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Chapter 15Capital Inflows:

Macroeconomic Effects and Policy Responses

© Pierre-Richard Agénor and Peter J. Montiel

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Capital Inflows in the Early 1990s. Factors Driving Capital Inflows. Policy Responses: Issues and Evidence. Variations in Policy Responses. Macroeconomic Outcomes. Policy Lessons.

Capital Inflows in Early 1990s

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The Domestic and External Context. Characteristics of the New Inflows.

Magnitude. Timing. Regional and Country Destinations. Asset Composition. Sectoral Destination.

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The Domestic and External Context

Capital-inflow episode of the early 1990s emerged in different international environment from the previous episodes that started in the 1970s and the period 1982-89.

Period 1989-93 was a slow growth period in the industrial world. Rate of growth of real GDP for the G-7 countries: 4.4% in 1988; 2.8% in 1989-90; 1.1% in 1991-93.

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In the United States: Monetary policy was used in countercyclical fashion

during that period. Both nominal and real interest rates fell to low levels. Rates of return on other assets were also low. Short-term nominal interest rates peaked at 9.1% in

1989, and had fallen to 3.2% by 1993. Long-term rates fell by roughly half.

International trading environment: During 1988-93 developing countries experienced

adverse movements in their terms of trade. For developing countries in the aggregate, the

cumulative deterioration amounted to 5.5%.

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Exports from both Asia and Latin America grew rapidly at the outset of the inflow episode.

Regulatory environment in industrial countries: Financial liberalization made their capital markets more

hospitable to borrowers from developing countries. Several industrial countries relaxed regulations on

foreign public issues in their capital markets. Market credit rating standards for public bond issues

were eased in Japan, and minimum rating requirements were eliminated in Switzerland.

Regulatory environment in developing countries: Undertook substantial changes in policy regimes,

moving in the direction of improved macroeconomic management and widespread liberalization.

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Before the capital-inflow episode of the early 1990s, inflation and fiscal deficits had both been reduced, and the rate of economic growth had increased.

Export composition had become more diversified in many countries.

Removal of restrictions on foreign ownership which had impeded inflows of foreign direct investment.

Broader capital account liberalization was undertaken in a number of countries.

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Characteristics of the New Inflows

Magnitude Conceptual problems in measuring the size of capital

inflows: whether the relevant measure should capture both

private and official flows; whether flows should be measured on gross or net

terms; whether in addition to the changes in the liabilities of

domestic residents changes in their foreign assets should be included as well;

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if so, whether foreign exchange reserves should be considered as part of those assets.

Figures 15.1 to 15.3: net changes in the liabilities of domestic agents to foreign private creditors.

How large were the new inflows, and how did they compare to those that preceded the debt crisis?

They were large compared to those in the 1980s, but smaller than in the years preceding the 1982 debt crisis when measured as a proportion of exports or national product.

1990-94 as a basis for the measurement of capital inflows in the episode of the 1990s.

1978-81 as a basis for the measurement of capital inflows in the surge preceding the debt crisis, and debt crisis period 1982-89.

11Source: World Bank.1/ SSA: Sub-Saharan Arica; EAP: East Asia and the Pacific; LAC: Latin America and Caribbean; MENA: Middle East and North Africa; SA: South Asia; ECA: Europe and Central Asia.

Figure 15.1Annual Long-Term Private Capital Net Flows 1/

SSA

EAP

LAC

MENA

SA

ECA

0 20,000 40,000 60,000

US dollars

SSA

EAP

LAC

MENA

SA

ECA

0 10 20 30

% exports

SSA

EAP

LAC

MENA

SA

ECA

0 1 2 3 4 5 6

% GNP

1978-81 1982-89 1990-97

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Figure 15.2aCapital Flows to Developing Countries

(In billions of U.S. Dollars)

Source: International Monetary Fund.

19911992

19931994

19951996

1997-50

0

50

100

150

200

250

-50

Developing Countries

Net Direct Investment Flows

Net Portfolio Investment Flows

Other Net Flows

Net Official Flows Private Capital Flows {

19911992

19931994

19951996

1997-5

0

5

10

15

20

-5

Africa

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Figure 15.2bCapital Flows to Developing Countries

(In billions of U.S. Dollars)

Source: International Monetary Fund.

Net Direct Investment Flows

Net Portfolio Investment Flows

Other Net Flows

Net Official Flows Private Capital Flows {

19911992

19931994

19951996

1997-50

0

50

100

150

-50

Asia

19911992

19931994

19951996

1997-50

0

50

100

-50

Western Hemisphere

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Figure 15.3Sectoral Destination of Long-Term Private Capital Net Flows

(percentages)

Private sector38.3%

Public sector61.7%

1978-81

Private sector40.7%

Public sector59.3%

1982-89

Private sector70.1%

Public sector29.9%

1990-97

Source: World Bank.

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In the developing world, average capital inflows increased from their debt-crisis levels by 1.5% of GNP to reach almost 3% of GNP.

Most of the “surge” took place in 1992-93, when total inflows averaged 3.8% of GNP.

Although inflows over 1990-93 were smaller in relation to GNP than those observed prior to the debt crisis, over 1992-94 magnitudes were similar.

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For developing countries a break with prior experience is suggested in 1991 but is not clearly evident until 1992-93.

In some regions a discernible change occurred before that time.

New surge in capital inflows first became manifest in Asia, a region in which developing countries did not lose access to world capital markets during the period following the outbreak of the international debt crisis.

Inflows accelerated during 1988 in Thailand, during 1989 in Malaysia, and during 1990 in Indonesia.

Surge started later in Latin America.

Timing

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Calvo, Leiderman, and Reinhart (1992): Break in the capital inflow experience of this region

came in 1990, when total net inflows were U.S.$ 24 billion.

