Frameworks for Monetary Stability

13 Capital Movements and Surveillance

Carlo Cottarelli, and Tomás Baliño
Published Date:
December 1994
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In recent years, many countries have experienced surges in capital inflows. Generally, these inflows were welcomed reversals of previous outflows or ongoing financing constraints and promised higher investment and output growth. However, for many countries the surges were so large that they challenged macroeconomic stability by contributing to an acceleration of demand and activity, a deterioration in the external current account and pressures on prices of goods, real estate, and financial assets—all the typical symptoms of overheating. The critical question for policymakers in these situations was whether these effects were simply an equilibrating response to inflows that could be efficiently absorbed in the economy or rather were signs of overheating that would prove disruptive. In other words, could financial policies be kept on a steady keel or were a sharp tightening of policies and even microeconomic measures to stem the inflows needed?

The objective of this paper is to examine this question, drawing particularly on the experiences of six countries—Chile, Colombia, Egypt, Mexico, Spain, and Thailand—that received surges in capital inflows during the past five to ten years. The episodes of surges in inflows to these countries—the causes of the inflows, policy responses to them, and macroeconomic developments during the episodes—are reviewed in detail in Schadler and others (1993). This paper is restricted to reviewing the principal conclusions about the appropriate response of policies to surges in inflows. The overarching conclusion is that the surges in inflows observed in recent years stemmed from a variety of causes, and the precise mix of these causes and therefore effects of the inflows in each country needed to condition decisions about the policy response. This paper, therefore, presents a simple framework in which to view the causes of surges in inflows, relates appropriate policy responses to these causes, and examines the range of effects that can be expected from the combination of the inflows and particular policy responses.

What Caused Surges in Capital Inflows?

In principle, most developing countries with stable financial policies and a reasonably welcoming environment for foreign investors should attract net capital inflows. These are after all economies with as yet unexploited potential for development, and profitable investment opportunities typically exceed what can be financed by domestic savings. What distinguishes the six countries reviewed in this paper are the size and suddenness of such inflows. In each country, net inflows rose from a relatively small share of gross domestic product (GDP) to twice or three times starting amounts within the space of one or two years (Chart 1).

Chart 1.Capital Inflows1

(In percent of GDP)

Source: International Monetary Fund staff estimates.

1First year of the surge in inflows noted in parentheses after country name.

2Overall balance of payments surplus.

3Average of three years prior to episode.

In principle, capital account data should provide valuable insights into the causes of such surges in capital inflows: whether the inflows are directed to private or public borrowers, banks or nonbanks; whether they originate from private or official sources; whether they are non-debt-creating flows; and if they are debt-creating, what their maturity is. In practice, national data on capital accounts are usually not very revealing. Frequently, financial instruments in which inflows arrive are not those in which they reside, data records do not distinguish between various types of inflows, and large errors and omissions in the balance of payments comprise capital inflows outside the net of official statistics.

These limitations mean that capital account data have often provided a hazy picture of the characteristics of surges in inflows. What could be discerned in the six countries reviewed is that almost all the increase in inflows was on account of flows to the private sector and that short-term, medium-term, and long-term inflows claimed roughly equal shares of the increase in total inflows to the private sector. Portfolio investment and inflows to domestic banks were typically not separated although both were believed to be important in most of the countries. Direct foreign investment constituted about 15 to 20 percent of the increase in inflows in most of the countries. In Colombia and, to a lesser extent, Egypt, “capital-like” inflows recorded in the current account were important. These were included in the current account because of problems with data recordation or because the inflows stemmed from shifts in workers’ remittances motivated by influences similar to those affecting conventionally defined capital inflows.

With limited information from capital account data, policymakers generally need to piece together an understanding of the causes of surges in capital inflows from domestic and external developments leading up to and during the inflow period. A critical question was the relative importance of external developments—such as changes in foreign interest rates and growth rates—and of domestic influences. This was important because whether inflows were generated by external or domestic influences determined the interpretation of their economic effects.

Without any changes in domestic conditions, inflows caused by changes in external influences elicit downward pressure on interest rates, but in other ways bring the standard signs of overheating—i.e., an increase in demand (possibly consumption as well as investment), higher output, a wider current account deficit, an acceleration in money and prices, and upward pressure on the real exchange rate.1 Most important is the considerable potential for a reversal of the inflows when external conditions themselves turn around.

