## _021411a - 1.         Inflow Episodes: Summary Statistics

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### Overview and Purpose
- Emerging markets (EMs) are experiencing a surge in capital inflows that lifts asset prices and growth prospects but can carry macroeconomic and financial stability risks.
- Purpose: review recent EM experience in dealing with capital inflows and suggest a framework for IMF policy advice on measures to manage inflows, including macroeconomic policies, prudential measures and capital controls.
- Framework goals: inform staff policy advice to Fund members with open capital accounts, sharpen Fund surveillance, preserve evenhandedness, and foster greater global policy coordination.

### Characteristics of the Recent Inflow Wave
- Largest recipients: Asian and Latin American EMs, South Africa and Turkey.
- Current episode predomination: volatile portfolio inflows.
- Pace and composition:
  - Gross inflows reached "6 percent of GDP" in only "three quarters" since the post-crisis trough; comparable surge pre-crisis took "three years".
  - Portfolio inflows account on average for "almost one-half" of inflows (Brazil and Korea are top recipients).
  - Direct investment and cross-border bank lending less predominant.

### Drivers and Risks
- Pull factors: improved EM fundamentals and growth prospects; surging commodity prices favor commodity exporters (Brazil, Peru).
- Push factors: loose AE monetary policy; AE balance sheet vulnerabilities triggering portfolio reallocation toward EMs.
- Cyclical/structural dynamics:
  - Two-speed global recovery likely to keep interest rate differentials between EMs and AEs wide for a prolonged period.
  - Move toward portfolio flows could be structural and imply continued volatility.
- Risks: inflows have tended to reverse suddenly and in a synchronized manner, causing sharp currency depreciation and balance sheet dislocations.

### Empirical Stylized Facts (episodes, waves, composition)
- Definitions:
  - Surge: period when gross inflows significantly exceed long-run trend and are large in absolute magnitude.
  - Episode: prolonged surge (string of surges).
  - Wave: many country episodes occurring simultaneously.
- Findings:
  - EMs experienced surges 20 percent of the time between 1990Q1 and 2010Q2.
  - Identified global waves: 1995Q4−1998Q2, 2006Q4−2008Q2, and ongoing wave since 2009Q3.
  - 48 EMs experienced 125 episodes of large capital inflows in the past two decades, with 26 classified as ongoing.
- Composition shifts by wave:
  - First wave: FDI ~40 percent of inflows.
  - Second wave: "other inflows" (mostly bank lending) rose to around 40 percent.
  - Current wave: portfolio inflows dominant, about one-half of total inflows.
- Portfolio inflows intensity:
  - Average pace of portfolio inflows during the ongoing wave rose from around 0.3 percent of GDP per quarter to 1.2 percent of GDP per quarter (more than quadrupled).

### Duration, Magnitude, Volatility (summary statistics)
- Trends:
  - Typical episode duration rose from about 13 quarters in the 1990s to around 20 quarters in the 2000s.
  - Average pace of aggregate inflows rose from slightly below 2 percent of GDP per quarter to around 3.3 percent of GDP per quarter.
  - Average cumulative size of an episode rose from 24.3 percent of GDP in the 1990s to 67.8 percent in the late 2000s.
- Table 1 key figures (by period Ended During):
  - 1990Q1−1998Q2:
    - Number of episodes: 32
    - Avg. duration (No. of quarters): 12.8
    - Avg. magnitude (percent of GDP): 24.3
      - of which portfolio inflows: 3.9
      - of which bank inflows: 13.8
    - Avg. pace (percent of GDP): 1.9
  - 1998Q3−2005Q2:
    - Number of episodes: 30
    - Avg. duration (No. of quarters): 20.1
    - Avg. magnitude (percent of GDP): 43.5
      - of which portfolio inflows: 6.3
      - of which bank inflows: 17.3
    - Avg. pace (percent of GDP): 2.1
  - 2005Q3−2009Q2:
    - Number of episodes: 37
    - Avg. duration (No. of quarters): 20.5
    - Avg. magnitude (percent of GDP): 67.8
      - of which portfolio inflows: 6.9
      - of which bank inflows: 28.3
    - Avg. pace (percent of GDP): 3.3
  - Ongoing (2009Q3−2010Q2):
    - Number of episodes: 26
    - Avg. duration (No. of quarters): N.A.
    - Avg. magnitude (percent of GDP): 32.3
      - of which portfolio inflows: 12.4
      - of which bank inflows: 10.6
    - Avg. pace (percent of GDP): 3.2
- Volatility:
  - Portfolio inflows historically more volatile; portfolio flow volatility has recently risen; bank flow volatility spikes around crisis times.

### Regression evidence on push and pull factors
- Panel fixed-effects model (log levels of gross capital flows to 48 EMs, 1990Q1–2010Q2) findings:
  - U.S. interest rates:
    - A yield shock of 100 basis points to the U.S. 10-year Treasury bond associated with, on average, a 31 percent reduction of bond inflows to EMs.
  - Global risk aversion:
    - A 1 percent increase in the VIX associated with a 0.5 percent drop of portfolio inflows to EMs.
  - EMs growth:
    - A one percentage point increase in EMs growth associated with, on average, a 4 percent increase in total inflows.
- Fitted values tend to underestimate inflows during surges and overestimate during droughts, implying factors beyond fundamentals matter.

### Case studies: seven EMs (Brazil, Indonesia, Korea, Peru, South Africa, Thailand, Turkey) — key observations
- Aggregate magnitude:
  - Net capital inflows to all EMs (excluding China) reached US$435 billion or about 3½ percent of GDP during 2009Q3−2010Q2.
  - Over one-half of those inflows is accounted for by the seven EMs in this study.
- Composition highlights:
  - Skew toward portfolio debt assets; sizable flows into local currency debt markets in Brazil, Indonesia, Korea, South Africa, and Thailand.
  - Foreign holdings of government securities rose to 20 percent in Indonesia and to 45 percent in Peru.
  - Turkey: almost one-half of total inflows reflected banks’ deposit inflows due to FX lending regulation changes and offshore branch intermediation.
  - Notable transaction: Petrobras capitalization accounted for an estimated US$14 billion of equity inflows in 2010.
- Macroeconomic implications:
  - Liquidity and lower cost of capital supported investment and consumption.
  - Potential costs: currency appreciation, monetary policy complications, and risks to fiscal discipline.
  - Emerging cyclical pressures: output gap closed or closing rapidly in all countries except South Africa; signs of overheating in Brazil, Peru, Indonesia, and to a lesser extent Turkey (credit growth and inflation pressures).
- Policy responses varied across cases: combinations of exchange rate flexibility, reserve accumulation, sterilized intervention, policy rate changes, reserve requirement adjustments, and CFMs targeted to specific risks.

### Country CFMs and selected measures (examples and observed effects)
- General patterns:
  - Measures included taxes on inflows, minimum holding periods, currency-specific reserve requirements, withholding taxes, reserve requirement increases, limits on short-term foreign borrowing, and prudential capital charges.
  - Motivations: protect export competitiveness, financial stability, reduce sterilization costs, and political constraints on fiscal tightening.
  - Effects: mixed; often slowed or halted nominal appreciation around measure introductions; measures frequently viewed as "at the margin" with limited lasting reduction in inflows.
- Selected country specifics (excerpted):
  - Brazil:
    - IOF re-introduced October 2009 and tightened October 2010 (debt inflows IOF raised to 6 percent; margin payments on derivatives taxed).
    - Banks’ short FX cash positions reached almost US$17 billion at end-2010; central bank introduced a 60 percent unremunerated reserve requirement on banks’ short-term FX borrowing early January 2011 (phase-in 90 days).
  - Indonesia:
    - June 2010: one-month minimum holding period for SBIs; foreign holdings of SBIs peaked at 32 percent in October and slipped to 27 percent.
    - December 2010: gradual increase in reserve requirements on foreign currency deposits and re-imposition of a 30 percent short-term foreign borrowing limit for banks (effective March 2011).
  - Korea:
    - June 2010: ceilings on FX forward positions of banks; January 2011 re-introduced withholding tax on foreign purchases of certain bonds; planned second-half-2011 macroprudential stability levy on non-deposit foreign currency liabilities.
  - Peru:
    - July–September 2010: reserve requirement increases and fees on nonresident purchases of central bank paper (CDs) raised to 4 percent; reserve requirements on nonresident deposits in local currency at 120 percent.
  - Thailand:
    - October 2010: reinstated withholding tax on state bonds for nonresidents (15 percent vs 1 percent for residents), temporarily dampening inflows; inflows recovered by December and grew in early 2011.
  - Turkey:
    - December 2010: reduced withholding tax rate on bonds issued abroad by Turkish firms; increased reserve requirement ratios and halted remuneration of reserve requirements; raised consumer loan levies and introduced LTV limits for mortgages.
- Market responses and implementation lessons:
  - Non-discriminatory application, clear communication, and addressing underlying macro imbalances with macro tools emphasized.
  - Measures that treat futures/margins differently from cash markets can shift positioning and create new intermediation channels, as seen in carry-trade dynamics.

### Framework for policy advice on managing inflows (summary)
- First-line defenses (priority):
  - Allow exchange rate appreciation when undervalued on a multilateral basis.
  - Purchase foreign exchange reserves—sterilize if inflation is a concern—if reserves are not more than adequate from a precautionary perspective.
  - Rebalance monetary and fiscal mix: lower policy rates, or tighten fiscal policy to allow monetary easing, consistent with inflation objectives and when overheating is not a concern.
- Use CFMs only when:
  - (a) exchange rate is not undervalued,
  - (b) reserves are in excess of adequate prudential levels or sterilization costs are too high,
  - (c) the economy is overheating (inflation outlook not benign or credit/asset booms are developing), precluding monetary easing, and fiscal tightening is not feasible or forthcoming.
- Design priorities for CFMs:
  - Give precedence to CFMs that do not discriminate on residency (e.g., currency-based prudential measures) over residency-based CFMs.
  - Ensure intensity and scope are commensurate with specific macroeconomic or financial-stability concerns.
  - CFMs are most appropriate for inflows driven by temporary or cyclical factors and should be lifted as risks recede.
  - Strengthen institutional capacity; prudential and structural measures that do not differentiate by residency can be used at any time if not designed to influence inflows.

### Policy recommendations and design principles (concise)
- Recipient countries should prioritize measures that enable absorption of inflows:
  - Structural reforms to deepen domestic capital markets.
  - Non-CFM prudential measures to enhance financial resilience.
- Macroeconomic policy first-line response:
  - Allow currency appreciation, accumulate reserves, rebalance monetary-fiscal stance.
- CFMs:
  - Use only under specified macroeconomic conditions (exchange rate not undervalued; reserves more than adequate; overheating).
  - Prefer non-residency-discriminating, targeted, temporary measures.
  - Ensure proportionality: blunt residency-based CFMs inappropriate for sectoral prudential concerns.
  - Design for administrative capacity, avoidance of undue market distortions, and clear communication.
- Fiscal policy:
  - Faster withdrawal of fiscal stimulus recommended once cyclical conditions accounted for; sustained fiscal discipline helps limit risks from widening current account deficits.

