The Capital Inflow “Problem” Revisited

Capital inflows can be a mixed blessing, especially in economies with thin domestic financial markets and when driven by investors with a short-term focus. Many levers of policy can be applied to resist the effects of the inflows. One that has been widely relied upon has been currency intervention. Key to that appears to be keeping their bilateral exchange rate stable vis-à-vis the U.S. dollar. But this requires them to resist currency appreciation and accumulate dollar reserves when the anchor country is mired in financial problems and keeps monetary policy accommodative in an unprecedented manner. The willingness of emerging market economies to limit exchange rate fluctuations will be tested as monetary policy in advanced economies remains geared toward domestic considerations. Meanwhile, some advanced economies will be looking to finance large deficits and to roll over large debts. In that environment, prior reticence toward capital controls and other restrictions on finance may well lift. For emerging markets, this insulates them from monetary policy in advanced economies that may be inappropriate for domestic circumstances. For advanced economies, this limits the competition for the debt they dearly have to sell. In such a world, the policy tools we discussed will be increasingly relied upon.capital flows, reserves, exchange rates,capital controls