A Survey of the Literature on Managing Capital Inflows

How to manage capital inflows remains an important policy issue for many emerging market economies. This paper presents a brief survey of the literature on managing capital inflows, with a focus on developing and emerging market economies. The paper, after discussing the economic characteristics of capital inflows, provides an overview of the evolution of thinking on capital account liberalization, the use of capital controls as an instrument of managing capital inflows, and the effectiveness and limitations of conventional macroeconomic and structural instruments. Although the literature is still evolving, it provides little practical guidance on capital account liberalization. For those countries facing a surge in capital inflows, consensus seems to be that, aside from learning to live with an appreciating (and fluctuating) currency, and strengthening the financial system, there is no effective and sustainable policy measure either to reduce the size of inflows or to prevent the adverse consequence of such inflows. Additional work is especially needed to develop tools to identify and quantify the various risks of capital inflows.

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1. Dawood Mamoon
   (posted 08 August 2008 / 11:10:13 PM)
   
   It is quite an informative paper and reviews one of the key literature in understanding the workings of international capital markets and sometimes the surprise they may omit.
   
   My response is more specifically for developing countries who under liberalised framework witness rapid capital inflows and thus also expose themselves to greater risks of a crises or in case a crises hits them:
   
   Capital market inflows do not put a country at a risk of financial crisis. Only under certian conditions it may, and these conditions are more to do with the real economy of a country in a long term and its development track record.
   
   
   Capital markets are much like water currents in an ocean. Capital accumulation generated in asset rich countries have affects on smaller countries with visibly liberalised capital markets as they would benefit from foreign inflows in their domestic capital markets. It would then work as a supply shock in the macro-economy of smaller countries and financial sector would rapidly facilitate macro economic activity even in a shorter run. And if there is a slowdown, esspecially at the end of an asset rich country, it will have a small but significant impact on smaller countries. Costs of businesses on average would rise, Banks would come under strain esspecially on their lendings, investment climate gets shaky. However such negative shocks can be sustained in the longer run through steady macro-economic interventions which would range from a set of fiscal and monetary re-settings or re-adjustments. Thus there is an element of endogeniety which can be exploited. The central banks have an important role to play here.
   
   
   The problem of rapid capital outflows, which is akin to a financial crisis, is more to do with institutional robustness in a country and less to do with rapid capital inflows in the first place. Any amount of capital is good for the country. However an over-emphasis on capital formation alone by many developing countries may lead to an increasing risk that any negative shock in the real economy or money markets may start a chain reaction of investor's back tracking. These shocks may arise through balance of payment problems caused by mismangement of monetary policy or other exogenous externalities (i.e. rise in food prices or oil prices.
   
   Investors, unlike a popular obseravtion, would not necessary show herd mentality and may actually have long term stakes on their investments in a country under risk of a crises only if they are confident with the long run absorption capacity of a country which would come through precedence of strong institutions or a track record of good commitment by the governments to preserve good institutional framworks even under stress. Thus good governance is the key as well as larger development of the country which may also mean long term commitment to poverty alleviation, social sector development as well as smart market friendly policies on the larger onset.
   
   Macro-economic problems are just temporary dead ends in a jiggsaw puzzle and there can be short term case specific temporary solutions. But one has to have the basics right to eventually solve the puzzle and at least most of the economic research have got the basics right and it is only good that institutions like ADB are implementing the larger framework of economic development with a greater understanding of the fundmentals of economic progress in nation states of Asia.