The Global Crisis and its aftermath saw boom-bust cycles in cross-border capital flows of unprecedented magnitude, rekindling debates on whether – and how – to deal with these flows. Traditionally, emerging market economies (EMEs) were counselled not to impede capital flows, but to use exchange rate flexibility and prudent fiscal policy in the face of large inflows. Yet since the crisis, there have been calls for EMEs to take a more proactive stance and deploy a range of policy tools – including prudential measures and capital controls – to better manage the macroeconomic and financial-stability risks associated with capital inflows (Ostry et al. 2010, 2012, IMF 2012).
Anecdotal evidence suggests that EMEs do try to manage capital flows through different policy tools, but there is not much formal empirical evidence, and what exists is contradictory. Eichengreen and Rose (2014) and Fernandez et al. (2015), for instance, show that capital controls across countries are highly persistent, and do not vary in response to economic and financial cycles. Végh and Vuletin (2012) find that monetary policy in many EMEs tends to be procyclical relative to output, while Kaminsky et al. (2005) and Ilzetzki and Végh (2008) find that fiscal policy in EMEs is also highly procyclical. Given that capital inflows to EMEs are typically expansionary and result in economic overheating, these studies imply that policy is either not responding to them, or doing so in the wrong direction.
There are several reasons, however, why the existing literature may have been unable to identify systematic policy response by EMEs to capital flows. First, studies generally focus on a single policy instrument (monetary, fiscal, or capital controls). But it is quite plausible that political or structural constraints prevent the use of specific instruments in some countries, so we cannot make a more general statement about whether policies respond to capital flows by looking at instruments one at a time. Second, most studies consider broad samples of countries for a long time, and mix emerging markets with advanced countries or developing countries. Yet, the challenges that capital flows pose to EMEs are often quite different from those they pose to advanced or developing economies. It is also only in recent years that most EMEs have liberalised their capital account sufficiently that large flows create the macroeconomic and financial-stability risks that might need a policy response. Third, for studies analysing capital controls, an additional problem is how we measure those controls: the practice has been to use slow-moving indices reflecting the existence of restrictions rather than the cyclical variations in the intensity of restrictions. Since most responses to flows involve varying the intensity of existing measures (rather than imposing new restrictions or eliminating them entirely), indices based on the existence of restrictions may fail to adequately capture the response by EMEs to capital flows.
In a recent paper, we address these issues and examine systematically how policymakers respond to capital inflows using all of monetary policy, fiscal policy, exchange rate policy, prudential measures, and capital controls (on both inflows and outflows) (Ghosh et al. 2017). For our analysis, we use quarterly data compiled from existing and new databases for about 50 EMEs between 2005 and 2013 – a period when capital flows to EMEs have been particularly volatile, and the debate on how to manage them has been especially vigorous. We particularly examine the response of capital controls and prudential policies by using change-based measures that better captured the higher-frequency tightening and relaxation of policies, rather than relying on indices based on the existence of measures.
Policymakers in EMEs have potentially five tools to manage capital flows and mitigate any untoward consequences: monetary (interest rate) policy, fiscal policy, exchange rate policy, prudential measures, and capital controls. In deploying these tools, there is a logical reasoning (or natural mapping) between instruments and risks (Blanchard et al. 2014). Monetary and fiscal policies can help address the inflation and economic overheating concerns raised by capital inflows. When the currency is not undervalued, foreign exchange (FX) intervention can be used to limit currency appreciation that threatens competitiveness. Prudential measures can be applied to curb excessive credit growth and related financial stability risks. Capital inflow controls, if applied sufficiently broadly, can buttress these other policies by limiting the volume of capital inflows in the first place, or more targeted controls can be used to address balance sheet vulnerabilities such as currency and maturity mismatches. Countries with controls on capital outflows can also relax these restrictions to lower the volume of net flows, reducing overheating and currency appreciation pressures.
Macroeconomic policy response
A look at the raw data suggests that capital flows to EMEs have been volatile over the sample period, but that EME central banks have reacted to this volatility. FX intervention – defined as a change in foreign reserve assets (excluding valuation changes) scaled by GDP – follows the ebbs and flows of capital, with a strong correspondence between reserve accumulation and net inflows (Figure 1a). For the policy interest rate the pattern is less clear, with the raw correlation between net capital flows to EMEs and the policy rate suggesting some counter-cyclicality (that is, the policy rate increased during periods of inflows and decreased during reversals), but this is not statistically significant. Fiscal policy – which, following existing studies, is proxied by real government consumption expenditure – shows no discernible relationship with net capital flows, with the unconditional correlation between the two series being close to zero and not statistically significant (Figure 1b).
Figure 1 Capital flows and macroeconomic policy response in EMEs, 2005Q1-2013Q4
Source: Authors’ calculations based on IMF’s IFS and WEO databases.
Notes: Statistics are averages for the corresponding samples. Real government expenditure is the cyclical component of (seasonally adjusted) real government spending in percent of trend real government spending.
Formal empirical analysis confirms these observations, and we find that:
- Net capital inflows were strongly associated with reserve accumulation. On average, EME central banks purchased some 40% of the inflow, though there was significant variation across individual countries.
