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

_IMF Blog, April 21, 2011_

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## Bibliographic details
- Authors: Leslie Lipschitz
- Published: April 21, 2011

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### 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*

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## References

- [have grappled with the idea](http://www.imf.org/external/pubs/ft/fandd/2002/09/lipschit.htm)
- [substantial private sector vulnerability to foreign exchange risk](http://www.imf.org/external/pubs/ft/fandd/2007/03/lipsch.htm)
- [emerging economies in Europe](http://blogs.imf.org/2010/10/20/emerging-europe%e2%80%94lessons-from-the-boom-bust-cycle/)
- [menu of policy options](http://www.imf.org/external/pubs/ft/survey/so/2011/NEW040511B.htm)
- [macro-prudential](http://blogs.imf.org/2010/10/22/macro-prudential-policies-putting-the-%E2%80%9Cbig-picture%E2%80%9D-into-financial-sector-regulation/)

_Source: https://www.imf.org/en/blogs/articles/2011/04/21/monetary-policy-and-capital-flows-into-emerging-economies_