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Emerging Europe: Managing Large Capital Flows

Conventional wisdom has been that capital flows are a blessing to emerging economies, bringing needed funds to countries where investments are most productive. But if history is any guide, capital flows have proven to be highly volatile—surging in good times and collapsing in gloomy ones.

The global financial crisis has renewed the debate over the desirability of capital flows to emerging economies. Adding fuel to this debate is the fact that two of the world’s largest emerging economies—China and India—have experienced strong growth and relatively limited fallout from the crisis, all the while maintaining hefty restrictions on the flow of foreign capital.

What can be done to ensure that emerging economies still benefit from productive foreign capital, while reducing the risks associated with highly volatile flows? Can we throw out the bathwater, but keep the baby?

The case of emerging Europe

In emerging Europe, the transition from planned economies to capitalism has resulted in a rapid and near-complete openness to trade and foreign capital. In the years before the crisis, foreign money flowed generously to the region and to banks in particular.

This precipitated a credit boom—with banks extending loans to households and firms on an unprecedented scale. Once the crisis hit, the boom turned to bust. And although the withdrawal of foreign capital was less aggressive than initially feared, it is clear that the large pre-crisis capital flows to the region were unsustainable and destabilizing.

Macroeconomic policy options

So, what are the options for dealing with large capital flows? The tradeoffs arising from macroeconomic policies are well-known:

An expanded toolkit

Since macroeconomic policies may not be enough to deal with massive inflows of foreign capital, the toolkit has to include other instruments.  Strengthening the prudential framework can help mitigate the adverse consequences of surging capital inflows, but other options—notably controls on capital inflows—may also need to be considered.

In emerging Europe, stronger prudential regulations could have gone a long way to reducing the credit boom fueled by foreign capital.

But what if foreign capital is not just flowing into banks? And what if it is, in fact, an unintended consequence of policies in other countries? In many countries in emerging Europe, companies besides banks borrowed directly from foreign investors. And some of the foreign funds that the region attracted came from investors in search for yield, given low interest rates in advanced economies. In such situations, capital controls could provide a useful remedy.

This means that controls need to be part of a broad package of policies to deal with large capital flows. It also means that they may be most effective as a temporary response to adverse spillovers or distortions in the global financial system that are also likely to be temporary.

What next for the new member states

Finally, let us not forget that the challenges facing the new member states, which are constrained in their ability to impose capital controls by the rules of the European Union. For some of these countries, greater use of prudential regulations—following Poland’s example—could be a first step. And given the broader debate underway on financial transactions taxes in international fora, such as the G-20 group of advanced and emerging economies, the new member states should consider whether this form of regulation would be appropriate for their economies and take part in the discussion.

The bottom line

In our highly globalized economy, large and rapid flows of money across borders are here to stay. The challenge for emerging economies is to find ways to manage these flows so that they don’t exacerbate boom-bust cycles, while still leaving the door open to productive (and hopefully stable) investment. This means using all available tools, particularly greater use of prudential regulations, and keeping an open mind when it comes to capital controls.

Note: also reproduced on Huffington Post.