VI. Conclusions

Robert Kahn, Adam Bennett, María Carkovic S., and Susan Schadler
Published Date:
September 1993
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The experiences of the six countries reviewed reveal considerable diversity, yet there were a number of basic patterns in the causes and effects of surges in capital inflows and in the effectiveness of policy responses to them.

Surges in capital inflows ease the external constraint and hold the potential for sharply raising investment and growth. The enormity of these inflows in relation to the receiving economies, however, raises the spectre of several effects worrisome to policymakers: rising current account deficits as the transfer is effected; excessive money growth and pressures on prices and the real exchange rate; inflow-financed increases in private consumption; and vulnerability to a sudden reversal of the inflows. Whether these effects are realized, and whether they are in fact destabilizing depends on the causes of the inflows.

There are many possible causes of surges in capital inflows, the identification of which is critical to interpreting the effects of the inflows and formulating a policy response. The episodes examined arose from three main causes: changes in structural or fiscal policies that improved the investment climate; a tightening in domestic credit policies that pushed up domestic interest rates; and changes in conditions in external markets. Inflows arising from each of these causes may have been enlarged by bandwagon effects. These developments contained the seeds of a massive transfer of capital into everything from real investments to currency holdings. A mix of these was at play in each of the countries under review, although the mix varied markedly among the countries.

The larger the role of structural and fiscal policy changes in attracting the inflows, the greater are the beneficial effects of the inflows on investment and growth. These gains tend to be accompanied by pressures on prices and the real exchange rate, as well as a widening current account deficit. To a large degree these are equilibrating adjustments, helping to effect the transfer and channel resources toward meeting increased demand for nontraded goods. In these circumstances, the principal role for policies is to improve the absorptive capacity of the economy, although some adjustments in macro-policies may be needed to contain rapid surges in investment and growth and real appreciations.

When surges in inflows are generated principally by changes in external macroeconomic conditions or bandwagon effects, it is less certain that the inflows will be channeled into productive investments: the threats of inflows feeding consumption and speculative investments, unsustainable real appreciation, and a reversal of the inflows are greater. These are circumstances in which restraint from policies is especially important.

When inflows are attracted principally by a tightening of domestic credit, their effects are largely confined to increasing official reserves. Changes in investment and growth are likely to be negligible, but any lowering of inflation—usually the objective behind the tightening of credit—is also unlikely to materialize. These observations underscore the difficulty with disinflation programs based on tight credit and a nominal anchor exchange rate policy, without adequate fiscal adjustment, in an economy open to large inflows.

Even though a mix of causes was at play in each of the countries reviewed, not all of the feared effects of the inflows materialized. Typically, money growth was little affected and inflation did not rise, although inflation persistence was a problem; increases in the share of private consumption in GDP were not evident, except in Mexico; and, while the pace of inflows has recently subsided in Colombia and Thailand, significant outflows or downward pressure on the exchange rate have occurred only in Spain. The actual developments that concerned policymakers most were sizable real appreciations and, in countries that did not sterilize aggressively, a sharp widening of current account deficits. On the positive side, except in countries that sterilized aggressively, investment and growth benefited considerably from the inflows.

Surges in capital inflows were a major shock—albeit one with many beneficial effects—and no government ignored it in formulating policy. There is, therefore, no case study of a country that did nothing in the face of a surge of inflows. In principle, policy responses should have been informed by the causes of the inflows: in practice, uncertain of the causes, each country responded, at least to some degree, by containing its vulnerability to a reversal of the inflows and by minimizing the risk of overheating, excessive real appreciation, and unsustainable growth of consumption.