This was U.S.$ 15 billion as a peak during the post-debt crisis period 1983-89.

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Regional and Country Destination

Regional breakdown of capital inflows to developing countries reveals that the surge phenomenon was widespread, but was especially pronounced in East Asia and Latin America.

Figure 15.1: regional allocation of long-term private net flows, using the regional definitions employed by the World Bank.

“Surge” was primarily an East Asian and Latin American phenomenon.

Whether measured in absolute terms, as a percent of exports, or as a percent of GNP, the East Asian and Latin American regions received the bulk of capital inflows to developing countries during the 1990s.

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Within each region, inflows tended to be concentrated in several large developing countries.

Gooptu (1993): Over the period from 1989 to mid-1993, 85% of all

portfolio flows to East Asia were accounted for by China, Indonesia, Korea, and Thailand.

In Latin America Argentina, Brazil, Mexico, and Venezuela accounted for 95% of portfolio flows over the same period.

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Asset Composition

Figure 15.2: Estimates of the broad asset composition of the

portfolio of claims by private external investors on developing countries during the 1990s.

Decomposing the flows into foreign direct investment, portfolio flows, and other.

Episode of the 1990s was different from that of the 1970s.

Equity instruments, both direct and portfolio, played an important role in the 1990s.

Flows in the 1970s were dominated by debt instruments.

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Portfolio flows dominated the resurgence of capital inflows in the 1990s.

Reduced role of commercial banks during the 1990s is evident in the relatively small share of the category “other” among private capital flows during 1991-97 for all developing countries in Figure 15.2.

Trends away from commercial bank lending and in favor of portfolio and equity investment were geographically widespread.

Significant disparities are also apparent. Latin America: other debt flows were negligible, and

portfolio investment accounted for the majority of the new inflows.

East Asia: composition was more balanced, with FDI being the most important item.

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Although changes in FDI flows were significant in the aggregate, their regional distribution was not uniform.

Calvo, Leiderman, and Reinhart (1993): 44% of the increase in inflows was initially in the form

of FDI in Asia; FDI accounted for 17% of new inflows in Latin

America. Lack of uniformity in composition of inflows

characterized country experience. Bercuson and Koenig (1993): long-term flows accounted

for 45% of improvement in capital account in Thailand; 70% in Malaysia; all of the improvement in Indonesia.

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New flows were generally denominated in domestic currency, in contrast with the syndicated bank loans associated with the previous episode.

This means that, unlike in the earlier episode, external creditors were exposed to exchange-rate risk.

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Sectoral Destination

Figure 15.3: share of long-term private-source capital inflows that was directed to the private sector of the recipient economy.

Drastic change took place in the sectoral composition of capital inflows during the recent episode.

In the most recent episode, more than two-thirds of external financing went to the private sector, compared to only about two-fifths in the two earlier periods.

Factors Driving Capital Inflows

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“Pull” Factors, “Push” Factors, and Changes in Financial Integration. “Pull” Factors. “Push” Factors. Financial Integration.

The Empirical Evidence. An Assessment.

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“Pull” Factors, “Push” Factors, and Changes in Financial

Integration “Pull” factors attract capital from abroad as a result of

improvements in the risk return characteristics of assets issued by developing-country debtors.

“Push” factors operate by reducing the attractiveness of lending to industrial-country debtors.

Both factors can be operative in the context of a given degree of financial integration of the recipient country with world capital markets.

Third factor is a change in that degree of integration due to regulatory changes.

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Welfare implications associated with “push” and “pull” factors depend on the specific “pull” or “push” phenomena that are at work, rather than on whether the origin of the shock is domestic or external.

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“Pull” Factors

If social risk-return tradeoffs in the domestic economy are improved by economic reform, capital inflows attracted by higher domestic returns would be welfare-enhancing.

Reason: they reflect wealth-increasing borrowing for the financing of new high-yield domestic investment opportunities that

were not previously available and/or consumption smoothing motivated by reform-induced

increases in national wealth. Characteristics of claims on domestic agents by external

lenders may have improved due to removal of distortions creating gaps between social and private rates of return.

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Example: if debt-overhang problems created a gap between social and private rates of return in heavily indebted countries, then resolution of such problems in the context of Brady Plan agreements may have allowed private rates of return to reflect social returns

more accurately and thus helped to create the incentive for a renewed flow

of capital. Even an exogenous change in domestic portfolio

preferences may trigger welfare-enhancing capital inflows.

Example: Domestic money-demand shock could attract capital

inflows by causing the prices of domestic interest-bearing assets to fall.

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In this case, capital inflow makes it possible to accommodate the shift in domestic portfolio preferences and would be welfare-enhancing.

Dooley (1996): adoption of fixed exchange rates and deposit guarantees in the context of a liberalized but poorly supervised financial sector may create an opportunity for foreign lenders to reap high

and secure private rates of return; cause welfare to reduce.

Welfare implications of capital flows driven by “pull” factors depend on whether these reflect removal of a previously-existing distortion; exogenous change in an undistorted environment; introduction of a new distortion.

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“Push” Factors Most important “push” factor driving capital inflows to

developing countries: deterioration in the risk-return characteristics of assets issued by industrial-country debtors.

Examples: collapse of asset values in Japan; decrease in interest rates in the United States as a

result of stimulative monetary policy adopted in response to the 1990-91 recession;

reduction of interest rates in the United Kingdom after the pound dropped out of the ERM in September 1992.

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From the perspective of the developing country, this represents an external financial shock: for credit-constrained and heavily indebted countries,

the shock is a favorable one; but its cyclical origin makes it temporary.

Important question for policy in borrowing countries raised by shocks of this type: whether domestic private response is likely to optimally take into account the possibility of reversal.

