## Global cooperation is needed to reap the benefits and avoid the pitfalls of cross-border capital flows

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**Canonical URL:** [Global cooperation is needed to reap the benefits and avoid the pitfalls of cross-border capital flows](https://www.imf.org/-/media/files/publications/fandd/article/2019/june/crossborder-capital-flows-rajan.pdf)

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### Role and risks of cross-border capital flows
- Cross-border capital flows can:
  - Make up deficiencies in the availability of long-term risk capital.
  - Reduce gaps in local corporate governance.
  - Offer investment avenues for savings generated by aging populations.
- Cross-border capital flows can also be problematic when they:
  - Arrive at the wrong time, adding credit to an investment boom and fueling asset-price bubbles.
  - Come in the wrong form, as short-term claims with the option to leave quickly.
  - Leave at the wrong time, when higher interest rates in sending countries summon them back.
- The net effect of capital flows depends on how they are used; there are no obvious policy remedies that reliably tame capital inflows.

### Mechanism: domestic credit boom → deterioration in governance → sudden stop
- Sustained expectations of high future liquidity:
  - Incentivize companies to load up on debt.
  - Reduce managerial incentives to put in place costly governance structures (good accounting, unimpeachable auditors).
  - Lead lenders to relax due diligence (analogy: mortgage lender during housing booms, NINJA loans).
- Three additional ingredients in emerging market context:
  - Domestic firms have substantial outstanding borrowing from source countries or denominated in source-country currency (typically the United States and the dollar).
  - Easier monetary policy in source countries pushes capital into higher-interest-rate environments (emerging markets), raising the receiving country’s currency value in dollar terms and increasing expected corporate liquidity.
  - Subsequent normalization (tightening) of source-country monetary policy leads to a depreciating emerging market currency, higher repayments on foreign borrowing in local currency terms, and lower corporate liquidity.
- Consequences of tightening:
  - High preexisting leverage makes debt repayment and rollovers difficult.
  - Neglected corporate governance exacerbates the decline in debt capacity.
  - Short-term foreign borrowing can precipitate runs and immediate distress.
- The boom–bust in the emerging market can be a genuine spillover from source-country monetary policy, independent of emerging-market macroeconomic policies.

### Historical example and context
- The 2013 “taper tantrum”:
  - Then-Chairman Ben Bernanke signaled potential Fed tapering; result was outflows from emerging markets and a sharp decline in emerging market assets and currencies.
- The global financial crisis context:
  - Pre-2007–08, policymakers believed in a “great moderation” achievable via domestic-focused flexible inflation targeting and allowing exchange rates to adjust.
  - Post-2007–08 research suggests that allowing exchange rates to appreciate does not necessarily offset spillovers from capital inflows; more capital can chase earlier investors’ returns (Bruno and Shin 2015).

### Exchange-rate management, reserves, and moral hazard
- Exchange rate fluctuations drive corporate liquidity changes in receiving countries.
- Emerging market authorities often smooth exchange rate movements to avoid large swings in credit availability and macroeconomic volatility.
- Building foreign exchange reserves (for example, purchases of US Treasury securities) can be interpreted as:
  - Demand for safe assets, and
  - An attempt to slow currency appreciation while accumulating resources to combat eventual depreciation.
- Such intervention can exacerbate moral hazard by encouraging corporate foreign-currency borrowing; some countries (for example, China and India) also control corporate foreign borrowing.

### Policy tools available and their limits
- Receiving-country options are limited:
  - Tighter domestic monetary policy can push corporations toward dollar-denominated borrowing and exacerbate appreciation pressures.
  - More accommodative domestic monetary policy can encourage excessive credit expansion.
- Macroprudential policies:
  - Are narrow in scope (jurisdictional limits) and may not cover the whole financial system.
  - Have had mixed evidence of effectiveness (Spain’s dynamic capital provisioning smoothed cycles but did not avert excesses).
- Multiple tools may be needed; no single tool is sufficient.

### Responsibility of source countries and multilateral options
- Divergent views on source-country responsibility:
  - Some advanced-economy central bankers focus on domestic mandates and deny international responsibility.
  - Others accept spillovers exist but see little scope to alter sending-country behavior, thus focus on recipient-country measures.
- Proposals and frameworks discussed:
  - Mishra and Rajan (2019) suggest constraining certain unconventional monetary policy actions in specific environments because of large adverse spillovers—analogous to prior limits on sustained one-directional exchange-rate intervention.
  - A rules-based international framework recommended by an Eminent Persons Group (G20 tasking) to:
    - Provide policy advice to avoid policies with large spillovers.
    - Develop resilient markets and help countries benefit from capital flows while managing financial stability risks.
  - The IMF should develop a framework enabling sending countries “to meet their domestic objectives while avoiding large international spillovers.”
- Domestic financial stability mandates for source-country central banks:
  - The model suggests prolonged easy monetary policy can inflate leverage and asset prices and create risks to the source country’s own financial stability.
  - Including domestic financial stability in central bank mandates might alter policy in ways that mitigate external spillovers.

### Recommendations and way forward
- Use multiple tools responsibly by all countries; single-country or single-tool approaches are insufficient.
- The IMF should:
  - Conduct necessary research.
  - Lay out a mutually agreed framework.
  - Call out habitual defaulters.
- Consider development of rules or constraints on certain central bank actions in extreme circumstances, consistent with existing international obligations (IMF Articles of Agreement).
- Recognize that tempering sovereign policymaking with international responsibility is necessary to:
  - Meet saving needs of aging rich countries.
  - Fulfill financing needs of developing and emerging market economies without precipitating periodic crises.

*Raghuram Rajan. Finance & Development, June 2019.*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2019/june/crossborder-capital-flows-rajan.pdf_