There is ample evidence that changes in external conditions played a role in the surges in capital inflows that occurred during the late 1980s and early 1990s.2 Two of the most obvious developments were the drops in interest rates and growth rates in industrial countries during that period; both sent capital in industrial countries looking for higher rates of return in other countries. However, the fact that these developments were not uniform across the industrial countries nor precisely coincident with the surges in inflows to some countries suggests that other domestic factors must also have played an important role.

Domestic Influences

Two types of domestic influences were most common in attracting surges in inflows, and each led to quite different effects from the inflows. The first was changes in real domestic economic policies—for example, structural changes that improved potential productivity or reductions in public sector deficits that promised greater macroeconomic stability and permitted real depreciations. When these influences dominated, the potential benefits from capital inflows for investment and output from capital inflows were large. The inflows did tend to increase the current account deficit and put upward pressure on money, nontraded goods’ prices, and the real exchange rate. But rather than being signs of instability, such effects in these circumstances were equilibrating and sustainable; they reflect the scope for profitable investment and adjustments needed to effect the foreign transfer and mitigate excess demand for nontraded goods. Any rise in consumption was likely to be the result of higher permanent income rather than easier financing. With constancy in the stance of structural policies, the risk of reversal of the inflows was small.

The second common domestic cause of surges in capital inflows was a tightening of domestic credit policies or increase in administered interest rates, without an adequately corresponding fiscal adjustment, usually in an effort to reduce persistent inflation. With the exchange rate fixed (or on a fixed nominal path), inflows were attracted by high domestic interest rates and accommodated an unchanged demand for broad money and inertial inflation. Without sterilization, the effects of inflows when this was the dominant cause would be confined to reversing the increase in interest rates and raising foreign-backed money, thereby thwarting the effort to lower money growth and inflation. Effects on investment, growth, and the current account would be minimal. Because such a mix of tight money, easier fiscal policy, and a fixed exchange rate is likely to be unsustainable, the risk of a reversal of the inflows would be high.

In each of the six countries studied each of the influences was at work to some degree. The relative importance of each, however, differed enormously—from Thailand, where changes in regional patterns of comparative advantage and changes in domestic policies that affected external competitiveness dominated, to Colombia, where the inflows occurred in a period of structural reform but also a sharp tightening of credit in an effort to contain inflation. There was also some fear that one (or all) of these influences was augmented by bandwagon effects. These reflected financial markets’ following fashions or overreacting to new information. The concern was that if the volume of the inflows was outpacing the volume caused by changes in domestic conditions, inflows influenced by bandwagon motives would have effects similar to those inflows caused by changing external conditions—that is, the risk of inefficient absorption of the inflows (and, ultimately, reversal) would be great.

Policy Responses to Surges in Capital Inflows

The discussion thus far suggests that, unless a tightening of credit alone attracts the inflows, a surge in capital inflows is likely to cause signs of overheating. Whether these effects are unsustainable or destabilizing—that is, whether a policy response is needed—has to be interpreted in light of the causes of the inflows. When inflows are attracted by improvements in potential productivity or competitiveness, these effects are less signs of instability than of equilibrating adjustments; governments can allow the inflows to stimulate demand and growth and focus policy more on improving the absorptive capacity of the economy than on containing destabilizing effects. When external influences and bandwagon effects are the more important causes of the inflows, the effects may be unsustainable, particularly if a substantial share of the inflows finances consumption rather than investment. Moreover, the risk of a reversal of the inflows is high. In this case, policies need to be concentrated on containing or neutralizing the inflows. In practice, surges in inflows usually stem from a combination of these influences. This tendency, together with difficulties in interpreting the causes of the inflows, creates uncertainty about the needed restraint from policies. Thus, most governments direct policies at least to some extent toward limiting the risks of destabilizing effects.

