## 1. Common Factors Significant in Attracting the Flows

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### Major determinants (pull and push factors)
- Pull (demand) factors:
  - Improvement in economic conditions, greater macroeconomic stability, and EU accession prospects (timing varies by country, e.g., from 1994 for Poland; momentum from 2003 for Lithuania).
  - Privatization/deregulation of banks attracting foreign capital.
  - Arrival/entry of foreign banks with easy access to foreign funds (including from parent banks); example: Lithuania (5 of 9 banks are subsidiaries and 4 are branches).
  - Need to cofinance projects supported from EU structural funds.
  - Improved productivity and export performance in several countries (e.g., Bulgaria, Poland, Czech Republic).
- Push (supply) factors:
  - Global ample liquidity and low interest rates in advanced economies in the 2000s.
  - Large interest rate differentials (e.g., in the 1990s adjusted for expected exchange rate depreciation).
  - Stable/predictable exchange rates and perceived low FX risks under fixed peg regimes or currency boards (examples: longstanding fixed peg since 1994 in an unspecified case; currency board in Lithuania).
  - Hedging needs of foreign issuers after redenomination episodes (Turkey).
  - Speculative inflows driven by high interest rate differentials and predictable exchange rate movements (Romania until 2005).

### Stylized facts on flows and composition (sample 1994–2005)
- Average gross capital inflows in sample countries during 1994-2005: 9.6 percent of GDP.
- Country range (gross inflows as percent of GDP): Turkey 3.4 percent; Estonia and Latvia 17 percent.
- Composition evolution by country:
  - Initially FDI dominant in Bulgaria, Hungary, Poland; portfolio investment gained importance over time.
  - Israel: foreign currency credits initially dominant; later FDI became largest component.
  - Czech Republic: "other investment" dominated until 1997 turmoil; subsequently FDI generally most significant.
  - Portfolio inflows channeled primarily into debt securities, with equity following later (notably Israel).
  - Marked rise in inflows to banking systems in Bulgaria, Croatia, Hungary, Romania, Turkey; Baltics have largest share via banking.
- Reversals:
  - Notable flow reversals occurred in the Baltics in the late 1990s, the Czech Republic (1997 and 1998), Croatia (1998), and Turkey (2001).

### Financial sector dynamics facilitating inflows
- Foreign banks hold an average of 80 percent of domestic banking system assets in the sample, except in Turkey where share of foreign-controlled banks is about ¼ of total assets.
- Arrival of foreign banks facilitated funding of rapid bank credit growth through borrowing abroad.
- Real growth of banking sector credit ranged from 16–45 percent in the Baltics, Bulgaria, Croatia, Hungary, and Romania during 2002–2005.
- FX component of loans ranged from 40–80 percent of total loans in several countries.

---

### Macroeconomic impacts observed (selected country highlights)
- Bulgaria (1997–present):
  - Helped improve productivity and export performance.
  - Helped financing of CA deficits.
  - Later periods: other inflows caused difficulties in monetary management under CBA with limited instruments (reserve requirement often the only instrument).
- Croatia (1993–present):
  - Associated with widening of the CA deficit and rapid monetary expansion; sterilization complicated by euroization and lack of instruments.
  - Rapid increase in external indebtedness of banks and corporates borrowing abroad.
  - Volatile short-term inflows contributed to FX market instability in 1998/99.
- Czech Republic (1993–2004):
  - Improved technological possibilities, export performance, and competitiveness.
  - Led to rapid monetary expansion and large sterilization needs under pegged exchange rate—“holy trinity” dilemma.
- Estonia (mainly since 2000):
  - Sharp deterioration of the current account deficit (to an estimated 15 percent of GDP in 2006, compared with 5 percent in 2001).
  - Net external liabilities approaching 100 percent of GDP by end-2006.
- Hungary (1995–present):
  - Helped finance CA and public sector deficits; persistent inflows complicated policy implementation under exchange rate band while targeting inflation.
- Latvia (1998–present):
  - Widening CA deficit (to 21 percent of GDP in 2006) financed by banks’ net foreign borrowing and deposit taking (22.4 percent of GDP).
  - NFL rose to 69 percent of GDP in 2006; net debt share increased from 9 percent of GDP in 1999 to 43 percent in 2006.
- Lithuania (mid-late 1990s and 2002–present):
  - Net foreign borrowing financed on average ½ of credit growth in 2006, compared with 1/10th in 2005.
- Poland (1991–2005):
  - Helped improve technological possibilities and create a competitive export sector.
  - Contributed to economic overheating and costly sterilizations; switch to inflation targeting (1998) and floating exchange rate (2000) resolved sterilization problem.
- Romania (2004–present):
  - Deterioration of macroeconomic balances: expansion in domestic demand, widening CA deficit, slowdown in disinflation.
- Turkey (2003–2005):
  - Appreciation pressures under floating rate raised competitiveness concerns and widened CA deficit.

---

### Financial sector impacts observed (selected features)
- Entry of foreign banks often improved financial sector development, introduced technology and credit management practices, and supported privatization (Czech Republic, Lithuania, Poland).
- Rapid credit expansion financed by foreign borrowing raised financial stability concerns: rising FX-linked lending, indirect FX exposure through lending to unhedged borrowers, liquidity and rollover risks.
- Concentration of lending in housing and household markets created real estate and mortgage sector vulnerabilities (Estonia: mortgages constitute more than 80 percent of household liabilities).
- Competitive pressures and rapid inflows often led to deterioration in lending standards and increase in irregular/nonperforming loans (Poland early 1990s; Hungary after 2000; Latvia easing mortgage origination).
- Disintermediation and circumvention: tightening bank regulation sometimes pushed activity toward nonbank financial institutions not subject to reserve requirements or supervisory scrutiny (Bulgaria, Croatia, Lithuania).

