I. Introduction

Robert Kahn, Adam Bennett, María Carkovic S., and Susan Schadler
Published Date:
September 1993
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In recent years, many countries have experienced surges in net capital inflows. These inflows eased external financing constraints and held the potential for higher investment and growth. Often, however, they were so large as to challenge macroeconomic stability by contributing to an acceleration in domestic demand and activity, a deterioration in the external current account, and pressures on prices of goods, real estate, and financial assets—all the typical symptoms of overheating. The threat to stability was great enough that offsetting policy actions were taken. These actions sought to balance governments’ desires to accommodate the higher investment and growth afforded by the inflows and to curb their destabilizing effects.

The conventional wisdom on policies to contain the destabilizing effects of inflows is clear: rein in fiscal policy; accept some real appreciation (preferably through a change in the nominal exchange rate rather than domestic inflation); and avoid sterilization (which only keeps domestic interest rates high and accelerates inflows) and capital controls (which are either ineffectual or distortionary). Microeconomic policies, such as liberalizing trade and capital outflows, are seldom discussed as responses to this essentially macroeconomic problem. Yet, when policymakers actually confronted surges in inflows, the prescriptions did not answer many practical questions. How much fiscal adjustment was needed to stem pressures on prices and the real exchange rate? How much real appreciation was warranted? Would a pre-emptive nominal appreciation heighten the tendency toward real appreciation? Moreover, policymakers were not convinced that sterilization, capital controls, and micro measures were ineffectual; in fact, surges in inflows almost always elicited resort to such measures. Often, policymakers and the Fund staff sought answers in the experiences of other countries that had faced similar circumstances; but the difficulty of finding relevant information in comparable form was frustrating.

This paper attempts to fill that vacuum. The experiences of six countries that have had recent surges in capital inflows, Chile, Colombia, Egypt, Mexico, Spain, and Thailand, are reviewed. The countries were chosen because they span a wide spectrum in terms of the severity of the external constraint before the inflows, the policy response, and the effects of the inflows. Inflows to most of these countries remain large, although in some they have diminished since the initial surge. Spain is the exception, but the weakening of inflows is so recent that the effects of and policy response to it are not addressed here. The aim is to complement textbook explanations and prescriptions with analysis of actual experiences.

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