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Capital Flows: Issues and Policies

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Abstract

This paper presents an analytical overview of recent contributions to the literature on the policy implications of capital flows in emerging and developing countries, focusing specifically on capital inflows as well as on the links between inflows and subsequent capital-flow reversals. The objective is to clarify the policy challenges that such inflows pose and to evaluate the policy alternatives available to the recipient countries to cope with those challenges. A large menu of possible policy responses to large capital inflows is considered, and experience with the use of such policies is reviewed. A policy “decision tree”—i.e., an algorithm for determining how to deploy policies in response to an exogenous inflow episode—is developed, and strategies to achieve resilience to both inflows and outflows in a world where exogenous events may frequently drive capital flows in both directions are discussed.

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Notes

  1. The capital flow data for emerging and developing economies used in the figures below include China, but none of the observations based on the figures would change if China were excluded from the data. The figures excluding China are available from the author on request.

  2. See Milesi-Ferretti and Tille (2011).

  3. See Fernandez-Arias and Montiel (1996).

  4. In this list, I am ignoring potential distributional effects of capital inflows. Prasad (2011) has argued that capital account openness may have adverse distributional consequences, for various reasons: a) During the early stages of opening up, large, politically well-connected firms may obtain preferential access to foreign financing, giving them advantages over smaller firms that are reliant on inefficient domestic financial institutions; b) Positive effects of inflows on equity values differentially favor richer households that hold such equity; c) Richer households are better able to take advantage of the diversification and risk sharing opportunities created by open capital accounts; d)Poorer households, with restricted assets to external financial markets, have to disproportionately bear the costs of domestic financial repression.

  5. These negative welfare implications can be interpreted as arising from a coordination failure. Aggregate welfare could be improved by moving the average level of wages and prices to a lower or higher level, but the market cannot produce such a coordinated move in a decentralized fashion.

  6. See World Bank (1997).

  7. In a simple IS-LM framework, the real appreciation has a contractionary effect in the goods market, and thus shifts the IS curve to the left. The domestic interest rate and real output must both fall.

  8. As mentioned above, asset price bubbles associated with capital inflows need not reflect such preexisting distortions. They may also arise endogenously through the effects of inflows on the liquidity of domestic assets, which increases their value (Calvo 2011).

  9. In advanced countries bonanzas are associated with more volatile outcomes for growth, inflation, external accounts. Equity and house prices rise when capital flows in, fall when it flows out.

  10. Wei (2006) finds that FDI is more stable than bank lending.

  11. See McKinnon and Mathieson (1981).

  12. The term “macroprudential” has come into wide usage, but there is little agreement on its definition. I use it here to refer to prudential policies toward the financial system that are adopted for their macroeconomic implications. Others (e.g., Hanson et al. 2010) use the term microprudential to identify policies aimed to avoid the failure of individual financial institutions, and denote as macroprudential policies intended to safeguard the financial system as a whole. My definition is broader than that of Hanson, Kashyap and Stein, since it encompasses policies that prevent the financial system from unduly magnifying the effects of macroeconomic shocks, even if its doing so would not necessarily imperil the financial system itself.

  13. Ostry and others (2011) argue that the design of restrictions should depend on whether the concerns that inflows raise are mostly about the domestic financial system or are more broadly macroeconomic in nature. In the former case, they should be narrowly targeted on the most risky inflows, may include administrative measures, and can be used against more persistent inflow surges. From a purely macroeconomic perspective, on the other hand, if the external financial environment is volatile, and other policy instruments are not available to stabilize the domestic economy, or if such instruments are too costly to use, direct intervention may be the preferred option. In this case controls should have broad coverage, be primarily price-based, and only be imposed when inflows are expected to be temporary.

  14. See Ulan (2000) for a review of the literature on the effectiveness of market-based controls (in the form of unremunerated reserve requirements) during the 1990s in Chile and Colombia.

  15. For example, few such studies address the endogeneity of capital account restrictions. Cardoso and Goldfajn (1998) is an exception.

  16. On the other hand, recall that both Forbes and Warnock (2011) as well as Fratzscher (2011) found that various measures of capital account restrictions had no role in explaining surges, stops, flight, or retrenchment.

  17. See Bartolini and Drazen (1997).

  18. See Dooley (1996).

  19. Somewhat counter-intuitively, Cottarelli et al. (2010) found that greater resistance to exchange market pressures tended to make a “sudden stop” more likely at the end of an episode and was associated with a sharper decline in real GDP growth after the completion of the inflow episode.

  20. Cardenas and Barrera (1997) estimated offset coefficients for Colombia based on data over the period 1978:1 to 1992:3 and found them to be significantly less than unity, implying that sterilization was feasible over this period.

  21. Even if fiscal policy can be changed, the desired effects on domestic demand (and thus on the real exchange rate) will be forthcoming—i.e., the policy will be effective—only if expenditure cuts fall on nontraded goods.

  22. This applies to temporary inflows. If inflows are perceived to be permanent, then adjustment is indicated, presumably in the form of exchange rate appreciation.

  23. For recent evidence that in contrast to FDI and portfolio equity flows, short-term debt flows have had neutral or negative effects on growth, see Aizenman et al. (2013).

  24. The usual assumption in discussions of this issue is that the economy is in the top right-hand cell, so both real appreciation and expansion of aggregate demand are undesirable.

  25. De Gregorio (2012a, b) analyzes the characteristics that promoted resiliency among emerging and developing economies in Latin America in response to the recent global crisis.

  26. For the effects of institutional quality on the composition of inflows see Wei (2006) as well as Ju and Wei (2007).

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  1. Williams College, Williamstown, MA, USA

    Peter J. Montiel

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Montiel, P.J. Capital Flows: Issues and Policies. Open Econ Rev 25, 595–633 (2014). https://doi.org/10.1007/s11079-013-9295-3

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