WASHINGTON (MNI) – The following are excerpts from the text of
Federal Reserve Vice Chair Janet Yellen’s remarks on “Reaping the Full
Benefits of Financial Openness” prepared for the Bank of Finland 200th
Anniversary Conference in Helsinki Friday:

I continue to believe that open capital markets offer significant
benefits in terms of greater efficiency and improved standards of
living, and that they represent a long-run goal to which policymakers
should remain committed. That said, recent experience suggests that
reaping the full benefits of capital mobility requires prerequisites,
including a sound legal and institutional infrastructure, solid
prudential supervision and regulation, and appropriate incentives for
risk management by domestic financial institutions. Suffice it to say
that the achievement of these objectives takes time. In the interim,
countries may need to employ a variety of tools to effectively manage
capital flows. Such tools may include macroeconomic policies, exchange
rate flexibility, liberalization of capital outflows, and, perhaps in
some particularly challenging instances, constraints on capital inflows.

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To start off, the arguments in favor of countries being open to
financial flows are compelling. First, countries that open their markets
to capital flows can be expected to reap stronger economic growth.
Indeed, the economic history of a number of small, open advanced
economies, such as Australia, Canada, and New Zealand, points to a
notable role for foreign capital, especially from the United Kingdom and
the United States. And the United States was itself aided by foreign
capital at an early stage of its development.4 That the advanced
economies have achieved high standards of living, while at the same time
embracing financial openness, suggests that such openness is likely to
bring longterm benefits for other countries as well.

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Being more open to the rest of the world — both to financial flows
and to trade — may help countries better absorb economic shocks by
allowing temporary current account surpluses and deficits. For example,
a spending boom that leads the economy to overheat could induce a rise
in the countrys currency and a decline in exports, restoring more
normal conditions and avoiding an undesirable rise in inflation. Any
impediments to the free operation of international capital markets,
including their role in setting exchange rates, can hamper this
rebalancing of demand across countries.

Finally, openness also improves welfare by allowing countries
greater scope to share risk. Although financial openness may or may not
reduce the volatility of an economys output, risk-averse consumers
should benefit by diversifying their portfolios across countries and
thus insuring themselves against the shocks hitting their own particular
economy. During domestic recessions, lower income from domestic assets
may be offset by higher income from abroad, thereby reducing consumption
volatility, as long as the shocks hitting the domestic and foreign
economies are not too similar.

Despite the strong case for financial openness, countries have
faced some practical challenges in the pursuit of this objective. In
particular, capital flows can be volatile, and many countries have
struggled with the adverse effects of this volatility on the domestic
economy. Access to foreign capital may also exacerbate domestic
financial distortions, such as maturity mismatches or agency problems,
by channeling funds into the domestic system that would not have
otherwise been available. A related matter is that the domestic
financial system may simply not have the capacity to effectively
intermediate large volumes of inflows. For example, if financial
supervision is not sufficient to ward off such problems, short-term
lending from abroad (so-called hot money) can result in maturity
mismatches, which can bankrupt domestic institutions in the event of
sharp and sudden outflows. Unhedged borrowing in foreign currencies
creates an additional mismatch, where a sharp currency depreciation can
dramatically boost debt burdens, push borrowers into insolvency, and, in
a vicious circle, induce further curtailment of finance from abroad.
Heavily managed exchange rate regimes may also provide incentives for
such mismatches to arise. In addition, increased financial openness may
increase countries exposure to the risk of contagion and spillovers
from financial shocks elsewhere in the global economy.

Many of these vulnerabilities have been manifest in the emerging
market crises of the past several decades. For example, in the lead-up
to the 1997-98 Asian crisis, domestic financial intermediation failed to
prudently allocate capital, and these deficiencies were amplified by
large amounts of external borrowing in foreign currencies, encouraged by
heavily managed exchange rate regimes. As such deficiencies came to
light, exchange rates collapsed, resulting in large balance sheet
losses. Foreign investors lost confidence in much of the region,
precipitating capital flight, the spread of the crisis to additional
countries, and a sharp downturn in activity in these economies.
Consistent with the broad set of practical challenges posed by capital
flows that I have just highlighted, the empirical literature on the
connection between openness and growth contains a wide range of
findings. For example, work using firm-level data finds notable positive
effects, while other papers that draw on cross-country data find little
or no effect.

Despite the practical challenges associated with managing capital
inflows, we should be careful not to conclude that limiting capital
mobility is a first-best policy outcome. The recent financial crisis
certainly highlighted the fact that financial markets are prone to
speculative excesses and behavior that may exacerbate systemic risk.
But, as central bankers and supervisors, we must remain humble about our
ability to preempt market forces in ways that predictably enhance
welfare.

An alternative to limiting capital mobility is for countries to
rely on more standard policy tools as an initial line of defense against
the challenges posed by capital flows. For example, the effects of
undesired capital movements prompted by variations in the business cycle
can be addressed directly with the mix of fiscal and monetary policies.
Countries facing overheating, with strong capital flows being attracted
by rising interest rates, may consider a tighter fiscal policy to reduce
both the extent of overheating and the related strength of capital
inflows. And some countries facing strong capital inflows may help
alleviate pressures by lifting controls on capital outflows. Exchange
rate flexibility can also play a crucial role in helping modulate the
effects of capital flows, as exchange rates appreciate in response to an
inflow (or depreciate in the face of outflows), thereby contributing to
external balance and damping further such flows by altering asset
valuations. Increased exchange rate flexibility should also discourage
excessive currency mismatches, as market participants better gauge the
risks of future currency movements. Notably, in some cases, volatile
capital flows have been a symptom of deeper distortions within the
recipient country, and addressing these distortions has required a shift
in the underlying mix of the countrys policies. Past experience also
highlights that attempts to limit financial openness are themselves
imperfect. Clearly, capital controls can influence capital flows if
applied with enough force. But how effective are they and at what cost?
The Chilean controls on capital inflows during the 1990s are often cited
as an example of an approach that other countries might use.

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** Market News International Washington Bureau: 202-371-2121 **

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