Fiscal restraint is arguably the only means of preventing overheating and avoiding a real appreciation in the face of a sustained surge in capital inflows, regardless of its causes. The adjustment needed to significantly stem inflation and a real appreciation may be large, however: in Thailand—the only country reviewed that avoided a significant real appreciation and increase in inflation, yet enjoyed a surge in investment and growth—the central government position shifted from a deficit of 4 percent of GDP before the inflow to a surplus of 5 percent of GDP some four years into the episode. Thailand’s success cannot be separated from its favorable initial position—a history of low inflation and outward-looking policies. The adjustment needed to stabilize the real exchange rate may well be larger when recent history is less favorable. In practice, aggressive use of fiscal restraint may be constrained by the government’s ability to garner public support quickly and, in unusual circumstances, by an initially large surplus or net creditor position of the government. While such constraints severely limit a country’s chances of escaping at least some of the unwanted effects of a surge in inflows, second best policy responses need to be considered.

Sterilization—narrowly defined as the exchange of bonds for foreign exchange—is often effective in insulating an economy for short periods from some of the unwanted effects of surges in inflows. It is easy to implement quickly and, for several of the countries reviewed, appears to have prevented a widening of the current account deficit while locking in large increases in official reserves that limited countries’ vulnerability to a reversal of the inflows. It appears to have been less effective in securing inflation targets and preventing real appreciations—probably owing to the large role of credibility and inflation expectations in these developments. Countries that sterilized most aggressively benefited least from the effects of inflows on investment and growth. Thus, aggressive sterilization is not appropriate when structural and fiscal changes that raise the profitability of investment are an important cause of the inflows. More generally, however, full sterilization proved infeasible on a sustained basis: by keeping upward pressure on domestic interest rates, sterilization both perpetuated large inflows and entailed untenable quasi-fiscal costs.

While full sterilization is not viable as a sustained response to surges in inflows, this is not to say that credit policies should be formulated without regard for the effects of inflows on domestic credit markets. In practice, all countries partially sterilize, in the broad sense of restraining the growth of net domestic assets of the central bank when inflows satisfy a large share of credit needs. To some degree this reflects changes in the demand for credit from the central bank—on the part of banks flush with liquidity and of government; but there is also an element of supply restraint. Determining the optimal degree of restraint is complicated by the general uncertainty about the causes and effects of the inflows and the volatility in the demand for money during episodes of large inflows. The experiences of the countries reviewed suggest a number of indicators that should form the basis for decisions about the degree of broadly defined sterilization: domestic relative to foreign interest rates (particularly when domestic risk premiums and targets for inflation are being reduced, increases in the differential may signal unsustainable restraint); unduly large increases in reserves (these may indicate that excessive sterilization is perpetuating large inflows and preventing desirable transfers from being effected); the current account position itself (large increases in the deficit particularly reflecting rising private consumption would indicate the need for greater restraint).

In principle, there is a case for impediments to inflows when bandwagon effects are important or there are doubts about the capacity of the economy to absorb inflows efficiently; in practice, there is little evidence to argue for their effectiveness. Several countries imposed some form of impediments to capital inflows, but generally these were piecemeal and not a central feature of the response to inflows. Where such actions were more concerted, evasion occurred quickly, and their effects on the level of inflows appear to have been transitory.

In the absence of a sizable fiscal adjustment, most countries experiencing surges in capital inflows have to accept some real appreciation of their currencies. In general, this is best accommodated in a nominal appreciation, which, of course, has the side benefit of containing inflation. Exchange rate action must be approached with caution, however. To the extent that a tightening of domestic credit caused the inflows, any change in the equilibrium real exchange rate is unlikely, yet a change in the nominal rate may well push up the actual real rate. More generally, nominal appreciations may produce larger real appreciations than would occur in their absence. While these fears cannot be substantiated, they were a limiting influence on the use of exchange rate policy.

The easing of the external constraint provides an ideal opportunity to address structural weaknesses by liberalizing trade, moving toward capital account convertibility, and reforming the financial sector. Such measures were not an important feature of the discretionary response to the inflows in most of the countries under review, and probably could not have been in the short time in which countries wished to respond. Nevertheless, structural weaknesses—particularly in the financial sector—were a constraint on the capacity to absorb inflows efficiently and on the ability of governments to give free rein to the private sector’s use of the inflows. In light of the growing number of adjustment programs that now give rise to surges in capital inflows, this argues for strengthening the priority attached to structural reform early in the program.

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