The strong increase in net private capital inflows to emerging market economies over the past few years is proving to be a mixed blessing. Although these flows help deliver the benefits of increased financial integration, they also create challenges for policymakers because they can lead to overheating, a loss of competitiveness, and increased vulnerability to crisis.
While a number of studies have examined the policy responses to capital inflows in the 1990s, focusing on a limited number of country cases, there have been fewer studies involving recent episodes of capital flows and even fewer attempts to systematically compare how different countries have responded in terms of new policies.
A chapter in the October 2007 World Economic Outlook titled “Managing Large Capital Inflows,” tries to fill this void.
Episodes of large capital inflows
There have been two great waves of private capital flows to emerging market countries in the past two decades (see chart). The first began around the early 1990s and then ended abruptly with the 1997-98 Asian crisis. The recent wave has been building since 2002, but has recently accelerated markedly, with flows in the first half of 2007 already far exceeding the total for 2006. How have policymakers dealt with these inflows?
Main question: Private capital inflows can result in long-term benefits if put to good use, but they can also pose significant risks to macroeconomic stability. What policy measures were adopted in the past to counteract instability, and did they work?
Learning from experience: Although the appropriate policy response to large capital inflows depends on a country’s specific circumstances, a comprehensive cross-country analysis of policy responses can help us understand what has worked and what hasn’t.
Main lesson: Keeping government spending along a steady path—rather than engaging in excessive spending during periods of heavy capital inflows—helps mitigate the adverse effects of large inflows.
A flood of money
Capital flows to emerging markets have surged since 2002, following a decline in the wake of the Asian crisis.
Sources: IMF, Balance of Payments Statistics; and IMF staff calculations.
Note: Values for 2007 are IMF staff projections.
The “impossible trinity” paradigm of open economy macroeconomics—the inability simultaneously to target the exchange rate, run an independent monetary policy, and allow full capital mobility—suggests that, in the absence of direct capital controls, countries facing large capital inflows must choose between nominal appreciation and inflation. In practice, however, given that capital mobility is far from perfect (even in the absence of direct capital controls), policymakers may have more scope to pursue intermediate options than this paradigm would suggest.
Indeed, the influx of large capital inflows has generally prompted policymakers to adopt a variety of measures to prevent overheating and real currency appreciation, and to reduce the economy’s vulnerability. Our analysis focused on four policy measures: exchange rate policy, sterilization policy, fiscal policy, and capital controls.
We identified four key lessons:
- Countries with relatively high current account deficits are more vulnerable to a sharp reversal of capital inflows because they are particularly affected by increases in aggregate demand and the real appreciation of their currencies.
- Keeping public expenditure growth steady during inflow episodes—rather than ratcheting up spending—can contribute to both a lower real exchange rate appreciation and better GDP growth performance in the wake of large inflows.
- Attempts to resist nominal exchange rate appreciation have generally not been successful in preventing real appreciation and have often been followed by sharper reversals of capital inflows, especially when these inflows have persisted for a longer time.
- Capital controls might have a role to play in certain cases, but restrictions on capital inflows have not, in general, facilitated lower real appreciation and a soft landing.
Stabilization challenges arising from large capital inflows are most serious for countries with substantial current account imbalances. The most effective tool policymakers have at their disposal to avoid overheating and output instability is likely to be fiscal restraint, especially in the context of relatively inflexible exchange rate policies.
Our research also suggests that even if a central bank intervenes to resist nominal exchange rate appreciation when capital inflows begin, this stance should be progressively relaxed if the inflows persist. As time goes on, central bank intervention is less likely to prevent real appreciation and a painful end to the inflows.
Roberto Cardarelli, Selim Elekdag, and
M. Ayhan Kose
IMF Research Department