The winds may fell the massive oak, but bamboo, bent even to the ground, will spring upright after the passage of the storm.
- Japanese Proverb
Capital flows to emerging market economies are a source of particular and enduring concern to many policymakers. As seen in the 1997-98 Asian crisis, surging inflows can fuel excessive credit growth, expanded current account deficits, appreciated exchange rates and a loss of competitiveness—followed by painful adjustment when the inflows reverse. Countries often fight these buffeting winds with tight controls on exchange rates, capital flow management and aggressive interest rate movements. While these sometimes work, and are sometimes the best response to a crisis, all too often countries can find themselves felled by the wind like the massive oak.
In the most recent World Economic Outlook we discuss an approach to dealing with volatile international capital flows that emphasizes the soft and flexible response to capital flows rather than the hard and oak-like. Instead of trying to resist foreign inflows, countries can bend. We find that the countries that proved to be more resilient to the turbulent gusts of international capital flows were not necessarily those that controlled the inflows, but those where foreign inflows were balanced by offsetting resident outflows.
What is soft is strong
But what does this look like in practice? What distinguishes countries where volatile capital inflows are balanced by offsetting resident outflows from those where they fuel destabilizing current account booms and busts?
We find that these countries typically have:
- strong institutions, such as independent inflation targeting central banks as well as fiscal policy rules that result in lower inflation and more countercyclical fiscal policy outcomes
- stronger financial supervision and regulation
- more flexible exchange rate regimes and limited restrictions on capital flows
We also find that these resilient emerging markets are not merely lucky: they face foreign inflows that are just as volatile as in less resilient economies, they are no more wealthy than less resilient economies and their shares of resources and manufacturing are similar. Significantly, we observe that many of these economies were once just as vulnerable to international capital flows as some of today’s economies. But, through a series of policy choices, they have been able to encourage much greater resilience in their economies.
Learning to bend with the wind
By looking closely at the process of transition in Chile, the Czech Republic, and Malaysia, we suggest steps that countries can take to develop their own resilience. Notably, we find that the transition can take place surprisingly quickly. Indeed, in some cases (such as the Czech Republic), countries were forced to adopt new policy regimes almost overnight as previous approaches proved unsustainable.
Each of the countries we study improved their prudential regulation to limit excessive risk taking by domestic financial institutions. The countries also took steps to encourage the development of their domestic financial systems. For example, in Chile, allowing pension funds to invest more of their assets overseas provided the catalyst for the development of foreign exchange derivatives markets that allowed both the pension funds and domestic firms to better manage their exposure to exchange rate fluctuations. While in Malaysia there was a very deliberate and staged process whereby domestic financial strength was built before gradual re-opening of the financial account.
Importantly, floating exchange rate regimes appear to be a key element in encouraging domestic residents to buffer foreign capital inflows. In countries with managed exchange rates, domestic residents commonly react in similar ways to foreign investors – moving capital overseas when foreigners are withdrawing and keeping capital at home when foreigners are piling in. Conversely, in countries with more flexible exchange rate regimes, exchange rate fluctuations seem to serve to encourage domestic residents to repatriate funds when foreign residents are leaving.
While the reasons for this balancing behavior are not yet fully understood, some theories suggest that this happens because domestic residents understand their own countries best. When foreigners are withdrawing, residents see buying opportunities because of their better knowledge of the economy. As Adam Smith put it over 300 years ago, “every individual endeavours to employ his capital as near home as he can… He can know better the character and situation of the persons whom he trusts, and if he should happen to be deceived, he knows better the laws of the country from which he must seek redress.”
In sum, countries should consider cultivating the qualities of bamboo when contending with the winds of international capital flows – by improving domestic policy institutions and providing the incentive and ability for private resident outflows to buffer volatile foreign inflows – so that, when they are subject to turbulent capital inflows, they bend rather than break.