Emerging Europe: Managing Large Capital Flows

By Marek Belka

Conventional wisdom has been that capital flows are a blessing to emerging economies, bringing needed funds to countries where investments are most productive. But if history is any guide, capital flows have proven to be highly volatile—surging in good times and collapsing in gloomy ones.

The global financial crisis has renewed the debate over the desirability of capital flows to emerging economies. Adding fuel to this debate is the fact that two of the world’s largest emerging economies—China and India—have experienced strong growth and relatively limited fallout from the crisis, all the while maintaining hefty restrictions on the flow of foreign capital.

What can be done to ensure that emerging economies still benefit from productive foreign capital, while reducing the risks associated with highly volatile flows? Can we throw out the bathwater, but keep the baby?

The case of emerging Europe

In emerging Europe, the transition from planned economies to capitalism has resulted in a rapid and near-complete openness to trade and foreign capital. In the years before the crisis, foreign money flowed generously to the region and to banks in particular.

This precipitated a credit boom—with banks extending loans to households and firms on an unprecedented scale. Once the crisis hit, the boom turned to bust. And although the withdrawal of foreign capital was less aggressive than initially feared, it is clear that the large pre-crisis capital flows to the region were unsustainable and destabilizing.

Macroeconomic policy options

So, what are the options for dealing with large capital flows? The tradeoffs arising from macroeconomic policies are well-known:

  • Exchange rate appreciation. Allowing the exchange rate to appreciate can lead to overvaluation and is not an option for countries with exchange rate pegs. To reduce pressures on the exchange rate, interest rates can be cut, provided that inflation is not a concern.
  • Reserve accumulation. Accumulating international reserves can be effective for a while if reserves are deemed to be too low. However, if purchases of foreign currency are unsterilized—if they increase domestic liquidity—inflation may become a problem. And sterilized intervention can become self-defeating, as rising interest rates create a more attractive destination for foreign capital.
  • Fiscal policy. Fiscal policy can be tightened, but there are limits (both political and economic). And strong fiscal or external positions can end up attracting even more inflows. Just look at Russia—as reserves increased by some $500 billion in the pre-crisis years, investors lent the private sector roughly the same amount.

An expanded toolkit

Since macroeconomic policies may not be enough to deal with massive inflows of foreign capital, the toolkit has to include other instruments.  Strengthening the prudential framework can help mitigate the adverse consequences of surging capital inflows, but other options—notably controls on capital inflows—may also need to be considered.

In emerging Europe, stronger prudential regulations could have gone a long way to reducing the credit boom fueled by foreign capital.

  • Limiting foreign currency lending. Many of the loans to emerging European households in the boom years were denominated in foreign currency (such as Swiss francs), even though these households only had income in domestic currency. This type of “currency mismatch” created significant risks not only to households—who faced very large increases in their loan payments when their currency depreciated—but also to banks—because when households could no longer afford their loans, they defaulted. Thus, one possible prudential measure would be to limit (or potentially ban) foreign currency lending to borrowers without foreign currency income.
  • “Countercyclical regulatory requirements.” Put simply, these require banks to hold extra capital in good times that would serve as a buffer in bad times. Operationally, these requirements mean that banks would have fewer funds to lend out in good times, which would help to dampen a credit boom. Countries that took such measures in the run-up to the crisis had mixed success, but this might mean that a more aggressive effort may be needed going forward.

But what if foreign capital is not just flowing into banks? And what if it is, in fact, an unintended consequence of policies in other countries? In many countries in emerging Europe, companies besides banks borrowed directly from foreign investors. And some of the foreign funds that the region attracted came from investors in search for yield, given low interest rates in advanced economies. In such situations, capital controls could provide a useful remedy.

  • Capital controls to reduce investors’ returns. Such capital controls can be in the form of a direct tax (such as the ones recently introduced in Brazil and Taiwan) or an indirect tax (such as requirements that investors place a portion of the invested funds in non-interest bearing accounts).
  • Temporary in nature? But capital controls are not a panacea—they can be difficult to administer, they can be circumvented, and their effectiveness appears to decrease over time.

This means that controls need to be part of a broad package of policies to deal with large capital flows. It also means that they may be most effective as a temporary response to adverse spillovers or distortions in the global financial system that are also likely to be temporary.

What next for the new member states

Finally, let us not forget that the challenges facing the new member states, which are constrained in their ability to impose capital controls by the rules of the European Union. For some of these countries, greater use of prudential regulations—following Poland’s example—could be a first step. And given the broader debate underway on financial transactions taxes in international fora, such as the G-20 group of advanced and emerging economies, the new member states should consider whether this form of regulation would be appropriate for their economies and take part in the discussion.

The bottom line

In our highly globalized economy, large and rapid flows of money across borders are here to stay. The challenge for emerging economies is to find ways to manage these flows so that they don’t exacerbate boom-bust cycles, while still leaving the door open to productive (and hopefully stable) investment. This means using all available tools, particularly greater use of prudential regulations, and keeping an open mind when it comes to capital controls.

Note: also reproduced on Huffington Post.

5 Responses

  1. Concerning foreign currency lending.

    Which measure looks better, more pragmatic
    – to ban / limit foreign currency lending through regulations
    – or to keep monetary policy, such that the perception of exchange rate risk is much greater that perception of interest rate risk and thus disencourage people to have debt in CHF ?

  2. […] historically opposed to capital controls, finding them costly and ineffective. But the IMF blog, iMFDirect, recently softened. “Large and rapid flows of money across borders are here to stay,” […]

  3. There is a very fine balance between the necessary reduction of the margin between emerging markets borrowings, which is due to the biased rating they get from the rating agencies, and their developed counterparts. That is of course welcome.

    The currency and equity markets might find it less appropriate.

    • Credit rating agencies should be free to rate as they believe they should rate… what should not be allowed though is for the regulators to potentiate whatever bias the credit rating agencies might have with their capital requirements for banks:

      Capital Requirements (CR) for banks on sovereign risks.

      Rating AAA to AA- = CR of 0%
      Rating A+ to A- = CR of 1.6%
      Rating BBB+ to BBB- = CR of 4%
      Rating BB+ to BB- = CR of 8%
      Rating Under B- = CR of 12%
      Unrated = CR of 8%

  4. The bottom line is that most of our economies are like bathtubs placed on the shores of the financial oceans. We need water to keep our bathtubs filled and fresh but we are most certainly hurt when we get hit by tsunamis.

    The most important issue is the term of those flows. Long term capital investments will not differ a lot whether local or foreign but short term speculative flows can produce horrendous damages… By the way we often think of financial damages as a result of outflows of capital but in my experience I would say that it is really in the inflow that they have the worst effects… quite often financing governments at much lower rates than the better knowing locals would do.

    I have always favored the old Chilean capital controls that had the basic intention of allowing the entrance of any capital with good long term intentions but keeping out those who were only out to have a brief affair. Unfortunately these Chilean controls were prohibited by the US in the free-trade agreement they signed, but I guess that could be revised because what was also prohibited in that trade-agreement was to introduce those restrictions in the banking sector that Volcker-Obama now are proposing.

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