Old Dilemmas, New Challenges: Monetary Policy and Capital Flows into Emerging Economies
IMF Blog, April 21, 2011
Source details
- Canonical URL
- Old Dilemmas, New Challenges: Monetary Policy and Capital Flows into Emerging Economies
Other formats
Bibliographic details
- Authors: Leslie Lipschitz
- Published: April 21, 2011
Overview
- Author: Leslie Lipschitz
- Date: April 21, 2011
- Theme: Reassessment of policy challenges posed by large and volatile capital inflows into emerging market economies, drawing on recent experience in emerging European economies.
Awkward dilemma
- Core argument:
- Capital was scarce in emerging market economies relative to advanced economies, implying higher rates of return as technology and institutional effectiveness caught up.
- Higher returns, together with the likely strengthening of emerging market currencies, would probably elicit large capital inflows.
- Policy trade-offs for monetary authorities:
- If monetary policy raised interest rates to contain demand, this would attract more capital inflows and lead to correspondingly larger current account deficits.
- If interest rates were set relatively low to avoid inflows, domestic investment would far exceed saving, again producing large current account deficits.
- Role of market discipline:
- The dilemma could be resolved if market risk premiums took proper account of underlying vulnerabilities (like the size of the current account deficit), but this is conditional: “a rather big ‘if.’”
- Warning signs on the path from inflows to crises:
- 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
- a sudden jump in market risk premiums, often for reasons unrelated to domestic policies
Benign or dangerous?
- Historical views:
- Old view: capital inflows were wholly benign and helpful to development and growth by easing domestic financing constraints.
- New view: surges in capital inflows can have seriously detrimental effects.
- Mechanisms of harm:
- Easing of credit conditions raises asset prices, chiefly real estate prices, diverting resources away from domestic manufacturing.
- Overseas-funded bank loans can make real estate price increases self-reinforcing, leading to housing price bubbles and harm to export production.
Theory becomes reality
- Experience in emerging European economies:
- In the decade or so before the global financial crisis, rapid growth proceeded largely benignly until about 2003, driven by integration with advanced western European countries and booming trade.
- Later 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
- current account deficits widened
- The global financial turbulence produced a reassessment of risk—a jump in market premiums—that interacted with these vulnerabilities to trigger crises:
- housing bubbles were pricked and burst
- foreign-financed bank credit dried up and harmed bank balance sheets
- Outcome heterogeneity:
- underlying vulnerabilities, and thus the severity and duration of the downturn, differed substantially across these countries
Live and learn — policy implications and recommendations
- Exchange rate regime considerations:
- Fixed exchange rate regimes:
- A fixed exchange rate, insofar as it is seen as an exchange rate guarantee, encourages rapid inflows and foreign exchange exposure, exacerbating vulnerabilities.
- Under a fixed exchange rate it is very difficult to stop credit booms: rising inflation leads to a drop in real interest rates, further boosting demand for credit.
- Floating exchange rate regimes:
- Under a floating regime, countries can moderate excessive credit growth by letting the exchange rate strengthen.
- Exchange rate appreciation will lower inflation, keep real interest rates higher, and possibly elicit a perception of foreign exchange risk.
- Empirical contrast cited:
- Poland and the Czech Republic—both of which have floating exchange rates—managed to avoid much of the overheating that took place in fixed exchange rate countries like Latvia, Lithuania and Bulgaria.
- With much lower initial imbalances and vulnerabilities, Poland and the Czech Republic weathered the global crisis much better and have had much faster recoveries.
- Strengthening monetary and broader stabilization policy:
- Monetary policy—and policy to stabilize the economy more generally—needs substantial reinforcement, especially for countries with some inflexibility in their exchange rates because of their commitment to the euro or a particular path to euro adoption.
- Stabilization requires policymakers to be keenly attuned to financial conditions and to draw on a menu of policy options, including:
- the right structural reforms
- appropriate macroeconomic policies
- regulatory instruments (both micro- and macro-prudential)
- taxes
- in some cases, disincentives for foreign currency borrowing or lending
Source: Old Dilemmas, New Challenges: Monetary Policy and Capital Flows into Emerging Economies — Leslie Lipschitz, April 21, 2011