Capital inflows to emerging economies are rebounding. These flows could surge in coming years and contribute to inflationary pressures and large asset bubbles in emerging markets. Policy responses designed to moderate the effects of large capital inflows may include increasing currency flexibility, deepening and broadening capital markets, building up foreign currency reserves, shifting deposits to central banks, tightening fiscal policy, and enacting prudential regulations. Capital controls may also be needed if the other instruments do not work.
To address issues related to capital inflows to emerging economies, Carnegie hosted Amar Bhattacharya, director of the G24, John Williamson, senior fellow at the Peterson Institute for International Economics, and Arturo Porzecanski, distinguished economist-in-residence at American University’s School of International Service. Carnegie’s Uri Dadush moderated.
The level of capital flows to developing countries increased greatly over the decade preceding the 1997–1998 Asian crisis, recovered after the crisis, and then accelerated to reach record levels in 2006 and 2007. While developing countries have drawn many benefits from the inflow of foreign capital and their integration into global financial markets, they have also experienced destabilizing effects at times, including currency appreciation and rises in inflation.
Bhattacharya discussed the major characteristics of capital flows during the last decade:
Given their strong economic recovery and sounder balance sheets, emerging markets could see a flight to safety into their bonds, Williamson predicted.
Panelists discussed policy options to help prevent real exchange rate appreciation and overheating, as well as reduce vulnerability to a sharp reversal of capital inflows.
According to Bhattacharya, the fiscal vulnerabilities that were exposed by the crisis are not much of an issue for developing countries. However, developing countries need to continue to improve their fiscal and debt situations in order to reduce their vulnerabilities to capital flow reversals.
In addition, they need to deepen their capital markets by developing a monetary framework that allows for inflation targeting and more flexible exchange rate policies.
Williamson outlined possible policy reactions to surges of capital flows designed to mitigate inflation and currency appreciation and guard against the effects of reversals.
Williamson also discussed other policy options, which included introducing a flexible exchange rate policy, limiting the ability of private banks to make foreign exchange loans, withdrawing artificial incentives that encourage capital inflows, liberalizing imports, and tightening fiscal policy.
Bhattacharya and Williamson suggested that capital controls, the most controversial policy response to capital inflows, should be implemented when other instruments are not effective.
Williamson argued for limiting the duration of capital controls. In addition, in order to limit capital flows to what can safely be invested, Williamson recommended that capital inflows should not exceed 3 percent of a country’s GDP.
Bhattacharya favored capital controls if the other instruments do not work, but emphasized that the magnitude and type of action should vary across countries.
Bhattacharya discussed regional and global options for managing capital inflows.
In addition, multilateral development banks, such as the World Bank, need to play a much bigger role in intermediating public finance for public goods in developing countries.
Porzecanski argued that managing capital flows is a difficult task and economists should be modest in providing advice. Sentiment in financial markets, for example, turned around much faster than anyone expected over the past few months.
Instead of trying to micro-manage capital flows, or to control them directly, Porzecanski argued for the establishment of sound long-term policy frameworks:
The Carnegie International Economics Program monitors and analyzes short- and long-term trends in the global economy, including macroeconomic developments, trade, commodities, and capital flows, drawing out their policy implications. The current focus of the program is the global financial crisis and its related policy issues. The program also examines the ramifications of the rising weight of developing countries in the global economy among other areas of research.
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