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Managing Capital Flows

Shahrokh Fardoust's picture

With sluggish growth in advanced economies, much investment money is heading south to more favorable climates. And while capital flows can provide greater opportunities for emerging and developing economies to pursue economic development and growth, capital inflows can also pose some serious policy challenges for macroeconomic management and financial sector supervision. Recently, large capital inflows in some middle-income countries have placed undue  upward pressure on their currencies, adversely affecting  macroeconomic and financial system stability as well as export competitiveness in a number of  these countries. Furthermore, the pro-cyclical nature of global capital flows to emerging and developing economics can serve to aggravate these risks.

In their recently published book, Managing Capital Flows: The Search for a Framework, Masahiro Kawai (Dean and CEO of the Asian Development Bank Institute) and Mario Lamberte, provide analyses that can help policymakers develop a framework for managing capital flows that is consistent with prudent macroeconomic and financial sector stability. The expert contributors cover a wide range of issues related to managing capital flows and analyze the experience of emerging Asian economies in dealing with surges in capital inflows.  The authors suggest possible policy measures to manage capital flows that are consistent with macroeconomic and financial sector stability. These include: “improving prudential regulations, using capital controls at the time of inflow surges rather than as a permanent measure in a country where the regulatory authorities have the administrative capacity to enforce them, making the fiscal stance countercyclical to surges in capital inflows, rebalancing growth, and exploring regional collective action such as exchange rate coordination and strengthening of regional financial market surveillance and integration.” 

Developing countries for the most part have largely recovered from the global financial crisis of 2008-09, and the crisis is no longer the major force dictating the pace of their economic activities.  The majority of developing countries are close to having regained full-capacity activity levels. Aggregate growth in developing economies is projected to ease from 7.4 percent in 2010 to a still strong 6.3 percent pace in 2011 through 2013, while high-income countries’ 2.2 percent growth in 2011, expect to rise a bit  to near 2.6 percent in 2012 and 2013, as the negative effects of household, banking, and government budget consolidation begin to fade and rebuilding in Japan intensifies (Global Economic Prospects 2011). Although solid growth led by developing-countries is the most likely outcome going forward, high food prices, possible additional oil-price spikes, and lingering post-crisis difficulties (including debt sustainability) in high-income countries, particularly in Europe, pose considerable downside risks. Given the forecast of higher growth and potential return on investment in developing countries, it is therefore likely that capital inflows into these countries will continue to rise and remain volatile, thus making the policy response to  these flows all the more important and challenging.

Overall, net private capital flows to developing countries, which reached $860 billion in 2010, are anticipated to reach more than $1 trillion by 2013 (close to the peak reached in 2007), but their share in developing country GDP is expected to fall slightly (GEP 2011) .  However, in recent months these private inflows have been characterized by increased volatility and a higher share of portfolio investment and “hot money.”

There is little agreement on whether  capital flows should be managed or controlled. After years of calling for the abolition of capital controls, prevailing winds shifted somewhat post-crisis when the IMF, in a historical shift, agreed that capital controls may be a useful tool for managing inflows and may used on a case-by-case basis in appropriate circumstances, although there continues to be little agreement on if capital controls actually work. 

However, there are still sound reasons why the adoption of generally-accepted principles for the use of capital controls may be of value to emerging economies. First, the imposition of capital controls by one country can have negative externalities for other countries (e.g., the closed capital account of some large countries has resulted in greater inflows into to those emerging markets with open capital accounts) and second, while the largest emerging markets may have the resources and experience to manage capital surges, this may not be the case for smaller emerging markets and some low-income countries. 
Aside from implementing capital controls, other options for managing capital inflows include: (a) let the exchange rate appreciate in nominal terms or intervene in exchange rate markets and let inflation rise, leading to appreciation of the real exchange rate; (b) manage exchange rate by accumulating international reserves and then sterilize capital inflows through sales of government bonds; and (c) conduct counter-cyclical fiscal and monetary policies, tightening financial regulations and controlling accumulation of public debt. (See presentation)

My thoughts are that capital controls are only a short-term and temporary remedy and may in fact carry with them significant longer-term costs. The implications for capital controls are very different for countries with different degrees of openness to trade and finance, and capital inflows can put pressure on currencies to appreciate, thus undermining their export competitiveness. While long-term real exchange rates affected by other factors, short-term real exchange rates are hard to influence unless controls are high enough (which in turn have other negative effects).
Instead of capital controls, we should think about counter-cyclical fiscal and monetary policies and focus on better balance sheets: controlling public debt. We must use the opportunity of large capital inflows to invest cheaply and make economic booms sustainable.  Countries must save more and invest more domestically and abroad. Saving more abroad has advantage of exerting less pressure on exchange rate in the short run, but it’s hard to do it given opportunities at home and home-bias preferences. Overall, policymakers should be as counter-cyclical as possible, with all available tools, but one must also be aware that better policies might result in more capital flows. And since implementing countercyclical policies might be more politically difficult to achieve, we may need to lean even harder against the prevailing wind of capital controls! Furthermore, given the global nature of financial flows and the increasing interconnectedness of the global financial system, national policies alone are insufficient to tackle these challenges. Greater international and regional cooperation is needed to make risks posed by volatile capital flows to global financial stability.

Related Links
Global Development Horizons 2011
World Economic Outlook Update
IIF- Capital Flows to Emerging Market Economies