---

### Macro vulnerabilities and tensions
- Impossible trinity tensions when pursuing inflation and exchange rate objectives amid capital account opening (the Baltics, Hungary, the Czech Republic and Israel until 1997, Poland until 1999, Romania until 2005).
- Appreciation pressures and monetary expansion when resisting appreciation (Croatia, the Czech Republic, Poland during 1994–98).
- Slower disinflation and larger current account deficits in several countries (the Baltics, Hungary, Poland in late 1990s, Romania).
- Under flexible rates, concerns about undershooting inflation targets and loss of competitiveness due to appreciation (Czech Republic, Israel, Poland, Romania, Turkey).
- Balance sheet mismatches: banks borrowed abroad in foreign currency and lent domestically in local currency.
- FX-linked loans to borrowers with limited FX income or hedging raised FX-related credit risk.
- Pegged exchange rates proved vulnerable to sudden inflow reversals (Baltics, Hungary).

---

### Policy responses: overview and main measures
- Framing:
  - Responses differed by monetary framework (exchange rate targeting vs. flexible/IT) and by EU/OECD integration constraints.
  - Responses aimed either to affect the inflows themselves (size, composition, maturity) or to cope with inflows’ implications (inflation, exchange rate vulnerability, current account deterioration, financial risks). Many countries used mixes of both.

- Responses under exchange rate targeting:
  - Sterilized FX intervention:
    - Most common response to preserve exchange rate targets; sterilization aimed to limit money supply impact.
    - Often unsustainable: kept interest rates high and generated large quasi-fiscal costs; limited by inadequate monetary tools, high dollarization/euroization, underdeveloped financial sectors, and presence of foreign banks.
    - Reserve requirement adjustments were a primary sterilization tool where independent monetary policy lacked (Bulgaria, Croatia, Estonia, Latvia, Lithuania).
  - Exchange rate adjustments:
    - Exchange rate changes and greater flexibility used in many countries (Czech Republic, Israel, Poland, Hungary).
    - Step appreciations and reductions in periodic depreciation rates in bands used in some episodes.
  - Measures to affect inflows directly:
    - Controls on inflows in response to surges in short-term inflows (Croatia, Czech Republic).
    - Liberalization of outflows to reduce net inflows (Bulgaria from 2000, Czech Republic from 1995, Hungary and Israel in late 1990s).
    - Trade and FX system liberalizations to reduce net FX inflows by encouraging imports and allowing FX revenues to remain outside the country (Bulgaria (1997), Hungary (1995–96), Poland (1995–97)).
    - Incentives for FDI to lengthen maturity and reduce volatility (Poland, Hungary, and after 1997 Czech Republic, Lithuania).

- Responses under more flexible exchange rates and inflation targeting:
  - Letting exchange rate appreciate:
    - Several countries allowed nominal appreciation (Czech Republic after 1998, Hungary after 2001, Israel after 1997, Poland since 1998, Romania after late 2004, Turkey after 2001) to absorb inflows while supporting IT and discouraging speculative inflows.
  - Sterilized interventions under floats:
    - Used to limit nominal appreciation (Czech Republic, Hungary, Israel, Poland until June 1999); effectiveness limited if pressures reflected fundamentals.
    - Interventions inconsistent with IT when motivated by competitiveness concerns undermined credibility (Hungary, Israel until 1997, Romania until 2005).
  - Interest rate policy:
    - Central banks used policy rate cuts to reduce risk of undershooting inflation targets, discourage interest-sensitive inflows, and offset appreciation effects (Czech Republic, Hungary, Poland, Romania, Turkey).
    - Challenges in reducing rates: weak or evolving monetary transmission mechanisms, difficulty gauging appropriate easing consistent with inflation targets, risk of fueling credit/asset growth (Romania, Turkey).
  - Fiscal policy:
    - Limited use of fiscal tightening in response to inflows; Turkey tightened fiscal policy to counter overheating.

- Prudential, debt management, and administrative measures:
  - Strengthening prudential regulation and supervision, and capital flows monitoring (Bulgaria, Estonia, Hungary, Israel, Latvia, Lithuania, Poland, Romania, Croatia from 2000).
  - Debt management measures to affect currency and maturity composition and reduce liquidity implications (Bulgaria, Croatia, Hungary, Poland, Turkey).
  - Indirect interventions (special central bank accounts for conversion of FX revenues) used to reduce market FX inflows related mostly to privatization proceeds (Czech Republic, Poland, Hungary); tensions with IT credibility when covert.
  - Administrative measures and delays in liberalization used as contingent safeguards (Poland, Czech Republic, Israel, Romania, Hungary); constrained by EU accession requirements.

- Sequencing and coordination of liberalization:
  - Better coordination: liberalize long-term inflows earlier than short-term ones; align capital account liberalization with exchange rate flexibility, market development, and prudential strengthening (Israel, Poland, Hungary, Czech Republic after the late 1990s).
  - FDI promotion used to lengthen inflow maturity.
  - Liberalization of capital outflows used to reduce net inflow pressures (Bulgaria, Czech Republic, Hungary, Israel, Poland).

---

### Box (selected): Responses to Credit Growth and Capital Inflows — Croatia and Romania
- Croatia measures:
  - Introduced an unremunerated marginal reserve requirement (MRR) on foreign borrowing in July 2004.
  - MRR increased in steps during 2004–06 from 30 percent to 55 percent currently.
  - Accompanying actions: introduction and broadening of FX liquidity requirements; moral suasion by the HNB; supervisory and administrative measures; establishment of a unified supervisory agency for nonbank institutions.
  - Outcomes: some scaling down of banks’ borrowing plans after successive rate increases; circumvention efforts prompted CNB to widen scope of regulations; CNB reintroduced direct controls on bank credit growth, effective in 2007.
- Romania measures:
  - Introduced a higher reserve requirement on all FX-denominated liabilities (mid-2004–2005).
  - Combined with limits on banks’ exposure to unhedged borrowers (300 percent of capital) and refinements in loan classification and provisioning to account for FX risk.
  - Outcomes: strong credit growth with an FX component persisted throughout 2005-06; banks raised capital and resumed FX lending; NBR removed the ceiling as of January 1, 2007; cross border integration following EU membership made the measure increasingly less effective.
- Regional complementary responses:
  - Prudential supervision and regulation improvements (Bulgaria, Czech Republic, Hungary, Israel, Poland, Baltics).
  - Financial market development measures (reform of nonbank supervision, improved access to FX markets, development of domestic money and capital markets).
  - Debt management and liquidity measures (shift from foreign to domestic borrowing sources; buybacks of discounted bonds; use of privatization receipts to repay IFIs; transfer of government deposits to central bank).