Followings represent a change that favors lending to emerging markets for portfolio diversification reasons: increased role of institutional lenders such as mutual

and pension funds as financial intermediaries, increased importance of securitization.

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If this is the case, sustainability implications would be different from those associated with cyclical factors.

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Financial Integration

Resurgence of capital flows may reflect increased financial integration due to the removal or barriers impeding cross-border capital flows.

Such barriers may arise either as the result of policy choices or technological conditions affecting.

Capital-account liberalization was adopted in both industrial and developing countries at the onset of the capital-inflow episode of the 1990s.

Removal of distortions may be welfare-reducing, if previously existing restrictions reflected a second-best response to other distortions in the economy.

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The Empirical Evidence No general consensus on the importance of specific

factors in driving the current capital inflow episode. Works on causation have focused on identifying

whether the changes that triggered the recent capital-inflow episodes originated in the creditor or debtor countries.

Fernández-Arias (1996): Capital flows are assumed to potentially occur in the

form of transactions in various classes of assets, indexed by s, where s = 1,...n.

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Domestic return on an asset of type s: “project” expected return Ds;

“country creditworthiness” adjustment factor Cs between zero and one.

Project return: inversely related on the vector F of net flows to projects of all types.

Creditworthiness factor: negative function of the vector of the end-of-period stocks of liabilities of all types, S.

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Voluntary capital flows (components of the vector F) are determined by the arbitrage condition:

Ds(d, F)Cs(c, S-1 + F) = Rs(R),

Rs: opportunity cost of funds of type s in the creditor country, taken to depend on creditor-country financial conditions (proxied by long-term risk-free external interest rate R);

c, d: shift factors associated with country creditworthiness and with domestic economic climate.

Convention adopted is that the functions Ds, Cs, and Rs are increasing in these shift parameters.

Capital flows will be determined by c, d, and R.

(1)

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Components of F are increasing in d and c, but decreasing in R and S-1.

c reflects expected present value of resources available for external payments.

If such resources grow at rate g from an initial value W, c is given by:

c = W/(R - g).

When creditworthiness is sufficiently low, the solution entails extremely low capital inflows or capital outflows.

In this case: voluntary capital flows of such types would cease; condition would become an inequality no longer

determining the corresponding capital flows.

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This explains how inflows could be externally driven, yet not uniform across developing countries.

Empirical evidence has provided support for the role of R, c, and d in determining F.

Calvo, Leiderman, and Reinhart (1993): Domestic factors are important in attracting inflows. But such factors cannot explain

why inflows occurred in countries that had not undertaken reforms;

why when reforms were started earlier, inflows did not materialize till 1990.

Emphasize the role of external factors.

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Their formal analysis took the following form: Principal component analysis established a

significant degree of comovement among foreign reserves and real exchange rates for ten Latin American countries during 1990-1991.

First principal components of both the reserve and real exchange rate series displayed a large bivariate correlation with several U.S. financial variables.

In individual countries, Granger-causality tests frequently had reserves causing real exchange rates.

Structural VARs involving reserves, real exchange rates, and the first two principal components of the U.S. financial variables, suggested that

foreign factors exerted causal influences over the domestic variables;

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both variance decompositions and impulse response functions indicated that the foreign factors played a large role in accounting for reserve and real exchange rate movements.

Fernández-Arias (1996): Used the model described above to decompose post-

1989 portfolio inflows for thirteen developing countries into portions attributable to changes in c, d, and R.

He did this by regressing deviations in such flows from their 1989 values on corresponding deviations in external interest rate and price of debt on the secondary market.

Changes in international interest rates explain surges in capital inflows, accounting for over 60% of the deviation from the 1989 level.

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25% was due to changes in creditworthiness, 12% was due to improvements in domestic investment climate.

Role of external interest rates in determining secondary-market debt price (creditworthiness indicator): 86% of surge in inflows was attributed to movements in external interest rates.

Dooley, Fernández-Arias, and Kletzer (1994): Based on the decomposition of creditworthiness into

domestic and foreign components. Price of commercial-bank debt is a sensitive proxy for

capital inflows. Reason: shifts in the demand for claims on developing

countries should be reflected in these prices.

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Rather than explaining capital inflows directly, they accounted for the behavior of secondary-market prices on debt since 1989 which have risen markedly.

All of the increase in price could be accounted for by reductions in the face value of debt and international interest rates.

Schadler, Carkovic, Bennett, and Kahn (1993): While foreign phenomena may have been important,

they cannot be dominant for two reasons: Timing, persistence, and intensity of inflows varied

across countries, suggesting that investors have responded to changes in country-specific factors.

Surges in capital inflows were not universal within regions of developing countries, so external creditors have exercised some cross-country discrimination.

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Analytical framework described above is helpful in sorting out these issues.

Reduced-form solution for F from (1) for country i:

Fi = F(ci, di, R; S-1),

which implies

Fi = Fcdci + Fdddi + FRdR + FSdSi-1.

Partial derivatives of F depend on the country-specific values of c, d, and S-1, as well as on R.

Cross-country differences in capital-inflow variations are compatible with a primary role for the “push” factor R.

(3)

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Differences in the timing and persistence of changes in capital inflows suggest a role for changes in “pull” factors.

Separate branch of the “push-pull” literature has attempted to estimate (3) directly.

Chuhan, Claessens, and Mamingi (1998): Disentangled the roles of domestic and external factors

in motivating portfolio capital inflows. Used monthly bond and equity flows from the U.S. to

nine Latin American and nine Asian countries over the period January 1988 to July 1992.

Estimated separate panel regressions explaining bond and equity flows as functions of country-specific variables and external variables.

Bond flows responded strongly to country credit rating.

