March 2002 Insights Issue #40

Back to Insights #40

Capital flows?
Balance of payments management

The free movement of capital across national boundaries can ensure a more efficient allocation of savings, channelling resources to countries where they can be used productively to increase growth and welfare.

Further arguments in favour of the free movement of capital relate to allocational efficiency and macroeconomic policy discipline, according to research by the University of Oxford, but may have to be set against the public good of financial stability:

• Access to foreign capital markets may enable investors to achieve a higher degree of portfolio diversification, allowing them to obtain higher risk adjusted returns.
• Full convertibility for capital account transactions may complement the multilateral trading system, broadening the channels through which emerging market countries can obtain trade and investment finance.
• By subjecting governments to greater market discipline and penalising unsound monetary and fiscal policies, liberalisation may improve macroeconomic performance.

Both theory and experience indicate the desirability of scheduling capital account liberalisation after appropriate domestic financial liberalisation. Significant foreign investment in domestic financial markets and foreign borrowing by domestic banks and corporations call for minimum levels of market efficiency and institutional and regulatory capacity to safeguard stability. The liquidity and volume effects of large foreign capital inflows on the domestic equity, bond and foreign exchange markets, can be highly destabilising.

Following convention wisdom, major industrial countries and OECD members adopted the gradual and sequenced approach toward capital account liberalisation in the 1960s and early 1970s. Yet in recent decades, some emerging market economies adopted wrongly sequenced liberalisation programmes and undertook 'big bang' approaches instead, often under pressure from G7 governments.

A shift in external market sentiment can cause a sudden (possibly excessive) reversal in the availability of external finance, destabilising the economy. Experience indicates that before liberalising capital account, fiscal balance and discipline, measures to attain a private sector savings-investment balance, and prudential regulation of bank and non-bank financial intermediaries should be in place. However, such measures have not proved sufficient to prevent the overheating of domestic financial markets, following capital inflows, and their subsequent market collapse.

Until recently, international financial institutions were pressing for the immediate liberalisation of the capital account. But recent experience suggests that premature opening without macroeconomic pre-conditions, capital market depth (volume of trading, number of participants, capitalisation, turnover and so on) and sound financial regulation and supervision may be destabilising. This problem arises not only from distortions or imbalances in the host economy but also from the lack of breadth and depth in emerging capital markets.

Unrestricted capital inflows lead to excessive appreciation of the domestic currency, current account deterioration, and increased instability of the economy in general. What are the policy options?

• Active intervention in money markets to sterilise capital inflows is one possible response. Large-scale sterilisation policies could lead, however, to higher domestic short-term interest rates, which in turn would further stimulate short-term capital inflows.
• A free-floated exchange rate system would maintain free capital mobility. However, large exchange rate fluctuations in emerging economies may have significant economic impacts.
• If emerging market economies decide to stay with managed exchange rate regimes that target a competitive real exchange rate, they could establish mechanisms of managing short-term capital movements.
• The IMF still advocates the overall liberalisation of capital account transactions but also recognises the necessity of measures to influence the volume and composition of capital flows. Market-based instruments, such as taxes on short-term foreign borrowing, can thus be used to lengthen the maturity structure of external liabilities.

Valpy FitzGerald
Finance and Trade Policy Research Centre
University of Oxford
21 St. Giles
Oxford OX3LA

edmund.fitzgerald@queen-elizabeth-house.oxford.ac.uk

See also

'Go with the Flows? Capital Account Liberalisation and Poverty', Oxford: OXFAM and Bretton Woods Project by A. Cobham, 2001
http://www.brettonwoodsproject.org/topic/financial/f22gowithflows1.htm

'Rebuilding the international financial architecture' Seoul Report, Emerging Markets Eminent Persons Group, October 2001 http://www2.qeh.ox.ac.uk/pdf/misc/emepgr.pdf

'Short Term Capital Flows, the Real Economy and Income Distribution in Developing Countries' by E.V.K. FitzGerald, in 'Short term capital flows and economic crises' edited by S. Griffith-Jones et al, OUP: Oxford, for WIDER, 2001

'Policy Issues in Market Based and Non Market Based Measures to Control the Volatility of Portfolio Investment' presented at the UNCTAD Expert Group meeting, 'The Relationship between Foreign Portfolio Investment and Foreign Direct Investment', Geneva June 1999) QEH Working Paper Series #26, by E.V.K. FitzGerald, 1999
http://www2.qeh.ox.ac.uk/research/wpaction.html?jor_id=34