### Assessing eligibility for CFMs — illustrative results
- Two-part analysis (judgment-based and thresholds-based) yields:
  - Judgment-based (November 2010 desk survey of 22 countries): CFMs appropriate in 7 of 22 countries; 19 exchange rates judged "not undervalued"; 10 cases met overheating criterion; 18 judged to have adequate reserves.
  - Thresholds-based (39 countries, Fall 2010 VEE data): 9 of 39 sample countries potentially met criteria for using CFMs in late 2010.
- Threshold robustness (examples):
  - If inflation threshold raised from 3 percent to 5 percent: countries meeting all three criteria decline from nine to seven.
  - If reserves adequacy threshold increased to 150 percent: countries meeting all three criteria decline to six.
  - Exchange rate assessment adjustments produced limited changes in countries meeting all three criteria.

### Practical data and operational notes
- High-frequency proxies for capital flows can aid timely assessment:
  - EPFR weekly EM mutual fund flows: leads BOP trends but covers only part of portfolio flows (~one-third of BOP portfolio equity inflows; ~one-fifth of portfolio bond inflows).
  - Capital flows tracker: monthly change in international reserves minus trade balance; good trend proxy for EMs overall but has caveats (services, transfers, valuation effects).
- Surge/episode identification methodology:
  - Uses quarterly gross inflows from IFS; surge defined by exceeding long-run trend by one standard deviation and being >1.5 percent of annual GDP; H-P filter smoothing parameter 1600 used to calculate trends; minimum episode duration four quarters; episodes end at peak cumulative inflows.

*Italic source: IMF staff paper excerpts from content unit _021411a.*

### 1.         Inflow Episodes: Summary Statistics .........................................................................

### _021411a - 1.         Inflow Episodes: Summary Statistics

### Overview and Introduction
- Emerging markets (EMs) are experiencing a surge in capital inflows, lifting asset prices and growth prospects; inflow surges can carry macroeconomic and financial stability risks.
- Purpose: review recent EM experience in dealing with capital inflows and suggest a possible framework for IMF policy advice on measures to manage inflows, including macroeconomic policies, prudential measures and capital controls.
- The framework is intended to inform staff policy advice to all Fund members with open capital accounts and to sharpen Fund surveillance, preserve evenhandedness, and foster greater global policy coordination.

### Characteristics of the Recent Inflow Wave
- The largest recipients are Asian and Latin American EMs, South Africa and Turkey.
- Compared to other waves, the current episode is characterized by a predominance of volatile portfolio inflows.
- Gross inflows have reached "6 percent of GDP" in only "three quarters" since the post-crisis trough—it took "three years" to reach a similar magnitude in the surge that preceded the global crisis.
- Portfolio inflows account on average for "almost one-half" of inflows (Brazil and Korea are the top two recipients).
- Direct investment and cross-border bank lending are less predominant this time, reflecting lagging economic performance and impaired financial intermediation in advanced economies (AEs).

### Drivers of Inflows
- Pull factors: improved fundamentals and growth prospects in EMs; surging commodity prices favor commodity exporters such as Brazil and Peru.
- Push factors: loose monetary policy in AEs; exposure of AE balance sheet vulnerabilities post-global crisis has triggered a gradual shift in portfolio allocation toward EMs.
- Cyclical dynamic: the two-speed nature of the ongoing global recovery is likely to keep interest rate differentials between EMs and AEs wide for a prolonged period of time.
- Structural shift implication: the move toward portfolio flows could be structural and imply continued volatility.
- Risks: inflows have tended to reverse suddenly and in a synchronized manner in the past, causing sharp currency depreciation and severe balance sheet dislocations.

### Case Studies and Observed Effects
- Seven country cases examined: Brazil, Indonesia, Korea, Peru, South Africa, Thailand, and Turkey.
- These countries face large capital inflows mainly in the form of long-term portfolio debt flows; commodity exporters continue to enjoy large direct investment inflows.
- Despite significant accumulation of international reserves, real exchange rates have in most cases appreciated back to pre-crisis levels; nominal appreciation has been less pronounced and more varied across countries.
- Surging portfolio inflows helped propel stock and bond prices, especially in countries with shallower capital markets.
- So far limited signs of bubbles, but cyclical pressures are emerging, with private sector credit picking up strongly in some cases.

### Macroeconomic Policy Responses
- Monetary policy: most countries have begun clawing back easier monetary policy adopted during the global crisis, but countries have refrained from tightening aggressively despite emerging inflationary pressures, fearing that tightening would pull in more capital.
- Example: Turkey lowered policy rates and offset domestic expansionary effect by increasing reserve requirements.
- Fiscal policy: varied widely across countries; some have started to tighten fiscal policy with strengthening in the cyclically-adjusted primary balance, but many have yet to fully unwind structural loosening adopted during the crisis.
- Consequence: in some countries fiscal policy remains accommodative even though the output gap has closed, implying a procyclical stance.

### Controls, Prudential Measures, and Capital Flow Management Measures (CFMs)
- Countries have complemented macroeconomic policy with measures such as taxes on certain inflows, minimum holding periods, and currency-specific reserve requirements.
- Motivations for measures: concerns about export competitiveness, financial stability, sterilization costs, and political constraints on fiscal policy.
- Design: many measures targeted specific risks associated with certain types of flows (e.g., short-term nature, impact on certain asset markets) and to guard against flow reversal.
- Effectiveness: evidence is mixed; in most cases currency appreciation has slowed or halted around the time of measure introductions.
- Market reaction: concerns about policy and regulatory uncertainty and distortions from measures that go beyond macroeconomic policies; however, measures implemented have been considered "at the margin" and investors likely to continue investing where structural fundamentals dominate.

### Nomenclature and Distinctions
- Toolkit includes administrative, tax, and prudential measures.
- Capital Flow Management measures (CFMs) are those designed to influence capital inflows, comprising:
  - (i) residency-based CFMs (often referred to as capital controls) that discriminate on basis of residency; and
  - (ii) other CFMs that do not discriminate on residency but are designed to influence inflows (e.g., currency-differentiated prudential measures, minimum holding periods, taxes).
- Non-CFM measures: measures not designed to influence capital inflows (do not discriminate by residency and typically do not differentiate by currency), e.g., prudential measures like capital adequacy requirements, loan-to-value ratios, limits on net open foreign exchange positions, and limits on foreign currency mortgages.
- Judgment required: classification of a measure as CFM or non-CFM depends on whether it was designed to influence capital flows, assessed from the totality of circumstances and timing (e.g., introduced or intensified during an inflow surge).

### Framework for Policy Advice on Managing Inflows (summary of Box 1)
- Allow the exchange rate to appreciate when it is undervalued on a multilateral basis.
- Purchase foreign exchange reserves—sterilizing the impact when inflation is a concern—if reserves are not more than adequate from a precautionary perspective.
- Lower policy rates, or tighten fiscal policy to allow space for monetary easing, consistent with inflation objectives and when overheating is not a concern.
- Use CFMs (as defined) if:
  - (a) the exchange rate is not undervalued,
  - (b) reserves are in excess of adequate prudential levels or sterilization costs are too high, and
  - (c) the economy is overheating (e.g., the inflation outlook is not benign or credit/asset price booms are developing), precluding monetary policy easing, and there is no scope to tighten fiscal policy.
- Do not deploy CFMs if the exchange rate is undervalued or as a substitute for necessary policy adjustments (e.g., addressing procyclicality in fiscal policy); CFMs could complement fiscal tightening plans already in place due to fiscal consolidation lags.
- Give precedence to CFMs that do not discriminate on residency (e.g., currency-based prudential measures) over residency-based CFMs.
- Ensure intensity of CFMs, whether residency-based or not, is commensurate to the specific macroeconomic or financial stability concern at hand.
- Lift CFMs when the risks they were designed to address recede; CFMs are most appropriate for inflows driven by temporary or cyclical factors.
- In designing CFMs, consider country-specific circumstances (e.g., administrative and regulatory capacity, degree of openness of the capital account) and effectiveness/efficiency criteria (e.g., whether inflows are intermediated through regulated institutions).
- Strengthen institutional framework on an ongoing basis; prudential and structural measures that do not differentiate on residency or typically currency and are designed to strengthen financial sector resilience can be used at any time, provided they are not assessed to have been designed to influence inflows.

* _021411a - 1.         Inflow Episodes: Summary Statistics_

### 8.      Policy considerations. From the perspective of recipient countries, primacy should be

### 8.      Policy considerations. From the perspective of recipient countries, primacy should be

### Policy considerations and first-line responses
- Recipient countries should give primacy to measures that enable absorption of inflows, putting a premium on structural reforms that increase the capacity of domestic capital markets and on non-CFM prudential measures that enhance the resilience of the financial system.
- When confronted with surging inflows, the first line of defense is macroeconomic policies:
  - allowing the currency to strengthen,
  - accumulating reserves, and/or
  - rebalancing the monetary and fiscal policy mix.
- CFMs (capital flow management measures) warrant greater scrutiny because they can potentially be used to avoid necessary macroeconomic policy adjustments and should be used only when appropriate macroeconomic conditions are already in place:
  - when the exchange rate is not undervalued,
  - reserves are more than adequate, and
  - the economy is overheating so that lowering policy rates would not be advisable.
- If the above conditions exist but fiscal policy is procyclical, CFMs could be used to complement fiscal tightening plans that are already in place, given the lags associated with the macroeconomic impact of fiscal consolidation.
- If CFMs are adopted, residency-based measures should be given lower priority, consistent with the general standard of fairness that Fund members expect from their participation in a multilateral framework (see ¶s 46 and 53).
- An illustrative application of this framework (Section IV.C.) shows that several countries could qualify for using CFMs based on their current circumstances.

### CFM design principles
- CFMs should be proportional to the specific macroeconomic or financial stability concern:
  - a blunt CFM that generally bans flows is inappropriate to deal with a sectoral prudential concern,
  - a blunt CFM would be appropriate when currency overvaluation is the relevant concern.
- CFMs should be designed to maximize effectiveness and efficiency:
  - consider whether flows are intermediated through the regulated financial sector (e.g., residency-based CFMs may be more effective than prudential measures in dealing with inflows not intermediated by regulated financial institutions).
- CFMs are most effective as temporary responses, though the administrative apparatus to cope with future surges might be permanent.