In the six countries studied, several general considerations usually affected governments’ decisions about how aggressively to limit the risks of destabilizing effects. The first was the degree of concern about a loss of monetary control, particularly when the surge came in the midst of a disinflation program as in Chile, Colombia, and Mexico. The second was the extent to which policymakers adhered to the so-called Lawson doctrine, which states that when public sector accounts are balanced, capital inflows and resulting current account deficits reflect a gap between private savings and investment that should not be a concern of the government: the stronger the adherence to the Lawson doctrine, the more likely a laissez-faire policy response.3 A third important issue was the absorptive capacity of the economy. Two aspects of this issue proved particularly important: the efficiency of the banking system, especially as inflows increased the scope for systemic risk; and the adequacy of physical infrastructure to accommodate sharply higher investment and growth. Against these concerns, several policy options were pursued by governments.


Sterilization was usually the first line of defense against a surge in inflows, regardless of its cause. It could be implemented quickly and bought time to consider the likely causes and persistence of the inflows and to formulate a longer-term response. To some degree, it curbed the monetary effect of the inflows and tended to lock in a cushion of reserves against a possible reversal.4 Sterilization took a range of forms from the narrowly defined exchange of bonds rather than money for foreign exchange, to more broadly defined ways of central banks’ limiting the influence of capital inflows on money—e.g., increases in reserve requirements on all or selected parts of bank deposits, various forms of central bank borrowing from commercial banks, and curtailing access to rediscount facilities.

As inflows persisted, most governments reduced their reliance on sterilization for several reasons. First, it carried large quasi-fiscal costs. These were most clear when sterilization took the form of open market operations. Then the net cost to the central bank per bond issued was the difference between the interest on domestic bonds and the return on foreign reserves. A broader measure of the cost would account for the effect of higher interest rates on the government’s debt-service payments. The costs of other forms of sterilization are varied. For example, because increases in unremunerated reserve requirements tax commercial banks, they actually augment profits of the central bank. Second, aggressive sterilization through open market operations risked intensifying the conditions that attracted large inflows in the first place; by adding to the supply of bonds, it put upward pressure on domestic interest rates, sustaining an important attraction to additional inflows. Third, by forcing foreign inflows into purchases of government bonds and sustaining high domestic interest rates, sterilization deprived the economy of the benefits of inflows—higher domestic investment and growth.

Even though full sterilization was not viable as a sustained response to surges in inflows, credit policies were not formulated without regard for the effects of inflows on domestic credit conditions. In practice, all countries partially sterilized, in the broad sense of restraining the growth of net domestic assets of the central bank when inflows satisfied a large share of credit needs. Several indicators should feed into decisions on the optimal degree of restraint: (1) domestic relative to foreign interest rates (particularly, when domestic risk premiums and inflation are falling, increases in the differential may signal unsustainable restraint); (2) unduly large increases in reserves (these may indicate that excessive sterilization is perpetuating large inflows and preventing desirable transfers); and (3) current account positions (large increases in the deficit, particularly reflecting rising consumption, indicate the need for more restraint).

Exchange Rate Policy

For countries that fixed their exchange rate or moved it according to a rule, surges in inflows quickly raised the question of whether the peg was sustainable or whether a real appreciation was unavoidable. Unchecked, inflows tended to feed the demand for nontraded goods, pushing up prices and the real exchange rate. Thus, whether inflationary pressures should be pre-empted through a nominal appreciation became a policy issue.

Exchange rate action unleashed questions about the role that market forces should play in determining the change. Here the decisions of the six countries studied varied widely. Spain resisted giving freer rein to market forces and eventually even moved to a more fixed regime; as inflows pushed up the value of their currencies, this response reflected the combination of reacting to the inflows and the underlying motivation to join the exchange rate mechanism (ERM). In principle, the case for a fixed regime when faced with a surge in inflows rests on several considerations: (1) the view that a market-determined appreciation encourages speculative behavior; (2) the presumption that restraining reliance on nominal appreciation limits the risk of overshooting and forces more of the adjustment onto fiscal policy, which would constrain inflation and the real appreciation; and (3) a wish to preserve a credible nominal anchor in case the inflows reverse.

Chile and Mexico, on the other end of the spectrum, moved to greater, albeit limited, flexibility by enlarging the band within which their exchange rates move. These countries gave weight to three considerations: (1) the position of the exchange rate in the band provides an indicator of the appropriateness of the rate, which helps assuage any public perception that it is overvalued; (2) permitting some flexibility increases the exchange rate risk for foreign investors; and (3) a reversal in inflows would elicit an immediate offsetting response through a change of the exchange rate in the band.

