Concluding Thoughts

This concluding chapter argues that the policy makers' vade mecum laid out in the previous chapter raises broader issues for the global monetary system. Notwithstanding the fact that some of the emerging markets may have liberalized their capital accounts prematurely, it questions whether emerging markets have further to gain from opening up, or indeed whether they would not be better off retaining restrictions on at least the riskiest forms of foreign liabilities and transactions. This is particularly pertinent since most of these countries do not enjoy the liquidity insurance provided by swap facilities let alone the reserve currency status. They are forced to self-insure through reserve accumulation, which is costly both to the country and to the international monetary system. Alternative forms of insurance could arguably yield favorable benefit–cost trade-offs, particularly if they result in a safer mix of flows that makes economies less prone to risks from changes in global push factors.

Multilateral Considerations

This chapter discusses international spillovers, the multilateral impact of individual countries' policies, and the scope for international policy cooperation. Theory and empirics suggests that recipient countries would benefit from coordinating their policy responses to capital inflows. Specifically, because of spillovers of one country's measures on another, uncoordinated responses might result in barriers that—abstracting from terms of trade effects—are inefficiently high, reducing both global and recipient-country welfare. Theory also suggests that, under plausible conditions, it would be globally efficient if source and recipient countries could act “at both ends” in managing cross-border capital flows. For the recipient country, there would be a clear benefit if part of the distortive cost of capital controls could be shifted to the source country. Even though source countries might incur some economic or administrative cost in managing outflows, they would benefit from the terms of trade improvement.

Regulating Capital Flows: A Historical Perspective

This chapter summarizes how thinking about capital flows and their management has evolved in both policymaking and academic circles. Many advanced economies used restrictions on capital inflows for prudential purposes—even as they pursued financial liberalization more broadly—until the 1980s, when capital account restrictions began to be swept away as part of broader liberalization efforts. Likewise, many emerging markets that had inflow controls for prudential reasons dismantled them when liberalizing domestic financial markets and controls over outflows. That the use of capital controls as a means of managing inflows is often viewed with suspicion may be partly a “guilt by association” with outflow controls and exchange restrictions. Historically, these have been more prevalent and more intensive, and their purpose has been to prop up authoritarian regimes or poor macroeconomic policies, often affecting both current and capital transactions.

Toward the Policy Maker’s Vade Mecum

This chapter provides concrete policy advice for dealing with capital inflows. In sum, once the monetary authorities have allowed the exchange rate to appreciate to a level that is not undervalued from a multilaterally consistent medium-term perspective, they may want to start intervening in the foreign exchange (FX) market to prevent further appreciation, sterilizing the intervention if there are inflationary pressures. If the economy shows signs of overheating, monetary and fiscal tightening might be necessary, together with macroprudential measures to contain excessive credit growth. To the extent these policies prove insufficient, the authorities need to consider bolstering them by imposing or tightening capital controls. At the same time, national authorities must be mindful of growing balance-sheet mismatches in the economy and should avail themselves of both prudential measures and capital controls to shift the composition of inflows toward less risky forms of liabilities.

Should Inflation Targeters Intervene in the Foreign Exchange Market?

This chapter addresses whether foreign exchange (FX) intervention—and, more generally, activist policies including the use of macroprudential measures and capital controls—is really incompatible with an inflation-targeting (IT) framework. While a purist view of inflation targeting would argue for the central bank to use only its policy interest rate, and to target only the inflation rate, a broader perspective is that policy makers should try to address all of the various macroeconomic imbalances associated with large inflows—not just consumer price inflation—and should make use of all of the relevant policy instruments. Focusing on the use of sterilized intervention to manage the exchange rate, the chapter shows that having a second instrument and a second objective is not at all inconsistent with the central bank attaining its inflation target. If anything, it makes inflation-targeting more attractive and enhances welfare if exchange rate movements are costly.

Introduction

This introductory chapter provides an overview of capital flows to emerging markets. In principle, cross-border capital flows to emerging markets have the potential to bring several benefits; in practice, however, such flows are inherently risky—though some forms may be worse than others—potentially widening macroeconomic imbalances and creating balance-sheet vulnerabilities. As such, capital flows require active policy management, which might mean mitigating their undesirable consequences using macroeconomic and macroprudential policies, or controlling their volume and composition directly using capital account restrictions, or both. By the same token, if the inflow phase is successfully managed—through the use of structural measures to steer flows toward less risky types of liabilities, and the use of macroeconomic policies, prudential measures, and capital controls for abating the cyclical component of flows and their consequences—the economy is likely to benefit from foreign capital and to remain resilient when flows recede or reverse.

Consequences and Crashes

This chapter explores the macroeconomic and financial-stability consequences of capital inflows in emerging market economies (EMEs), and how these translate into greater risk of crisis, both generally and particularly after surge episodes. Capital inflows can lead to macroeconomic imbalances—positive output gaps and overheating of the economy, currency appreciation, and excessive credit growth—as well as to balance-sheet vulnerabilities. Domestic credit expansion and currency overvaluation are the principal macroeconomic imbalances that raise the risk of a subsequent financial crisis. Meanwhile, there are also risks that are likely related to balance-sheet vulnerabilities. In this regard, other investment flows and portfolio debt appear to be the most risky types of inflows, while foreign direct investment (FDI) seems to be the safest. As such, policy should try to shift the composition of inflows away from the relatively risky flows toward safer types of liabilities.

What Do Countries Do?

This chapter examines how emerging markets typically respond to capital inflows in practice. Confronted by an inflow surge, national authorities respond through a combination of policy instruments—both macroeconomic tools and less orthodox measures. While the thrust of the policy responses across countries is largely the same, there are differences in the specific instruments deployed that likely depend on economic, historical, and institutional characteristics. Central banks seem to use the policy interest rate to address inflation and overheating concerns associated with capital inflows, and to reduce currency appreciation. Most emerging market central banks intervene quite heavily in the face of inflows, nearly always sterilizing that intervention. Finally, emerging market economies also seem to be using capital controls and macroprudential measures in the face of large inflows, but capital controls appear less frequently, often acting as a backstop to other measures.

Managing Macroeconomic Imbalances: A Simple Model

This chapter discusses a simple theoretical framework linking capital flows and various policy measures to macroeconomic outcomes. In the face of macroeconomic imbalances, policy makers need to decide whether to try to reduce the volume of flows or to tackle any collateral damage that they may cause. If the inflows are such that they bring little genuine benefit to the recipient country, then the obvious solution is to try to stop them entering the economy in the first place. But inasmuch as the capital inflow is considered to be beneficial, then dealing with any negative repercussion would naturally be the preferred option. To this end, the central bank—or national authorities more generally—have potentially three instruments at their disposal: the policy interest rate, foreign exchange (FX) intervention, and macroprudential measures. These instruments map naturally to maintaining price stability, curbing the appreciation of the currency, and safeguarding financial stability.

Surges

This chapter examines the drivers of exceptionally large net capital flows—surges—to emerging market economies. Most surges to emerging markets are driven by foreign investors rather than by retrenchment of domestic residents liquidating their investments abroad. Moreover, while both domestic and foreign investors respond to global and local factors, foreign investors tend to be more sensitive to global conditions, making them more flighty when conditions turn. The result is that the occurrence of surges—being at least partly determined by global factors—is not under the control of emerging markets, and most of those factors that make individual destinations attractive to foreign capital, such as good growth prospects and strong institutions, are hardly characteristics that the country would want to forgo purely for the sake of avoiding inflow surges. This puts a premium on identifying any negative repercussions of inflow surges and finding policy tools for managing them.