### Stylized facts about capital flows: overall picture
- Capital flows to EMs are recovering at a fast pace—in net terms already close to all-time highs.
- Strong growth prospects and healthy sovereign and private balance sheets are likely to continue drawing inflows, promoting investment and growth, and expanding financing opportunities.
- Large inflows may result in sharp, sustained currency appreciation, which can make export sectors uncompetitive.
- Historically volatile portfolio inflows now comprise a bigger proportion of total flows; higher inflow volume may be accompanied by increased volatility if past trends continue.
- Capital flows, especially when investors are leveraged, can suddenly and sharply reverse; when reversals come on the back of domestic credit booms, resulting damage can be protracted.

### Terminology and observed patterns
- Surge:
  - a quarter or year during which gross inflows significantly exceed their long-run trend and are also large in absolute magnitude.
  - EMs experienced surges 20 percent of the time between 1990Q1 and 2010Q2.
  - Identified surges cluster in two seven-quarter periods: 1996Q4−1998Q2 and 2006Q4−2008Q2, and in the post crisis period.
- Episode:
  - a prolonged surge.
  - 48 EMs experienced 125 episodes of large capital inflows in the past two decades, with 26 of them classified as ongoing.
- Wave:
  - a large number of country episodes occurring at the same time, typically reflecting a stock adjustment in investor portfolios.
  - The analysis identifies 3 global waves of capital inflows: 1995Q4−1998Q2, 2006Q4−2008Q2, and the ongoing wave since 2009Q3.

### Patterns of synchronization and regional shifts
- Inflow episodes often start at different times across countries (reflecting country-specific pull factors) but often end together, particularly in 1997−98 and 2008−09, suggesting reversal of push factors (e.g., rise in global risk aversion) dominates episode endings.
- The destination of inflows during waves has changed:
  - prior to 1998, more than one-half of total inflows were destined for Asia;
  - after the Asian financial crisis and especially with EU entry, inflows gravitated more toward emerging Europe and CIS, peaking on the eve of the global financial crisis;
  - the ongoing wave is broad-based across regions except emerging Europe.

### Composition shifts across waves and recent developments
- Composition by wave:
  - First wave: foreign direct investment accounted for 40 percent of total inflows to EMs.
  - Second wave: other inflows (mostly bank lending) doubled their share from about 20 percent to around 40 percent.
  - For emerging European countries, around one-half of total inflows were other inflows between 2006Q4 and 2008Q2.
  - Current wave: portfolio inflows are dominant for EMs, accounting for about one-half of total inflows.
- Portfolio inflows in the ongoing wave:
  - compared to past episodes, the average pace of portfolio inflows during the ongoing wave (total portfolio inflows over the period in percent of GDP divided by the number of quarters in the episode) more than quadrupled from around 0.3 percent of GDP to 1.2 percent of GDP per quarter.
  - The larger role of portfolio flows likely reflects that international banks that intermediate cross-border flows are still in the process of balance sheet repair.

### Duration, magnitude, and volatility trends (summary statistics)
- Duration and magnitude have risen with each wave:
  - typical episode duration rose from about 13 quarters in the 1990s to around 20 quarters in the 2000s.
  - average pace of aggregate inflows rose from slightly below 2 percent of GDP per quarter to around 3.3 percent of GDP per quarter.
  - average cumulative size of an episode rose from 24.3 percent of GDP in the 1990s to 67.8 percent in the late 2000s.
- Table 1 (Inflow Episodes: Summary Statistics) key figures (by period Ended During):
  - 1990Q1−1998Q2:
    - Number of episodes: 32
    - Avg. duration (No. of quarters): 12.8
    - Avg. magnitude (percent of GDP): 24.3
      - of which portfolio inflows: 3.9
      - of which bank inflows: 13.8
    - Avg. pace (percent of GDP): 1.9
  - 1998Q3−2005Q2:
    - Number of episodes: 30
    - Avg. duration (No. of quarters): 20.1
    - Avg. magnitude (percent of GDP): 43.5
      - of which portfolio inflows: 6.3
      - of which bank inflows: 17.3
    - Avg. pace (percent of GDP): 2.1
  - 2005Q3−2009Q2:
    - Number of episodes: 37
    - Avg. duration (No. of quarters): 20.5
    - Avg. magnitude (percent of GDP): 67.8
      - of which portfolio inflows: 6.9
      - of which bank inflows: 28.3
    - Avg. pace (percent of GDP): 3.3
  - Ongoing (2009Q3−2010Q2):
    - Number of episodes: 26
    - Avg. duration (No. of quarters): N.A.
    - Avg. magnitude (percent of GDP): 32.3
      - of which portfolio inflows: 12.4
      - of which bank inflows: 10.6
    - Avg. pace (percent of GDP): 3.2
- Volatility:
  - Portfolio inflows have historically been “hotter” (more volatile) than other types of flows.
  - Portfolio flow volatility has recently risen; bank flow volatility rises sharply around crisis times.

### Push and pull factors: qualitative and regression-based findings
- Push factors (examples): low US interest rates, low global risk aversion, strained AE balance sheets, international portfolio diversification, low AE potential growth.
- Pull factors (examples): high commodity prices, high domestic interest rates, low domestic inflation, improving EM balance sheets, high EM potential growth, trade openness.
- Regression analysis (panel fixed-effects model for log levels of gross capital flows to EMs, 48 EMs, 1990Q1–2010Q2) main quantitative findings:
  - U.S. interest rates negatively affect total inflows and its components, particularly bond inflows:
    - A yield shock of 100 basis points to the U.S. 10-year Treasury bond is estimated to be associated with, on average, a 31 percent reduction of bond inflows to EMs.
  - Global risk aversion affects total inflows and portfolio equity inflows in particular:
    - A 1 percent increase in the VIX is associated with a 0.5 percent drop of portfolio inflows to EMs.
  - EMs growth is the most significant pull factor for total inflows, direct, and banking flows:
    - A one percentage point increase in EMs growth is estimated to be associated with, on average, a 4 percent increase in total inflows.
- The fitted values from the regression tend to underestimate inflows during surges and overestimate during droughts, suggesting factors beyond fundamentals play a role in surges and droughts.

*Source: IMF staff paper (excerpts from the PDF chapter titled "8.      Policy considerations. From the perspective of recipient countries, primacy should be").*

### 23.      This section reviews the recent experience with capital inflows in selected

### 23. This section reviews the recent experience with capital inflows in selected emerging market countries

### A. Nature of Capital Inflows
- Countries covered: Brazil, Indonesia, Korea, Peru, South Africa, Thailand, and Turkey.
- Aggregate magnitude:
  - Net capital inflows to all EMs (excluding China) reached US$435 billion or about 3½ percent of GDP in total during 2009Q3−2010Q2.
  - Over one-half of those inflows is accounted for by the seven EMs in this study.
- Relative position versus pre-crisis:
  - Net capital inflows have already exceeded pre-crisis peaks in Brazil, Indonesia, Korea, and Thailand; and are approaching pre-crisis highs in Peru, South Africa, and Turkey.
- Composition:
  - Skewed toward portfolio debt assets, with sizable flows into local currency debt markets in Brazil, Indonesia, Korea, South Africa, and more recently Thailand.
  - Nonresidents’ participation in domestic bond markets is large and increasing (examples: foreign holdings of government securities rose to 20 percent in Indonesia and to 45 percent in Peru).
  - Portfolio debt flows to the corporate sector limited in countries with underdeveloped corporate bond markets (e.g., Indonesia and Peru).
  - Equity inflows sizable in Brazil and Korea; insignificant in other countries.
  - In Turkey, almost one-half of total inflows to date reflected banks’ deposit inflows due to changes in FX lending regulation and the intermediary role of offshore branches.
- Notable single transactions:
  - The capitalization of Petrobras in Brazil accounted for an estimated US$14 billion of total equity inflows in 2010.
- Intermediation and sources:
  - Institutional investors (pension funds, mutual funds) have tended to enter longer-term securities, particularly in Brazil, South Africa, and Asian sovereign bond markets.
  - A large share of flows has been intermediated through a few financial centers (conduits such as Luxembourg), limiting direct flows from individual countries.

### B. Drivers of Inflows
- Country-specific attractiveness:
  - Investors favor countries with fewer capital account restrictions; large, well-developed and actively traded securities markets; and transparent regulatory frameworks.
  - Deep and liquid markets, coupled with high nominal and real yields, in Brazil, Korea, and South Africa drew larger capital flows.
  - Inclusion of South Africa (and expectations of Korea’s inclusion) in major global emerging market indices attracted institutional investor interest.
  - Expectations of upgrades to investment status may have boosted sentiment in Indonesia and Turkey.
  - Peru’s rising terms of trade and possible investment grade ratings stimulated portfolio inflows despite small capital markets.
  - Strong terms of trade from high world metal prices attracted FDI to mining sectors in Brazil and Peru.
- Outlook for persistence:
  - Inflows expected to remain strong and persistent due to structural factors: EM resilience during the global crisis, stronger growth outlooks, sounder fiscal fundamentals and banking sectors relative to many AEs, and continued institutional investor rebalancing toward EMs.

### C. Domestic Macroeconomic Implications
- General effects:
  - Large inflows reduce the cost of capital for public and corporate sectors, supporting investment and consumption and promoting financial market development.
  - Potential costs: upward pressure on exchange rates (loss of competitiveness), complication of monetary policy (long-term bond yields pushed below domestic levels), and risks to fiscal discipline via lower government borrowing costs.
- Country examples of macro effects:
  - Brazil: large inflows into government bonds associated with compression in longer-term yields, procyclical fiscal policy, and high real interest rates.
  - Indonesia: limited bond market liquidity; strong portfolio flows into the long end may have reduced term risk premia on government bonds.
  - Thailand: inflows into bond market plus easy monetary conditions associated with a flattening of the yield curve.
- Risks to macro-financial stability:
  - Volatile, short-term inflows can trigger sharp asset price movements and sudden stops or reversals, as in 2008 for Indonesia (SBI holdings by nonresidents fell sharply) and Korea (rapid reversal of banks’ short-term debt inflows).
- Asset price and credit developments:
  - Stock markets: indices in Indonesia and Thailand rose by about 40 percent in 2010; Peru’s equity prices up 60 percent in 2010 (dominated by commodity companies); Brazil’s stock prices remained fairly flat despite equity inflows due to large absorptive capacity from corporate IPOs.
  - Fixed income: portfolio flows into government securities lowered public borrowing costs by pushing down longer-term bond yields in Brazil, Indonesia, Peru, Thailand, and South Africa; Turkey saw historical highs in both equity and government security prices in 2010.
  - Bubbles: no clear evidence of equity or property bubbles at this stage; valuations high in some cases (Indonesia, Thailand) but not exceptional historically; property markets subdued in Korea, South Africa, and Turkey.
- Emerging cyclical pressures:
  - Except for South Africa, the output gap is already closed or rapidly closing in all countries.
  - Signs of overheating in Brazil, Peru, Indonesia, and to a lesser extent Turkey: pickup in credit growth and in some cases inflation rising above targets and worsening inflation expectations.
  - Indonesia: inflation driven in part by higher food prices due to strong demand and adverse weather.
  - Turkey: inflows facilitating bank lending and fueling credit growth.
  - Brazil: credit growth sustained by rapid lending growth in public banks.
  - Peru: credit growth partly driven by strong terms of trade and rebound in domestic demand.
  - In other countries, credit growth not yet a concern.
- Selected indicators cited:
  - Food prices have picked up globally and appear poised to accelerate further in the near term.