---

### Lessons and policy implications (synthesized)
- Policy mixes must recognize the “impossible trinity” trade-offs: maintaining exchange rate targets, pursuing low inflation, and opening capital accounts create tensions.
- When independent monetary policy is limited (hard pegs), fiscal policy and reserve requirement adjustments become critical tools, but carry trade-offs for financial intermediation.
- Under flexible rates and IT, allowing exchange rate adjustment and cautious interest rate easing can be consistent responses, provided monetary transmission and inflation forecasting are adequate.
- Sterilized interventions can be costly and unsustainable if they maintain high domestic interest rates that attract inflows or create quasi-fiscal losses.
- Strengthening prudential regulation, supervision, and capital flow monitoring is essential to enhance resilience and absorb inflows without undermining financial stability.
- Sequenced and coordinated liberalization—prioritizing long-term flows and aligning with market/institutional development—helps reduce volatility and vulnerability.
- Establish positive initial conditions: good macroeconomic and financial fundamentals, efficient and well-regulated financial system, deeper financial markets, and policy implementation capacity.
- Availability of hedging instruments is particularly helpful in mitigating exchange rate volatility.
- Focus on reducing risks and adverse consequences associated with inflows, rather than attempting to affect the flows and their composition directly; administrative measures have limited effectiveness as integration increases.

*Source: _wp07190 — extracts from chapters 1, 2, 3, 6, Box 1, and appendices as provided in the content unit.*

### 1. Common Factors Significant in Attracting the Flows ...........................................................8

### 1. Common Factors Significant in Attracting the Flows

### Major themes and chapter structure
- The document is organized into major sections:
  - "1. Common Factors Significant in Attracting the Flows" (page 8)
  - "2. Macroeconomic and Financial Sector Implications of the Capital Inflows" (page 9)
  - "3. Selected European Countries: Policy Responses to the Inflows, 1993—Present" (page 18)
- Supporting materials include:
  - References (page 41)
  - Figures:
    - "1. Selected Countries: Gross Capital Inflows, 1994–2005" (Figure 1)
    - "2. Selected European Countries: Current Account Balance and Credit Growth" (Figure 2)
  - Boxes:
    - "1. Responses to Credit Growth and Capital Inflows: Croatia and Romania" (Box 1)
  - Appendixes:
    - "I. Factors Motivating Capital Inflows, Their Implications, and Policy Responses" (Appendix I)
    - "II. Experiences of Israel and Poland with Capital Account Liberalization" (Appendix II)
  - Appendix Tables:
    - "4. Selected European Countries: Factors Underlying the Capital Inflows" (Appendix Table 4)
    - "5. Selected European Countries: Macroeconomic and Financial Implications of Inflows" (Appendix Table 5)

### Implied analytic focus (as indicated by section and appendix titles)
- Identification of common factors that attract capital flows to countries (section 1).
- Assessment of macroeconomic and financial-sector consequences of such inflows (section 2).
- Survey of policy responses implemented by selected European countries over the period 1993—Present (section 3).
- Case-level examination of specific country experiences and policy responses:
  - Croatia and Romania (Box 1)
  - Israel and Poland with respect to capital account liberalization (Appendix II)
- Aggregate and country-level data presentation:
  - Gross capital inflows across selected countries for 1994–2005 (Figure 1).
  - Current account balance and credit growth dynamics for selected European countries (Figure 2).
  - Appendix Tables providing factors underlying inflows and their macro/financial implications (Appendix Tables 4 and 5).

### Key structural takeaways for ingestion and indexing
- The unit links determinants of capital inflows to subsequent macroeconomic and financial sector implications, and to policy responses.
- Empirical coverage spans at least 1993—Present with data series explicitly covering 1994–2005.
- Contains targeted country case material (Croatia, Romania, Israel, Poland) alongside cross-country figures and appendix tables.

*Source: _wp07190 - 1. Common Factors Significant in Attracting the Flows*

### 6. Policy Responses to the Capital Inflows in the Selected European Countries ....................31

### 6. Policy Responses to the Capital Inflows in the Selected European Countries

### I. Introduction: objective and context
- Objective: present experiences of 11 European countries (Bulgaria, Croatia, the Czech Republic, Estonia, Hungary, Israel, Latvia, Lithuania, Poland, Romania, and Turkey) to draw lessons for countries experiencing large capital inflows.
- Context: inflows occurred amid liberalization and integration with international capital markets and institutions (EU, OECD), shifting monetary regimes (greater exchange rate flexibility, adoption of inflation targeting (IT)), and changing composition of inflows (from FDI-dominated toward larger portfolio and banking inflows).

