 most attractive EMCs for

FDI

1. India2. Russia3. Vietnam4. Ukraine5. China6. Chile7. Latvia8. Slovenia9. Croacia10. Turkey11. Tunisia12. Tailandia13. Korea14. Malaysia15. Macedonia16. UAE17. Arabia Saudita18. Slovakia19. México20. Egypt21. Bulgaria22. Rumania23. Hungary24. Taiwan25. Bosnia26. Lituania27. Brasil28. Morroco29. Colombia30. Kazajstan

Economic + political riskMarket Potential

AT Kearney GRDI 2006

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The most attractive EMCs in 2006

HIGHRisk

LOWRisk

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Identifying the next leaders?

The BRICs: « The path to 2040 » : Goldman Sachs:

Brazil, Russia, China & India’s GDP > G7 en US$

Challenge: How to forecast the « Top 10 » of 2040?

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The BRICs catching upcatching up with the G7

Goldman Sachs 2007

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Share in global GDP

0

5

10

15

20

25

30

35

1820 1870 1913 1950 1973 1998 2001 2004 2006

Chine

Inde

JaponChine= 15,4%Japon= 6,4%Inde= 6%

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The leaders of 2040?

0

5000

10000

15000

20000

25000

30000

35000

40000

45000

Source: Goldman Sachs

GDP in billions of US$

The « BRICs »The « BRICs »

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III- The Asian challenge Strong Investment rate

High Savings rate Dynamic Productivity

Low Labour cost Current account surplus

Large Internacional reserves High liquidity and solvency indicators

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The dynamics of investment rate

15

20

25

30

35

40

45

50

1990 1995 2000 2001 2002 2003 2004 2005Perú Thailand Korea Malaysia Hungary Chile

I/GDP %

IMF, IIF

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National savings and Investment dynamics

Investment and saving rates in Thailand 1978-2005

20

25

30

35

40

I/PBI%

S/PBI%

IIF

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Share of EMCs Official Reserves in 2007

11%

36%

4%2%2%

45%

RussiaChinaIndiaBrazilMexicoOthers

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Asian crisis and Thailand’s recovery

FMI

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FDI and portfolio flows in Thailand

0

1000

2000

3000

4000

5000

6000

7000

8000

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

FDIPortfolio

US$ million

GLOBAL FINANCE

CHINA Inc. : A Global supremacy strategy

Oil

Oil

US$US$

NTICFDI

MNCs

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« Made in China » and « Made by China » China IncChina Inc holds a two-fold comparative advantage to

attract foreign capital flows:

1. Labour intensive activities with very competitive labour costs: textile, shoes, garment, components…

2. High value added activites incorporating new technologies (electronics, software, NTIC…)

Key role of MNCs (majority from Asia: South Korea, Japan, Malaysia) : 60% of China’s exports stem from foreign companies and/or joint-ventures

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made inin China y made byby ChinaShare of capital origins in China’s exports

0

10

20

30

40

50

60

70

80

HIFI/Vidéo High Tech

ChinaJoint venturesEMNs

Source: Le Monde, 16/6/2006

%

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IV- Where do capital flows goIV- Where do capital flows go??

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WhoWho finances whom?Current account balances of OECD and EMCs

(billions of US$)

-800

-600

-400

-200

0

200

400

600

800

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

OECDEMCs

Source: FMI/2006

Asian crisis

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Net capital sources for emerging market countries

-100

0

100

200

300

400

500

600

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

privatepublic

IIF/IMF

US$ billion

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Net capital flow sources for Latin American countries (US$ billion)

IIF-2006

Net private flows

Net public flows

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Net private capital flows to EMCs

0

100

200

300

400

500

600

1990 1994 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

TotalAsiaLat America

Billion of US$

Source: IIF/IMF

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Net portfolio capital funds to EMCs

(US$ billion)

IIF-2006

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OECD (81%)

EMCs (19%)

ASIA (64%)

LATIN

AMERICA

(29%)GLOBAL ECONOMY

EMCs

LATIN AMERICA

MEXICO (32%)

CHILE (10%)

PERU (4%)

CHINA (80%)

ASIA

GLOBAL FDI FLOWSGLOBAL FDI FLOWS

Source: IIF, OECD

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FDI FLOWS(US$ billion)

-10 000

0

10 000

20 000

30 000

40 000

50 000

60 000

70 000

80 000

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006f

Argentina Chile China,Hong Kong Korea Mexico Thailand Peru Vietnam

IIF/FMI

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Net FDI and portfolio capital flows to EMCs

0

50

100

150

200

250

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

FDI

ASIA

Am Latina

US$ billion

Fuente: IMF/IIF

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Total FDI inflows in US$ trillion

Post-2003 bounceback has been driven byemerging markets. However, FDI flows to emerging markets will remain buoyant in 2006-10, averaging over US$400bn per year, but growth rates will be modest asprivatisation tails off and the global economy slows.

