Comments: Policy Options for Capital Importers
- Alexander Swoboda, and Peter Kenen
- Published Date:
- December 2000
The paper by Mussa, Swoboda, Zettelmeyer, and Jeanne is a very complete and up-to-date contribution to a major topic in international finance. It focuses principally on issues and policy measures at the international or systemic level. I will concentrate, instead, on issues and policy options as they appear from the perspective of an emerging market economy that is the recipient of a surge of capital inflows. But I would like to begin by offering two general comments on the paper.
First, the paper fails to analyze a basic point, namely that the liberalization of capital movements is not the same thing as trade liberalization, both in theory and in practice.1 Furthermore, the institutional framework, including supervision and regulation of financial and asset markets, is less developed and effective at the international than at the national level. Although booms and busts are endemic in all financial markets, recent experience suggests that international swings particularly need to be brought under control.
Second, the paper focuses more on capital outflows from emerging market economies and on crisis management than on crisis prevention. Experience has shown that by moderating the booms in capital inflows, authorities can prevent the subsequent busts. In short, there is a need for a stronger regulatory framework at the international level.
There is thus a need for further research on specific measures aimed at increasing the private cost of short-term international finance for both lenders and borrowers in order to internalize the externalities that currently exist in international capital markets. It would also be appropriate to focus on “excessive” capital inflows and prevention, as well as on measures by individual countries—both capital importers and capital exporters—to moderate the boom-bust pattern of capital flows.
Foreign creditors need to be made aware of the levels of economic risk in developing countries. The biggest challenge appears to be how to improve prudential regulation in the creditor countries, particularly with respect to short-term bank loans and portfolio flows.2 Experience has shown that there is an asymmetry in the way foreign lenders tend to assess risk in emerging economies. Creditors tend to see the benefits they may derive from developing economies, in the form of high interest rates (including exchange rate and country risk) and low asset (mainly share) prices and to discount the risks. The challenge lies in creating incentives for foreign lenders to better allocate and allow for risk in emerging economies. For example, how can potential international lenders be made to take the risk of exchange rate depreciation into account? How can creditors’ expectations of guarantees on financial assets in emerging market countries, as well as of bailouts by the IMF or the governments of industrial countries, be eliminated? Responsibility in this area rests with the creditor countries and international financial institutions. Better information standards, better data on the aggregate exposure of countries, and better in-depth analysis of country risk and exchange rate risk on the part of rating agencies and international financial institutions could contribute to more realistic behavior by suppliers of private international finance to developing economies.
Two general conclusions of the paper, which are relevant to measures taken by individual emerging market countries that I consider below, deserve to be highlighted. First, in analyzing possible ways to moderate the boom-bust pattern of international capital movements, the authors conclude that “there is no universally applicable, first-best approach” to dealing with the problem.3 Second, they state that “there is a trade-off in policies that tend to maintain a relatively closed capital account, which presumably provide significant protection against international financial crises while they substantially impair a country’s ability to take advantage of the efficiency gains from broader participation in the global financial system.… The terms of this trade-off can be made worse by imprudent measures of capital market opening, and it can be improved by a gradual and prudent approach” to the opening of the capital account of the balance of payments.4
Reducing the Boom-Bust Cycle: Individual Country Measures
Benefits and Costs of Financial Openness
Financial integration with the rest of the world offers significant opportunities for emerging market economies. These include the possibility of using external savings to finance investment, the chance to deflect temporary terms-of-trade shocks, and the ability to diversify risks, more generally the possibility to smooth out fluctuations in consumption and more fully to explain comparative advantage. Additionally, capital movements that are the outcome of well-informed decisions help impose discipline on policymakers.
Greater financial openness also entails risks, however, and can impose both permanent and transitional costs. The loss of degrees of freedom in the management of monetary policy and, sometimes in small economies, the destabilizing effects of short-term capital movements are examples of the permanent costs of increased financial openness. The risks associated with switching from what has traditionally been a closed capital account to an open one are transitional costs.