### D. Recent Policy Responses
- Exchange rate and reserve behavior:
  - Willingness to allow exchange rate appreciation and reserve accumulation has varied widely.
  - Only Thailand saw nominal exchange rates appreciate above pre-crisis highs.
  - In real effective terms, all countries except Korea have appreciated relative to pre-crisis levels; in some cases REER appears overvalued relative to medium-term fundamentals.
- Sterilized FX interventions:
  - Degree of sterilization varied across countries.
  - Brazil and Peru: sterilized interventions a dominant response to surging inflows.
  - Indonesia, Peru, and Thailand: sterilized interventions used to smooth exchange rate volatility and slow appreciation in the short term.
  - Reserves in these countries are 30-40 percent above their pre-crisis levels, and up by 35-50 percent since the second half of 2009.
  - Sterilization costs are high and increasing for some countries and can pose a constraint where fiscal positions are weak.
  - Turkey: largely did not sterilize interventions; instead raised required reserve ratios to withdraw liquidity.
- Monetary policy stance and other macro tools:
  - Some countries continued to lower policy interest rates despite inflows.
    - Turkey reduced the overnight borrowing rate and widened the interest rate corridor, and has more recently combined lower policy rates with higher reserve requirements; since December it lowered the policy rate by 75 basis points to a record low level.
    - South Africa cut rates further since mid-2009 given persistent negative output gap.
    - Indonesia left policy rates unchanged through January 2011 after a 300 basis point cut during the global crisis.
  - Other countries raised policy rates as output gaps closed and inflation risks surfaced:
    - Brazil and Peru began to raise rates in 2010.
    - Brazil and Peru have hiked policy rates by 50 and 225 basis points respectively since the beginning of the year referenced in the text, bringing the total increase in Brazil to 250 basis points since April 2010.
  - Quantitative measures used by several countries include higher reserve requirements.
- Additional policy considerations:
  - Policymakers have at times been reluctant to raise interest rates—even with rising inflation—out of concern that higher rates would attract even more inflows; instead some have opted for quantitative measures to curb inflows and limit credit growth.

*Source: IMF staff analysis in Section 23 of the provided IMF chapter/section PDF.*

### 37.      Other emerging markets may also be keeping policy rates lower than “normal.”

### _021411a - 37.      Other emerging markets may also be keeping policy rates lower than “normal.”

### Policy rates versus inflation (Figure 5)
- Current policy rates in a broad sample of EMs are lower than policy rates when inflation was last at the same level (in each case the green dotted line is below the green solid line).
- November 2010 is used as the latest period for the comparison. The past reference dates (when inflation reached current levels) are:
  - Brazil- 5/2008
  - Chile- 6/2007
  - Hungary- 9/2006
  - India-10/2008
  - Indonesia- 8/2007
  - Israel-10/2007
  - Korea-10/2007
  - Malaysia-10/2007
  - Mexico- 3/2008
  - Peru- 7/2007
  - Philippines- 11/2007
  - Poland- 10/2007
  - Romania- 2/2008
  - South Africa- 8/2006
  - Thailand- 11/2007
  - Turkey- 9/2007

### Fiscal policy responses to inflows (¶38)
- Fiscal stances and actions:
  - Brazil: fiscal policy remained expansionary up to end-2010, including through subsidized lending by the public development bank, putting pressures on inflation.
  - Turkey: fiscal policy poised to remain expansionary in 2011.
  - Peru: broadly neutral fiscal stance for 2010 as a whole; expected to tighten going forward.
  - South Africa: expected to tighten fiscal stance going forward.
  - Indonesia, Korea, Thailand: fiscal policy not expected to play an active role in managing inflows, apart from gradual withdrawal of discretionary stimulus introduced during the crisis.
- Note: Adjustments to the cyclically-adjusted balance may be needed to account for transient revenue and/or quasi-fiscal lending to assess true fiscal stance and procyclicality.

### Capital Flow Management Measures (CFMs) and related measures (¶39–41)
- General findings:
  - Countries implemented a range of CFMs and other measures to cope with capital flows and associated risks.
  - Measures generally followed periods of rapid exchange rate appreciation and often coincided with a slowdown or halt in currency appreciation.
  - Measures were typically designed to target specific risks (e.g., short-term flows, asset-market impacts) and to leave open long-term productive flows.
  - South Africa among the seven EMs introduced only measures relating to outflows.
  - Evidence on effectiveness is mixed: measures altered composition of flows and targeted risks but did not consistently or lastingly reduce targeted inflows; attribution is difficult and measures were often “at the margin.”
  - Market perceptions: policy and regulatory uncertainty and concerns about credibility affected impact; non-discriminatory application and clear communication were important.

- Examples of country-specific CFMs and related measures:
  - Brazil:
    - Reinstated IOF in October 2009; increased it twice on debt inflows in October 2010; extended it to margin requirements in derivatives transactions in October 2010.
    - January 2011: imposed reserve requirements on banks’ short FX positions in the cash market.
    - Original IOF design provided lower tax incidence on positions via domestic futures markets, prompting increased nonresident futures positions and resident banks’ short FX spot positions.
  - Peru:
    - July 2010: additional capital requirements for FX credit risk exposure.
    - August 2010: fee on nonresident purchase of central bank paper (CDs) increased to 4 percent.
    - September 2010: reserve requirements on deposits were raised, including a 120 percent reserve requirement for nonresidents’ deposits in local currency.
    - Limits on banks’ net FX position unlikely to have much impact as banks were within limits.
  - Indonesia:
    - June 2010: one-month minimum holding period for central bank paper (SBIs) for primary and secondary market purchases, applied equally to residents and nonresidents; introduced longer tenors for SBIs.
    - Measures initially sharply reduced foreign participation in SBIs and dampened volatility; foreign ownership later rose above pre-holding period levels and nonresidents shifted to government bonds.
    - December 2010: announced gradual increase in reserve requirements on foreign currency deposits (effective March and June 2011) and re-imposition of a limit on short-term foreign borrowing by banks to 30 percent of capital (effective March 2011).
  - Korea:
    - June 2010: ceilings on FX forward positions of banks to lower leverage and lengthen maturity of banks’ funding; succeeded in reducing banks’ FX derivative positions and related short-term external debt.
    - January 2011: re-introduced withholding tax on foreign purchases of treasury and monetary stabilization bonds (limited impact due to double taxation treaties and exemptions).
    - Planned from second half of 2011: a “macroprudential stability” levy on non-deposit foreign currency liabilities of banks.
  - Thailand:
    - October 2010: reinstated withholding tax for state bonds on nonresident individual investors; withholding tax for nonresident institutional investors set at 15 percent versus 1 percent for resident counterparts.
    - Withholding tax uncertainty dampened inflows temporarily; inflows quickly recovered. Double taxation agreements limit effectiveness.
  - Turkey:
    - December 2010: reduced withholding tax rate on bonds issued abroad by Turkish firms, with lower rates for longer maturities.
    - Halted remuneration of reserve requirements while raising ratios across maturities.
    - To moderate credit growth: raised levy on interest from consumer loans; increased minimum payment amount for credit cards based on credit limit; introduced limits to loan-to-value (LTV) ratios for all mortgages.
    - Monetary policy strategy helped steepen the yield curve by lowering the short-end; central bank and government measures appear effective at discouraging inflows amid global uncertainty.
  - Regulations easing capital outflows:
    - Korea, Peru, South Africa, and Thailand eased regulations on capital outflows to encourage overseas investment. Impact limited so far in South Africa and Thailand; Peru increased Pension Fund overseas investment limits four times in the past year.

### Mixed evidence on effectiveness and market responses (¶40–41)
- CFMs altered composition of flows (e.g., reducing short-term or volatile flows) without wholesale reduction in all inflows.
- Measures often perceived as “at the margin,” leaving perceived returns favorable and limiting lasting impact.
- Potential large effects if CFMs change a country’s weight in EM investor indices, prompting portfolio rebalancing by institutional investors.
- Markets emphasized need for:
  - Non-discriminatory application of measures to residents and nonresidents.
  - Clear communication of objectives and intended next steps.
  - Addressing underlying domestic imbalances with macroeconomic tools before resorting to CFMs.
  - Avoiding abrupt announcements that increase uncertainty.

### Box 2 — Brazil’s IOF: design, impact, and policy response
- IOF timeline and rates:
  - Re-introduced prior to the crisis during March-October 2008.
  - October 2009: brought back with broader coverage and a higher rate (2 percent) on nonresident portfolio equity and debt inflows.
  - October 2010: tightened twice on nonresident portfolio debt inflows to 6 percent; tax raised to 6 percent (from 0.38 percent) on margin payments required on derivatives traded in the BM&F Bovespa, including FX futures.
- Empirical impact:
  - IOF measures did not have a clear, long-lasting effect on the exchange rate relative to its level when introduced.
  - IOF did not trigger a significant reduction in nonresidents’ positioning in the futures market.
- Composition effects:
  - IOF may have contained short-term/speculative inflows by increasing uncertainty about future measures.
  - IOF’s favorable treatment of futures positions (applies to margin payments rather than notional amounts) encouraged inflows into the futures market, contributing to large long real/short US$ positions by nonresidents in the futures market.
  - Banks took the other side of these positions, hedging by undertaking FX borrowing and generating large short FX cash positions.
  - Banks’ short FX cash positions reached almost US$17 billion at end-2010.
- Policy response:
  - Early January 2011: central bank introduced a 60 percent unremunerated reserve requirement on banks’ short-term FX borrowing that exceed US$3 billion or Tier I capital (phase-in period of 90 days).
  - The reserve requirement aims to reduce returns to local banks from providing intermediation to nonresident futures investors, constrain the carry-trade channel, and reduce vulnerabilities in the banking sector.

