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THE CAPITAL
INFLOWS
PROBLEM: CONCEPTS AND ISSUES
GUILLERMO A. CALVO, LEONARD0 LEIDERMAN,
and
CARMEN
M.
REINHART*
Since
1990,
capital has flowedfrom industrial countries to developing regions like
Latin America and parts of Asia. Most countries welcome reentry into international
capital markets. However, capital inflows often are associated with inflationa
y
pres-
sures, a real exchange rate appreciation, a deterioration in the current account, and
a
boom
in bank lending. This paper briefly examines
how
these inflows have altered
the macroeconomic environment in a number
of
Asian and Latin American countries,
and discusses the pros and cons
of
the policy options.
1.
INTRODUCTION
After about a decade in which little cap-
ital flowed to the developing nations, the
1990s
appear to have launched a new era
in which capital has started to move from
industrial countries, like the United States
and Japan, to developing regions, like
Latin America, the Middle East, and parts
of Asia. Preliminary data indicate that in
most countries, a resurgence in economic
growth and a marked accumulation
of
in-
ternational reserves accompany the in-
creased capital inflows.
Capital inflows, however, are not an un-
mitigated blessing. Large capital inflows
often are associated with inflationary pres-
sures, a real exchange rate appreciation,
and a deterioration in the current account.
In addition, the history of Latin America
provides ample evidence that massive
capital inflows also may contribute to
stock market bubbles and lead to an exces-
sive expansion in domestic credit, jeopard-
izing the financial system’s stability. Short-
term capital inflows intensify these prob-
*Professor, Department of Economics, University of
Maryland, Professor, Department of Economics, Tel
Aviv University, and economist, Research Department,
International Monetary Fund, respectively. The au-
thors thank Kenneth Bercuson, Steven Dunaway,
Susan Schadler, and Brian Stuart for helpful comments.
The authors’ views do not necessarily represent those
of
the International Monetary Fund.
Contemporary Economic Policy
Vol.
XII,
July
1994
lems as the probability of an abrupt and
sudden reversal increases. Not surpris-
ingly, therefore, effective buttressing of
these capital inflows is a key economic
policy issue today.
This paper addresses
two
main ques-
tions. (i)
How
has the current episode of
capital inflows to Latin America and
Southeast Asia affected the macroeco-
nomic environment? The analysis dis-
cusses the important cross-country differ-
ences in the macroeconomic impact of the
inflows and draws on Calvo, Leiderman,
and Reinhart
(1993,
1994).
(ii) What main
concepts and issues have surfaced in the
current policy debate? Section I1 outlines
the relationships between capital inflows,
changes in reserves, and the gap between
national saving and investment. Section I11
briefly discusses the causes of capital in-
flows. Section
IV
reviews the stylized facts
of the current episode of capital inflows.
Section
V
examines the role of credit. Sec-
tion VI discusses the policy response to the
capital inflows. Section
VII
contains con-
cluding remarks.
II.
DEFINITIONS AND CHARACTERISTICS
Capital inflows are the increase in net
international indebtedness of the private
and the public sectors during a given pe-
riod of time and are measured-albeit im-
precisely-by the surplus in the capital ac-
54
@Western Economic Association International
CALVO
et
al.:
THE CAPITAL
INFLOWS
PROBLEM-CONCEPTS
AND
ISSUES
55
count of the balance of payments. There-
fore, except for errors and omissions, the
capital account surplus equals the excess
of expenditure over income (i.e., the cur-
rent account deficit)
plus
the change in of-
ficial holdings of international reserves.
Thus, increases in capital
inflows
are iden-
tified with
wider
current account deficits
and/or reserve
accumulation.
(National in-
come accounting implies that the current
account is equal to the difference between
national saving and investment.)
