International Monetary Fund
Published Date:
August 1997
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Giorgio Gomel

The paper by Guillermo Calvo, Ratna Sahay, and Carlos Végh addresses an issue of keen policy relevance whose ramifications go well beyond the geographic boundaries of the region on which this seminar is focusing its attention. The analytics of the paper and the policy prescriptions the authors offer to the discussion can be applied to other areas of the world that have experienced large inflows of foreign capital. The topic, though seemingly peripheral to the main theme of the conference (since it does not explore the implications for the West of economic events unfolding in Europe), is not at all irrelevant. It serves as an appropriate complement to the analysis provided by the IMF researchers in an earlier session of this conference in which the effects on capital markets, the savings-investment balance, and interest rates in the West of capital transfers to the East were examined.

The first three sections of the paper are descriptive in nature. They record the factual evidence on capital flows before and after the process of reform. The focus of this review is the swing in the capital account from a negative to a positive balance that was experienced by five Central and East European countries (the only exception being Bulgaria) in 1992–93, relative to the 1987-91 period. The magnitude of the capital inflows is impressive from a comparative perspective: in 1993 such flows amounted to 6 percent of GDP for the region as a whole, as against 1.2 percent on average for Latin America (during the 1990–92 period) and 3.2 percent for Asia (during the 1989–92 period).

One might wonder, though, whether these figures are reliable, since GDP calculations in dollar terms are distorted downward for those countries by the massive depreciation of the national currencies vis-à-vis the U.S. dollar.

Moving on to the substance of the argument, I shall note first that in general I found the propositions in the paper at times rather bold and the conclusions somewhat too strong. While such statements are a useful dialectic device in argumentation, my purpose in the following comments will be to urge some caution and a tempering of the boldness of some assertions.

For example, the authors contend that capital inflows to the East have financed a permanently higher level of consumption in those countries, not a temporary binge in spending. Hence, there should be no reason for concern: in the transition to greater efficiency in the use of all resources, the private sector borrows from abroad to satisfy its increased demand for consumer goods. In the process, it generates a sustainable current account deficit that will be adjusted as the gap between absorption and income is closed by the increase in income brought about by a more productive use of resources. The argument is a reasonable one, but it should be noted that in 1993, some 70 percent of capital inflows were accounted for by net borrowing to finance external deficits; only a small portion were in the form of foreign direct investment. Also, most of the borrowing reflected increases in consumption. The Latin American episode of the late 1970s and early 1980s should be recalled in this connection (while allowing for the obvious differences); in at least two important cases—Mexico and Brazil—the debt increase was caused by a consumption binge, and the consequences were disruptive.

Another way of expressing the same concern is to point out that the rate of capital accumulation has been quite disappointing, with investment ratios declining everywhere to a significant degree. This problem is serious, given the need for the extensive recapitalization of enterprises and the expansion of productive capacity. Policymakers in the countries concerned should carefully watch future developments in this area so that servicing the accumulated foreign debt does not cause income and spending to fall.

The core of the paper presents an analysis of the monetary problems arising from capital inflows. The analysis, in rather standard fashion, proceeds to show that central banks, confronted with massive inflows of external finance, can either intervene by buying foreign exchange and sterilizing the inflows through the sale of public sector securities; issue domestic money in return for foreign exchange (nonsterilized intervention); or let the nominal exchange rate appreciate. The authors suggest that a central banker’s conservative instinct in such circumstances would be not to let the supply of money or the exchange rate react to the capital inflows. To keep the money supply unchanged, central banks would need to engage in sterilized intervention; consequently, interest rates would rise, in turn attracting new external funds, and the process would thus become unmanageable.

It seems to me that the chain of reasoning is logically correct but that the whole argument hinges on the proposition that “contrary to what is sometimes conjectured, on impact the surge in capital inflows may bring about an increase, not a decrease, in interest rates.” I must say I have misgivings about this assertion, the epistemological status of which is unclear. In Section VII, for instance, it is mentioned as an assumption. Yet it seems to me that capital inflows give rise first to an increase in the supply of money and that the demand for money subsequently rises when, in due course, investment financed by foreign funds generates new income. The argument is carried to the extreme later on when it is suggested that, contrary to the popular view, capital inflows can lead to deflation, not inflation, since with sterilized intervention the money supply is constant, money demand increases, the interest rate rises, and the price of home goods tends to fell. In the authors’ view, therefore, nonsterilized intervention has benefits and no costs and is clearly superior to sterilized intervention.

The paper’s contention that nonsterilized intervention and the expansion of money can and should be pursued without undue concern can be disputed in its basic premises, as I argue. Empirically, I think one should be careful to distinguish between “inflation-prone” and “non-inflation prone” countries. In the latter (for example, the Czech Republic), there was no monetary overhang prior to price liberalization, the inflation risk was fairly low, and the budget deficit was fairly small. Nonsterilized intervention in such circumstances can be regarded as the proper strategy if the authorities do not want to deflate the economy. I would agree with the authors that for such countries one should not exaggerate the dangers of nonsterilized intervention. In other countries, though, where the past record of inflation is poor and the risk of future price increases high, the authorities should opt for letting the exchange rate appreciate gradually. This policy rule is clearly constrained by the undesirable effects of losses in competitiveness. To the extent that sterilization is ineffective in controlling the supply of money, I believe, like the authors, that measures of a second-best nature should be considered, such as direct controls or taxes on new loans.

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