*Source: IMF staff analysis and figures from GDS, Haver, Datastream, Central Banks, and Fund staff calculations (text unit _021411a).*

### Box 3. The Impact of Thailand’s Withholding Tax

### Box 3. The Impact of Thailand’s Withholding Tax

### Background
- Against the backdrop of record-high bond inflows, rumors of an impending capital control surfaced on October 8, 2010, leading to a small outflow.
- On October 12, the authorities officially announced the re-instatement of a withholding tax on nonresident interest earnings and capital gains that would apply only to state bonds purchased on or after October 13.
- Thailand had previously implemented an unremunerated reserve requirement in 2006 (referenced in media coverage at the time of the October 2010 announcement).

### Impact on flows and markets
- Even though the tax applies only to state bonds, when the tax was announced inflows into both bonds and equities halted.
- Factors contributing to the halt in inflows:
  - Initial uncertainty regarding the collection of the tax.
  - Market concerns of further stricter measures to come (Brazil had raised the IOF the previous week; media references to Thailand’s 2006 unremunerated reserve requirement).
  - Subsequent global and regional developments that kept equity inflows to East Asia low through November, including funding pressures in Europe, political tensions in the Korean peninsula, and tightening of bank regulations in China.
- Subsequent timeline of flows after the announcement:
  - After temporarily stabilizing in December, equity inflows turned once again negative due to monetary tightening in the region and some political tensions in Thailand.
  - Bond inflows recovered in December, and remained strong through the first several weeks of 2011.

### Effectiveness and interpretation
- Overall assessment:
  - The withholding tax appears to have had some impact in slowing portfolio inflows, albeit temporarily.
  - Inflows stopped as soon as rumors of the measure surfaced, but the drying up of inflows to both equities and bonds suggests that its efficacy came from the uncertainty the tax created, rather than the cost it bore to bond investors.
- Distributional and legal considerations:
  - Since Thailand has double taxation agreements with over 50 countries, investors from these countries (or investing through institutions registered in these countries) do not bear an additional cost because of the tax.

*Source: Box 3, "The Impact of Thailand’s Withholding Tax" (excerpt).*

### 48.      The exchange rate should be allowed to appreciate when it is undervalued on a

### The exchange rate should be allowed to appreciate when it is undervalued on a multilateral basis

### Exchange rate policy
- Allow appreciation when the exchange rate is undervalued on a multilateral basis to reflect structural drivers of inflows (improved private and public sector balance sheets in emerging markets relative to advanced economies).
- A demonstrated commitment to exchange rate flexibility can diminish one-way bets by investors and help preserve credibility of the policy framework in inflation-targeting countries.
- Caveat: a sharp, sustained rise in the currency can create problems when there is strong evidence the exchange rate is already overvalued.

### Reserve management and intervention
- Countries with foreign exchange reserves that are not more than adequate from a precautionary perspective can respond to inflows by building reserves.
- Intervention can be sterilized where domestic liquidity growth may lead to overheating or be inconsistent with inflation objectives.
- Sterilization can become counterproductive if inflows are being driven by yield differentials.
- Excessive reserve holdings are associated with diminishing marginal benefits and rising costs.

### Policy mix: monetary and fiscal options
- Lowering policy rates or tightening fiscal policy to allow space for monetary easing could offer a more sustained response to deal with inflows.
- Any monetary easing must be consistent with inflation objectives.
- Lowering policy rates may not be an option if the economy is already overheating with high or rising inflation or a developing credit or asset price boom.
- Rebalancing the monetary-fiscal policy mix can be viable but coordination is often difficult, especially with independent central banks.
- Outright fiscal tightening is an option if fiscal policy is judged procyclical, though it may require a lengthy legislative process and have long implementation lags; however, its announcement could have an immediate impact on exchange rate expectations and inflows.

### Capital Flow Management (CFM) policies: when and how to use them
- CFMs may be needed when:
  - (a) the exchange rate is not undervalued on a multilateral basis in relation to medium-term fundamentals,
  - (b) reserves are in excess of adequate precautionary levels or sterilization costs are excessive,
  - (c) the economy is overheating (inflation outlook not benign or developing credit/asset price boom) precluding monetary easing.
- CFMs can complement fiscal tightening plans if fiscal policy is procyclical given fiscal consolidation lags.
- Experience with CFMs is limited and the evidence on their effectiveness is mixed.

### Design priorities for CFMs
- Targeted CFMs that do not discriminate by residency:
  - Directly target the risk and avoid burdens associated with measures targeting nonresident investors.
  - Examples for banks: currency-specific reserve and liquidity requirements, differentiated risk weights for domestic vs foreign currency loans.
  - Examples for non-banks: differentiated tax treatment of domestic vs foreign currency borrowing.
  - Currency-based restrictions can be circumvented through derivatives.
- Residency-based CFMs:
  - Consider when other options have been deployed or are infeasible (e.g., flows bypass regulated financial institutions or institutional constraints prevent direct targeting).
  - Priority of measures should consider institutional and political economy concerns and the Fund’s mandate regarding transactions between residents and nonresidents.
  - Residency-based measures may introduce additional distortions and evasion risks.
- Intermediation considerations:
  - If flows are intermediated through regulated financial institutions (RFIs), prudential measures are often preferred.
  - If flows bypass RFIs, residency-based CFMs are more likely to be indicated, though nonprudential, non-residency-discriminating CFMs may be preferable if available.
- Intensity and scope:
  - CFM intensity should be commensurate with the macroeconomic or financial-stability concern.
  - Blunt, broad residency discrimination is inappropriate for narrow prudential risks; broad measures may be appropriate for exchange rate overvaluation.

### Design and implementation considerations
- CFMs should not be treated as permanent; scale back when capital inflow pressures ease.
- Do not treat taxes on certain inflows as permanent fiscal revenue without reassessing exchange rate valuation and relying more on macroeconomic policy responses if inflows become perceived as permanent.
- Price-based measures (taxes on inflows, URRs) are typically more transparent than administrative measures (ceilings, bans).
- Effectiveness depends on the administrative and regulatory capacity of agencies (tax agency, bank regulator, securities regulator).
- Design CFMs to allow adjustments in response to experience and circumvention; small initial measures may be preferable, but the signaling effect must be weighed against potential adverse market reactions.
- Communications strategy is important due to risks of triggering capital outflows or market turmoil.

### Costs and risks of CFMs
- CFMs can slow capital market development in EMs by reducing volume and the incentive to develop hedging markets.
- All CFMs are prone to circumvention, increasing enforcement and administration costs over time.
- Active suppression of exchange rate volatility through CFMs can raise risk-adjusted returns for investors by reducing volatility, potentially making the country more attractive in the short run.
- CFMs or expectations of their use could trigger capital outflows, market turmoil, and affect investor memories and future willingness to invest; policy reversals can affect credibility.

### Applying the framework: illustrative exercises and key results
- Two-part analysis:
  - Judgment-based assessment of three criteria (exchange rate valuation, reserve adequacy, economic overheating) using recent desk judgment (available for 22 countries with large capital inflows).
  - Thresholds-based exercise applying consistent numerical thresholds across a larger sample of 39 EMs using Fall 2010 VEE data.
- Main message:
  - About one-quarter to one-third of countries are likely to meet criteria potentially validating the use of CFMs; about one-third of each sample constitute cases where the exchange rate is not undervalued, reserves are in excess of adequate levels, and there are signs of overheating.
- Judgment-based results (November 2010 desk survey of 22 countries):
  - It would be appropriate to consider CFMs in seven of the 22 countries.
  - Exchange rate criterion: 19 countries’ exchange rates were judged "not undervalued".
  - Overheating criterion: 10 cases met the overheating criterion (output gap closed or closing rapidly).
  - Reserve adequacy: 18 countries judged to have adequate reserves.
- Thresholds-based results (39 countries, Fall 2010 VEE data):
  - Nine of the 39 sample countries potentially met the criteria for using CFMs in late 2010.
  - Common thresholds used:
    - Reserves judged adequate if reserves / (short-term debt (residual maturity) + current account deficit) exceeded 100 percent.
    - Economy considered not overheating when (i) year-on-year CPI inflation rate averaged less than 3 percent over the last two years, or less than 10 percent in 2010 and declined from the average level of 2009; and (ii) bank credit did not rise by more than 5 percent of GDP in the last year.
    - Exchange rate assessment taken from the Fall 2010 VEE (average of CGER estimates where available); exchange rate assessed as not undervalued if the average estimate for misalignment was above zero percent.

*Source: IMF content unit _021411a - 48.*

### 63.      Because assessments of the macroeconomic criteria are difficult to undertake

### _021411a - 63.      Because assessments of the macroeconomic criteria are difficult to undertake

### Robustness of threshold-based assessments of eligibility criteria
- Boundaries in the Venn diagram are to be viewed as “thick” because assessments of the macroeconomic criteria are difficult to undertake with precision.
- Robustness checks using the thresholds-based exercise suggest limited sensitivity to moderate threshold changes:
  - If the inflation threshold is changed from 3 percent to 5 percent:
    - Number of countries that meet all three criteria declines to seven (from nine).
    - Total number of economies assessed to be overheating declines from 28 to 20.
  - If the reserves adequacy threshold is increased to 150 percent:
    - Number of countries meeting all three criteria declines to six.
    - Number with adequate reserves coverage falls to 15 (from 28 under the 100 percent threshold).
  - If exchange rate assessment is based on two of the CGER estimates taking a value of at least zero, with no restriction on the third estimate:
    - Number of countries judged not to be undervalued increases to 20 (from 18 in the base case in Figure 10).
    - Number meeting all three criteria is unchanged.
- Note: In the VEE, estimates for misalignments are based on CGER. Where CGER estimates are not available, misalignment is measured as the deviation of the real exchange rate from its long-run average, or on the basis of desk estimates.

### Policies to cope with inflows — issues for discussion (as presented)
- Do Executive Directors support the framework for managing large-scale capital inflows?
- Do Directors support the proposed elements that should be taken into consideration in the design of CFMs?
- What other operational aspects do Directors consider important to facilitate the application of the framework?

### High-frequency proxies for capital flows data (Annex I)
- Motivation:
  - Lack of up-to-date BOP data (3-6 month lag, sometimes not monthly/quarterly) constrains timely policy assessment.
- Two commonly used timely proxies:
  - EPFR weekly EM mutual fund flows:
    - Provides daily, weekly, and monthly information on equity and bond fund flows to EMs.
    - Covers funds registered for sale in multiple jurisdictions (examples listed in source).
    - Caveats: subset of portfolio flows, covers only one class of institutional investors, does not cover all EM destinations.
  - Capital flows tracker (proxy for net capital flows):
    - Computed as the difference between monthly change in international reserves and the trade balance.
    - Advantages: reserves and trade balance data typically available at higher frequency and with smaller lag than BOP data.
    - Caveats: may differ from BOP measures where services, transfers, and income balances matter; does not control for valuation and other changes affecting reported stock of reserves.
- Empirical comparison with BOP data:
  - EPFR vs BOP:
    - EPFR magnitudes are much smaller than BOP recorded flows.
    - For EMs as a whole, EPFR covers around a third of BOP reported portfolio equity inflows and around a fifth of BOP reported portfolio bond inflows.
    - EPFR trend is a leading indicator of BOP recorded capital flows for most time periods, though important regional differences can occur (e.g., Emerging Europe and Other EMs in 2005−07).
  - Capital flows tracker vs BOP:
    - Tracker works well for flows to EMs as a whole and for most regions in terms of trends.
    - In magnitudes it works well for most regions but less well for some (e.g., Other EMs).

