Bending with the Winds of International Capital Flows
IMF Blog, September 30, 2013
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Bibliographic details
- Authors: John Simon
- Published: September 30, 2013
Overview
- Author: John Simon
- Date: September 30, 2013
- Central metaphor: Compare rigid resistance to volatile capital inflows (massive oak) with flexible adaptation (bamboo) that bends and springs back after shocks.
- Core proposal: Emphasize soft and flexible responses to volatile international capital flows that encourage domestic resident outflows to offset foreign inflows, rather than hard resistance (tight controls, fixed exchange rates, aggressive interest rate moves).
Key findings
- Historical concern: Surging inflows can fuel excessive credit growth, expanded current account deficits, appreciated exchange rates, loss of competitiveness, and painful adjustment when inflows reverse (as seen in the 1997-98 Asian crisis).
- Resilience is associated with offsetting resident outflows rather than merely controlling foreign inflows.
- Resilient countries experienced foreign inflows that were "just as volatile" as less resilient peers, and were not wealthier nor structurally different in resource or manufacturing shares.
- Transition to greater resilience occurred in some countries and can happen quickly (example: Czech Republic forced to adopt new policy regimes almost overnight).
- Exchange rate regime matters:
- More flexible exchange rate regimes encourage domestic residents to repatriate funds when foreigners are leaving and to behave differently from foreign investors.
- Managed exchange rates tend to produce parallel resident behavior with foreign investors (residents pull funds out when foreigners withdraw and keep funds at home when foreigners pile in).
Institutional and policy characteristics of resilient countries
- Strong institutions, including:
- Independent inflation targeting central banks
- Fiscal policy rules that result in lower inflation and more countercyclical fiscal outcomes
- Stronger financial supervision and regulation
- More flexible exchange rate regimes and limited restrictions on capital flows
- Development of domestic financial systems and instruments (e.g., foreign exchange derivatives) to allow residents and firms to better manage exchange rate exposure
- Prudential regulation to limit excessive risk taking by domestic financial institutions
- Deliberate, staged processes to build domestic financial strength before gradual re-opening of the financial account (example cited: Malaysia)
Case studies and transition pathways
- Chile:
- Allowed pension funds to invest more of their assets overseas, catalyzing development of foreign exchange derivatives markets and improving risk management for pension funds and firms.
- Czech Republic:
- Underwent rapid policy regime change when previous approaches became unsustainable; demonstrates speedy transition is possible.
- Malaysia:
- Employed a deliberate, staged approach building domestic financial strength before gradual re-opening of the financial account.
Theoretical explanations for resident buffering behavior
- Hypothesis: Domestic residents understand their own countries better and see buying opportunities when foreigners withdraw, prompting repatriation of funds.
- Historical reference: Adam Smith—“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.”
- Mechanism not fully understood; exchange rate flexibility appears to play a key role in incentivizing resident offsets.
Policy recommendations and implications
- Favor policies that cultivate flexibility and domestic capacity to buffer capital flow volatility:
- Strengthen monetary and fiscal institutions (independent inflation targeting central banks, fiscal rules).
- Improve financial supervision and regulation to limit excessive risk taking.
- Develop domestic financial markets and risk-management instruments (e.g., FX derivatives).
- Adopt more flexible exchange rate regimes and avoid excessive restrictions on capital flows where appropriate.
- Sequence liberalization carefully: build domestic financial strength before fully opening the financial account.
- Objective: Encourage resident outflows that offset foreign inflows so economies "bend rather than break" when subject to turbulent capital inflows.
Source: Bending with the Winds of International Capital Flows — John Simon, September 30, 2013