Are Capital Flows Expansionary or Contractionary? It Depends What Kind


By Olivier Blanchard, Jonathan D. Ostry, Atish R. Ghosh, and Marcos Chamon

(Version in Español)

With the expected move by the Federal Reserve to raise interest rates before the end of the year, many are asking about the effects on emerging market countries. Will outflows increase, and how will this affect economic activity in emerging markets? To answer that, we need to know if capital inflows are in general expansionary or contractionary.

One would think that the question was settled long ago. But, in fact, it is not. It is a case where theory suggests one thing and practice another. The workhorse model of international macro (the Mundell-Fleming model), for example, suggests that, for a given monetary policy rate, inflows lead to an appreciation, and thus to a contraction in net exports—and a decrease in output. Only if the policy rate is decreased sufficiently can capital inflows be expansionary. Symmetrically, using a model along these lines, Paul Krugman argued in his 2013 Mundell-Fleming lecture that capital outflows are expansionary.

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Emerging Market Corporate Debt in Foreign Currencies


By Selim Elekdag and Gaston Gelos

Debt held by firms in emerging market economies in a currency other than their own poses extra complications these days. When the U.S. Fed does eventually raise interest rates, the accompanying further strengthening of the U.S. dollar will mean an emerging market’s own currency will depreciate against the higher value of the U.S. dollar, and would make it increasingly difficult for firms to service their foreign currency-denominated debts if they have not been properly hedged.

In the latest Global Financial Stability Report, we find that firms in emerging markets that have increased their debt-to-assets ratios have generally also increased their overall sensitivity to changes in the exchange rate—commonly called exchange-rate exposure.

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Bending with the Winds of International Capital Flows


John_SimonBy: John Simon

The winds may fell the massive oak, but bamboo, bent even to the ground, will spring upright after the passage of the storm.
–  Japanese Proverb

Capital flows to emerging market economies are a source of particular and enduring concern to many policymakers. As seen in the 1997-98 Asian crisis, surging inflows can fuel excessive credit growth, expanded current account deficits, appreciated exchange rates and a loss of competitiveness—followed by painful adjustment when the inflows reverse. Countries often fight these buffeting winds with tight controls on exchange rates, capital flow management and aggressive interest rate movements. While these sometimes work, and are sometimes the best response to a crisis, all too often countries can find themselves felled by the wind like the massive oak.

In the most recent World Economic Outlook we discuss an approach to dealing with volatile international capital flows that emphasizes the soft and flexible response to capital flows rather than the hard and oak-like. Instead of trying to resist foreign inflows, countries can bend. We find that the countries that proved to be more resilient to the turbulent gusts of international capital flows were not necessarily those that controlled the inflows, but those where foreign inflows were balanced by offsetting resident outflows.

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