- Robert Kahn, Adam Bennett, María Carkovic S., and Susan Schadler
- Published Date:
- September 1993
Surges in capital inflows are beneficial to recipient countries: they ease the external constraint, push down domestic interest rates, and often afford higher investment and growth. Yet too much of a good thing can be bad: when large capital inflows feed developments that signal overheating and instability, they become a policy concern.1 Such signals include the following:
- Widening current account deficits. Greater availability of external financing frequently leads to large increases in the current account deficit. Some governments appeal to the so-called Lawson doctrine, which states that when public sector accounts are balanced, current account deficits reflect a gap between private savings and investment that should not be a concern of the government;2 others, however, view the external imbalance as a problem.
- Higher consumption financed by inflows. Whether widening current account deficits reflect higher investment or lower savings is important. An increase in consumption financed by inflows is unsustainable; only that associated with higher permanent income growth, made possible, for example, by investing the inflows, can be sustained.
- Weaker monetary control and rising or sustained high inflation. To the extent that capital inflows do not leave the country through a widening of the current account, large inflows can push up monetary aggregates and derail inflation targets. Prices of financial assets and real estate also are frequently affected.
- Real appreciation. Strong growth of domestic demand—whether consumption or investment—pushes up the real exchange rate. This is generally unwelcome because governments are loathe to give up hard-won improvements in competitiveness and to risk an overshooting when they are uncertain about the likelihood of a reversal of the inflows and the sustainability of a real appreciation.
- Vulnerability to reversals. If inflows reverse, a tightening—perhaps severe and disruptive—of financial policies or a depreciation, or both, may be needed. Some countries are reassured by the Lawson doctrine, but most view surges in inflows as setting up a systemic risk, particularly to the banking sector.
It is tempting to assume that these effects are homogeneous across countries experiencing surges in inflows and, accordingly, that policy responses can be guided by a common formula. The experience of the six countries reviewed here belies this assumption: not all of the beneficial or unsettling effects occurred in each country. Much of what differentiated the experiences was the causes of the inflows. Thus, detecting the causes is essential to understanding the effects of the inflows and fashioning a policy response. For the countries reviewed here, there were four principal causes of the inflows—the balance between them differing among the countries.3
One cause was changes in real domestic economic policies, for example, structural changes that improved potential productivity or reductions in public sector deficits that promised greater macroeconomic stability and permitted real depreciations. In these circumstances, the potential benefits of higher investment and output from capital inflows are large. The inflows also have the effect of increasing the current account deficit and putting upward pressure on money, nontraded goods’ prices, and the real exchange rate. But rather than being signs of instability, such effects in these circumstances are equilibrating and sustainable; they reflect the scope for profitable investment and adjustments needed to effect the foreign transfer and mitigate excess demand for nontraded goods. Any increase in consumption is likely to be the result of higher permanent income rather than easier financing. With constancy in the stance of structural policies, the risk of reversal of the inflows is small.
A second cause was a tightening of domestic credit policies or an increase in administered interest rates, without corresponding fiscal adjustment, usually done in an effort to reduce persistent inflation. With the exchange rate fixed (or on a fixed nominal path), inflows are attracted by high domestic interest rates and accommodate an unchanged demand for broad money and inertial inflation. Without sterilization, the effects of the inflows in these circumstances are confined to reversing the increase in interest rates and raising foreign-backed money, thereby thwarting the effort to lower money growth and inflation. Effects on investment, growth, and the current account are minimal. Because such an unbalanced mix of tight money, easier fiscal policy, and a fixed exchange rate is likely to be unsustainable, the risk of a reversal of the inflows is high.
A third cause was external influences, for example, a lowering of foreign interest rates or recession abroad. Without any changes in domestic conditions, inflows caused by changes in external influences elicit downward pressure on interest rates, but in other ways they elicit the standard signs of overheating: an increase in demand (possibly consumption as well as investment), higher output, a wider current account deficit, an acceleration in money and prices, and upward pressure on the real exchange rate. If interest rates adjust quickly and domestic activity is closely linked to foreign demand, incentives for inflows can be short-lived.
A fourth cause was bandwagon effects, which may have reflected financial markets following fashions or overreacting to new information. Insofar as domestic conditions may not have changed (at least not commensurately with the size of the inflow), effects are likely to be similar to those of inflows caused by external influences. The risk of reversal is great.
Each of these causes can attract inflows in forms ranging from direct foreign investment to currency substitution. Of course, it is likely that structural and fiscal policy changes will attract a larger share of direct foreign investment and that other causes will attract more liquid forms of inflows, but these linkages are not tight. Moreover, the form of the inflow is not always important: all inflows that do not directly finance imports find their way into the banking system and have monetary effects. How they are used then depends on underlying economic conditions and the efficiency of the banking system.
This discussion suggests that, unless a tightening of credit alone attracts the inflows, a surge in capital inflows is likely to cause signs of overheating. Whether these effects are unsustainable or destabilizing, that is, whether a policy response is needed, has to be interpreted in light of the causes of the inflows. When inflows are attracted by improvements in potential productivity or competitiveness, the effects are less signs of instability than equilibrating adjustments; policy can be more focused on improving the absorptive capacity of the economy than on containing destabilizing effects. When external influences and bandwagon effects are the important causes of the inflows, the effects may be unsustainable, particularly if a substantial share of the inflows finances consumption rather than investment. Moreover, the risk of a reversal of the inflows is substantial. In this case, policies need to be concentrated on containing or neutralizing the inflows. In practice, difficulties in interpreting inflows create uncertainty about the balance between various causes and the needed restraint from policies. Thus, most governments implement policies to limit the risks of destabilizing effects.
What is the conventional wisdom about policies to contain or neutralize the unwanted effects of large capital inflows? In a fixed exchange rate setting, it is to reduce the fiscal deficit in order to restrain demand, inflationary pressures, and real appreciation. Even when inflows are caused by a tightening of domestic credit policy (so that inflows do not unleash an increase in demand), tighter fiscal policy is essential to reaching a sustainable policy mix. The principal concern about aggressive fiscal adjustment, that is, adjustment well beyond the operation of automatic stabilizers, is that basic decisions about the role of government are held hostage to the capital inflows. This could be particularly unwarranted when the government’s role in providing infrastructure affects the economy’s absorptive capacity. Sterilization, particularly on a prolonged basis, is discredited as a response to inflows, because it sustains the high domestic interest rates that attract inflows and because it usually proves to be costly. Of course, inflows attracted by a tightening of credit in the first place will not continue unless they are sterilized. Nominal appreciation affords domestic monetary autonomy and lowers inflation. In theory, the same real appreciation would result whether or not the nominal exchange rate is adjusted; that is, without a nominal appreciation, inflation would produce the same real change.
The analytical underpinnings of microeconomic measures to address unwanted effects of large inflows are less simple. Some such measures, notably, financial sector reform and liberalizing capital outflows and trade, improve the efficiency with which inflows are absorbed. Often, however, these measures are also aimed at increasing overall balance of payments outflows, and here the effects are ambiguous. For example, easing restrictions on outflows can actually increase net inflows if confidence is raised; and trade liberalization can strengthen the current account if freer access to intermediate inputs improves the competitiveness of exports. Controls or taxes on capital inflows are the most controversial of microeconomic measures. They are generally seen as welfare-detracting distortions, although a case for them can be argued on the grounds that existing distortions prevent the efficient absorption of inflows. In a more practical vein, it is expected that such controls will be circumvented in even minimally sophisticated financial markets.