The official reserves account records
central banks’ purchases
or
sales of official
reserve assets. Thus, this account mea-
sures the extent of the authorities’ foreign
exchange intervention, which often is re-
ferred to as the overall balance of pay-
ments. Two polar cases of central bank re-
sponse to increased capital inflows corre-
spond to floating and fixed exchange rate
regimes.
(i)
If
the central banks do not in-
tervene, as under a pure float, the in-
creased net exports of assets in the capital
account are financing an increase in net
imports
of
goods and services, and capital
inflows would
not
be associated with
changes in central banks’ holdings of offi-
cial reserves. (ii) At the other extreme, if
the domestic authorities actively intervene
and purchase the foreign exchange
brought in by the capital inflow, the in-
crease in the capital account is matched
one-to-one by an increase in official re-
serves. In this case, no change occurs in
the gap between national saving and na-
tional investment nor in the net foreign
wealth of the economy.
111.
EXTERNAL AND INTERNAL CAUSES
The incidence of capital inflows has
varied drastically over time.
For
example,
capital inflows to developing countries
were relatively large in the late
1970s
and
early
1980s;
such inflows ended abruptly
with the onset of the debt crisis in
1982.
Private financing to the developing re-
gions was nil
or
negative during most of
the
1980s
(see Calvo, Leiderman, and
Reinhart
1992, 1993).
Therefore, a central
policymaking issue is ascertaining the de-
gree of persistence
of
the capital inflows.
Evaluating persistence is critical to identi-
fying the factors that lie behind those in-
flows.
It
is important to distinguish between
the external and internal factors that gave
rise to the capital inflows. External factors
are outside a given country’s control. Ex-
amples of such factors for ”small” open
economies include: (i) declines in interna-
tional interest rates and (ii) a rest-of-world
recession, which may reduce profit oppor-
tunities
in
the financial centers. These fac-
tors are likely to have an important ”cycli-
cal”
or
reversible component. Internal fac-
tors, on the other hand, most often are re-
lated to domestic policy. Natural disasters
and/or wars are part of the internal factors
but are not relevant to the discussion here.
Examples of policies that would attract
long-term capital inflows are: (i) success-
ful price stabilization programs that may
be accompanied by improved fiscal policy
fundamentals and greater macroeconomic
stability, (ii) institutional reforms, such as
the liberalization of the domestic capital
market, and (iii) policies that credibly in-
crease the rate of return on domestic in-
vestment projects, such as tax credits and
debt-equity swaps. But domestic policies
also may attract highly ”reversible” capi-
tal. Such policies include: (i) not-fully-
credible trade liberalizations and price sta-
bilization programs, which are likely to in-
duce a consumption boom and increase in-
ternational indebtedness in the short run,
or
(ii) tariff cuts under downward price
rigidity, which induce (temporarily) exces-
sively high prices of domestic goods and,
hence, a current account deficit on the ex-
pectations that the relative price of import-
ables with respect to domestic goods will
increase over time.
Empirical evidence for
10
Latin Ameri-
can countries indicates that foreign factors
have played an important role in the re-
cent episode: Calvo, Leiderman, and
56
CONTEMPORARY ECONOMIC POLICY
Reinhart (1993) find that, depending on
the country, foreign factors accounted for
30 to
60
percent of the variance in real ex-
change rates and reserves. Chuhan,
Claessens, and Mamingi (1993) find sim-
ilar results for bond and equity flows from
the United States and suggest that foreign
factors explain about half of such flows for
a panel of Latin American countries. Their
results also show that external develop-
ments were less important than domestic
factors for the Asian region and that do-
mestic variables are about three times
more important than external variables in
explaining the behavior of portfolio flows.
Low short-term
U.S.
interest rates, de-
creasing returns in other investments, and
a recession in the United States as well as
in other industrial countries converged to
stimulate capital flows to regions where
ex-ante
returns are higher. Fernandez-
Arias (1993) notes that the decline in
U.S.
interest rates also reduced the external
debt servicing costs and increased the sol-
vency of the debtor countries.