### II. Stylized features and determinants of the inflows
Key statistics and patterns:
- Average gross capital inflows in sample countries during 1994-2005: 9.6 percent of GDP.
- Country range (gross inflows as percent of GDP): Turkey 3.4 percent; Estonia and Latvia 17 percent.
- Composition evolution:
  - Initially FDI dominant in Bulgaria, Hungary, Poland; portfolio investment gained importance over time.
  - Israel: foreign currency credits initially dominant; later FDI became largest component.
  - Czech Republic: "other investment" dominated until 1997 turmoil; subsequently FDI generally most significant.
  - Portfolio inflows channeled primarily into debt securities, with equity following later (notably Israel).
  - Marked rise in inflows to banking systems in Bulgaria, Croatia, Hungary, Romania, Turkey; Baltics have largest share via banking.
- Reversals: notable flow reversals occurred in the Baltics in the late 1990s, the Czech Republic (1997 and 1998), Croatia (1998), and Turkey (2001).
Determinants (country-specific and global):
- Country-specific pull factors: lower risk premia from stabilization; improved policy credibility; EU-related reforms; privatizations; regulatory improvements; financial deregulation; institutional restructuring of foreign debt; EU transfers.
- Push/global factors: declining interest rates in industrial countries relative to domestic rates; increased global liquidity; exogenous geopolitical events (e.g., decline in Israel’s risk premium).
- Financial sector dynamics: arrival of foreign banks (foreign banks hold an average of 80 percent of domestic banking system assets, except in Turkey where share of foreign-controlled banks is about ¼ of total assets) facilitated funding of rapid bank credit growth through borrowing abroad.

### III. Macroeconomic and financial impacts
Macro benefits and contributions:
- Expanded resources for funding productive investment, privatization, and export capacity (Bulgaria, the Czech Republic, Hungary, Poland, Romania).
- Helped finance current account deficits (the Baltics, Bulgaria, the Czech Republic, Hungary, Poland, Turkey).
- Contributed to development of domestic financial markets and banking efficiency (the Baltics, Bulgaria, Croatia, the Czech Republic, Poland, Turkey).
- Foreign participation improved liquidity and sophistication in government securities markets (Hungary, Poland).
- FDI transferred managerial and technological skills and strengthened institutions.

Macro vulnerabilities and tensions:
- Impossible trinity tensions when pursuing inflation and exchange rate objectives amid capital account opening (the Baltics, Hungary, the Czech Republic and Israel until 1997, Poland until 1999, Romania until 2005).
- Appreciation pressures and monetary expansion when resisting appreciation (Croatia, the Czech Republic, Poland during 1994–98).
- Slower disinflation and larger current account deficits in several countries (the Baltics, Hungary, Poland in late 1990s, Romania).
- Under flexible rates, concerns about undershooting inflation targets and loss of competitiveness due to appreciation (Czech Republic, Israel, Poland, Romania, Turkey).

Financial sector risks:
- Rapid credit growth financed from abroad increased external indebtedness of banks and corporations (notable in the Baltics, Turkey, Croatia).
- Balance sheet mismatches: banks borrowed abroad in foreign currency and lent domestically in local currency.
- FX-linked loans to borrowers with limited FX income or hedging raised FX-related credit risk.
- Real growth of banking sector credit ranged from 16-45 percent in the Baltics, Bulgaria, Croatia, Hungary, and Romania during 2002–2005; FX component of loans ranged from 40–80 percent of total loans.
- Credit risk concentration in mortgage and household sectors (e.g., Baltics).
- Pegged exchange rates proved vulnerable to sudden inflow reversals (Baltics, Hungary).

### IV. Policy responses: overview and main measures
Framing:
- Policy responses differed by monetary framework (exchange rate targeting vs. flexible/IT) and by EU/OECD integration constraints.
- Responses aimed either to affect the inflows themselves (size, composition, maturity) or to cope with inflows’ implications (inflation, exchange rate vulnerability, current account deterioration, financial risks). Many countries used mixes of both.

A. Responses under exchange rate targeting
- Sterilized FX intervention:
  - Most common response to preserve exchange rate targets; sterilization aimed to limit money supply impact.
  - Often unsustainable: kept interest rates high (attracting more inflows) and generated large quasi-fiscal costs; limited by inadequate monetary tools, high dollarization/euroization, underdeveloped financial sectors, and presence of foreign banks.
  - Reserve requirement adjustments were a primary sterilization tool where independent monetary policy lacked (Bulgaria, Croatia, Estonia, Latvia, Lithuania).
- Exchange rate adjustments:
  - Exchange rate changes and greater flexibility used in many countries (Czech Republic, Israel, Poland, Hungary) to let appreciation absorb inflows and discourage short-term speculative entry.
  - Step appreciations and reductions in periodic depreciation rates in bands used in some episodes.
- Measures to affect inflows directly:
  - Controls on inflows in response to surges in short-term inflows (Croatia, Czech Republic).
  - Liberalization of outflows to reduce net inflows (Bulgaria from 2000, Czech Republic from 1995, Hungary and Israel in late 1990s).
  - Trade and FX system liberalizations to reduce net FX inflows by encouraging imports and allowing FX revenues to remain outside the country (Bulgaria (1997), Hungary (1995–96), Poland (1995–97)).
  - Incentives for FDI to lengthen maturity and reduce volatility (Poland, Hungary, and after 1997 Czech Republic, Lithuania).

B. Responses under more flexible exchange rates and inflation targeting
- Letting exchange rate appreciate:
  - Several countries allowed nominal appreciation (Czech Republic after 1998, Hungary after 2001, Israel after 1997, Poland since 1998, Romania after late 2004, Turkey after 2001) to absorb inflows while supporting IT and discouraging speculative inflows by imposing FX risk on market participants.
  - Authorities sometimes reluctant to allow appreciation because of competitiveness and current account concerns.
- Sterilized interventions under floats:
  - Used to limit nominal appreciation (Czech Republic, Hungary, Israel, Poland until June 1999); effectiveness limited if pressures reflected fundamentals.
  - Interventions inconsistent with IT when motivated by competitiveness concerns undermined credibility (Hungary, Israel until 1997, Romania until 2005).
- Interest rate policy:
  - Central banks used policy rate cuts to reduce risk of undershooting inflation targets, discourage interest-sensitive inflows, and offset appreciation effects (Czech Republic, Hungary, Poland, Romania, Turkey).
  - Challenges in reducing rates: weak or evolving monetary transmission mechanisms, difficulty gauging appropriate easing consistent with inflation targets, risk of fueling credit/asset growth (Romania, Turkey).
  - Interest rate cuts must be cautious and guided by reliable inflation projections, effective transmission, and robust flow monitoring.
- Fiscal policy:
  - Limited use of fiscal tightening in response to inflows; Turkey tightened fiscal policy to counter overheating. Hungary and Poland did not tighten fiscal policy through much of the mid-1990s; the Czech Republic tightened only later. Lack of fiscal restraint in some cases contributed to slower disinflation or larger current account deficits.