Paradoxically, the increase in the current account deficits that frequently accompanies surges in inflows at times raised questions of whether a devaluation would be desirable. The answer for each of the countries studied, and indeed for most countries that experience surges in inflows, is no. In the circumstances of these countries a devaluation would likely attract larger capital inflows and exacerbate the signs of overheating—inflation and widening current account deficits—and ultimately be self-defeating.

Fiscal Policy

As the persistence of the inflows became obvious, a tightening of fiscal policy proved to be the only means of containing inflation and avoiding a real appreciation. To the extent that the inflows stemmed from an unsustainable financial policy mix—relatively tight credit with an easier fiscal policy—reducing the fiscal deficit would eliminate the problem at its source. When other causes of inflows were at play, fiscal adjustment—additional to the adjustment that might already have occurred—would restrain domestic demand and inflation. In fact, in the six countries reviewed, only Thailand responded to the inflows with a strong fiscal retrenchment—shifting from a deficit of the central government from about 4 percent of GDP prior to the surge in inflows to a surplus of about 5 percent of GDP three years into the inflow episode. This adjustment proved remarkably successful in reaching the government’s objective of containing inflation and avoiding any real appreciation. Indeed, Thailand was the only country of the six studied that avoided any significant real appreciation.

The experiences studied suggest several considerations in designing a fiscal policy response to surges in inflows. First, the form of fiscal adjustment influences its restraining effect. An adjustment that moderates the demand for nontraded goods and services, whether directly by cutting government spending on them or indirectly by raising taxes, reduces domestic inflationary pressures; however, one that falls on traded goods tends to strengthen the external current account, which could even add to pressures for appreciation. Second, discretionary measures, to the extent that they are perceived as sustainable, have a stronger effect than cyclical influences on inflation expectations and interest rates, although both reduce demand. Third, unless private savings behavior fully offsets shifts in government saving, containing expenditure should have a stronger effect on domestic demand than revenue increases; expenditure cuts affect demand directly, but revenue increases absorb resources that might have been saved.

In view of the powerful effects of a fiscal contraction in preventing the unwanted results of surges in inflows, why was it not more common in the countries studied? An important reason for most of the countries was the difficulty of garnering public support for a tightening of fiscal policy, when economic conditions are perceived as favorable. Added to this was the need in some countries for investment in infrastructure to accommodate higher investment stemming from the inflows.5 In principle, of course, it is not objectives for the real exchange rate that should determine the stance of fiscal policy. Rather, a medium-term course for public finances should be set on the basis of the initial fiscal position and the desired and sustainable stock of government debt. Specifically, in countries where the government is a creditor or even a small debtor at the outset of the surge in inflows, it may be judged that a further accumulation of credit would be incompatible with the appropriate function of the government. In fact, however, in most of the countries reviewed, the debtor position of the government still provided substantial scope for fiscal consolidation.

Microeconomic Policies

Although the thrust of the response to surges in inflows was focused on macroeconomic policies, microeconomic policies also played a role in two main ways: (1) in some countries, impediments to inflows or trade liberalization appear to have slowed down reserve accumulation for short periods; and (2) financial sector reform and trade liberalization increased the efficiency with which inflows were absorbed.

Impediments to inflows—taxes or quantitative restrictions on foreign access to domestic financial instruments—were, like sterilization, quick and easy to impose. Unlike sterilization, however, by locking out inflows they precluded even future benefits of incipient inflows for investment and growth. Thus, resort to them (greatest in Chile, Colombia, and Spain) usually followed efforts to sterilize and tended to reflect several considerations: (1) a judgment that the inflows were prone to reversal and would not provide lasting benefits to the economy; (2) concerns about the effect of sterilization on interest rates; and (3) fears about the efficiency with which the economy could absorb inflows—because of implicit government guarantees, inadequate infrastructure, or deficiencies in the banking system. Against these considerations was the threat that prolonged restrictions or taxes on inflows to the banking system would weaken bank profits and encourage disintermediation. In fact, there is little evidence to argue for the effectiveness of restrictions. When actions were relatively aggressive, evasion tended to occur within months, forcing governments to abandon the effort or progressively broaden the coverage of controls.

