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Old Dilemmas, New Challenges: Monetary Policy and Capital Flows into Emerging Economies

For all the talk today about capital flows into emerging economies, the topic has actually been debated for many years within the IMF.

For a decade or more, we have grappled with the idea that very large capital flows into successful emerging market countries were almost inevitable and would prove extremely difficult to manage.

And now, with capital flows becoming larger and more volatile, old policy dilemmas are resurfacing with even greater force.

Awkward dilemma

The argument went as follows:

Along the route from very large capital inflows to excessive current account deficits and eventual financial crises there would be numerous warning signs: very rapid credit expansion, much of it in foreign currency; asset price bubbles; a shift in resource allocation out of tradable goods and into nontraded assets (most obviously, housing); substantial private sector vulnerability to foreign exchange risk; and, finally, a sudden jump in market risk premiums, often for reasons unrelated to domestic policies.

Benign or dangerous?

Perhaps the most interesting part of this whole story is this generalization: different markets react to external forces at different speeds—asset markets much more quickly than product markets. And the speed of reaction is critical in determining the path an economy will take.

Theory becomes reality

Since these topics were first broached at a theoretical level, we have witnessed developments in a number of emerging economies in Europe that reinforce the concerns and underscore the implications for policy.

In the decade or so before the global financial crisis we saw very rapid growth in these economies. Until about 2003 this proceeded, for the most part, in a benign fashion—these countries were becoming more integrated into the advanced western European countries, and trade was booming. All was well.

But, then the warning signs emerged: capital inflows fueled excessive credit expansion, very large foreign exposures increased vulnerability, resources shifted out of tradable goods and into nontraded assets, real estate booms took off, and current account deficits widened.

The global financial turbulence prompted a reassessment of risk—a jump in market premiums—that interacted with the vulnerabilities in these emerging European economies to set off crises. Housing bubbles were pricked and burst, the foreign-financed bank credit dried up and wrought havoc on bank balance sheets.

But the underlying vulnerabilities, and thus the severity and duration of the downturn, differed substantially across this group of countries.

Live and learn

Two lessons may be learned from the experience.

First, the choice between fixed and flexible exchange rates is important, but perhaps not for reasons that are usually put forward.

Second, monetary policy—and policy to stabilize the economy more generally—needs substantial reinforcement. This is particularly true for countries with some inflexibility in their exchange rates because of their commitment to the euro or a particular path to euro adoption. Stabilizing the economy will require policymakers to be keenly attuned to financial conditions and to draw on a menu of policy options, combining the right structural reforms and macroeconomic policies with regulatory (both micro- and macro-prudential) instruments and taxes, and in some cases, even disincentives for foreign currency borrowing or lending.