C. Prudential, debt management, and administrative measures
- Strengthening prudential regulation and supervision, and capital flows monitoring, to increase financial system resilience (Bulgaria, Estonia, Hungary, Israel, Latvia, Lithuania, Poland, Romania, Croatia from 2000).
- Debt management measures to affect currency and maturity composition and reduce liquidity implications (Bulgaria, Croatia, Hungary, Poland, Turkey).
- Indirect interventions (special central bank accounts for conversion of FX revenues) to reduce market FX inflows related mostly to privatization proceeds (Czech Republic, Poland, Hungary); tensions with IT credibility when covert.
- Administrative measures and delays in liberalization:
  - Some countries delayed liberalization of specific transactions or retained possibilities under FX laws as contingent safeguards (Poland, Czech Republic, Israel, Romania, Hungary).
  - Croatia and Romania used administrative measures in 2004–06 to address short-term inflows and prudential risks; however, inflows and credit growth persisted.
  - EU accession and adoption of the acquis constrained the use of administrative capital controls and required sequencing of liberalization, limiting room for administrative responses.

D. Sequencing and coordination of liberalization
- Better coordination: liberalize long-term inflows earlier than short-term ones; align capital account liberalization with exchange rate flexibility, market development, and prudential strengthening (Israel, Poland, Hungary, Czech Republic after the late 1990s).
- FDI promotion used to lengthen inflow maturity and align inflows with investment needs.
- Liberalization of capital outflows used to reduce net inflow pressures (Bulgaria, Czech Republic, Hungary, Israel, Poland).

### V. Lessons and policy implications (synthesized)
- Policy mixes must recognize the “impossible trinity” trade-offs: attempts to simultaneously maintain exchange rate targets, pursue low inflation, and open capital accounts create tensions.
- When independent monetary policy is limited (hard pegs), fiscal policy and reserve requirement adjustments become critical tools, but carry trade-offs for financial intermediation.
- Under flexible rates and IT, allowing exchange rate adjustment and cautious interest rate easing can be consistent responses, provided monetary transmission and inflation forecasting are adequate.
- Sterilized interventions can be costly and unsustainable if they maintain high domestic interest rates that attract inflows or create quasi-fiscal losses.
- Strengthening prudential regulation, supervision, and capital flow monitoring is essential to enhance resilience and absorb inflows without undermining financial stability.
- Sequenced and coordinated liberalization—prioritizing long-term flows and aligning with market/ institutional development—helps reduce volatility and vulnerability.

*Source: _wp07190 - 6. Policy Responses to the Capital Inflows in the Selected European Countries (chapter/section content).*

### Box 1. Responses to Credit Growth and Capital Inflows: Croatia and Romania

### Box 1. Responses to Credit Growth and Capital Inflows: Croatia and Romania

### Measures adopted: Croatia
- Introduced an unremunerated marginal reserve requirement (MRR) on foreign borrowing in July 2004.
- MRR increased in steps during 2004–06 from 30 percent to 55 percent currently.
- Objective: reduce external vulnerability and funding sources for FX-linked bank lending.
- Accompanying actions:
  - Introduction and broadening of FX liquidity requirements.
  - Moral suasion by the HNB to relax or tighten some of its instruments depending on banks’ foreign borrowing.
  - Supervisory and administrative measures to slow rapid credit growth and improve management of related risks.
  - Establishment of a unified supervisory agency for nonbank institutions to monitor switch of private sector borrowing from banks to leasing companies in response to regulations on bank borrowing and lending.

### Measures adopted: Romania
- Introduced a higher reserve requirement on all FX-denominated liabilities (mid-2004–2005) to curtail FX-denominated lending.
- Combined with:
  - Limits on banks’ exposure to unhedged borrowers (300 percent of capital).
  - Refinements in loan classification and provisioning requirements to take into account the FX risk of borrowers.

### Persistence of inflows and banking-sector responses
- Croatia:
  - Banks seem unwilling to raise lending rates to offset rising costs imposed by measures, to preserve market share.
  - MRR appears to have resulted in some scaling down of banks’ borrowing plans after successive rate increases, but an upturn has already been observed and banks have sought other financing methods.
  - Circumvention efforts prompted CNB to widen the scope of existing regulations.
  - CNB reintroduced direct controls on bank credit growth, effective in 2007.
  - Imposing controls on direct borrowing by the private sector has been viewed unfavorably by the authorities given EU membership aspirations.
  - Examples of circumvention included: using retained earnings, injection of capital by parent banks, directing clients to parent banks (i.e., direct borrowing by the private sector), and intensifying efforts to attract deposits.
- Romania:
  - Strong credit growth with an FX component persisted throughout 2005-06 given persistent expectations of lei appreciation.
  - Banks adapted by:
    - A wave of loan exports by subsidiaries.
    - Raising capital, rather than reducing FX-denominated loans.
    - Engaging in various window-dressing activities.
  - After a brief decline, FX lending by banks resumed as banks increased their capital.
  - NBR removed the ceiling as of January 1, 2007.
  - Cross border integration following EU membership made the measure increasingly less effective.