Some specific features of emerging markets add to the costs and risks. Consider the size of capital movements. What is a very small percentage of the total assets of an industrialized country’s bank or pension or investment fund, could very well have a significant impact on the foreign exchange and capital markets of small emerging market economies. And for such financial institutions, with little at stake, it may be “rational” not to allocate much time or resources to a rigorous evaluation of small emerging market economies. As a consequence, what tends to dominate in the market are “herd” and “contagion” effects that, while “rational” from the viewpoint of the individual creditors, may prove very harmful to capital-importing countries. This type of creditor behavior does very little to discipline weak, or reward sound, macroeconomic management.
The time dimension of capital movements matters as well. Whereby FDI is measured in years, some forms of financial capital movements are measured in months, weeks, and sometimes days or even hours. This is an additional challenge for policymakers in debtor countries; they should optimally have medium- and long-term time horizons in which to make their policy decisions, but they usually lack adequate instruments and the necessary flexibility to counter the significant short-term effects of some capital movements.
Finally, the destabilizing and harmful effects of huge short-term capital inflows are aggravated by the practice of bailing out participants in international financial markets. Bailouts do have some systemic and international rationale5 but even though they may help problem countries regain rapid access to world capital markets, bailouts have on occasion led to undesirable behavior and huge short-term international flows.
Financial Liberalization in the 1990s
Access to external finance for emerging market economies had become extremely limited after the Latin American debt crisis in the 1980s but increased dramatically in the 1990s. The perception of lower country risk, low interest rates in industrialized countries, and widespread financial flows to emerging economies significantly increased the available supply of external funds during the first half of the 1990s. Within this context, some countries found themselves in a situation where, after adjusting for country risk and for changes in exchange rate expectations, the domestic rate of return on capital exceeded the external cost of funds.6 Previously, perceived country risk and lack of confidence in local currencies would have limited international arbitrage, allowed a discrepancy in rates of return to endure, and not resulted in significant capital inflows, if any. The pervasive openness of financial markets in the 1990s, however, left unchecked, attracted huge short-term inflows, thus destabilizing domestic spending and asset prices as well as key prices such as the real exchange and interest rates.
The consequences of such large inflows are well known. The first stage of the transfer process is an economic boom—asset prices and wages rise, consumption and investment increase, the currency appreciates, and imports become cheaper. This is a difficult stage for macroeconomic management. Policymakers must curb the inflationary pressures generated in domestic markets, head off financial bubbles—which drive the movement of prices farther away from equilibrium—and forestall the influx of even greater amounts of short-term foreign financing.
This expansionary phase of the cycle sows the seeds for a subsequent contractionary phase. As the current account deficit grows and external liabilities accumulate, the perceived level of country risk begins to rise, the supply of external funds starts to shrink, the volume of external transfers decreases, and, as a result, prices and expenditure start moving in the opposite direction.
Ideally, inflows are gradually reversed and adjustments in key prices are accomplished smoothly, without generating any major disequilibrium in the economy. The most likely and realistic scenario, however, is one in which capital inflows stop and may even reverse direction suddenly, triggering a traumatic adjustment.7 The economy then finds itself in a very vulnerable position, with a high level of indebtedness and a large current account deficit, and this is aggravated if its external financing is mainly short term. Increases in international interest rates, a deterioration in the terms of trade, or simply a change in external or domestic expectations can set off a sudden confidence crisis that abruptly halts external transfers of resources. The external debt crisis that overtook Latin America in the 1980s and the turbulence that arose in international financial markets in late 1994 and in 1995, as well as the Russian crisis in August 1998, clearly illustrate these risks. In such cases, the necessary adjustment involves a dangerous mix of high domestic interest rates, falling domestic asset prices, and a steep depreciation in the real exchange rate. The results are inevitably serious problems in domestic financial markets, inflationary pressures, a significant increase in unemployment, and a decline in the level of economic activity, along with a sharp drop in expenditure. Again, the Latin American experience in the early 1980s and the crises in Mexico, East Asia, and Russia demonstrate that this pessimistic scenario is highly probable.
The behavior of the domestic real interest rate is crucial for internal balance but is also an important consideration in the process of financial liberalization. The level and growth rate of domestic spending has to be compatible not only with a prudent recourse to external savings but also with the level and growth of the economy’s production potential. This generally requires domestic interest rates to be higher than the interest rates prevailing in the main industrialized economies.8 This is why in the 1990s certain countries, in order to uphold and consolidate macroeconomic discipline and external equilibrium, chose to undertake liberalization of the capital account of their balance of payments in a prudent, gradual, and selective manner.