Domestic developments alone cannot
explain why capital inflows have occurred
in countries that have not undertaken re-
forms
or
why until only recently inflows
did not occur in countries that introduced
reforms well before 1990. However, the
crucial role that reforms played in attract-
ing capital is evident in the differences
across countries in the orders of magni-
tude of the capital inflows.
For
example,
Argentina, Chile, and Mexico have at-
tracted far more capital than have other
countries in the region. Further, the role of
domestic policies also is evident in the
composition of flows. Countries that have
undertaken reforms attract a higher pro-
portion of long-term capital.
IV.
THE
STYLIZED
FACTS
A.
Capital
Inflows:
Orders
of
Magnitude
Table
1
divides Latin America’s balance
of payments into its three main accounts.
The capital inflows under consideration
appear in the form of surpluses in the cap-
ital account and were about $24 billion in
1990, about $39 billion in 1991, and $53
billion in 1992. Thus, in those three years,
Latin America received as much capital as
it had received during the entire 1982-1989
period. A substantial fraction of the in-
flows was channelled to reserves, which
increased by about $52 billion in 1990-
1992.
For
1990-1992 as a whole, the net
capital inflow was split between widening
the current account deficit and increasing
official reserves. The former suggests that
capital inflows have been associated with
an increase in the gap between national
investment and national saving. The sharp
increase in reserves, in turn, indicates that
the various monetary authorities met the
capital inflow with a heavy degree of for-
eign exchange market intervention. Fig-
ure
1,
depicts monthly data on interna-
tional reserves for selected countries in the
sample and reveals a pronounced upward
trend in the stock of reserves starting from
about the first half of 1990. While part of
the capital inflows is repatriation of flight
capital, there are also new investors in
Latin America. (On the role of policies to
reverse capital flight, see International
Monetary Fund, December 1992, and
Mathieson and Rojas-Suhrez, 1993.)
Other regions also have received sizable
capital inflows in recent years.
In
effect,
capital began to flow to Thailand in 1988
and to a broader number of Asian coun-
tries sometime in 1989-1990 (see Bercuson
and Koenig, 1993). The bottom panel of
table
1
shows that capital inflows
amounted to $144 billion during the 1989-
1992 period. While access to international
credit markets was not as limited for most
of the Asian countries as for their more
indebted Latin American counterparts, the
pace of inflows, particularly to southeast
Asia, has accelerated in the past four
years. During the prior four years, total
inflows to the region amounted to $81 bil-
lion U.S. dollars.
As
is the case for the
CALVO et al.: THE CAPITAL INFLOWS PROBLEM-CONCEPTS AND
ISSUES
57
TABLE
1
Balance
of
Payments, 1985-1992
Balance
of
Goods
Private Transfersa Errors and Omissionsb Reserves‘
Year
$
Billion
$
Billion
$
Billion
Balance
on
Capital
Services, and Account Plus Net Changes in
Latin America
1985
1986
1987
1988
1989
1990
1991
1992
1985
1986
1987
1988
1989
1990
1991
1992
-5.5
-19.8
-11.8
-13.4
-10.1
-8.5
-20.5
-34.6
6.5
13.2
15.0
5.7
12.7
23.6
38.9
53.4
Asia
-18.7
-1.1
14.8
2.6
-8.1
-10.0
-10.2
-25.2
22.7
25.5
24.7
8.7
17.1
31.7
48.9
46.3
-1.0
6.6
-3.2
7.7
-2.6
-15.1
-18.4
-18.8
-4.0
-24.4
-39.5
-11.3
-9.0
-21.7
-38.7
-21.1
~~
aData for Western Hemisphere and Asia from IMF’s World Economic Outlook.
bA
minus sign indicates a deficit in the pertinent account. Balance on goods, services, and private
transfers is equal to the current account balance less official transfers. The latter are treated in this
table as external financing and are included in the capital account.
‘A minus sign indicates an increase.
