Managing Capital Flows in the Aftermath of the Global Crisis

Originally published by the Carnegie Endowment for International Peace
Participants: Amar Bhattacharya, John Williamson, Arturo Porzecanski, Uri Dadush

Capital inflows to emerging economies are rebounding. These flows could surge in coming years and contribute to inflationary pressures and large asset bubbles in emerging markets. Policy responses designed to moderate the effects of large capital inflows may include increasing currency flexibility, deepening and broadening capital markets, building up foreign currency reserves, shifting deposits to central banks, tightening fiscal policy, and enacting prudential regulations. Capital controls may also be needed if the other instruments do not work.

To address issues related to capital inflows to emerging economies, Carnegie hosted Amar Bhattacharya, director of the G24, John Williamson, senior fellow at the Peterson Institute for International Economics, and Arturo Porzecanski, distinguished economist-in-residence at American University’s School of International Service. Carnegie’s Uri Dadush moderated.

Recent Dynamics

The level of capital flows to developing countries increased greatly over the decade preceding the 1997–1998 Asian crisis, recovered after the crisis, and then accelerated to reach record levels in 2006 and 2007. While developing countries have drawn many benefits from the inflow of foreign capital and their integration into global financial markets, they have also experienced destabilizing effects at times, including currency appreciation and rises in inflation.

Bhattacharya discussed the major characteristics of capital flows during the last decade:

• Private Flows: Private capital flows dominated official ones, which include official development assistance.
• Bank Intermediation: Much of the private capital flows—short-term debt, bank lending, and bonds—were intermediated through banks. Banks were hard hit by the recent financial crisis, which resulted in a collapse of private capital flows.
• Pro-cyclical: Private capital flows to developing countries were pro-cyclical.
• Eastern and Central Europe: The big boom and bust in capital flows occurred in Eastern and Central Europe. While other developing countries, including many in Asia, were beginning to see a boom in 2006/2007, the global crisis hit before they experienced the worst effects of surging capital inflows.
• Faster Recovery: The recovery in capital flows from the recent financial crisis has been faster than that following any preceding crisis, and access to financial markets was restored quickly.

Given their strong economic recovery and sounder balance sheets, emerging markets could see a flight to safety into their bonds, Williamson predicted.

Policy Options for Managing Capital Flows

Panelists discussed policy options to help prevent real exchange rate appreciation and overheating, as well as reduce vulnerability to a sharp reversal of capital inflows.

Fundamentals

According to Bhattacharya, the fiscal vulnerabilities that were exposed by the crisis are not much of an issue for developing countries. However, developing countries need to continue to improve their fiscal and debt situations in order to reduce their vulnerabilities to capital flow reversals.

In addition, they need to deepen their capital markets by developing a monetary framework that allows for inflation targeting and more flexible exchange rate policies.

Beyond Fundamentals

Williamson outlined possible policy reactions to surges of capital flows designed to mitigate inflation and currency appreciation and guard against the effects of reversals.

• Building Up Reserves: Governments can purchase capital inflows and add them to reserves until they can be sold for a profit. This would also help stabilize the exchange rate—an important consideration, especially in small open economies.
• Raise Reserve Requirements: Raising the reserve requirement—a certain percentage of foreign currency that must be held by the central bank—can help moderate the credit expansion.
• Government Deposits: Shifting public sector deposits from commercial banks to central banks can sterilize capital inflows, as was done in East Asia, where public sector deposits account for a large share of the banking system’s deposits.
• Liberalize Outflows: Relaxing controls on capital outflows, by permitting local pension funds to make investments abroad, for example, could help. On the other hand, it could also encourage more inflows of capital, which are partly determined by confidence in the ability to get capital out again if the need arises.

Williamson also discussed other policy options, which included introducing a flexible exchange rate policy, limiting the ability of private banks to make foreign exchange loans, withdrawing artificial incentives that encourage capital inflows, liberalizing imports, and tightening fiscal policy.

Capital Controls as an Option?

Bhattacharya and Williamson suggested that capital controls, the most controversial policy response to capital inflows, should be implemented when other instruments are not effective.

Williamson argued for limiting the duration of capital controls. In addition, in order to limit capital flows to what can safely be invested, Williamson recommended that capital inflows should not exceed 3 percent of a country’s GDP.

Bhattacharya favored capital controls if the other instruments do not work, but emphasized that the magnitude and type of action should vary across countries.

Regional and Global Responses

Bhattacharya discussed regional and global options for managing capital inflows.

• Regional: Policy options include surveillance, coordinated financial arrangements, and coordinated capital controls.
• Global: Strengthening the capacity of the IMF will enable it to respond to liquidity crises and provide flexible, fast, and speedy responses to systemic crises.

In addition, multilateral development banks, such as the World Bank, need to play a much bigger role in intermediating public finance for public goods in developing countries.

Can Capital Flows Be Managed?

Porzecanski argued that managing capital flows is a difficult task and economists should be modest in providing advice. Sentiment in financial markets, for example, turned around much faster than anyone expected over the past few months.

Instead of trying to micro-manage capital flows, or to control them directly, Porzecanski argued for the establishment of sound long-term policy frameworks:

• Flexible Exchange Rates: Flexible exchange rates discourage currency mismatches and can be used to signal prices to investors. If exchange rates are allowed to appreciate during large capital inflows, assets denominated in the local currency become expensive for foreigners.
• Prudential Regulation: Guidelines for financial intermediaries help limit banks’ foreign currency exposure.
• Transparency: Making the risks of investing in developing countries, like those that come with fiscal mismanagement, more transparent to investors discourages capital inflows.
• Anti-cyclical Fiscal Policy: Greater restraint on expenditure growth may reduce the incentives for inflows of capital.