Capital Flows and Emerging Market Economies
“Excessive” capital inflows—the boom—have been a major cause of balance of payments problems, financial sector problems, and recession in emerging economies. The reversal of these flows—the bust—has inflicted high domestic adjustment costs in terms of negative economic growth, unemployment, and a fall in profits and real wages. In such a context, what is the proper regulatory regime for capital outflows and capital inflows, and what is the appropriate macroeconomic policy? These issues are discussed below.
As a norm, capital outflows should be free. In other words, all individuals and most enterprises should be able to spend capital (i.e., consume and invest) abroad. The major exception to this norm applies to financial institutions, such as banks, pension funds, and insurance companies, if they operate (in legal or in practical terms) with complete or partial government backing or guarantee.
For these financial institutions, prudential considerations suggest a strategy of gradual and selective liberalization. Banks typically have an explicit or well-recognized implicit government guarantee on most of their domestic and foreign liabilities. If banks located in emerging markets want to invest abroad by buying other banks, special scrutiny should be given to the accounts and consolidated balance sheets of the banks in which the investment is planned. Additionally, external ratings and, especially, an adequate regulatory framework and appropriate supervisory practices in the host country, together with bilateral agreements between regulators, should be required. Furthermore, experience suggests that, initially, a ceiling should be put on the maximum percentage of a bank’s capital and reserves allowed to be invested abroad—a percentage that could be increased through time as knowledge and experience with business in third countries accumulate.
A similar gradual and selective approach toward pension funds’ investment abroad, with respect to countries, financial assets, and currencies, appears to be advisable, again because usually contingent drains of fiscal resources are involved. These transfers, although usually excluded from the traditional and accounting definition of fiscal spending, as well as from parliamentary discussion and approval, in reality, increase the private sector’s expected wealth and affect their spending decisions. This “imperfection” had a major impact in Latin America’s foreign (and domestic) debt crisis of the early 1980s. More recent examples were Mexico’s “tequila crisis” of December 1994 and some of the countries in the Asian crisis of 1997.
The calculation of these contingent fiscal liabilities should include an appropriate percentage of implicit and certainly explicit banking deposit insurance guarantees, as well as a percentage of exchange insurance and other contingent support typically given by governments to banking system depositors, creditors, and borrowers in the event of a banking sector crisis. Similarly, the government, even when dealing with reformed and privatized social security capitalization schemes, usually guarantees minimum pension funds.
If these contingent transfers were taken into account, public sector liabilities, appropriately measured, would have been growing at a faster rate than official statistics show. This transparency in information would have beneficial effects on the economic authorities’ evaluation of the soundness and sustainability of macroeconomic policy and the consequent need for the adoption of proper and timely corrective measures.
There is a distinction between foreign direct investment, which is usually anticyclical and long term, and other types of foreign financing. Short-term financing as well as portfolio inflows tend to be procyclical. Perhaps more important, these inflows usually are of a size, time duration, and speed that can contribute to creating and amplifying macroeconomic and financial disequilibrium in emerging market economies. In fact, it was these flows that were associated with the recent crises in Mexico, Asia, and Russia and with creating problems of domestic currency overvaluation and loss of competitiveness in other emerging markets.
From a macroeconomic perspective, it is important to recognize that the current account, as well as short-term foreign debt, matters, and that each matters a lot, especially in emerging markets. Then, by definition, if the net capital account surplus is “too big,” and especially if it is short-term, there will most likely be a capital inflow problem for certain countries.9 Although this problem may arise in countries that have mismanaged economic policy or wrong institutional setups (with respect to guarantees and financial regulation and supervision), it is more likely to affect those countries with strong and sound macroeconomic management.
The problem is especially relevant if a country faces significant “voluntary” short-term capital inflows. In fact, recent experience shows that, in many cases, capital-importing country authorities may be tempted to rationalize the existence and persistence of consequent large current account deficits on the grounds that they are not originating in excessive (public) domestic spending, but rather in private spending financed by voluntary capital inflows. Furthermore, the assertion is that the associated significant current account deficits are a sign of a healthy economy, with plenty of investment opportunities and a good credit standing in international markets.