Latin American countries, there is a
marked accumulation of international re-
serves during the capital inflow period
(see figure
l),
indicating that the capital
inflow was met with a heavy degree of
intervention in these Asian countries too.
B.
Macroeconomic Effects
Comparing the empirical regularities of
the Latin American and Asian experience,
reveals several interesting similarities, (i)
Table
2
illustrates that the swing in the
balance on the capital account is of a sim-
ilar order of magnitude for the countries
under study in the two regions. For the
Latin American countries, the change in
the capital account amounts to
3.3
percent
of Gross Domestic Product (GDP). For the
Asian countries, the capital account sur-
plus
widens by
2.7
percent of GDP.
(ii)
There is a marked accumulation in inter-
national reserves across countries and
across regions.
(iii)
Stock prices experience
sharp increases. During 1991, stock prices
registered gains
of
400
percent for Argen-
tina and gains of about 100 percent for
Chile, Colombia, and Mexico. Similarly,
during the current inflow episode, a num-
ber
of
the emerging stock markets in Asia
outperformed
U.S.
and Japanese stock
markets by considerable margins. (iv) In
58
CONTEMPORARY ECONOMIC POLICY
FIGURE
1
Official Reserves minus Gold: Selected Latin American and Asian Countries
(Billions
of
US.
dollars)
ARGENTINA
:/I
4.8
-
PHIUPPINES
4.
3.8.
5-
2.8
-
2'
1.8-
1-
0.8.
PERU
2.8
2.6.
2.4
-
22.
2-
1.8-
1.0-
1.4-
12-
~
MALAYSIA
12
Sourue:
Intornational Financial Statlatior, International Monetary Fund.
TABLE
2
Key Indicators
for
Selected Latin American and Asian
Countries
(As
percent
of
GDP)
Latin
America
Average
of
Argentina Bolivia Brazil Chile Colombia Ecuador Mexico Peru Uruguay Venezuela
10
Countries
Capital Accounta
1984-1989 -1.6 0.6 -2.3 -1.7 2.0 -6.3 -0.4 -5.3 -2.5 -3.1 -2.1
1990-1992 2.2 3.3 -0.3 5.9
1.0
-5.1 6.2 -0.3 0.5
-1.0
1.2
1984-1989 0.9 0.5 0.5 0.5 1.5 0.6 0.8
-
-
0.1
0.5
1990-1992 1.8
1.0
0.3 1.9 1.2
0.8
1.6 0.2
-
1.8
1.1
1984-1989 18.1
10.1
17.2 16.0 19.7 18.7 20.1 19.4 12.2 17.7 16.9
1990-1992 15.1 13.5 15.8 20.1 17.7 20.2 21.7 16.4 13.8
14.1
16.8
1984-1989 12.4 11.3
11.1
10.9 10.3 11.6
11.1
9.6 14.4 10.4 11.2
1990-1992 14.2 11.6 12.4 8.8
10.1
8.4 10.3 9.0 13.3
11.1
10.9
Direct
Investment
Investment
Public Consumption
Asia
Taiwan Average
of
Indonesia Korea Malaysia Philippines Singapore Sri Lanka Prov.
of
China Thailand
8
Countries
Capital Account
1984-1988
Direct
Investment
1984-1988
1989-1992
1989-1992
Investment
1984-1988
1989-1992
Public Consumption
1984-1988
1989-1993
2.2
5.0 -2.0
1.3 -0.4
8.7 -3.8
1.9 5.0
3.3 4.6
4.8
0.1
-4.9 4.2
11.0
1.2
3.9
0.5
1.2 0.3
-
2.7
6.2 0.8
1.7 9.4
11.3 0.6
0.5 -0.3
-1.7 0.8
1.5 1.9
2.6
23.8
25.4 28.9
36.3 26.0
32.8 18.3
20.8 38.9
39.0 23.0
19.5 19.3
22.7 21.8
28.2 25.0
28.1
10.0
10.2 9.8
9.7 12.5
10.6 6.8
8.0 12.8
10.9 9.6
7.6 15.0
16.5 13.6
9.9 11.3
10.4
Source:
World
Economic
Outlook;
International Financial Statistics.
