Taming Volatile Capital Flows in Emerging Economies

By Grenville, Stephen | Agenda: A Journal of Policy Analysis and Reform, April 1, 2012 | Go to article overview

Taming Volatile Capital Flows in Emerging Economies


Grenville, Stephen, Agenda: A Journal of Policy Analysis and Reform


Just about all economists agree that international trade in goods and services is beneficial and should be unrestricted. There is much less unanimity, however, on the benefits of international capital flows. The volatility and 'sudden stops' experienced over recent decades, especially in emerging economies, have provoked some rethinking. It is argued here that this re-think has much further to go before the analytical discussion fits the reality of capital-flow behaviour and policy comes to grips with the challenge of living with capricious capital flows. Flows to East Asian emerging economies illustrate the argument.

Prologue

The attitude to international capital flows has changed markedly since Bretton Woods established the framework and norms for international transactions after World War II. At the time of Bretton Woods (and for more than two decades afterwards) it was widely accepted that capital flows might be disruptive and should be treated differently from trade flows. Controls were not only acceptable, but were the norm.

With generalised floating of exchange rates in 1971, capital flows came to be seen as part of the equilibrating process, the more so because market-based outcomes had become the intellectual norm. The central policy message was that flows should be unimpeded by regulation or restrictions. Advocacy of unregulated capital flows reached its peak in 1997, with efforts to incorporate free capital flows into the IMF Articles, on a par with the commitment to free trade in goods and services (see IMF Independent Evaluation Office 2005).2

Now, a rethinking is under way, best illustrated by the IMF's shifting position. For decades a proselytiser for free capital flows, the active debate by the IMF staffover the past two years recognises the potential downside of excessive capital flows (Ostry et al. 2010; 2011). Even the more staid IMF Executive Board is prepared to countenance measures to manage flows (IMF 2012(a) and 2012(b)).

Other international institutions are also exploring new ways of thinking about capital flows (at the Bank for International Settlements; see Borio and Disyatat 2011). These changes in mindset occur slowly, with some largely oblivious to the shift(see, for example, Yellen 2011).

The analytical framework

Neither the Mundell/Fleming framework (the workhorse of much policy thinking) nor the academically more-favoured intertemporal3 framework specifically addresses what is happening in financial markets. It is here, in sometime-aberrant market behaviour, that much of the volatile action and puzzles are to be found. It's often useful to think of these flows in the same way that financial markets view them, in terms of portfolio balance. Capital flows to where the (risk-adjusted) expected returns are highest.

This portfolio-based approach needs to be reconciled with the national accounts. Capital flows are, of course, identically equal to the savings/investment balance and also the current-account balance.4 Some general equilibrium process is needed to reconcile the different factors driving portfolio balance and the national accounting components. That said, capital flows have often been seen as the passive equilibrating mechanism which would, to a large extent, allow the national accounts components (consumption, savings and investment) to be the main determinants of the general equilibrium outcome. All that seemed to be required to make this work satisfactorily were well-functioning financial markets and capital flows which are unrestrained by regulation or controls. This was, indeed, the thrust of policy advice, particularly from the IMF. Where this narrative has departed from reality is that financial markets have not always been well-functioning.

What are the characteristics of capital flows in practice?

The flows are very volatile: The Mexican crisis (1994-5) and the Asian crisis (1997-8) demonstrated that capital flows were not a smooth equilibrium process with well-defined parameters, largely determined by interest differentials and stable exchange rate expectations. …

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