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Price-earning ratios were uniformly important. U.S. interest rates are significant with the theoretically

expected negative sign in all the regressions. Domestic and external variables have been equally

important in Latin America. But domestic variables were three to four times larger

than those of external variables in Asia for both bond and equity flows.

Problem: attribution of variation in country-specific financial variables to domestic shocks is improper (Fernández-Arias, 1996).

Reason: country creditworthiness, as indicated by the price of debt on secondary markets, is itself dependent on external factors.

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Hernández and Rudolf (1994): Examined the extent to which standard creditworthiness

indicators explain long-term capital inflows for twenty-two developing countries over the period 1986-1993.

They used two methodologies: Split their sample of countries into groups of high

capital inflow recipients and low capital inflow recipients. They found that the former

had domestic saving rates twice as large as the latter,

invested a much larger proportion of GNP, exhibited significantly lower fiscal deficits and

inflation rates,

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had lower stocks of debt, larger stocks of foreign exchange reserves and faster rates of export growth,

exhibited lower variability of inflation and real exchange rates,

scored lower on a political risk index. Estimated capital-flow equations for a broad category

of long-term flows as a function of lagged domestic consumption and investment

rates, external interest rates, ratio of net external debt to GNP, variability of the real exchange rate, presence of a Brady bond deal.

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They found statistically significant role for domestic creditworthiness indicators, but no role for the external interest rate.

World Bank (1997): Factors driving inflows have been changing over time,

and domestic factors may have played a more prominent role during 1994-1995.

Adopting the Calvo, Leiderman and Reinhart methodology, the Bank found that quarterly portfolio flows from the U.S. to 12 emerging

markets in East Asia and Latin America were characterized by substantial amount of co-movement during 1990-1993;

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first principal component of these series was negatively correlated with first principal component of a set of representative U.S. asset returns.

Findings are consistent with the findings of Calvo, Leiderman, and Reinhart for this period.

But, over 1993-1995, co-movements among portfolio flows became much weaker, correlation with U.S. asset returns reversed signs and became much weaker.

Implication: idiosyncratic country factors may have played a larger role in recent years.

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An Assessment Formal evidence strongly supports the “push” view that

falling U.S. interest rates have played an important role in driving capital flows to developing countries.

Strongest evidence for the “pull” view during the early years of the inflow episode is that provided by Hernández and Rudolf (1994).

But, their evidence is not inconsistent with the “push” view.

Their focus on long-term capital flows and the weight given to 1980-86 period in their data suggest that their results may primarily apply to FDI flows; are not necessarily applicable to other types of

capital flows.

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Importance of “push” factors does not preclude the relevance of “pull” phenomena: “push” factors may help to explain the timing and

magnitude of the new capital inflows; “pull'' factors are necessary to explain the geographic

distribution of flows during this time. Differences in capital inflow levels across countries and

within countries across time point to the importance of specific country characteristics for foreign capital flow.

Policy Responses: Issues and Evidence

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Policy Options. Restrictions on Gross Inflows. Encouragement of Gross Outflows. Trade Liberalization. Exchange-Rate Flexibility. Sterilization. Policies to Influence the Money Multiplier. Fiscal Contraction.

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Almost all of the developing countries that have participated in the capital inflow episode of the 1990s maintained officially-determined nominal exchange rate.

Macroeconomic challenge posed by arrival of capital inflows: possibility of such inflows to result in excessive expansion of aggregate demand, thus increase in domestic inflation and appreciation

of real exchange rate.

Mechanism through which inflows could have this effect:

With predetermined exchange rate, large capital inflows generate an overall balance of payments surplus.

Policy Options

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To avoid an appreciation of nominal exchange rate, the central bank has to buy the excess supply of foreign currency at the prevailing exchange rate.

Ceteris paribus, this would result in an expansion of monetary base.

Base expansion leads to growth in broader monetary aggregates, which would fuel expansion of aggregate demand.

This put upward pressure on domestic price level. With fixed nominal exchange rate, rising domestic

prices imply appreciation of real exchange rate.

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This chain can be broken by following policy intervention.

Policies designed to restrict the net inflow of capital, either by restricting gross capital inflows or promoting gross capital outflows: imposition of administrative controls on capital

inflows; elimination of a variety of restrictions on capital

outflows; widening of exchange rate bands with the intention of

increasing uncertainty . Policies that seek to restrict the net foreign exchange

inflow by encouraging a current account offset to a capital account surplus:

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trade liberalization; nominal exchange rate appreciation.

Policies that accept the reserve accumulation associated with a balance of payments surplus, but attempt to ameliorate its effects on the monetary base: sterilized intervention; limit recourse to the central bank's discount window.

Policies that accept an increase in the base, but attempt to restrain its effects on broader monetary aggregates: increases in reserve requirements; increases in quantitative credit restrictions.

Policies that accept a monetary expansion, but attempt to offset expansionary effects on aggregate demand: fiscal contraction.

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Key requirement for controls to improve welfare is the presence of a preexisting distortion that creates an excessive level of foreign borrowing.

Example: when act of foreign borrowing itself creates externalities.

If costs of default on international loan contract are shared by domestic agents other than the borrowing agent, foreign borrowing have negative external effects in domestic economy.

Since domestic agents do not internalize such effects, they will tend to overborrow.

Restrictions on Gross Inflows

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Capital controls cause agents to internalize the costs that their external borrowing impose on others: first-best policy intervention.

Second-best cases can be made for capital controls, when negative welfare consequences of a preexisting domestic distortion are magnified by external borrowing.

Example: distortions in the domestic financial system may

cause resources borrowed from abroad to be allocated in socially unproductive ways;

if distortion causing the problem cannot be removed, second-best option may be to limit foreign borrowing.