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Incestuous globalization?The key recipients of FDI

0

10

20

30

40

50

60China

France

Germany

USA

Netherlands

UK

Spain

Canada

Ireland

Belgium

Brazil

Italy

Australia

HK

Mexico

Sweden

Japan

In US$ billion

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FDI in China

0

10

20

30

40

50

60

70

80InflowsOutflows

US$ billion

OCDE

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V- How analyzing global risk and opportunities?

The role of Rating agenciesThe role of Rating agencies (after the Asian crisis, Enron, LTCM,

Arthur Andersen, Parmelat, and the US subprime market…)

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Risk Ratings

Advantages/ ProsAdvantages/ Pros Simple cross-country

comparison comparison across time shrinks a large number

of variables into one single grade

Reliable for smooth risk evolution

Shortcomings/Cons “reductionist” oversimplistic risk of self-fulfilling

prophecy little predictive value weighted average tends to

bury salient trends Gives “market consensus”

often made of herd instinct

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Moody’, Fitch, S&P’s, Coface

Objective: assessing willingness + capacity

to repay a debt at maturity

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Investment grade vs speculative investment

  Moody's S & P

Investment grade

AaaAaA

Baa

AAAAAA

BBB

Speculative risk ("Junk Bonds")

BaB

CaaCaC

BBB

CCCCCC

Default   D

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LT & ST Ratings of Moody’s

L.T. S.T.

Investment grade

Aaa; Aa; A

Baa, BaFrom Prime 1 to

Prime 3

Speculative investment

B; Caa; Ca; C Subprime

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Rating Moody’s

Countries Rating

Argentina B3

Perú Ba2

Chile Baa1

Brazil Ba3

México Baa1

Túnisia Baa2

Venezuela B2

Colombia Ba2

Russia Baa2 (stable)

2007

GLOBAL FINANCE

BRASIL

PERU

COLOMBIA

MEXICO

CHILE

RATING MOODY´S (mid- 2007)

Investment grade

Fuente: Scotiabank/Moody’s

Baa1

Baa1

Ba2

Ba3

Ba3

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How does S&P build its Rating?

10 Parameters:

Political risk, Economic structures, Growth potential, fiscal flexibility, budget balance,

debt ratios, Inflation, external liquidity, public and private external debt (liquidity

and solvency)

GLOBAL FINANCE

Rating of S&PL.T. S.T.

Investment grade

AAA; AA; A

BBB; BB;A1; A2; A3

Speculative investment

B; CCC; C; SD; D B; C; SD; D

GLOBAL FINANCE

ARGENTINA

VENEZUELA

COLOMBIA

BRASIL

PERU

MEXICO

CHILE

Investment grade

B

BB-

BB

BB

BB+

BBB

A

Source: S&P

RATING S&P LT

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RATING FITCH

Source: Fitch IBCA

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OECD Country risk classification in 2007

1 2 3 4 5 6 7

Chile Israel Algeria

Morocco

Peru Albania Bolivia

Haiti

Hungary South Africa

Bulgaria Turkey Pakistan Cameroon

Niger

Nigeria

Trinidad & Tobago

Thailand Russia Vietnam Brazil Argentina

Kuwait Mexico Guatemala Gabon

RCI

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COFACE 140 countries Country rating definition:

Investment grade A1= steady economic and political situation A2= weak default probability A3= adverse circumstances may lead to worsening payment

record A4= patchy payment record could be worsened by adverse

econmic/politicval developments Speculative grade:

B= unsteady economic and poltical environment C= bad payment record D= high risk profile and very bad payment record

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Coface credit Rating (2007) Canada= A1 Australia= A1 USA= A1 Japan= A1 Korea= A2 Chile = A2

Thailand= A3 China= A3 India= A3 Poland= A3 Mexico= A4 Morocco= A4 Algeria= A4 Romania=A4

Egypt= B Brazil= B Russia= B Turkey= B Vietnam= B Congo= C Ukraine= C

Venezuela= C Argentina= D

Turkménistan= D Chad= D RCI= D

Nigeria= D

GLOBAL FINANCE

Ratings09/2007

Countries Rating

Argentina C

Perú B

Bolivia D

Brazil A4

Chile A2

China A3

Russia B

Cuba D

North Korea D

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KOREA: Index of payment arrears 1993-2006(base 1995 = 100)

COFACE

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VI-Shortcomings of rating agencies?