Macroeconomic Response to “Excessive” Capital Inflows
Under conditions of excessive capital inflows, a first response is fiscal policy should be tightened. Both the fiscal deficit/surplus and the rate of growth of fiscal absorption should be looked at, and improved. In practice, however, reducing fiscal deficits or increasing surpluses has limits, because fiscal policy tends to be quite rigid and there is a scarcity of adequate fiscal instruments to compensate for significant short-term capital inflows.
Second, exchange rate policy also plays an important role with respect to short-term inflows. In particular, exchange rate flexibility, with its associated uncertainty as to the future value of the domestic currency, contributes to discouraging short-term capital flows. The magnitude of capital inflows relative to the site of the domestic foreign exchange market, however, may require wild exchange rate fluctuations to discourage those flows. And given the rudimentary development of futures and derivative markets in developing countries, frequent and significant exchange rate instabilities may create serious problems for the tradable sector.10
Third, international reserve policy can also help compensate for the effect of capital inflows on domestic currency appreciation and on the widening of the current account deficit. Reserve accumulation, however, is usually associated with an increase in the central bank’s quasi-fiscal deficit and its efficiency is therefore limited.
Fourth, to help moderate capital inflows, monetary policy would have to be loosened so that domestic interest rates are lowered and the gap between the domestic and international rates reduced. The control of aggregate domestic spending aimed at reducing both inflation and the current account deficit, however, usually requires higher domestic than international interest rates. Furthermore, from a more structural perspective, capital-to-labor ratios in emerging markets as well as natural excess demand for investment also point to the need for high marginal productivity of capital and interest rates in those countries. Therefore, unless fiscal policy is extremely tight, there is almost no room for monetary policy to help moderate capital inflows to emerging market economies.
The macroeconomic response to capital inflows is further complicated by a number of additional and related factors. Significant short-term capital inflows may also disrupt monetary policy through the monetization of foreign debt, with a consequent increase in money supply and/or decrease in domestic interest rates. This stimulates domestic spending over and above what was initially contemplated in the monetary and fiscal programming.
As noted above, capital inflows may also disrupt foreign exchange markets by appreciating the domestic currency, generating a short-term equilibrium exchange rate of a very unstable and unsustainable nature when compared to the long-run equilibrium value of the real exchange rate. This appreciation tends to trigger a relaxation of monetary and fiscal policy—as it temporarily reduces domestic inflation—while at the same time stimulating a larger current account deficit.
From a financial and, especially, banking sector perspective, significant short-term capital inflows are also a matter of concern because most shortterm foreign debt is transmitted to the domestic economy through the banking system. If the latter is not properly supervised and regulated, the increase in its liabilities tends to be transferred to the domestic economy in the form of excessive and too risky (related, concentrated, and mismatched) credit. The outcome, in addition to weakening the banking sector, is to generate macroeconomic disequilibrium. This occurs not only because of the increase in overall spending but also because of the economy’s vulnerability to foreign sector and exchange rate developments, considering that under conditions of overabundant liquidity, lax credit standards tend to be the norm in the financial sector’s resource allocation.
Excessive capital inflows may thus disrupt the functioning of domestic financial markets. As high levels of domestic real interest rates attract massive financial inflows intermediated by the domestic banking system, domestic bankers tend to relax their credit standards and lending policies, thus deteriorating the quality of their loan portfolio. Nonbank financial markets, in turn, are usually less developed than the banking sector and lack adequate depth and liquidity, as well as regulation and supervision. When an important part of net short-term capital inflows are directed to the stock exchange and other (nontradable) asset markets, like land and urban property, it usually translates into an inflated price for these assets, that is, stock market and property price bubbles. This further stimulates domestic spending because of (perceived although unrealized) wealth effects, leading to a higher current account deficit and increasing the odds of a currency crash even when the banking sector is strong. The higher asset prices also distort the banking sector by biasing banks’ collateral valuations upward, and thus also contribute to the weakness in banks’ loan portfolios.