Efficacy of controls depend on a wide range of factors, including whether controls are imposed on inflows or outflows;

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controls have been imposed previously; their coverage is comprehensive or partial.

Effectiveness of controls differ both across countries as well as over time, making it difficult to draw general conclusions.

Dooley (1996): Controls can be effective in the sense of preserving

some degree of domestic monetary autonomy. But little evidence on that controls helped governments

meet policy objectives or improve economic welfare.

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Efficiency of restrictions on outflows: Evidence was mixed prior to inflow episode of the

1990s. Mathieson and Rojas-Suárez (1993): responses to fiscal

imbalances were slower, default risk were weaker in countries with strong capital controls.

Even if outflow restrictions are effective their removal may not have the desired effect of reducing net inflows.

Reason: act of removing such restrictions may attract additional inflows.

Two sets of arguments to suggest how this could happen.

Encouragement of Gross Outflows

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Labán and Larraín (1997): if future policies affecting the return on loans to

domestic agents are uncertain, the option to keep funds abroad becomes valuable.

Foreign creditors may thus refrain from lending. Removing the outflow restrictions eliminates the

irreversibility. This increases relative return on domestic lending

by eliminating the value of the option to wait. Bartolini and Drazen (1997):

Controls on outflows are often maintained for fiscal reasons.

Their removal is interpreted by foreign investors as a signal that future capital taxation is less likely.

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This induces capital inflows.

Optimality of restrictions on outflows: Liberalizing capital outflows should be one of the last

steps in economic liberalization. As long as domestic fiscal stability is not achieved,

reliance on revenues from financial repression would be necessary.

Financial openness reduces the revenues that can be collected from

financial repression, thus requires a higher rate of inflation to finance a

given fiscal deficit. Distortions introduced by a higher rate of inflation may

be more costly than those associated with controls on capital outflows (McKinnon and Mathieson, 1981).

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Trade Liberalization

This policy raises issues that concern efficacy. Trade liberalization lowers

domestic currency price of importables directly, price on nontradables indirectly.

If it induces a trade deficit, it absorbs some of the foreign exchange generated by the capital inflow, easing monetary pressures as well.

Effect of trade liberalization on trade balance depends on how saving and investment are affected.

Both theory and evidence suggest that the effects of trade liberalization on the trade balance are ambiguous, depending on

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structural characteristics of domestic economy: importance of nontraded goods, sectoral factor intensities, nature of accompanying fiscal policies, extent of labor market rigidities,

nature of the liberalization program: incidence of tariffs, their projected future paths.

Ostry (1991): Reduction in tariffs on intermediates results in short-run

real appreciation as traded goods sector expands, absorbing resources from the nontraded sector.

This real appreciation causes agents to expect a larger real depreciation, since future trade policy is unaffected.

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Thus, real interest rate rises, and consumption tilts toward the future, increasing domestic saving.

Increase in future consumption causes a future real appreciation which shifts capital from the traded to the nontraded sector in the future.

Since traded sector is more capital-intensive, implication: reduction in today's aggregate investment.

With saving higher and investment lower, the trade balance unambiguously improves.

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Exchange-Rate Flexibility This policy raises issues that concern optimality. Potential inflationary implications of capital inflows can

be avoided by refraining from intervention in the foreign exchange market.

Appreciation of nominal exchange rate dampens expansionary effect of foreign shock on domestic aggregate demand, by appreciating real exchange rate.

Capital inflow arising from a reduction in external interest rates becomes a deflationary shock under fully flexible exchange rates.

This is desirable if domestic macroeconomic conditions are such that policymakers seek to avoid stimulating aggregate demand.

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If capital inflows are permitted to materialize, desirability of foreign exchange intervention depends on the requirements for macroeconomic stability.

But tradeoff concerns implications for domestic resource allocation.

Appreciation of nominal exchange rate in response to capital inflows causes profitability of traded goods sector to be affected adversely.

Policymakers may have two reasons to be concerned with this outcome. If the capital inflow is temporary, appreciation of official exchange rate may aggravate

effects of domestic distortions biasing domestic resource allocation away from traded goods sector;

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since associated real exchange rate is also temporary, any costly resource reallocations would later have to be reversed.

Since such costs are fixed costs, associated resource reallocations would not be undertaken unless incentives for doing so were perceived to be long-lasting.

Since agents want to avoid costs of transitory resource reallocation, the noise introduced into relative price signals may reduce efficiency of resource allocation.

Besides to being an instrument of short-run stabilization policy, exchange rate also plays another role in small open economies (nominal anchor).

When exchange rate plays such a role, the issues are whether institutional arrangements are flexible to allow

the rate to move and, if so,

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whether perceptions of the authorities' anti-inflationary commitment would be jeopardized by an appreciation of the nominal rate.

Even an appreciation may convey the signal that the exchange rate is not immutable.

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Sterilization

Feasibility issues: By keeping domestic interest rates higher, sterilization

causes cumulative capital inflow: the higher the degree of capital mobility, the larger is accumulation of reserves.

Sterilized intervention has quasi-fiscal costs, since the central bank exchanges high-yielding domestic assets for low-yielding reserves. These costs will be greater the higher the degree of capital mobility; the larger the gap between domestic and foreign

rates of return. Even if sterilization succeeds in limiting domestic

monetary expansion, it may not insulate the economy from the effects of capital inflows.

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This is true under two sets of circumstances: If domestic interest-bearing assets are perfect

substitutes, insulation would fail if the shock that triggers the

inflows affects domestic money demand; in this case, with shifting money demand but fixed

supply, domestic interest rates would change. If domestic interest-bearing assets are imperfect

substitutes, capital inflow may be associated with

shift in the composition of demand for domestic interest-bearing assets,

increase in the total demand for such assets;

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in this case, unless composition of domestic assets emitted in sterilization operations matches that demanded by creditors, structure of domestic asset returns would be altered.