"Includes errors and omissions.
60
CONTEMPORARY ECONOMIC POLICY
both regions, an acceleration in growth
accompanies the capital inflows.
There also are differences in the macro-
economic impact of the capital inflows
into Asia and Latin America. Figure 2 il-
lustrates that in the majority of the Latin
American countries in the sample, a real
exchange rate appreciation has accompa-
nied capital inflows. In Asia, such an ap-
preciation is less common (figure
2).
The
appreciation of the Won during 1988-1989
predates the surge of capital inflows. (The
analysis here uses the IMF indices of the
real effective exchange rate, and thus an
appreciation is represented by an increase
in the index.) The reasons why the real
exchange rate responds differently to cap-
ital inflows in the two regions likely are
numerous, but important differences in
the composition of aggregate demand may
play a key role in determining whether the
real exchange rate appreciates
or
not.
For
the Asian countries, investment as
a share of
GDP
increases by about
3
per-
centage points during the capital inflows
period (table 2). Marked differences occur
across the Latin American countries, but
on average investment falls. The inflows
during the 1990-1992 period are associ-
ated primarily with a decline in private
saving and with higher consumption. Very
disparate initial conditions in excess ca-
pacity between the two regions may help
explain why investment surges in Asia
and not in Latin America. Most Asian
countries enter the capital inflow episode
closer to full capacity utilization than do
their Latin American counterparts, where
growth had been sluggish
or
nonexistent
(an exception is Chile). Often for these
countries, the increase in investment falls
primarily on imported capital goods. On
the other hand, relative to investment, the
increase in consumption is less tilted to-
ward traded goods. Other things equal,
this observation suggests that a real ex-
change rate appreciation is more likely
when capital inflows finance consumption
rather than investment.
The behavior of public consumption
also influences the real exchange rate by
affecting both the level and composition of
aggregate demand. In some of the Asian
countries, most notably Thailand, the cap-
ital inflows coincided with a contraction
in fiscal expenditure. However, this early
contraction was not sustained (see Bercu-
son and Koenig, 1993). A number of Latin
American countries also have enacted
major fiscal adjustment programs. How-
ever, these predate the surge in capital in-
flows. These expenditure cuts may reduce
or
eliminate the real exchange rate pres-
sures in
two
ways: (i) The fiscal contrac-
tion tends to reduce aggregate demand,
and (ii) public consumption may be more
biased toward nontraded goods than pri-
vate consumption.
Another factor possibly limiting the real
exchange rate appreciation in Asia is the
fact that a higher share of the inflows to
that region takes the form of foreign direct
investment. Since direct investment
usu-
ally is not intermediated through the do-
mestic banking system, no accompanying
expansion in domestic credit and money
occurs (see section V). Hence, the potential
for ”overheating” likely is lessened. In the
Asian countries,
44
percent of the increase
in capital inflows came from foreign direct
investment. In the Latin American coun-
tries, direct investment accounted for
17
percent of the increase in inflows. This dif-
ference may help explain why concerns
over ”hot money” and a sudden reversal
are more prevalent among Latin American
policy circles than among their Asian
counterparts. It also may partially explain
why the increase in investment is much
greater for most of the Asian countries.
V.
THE
ROLE
OF
CREDIT
The impact of capital inflows on the real
exchange rate and in turn on international
competitiveness is a major source of con-
cern to policymakers. However, other
areas of the economy are vulnerable to
changes in flows of capital. These areas
CALVO
et
al.:
THE CAPITAL INFLOWS PROBLEM-CONCEPTS AND ISSUES
61
FIGURE
2
Real Effective Exchange Rates: Selected Latin American and Asian Countries
(Logs
of
Index Levels,
1980
=
100)
ARGENTINA
4.4
43
-
4.2
-
4.1
.