### Identifying episodes of large capital inflows (Annex II)
- Definitions and methodology:
  - Data: Quarterly gross capital inflows (credit inflows minus debit outflows from the liabilities side of the BOP) from IFS database; excludes remittances, IMF lending, official transfers that are not market based or return driven.
  - Surge: single year (or quarter) of large inflows.
  - Episode: drawn-out period of large capital inflows; for a particular country, an episode consists of a string of surges.
  - Surge detection criteria:
    - Inflows in a given period significantly exceed their long run trend (by one standard deviation).
    - Inflows are large in absolute magnitude (larger than 1.5 percent of annual GDP).
    - Country-specific trend calculated by applying an H-P filter with smoothing parameter of 1600 for quarterly gross capital inflows.
  - Episode construction rules:
    - Contiguous surges are connected to form an episode.
    - Two adjacent episodes separated by four quarters or less are combined if capital inflows in all intermediate quarters remain positive.
    - Minimum duration of four quarters required for a period to be identified as an episode.
    - End of an episode defined as the peak of cumulative inflows (point at which gross inflows turn negative).
    - Ad hoc fine-tuning: include adjacent periods where inflows are normally not below one percent of GDP unless there is a salient change of pace.
- Key empirical findings:
  - Based on the two surge criteria, EMs experienced surges 20 percent of the time between 1990Q1 and 2010Q2.
    - This corresponds to 718 incidents of surges out of the 3632 observations available from a sample of 48 emerging markets for 1990Q1−2010Q2.
  - Temporal clustering:
    - Surges cluster in two seven-quarter periods: 1996Q4−1998Q2 and 2006Q4−2008Q2.
    - In 2007Q4, 26 EMs witnessed gross capital inflows significantly larger than their trend.
    - No surge was identified in 2009Q1 after the outbreak of the global financial crisis.
  - Episodes counts:
    - Using contiguous-surges rule and combining close episodes: the 48 EMs experienced 158 episodes of capital inflows over the past 20 years.
    - Applying the refined criteria (mechanical rule plus ad hoc fine-tuning): EMs experienced 125 episodes of large capital inflows, with 26 of them classified as ongoing.
  - Regional distribution:
    - Episodes are unevenly distributed across regions and countries.
    - Latin America and emerging Europe often experienced three to four episodes in the past 20 years.
    - Asian and Other EMs had less frequent alternations of inflows and outflows.
- Sample composition (as used in the analysis):
  - 48 EMs divided into four regional groups:
    - Asia: China, India, Indonesia, Korea, Malaysia, Pakistan, The Philippines, Sri Lanka, Thailand, Vietnam.
    - Latin America: Argentina, Brazil, Chile, Colombia, Costa Rica, Dominican Republic, Ecuador, El Salvador, Guatemala, Jamaica, Mexico, Paraguay, Peru, Uruguay, Venezuela.
    - Emerging Europe and CIS: Armenia, Bulgaria, Bosnia & Herzegovina, Croatia, Czech Republic, Estonia, Hungary, Kazakhstan, Latvia, Lithuania, Poland, Romania, Russia, Serbia, Ukraine.
    - Other EMs: Egypt, Israel, Jordan, Lebanon, Morocco, South Africa, Tunisia, Turkey.
  - Note: list includes economies such as the Czech Republic, which are now classified as advanced economies in the World Economic Outlook but were classified as emerging markets at the beginning of the time period used.

### Brazil case study (Annex III) — Background, impact, and policy responses
- A. Background and drivers of flows
  - Deep capital markets and high interest rates make Brazil a preferred EM destination.
  - Cyclical factors (strong post-crisis growth) reinforced structural factors (very high interest rates), producing large capital inflows and appreciation pressures.
  - First eleven months of 2010:
    - Gross capital inflows amounted to close to US$141 billion (6.8 percent of 2010 GDP), compared with US$92 billion in 2009 as a whole.
    - Brazil dominated capital inflows to Latin America and attracted a large share of global equity issuance in 2010.
    - Petrobras issue: total US$70 billion, of which about US$14 billion was subscribed by foreign investors.
  - Fixed income inflows remained steady during 2010, reflecting “real money” flows, retail flows (especially from Japan), and near-record external corporate bond issuance.
  - Macroeconomic policy stance:
    - Fiscal policy remained expansionary; structural primary balance deteriorated in 2010 by 1 percent of GDP over 2009.
    - Central Bank of Brazil (BCB) hiked rates by 250 basis points to 11.25 percent since April 2010, while intervening in large amounts.
    - Intervention in FX spot market reached US$41 billion in 2010, pushing reserves to US$287 billion (17 months of imports; 600 percent of short-term debt) at end-2010.
    - BCB resumed intervention in the forward FX market.
    - Despite intervention, the exchange rate appreciated around 50 percent since its bottom in December 2008; staff estimates suggest the real is significantly overvalued in real terms.
- B. Impact of inflows
  - Large capital inflows had limited observed impact on domestic asset markets beyond exchange rate effects:
    - Equity market received large inflows in 2010 but stock market valuations were mostly flat during the year (increase in supply of shares and a prior large rally).
    - Bank credit grew rapidly in 2010; 43 percent of credit expansion in 2010 came from public banks.
    - Banks generally did not rely on external funding for their credit expansion (though small and medium banks more recently issued external debt to finance new lending).
    - Rapid credit growth sustained a rapid rise in property prices in certain urban areas; anecdotal evidence suggests this phenomenon appears circumscribed and not linked to capital inflows.
- C. Policy responses
  - BCB engaged in large-scale intervention operations to curb exchange rate appreciation pressures.
  - Beginning in December 2010, BCB tightened prudential and regulatory measures, noting these measures would lessen the burden on monetary policy and help moderate pull factors. Measures included:
    - Increase in capital requirements for most consumer credit operations with maturities over 24 months (primarily car loans).
    - Increase in unremunerated reserve requirements on time deposits from 15 percent to 20 percent.
    - Increase in the additional (remunerated) reserve requirement on sight and time deposits from 8 percent to 12 percent.
  - IOF (Imposto de Operações Financeiras) tax on inflows played a central role:
    - IOF originally established in 1993 and used intermittently since then.
    - Applied to fixed income inflows at 1.5 percent between March and October 2008 (peak pre-crisis surge).
    - Re-introduced on October 19, 2009, with a higher rate (2 percent) and broader coverage (extended to equity inflows).
    - Rate on fixed income inflows raised to 4 percent on October 4, 2010, and to 6 percent on October 18, 2010.
    - On October 18, 2010, tax also raised to 6 percent (from 0.38 percent) on margin payments required on derivatives traded in the BM&F Bovespa, including FX futures.
      - The tax applied only to actual margin payments rather than notional amounts, creating favorable tax treatment for currency positions in domestic futures markets compared with positions in underlying cash markets; this feature had important implications (discussed in the source).

*Italic source: Extracted from the IMF content unit titled "_021411a - 63.      Because assessments of the macroeconomic criteria are difficult to undertake"*

### 6.      Empirical evidence suggests that the IOF measures did not have a clear, long-

### 6.      Empirical evidence suggests that the IOF measures did not have a clear, long-lasting effect on the exchange rate—at least relative to its level at the time the various IOF measures were introduced—although they may have eased appreciation pressures when compared with other commodity currencies.

### Exchange rate effects of IOF episodes
- Three IOF episodes examined: March 2008, October 2009, and October 2010.
- During March 2008 and October 2009 there was an initial depreciation in the exchange rate, which was however rapidly reversed.
- In October 2010, only after the tax rate was hiked for a second time (to 6 percent) was there a reversal in appreciation pressure—but again this was short-lived.
- Broadly similar conclusions when the real response is set against the behavior of currencies in other EMs countries during the same period.
- Possible explanation: the introduction of the IOF did not trigger a significant reduction in nonresidents’ positioning in the futures market.

### Impact on asset markets and yields
- IOF may have had some impact on local currency debt markets: the entire local nominal yield curve shifted upwards following its tightening in October 2010.
- Adjustment may have been more pronounced at the long-end of the curve, where nonresident investors are more active.
- Suggests low incidence on nonresident investors, as higher yields have offset the tax.
- Market participants expressed concerns that the IOF could reduce liquidity in the longer end of the yield curve and in the interest rate swap market.

### Effects on investor positioning and flow composition
- IOF’s favorable treatment of futures positions likely contributed to the buildup of large long real/short US$ positions by nonresident investors in the futures market during 2010.
- Long real positions in the futures market are a form of carry trade funded by borrowing in foreign currency.
- Growing open real positions by nonresident investors were mirrored closely by banks’ short FX cash positions—reaching almost US$17 billion at end-2010, a historically high level.
- Anecdotal evidence points to the IOF having some impact in containing short-term or speculative capital inflows, possibly by increasing uncertainty about other potential measures.
- One area of impact: encouraging inflows into the futures market due to favorable treatment of futures positions.

### Macro-prudential response and rationale
- The carry trade relies on resident banks’ ability to increase short spot FX positions to hedge futures exposure; banks’ short FX positions increased significantly in H2 2010.
- In early January 2011 the BCB introduced a 60 percent non-remunerated reserve requirement on banks’ short FX position in the spot market that exceed US$3 billion or Tier I capital (with a phase-in period of 90 days).
- Authorities’ intention: reduce return to local banks from providing a “bridge” to nonresident investors in the futures market, affecting an important carry-trade channel and reducing potential banking sector vulnerabilities.
- Measure has similarities in design and goals to a macro-prudential measure introduced in Korea in June 2010 aimed at limiting external indebtedness linked to carry trades.

### Carry-trade mechanism in the domestic futures market (Box A summary)
- Mechanism relies on a resident counterparty (typically a resident bank) taking the opposite position in domestic futures and hedging via FX borrowing (not subject to the IOF).
- Chain of trades (steps):
  - Nonresident investor sells a US$ futures contract in the domestic futures market; at maturity pays US$ and receives reais (settlement in local currency).
  - Resident counterparty (local bank) agrees to receive US$ at maturity against payment in reais.
  - Bank hedges by borrowing US$ offshore, creating a US$ liability that matches the futures obligation.
  - External borrowing by the bank is recorded in the balance of payments as a capital inflow; if the central bank intervenes, the bank sells the proceeds from external borrowing into the spot FX market.
  - Bank invests the reais proceeds at the domestic interest rate and earns an arbitrage profit whenever the cupom cambial is higher than the interest rate paid on external borrowing (typically Libor plus a spread).
- Residual risk for the bank is counterparty risk on the futures contract, limited by margin payments in the domestic futures market.