### Regional and sectoral complementary responses
- Prudential supervision and regulation improvements enhanced capacity to absorb inflows in Bulgaria, the Czech Republic, Hungary, Israel, and Poland, as well as the Baltics.
  - Strengthening included bringing prudential regulations in line with international standards, accelerated through harmonization with EU legislation during EU accession.
  - Prudential frameworks allowed banks to manage open currency positions and develop internal risk management systems.
- Financial market development measures helped increase capacity to absorb and manage inflows.
  - Examples: reform of nonbank financial supervision (1998–99) and harmonization with EU legislation in 2004-06 in Bulgaria; improved access to FX markets in Croatia; continuous development of domestic money and capital markets in Israel and greater sophistication of monetary operations.
- Debt management and liquidity measures employed by some countries:
  - Shift from foreign to domestic borrowing sources (Bulgaria, Croatia, Hungary, Poland).
  - Bought back outstanding Brady discount bonds (Bulgaria and Poland).
  - Used inflows to over-borrow and moved to medium and long-term domestic borrowing (Turkey).
  - Used part of privatization receipts to repay international financial organizations (Hungary).
  - Transferred government deposits to the central bank and instructed Deposit Insurance Fund to invest cash balances and maturing repos in government debt (Bulgaria).

### Use of indirect interventions and moral suasion
- Given limits on administrative measures and potential adverse effects of FX interventions on credibility of IT regimes, some countries used indirect practices to limit exchange rate impact of inflows:
  - Special accounts for government FX revenues set up at the central bank with proceeds converted into domestic currency off the market via the central bank (the Czech Republic and Poland).
  - Moral suasion tools (example: in Hungary, if a bank’s on-balance sheet open position exceeded 30 percent of its capital the central bank reduced reserves remuneration and warned of stricter reserve requirements to stem inflows).
  - Such covert operations sometimes raised questions of consistency with IT and a floating exchange rate.

### Summary findings
- Capital inflows were often helpful for economic and financial development but complicated macroeconomic management and increased the need for prudent policies.
- Inflows led to:
  - Rapid monetary expansion.
  - A slowdown in the disinflation process.
  - Wider current account deficits.
- Adoption of more flexible exchange rates and IT regimes relieved tensions, but continued inflows required a careful mix of interest rate and intervention policies to avoid disorderly exchange rate adjustments while preserving IT credibility.
- Inflows posed financial stability risks when intermediation led to rapid bank credit growth and maturity and currency mismatches in private sector balance sheets.
- Institutional improvements allowed countries to combine macroeconomic policy tools with strengthened prudential regulation and supervision, financial market development, better monitoring of capital flows, debt management measures, and indirect intervention schemes rather than relying on capital controls.

### Policy implications and recommendations
- Establish positive initial conditions: good macroeconomic and financial fundamentals, efficient and well-regulated financial system, deeper financial markets, and policy implementation capacity.
- Availability of hedging instruments is particularly helpful in mitigating exchange rate volatility.
- Appropriate policy mix and sequencing:
  - Greater exchange rate flexibility, where feasible, is often one of the best and most effective responses to large capital inflows.
  - Even with flexible exchange rates and strong commitment to price stability, monetary policy may need to respond to exchange market pressures; interventions should limit undue volatility but not resist changes driven by fundamentals.
  - Where monetary policy is constrained by a pegged exchange rate, tightening fiscal policy and eliminating excessive fiscal incentives may be the only option for aggregate demand management.
  - Focus on reducing risks and adverse consequences associated with inflows, rather than attempting to affect the flows and their composition directly.
  - As integration with international financial markets increases, administrative measures have limited effectiveness; appropriate sequencing of liberalization and debt management policies can help address implications of inflows.
  - Deepening financial markets and strengthening supervision and regulation increase absorption capacity and resilience and help channel inflows into productive uses.

*Source: Box 1. Responses to Credit Growth and Capital Inflows: Croatia and Romania (excerpt).*

### 2.9  percent in 2003, 6.2 percent in 2004, 6.7 percent in 2005,

### _wp07190 - 2.9  percent in 2003, 6.2 percent in 2004, 6.7 percent in 2005,

### Pull (Demand) and Push (Supply) Factors for Capital Inflows
- Common pull factors across countries:
  - Improvement in economic conditions, greater macroeconomic stability, and EU accession prospects (timing varies by country, e.g., from 1994 for Poland; momentum from 2003 for Lithuania).
  - Privatization/deregulation of banks attracting foreign capital.
  - Arrival/entry of foreign banks with easy access to foreign funds (including from parent banks); examples: Lithuania (5 of 9 banks are subsidiaries and 4 are branches), broader regional examples across Estonia, Latvia, Hungary, Croatia, Romania, etc.
  - Need to cofinance projects supported from EU structural funds.
  - Improved productivity and export performance in several countries (e.g., Bulgaria, Poland, Czech Republic).
- Common push/supply factors:
  - Global ample liquidity and low interest rates in advanced economies in the 2000s.
  - Large interest rate differentials (e.g., in the 1990s adjusted for expected exchange rate depreciation).
  - Stable/predictable exchange rates and perceived low FX risks under fixed peg regimes or currency boards (examples: longstanding fixed peg since 1994 in an unspecified case; currency board in Lithuania).
  - Hedging needs of foreign issuers after redenomination episodes (Turkey).
  - Speculative inflows driven by high interest rate differentials and predictable exchange rate movements (Romania until 2005).