4-
-
Jw-as
AndB
An-W
An91
J.n-02
MEXICO
4.4
42
4.11
4.1
MEXICO
46
-
4.48
-
4.4
4.s
-
43
-
4s
-
42
-
4.11-
4.1.
-
4.0s
-
AndO
An40 An40 Anal An=
--
AndO
An40 An40 Anal An=
4.m
4
/
\I
\
PHI
LIP
PIN
ES
4.w
4.34
-
4.52
-
4.3-
4.21
-
4.28-
4.24
-
4.22-
4.2
-
4.18-
4.18-
4.14-
4.12-
4.17
1087 1W 1989
1980
1991
1992
PERU
8.8
8.7
.
8.8
-
8.8.
8.4
-
8.3.
82
-
8.1.
8-
4.9
-
4.8
-
4.7
-
4.8
-
4d
7
-
J.n-88
An40
J.rr00
An41 An-
4.44
"f\
4.40
4.42
THAILAND
4.m-
.
An47 An-88 An-8e An-W An-01 An-92
Note:
An
lncreare In the Index denotes
a
real exchange rate appreciation.
Source:
Information
Notlce
Syetem.
International Monetary Fund.
62
CONTEMPORARY ECONOMIC
POLICY
receive less attention. Specifically, one
must consider the banking
or
financial sys-
tem that intermediates part of these in-
flows.
Domestic intermediation of capital in-
flows is not strictly necessary; for example,
foreign direct investment rarely relies on
domestic intermediation. In addition, a
domestic consumer
or
investor could bor-
row
in international markets in order to
purchase the desired goods and services.
However, in practice, domestic credit mar-
kets-banks in particular-play a key role
in intermediating capital inflows. Domes-
tic banks operate in the country in ques-
tion but may have headquarters else-
where. Allowing banks to offer competi-
tive interest rates and ensuring that re-
serve requirements are not large enhances
banks’ intermediating role.
Banks play a central role in cases where
the monetary authority sterilizes all
or
part of such inflows by issuing treasury
bills. As many sterilization examples
show, banks often ended up as the major
investors in treasury bills. However, banks
also may play an important role in non-
sterilization episodes. Bank deposits are
attractive to short-term investors who typ-
ically ”park their funds in a local bank
until better opportunities arise abroad
or,
on occasion, at home. In turn, banks invest
those funds-usually as loans at home.
The
two
major concerns about the in-
termediation of capital flows through the
domestic banking system are that (i) in-
terest rates reflect “country risk and (ii)
unpaid-for explicit
or
implicit insurance
on bank deposits increase bank risk. The
first factor implies that domestic interest
rates are higher than international ones.
Hence, when the central bank intervenes
and sterilizes, it issues high-yielding trea-
sury bills and acquires low-yielding inter-
national reserves (e.g.,
U.S.
Treasury bills).
Such an operation increases what analysts
often call the “quasi-fiscal deficit.” This
fiscal cost can be substantial when massive
sterilization of inflows takes place, as the
recent experiences in Egypt and Colombia
illustrate.
Free implicit bank deposits’ insurance
is of concern because it induces banks to
increase their risk exposure and to pay lit-
tle attention to loan quality and to match-
ing the maturities of deposits with that of
loans-the former normally being shorter
than the latter.
A
surge in lending may
thus create
or
exacerbate a maturity
(and/or currency) mismatch between
bank assets and liabilities. Hence, sudden
capital outflows may result in a financial
crisis. The problem is magnified if banking
supervision is poor and banks do not ster-
ilize the capital inflows and lend these
funds to the private sector to invest in non-
liquid assets
or
to finance current expen-
ditures. However, someone must finance
insurance, and such schemes probably in-
crease country risk, preventing domestic
interest rates from converging to interna-
tional levels.