Criticisms: * Power without accountability * Conformity bias * Sociocultural bias * Punishment of disobedient firms/countries that do not

request a rating * Procyclical bias, hence followjng the majority opinion

of market participants without any early warning signals nor predictability track record

Spill-over effect!

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Rating = poor early warning signals?

South Korea was rated as Italy and Sweden as recently as October of 1997! But has been downgraded abruptly to junk bond status during the crisis

« There were no early warnings about Korea from us or, to the best of our knowledge, from other market participants and our customers should

expect a better job from us » FICHT IBCA January 14, 1998

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After Asia: some lessons of the crisis “Any agency which rated the Republic of Korea

at the high investment grade rating of AA- (in the case of Fitch IBCA and S&Ps) or A1 (in the case of Moody’s) before the crisis, and which now rates Korea at a speculative grade B-, was clearly either wrong initially or subsequently. Clients are entitled to expect us to perform better in the future!”

Fitch IBCA January 13, 1998

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The Perceived Situation

Was the crisis anticipated by rating agencies?

June 1996 June 1997 June 1996 June 1997Indonesia BBB BBB Baa3 Baa3Korea AA- AA- A1 A1Malaysia A+ A+ A1 A1Philippines BB BB+ Ba2 Ba1Thailand A A A2 A2

Standard & Poor' s Moody' sCredit Ratings

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EUROMONEY Risk Ratingthe higher the ranking, the higher the risk

1996 1997 1998 1999 2000 2005

Korea 28 30 4242 44 29 28

Thailand 45 51 54 49 65 49

Philippines 55 57 55 53 78 75

Malaysia 33 35 5656 46 46 46

Indonesia 45 49 9191 98 107 81

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Macroeconomic success of the tigers… until 1996

Source: IMF/International Financial Statistics 1999

Changes in GDP

-2,0%

0,0%

2,0%

4,0%

6,0%

8,0%

10,0%

1992 1993 1994 1995 1996 1997

Korea IndonesiaMalaysia PhilippinesThailand

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Prudent macroeconomic management of the tigers: low inflation, low budget deficits

Fuente: IMF/ International Financial Statistics 1999

Changes in CPI

0,0%

2,0%

4,0%

6,0%

8,0%

10,0%

12,0%

1992 1993 1994 1995 1996 1997

Indonesia KoreaMalaysia PhilippinesThailand

Fiscal Balance

-2,0%

-1,0%

0,0%

1,0%

2,0%

3,0%

4,0%

1993 1994 1995 1996 1997

Indonesia KoreaMalaysia PhilippinesThailand

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Example: Russia attracts large capital inflows thanks to a strong rating

by Coface and Fitch… despite bad competitiveness and governance indicators!

Económic Freedom 122 / 157 Heritage Foundation

HDI 62 / 177 UNDP

Ease of Doing Business 70 / 155 World Bank

Credit Rating B Coface

Credit Rating BBB stable Fitch

Country risk 158 / 209 OECD

Growth Competitive Index 75 / 117 World Economic Forum

Opacity Index 46 / 59 PriceWaterhouseCoopers

CPI 126 / 158 Transparency International

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Ratings and the US subprime mortgage-backed securities market in the summer of 2007

Rating agencies responded to issuers’ rating requests and kept a AAA rating for debts whose collateral was rapidly deteriorating!

Ratings agencies failed to warn investors about the risk of complex financial instruments

Challenge: how measuring liquidity and market value risks?

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World Bank: Doing business in 2007

7 criteria 175 countries

New company creation; employment procedure; company registration; financing mobilization; investment protection;

contract enforcement; liquidation

3 days to set up a company in Canada vs 12 days in New Zealand and 52 in Slovakia and 153 in Mozambique

GLOBAL FINANCE

World Bank: « Doing Business » in 20071. Singapore

2. New Zealand3. USA

4. Canada5. HK6. UK

7. Denmark8. Australa9. Norway11. Japan

21. Germany35. France (44 en 2006)France (44 en 2006)

39. Spain93. China96. Russia121. Brazil134. India171. RDC

« Ease of doing business »The ranking does not take

into account the macroeconomic framework

nor organized crime

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Quality of regulatory framework matters

