Managing Capital Flows in Frontier Economies
IMF Blog, April 29, 2015
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Bibliographic details
- Authors: Jonathan D Ostry, Mahvash S Qureshi, Atish Rex Ghosh
- Published: April 29, 2015
Overview
- Authors: Jonathan D. Ostry, Mahvash S. Qureshi, Atish Rex Ghosh
- Date: April 29, 2015
- Key premise: Private financial flows to frontier economies have increased markedly and, relative to their economic size, are now on par with those to emerging economies.
- Risk profile: These large private flows can be volatile—responding strongly to changes in global conditions—and generate financial-stability and macroeconomic risks.
- Near-term risk driver: The anticipated rise in U.S. interest rates sometime this year is expected to create macroeconomic volatility for both emerging and frontier economies.
Heterogeneity in liberalization approaches ("No one-size-fits-all")
- Observed policy diversity among frontier economies:
- Bangladesh: more cautious stance; allows flows into the tradable sector, regulates foreign investors’ access to the financial sector, and has so far refrained from issuing sovereign bonds in international markets.
- Uganda and Zambia: largely open financial accounts and increasingly face macroeconomic challenges—notably exchange rate overshooting—from volatile portfolio flows that appear to overwhelm their domestic financial markets.
- Ghana: pace of liberalization slowed after large capital inflows induced fiscal excesses and volatility in the exchange rate.
- Finding: Frontier economies have not taken a “one-size-fits-all” approach toward the pace and extent of capital account liberalization.
"Pragmatic" approach to liberalization
- Theoretical tension:
- Standard argument: Developing countries benefit from liberalization because foreign saving helps finance investments when countries are saving-constrained.
- Dani Rodrik’s view: Many frontier economies are more likely to be investment-constrained rather than saving-constrained; liberalization that strengthens the currency can harm tradable-goods industries and undercut growth, arguing for structural capital controls and a “pragmatic” approach to financial integration.
- Olivier Jeanne’s note: There may be a tension between the exchange rate level desirable for economic growth and the one produced by financial markets upon opening to foreign flows.
- Empirical example: China achieved impressive growth and graduated from frontier to emerging economy status in the last twenty years without fully opening up its capital accounts.
Institutional challenges to managing flows
- Institutional weaknesses complicating management of large inflows:
- Lack of central bank independence.
- Public debt sustainability concerns (in some frontier economies, much of the flows represent foreign borrowing by governments).
- Weak financial supervision and regulation.
- Policy implication: Frontier economies with largely or fully open capital accounts could potentially benefit from rolling back liberalization in the form of additional regulation of more fickle types of capital flows.
Lessons from emerging economies
- Policy toolkit for managing volatile capital flows (drawn from emerging economy experience):
- Monetary policy geared to meeting the inflation target.
- Foreign exchange intervention (used to counter currency appreciation pressures and to the extent sterilization costs are manageable and monetary policy credibility is not jeopardized).
- Prudential measures or capital controls, as appropriate.
- IMF stance: The IMF has recognized the role for capital controls to mitigate financial-stability risks.
- Divergent views: Some experts, such as José de Gregorio, remain skeptical of capital controls and foreign exchange intervention and argue that the first line of defense is sound macroeconomic policies (inflation targeting; fiscal prudence; greater exchange rate flexibility) and prudential measures.
Capital controls vs. macroprudential measures
- Evidence and research needs:
- Recent studies point to the effectiveness of capital controls and prudential measures in mitigating financial-stability risks.
- More research is warranted to evaluate effectiveness across contexts: more versus less financially developed systems; inflow versus outflow shocks; different types of capital flows—direct investment, portfolio equity, portfolio debt, or banking flows.
- Practical recommendation (Dani Rodrik): Create an inventory of capital controls and prudential measures tailored to different circumstances; these measures should be monitored, evaluated, and revised as needed.
Open questions and next steps
- Persistent policy questions highlighted:
- Is more liberalization always desirable, or might it frustrate other economic goals, including income convergence with high-income countries?
- Does full liberalization expose frontier markets (FMs) to a greater risk of destabilizing shocks that are difficult to manage in practice, and outweigh the benefits of financial integration, or can such risks be offset by more vigorous deployment of different policy tools?
- What is the role, right combination, and possible effectiveness of different policy tools—including foreign exchange intervention and capital controls—to manage capital flow volatility?
- Conclusion: More research and debate are needed; peer-to-peer discussions and exchange of policy information among policymakers, academics, and financial sector experts are valuable steps forward.
Source: Managing Capital Flows in Frontier Economies (April 29, 2015).
Content in this bundle
- The Liberalization and Management of Capital Flows — Institutional View
- Managing Capital Flows in Frontier and Emerging Markets: Wh At Are the Lessons?
- Managing Capital Flows: Lessons from Emerging Markets for Frontier Economies
- Managing Capital Flows in Frontier and Emerging Markets: The Case of Zambia
- Kasekende
- Kazemi
- Narh
- Managing Capital Flows in Frontier Market Economies