Reasons other than banking sector vul-
nerability suggest that inadequate inter-
mediation is a source of concern.
For
ex-
ample, the private sector may overborrow
for one of three reasons: (i) static distor-
tions (e.g., wage rigidity, imperfect compe-
tition); (ii) dynamic
(or
capital market) dis-
tortions, which include unpaid-for deposit
insurance and lack of credibility in policy
announcements; and (iii) income distribu-
tion considerations. Thus, distortions can
induce inadequate financial intermedia-
tion. Static distortions may lead to choos-
ing the wrong technology, and access to
foreign credit can magnify this problem’s
deleterious effects. In turn, dynamic dis-
tortions directly induce the wrong kind of
intermediation. The last point corresponds
to the case in which the market outcome
is not optimal from the policymaker’s
viewpoint because of unwanted effects on
income distribution (either across mem-
bers of the same generation
or
across dif-
ferent generations).
In sum, any deleterious effects of
do-
mestic intermediation are likely to in-
CALVO
et
al.:
THE
CAPITAL INFLOWS PROBLEM-CONCEPTS AND
ISSUES
63
crease in the face of massive capital in-
flows. And these effects are likely to be
greater if the inflows are primarily short
term.
VI.
MANAGING CAPITAL INFLOWS
The optimal policy response to capital
inflows is very much a function of the an-
ticipated persistence of capital inflows and
the nature of domestic credit markets. In
addition, the prevailing “policy environ-
ment” and the authorities’ degree of cred-
ibility also are key determinants of the ap-
propriate policy response’s form and
timing.
The rationale for policy intervention
emerges from policymakers’ main con-
cerns. (i) Since capital inflows often are
associated with real exchange rate appre-
ciation, inflows may adversely affect the
export sector. (ii) Capital inflows may not
be properly intermediated and may lead
to a misallocation of resources. (iii) The
“hot money” variety of inflows could be
reversed on short notice and possibly lead
to a domestic financial crisis. These con-
cerns often lead authorities to react to the
capital inflows by implementing a broad
variety of policy measures. The remainder
of this section examines the relative merits
of some of the macroeconomic policies as
well as some of the more relevant micro-
economic issues. For a discussion of these
issues from the perspective of Chilean
monetary and exchange rate policies, see
Zahler
(1992).
A.
Moneta
y
and Exchange Rate
Policy
A country with poorly functioning
do-
mestic credit markets and concerns about
inflation and banking sector vulnerability
is likely
to
prefer sterilization unless, or
until, the fiscal costs become exorbitant.
Sterilization may allow a tighter grip on
liquidity (see Calvo and Wgh,
1992),
and
sudden capital outflows can be met by a
loss of reserves without affecting credit to
the private sector. In addition, if the mon-
etary authorities’ credibility is not well es-
tablished and is linked to the performance
of the monetary aggregates, there may be
grounds for sterilizing in order to curb the
growth of these aggregates. The sharp
across-the-board accumulation in reserves
(section 111) attests to an active policy of
intervention. In most instances, the inter-
vention was sterilized. Indeed, sterilized
intervention has been by far the most com-
mon policy response to the surge in capital
inflows in both Asia and Latin America.
However, difficulties arise when the fis-
cal costs of sterilization are large and
threaten to jeopardize the credibility of ex-
isting policies. In addition, in some in-
stances (Colombia and Malaysia) steriliza-
tion policies have driven up domestic in-
terest rates, further stimulating capital in-
flows. Under those circumstances, there are
three major monetary policy options: (i)
allow the exchange rate to float, (ii) increase
marginal cash/ deposit requirements, and
(iii) resort to unsterilized intervention.