In short, because of their size and short-term time frame, capital inflows can contribute to creating or amplifying macroeconomic and financial disequilibrium in developing countries, even when their economies are well managed.
The Liberalization of the Capital Account
The above analysis suggests that even if macroeconomic policies are well designed and properly implemented, and even if countries have sound banking systems and regulatory bodies, when facing significant short-term capital inflows they may incur a major risk.11 Under these circumstances, countries should, for macroeconomic reasons,12 attempt to regulate capital inflows, whatever the state of their banking systems.
If the financial and, specifically, the domestic banking systems are weak, the problem for policymakers is amplified. Improving the functioning, regulation, and supervision of financial markets must address this issue. But improvements take time. If most short-term capital inflows are intermediated by the domestic financial (banking) sector, this adds an argument, based on prudential considerations, for regulating capital inflows.13
Well-managed emerging economies should thus consider a prudent approach to financial liberalization. This can be done by reducing the speed at which domestic agents become indebted to foreign creditors abroad and/or by increasing the cost of short-term foreign financing.14 In this way, the pace of overall foreign indebtedness and the economy’s vulnerability to foreign financial shocks can be reduced simultaneously. Reduced vulnerability can be accomplished by changing the composition of the capital account of the balance of payments, with incentives given to risk capital (foreign direct investment) as compared to external debt, and to long-term foreign debt as compared to short-term foreign debt.
In view of the above, the adequate course of action at the level of the individual capital-importing country should be, first of all, to design and implement appropriate fiscal, monetary, exchange rate, and international reserve policies as well as financial sector policies. If short-term foreign financing nevertheless continues to flow into the country, it is essential that the process be slowed in order to prevent “excessive” foreign exchange inflows from undermining domestic and external equilibria through higher inflation or larger current account deficits. The correct course of action is to move toward greater financial integration with the rest of the world, but to do so prudently, gradually, selectively, and with sequencing and at a pace that supports the objective of overall macroeconomic equilibrium.
It is interesting to briefly describe the type of policies implemented by Chile starting in mid-1991 because the liberalization and opening up of its capital account was carried forth under this strategy.15
The Chilean Strategy
Various mechanisms were used in implementing this strategy. During the first half of the 1990s capital outflows were significantly liberalized. Exporters were allowed to dispose of the whole of their foreign exchange earnings and were freed of any obligation to repatriate them. But liberalization measures were adopted in a variety of other areas as well. For example, the minimum amount of time that must elapse before capital brought into the country by nonresidents is eligible for repatriation was reduced from three years to one year. The issuance of bonds and equities abroad (American depository receipts) was authorized, with gradually relaxed requirements over time. In addition, all restrictions on outflows of investment funds originating from external debt swaps (a mechanism linked to the debt crisis of the early 1980s) were lifted and liberalization measures were implemented regarding the prepayment of external debts and the minimum percentage of external credit that has to accompany any foreign direct investment.
Of great importance was the complete liberalization of foreign investments made by Chilean individuals and firms, which made it possible for investors to diversify their risks more fully. Steps were also taken to encourage national (especially institutional) investors to increase the international diversification of their portfolios. The liberalization of capital outflows from banks, pension funds, insurance companies, and mutual funds was also pursued, although at a gradual pace, partly because of legal restrictions and partly because of prudential considerations having to do with levels of systemic risk and contingent fiscal liabilities.
The liberalization of capital inflows was carried out on a gradual, selective basis and was combined with efforts to discourage shorter-term inflows. This type of liberalization entailed the implementation of certain specific controls on capital inflows. Steps were also taken to screen capital inflows more carefully in order to reduce the economy’s exposure to the volatility associated with short-term financial flows, to give monetary policy more autonomy, and to check the formation of bubbles in the stock market. These measures were intended to make it more expensive for foreign (especially short-term) financing to enter the country, to limit the total volume of external inflows, and to improve the quality and lengthen the maturities of Chile’s external liabilities.
First, a one-year requirement for the repatriation of foreign direct investment capital discouraged inflows into equity markets because funds liquidity was constrained. That helped prevent a price bubble in the stock market. It should be emphasized that the reduction in the time requirement for repatriation of foreign direct investment from three years to one year was a step toward capital account liberalization in relation to the preexisting situation.