In several of the countries reviewed, there were long-standing distortions in the financial sector and weaknesses in banking supervision and prudential standards. The increase in inflows added to the urgency of addressing these problems for three reasons: (1) because inflows tended to increase the flow of funds through the banking system, they could feed risky lending behavior; (2) to the extent that inflows increased banks’ open foreign exchange positions, they raised banks’ exposure to exchange risks; and (3) inflows presented the potential for pressures on the government to support institutions in the event of a reversal in inflows. Although explicit deposit insurance existed only in Chile, Colombia, and Spain, governments in the other countries had stepped in to avoid bank failures in previous banking crises and the risk of implicit government guarantees was substantial. To address these types of risks, regulations to ensure the adequacy of capital bases and limit banks’ exposure to foreign exchange risks were essential. Most of the countries studied had programs of financial reform in existence at the time of the surge and implemented remaining steps as planned. One area where steps were taken in response to the inflows, however, was in limiting banks’ open foreign exchange positions. Such limits, which were in place in most of the countries prior to the surge in inflows, were introduced or tightened in Egypt and Mexico during the inflow episode.

Some countries eased restrictions on capital outflows in an effort to lessen the buildup of reserves and to enhance efficiency by subjecting domestic financial markets to greater international competition and enabling residents to diversify their portfolios. Whether such measures actually promoted net outflows is unclear. Where capital flight had been sizable, the volume of pent-up capital may not have been large. Also, simplifying the process for repatriating profits and capital could have attracted inflows. Prepayment of public debt—another way some countries attempt to promote outflows—has no monetary effect beyond any corresponding drop in the fiscal deficit.

Most of the countries studied already had a program of trade liberalization in operation before the surge in inflows. For them, the initial motivation for trade reform—to improve economic efficiency—became all the more important when large inflows needed to be allocated throughout the economy. Moreover, a surge in inflows eased any perceived external constraint on the speed of trade liberalization and tariff reduction. There is a question, however, of whether an acceleration of trade reform helps contain increases in reserves. Initially, the main effect of lowering tariffs may be to increase import demand, weaken the current account, and slow reserve accumulation. Over time, however, efficiency gains, particularly if tariff reductions affect mainly intermediate inputs, are likely to improve competitiveness and the current account.6

What Were the Effects?

The diversity of the experiences of the countries reviewed makes it clear that the effects of surges in capital inflows clearly cannot be generalized; not only did countries’ differing policy responses result in different effects, but also the myriad coincident developments obscure the pure effect of the inflows. The earlier paper presented by Schadler and others (1993) includes a detailed presentation of key aspects of the macroeconomic outcome in each of the six countries studied. Here the objective is simply to present some of the main aspects of the economic outcomes in the six countries studied.

First, surges in inflows tended to push down domestic interest rates—both nominal and real—once any initial thrust of sterilization subsided. This effect was weakest in Thailand, where interest rates had been low prior to the inflow episode and where credit market conditions played a relatively small role in attracting the inflows. Surges in prices of other financial instruments—especially in equity and real estate markets—also occurred, and were particularly strong in the Latin American countries.

Second, in general, surges in inflows did not result in the much-feared surge in monetary aggregates (Chart 2). Two different mechanisms were at play in restraining the monetary effects of the inflows. In Chile, Colombia, and Egypt, large-scale sterilization resulted in a sizable shift in the backing of money—from domestic to foreign assets. In Mexico, Spain, and Thailand, where tight credit market conditions were relatively less important in attracting the inflows and sterilization was minimal, inflows were almost fully reflected in widening current account deficits.

Chart 2.Developments in Money, Official Reserves and the Current Account During Period of Surges in Capital Flows1

Source: International Monetary Fund staff estimates.

1 First year of episode noted in parentheses after country name.

2Uquid assets held by the public.

3A statistical discrepancy accounts for the difference between the current account of the balance of payments and foreign savings in the national accouts.

Third, reflecting the absence of large monetary effects, accelerating inflation was not a problem. However, each of the countries except Thailand was attempting to reduce inflation—in Mexico from very high levels—and inflation persistence was a problem. In Chile, Colombia, Egypt, and Mexico, accelerations in prices early in the inflow episode were reversed, although, except in Chile, inflation targets were typically not met. This experience underscores the difficulty of exerting financial restraint and disinflating in the face of large capital inflows. In other words, it typically is possible to prevent surges in money growth, but quite difficult to tame inflation expectations and actually reduce money growth.