Empirical evidence: Most developing countries have been characterized by

imperfect capital mobility implies that sterilized intervention has been a viable policy option.

Studies have supported this conclusion. But, recent capital account liberalization may increase

effective degree of financial integration for the liberalizing countries.

Result: whether sterilization remains viable after liberalization is an open empirical question.

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Policies to Influence the Money Multiplier Monetary expansion can be avoided by commensurate

reduction in the money multiplier achieved through increase in reserve requirements or other restrictions on credit expansion by the banking

system.

Feasibility issues: Increases in reserve requirements may have little effect

if banks are already holding excess reserves. If reserve requirements are changed selectively for

different components of banks' liability portfolios, effects could be evaded as bank creditors shift to assets not affected by these changes.

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Even if changes in reserve requirements are applied broadly across bank liabilities, domestic credit expansion could materialize through nonbank institutions.

Optimality issues: Measures directed at the money multiplier avoid quasi-

fiscal costs, but do so through implicit taxation of the banking system.

Economic implications of this tax depend on how the tax burden is shared among bank shareholders, their depositors, and their loan customers.

Likely effect is to shrink the domestic financial system.

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Fiscal Contraction Stabilization of aggregate demand requires fiscal

contraction if domestic monetary expansion is not avoided, or expansionary financial stimulus is transmitted outside

the banking system.

Feasibility issues: Fiscal policy may prove too inflexible to be available as a

tool to respond to fluctuations in capital movements. Even if fiscal policy can be changed, the policy will be

effective only if expenditure cuts fall on nontraded goods.

79

Optimality issues: Two goals:

whether fiscal policy should be designed to anchor long-run expectations of inflation and taxation;

whether policy should have countercyclical objectives. These are not mutually exclusive, because short-run

deviations from the medium-term fiscal stance can be designed to achieve stabilization objectives.

Problem: if government credibility is lacking, adherence to the medium-term stance in the face of shocks may be the surest way to achieve it.

If stabilization objective is adopted, changes in marginal tax rates in response to temporary capital inflows should be avoided, since fluctuations in such rates would distort intertemporal choices.

Variations in Policy Responses

81

Sample of 14 developing countries that experienced surges in capital inflows during recent years.

They include Indonesia, Korea, Malaysia, the Philippines and

Thailand in East Asia, Argentina, Bolivia, Brazil, Chile, Colombia, Costa

Rica, and Mexico in Latin America. Egypt and Sri Lanka.

These countries accounted for over 70% of portfolio and direct investment flows to developing countries during 1989-93.

Summary of policy measures is provided by Montiel (1996).

82

Measures to Impede Gross Inflows. Encouragement of Gross Outflows. Measures to Reduce Reserve Accumulation.

Commercial Policy. Exchange-Rate Policy.

Measures to Restrict Base Money Growth. Reduction in the Money Multiplier. Restrictive Fiscal Policy.

83

Measures to Impede Gross Inflows

Quantitative restrictions on foreign borrowing. Sri Lanka: applied during 1993. Indonesia: restrictions on borrowing abroad by public

sector entities in 1991. Mexico: limits on banks' foreign currency liabilities. Malaysia: for several months during 1994, Malaysia

imposed quantitative restrictions on inflows, including restrictions on sales of securities abroad by domestic

nonfinancial enterprises; limits on bank foreign exchange liabilities.

84

Explicit or implicit taxes on external borrowing. Most common form: requirement that banks with foreign

exchange liabilities maintain a nonremunerated account at the central bank, equal to a specified ratio of such liabilities.

Adopted in Chile (1991 and subsequently), Colombia (1993), and Mexico (1991).

In these countries reserve requirements were supplemented with other measures to increase the cost of carrying foreign exchange liabilities.

Chile: stamp tax to foreign loans. Colombia: “commission” on the sale of foreign

exchange to the central bank. Thailand: extension of withholding taxes to interest paid

on foreign loans.

85

Malaysia: imposition of interest rate ceilings on deposits held by foreign institutions.

Brazil: explicit “Tobin taxes” introduced in November 1993.

Increasing the risk associated with foreign borrowing. Chile, Colombia, and Mexico adopted exchange rate

bands, and widened them during the inflow episode. Chile permitted extensive variation of the exchange rate

within its band. Other countries intervened more systematically within

the band to stabilize the path of the exchange rate. Indonesia (in 1991) restricted the use of swap facilities

by commercial banks and increased their cost.

86

Two notable features of these experiences: quantitative controls and taxes on gross inflows were

adopted after preferred alternative response had been weakened or abandoned,

capital controls have not necessarily become permanent once imposed.

87

Encouragement for Gross Outflows

Many countries relaxed controls on capital outflows. Korea has promoted foreign investment by domestic

residents. Korea, Malaysia, and Thailand have accelerated the

repayment of external debt. Thailand, Chile, and Colombia removed a number of

restrictions on capital outflows: permitting residents to invest abroad, removing restrictions on repatriation of capital and

interest by foreign direct investors,

88

elimination of ceilings on tourist expenditures by residents,

elimination of export surrender requirements, extension of the period for advance purchase of

foreign exchange by importers. The Philippines removed all restrictions on the use of

foreign exchange for both current and capital transactions.

In many cases these measures represented a continuation of a liberalization process already under way when inflows began to arrive.

89

Measures to Reduce Reserve Accumulation

Philippines, Thailand, Colombia and Costa Rica: reduced tariffs during the period of large inflows.

Commercial Policy

90

Exchange-Rate Policy

Several countries permitted nominal appreciation of their currencies.