### Macroeconomic Impacts Observed (Selected Countries)
- Bulgaria (1997–present)
  - Helped improve productivity and export performance.
  - Helped financing of CA deficits.
  - Later periods: other inflows caused difficulties in monetary management under CBA with limited instruments (reserve requirement often the only instrument).
- Croatia (1993–present)
  - Associated with widening of the CA deficit and rapid monetary expansion; sterilization complicated by euroization and lack of instruments.
  - Rapid increase in external indebtedness of banks and corporates borrowing abroad.
  - Volatile short-term inflows contributed to FX market instability in 1998/99.
- Czech Republic (1993–2004)
  - Improved technological possibilities, export performance, and competitiveness.
  - Led to rapid monetary expansion and large sterilization needs under pegged exchange rate—“holy trinity” dilemma.
  - Insufficient coordination of fiscal and monetary policy under fixed rate required higher interest rates.
- Estonia (mainly since 2000)
  - Sharp deterioration of the current account deficit (to an estimated 15 percent of GDP in 2006, compared with 5 percent in 2001).
  - Net external liabilities approaching 100 percent of GDP by end-2006.
  - 2008 target for euro adoption pushed back until 2011 owing to inflation criteria difficulties.
- Hungary (1995–present)
  - Helped finance CA and public sector deficits; persistent inflows complicated policy implementation under exchange rate band while targeting inflation.
- Israel (1988–1998)
  - Tradeoff between low inflation and competitiveness under heavy inflows complicated monetary management; sterilizations costly and led to greater exchange rate flexibility.
- Latvia (1998–present)
  - Widening CA deficit (to 21 percent of GDP in 2006) financed by banks’ net foreign borrowing and deposit taking (22.4 percent of GDP).
  - NFL rose to 69 percent of GDP in 2006; net debt share increased from 9 percent of GDP in 1999 to 43 percent in 2006.
  - Rising inflation pressures delayed euro adoption target from 2008 to at least 2012.
  - In 2003–06, over 61 percent of new loans financed residential mortgages or corporate real estate; 11 percent for other household loans; 6 percent to manufacturing.
- Lithuania (mid-late 1990s and 2002–present)
  - Contribution to overheating pressures: rising CA deficit and inflation pressures; euro adoption target moved until at least 2010.
  - Net foreign borrowing financed on average ½ of credit growth in 2006, compared with 1/10th in 2005.
- Poland (1991–2005)
  - Helped improve technological possibilities and create a competitive export sector.
  - Contributed to economic overheating and costly sterilizations; eventual switch to inflation targeting (1998) and floating exchange rate (2000) resolved sterilization problem.
- Romania (2004–present)
  - Deterioration of macroeconomic balances: expansion in domestic demand, widening CA deficit, slowdown in disinflation.
  - Capital inflows facilitated rapid credit growth with significant FX component, exposing banking system to indirect FX risks.
- Turkey (2003–2005)
  - Appreciation pressures under floating rate raised competitiveness concerns and widened CA deficit.
  - Inflows increased premium on appropriate policy mix; disinflation may require sustained high interest rates, likely sustaining capital inflows.

### Financial Sector Impacts Observed (Selected Countries)
- Common patterns across countries:
  - Entry of foreign banks often improved financial sector development, introduced technology and credit management practices, and supported privatization efforts (Czech Republic, Lithuania, Poland).
  - Rapid credit expansion financed by foreign borrowing raised financial stability concerns: rising FX-linked lending, indirect FX exposure through lending to unhedged borrowers, liquidity and rollover risks due to debt-funded liabilities.
  - Concentration of lending in housing and household markets created real estate and mortgage sector vulnerabilities (Estonia: mortgages constitute more than 80 percent of household liabilities).
  - Banks’ foreign borrowing often financed large portions of credit growth (Lithuania: net foreign borrowing financed on average ½ of credit growth in 2006).
  - Competitive pressures and rapid inflows often led to deterioration in lending standards and increase in irregular/nonperforming loans (Poland early 1990s; Hungary after 2000; Latvia easing mortgage origination).
  - Disintermediation and circumvention: tightening bank regulation sometimes pushed activity toward nonbank financial institutions not subject to reserve requirements or supervisory scrutiny (Bulgaria, Croatia, Lithuania).

### Policy Responses Implemented
- Monetary and exchange rate measures:
  - Sterilized interventions and reserve requirement adjustments (Bulgaria, Croatia, Czech Republic, Hungary, Turkey).
  - Increased exchange rate flexibility or wider bands (Czech Republic, Hungary, Poland).
  - Delays in reduction of reserve requirements toward Euro area levels where currency board arrangements limited interest rate policy (Estonia, Lithuania).
- Prudential, supervisory, and administrative measures:
  - Raising and broadening reserve requirements, including marginal reserve requirements on banks’ external borrowing (Croatia: MRR introduced 7/2004, increased to 55 percent; overall RR of 17 percent on FX and kuna liabilities).
  - Tightening capital adequacy requirements, increasing risk weights on mortgage and FX loans, enhanced reporting and inspections, stress testing, consolidated supervision (Estonia, Lithuania, Latvia, Hungary, Poland).
  - Limits on exposures to FX-denominated lending to unhedged borrowers and refinement of loan classification and provisioning to account for FX risks (Romania 2004–06).
  - Creation or strengthening of nonbank supervisory agencies to limit circumvention (Croatia).
- Fiscal and debt management measures:
  - Shift from foreign to domestic borrowing sources; buybacks of discounted bonds; use of government accounts at central banks to manage FX proceeds (Bulgaria, Croatia, Poland, Turkey).
  - Using inflows to over-borrow and shift to medium- and long-term domestic local-currency borrowing (Turkey).
- Administrative/market-development measures:
  - Liberalization of FX and capital accounts staged and sequenced (Israel’s gradual approach after 1988; Poland’s phased liberalizations in 1991–2000).
  - Measures to attract long-term FDI and improve investment climate (Lithuania).
  - Moral suasion and public risk-awareness campaigns, with limited effectiveness where foreign banks dominate (Estonia, Latvia, Hungary, Croatia).

