The last 10 years have been a roller coaster ride of sorts for emerging market economies (EMEs), with many witnessing significant and unprecedented increases and subsequent declines in capital flows.
Sudden changes in capital flows from risk-on, risk-off investment decisions and resulting volatility have led to serious challenges to macroeconomic management including high inflation, overheating, real exchange rate misalignments, current account imbalances, and ultimately crisis. While in many instances domestic policies at EMEs have led to weak fundamentals and sharp sell-offs, in other instances policies adopted in advanced economies as part of crisis resolution - including quantitative easing - reverberated on EMEs, complicating matters further. Brazil, India, and Indonesia have been cases in point.
Against this backdrop and following many other EME crises, including the Asian financial crisis (1997-1998), the Russian crisis (1998), the Brazilian crisis (1999) and the Turkish crisis (2001), the key question is: have policymakers oversold the importance of capital flows to the economy? We outline three key messages that will not only explain the importance of capital flows but also point to improvements in capital flow management that enhance financial stability and enable more active and decisive policy making.
Message 1
The importance of capital flows: Standard arguments in favour of capital flows highlight two key benefits reflecting (i) allocative efficiency between the world's savers and investors, given the higher returns to investments in capital-deficient economies, and (ii) consumption smoothing over the medium term. Moreover, certain types of capital flows, such as foreign direct investment (FDI), are associated with productivity growth from technological advances and improvements in management capacity over and above capital formation.
However, against this backdrop, empirical evidence does not support the supposed virtues of financial openness. Studies have pointed out that on average over the past 25 years there have been three-to-four systemic banking crises per year. Further, a sample of 40 financial crises found that a quarter of them resulted in cumulative output losses in excess of 25 per cent of pre-crisis gross domestic product (GDP).
The key therefore lies in a country's ability to strike the right balance in terms of capital account liberalisation and ensuring certain speed controls are in place in this process. Speed controls would help to ensure that there is sufficient absorptive capacity in the economy, that priority is given to longer-term FDI instead of the more volatile portfolio flows, and that it does not lead to overshooting of critical asset prices. These speed controls would mitigate against financial instability and eventually financial crisis, both of which would undermine the benefits of capital flows on investment and growth. India, for example, has adopted a calibrated and gradual approach toward opening the capital account while prioritising the liberalisation of certain flows.
Message 2
Price stability does not guarantee financial stability: The critical question here is - how to ensure financial stability? To answer, one must recognise the death of the conventional wisdom that central banks should focus on price stability and lean against the wind if - and only if - rampant asset prices such as real estate could influence inflation. The new norm espoused by the Basel Committee on Banking Supervision is based on macro-prudential regulations. Macro-prudential regulations operate by having banks set aside sufficient pools of capital and liquidity levels to avoid externalities related to systemic risks. If effectively implemented - as witnessed during the sub-prime mortgage crisis - this would avoid risks to the real economy posed by closing or liquidating a bank, particularly a systemically important one. The government of Brazil and the country's central bank were proactive in using macro-prudential policies to deal with the risks to the Brazilian financial system.
Message 3
Active policy is critical to withstand financial headwinds: The alert reader will have noted the qualification in the penultimate sentence of the preceding paragraph. Effective implementation of macro-prudential policies and overall macro financial management is critical to avoid persistent exchange rate and interest rate misalignments that can lead to economic and financial fragilities. As observed during India's financial markets volatility in 2007-2012, a full arsenal of measures were adopted by the Reserve Bank of India on price and financial stability goals. These included calibrating the debt component of capital flows, liberalisation of policies with regard to capital outflows, flexibility in exchange rate movements with bouts of interventions in the foreign exchange market to smoothen volatilities, and sterilisation through changes in the cash reserve requirement and open market operations. While some measures may have been more effective than others, a potential crisis was nevertheless avoided.
In conclusion, the last 10 years have been challenging ones for EME economic policymakers, in particular central bankers. In Managing Capital Flows - Issues in Selected Emerging Market Economies, a volume we have edited that is being published by Oxford University Press, it is found that the experience of central bankers in Brazil, India, and Indonesia tends to demonstrate that flexibility and pragmatism is required during episodes of heightened volatility, rather than adherence to strict theoretical rules. With monetary policy independence cherished, EMEs have effectively learned how to become better at navigating the Impossible Trinity by shifting from hard-corner solutions to the middle ground. Further, conventional approaches that once relegated financial stability considerations to the side events displayed on the rear view mirror of the central bank dashboard are now obsolete. With these lessons, EMEs should be in a better position to reap the benefits of better-managed capital flows and enjoy a smoother ride.
Bruno Carrasco and Hiranya Mukhopadhyay are with the Asian Development Bank. Subir Gokarn is with Brookings India
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