Emerging Europe: Managing Large Capital Flows

IMF Blog, February 19, 2010

Source details

Authors: some $500 billion in the pre-crisis years, investors lent the private sector roughly the same amount.
Published: February 19, 2010

Publication date: February 19, 2010
Central question: How can emerging economies benefit from productive foreign capital while reducing risks associated with highly volatile flows?
Context: The global financial crisis renewed debate about capital flows, noting that China and India experienced strong growth and relatively limited fallout while maintaining hefty restrictions on the flow of foreign capital.

Transition to openness: The transition from planned economies to capitalism produced rapid and near-complete openness to trade and foreign capital.
Pre-crisis dynamics: Large foreign inflows—especially to banks—fueled an unprecedented credit boom to households and firms.
Crisis outcome: The boom turned to bust when the global crisis hit; withdrawal of foreign capital was less aggressive than initially feared, but pre-crisis flows were unsustainable and destabilizing.

Exchange rate appreciation:
- Allowing appreciation can lead to overvaluation and is not an option for countries with exchange rate pegs.
- Interest rates can be cut to reduce pressures on the exchange rate, provided that inflation is not a concern.
Reserve accumulation:
- Accumulating international reserves can be effective if reserves are deemed too low.
- Unsterilized foreign currency purchases can increase domestic liquidity and create inflationary problems.
- Sterilized intervention can become self-defeating, as rising interest rates make the country a more attractive destination for foreign capital.
Fiscal policy:
- Fiscal tightening is an option but faces political and economic limits.
- Strong fiscal or external positions can attract even more inflows (example noted: reserves increased by some $500 billion in the pre-crisis years in Russia, and investors lent the private sector roughly the same amount).

Rationale: Macroeconomic policies alone may not be enough to manage massive inflows; the toolkit should include other instruments.
Strengthening prudential framework:
- Could have mitigated the credit boom fueled by foreign capital in emerging Europe.
Limiting foreign currency lending:
- Many loans in the boom years were denominated in foreign currency (such as Swiss francs) while borrowers had income in domestic currency, creating “currency mismatch” risk.
- Currency mismatch risks: large increases in loan payments for households when domestic currency depreciates; higher defaults that harm banks.
- Possible measure: limit or potentially ban foreign currency lending to borrowers without foreign currency income.
“Countercyclical regulatory requirements”:
- Require banks to hold extra capital in good times to serve as a buffer in bad times.
- Operational effect: banks have fewer funds to lend in good times, helping to dampen credit booms.
- Experience: countries that enacted such measures before the crisis had mixed success, suggesting a more aggressive effort may be needed going forward.

Rationale: When foreign capital flows to nonbank sectors or is driven by foreign policies (e.g., investors seeking yield due to low interest rates in advanced economies), capital controls can be useful.
Forms of capital controls to reduce investors’ returns:
- Direct tax (example: recently introduced in Brazil and Taiwan).
- Indirect tax (example: requirements that investors place a portion of invested funds in non-interest bearing accounts).
Limitations:
- Controls can be difficult to administer and can be circumvented.
- Effectiveness appears to decrease over time.
- Implication: controls should be part of a broad package of policies and may be most effective as a temporary response to adverse spillovers or temporary distortions in the global financial system.

Constraint: New member states are constrained in their ability to impose capital controls by the rules of the European Union.
Policy options:
- Greater use of prudential regulations (Poland cited as an example) could be a first step.
- New member states should consider whether financial transactions taxes would be appropriate and participate in international discussions, including those in fora such as the G-20.

Large and rapid cross-border flows are a persistent feature of a highly globalized economy.
Challenge for emerging economies: manage flows so they do not exacerbate boom-bust cycles while keeping the door open to productive and hopefully stable investment.
Recommended approach: use all available tools, with particular emphasis on greater use of prudential regulations, and maintain openness to capital controls as part of a broader policy package.

Source: Emerging Europe: Managing Large Capital Flows (February 19, 2010).