*Italic source attribution: IMF staff analysis as presented in the supplied content.*

### 11. At the time of their

### _021411a - 11. At the time of their

### Indonesia — June 2010 BI measures: market perception and immediate effects
- Market participants viewed BI’s June 2010 measures as well targeted to address specific issues of monetary management in Indonesian markets and well explained to market participants.
- Participants did not view the measures as indicating likely additional initiatives to deter capital inflows.
- Since the announcement:
  - Foreign holdings of SBIs as a percent of the outstanding stock peaked at 32 percent in October, and have since slipped to 27 percent, but remain above pre-holding period levels.
  - NDF market pricing does not indicate a substantial increase in the wedge between onshore versus offshore interest rates; the difference widened only marginally since the announcement and remains near the historical average for this differential prior to the announcement.
- Note on SBIs and SPNs:
  - Dealers who bid at SBI auctions on behalf of foreign investors are required to hold the securities for one-month before the securities can be sold on to foreign investors. As a result, foreign investors can only buy “aged” SBIs (e.g., 6-month bills with 5-months left to maturity).
  - As of end-2010, outstanding issuance of SBIs was Rp 200 trillion, while that of SPNs was Rp 30 trillion.
  - Interest rates on 12-month SPNs have fallen below yields on three and six month SBIs, and have fallen even more 150 basis points below the policy rate.
  - 12-month SPNs are unlikely to substitute fully for one-month SBIs for short-term carry and arbitrage trades because of the longer tenor and lower amount outstanding.

### Indonesia — Money market and banking market structure effects
- Banks observed increasing purchases of SPNs by both foreign and domestic investors; SPNs are not subject to the one-month holding period.
- Changes to net open position (NOP) regulations (effective July 1, 2010):
  - Prior to July 1, 2010: banks’ NOP limits in foreign exchange were 20 percent, applied both on- and off-balance sheet and in real time.
  - June 16 measures: eliminated the on-balance sheet NOP limit, but imposed an overall NOP limit at 20 percent of capital, within 30 minute windows.
  - The 30-minute window allows increased opportunity for trading to maintain positions within the limit.
  - Banks are allowed to engage in foreign exchange swaps to meet overall position limits (example given: sell dollars in spot and buy back dollars at the forward date to obtain rupiah funding using dollar liquidity).

### Indonesia — Additional measures announced December 2010
- BI announced measures to address risks posed by continuing inflows:
  - Raising the reserve requirement on foreign currency deposits.
  - Re-imposing a limit on short-term foreign borrowings of banks to 30 percent of capital (this limit had been removed in 2008).
- The government announced it will direct state-owned banks and enterprises to purchase government securities to support the bond market if outflows cause disorderly market conditions.

*Italic source attribution: Excerpts from the IMF PDF chapter _021411a - 11. At the time of their*

---

### Korea — Nature and drivers of inflows
- Korea is a small open economy with an open capital account and vulnerability to volatile capital flows, including significant bank borrowing channel risks.
- Pre-Lehman buildup:
  - Banking system relied heavily on wholesale funding, including from abroad, leading to large build-up in short term external debt intermediated by the banking system.
  - Drivers included speculative demand for currency forward contracts by corporates and arbitraging interest rate differentials on- and off-shore.
- During the global liquidity squeeze of late 2008:
  - Korea suffered a "sudden stop" of short term external bank debt and outflows from local equity and bond markets.
  - Authorities provided foreign exchange liquidity using Korea’s official reserves and swap lines from the U.S. Federal Reserve.
  - Korea’s reserves fell by US$64 billion and the stock market declined by 70 percent in just a few months.
- After the liquidity squeeze, inflows resumed led by portfolio flows into debt and equity markets, driven by both push and pull factors (decline in global risk aversion, low interest rates, abundant liquidity abroad; Korea’s quick recovery and sound fundamentals).

### Korea — Policy responses (staged measures)
- Objectives: limit banks’ short-term foreign exchange exposure to sustainable levels, strengthen FX liquidity management, enhance capacity to deal with capital flows.
- November 2009 measures:
  - Introduced stronger foreign currency liquidity standards to reduce maturity mismatch and improve quality of liquid assets.
  - Imposed a 125 percent cap (relative to underlying export revenues) on forward foreign exchange contracts between banks and exporters.
  - Directed banks to reduce wholesale won (KRW) funding through a 100 percent loan-to-deposit ratio over time.
  - Tougher capital requirements for financial bank holding companies.
- June 2010 measures:
  - Introduced ceilings on foreign derivatives positions of banks as a ratio to their capital to reduce short-term external bank debt related to forward contracts to corporates.
  - Further strengthened 2009 measures: limits on foreign currency bank loans, further reduction of FX asset/liability maturity mismatches, and reduction of the ratio of forward contracts to underlying export revenues to 100 percent.
- Late 2010 planned measure:
  - Macroprudential stability levy on (initially banks’) non-deposit foreign exchange liabilities, planned for second half of 2011, with charges ranging between 5 and 20 basis points (higher charges on shorter term non-core liabilities).
- January 2011 measure:
  - Re-introduced a withholding tax on foreign purchases of treasury and monetary stabilization bonds, aligning it with tax on resident purchases. Foreign corporations and nonresidents are subject to the withholding tax; exemptions for those based in countries with double taxation treaties with Korea and official investors.

### Korea — Policy effectiveness
- Measures aimed at banking vulnerabilities appear to have succeeded in preventing banks’ external debt from returning to pre-crisis levels.
- Limits on forward contracts relative to underlying commercial transactions and ratios on derivatives to bank capital contributed to a sizable reduction in outstanding external short-term debt of banks.
- Caveats and leakages:
  - Decline in demand for currency forwards from shipbuilders (smaller order book) also contributed to the decline in forward demand.
  - Measures apply only to onshore entities; corporates can still use offshore NDFs, and offshore banks can offset short KRW positions by investing in the onshore government bond market.
- Impact on capital inflows likely marginal:
  - The withholding tax (early 2011) is likely to have limited impact on portfolio debt flows.
  - The macroprudential stability levy is likely to have a minimal impact given the relatively low magnitude being discussed.

*Italic source attribution: Excerpts from the IMF PDF chapter _021411a - 11. At the time of their*

---

### Peru — Scale and drivers of inflows
- Peru attracted strong capital inflows that represented approximately 7 percent of GDP in 2010.
- Composition:
  - Bulk directed to real economy as FDI; recent spike in debt portfolio flows raised concerns about credit and asset price booms.
  - Foreign investors have been increasing holdings of medium- and long-term government domestic debt (about 45 percent of total outstanding).
- Growth and fundamentals:
  - Peru grew at an average 6.3 percent since 2002.
  - Deposit and credit dollarization remain elevated: as of October 2010, deposit dollarization 47 percent and credit dollarization 44 percent.
- Supply and market structure:
  - Fixed income market (mostly public debt) is less developed and fairly illiquid; pension funds hold bulk of instruments and follow buy-and-hold.
  - As of end-2010, reserves were around US$44 billion; total external debt was US$39.1 billion; total domestic currency stock was US$27 billion; reserves amounted to 120 percent of short term external debt and foreign exchange deposits.

### Peru — Policy mix and macro response
- Monetary and fiscal stance tightened and calibrated:
  - Since early 2010, policy rate increased by 225 basis points up to 3.25 percent.
  - Cyclically-adjusted primary balance expected to improve from -0.8 percent of GDP in 2010 to 0.7 percent of GDP in 2011.
  - Credit growth was growing at 20 percent (y/y) in recent months (slower than pre-crisis boom near 40 percent).
- Central bank interventions to limit exchange rate volatility given high dollarization and balance sheet concerns.

### Peru — Reserve requirements, liquidity and prudential measures
- Reserve requirements and related measures used to manage liquidity and extend maturity of FX liabilities:
  - Deposit reserve requirements:
    - Minimum unremunerated reserve requirements in domestic and foreign currencies increased from 6 percent to 9 percent (step-increases) since June 2010.
    - Marginal reserve requirements in domestic currency increased from 0 to 25 percent (step increases) since July 2010 and in foreign currency from 30 to 55 percent since June 2010.
    - Average reserve requirements on both domestic and foreign currency deposits were increased by 25 basis points from 11.8 percent and 35.6 percent, respectively, in January 2011.
  - Reserve requirements on foreign currency liabilities with maturity less than two years:
    - Rate went from 60 percent in January 2010 to 35 percent in June 2010, then increased in steps to 75 percent in September 2010, and reduced to 60 percent in January 2011.
- Additional prudential and market-development measures:
  - February 2010: limits on banks’ net FX position changed — long net FX positions reduced to 75 percent of net equity from 100 percent; short net FX positions raised to 15 percent of net equity from 10 percent. In January 2011, the long net FX position was reduced to 60 percent of net equity.
  - Limits on pension funds’ investment abroad increased in steps since February from 24 percent to 30 percent (in September 2010).
  - June 2010: private pension funds’ limit on trading FX imposed at 0.85 percent of assets under management (for daily transactions) and 1.95 percent of assets under management (over 5-day period).
  - July 2010: additional capital requirements for FX credit risk exposure implemented.
  - December 2010: new law for covered bonds for mortgages established a loan-to-value ratio of 80 percent.
  - January 2011: Superintendency of Banks and Insurance imposed a limit on NDF and other derivatives of the financial system to either 40 percent of assets or PEN 400 million (US$144 million), whichever is the highest.

