Global Policy Responses to Capital Flow Volatility

IMF Blog, December 23, 2020

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Publication date: December 23, 2020
Author: Annamaria Kokenyne
Virtual workshop organizers: Bank of England, Banque de France, International Monetary Fund and the Organization for Economic Co-operation and Development (OECD)
Central theme: the COVID-19 health and economic crisis highlighted the fickleness of capital flows and the need for an adequate policy toolkit to manage risks while maximizing benefits.

The sudden stop in portfolio flows to emerging markets in response to the COVID-19 pandemic was particularly pronounced compared to previous episodes of financial stress.
Record capital outflows led to depreciating exchange rates, higher funding costs and limited access to external financing in many emerging markets.
Advanced economies, including some euro area economies and Japan, also experienced significant non-resident sales of portfolio assets in March 2020.
The outflow of portfolio capital in emerging and advanced markets was sharp but short-lived, cushioned by:
- significant central bank actions including continued monetary easing;
- large-scale asset purchase programs and increased liquidity operations in advanced economies;
- foreign exchange interventions in emerging markets.
Banking inflows slowed sharply but the decline was lower than during the global financial crisis in 2008, reflecting:
- the resilience of a better-capitalized global banking sector;
- the release of counter-cyclical capital buffers by regulators.
The decline in foreign direct investment flows was even more pronounced than during the global financial crisis, reflecting growth concerns in emerging markets.

The 2008 global financial crisis exposed weaknesses and excessive risk-taking in the global financial system, particularly by banks, and spurred major regulatory reforms increasing banking system resilience.
Increased use of offshore financial centers to channel cross-border flows, including by multinational banking groups following greater banking regulation since the global financial crisis, highlights the importance of:
- continued international efforts to end tax avoidance and evasion;
- broadening the regulatory perimeter.
Low U.S. interest rates and accommodative monetary policy by major central banks since the global financial crisis have contributed to:
- greater risk-taking by global banks, as they lend more to riskier borrowers in emerging markets and advanced economies;
- a steady build-up of corporate and sovereign debt in emerging markets;
- housing price appreciation in several advanced economies driven by substantial capital inflows.
Evidence indicates that certain supervisory powers can materially dampen risk-taking; micro-prudential tools can have systemic effects and complement macroprudential policy in strengthening financial stability.

The nexus between the global financial cycle and extreme capital flow episodes (sudden stops, flights, retrenchments, and surges), as well as currency crises, is persistent.
A capital flows-at-risk framework can help policymakers understand tail events in capital flows and take early action to mitigate risks. The framework is informative about:
- risks posed by different types of capital flows;
- how flows are intermediated;
- the effectiveness of policy responses.
Policymakers increasingly rely on multiple policy instruments to deal with capital flow volatility, including:
- monetary policy;
- macroprudential policies;
- foreign exchange interventions;
- capital flows management measures.
Key policy questions for the IMF agenda on the Integrated Policy Framework include which policies—or combinations—are most effective in mitigating risks from sharp capital flow movements generated by global shocks, and the near- versus medium-term trade-offs of different policies.

The global nature of recent crises underscores the desirability of a coordinated international response to mitigate cross-border spillovers and the need to address risks posed by economic agents outside the regulatory perimeter, in particular nonbank financial intermediaries.
Recent multilateral initiatives helping mitigate risks include:
- swap lines between the U.S. Federal Reserve and some foreign central banks;
- enhanced IMF lending facilities;
- efforts to coordinate regulatory responses, including on nonbank financial institutions under the umbrella of the Financial Stability Board;
- the G20 Debt Service Suspension Initiative for the poorest countries.
Discussions in international fora cited as facilitating the design of appropriate policy responses include:
- the G20 International Financial Architecture Working Group;
- the Advisory Task Force on the OECD Codes in relation to the OECD’s Capital Movements Code;
- the IMF in relation to its institutional view on capital flows.

The full list of authors: Annamaria Kokenyne, Gurnain Pasricha (IMF); Annamaria De Crescensio, Etienne Lepers (OECD); Dennis Reinhart, Ambrogio Cesa-Bianchi, Mark Joy (Bank of England); Julia Schmidt (Banque de France).
The views expressed are those of the authors and do not necessarily represent the views of the corresponding institutions.

Global Policy Responses to Capital Flow Volatility — Annamaria Kokenyne, December 23, 2020

The Liberalization and Management of Capital Flows
- The Liberalization and Management of Capital Flows (Markdown version)
- The Liberalization and Management of Capital Flows (PDF)