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Fickle Capital Flows Are a Fact of Life

Stock exchange in Mumbai, India. Capital flows to emerging market economies rise when global financing is easy, and fall later (photo: Punit Paranjpe/AFP)

WORLD ECONOMIC OUTLOOK ANALYSIS

Fickle Capital Flows Are a Fact of Life

IMF Survey online

April 7, 2011

  • Capital flows are variable, and volatility is increasing
  • Domestic conditions generally more important than international in driving flows
  • Flows to economies with greater global financial exposure more sensitive to world conditions

The IMF is cautioning that capital flows are fickle, ebbing and flowing with changes in global financial conditions.

Following a collapse during the global crisis, net capital flows to emerging market economies recovered in a strikingly short span, against a backdrop of low global interest rates and increasing risk appetite. The rebound, however, was more extraordinary in terms of its pace rather than the level capital flows reached.

In a chapter on international capital flows released as part of the IMF’s April 2011 World Economic Outlook, IMF economists find that net capital flows have become somewhat more volatile over the past 30 years. Net flows to emerging market economies temporarily rise in periods of easy global financing—that is, when global interest rates are low and investor risk appetite is high—and fall afterwards.

What drives net flows?

In general, domestic factors are more important than global factors in driving the variability of capital flows. However, greater direct financial exposure to the United States entails a greater effect of U.S. monetary changes on capital inflows. For a U.S. interest rate hike, the negative additional effect on net flows is even stronger when the hike is unanticipated and global financing conditions are easy.

At the same time, financially exposed emerging market economies with strong growth and deep domestic financial markets are less sensitive to U.S. monetary policy changes, the research shows.

IMF economists say capital flow variability is likely to remain a fact of life for both emerging market and advanced economies.

The key is to ensure that such variability does not compromise economic growth and financial stability. Policymakers need to adopt the right mix of macroeconomic policies and prudential measures to sustain strong growth and better cope with the restive nature of capital flows.

New IMF framework

To help policymakers with these choices, the IMF is developing a framework to consider the different possible policy responses to managing capital inflows.”

The framework helps countries

• Weigh the benefits of different policy responses on their economies.

• Choose from a menu of policy options to respond to capital inflows.

• Determine the appropriate circumstances to consider taxes, certain prudential measures, and capital controls, which together comprise “capital flow management” measures.


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