*Italic source attribution: Excerpts from the IMF PDF chapter _021411a - 11. At the time of their*

### 9.      Furthermore, the central bank has limited the array of instruments to channel

### 9.      Furthermore, the central bank has limited the array of instruments to channel short-term flows from nonresidents

### C. Effectiveness of the Measures
- Main aim: limit FX volatility to reduce the possibility of negative balance-sheet impacts from destabilizing outflows and exchange rate overshooting, and to protect macroeconomic stability.
- Actions taken by the central bank:
  - Increased fee on nonresidents’ purchases of central bank certificates of deposits (CDs) from 10 to 400 basis points (August 2010).
  - Increased reserve requirements for domestic currency deposits in financial institutions to 120 percent (September 2010), increasing from 35 percent in June 2010.
  - Shifted sterilization instrument from tradable instrument (CDs) to a non-tradable instrument (term deposits) in October 2010 — access limited only to financial institutions.
- Outcomes and effectiveness:
  - Nominal exchange rate: among the most stable in the region; authorities intervened heavily and sterilized intervention to maintain the overnight rate in line with the policy rate, limiting appreciation spikes and volatility.
  - Measures to limit carry trade operations were effective; carry trade operations had been done mainly by purchasing central bank short-term paper and through short term deposits in local currency at local banks.
  - Sterilization costs: 0.3 percent of GDP. The Central Bank currently has operating profits to cover these costs.
  - Reserve requirements applied to deposits and FX liabilities helped stabilize credit growth: credit growth declined from 40 percent before the crisis to 20 percent during 2010.
  - Measures extended maturity of FX liabilities in the financial system but carry the limitation of potential financial circumvention.
  - Measures to limit foreign investors’ exposure to local-currency-denominated assets were partially effective: investors shifted from short- to longer-term government bonds following the increase of the fee on central bank CDs, so flows to debt markets were not discouraged.
  - Imposition of reserve requirements for financial institutions on nonresident deposits and the shift from CDs to time deposits closed a window for nonresidents to gain exposure to short-term central bank paper.

*Source: _021411a - 9.      Furthermore, the central bank has limited the array of instruments to channel*

### 5.      Capital inflows are set to continue in the near to medium term. Nearly all factors

### 5.      Capital inflows are set to continue in the near to medium term. Nearly all factors that have driven inflows to Thailand are expected to remain in place, so inflows are likely to persist in the coming quarters. That said, the outlook for inflows into EMs in general changes rapidly and is subject to uncertainty in the short term. As for the medium term, the measures to liberalize outward investment should encourage Thai investors to take advantage of attractive investment opportunities in the region and lower net inflows.

### Outlook for Capital Inflows
- Capital inflows to Thailand are expected to persist in the coming quarters as nearly all driving factors remain in place; outlook for EM inflows remains subject to rapid changes and short-term uncertainty.
- Measures to liberalize outward investment should encourage Thai investors to invest regionally and lower net inflows over the medium term.

### Impact on the Economy — Thailand
- Financial markets have absorbed most of the impact to date:
  - Thai stock exchange market index rose by over 40 percent in 2010, which is more than three times the rise in the MSCI Asia ex-Japan index.
  - Corporate bond index rose 11 percent over the same period.
- These financial gains have likely supported domestic private demand when external demand was weaker.
- Property markets:
  - Property prices are still recovering from the recession trough; concern exists about possible oversupply in certain property types.
  - Higher transaction rates in some real estate segments point to potential supply saturation soon.
  - Conclusion: property price inflation is not an immediate concern but warrants close monitoring.
- Interest rates and yield curve:
  - Yield curves flattened over 2010; loose monetary policy during most of the period was also a factor.
  - Bank of Thailand (BoT) began policy normalization in July 2010 with a 25 basis point hike, followed by additional 25 basis point hikes in August and December 2010, and in January 2011.
  - Despite these hikes, the policy rate remains one of the lowest in absolute value in the region.
  - Concern: capital inflows may weaken the link between short- and long-term rates, potentially reducing monetary policy effectiveness.

### Policy Responses and Effectiveness — Thailand
- Authorities used a mix of macroeconomic and prudential policies, including significant appreciation and sterilized intervention, relaxation of capital outflows, and removal of a withholding tax credit to nonresident investors on state bonds.
- Exchange rate and reserves:
  - The baht appreciated against the U.S. dollar by 10 percent over 2010 (same in real effective terms), the largest appreciation among Asian EMs.
  - Gross international reserves grew by US$32 billion, even more than the net inflow of capital, which is estimated at about US$15 billion.
  - Current account surplus in the first 11 months is US$13 billion.
  - Constant reserve money indicates interventions were sterilized.
  - Cost of sterilization operations over 2010 is estimated to be around 0.1 percent of GDP.
- Capital outflow liberalization (September 22):
  - Ceilings on outward direct investment, lending abroad, and foreign currency holdings of Thai investors raised.
  - Pre-existing ceilings were not binding; these steps did not ease appreciation pressure on the baht but support regional financial integration.
- Withholding tax change (October 13):
  - Removal of withholding tax exemption for nonresident investors on earnings from state bonds.
  - Nonresident investors now pay a 15 percent withholding tax on earnings from government, BoT, and state enterprise bonds.
  - Resident institutional investors continue to pay a 1 percent withholding tax.
  - Double tax agreements exempt investors from over 50 countries; tax initially dampened debt and equity inflows but impact was short-lived as inflows resumed in December and grew strongly thereafter.
- Macroprudential: loan-to-value (LTV) and risk weights:
  - Effective January 2011, risk weight on loans for low-end condominiums ratchets up from 35 to 75 percent for loans with an LTV greater than 90 percent.
  - Similar risk weighting applies to loans for low-rise properties with an LTV exceeding 95 percent, effective January 2012.

### Annex IX — Turkey: Recent Trends, Impacts, and Policy Response

#### Recent Trends in Capital Flows and Composition
- Since the global crisis receded, Turkey has attracted increasing capital inflows but remains exposed to uncertainty in Europe and the Middle East.
- Push and pull factors: interest rate differentials, reduced political uncertainty, favorable near-term growth prospects, healthier balance sheets, less-leveraged households, and expectations of an investment-grade upgrade.
- Composition skewed toward short-term maturities and volatile portfolio assets:
  - Banks’ deposit inflows up to November 2010 have reached US$24 billion.
  - Foreign investors channeled inflows mostly through deposits and securities; FDI contribution declined sharply to 13 percent from over 50 percent in pre-crisis years.
  - Loan rollover rates improved but remain below pre-crisis levels at around 115 percent in 2010Q3.

#### Macroeconomic and Capital Market Impact — Turkey
- Short-term inflows support domestic demand and widen the current account deficit:
  - Growth projected to exceed 8 percent in 2010.
  - Current account deficit expected to widen to 6½  percent of GDP.
  - Headline inflation slightly below target at 6.5 percent.
- Exchange rate and external constraints:
  - Real exchange rate is already substantially overvalued; further appreciation would hinder current account improvement.
- Balance-sheet and market effects:
  - Increased foreign-currency denominated liabilities led to a surge in currency swap transactions:
    - Volume of currency swaps increased by US$12 billion in the three months to November 2010, but partially reversed since.
    - As of November 2010, about 37 percent of these swaps have an overnight maturity.
  - More than 70 percent of TL deposits inflows to Turkey for 2010 originate from offshore branches.
- Credit and banking sector:
  - Credit growing at an annualized rate just above 30 percent.
  - Recent tilt toward housing and profitable general purpose loans with close to 35 and 40 percent year-on-year growth respectively.
  - Nonperforming loan (NPL) ratio: 4 percent for total loans, and 8¼ percent for credit cards; NPLs in nominal terms recently rose.

#### Authorities’ Policy Actions and Market Response — Turkey
- Policy constraints: overvalued real exchange rate, above-target inflation, and need to sterilize FX purchases limit options.
- Four-pronged policy focus to preserve financial and price stability:
  - (i) encourage lower leverage ratios in public and private sectors;
  - (ii) extend maturities of domestic and external liabilities;
  - (iii) strengthen net foreign exchange position by promoting TL borrowing;
  - (iv) promote better risk management practices.
- Central Bank of Turkey (CBT) policy mix:
  - Low short-term interest rates, high reserve requirement ratios (RRR), and wider interest rate corridor; greater use of RRR and macroprudential measures alongside policy rate cuts.
  - Policy rate changes:
    - CBT slashed its overnight borrowing rate by a cumulative of 500 basis points to 1.50 percent.
    - At December and January meetings, reduced the one-week repo rate by a total of 75 basis points to 6.25 percent.
  - Objective: reduce incentives for carry trade, introduce volatility to discourage short-term lira conversion through currency swaps.
- Reserve requirements and remuneration:
  - TL reserve requirement ratios now range from 5 percent for deposits with maturity of at least one year to 12 percent for demand deposits.
  - Previous increases had raised RRRs for TL and FX liabilities to 6 and 11 percent, respectively.
  - Remuneration of reserve requirements was halted to withdraw liquidity and increase RRR effectiveness via the cost channel.
- FX purchase operations:
  - CBT cut total daily FX purchase auctions from US$140 million to US$50 million for 2011 to moderate FX purchases and reduce sterilization needs.
- Macroprudential and market measures:
  - Government raised the Resource Utilization Support Fund levy on interest from consumer loans to 15 percent.
  - Bank Regulation and Supervision Agency (BRSA) extended LTV limits previously reserved for securitized mortgages to all mortgages.
  - BRSA granting permissions for issuance of TL-denominated bonds by banks to encourage longer maturities.
  - Government abolished or reduced withholding tax on interest earnings from Eurobond issues by Turkish corporates for longer maturities.
  - Existing measures supported: ban for households to use FX-denominated or FX-indexed loans and FX net general position limits for the banking sector.

*Source: IMF staff report content provided in the supplied PDF content unit.*

### 16.      The role of fiscal policy in dealing with “hot money” flows should not be

### _021411a - 16.      The role of fiscal policy in dealing with “hot money” flows should not be

### Fiscal policy and "hot money"
- Sustained fiscal discipline in the public sector is seen as a key ingredient to limit the risks from the widening current account deficit.
- Staff view: the authorities’ fiscal anchor—the Medium Term Program (MTP)—does not adjust flexibly to current macroeconomic conditions.
- Policy recommendation: a faster withdrawal of the fiscal stimulus, once all cyclical conditions are accounted for, should be pursued beyond the scope of the MTP.

### Capital controls and authorities' stance
- Authorities’ position: capital controls should not be used.
- Rationale cited by authorities:
  - The free floating exchange rate and open trade and capital account have served Turkey well in the last decade.
  - Restrictions to capital inflows are regarded as inconsistent with the free floating regime and are ineffective in stemming the volume of capital inflows.
  - Such restrictions have only a limited impact in terms of capital flows composition, as increasing financial innovation and the integration of markets leave wide room for circumvention.
- Authorities acknowledge the need to implement policies to reinforce financial stability and enhance financial depth.

### Central Bank of Turkey (CBT) and government measures to discourage inflows
- Actions observed:
  - Widening the interest rate corridor.
  - Raising RR.
- Effects noted:
  - These measures seem to have helped slow capital inflows and restore a welcome degree of monetary policy independence.
  - Registered higher uncertainty among market participants about the next CBT steps (and effectiveness of recent policy rate cuts) also seems to help deter one-way bets.
- Caveats and limits:
  - It is difficult to draw definitive conclusions because of heightened uncertainty in Europe and the Middle East, which may have also deterred inflows.
  - The ability of these measures in containing inflation and credit growth is less apparent.

*Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2011/_021411a.pdf*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2011/_021411a.pdf_