All Hands on Deck: Confronting the Challenges of Capital Flows
IMF Blog, August 2, 2017
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Bibliographic details
- Authors: Atish Rex Ghosh, Jonathan D Ostry, Mahvash S Qureshi
- Published: August 2, 2017
Overview
- Authors: Atish Rex Ghosh, Jonathan D. Ostry, Mahvash S. Qureshi.
- Date: August 2, 2017.
- Data: Quarterly data over 2005–13.
- Central question: Do emerging market economies adopt a proactive approach in practice to manage capital inflows and avoid crises when flows recede?
Menu of policies
- Five policy tools available to emerging market policymakers:
- Monetary policy.
- Fiscal policy.
- Exchange rate policy (including foreign exchange intervention).
- Macro-prudential measures (examples: reserve requirements, capital adequacy ratios, dynamic loan loss provisioning).
- Capital controls (on inflows and outflows).
- Mapping of instruments to risks:
- Monetary and fiscal policies address inflation and economic overheating.
- Foreign exchange intervention limits currency appreciation that threatens competitiveness when the currency is not undervalued.
- Macroprudential measures curb excessive credit growth and related financial stability risks.
- Capital inflow controls limit volume of inflows or tilt composition toward less risky liabilities.
- Capital outflow controls can be relaxed to lower net flows and reduce overheating and appreciation pressures.
Proactive central bank response
- Finding: Emerging markets’ central banks respond to capital flow volatility rather than remain indifferent.
- Foreign exchange intervention:
- Reserve accumulation strongly corresponds to net inflows.
- On average, emerging markets’ central banks purchase some 30–40 percent of the inflow.
- Heavier intervention observed in some Asian and Latin American economies (examples: India, Indonesia, Malaysia, Brazil, Peru).
- Lower intervention observed in others (examples: Mexico, South Africa).
- Monetary policy:
- Capital inflows elicit higher policy rates on average.
- The monetary response depends on inflation, the output gap, and the real exchange rate.
- Policy rates are raised in response to higher inflation or a larger output gap (counter-cyclical stance).
- Policy rates are lowered in response to real exchange rate appreciation.
Procyclical fiscal policy
- Finding: Fiscal policy stance is strongly procyclical in the face of capital inflows.
- Observed behavior:
- Government consumption expenditure rises as capital inflows surge.
- Government consumption expenditure falls as capital inflows decrease.
- Possible explanations:
- Political economy constraints.
- Difficulty accessing international credit markets in bad times.
Less orthodox policies (macroprudential measures and capital controls)
- General pattern:
- Macroprudential measures and capital controls on inflows are generally tightened as inflows surge and relaxed when flows recede.
- Cross-country variation:
- Countries that tend to tighten these measures more often include Brazil, Korea, Turkey.
- Capital outflow controls:
- These measures are relaxed when inflows surge, but primarily in countries without fully open capital accounts (examples: India, South Africa).
Natural mapping between risks and instruments
- Observed correspondences:
- Foreign exchange intervention is generally used when the real effective exchange rate is appreciating.
- Monetary policy tightening is driven more by the output gap.
- Macroprudential measures are deployed in response to rapid domestic credit growth.
- Inflow controls are tightened when both credit growth and currency appreciation are concerns.
Bottom line and open questions
- Summary findings:
- Many emerging markets have internalized the need to manage capital flows to benefit from financial globalization while minimizing risks.
- Emerging markets typically deploy a combination of instruments, with some correspondence between the nature of the risk and the tool deployed.
- Important differences in policy response persist across countries, even in similar macroeconomic circumstances.
- Implication: Structural characteristics and political economy considerations likely shape country-specific policy responses.
- Open research question: Whether active policy management by emerging economies has contributed to fewer financial crises in recent years remains to be determined; future research is needed.
Source: All Hands on Deck: Confronting the Challenges of Capital Flows, Atish Rex Ghosh, Jonathan D. Ostry, Mahvash S. Qureshi, August 2, 2017.
