Capital flows to emerging market economies are a source of particular and enduring concern to many policymakers. As seen in the 1997-98 Asian crisis, surging inflows can fuel excessive credit growth, expanded current account deficits, appreciated exchange rates and a loss of competitiveness—followed by painful adjustment when the inflows reverse. Countries often fight these buffeting winds with tight controls on exchange rates, capital flow management and aggressive interest rate movements.
Instead of trying to resist foreign inflows, countries can bend. We find that the countries that proved to be more resilient to the turbulent gusts of international capital flows were not necessarily those that controlled the inflows, but those where foreign inflows were balanced by offsetting resident outflows.
Instead of trying to resist foreign inflows, countries can bend. We find that the countries that proved to be more resilient to the turbulent gusts of international capital flows were not necessarily those that controlled the inflows, but those where foreign inflows were balanced by offsetting resident outflows.
What distinguishes countries where volatile capital inflows are balanced by offsetting resident outflows from those where they fuel destabilizing current account booms and busts?
We find that these countries typically have:
- strong institutions, such as independent inflation targeting central banks as well as fiscal policy rules that result in lower inflation and more countercyclical fiscal policy outcomes
- stronger financial supervision and regulation
- more flexible exchange rate regimes and limited restrictions on capital flows
Many of these economies were once just as vulnerable to international capital flows as some of today’s economies. But, through a series of policy choices, they have been able to encourage much greater resilience in their economies.
Each of the countries we study improved their prudential regulation to limit excessive risk taking by domestic financial institutions. The countries also took steps to encourage the development of their domestic financial systems. For example, in Chile, allowing pension funds to invest more of their assets overseas provided the catalyst for the development of foreign exchange derivatives markets that allowed both the pension funds and domestic firms to better manage their exposure to exchange rate fluctuations. While in Malaysia there was a very deliberate and staged process whereby domestic financial strength was built before gradual re-opening of the financial account.
Importantly, floating exchange rate regimes appear to be a key element in encouraging domestic residents to buffer foreign capital inflows. In countries with managed exchange rates, domestic residents commonly react in similar ways to foreign investors – moving capital overseas when foreigners are withdrawing and keeping capital at home when foreigners are piling in. Conversely, in countries with more flexible exchange rate regimes, exchange rate fluctuations seem to serve to encourage domestic residents to repatriate funds when foreign residents are leaving.
Source: FMI
