A side effect of the abundant global liquidity in recent years is the surge of capital inflows to emerging market and developing countries. According to the International Monetary Fund’s (IMF) April 2007 World Economic Outlook, net private capital inflows to these countries increased from $57 billion in 2000 to more than $250 billion in 2006. In general, this is a positive development, reflecting, among other things, improvements in macroeconomic fundamentals in several of these countries. But can there be too much of a good thing?
Large capital inflows have complicated macroeconomic management in many countries. The overarching challenge is to tailor policies that can help countries benefit from greater access to capital, while minimizing the risks associated with potentially more volatile cross-border flows. The menu of policies available to address the challenges is well known, but the choice is often complicated by difficult trade-offs.
So, what should policymakers do?
To preview our conclusions: the policy response to large capital inflows will need to involve some combination of reserve accumulation, nominal currency appreciation, lower interest rates and, in some cases, fiscal tightening. But finding the appropriate balance is by no means an easy task, and will inevitably need to be based on judgment and calculated risks. The adoption of policies aimed at improving the risk-return profile of investments will also help. Any temporary benefits from the use of capital controls must be weighed against the resulting distortions and the risk of an enduring loss in investor confidence that could result in lower FDI or higher risk premia.
Policy options depend on individual country circumstances and the nature of capital inflows. In most instances, the policy of “first resort” tends to be intervention in the foreign exchange market. When the surge of capital inflows begins, it is often difficult to discern the composition of the inflows and whether or not they will be sustained. Thus, the focus tends to be on building up international reserves, including as a cushion against possible reversals in inflows. Indeed, reserve accumulation by emerging market and developing countries between 2000 and 2006 amounted to a whopping $2.6 trillion. But this kind of accumulation of reserves cannot go on forever. Intervention in the foreign exchange market injects liquidity into domestic markets, and could lead to overly rapid credit growth, overheating and inflation. This is evident in several countries including, India.
To head off this risk, a central bank could mop up this liquidity through the sale of domestic debt. But there are limits to doing this too. First, the cost of this strategy could be high, especially if the interest rate on such debt is higher than the return the central bank earns on its foreign asset holdings. Second, flooding the market with debt will raise interest rates, unless accompanied by significant fiscal tightening, which is a complicated and politically charged process and difficult to engineer at short notice. Is a rise in interest rates necessarily a bad thing? It depends. If capital is coming in mostly through the equity markets, then raising interest rates could—by cooling the economy—dampen capital inflows. However, if capital is coming mostly into debt markets, a rise in interest rates will exacerbate the problem.
Prima facie, a less complicated option is to allow the value of the currency to strengthen. Such an appreciation would tend, in theory, to limit capital inflows as domestic assets become more expensive in foreign currency. This would also give the central bank greater latitude in the conduct of monetary policy, including by providing the room to lower interest rates without undermining inflation targets, as recently evidenced in Brazil. But here, too, there can be difficulties. A gradual appreciation may end up intensifying capital inflows if market participants take the view that they can make one-way bets on the currency. What is needed is a large enough appreciation as to give rise to an expectation of a future depreciation or, more generally, an expectation that currency movements are likely to go in both directions. But such an appreciation does not come without costs. A rapid appreciation of the domestic currency could pose problems for export competitiveness, particularly in the context of rigid labour and product markets. Of course, measures aimed at making labour and product market more flexible will help mitigate the adverse impact on competitiveness, but such reforms generally are politically sensitive and thus take time to implement and to have effect.
The challenges posed by capital inflows could also be addressed through policies to improve the risk-return profile in equity markets and strengthen financial intermediation. In particular, in the event that capital is flowing into equity markets, emphasis may need to be placed on regulatory measures to reduce leverage. These measures could include tightening the scope for margin trading by retail and institutional investors, imposing collateral requirements by brokers and dealers, and limiting the access of investors as well as brokers to credit from the financial system to trade in stocks. Consideration could also be given to strengthening corporate disclosure and stock exchange listing requirements, with a view to allowing market participants make more informed investment decisions.
If capital flows are intermediated through the banking system, as is currently the case in many countries in Central and Eastern Europe (CEE), there could be risks associated with the accompanying domestic credit growth, particularly if such credit is denominated in foreign currency. For example, in the CEE countries, credit has on average increased by 26% annually since 2000, and nearly 50% on average of this has been in foreign currency. In these cases, prudential regulations and supervision need to be effectively enforced and possibly strengthened so that financial institutions are able to manage the risks associated with new inflows, and to reduce the vulnerability of the banking system to “sudden stops”. In particular, risks in providing foreign currency loans need to be appropriately reflected in the capital provisions that banks are required to make against these loans. Also, strict limits could be imposed on banks’ net open foreign exchange positions, and regulators need to ensure that banks have appropriately taken into account their customers’ ability to manage foreign currency risks.
Some of the pressures on domestic monetary management could be alleviated by liberalizing capital outflows. Such an opening up, however, should be an element of a well-designed strategy, and not a knee-jerk reaction to the surge of capital inflows, which carries the risk of being reversed in less favourable times.
What if—despite these steps—capital inflows continue unabated? Would it make sense to impose controls on inflows?
Capital controls could potentially reduce the volatility of inflows and, in turn, help reduce exchange rate volatility, although cross-country evidence on their effectiveness is mixed at best. The often quoted example of a control on capital inflows is the “Chilean-type” tax measure, which has won some popularity among policymakers.
The introduction of capital controls in Chile in the early 1990s was motivated both by the need to improve the effectiveness of macroeconomic policy in response to an overheating economy and by prudential considerations. Led by strong growth in investment and consumption, the Chilean economy began to show signs of overheating in 1989. Real GDP growth reached 10%; unemployment fell substantially, and inflation increased to 26%. On the external side, the current account deficit was beginning to widen, while the domestic currency was showing signs of strengthening in real terms. The central bank responded by raising domestic real interest rates which, in the context of declining world interest rates and improved market sentiment towards Chile, however, led to a surge in capital inflows.
When standard macroeconomic policies failed to stem capital inflows, the authorities introduced a one-year unremunerated reserve requirement on new foreign borrowing that was designed to discourage short-term borrowing while maintaining long-term foreign investments. The reserve requirement was extended several times to cover a wider range of transactions, including eventually portfolio and some foreign direct investment of “potentially speculative nature”. The evidence indicates that the effect of capital controls on domestic interest rates, total inflows and the real exchange rate was short-lived and small at best. But the controls were more effective in influencing the maturity structure of net capital inflows. The implication is that capital controls by themselves do not represent an effective tool in reducing capital inflows and, therefore, pressures on the currency, although they can serve to lower short-term inflows that tend to be volatile.
Overall, the weight of evidence suggests that controls on capital inflows should be considered only as a very last resort and as an element of a broader package of macroeconomic and structural policies to cope with sustained large capital inflows and the factors underlying them.
Kalpana Kochhar is a senior adviser in IMF’s Asia-Pacific department and Krishna Srinivasan is adviser in the research department. Comments are welcome at firstname.lastname@example.org