- Capital inflows tended to elicit higher policy interest rates – an increase in net flows by 10% of GDP, on average, raised the policy rate by 10 basis points. The impact of inflows on the policy rate, however, came through the behaviour of inflation, the output gap, and the real exchange rate (controlling for these variables, policy rates did not respond to flows). Policy rates were raised in response to higher inflation or a larger output gap – implying a counter-cyclical monetary policy stance – but tended to be lowered in response to real exchange rate appreciation.
- Fiscal policy was strongly procyclical in the face of capital inflows—thus government consumption expenditure rose as capital flows increased, and vice versa. The coefficient on capital flows was not statistically significant when we included the output gap variable in the regression, implying that much of the procyclicality in government consumption spending was a response to the expansion in output associated with capital inflows.
Turning to the less orthodox part of the policy toolkit – macroprudential measures and capital controls – and using indices that capture changes in these measures, a simple snapshot suggests that both the number of countries that tightened policies, as well as the total number of measures that were tightened (net of easing), was positively correlated with net inflows (Figures 2 and 3). Thus, EMEs tightened prudential policies and inflow controls as inflows surged, and relaxed them when flows receded.
Figure 2 Capital flows and macroprudential measures in EMEs, 2005Q1-2013Q4
Sources: Authors’ calculations based on data obtained from IMF’s IFS database, Federico et al. (2014), and Akinci and Olmstead-Rumsey (2015).
Notes: Net financial flows are the average for countries for which information on respective macroprudential policies/RR is available.
Figure 3 Capital flows and inflow controls in EMEs, 2005Q1-2013Q4
Sources: Authors’ calculations based on IMF’s IFS database, Ahmed et al. (2015), and IMF’s AREAER.
Notes: Net financial flows is the average for the countries in the sample for which information on changes in capital controls is available. Total no. of changes in panels [a] and [b] are the cumulative number of measures tightened net of measures relaxed for the countries in the sample.
For outflow controls, the reverse is true. The number of countries relaxing restrictions, as well as the total number of measures relaxed (net of measures tightened), corresponded to capital inflows (Figure 3b). It is, however, important to note that the countries relaxing outflow restrictions were those with partially liberalised capital accounts (for example, India and South Africa). For EMEs with largely open capital accounts, the policy option of further relaxing outflow controls in the face of capital inflows may not have been available.
These initial observations are supported by formal regression analysis, which shows that:
- Macroprudential policies – notably, debt-to-income and loan-to-value ratios, as well as reserve requirements – were tightened when capital inflows (especially, other investment liability inflows) increased.
- Similarly, EMEs tightened inflow controls and currency-based prudential measures when inflows (especially, portfolio and other investment inflows) surged.
- Countries without fully open capital accounts tended to relax capital outflow controls in the face of rising inflows.
While evidence suggests that EME policymakers responded to capital inflows through various tools, did the choice of policy instrument correspond with the nature of the risk posed by capital flows? In general, yes. The difference between the average real effective exchange rate (REER) appreciation in cases when FX intervention was used compared to when it was not used was significantly greater (about 5 percentage points). For monetary policy, the output gap mattered most, followed by the rate of domestic credit expansion, which were significantly larger when monetary policy was tightened.
Macroprudential measures were typically deployed in the face of rapid credit growth, while inflow controls were tightened when both credit growth and currency appreciation were a concern. On average, REER appreciation was 5 percentage points greater when both inflow controls and FX intervention were used compared to when FX intervention was used alone. Similarly, credit expansion was about 2 percentage points faster when both inflow controls and macroprudential measures were tightened than when the macroprudential measures were used alone. Moreover, inflow controls were generally used with at least one other instrument – suggesting that capital controls were deployed when countries were contending with multiple, and increased, risks that threatened financial and macroeconomic stability.
Figure 4 Policy Instruments and Risks, 2005Q1-2013Q4
Source: Authors’ estimates.
Note: Figures show the average year-on-year change in real domestic private credit growth and change in REER (in percent), output gap (in percent), and net capital flow/GDP (in percent) for the cases when policy instruments are used, and when they are not used. *, **, and *** indicate that the difference between the two group means is statistically significant at the 10, 5, and 1 percent levels, respectively.
Everything except fiscal tightening
We conclude that policymakers in EMEs have responded to capital flows by deploying a combination of instruments. Central banks used the policy interest rate to address inflation and overheating concerns, and intervened heavily in the face of capital inflows. Beyond these policies, EMEs tightened macroprudential measures, capital controls and currency-based measures that affect capital inflows, while countries with relatively closed capital accounts tended to relax restrictions on capital outflows. Moreover, there has been some correspondence between the tool deployed and the nature of the risk – thus, central banks intervened when the real exchange rate was appreciating, tightened monetary policy when the economy was overheating, and used macroprudential tools when financial-stability concerns dominated. Inflow controls were typically used when there were many, aggravated, risks. The orthodox policy prescription to tighten fiscal policy in the face of capital inflows was the least used instrument in practice, with no strong evidence that EMEs systematically tightened fiscal policy in response to large capital flows.
Disclaimer: The views expressed in this column are those of the authors, and should not be attributed to the IMF, its Executive Board, or its management.
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Akinci, O, and J Olmstead-Rumsey (2015), “How Effective are Macroprudential Policies? An Empirical Investigation”, Federal Reserve Board International Finance Discussion Papers No. 1136.
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Végh, C, and G Vuletin (2012), “Overcoming the Fear of Free Falling: Monetary Policy Graduation in Emerging Markets”, NBER Working Paper 18175.