World Bank 2007

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Economic Freedom Rating/Fraser Institute 2006

1. Hongkong2. Singapore

3. New Zealand4. Switzerland

5. US6. Ireland

7. UK8. Canada9. Iceland

10. Luxembourg11. Australia12. Austria13. Estonia14. Finland

15. Netherland

20. Chile 24. France24. France 30. Spain 35. Korea 45. Italy

60. Mexico 60. Thailand 83. Indonesia 88. Brazil 95. China 102. Russia 124. Algeria

126. Venezuela 130. Zimbabwe

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World Economic Forum: competitiveness ranking

The Global Competitiveness Report, which examines the growth prospects of 80 countries, remains the most up-to-date and comprehensive data source available on the comparative strengths and weaknesses of leading economies of the world.

Countries in The Global Competitiveness Report are ranked by the Growth Competitiveness Index (GCI) (GCI Rankings) and the Microeconomic Competitiveness Index (MICI) (MICI Rankings), which combined encapsulate the relative strengths and weaknesses of growth within each economy.

GLOBAL FINANCE

Davos-WEF 2007 Competitiveness IndexSwitzerland 1 Canada 16

Finland 2 Austria 17

Sweden 3 FranceFrance 18

Denmark 4 Australia 19

Singapore 5 Belgium 20

United States 6 Ireland 21

Japan 7 Luxembourg 22

Germany 8 New Zealand 23

Netherlands 9 Korea, Rep. 24

United Kingdom 10 Estonia 25

Hong Kong SAR 11 Malaysia 26

Norway 12 Chile 27

Taiwan, China 13 Spain 28

Iceland 14 Czech Republic 29

Israel 15 Tunisia 30

GLOBAL FINANCE

Davos-WEF 2007 Competitiveness Index

Thailand= 38 China= 57

Mexico= 58 Russia= 62 Brazil= 66

Vietnam= 77 Venezuela= 88 Pakistan= 91

Bolivia= 97 Nigeria= 101

Cambodia= 103 Paraguay= 106 Cameroon= 108 Zimbabwe= 119 Ethiopia= 120 Angola= 125

GLOBAL FINANCE

IMD Criteria

Economic Performance

(74 criteria) Macro-economic evaluation of the domestic economy.

Government Efficiency

(84 criteria) Extent to which government policies are conducive to competitiveness.

Business Efficiency

(66 criteria) Extent to which enterprises are performing in an innovative, profitable and responsible manner.

Infrastructure (90 criteria) Extent to which basic, technological, scientific and human resources meet the needs of business.

Over 300 competitiveness criteria are selected.

GLOBAL FINANCE

IMD 2007 Competitiveness Index

1. USA 2. Singapore 3. HK 3. Luxembourg 4. Denmark 5. Switzerland 15. China 16. Germany 20. UK 24. Japan 26. Chile

27. India 28. France 29. Korea 30. Spain 33. Thailand 35. Hungary 38. Colombia 43. Russia 44. Romania 47. Mexico 55. Venezuela

BEST

GLOBAL FINANCE

VII- What are the drivers of sustainable economic growth?

Sustainable developmentSustainable development =

Economic growth + those conditions that make it … sustainable! =

Strong infrastructures + socio-political stability + flexible institutions + good

governance… + democracy

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Correlation economic liberalization/growth

GLOBAL FINANCE

Correlation economic freedom –human development

y = 0,7755x + 21,431

R2 = 0,4899

0

20

40

60

80

100

120

140

160

180

200

0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160

Liberté Economique

IDH

GLOBAL FINANCE

Correlation between trade openness and corruption?

Corruption et ouverture commerciale

0

20

40

60

80

100

120

140

0

20

40

60

80

100

120

CPI

Trade

Corruption CommerceCorrelation corruption – trade openness

Low trade openness

High corruption

GLOBAL FINANCE

Correlation Human development /Corruption

y = 0,914x + 15,368

R2 = 0,5702

0

20

40

60

80

100

120

140

160

180

200

0 20 40 60 80 100 120 140 160IPC

IDH

GLOBAL FINANCE

The monitoring of corruption by the World Bank

World Bank 2006

GLOBAL FINANCE

World Bank: comparing the relative intensity of corruption in Latin America?

Control de la Corrupción (América Latina, 2004)

GLOBAL FINANCE

Conclusion: How to assess sustainability of global

capital flows?

1. Economic and financial risk analysis (quantitative)

2. Socio-polítical, institutional development, and structural reforms (qualitative)