Second, the speed at which Chilean firms could obtain financing on foreign markets was reduced. This was done through setting minimum amounts and certain other requirements with respect to international rating agencies that had to be met before a firm could place bonds or equities on foreign markets. The requirements varied, depending on the credit standing of the firms or the ratings of the instruments they wished to place on international markets. This measure helped limit the number of firms and how fast they could obtain financing on international markets, thereby preventing excessive inflows of foreign exchange. Another advantage of this strategy—considering the fact that before 1990, no Chilean firms were trading on international bond or equity markets—was that the solvency and stature of the first companies to venture into these markets created a positive externality for those that came afterward. A disadvantage of this measure is that, in practice, it favors large firms over small businesses or individuals.
Third, a non-interest-bearing reserve requirement was established, covering the first year that foreign credits and other forms of external finance were held in the country, regardless of their effective duration. This is a marketfriendly, direct, and flexible16 way of raising the cost of bringing in short-term capital.17 And it gave monetary policy more scope and autonomy so that, ideally, all economic agents would face the same interest rate set by the central bank, with a view to domestic equilibrium. This requirement was also intended to curb the volatility inherent in extremely short-term foreign financing and reduce opportunities for interest rate arbitrage.
From a more general standpoint, this package of gradual, selective foreign financial liberalization policies made it possible to change the structure or composition of external claims on Chile. It induced an increase in the share of risk capital (foreign direct investment) relative to external borrowing and, within the latter, the share of long-term indebtedness relative to short-term debt. This helped to reduce the economy’s vulnerability to the vagaries of the world economy, to the procyclical behavior usually found among external creditors, and to changes in the expectations of international economic agents.
During 1992-96, GDP grew at an average annual rate of 8.6 percent. Gross fixed capital formation increased at an annual rate of 16.3 percent (nearly twice as fast as GDP growth). The fiscal surplus was 2.2 percent of GDP and fiscal savings totaled 5.2 percent of GDP. The real annual interest rate on bank loans, for terms of between 90 days and one year, averaged 8.9 percent. Annual inflation averaged 9.7 percent (Chile’s lowest mean rate for any five-year period in over fifty years), declining from 27.3 percent in 1990, on a trend quite close to the central bank’s yearly inflation targets, and reaching 6.6 percent by the end of 1996. The Chilean peso appreciated at an annual rate of 4.4 percent in real terms (the smallest real appreciation rate among all major Latin American countries during that period) while exports grew by 10.5 percent per year in real terms. The average annual deficit on the current account of the balance of payments was 3.7 percent of GDP. Both inbound and outbound foreign direct investment hit record levels. Net international reserves equaled 23 percent of GDP and one year’s worth of merchandise imports. The external debt totaled an average of 39.1 percent of GDP (16.1 percent of GDP, net of international reserves). Long- and medium-term debt represented 93.4 percent of the accumulated debt during the period, with short-term debt contributing to only 6.6 percent of that total.
I have two final comments. First, it is often said Chile’s strong macroeconomic performance during the early 1990s was chiefly attributable to its high domestic savings rate rather than to its macroeconomic strategy. It should be noted, however, that domestic saving is not a constant that is independent of macroeconomic strategy in general or of external finance strategies in particular. Empirical studies and experience suggest that naive, misguided policies on foreign capital inflows usually lead to a situation in which external savings end up financing excessive expenditure on domestic consumption and reducing domestic saving.
Second, it is interesting to note that although during the 1990s there were other countries that implemented more liberal or aggressive financial liberalization policies, their domestic interest rates were higher than Chile’s and the spreads over international interest rates were wider. This seemingly paradoxical situation is chiefly explained by the fact that these countries had higher levels of country and/or devaluation risk than Chile. It is not a foregone conclusion then that just because a country carries out a complete and quick financial liberalization program it is necessarily going to insert itself permanently into international capital markets. In conclusion, the extent to which a country is more fully integrated into the international economy does not depend so much on how liberalized it is but, rather, on the quantity, cost, quality, and continuity of the capital transfers actually available to it, all of which are usually linked to how much confidence the rest of the world has in the prospects and management of that economy.
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