This implies reduced intervention in the foreign exchange market

by the central bank, and thus less pressure on the monetary base arising from

reserve accumulation.

Three observations regarding the application of the policy:

No country abandoned a predetermined peg for a freely-floating regime over the course of the surge episode, except in response to a currency crisis.

91

Tradeoff between holding the exchange rate for the purpose of

stabilizing price expectations and allowing it to appreciate to absorb monetary

pressures

was resolved in the case of some countries by the use of exchange rate bands.

Brazil, Chile, Colombia, Indonesia, and Mexico: used bands to focus price expectations around the

predetermined central parity; allowed movements within the band to absorb

some of the pressure from capital inflows. Colombia, Indonesia, and Mexico introduced

exchange rate bands during their surge episodes.

92

Chile widened its previously existing band. In the sample of countries covered here, nominal

appreciation was more common in Latin America than in East Asia. This reflects a greater weight given to an inflation

than a competitiveness target. Relative weight given to price stability in Latin

America reflects ongoing stabilization efforts. Magnitudes of nominal appreciations have been small.

93

Measures to Restrict Base Money Growth

Most common response to the receipt of capital inflows: sterilized intervention.

This reflects the combination of exchange regime characterized by predetermined

official rates policy concern with inflation and real exchange rate

appreciation. All of the countries except Argentina and Bolivia

pursued sterilized intervention.

94

Forms of this intervention: open-market sales of government or central bank

securities, central bank borrowing from commercial banks, shifting government deposits from commercial banks

to the central bank, raising interest rates on central bank assets and

liabilities, curtailing access to rediscounts.

Transfers of government deposits to the central bank took place in Indonesia, Malaysia, and Thailand.

Philippines: government borrowed from the private sector in order to make deposits in the central bank.

95

Mexico placed its privatization proceeds in the central bank during 1991, thus sterilizing inflows by selling real assets.

Korea (1986-88) and Thailand (1989-90): reduction of access to the discount window.

Chile, Colombia, Indonesia, and Malaysia: aggressive in their pursuit of sterilization, seeking to offset all effects of capital inflows on the monetary base.

Chile later, Korea, Mexico, the Philippines, and Thailand: not so ambitious, seeking only to ameliorate effects on the base.

Countries that received substantial inflows used sterilized intervention often in the first year. Indonesia, Malaysia, Thailand, Mexico, and Egypt

continued the policy of sterilization longer.

96

Chile and Colombia eased monetary policy in the second year of capital-inflow episodes.

Country experience: intensity of sterilization was used in countercyclical fashion.

Important feature of the sterilization episodes: countries succeeded in keeping domestic interest rates high in spite of the capital inflows.

Result: sterilization remained a realistic option for these countries, at least in the short run.

But capital mobility is stronger in the long run, so sterilization may represent only a temporary option.

97

Reduction in the Money Multiplier Some forms of changes in reserve requirements:

altering required reserve ratios on all domestic-currency deposits;

raising marginal reserve requirements on foreign-currency liabilities of banks.

Increases in general reserve requirements: Korea (1988-90), Malaysia (1989-94), the Philippines (1990), Chile (1992), Colombia (1991), and Costa Rica (1993).

Restrictions on the expansion of specific types of lending: Korea, Malaysia, and Thailand.

Each of these economies had a long history of using directed credit as an instrument of monetary policy.

98

Among countries with higher reserve requirements, money multipliers during the surge period fell in Korea and Malaysia, were stable in the Philippines, Colombia, and Sri

Lanka, rose only in Chile.

99

Restrictive Fiscal Policy Latin America: since stabilization efforts involved fiscal

tightening, it is difficult to identify instances in which tight fiscal policy was used in response to capital inflows.

East Asia: fiscal tightening was an important component of the policy response in several countries that were not in the midst of an attempt to stabilize from high inflation.

Tightening occurred in Indonesia (1990-94), Malaysia (1988-92), the Philippines (1990-92), and Thailand (1988-93).

Macroeconomic Outcomes

101

How well did these measures succeed in preserving macroeconomic stability in the face of inflows?

Montiel (1996): overview of macroeconomic outcomes.

Sterilization: Official foreign exchange reserves rose in all countries

and, the increase was largest in those countries that relied heavily on sterilized intervention.

By contrast, the current account offset to capital inflows was largest in Argentina, Bolivia, and Costa Rica, all of which sterilized either weakly or not at all.

Surges in money growth were not universal or persistent.

Indonesia, Malaysia, Argentina, Bolivia, Chile, and Sri Lanka registered accelerations of base money growth on average over the surge period.

102

Thailand, Malaysia and Indonesia: broad money growth accelerated.

Base money: Base money growth accelerated on impact in several

countries before sterilization was undertaken in earnest. But once monetary policy adapted to the persistence of

inflows, recipient countries were successful in keeping base money growth in check.

Result: sterilized intervention has been employed successfully almost everywhere to retain control over the monetary base.

Money multiplier: In 7 of 14 countries, money multiplier increased.

103

This outcome runs counter to what would have been required to offset accelerated growth in monetary base.

Result: control of money supply growth has been achieved by restricting growth of the base, rather than by reducing money multiplier.

Asset markets: Stock prices surged during the early phases of the

episodes, both in Asia and Latin America. Result: controls, sterilization, and increases in reserve

requirements may not have succeeded in preventing transmission of expansionary demand shock.

In spite of widespread boom in asset markets, there were no instances in which inflation accelerated during the inflow episode.

104

Real exchange rate: Chile experienced a mild appreciation. Appreciation was strong in Argentina and Mexico. In Asia, countries avoided real appreciation, although it

was temporary in the Philippines. Inflation and real exchange-rate outcomes reflect

limited acceleration in the growth of monetary aggregates;

use of exchange rate as a nominal anchor. Fiscal restraint has played a role in avoiding stronger

real appreciation and more rapid inflation.