### Impacts and Effectiveness of Policy Responses
- Sterilization and reserve-based tools:
  - Often costly, with substantial quasi-fiscal costs (Israel 1977 experience; Czech Republic and others).
  - Frequently of limited effectiveness when large foreign bank presence, euroization, or lack of independent monetary policy constrained domestic tools (Estonia, Latvia, Hungary, Croatia).
- Prudential measures and supervisory strengthening:
  - Helped increase buffers and monitor risks; however, effectiveness limited if cross-border supervisory coordination was weak and banks could circumvent via branches/foreign entities.
  - Increased reserve requirements and higher risk weights sometimes slowed credit growth or raised lending costs temporarily, but persistent inflows often continued (Latvia, Croatia).
- Exchange rate flexibility and monetary policy regime shifts:
  - Moving to greater exchange rate flexibility and inflation targeting (Poland) ultimately reduced the need for costly sterilizations and helped manage inflow-related overheating.
  - Abandoning tight bands provided temporary relief (Czech Republic in 1996; Israel post-1980s).
- Administrative controls and capital controls:
  - Short-term administrative controls could limit interest-rate sensitive inflows temporarily (Romania until 2005), but were often circumvented or costly if maintained.
  - Chilean-style controls in Croatia in early 1998 reduced short-term inflows initially but were partly reversed in late 1998.
- Moral suasion:
  - Generally limited effectiveness where foreign banks operate under home-country regulation and have easy access to funds; competition for market share reduced willingness to pass through higher costs (Bulgaria, Croatia, Estonia, Hungary).

### Appendix: Experiences of Israel and Poland with Capital Account Liberalization
- Israel
  - 1977 “Big Bang” liberalization: permitted unrestricted foreign credit, foreigners holding domestic liquid assets, domestic firms acquiring assets abroad; accompanied by a one-time 48 percent devaluation and market-determined exchange rate.
  - Result: extremely large short-term inflows; inflation surged (53 percent in 1978, 137 percent in 1980, hyperinflation by 1985); large FX-denominated borrowing and major banking crisis in 1983; liberalization largely rescinded by end-1979.
  - Key failures: lack of macroeconomic stability (inflation ~28 percent prior), public sector deficit (16 percent of GDP), undeveloped money and FX markets, lack of monetary instruments, undeveloped financial sector risk management, perceived implicit exchange rate guarantees.
  - 1988 evolutionary approach: gradual sequencing over more than a decade; liberalize long- and medium-term inflows first, short-term later; sector differentiation (foreign entities before domestic; businesses before households); accompanied by capital market development, prudential strengthening, FX market development.
  - Outcome: progressive lifting of controls, compliance with IMF Article VIII in 1993, most capital controls lifted by 1998, full convertibility of the shekel and abolition of the Controller of Foreign Currency at beginning of 2003.
- Poland
  - Stage 1: exchange-rate based stabilization in 1990 with internal convertibility, initial administrative capital controls.
  - Mid-1991 onward: Securities and Foreign Investment Laws abolished most restrictions on FDI inflows and liberalized nonresident equity portfolio investment; liberalization of foreign investment in T-bills and T-bonds from 1992 to early 1994.
  - Drivers: public sector deficits (5.0 percent of GDP in 1992) and low central bank FX reserves (USD$3.5 billion in June 1993).
  - Subsequent stages included OECD-related obligations and gradual sequencing toward full float (2000) and adoption of inflation targeting (1998), aiding resolution of sterilization costs and overheating associated with earlier capital inflows.

*Sources: Enoch and Ötker-Robe (2007), Hilbers, Ötker-Robe, Pazarbasioglu, and Johnsen (2005), Kapteyn, Keller, and McGettigan (2005) in EBS/05/67, Ötker-Robe and Vávra (2007), Arvai (2005), IMF Country Reports (various countries and issues) and the national central banks of the countries included in this paper.*

### 1994. Among others, it required fulfilling obligations resulting from the OECD Codes of

### _wp07190 - 1994. Among others, it required fulfilling obligations resulting from the OECD Codes of

### Capital liberalization: legislative and regulatory timeline
- January 1995: a new FX Law became effective; it codified earlier ordinances liberalizing portfolio inflows and permitted the selling of Polish securities on international markets.
- Mid-1995: expansion of internal convertibility regulations to all CA transactions allowed Poland to accept the obligations resulting from IMF’s Article VIII.
- 1996 and early 1997: further progress via Ministry of Finance ordinances; residents were allowed to invest abroad in FDI, real estate, and financial instruments with maturities above 1 year; gradually increased ceilings on the volume of some operations leading to capital outflows were applied; commercial credit activities with maturities above 1 year were liberalized.
- End of 1996: Poland joined the OECD, obliged to remove remaining capital restrictions with the OECD countries by the end of 1999.
- Early 1999: a new FX Law became effective, codifying earlier liberalizations and abolishing remaining regulations of the internal convertibility system introduced at the beginning of the decade.
- April 2000: Poland switched to the floating exchange rate regime.
- By the end of 2002: the European Commission was to publish its opinion on Poland’s readiness to join the EU.
- Fall of 2002: a new FX Law became effective, meeting the requirements of the EU (and OECD) membership.

### Asymmetry and remaining restrictions
- Many capital controls remained in place after initial liberalizations; they were largely asymmetric, favoring inflows over outflows.
- After 1999 liberalization steps, restrictions on up to 1 year portfolio flows and up to 3 months deposit flows were retained, with a clear asymmetric bias toward promoting capital inflows and discouraging capital outflows.
- From a very restrictive, formal point of view, Poland still does not enjoy full capital liberalization as some minor restrictions remain, most importantly on short-term capital flows with the so-called third (i.e. non-EU and non-OECD) countries (Pietrzak 2003, p. 195).

### Financial-market openness instruments and international issuance
- January 1995 FX Law permitted selling Polish securities on international markets.
- 1995: the Ministry of Finance issued its first Eurobonds while Polish companies issued Global Depository Receipts.

### Institutional and external integration drivers
- OECD accession created obligations to remove capital restrictions with OECD countries by the end of 1999.
- EU accession requirements, including the freedom of capital movements, necessitated continued liberalization and changes in exchange rate regime.

*Italicized source: _wp07190 - 1994. Among others, it required fulfilling obligations resulting from the OECD Codes of (source content provided).*

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