Fourth, real appreciations of domestic currency were difficult to avoid. Of the countries reviewed, only Thailand managed to escape sizable real appreciation (Chart 3). For Thailand, this appears to have been the result of a history of low inflation together with a large improvement in the fiscal position as the inflows occurred. Each of the other countries, except Egypt, opted for some degree of nominal appreciation to quell the monetary expansion, reduce reliance on sterilization, and stem inflationary pressures. Nominal appreciation, in turn, pushed up the real exchange rate as well. Moreover, the real appreciations tended to outpace changes in the nominal exchange rates owing to the persistence of inflation above that in trading partners.

Chart 3.Real Effective Exchange Rates1


Source: Information Notice System.

1Period t is the first year of the surge in capital inflows, the timing of which is indicated in parentheses after country name.

Fifth, particularly when sterilization was not aggressive, capital inflows fed increases in current account deficits. Whether these stemmed from increases in investment or reductions in saving was related to the causes of the inflows (Chart 4). Inflows stemming more from fundamental changes in structural or fiscal policies tended to push up investment by at least as much as saving might have fallen, while those stemming from changes in credit market or external conditions tended to have larger effects on consumption.

Chart 4.Savings and Investment1

(In percent of GDP)

Source: International Monetary Fund staff estimates.

1First year of episode noted in parentheses after country name.


    ArgyVictor and Pentti J.K.Kouri“Sterilization and the Volatility in International Reserves,”inNational Monetary Policies and the International Financial Systemed. by Robert Z.Aliber (Chicago: University of Chicago Press1974).

    CalvoGuillermoA.LeonardoLeiderman and Carmen M.Reinhart“Capital Inflows and Real Exchange Rate Appreciation in Latin America: The Role of External Factors,”Staff PapersInternational Monetary FundVol. 40 (March1993) pp. 10851.

    CordenW.Max“Does the Current Account Matter? The Old View and the New,”inInternational Financial Policy: Essays in Honor of Jacques J. Polaked. by Jacob A.Frenkel and MorrisGoldstein (Washington: International Monetary Fund1992) pp. 45578.

    GhoshAtishR. and Jonathan D.Ostry“Do Capital Flows Reflect Economic Fundamentals in Developing Countries?”IMF Working Paper No. 93/34 (Washington: International Monetary FundApril1993).

    ObstfeldMaurice“Can We Sterilize? Theory and Evidence,”American Economic Review Papers and ProceedingsVol. 72 (May1982) pp. 4550.

    OstryJonathanD.“Trade Liberalization in Developing Countries: Initial Trade Distortions and Imported Intermediate Inputs,”Staff PapersInternational Monetary FundVol. 38 (September1991) pp. 44779.

    RodríguezCarlosA.“Money and Credit Under Currency Substitution,”Staff PapersInternational Monetary FundVol. 40 (June1993) pp. 41426.

    SchadlerSusan and others Recent Experiences with Surges in Capital Inflows Occasional Paper No. 108 (Washington: International Monetary Fund1993).

For a review of the issues discussed in this paper as they apply to six countries: Chile, Colombia, Egypt, Mexico, Spain, and Thailand, see “Recent Experience with Surges in Capital Inflows” by Susan Schadler, Maria Carkovic, Adam Bennett, and Robert Khan, IMF Occasional Paper, No. 108.

See Rodriguez (1993) (or a discussion of the monetary effects of portfolio shifts.

See Calvo, Leiderman, and Reinhart (1992) for a discussion and econometric investigation of the role of changing external conditions in the surges in capital inflows to Latin American countries during this period. See Ghosh and Ostry (1993) for an analysis of the role of domestic economic fundamentals in attracting capital inflows to developing countries.

For a discussion of this issue, see Corden (1992).

A number of papers consider the measurement and effects of sterilization. See Argy and Kouri(1974) and Obstfeld(1982).

This was also an important consideration in Thailand, where fiscal policy was used aggressively. There, however, large increases in outlays for public capital spending failed to keep up with burgeoning GDP growth.

See Ostry (1991) for an analysis of the effect of trade liberalization on equilibrium exchange rates and trade flows.

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