Current account: Increases in current account deficits have been

common during inflow episodes.

105

Larger deficits: Korea, Malaysia, the Philippines, Thailand, Argentina, Bolivia, Costa Rica, Mexico, and Egypt.

Latin America: half of the monetary impact of the capital account surplus associated with the inflow has been offset by an increase in the current account deficit.

Latin America: increases in current account deficits have accommodated a reduction in domestic saving.

East Asia: saving rates were stable.

Consumption: Some Latin American countries have experienced

consumption booms led by private sector consumption. In East Asia, only the Philippines experienced a similar

boom. Egypt has done so as well.

Policy Lessons

107

Lessons are those that have been drawn by observers of individual country

experiences; can be crudely inferred from cross-country patterns

of policy choices and macroeconomic outcomes. They concern policy effectiveness. Policies that attempt to intervene directly to limit net

capital inflows: capital controls and liberalization of outflows.

Capital controls: Potential costs: microeconomic distortions introduced

when such controls represent neither a first- nor second-best policy response.

Little evidence exists on the magnitude of such costs.

108

Countries that resorted to controls did so after having initially liberalized capital transactions, having reduced the application of other measures to

counter the effects of the flows. Whether controls generate any benefits depends on

their effectiveness. Controls can work, at least in some cases and at least

temporarily due to the fact that substantial inflows have followed the removal of

controls in several cases; inflows have slowed after controls were reimposed.

109

Liberalization of outflows: Two issues were raised:

Does liberalization matter, if previous restrictions were ineffective in constraining outflows anyway?

Are they effective in restraining net inflows, since they may attract more inflows at the same time that they promote outflows?

Episodic evidence: such restrictions may matter, but they may have little effect on net capital flows.

Country experience: substantial inflows followed the removal of restrictions on outflows in many countries.

Removal of outward restrictions did not represent a complete solution to the inflow problem.

Removal of restrictions on outflows may attract additional inflows.

110

Trade liberalization: In spite of the theoretical ambiguities, trade liberalization

is often inhibited by a perceived balance of payments constraint.

Surge of capital inflows gave several countries a good opportunity to pursue trade liberalization.

At least 8 of 14 countries examined did so (Montiel, 1996)

No instances of major reversals of trade liberalization can be documented for this group of countries.

Lessons concerning exchange rate policy: Adoption of exchange-rate band:

This combines nominal anchor function of the exchange rate with

111

mechanism to allow nominal exchange rate movements to absorb some of the pressures exerted by capital inflows in foreign exchange market.

None of the countries experienced acceleration of inflation due to additional flexibility allowed for nominal exchange movements.

Nominal exchange-rate adjustment was essentially confined to two countries (Chile and Colombia) in the group considered. Thus, real exchange-rate appreciation was affected

through price level adjustments. But, many countries avoided real appreciation over

the course of the surge episode.

112

Result: while real appreciation may be inevitable if inflows are sustained, the loss of competitiveness does not have to be absorbed immediately.

Link between real appreciation and emergence of current account deficits is not airtight: Avoiding real appreciation has not necessarily implied

avoiding current account deficits. Both countries that experienced very substantial real

exchange rate appreciation (Argentina and Mexico) exhibited large current account deficits.

Lessons concerning sterilized intervention: Important lesson: sterilization has been possible in spite

of capital account liberalization and of large magnitude of recent inflows.

113

Many countries registered an increase in domestic interest rates over the period of sterilization.

This may reflect the operation of “pull” factor increasing the domestic demand for money (see Frankel, 1994).

But, many countries did not sustain policies of aggressive sterilization consistently over inflow period.

Importance of fiscal rigidities that made the quasi-fiscal costs of sterilizing too burdensome cannot be dismissed as an explanation.

Shifts in domestic economic circumstances that made lower interest rates more attractive have also played a role.

114

Effectiveness of sterilization in insulating economies from the effects of external financial shocks is open to question. Sterilization does not have insulated recipient

economies from the effects of capital inflows. Asset markets, in particular, recorded massive

increases in value during the surge periods. This is consistent with imperfect-substitutability story.

Fiscal policy: It is not a flexible instrument in responding to inflows. Not many countries found it possible to engage in

additional fiscal tightening.

115

This may reflect a variety of factors, including “stabilization fatigue” arising from substantial fiscal

adjustment that many countries had already undertaken prior to the inflow episode,

political economy considerations that make it difficult to undertake fiscal austerity when the external constraint is not binding.

Absence of additional fiscal tightening may have played an important role with regard to outcomes for the real exchange rate.

Real appreciation was avoided in East Asian countries that tightened fiscal policy in response to inflows. Avoidance of real appreciation requires a fiscal

contraction.

116

Reason: to free up requisite supply of nontraded goods without a relative price change.

But, tighter fiscal policy was not sufficient to avoid a real appreciation. Real appreciation accompanied fiscal tightening in

Argentina and Egypt. But each of these countries was in the midst of

stabilizing from high inflation. It is likely that the behavior of the real exchange rate

reflected inflation inertia.

117

Appendix: Reduction in the World Risk-Free Inteest Rate in the Three-Good

Model Figure 15.4.

118

E

c

Dz

N

N

S'

S'

C

C

D

D

E'

A

H

L

M

Permanent shock

Figure 15.4aReduction in the World Risk-Free Interest Rate

Source: Agénor (1997, p. 30).

119

E

c

Dz

N

N

S'

S'

D

D

E'

A'H

L

M

Temporary shock

F

A

B'B

S

S

Figure 15.4bReduction in the World Risk-Free Interest Rate

Source: Agénor (1997, p. 30).