## BACKGROUND NOTE: USING THE IPF ANALYTICAL TOOLKIT TO ENHANCE POLICY ASSESSMENTS

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### Purpose and framing
- The IPF examines the integrated use of all instruments: monetary policy, fiscal policy, FXI, MPMs, CFMs, and CFM/MPMs to guide the appropriate policy mix during an inflow surge. 1
- First step when facing large inflows: attempt to identify the nature of the underlying shock (fundamental, non-fundamental, or a mix) and country characteristics to determine warranted macroeconomic adjustments and the potential for economic and financial distortions.

### Types and composition of inflow shocks
- Fundamental shocks (may be persistent): changes in global interest rates, productivity, and commodity prices. 2
- Non-fundamental shocks: risk-on/risk-off episodes triggered by changes in investors' portfolio constraints not directly related to fundamentals. 2
- Composition matters: debt flows with short-term remaining maturity, in FX or domestic currency, increase rollover risks when flows reverse.

### Policy implications by shock type and country characteristics
- If the shock is at least partly fundamental/persistent:
  - Likely requires adjustments to monetary, fiscal, and financial policies.
  - For countries with flexible exchange rate regimes, adjustment to the nominal exchange rate is likely warranted.
  - Degree of adjustment depends on country characteristics (e.g., importance of commodity trade). 3
- If the shock is predominantly or exclusively non-fundamental:
  - It is not generally warranted to adjust macroeconomic policy settings away from levels consistent with inflation and growth objectives. 4

### Frictions that impede effective response and raise risk of overvaluation/overheating
- Non-fundamental shocks combined with shallow FX markets:
  - Rapid appreciation to a new fundamental level can help external adjustment after fundamental shocks, but for non-fundamental shocks shallow FX markets make overvaluation more likely.
  - Shallow FX markets can transmit shocks into lower premia on local currency debt, leading to overheating via excessive borrowing; as asset markets deepen, premia become less sensitive to shocks.
- Weak monetary policy credibility:
  - Appreciation that reduces inflation can drive medium-term inflation expectations down excessively while output expands via credit growth, worsening the inflation-output stabilization tradeoff and amplifying overheating.

### Role and trade-offs of FX interventions (FXI) and capital flow measures (CFMs)
- In presence of overvaluation and overheating, FXI and CFMs can enhance monetary autonomy in certain circumstances without generating other distortions.
- The combination of overvaluation and overheating is more likely (though not exclusively) in countries with shallow FX markets and weakly-anchored inflation expectations after non-fundamental shocks, reducing monetary autonomy: lowering the policy rate to reduce overvaluation may exacerbate overheating.
- If FX reserves are adequate or more than adequate, the IV suggests CFMs may be appropriate; this advice remains unchanged.
- FXI and CFMs can enhance monetary autonomy by partially insulating the economy from non-fundamental shocks, provided their use does not reduce autonomy in other ways or generate other large distortions.
- Under the IV, CFMs can also limit overvaluation and overheating by reducing appreciation pressures and external funding.

### Relative costs and country-specific considerations for FXI and CFMs
- FX reserve accumulation involves carry costs which may increase with the size of reserves. 4
- FXI may:
  - Create confusion about the nominal anchor,
  - Induce agents to increase their FX risk exposure,
  - Hinder development of FX markets. 5
- CFMs require enforcement mechanisms and may be constrained by international agreements; choice of CFMs depends on legal and administrative infrastructure and affects costs and benefits.

### Financial stability channels and systemic risks from surges
- Surges can generate systemic financial risks through:
  - Domestic collateral constraints: bubbles in domestic asset prices (e.g., housing) triggered by foreign inflow surges may excessively relax collateral constraints, leading to surges in local currency credit and vulnerability to debt overhang and sharp deleveraging once inflows reverse.
  - FX mismatches: surges in FX debt inflows may create elevated FX mismatches unsustainable once inflows reverse; the riskiest FX debt inflows tend to be short-term.

### Interaction of MPMs and CFM/MPMs with financial structure
- Assessment of CFM/MPMs should consider how financial system structure affects effectiveness and calibration of MPMs.
- CFM/MPMs can complement MPMs when risks arise from agents borrowing from abroad and cannot be fully addressed by MPMs alone.

*Source: BACKGROUND NOTE: USING THE IPF ANALYTICAL TOOLKIT TO ENHANCE POLICY ASSESSMENTS, February 18, 2022.*

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_Source: https://www.imf.org/-/media/files/publications/pp/2022/english/ppea2022012.pdf_