Option (i), floating exchange rates, has
the advantage of making money supply
and
domestic credit exogenous with re-
spect to capital inflows. While none of the
countries discussed have switched to a
floating exchange rate system, some coun-
tries such as Chile and Mexico have wid-
ened the bands in which the exchange rate
is allowed to fluctuate. One might argue
that the greater exchange rate uncertainty
may discourage short-run speculative in-
flows. The main disadvantage of a pure
float is that massive capital inflows may
induce a steep nominal
and
real apprecia-
tion of the domestic currency. The latter
may hurt strategic sectors of the economy,
like non-traditional exports. This clearly is
the case if the real appreciation
is
persis-
tent. But even when the latter does not
hold, the greater real exchange rate vola-
tility may have negative effects on trad-
able-goods sectors. Several countries-
Chile, Colombia, Malaysia, Singapore
among others-have avoided the ex-
change rate volatility associated with a
64
CONTEMPORARY ECONOMIC POLICY
pure float and still have limited the impact
of capital inflows on the money stock by
allowing for some appreciation of the
nominal exchange rate. To the extent that
the equilibrium real exchange rate appre-
ciates, this policy has an advantage in that
the real appreciation occurs all at once
through the nominal exchange rate appre-
ciation rather than gradually through in-
flation increases.
Option (ii), increasing marginal reserve
requirements lowers the capacity of banks
to lend. Chile and Malaysia have used this
policy, which is especially relevant in
countries where capital inflows have taken
the form of substantial increases in local
bank accounts. The higher reserve require-
ment limits the expansion in the monetary
and credit aggregates without the quasi-
fiscal costs associated with sterilized inter-
vention.
A
drawback is that over time this
policy may promote disintermediation, as
new institutions may develop in an at-
tempt to bypass these regulations. Eventu-
ally these new institutions could grow
large and end up under the insurance um-
brella of the central bank (by the principle
that they are “too large to fail”), recreating
all the problems associated with non-ster-
ilized intervention. Therefore, increasing
marginal reserve requirements likely will
not be effective beyond the short run.
Moreover, increasing bank reserve require-
ments amounts to reversing the underly-
ing trends of developing countries’ finan-
cial liberalization, which recently has re-
sulted in sharp reductions in reserve re-
quirements.
Option (iii), non-sterilized intervention.
(the case of Argentina), runs the risk
of
generating a vulnerable financial system.
The smaller the banking system’s capabil-
ities
(or
willingness) to increase lending to
the private sector, the more attractive this
option becomes. However, nonsterilized
intervention does allow capital inflows to
exert a downward pressure on domestic
interest rates. This effect will have the ad-
vantage of slowing down capital inflows
and of lowering the fiscal cost of the out-
standing domestic credit.
B.
Fiscal
Policy
Taxes on short-term borrowing abroad
were imposed in some countries-Israel in
1978 and Chile 1991. Although this policy
is effective in the short run, experience
suggests that the private sector quickly
finds ways to dodge those taxes through
over- and under-invoicing of imports and
exports and increasing reliance on parallel
financial and foreign exchange markets.
Another policy reaction to capital in-
flows could be to tighten fiscal policy.
Thailand adopted this policy. Tightening
fiscal policy is not likely to stop the capital
inflow but may lower aggregate demand
and curb the inflationary impact of capital
inflows. In addition, to the extent that a
tighter fiscal stance reduces the
government’s need to issue debt, such a
stance also is likely to lower domestic in-
terest rates. In that context, higher taxes
may be less effective than lower govern-
ment expenditure. Often when credit is
widely available-as it is when a country
experiences massive capital inflows-
individuals’ expenditures can be largely
independent of their tax liability. This is
especially true
if
higher taxes are transi-
tory-a somewhat plausible expectation
since higher the taxes would be associated
with transitory capital inflows. In contrast,
lower government expenditure-particu-
larly when this expenditure is directed to
purchasing nontraded goods and ser-
vices-has a direct impact
on
aggregate
demand. This impact is not likely to be
offset by an expansion of private sector
demand. However, contraction of govern-
ment expenditure always is a sensitive
po-
litical issue. Overall, it
is
hard to provide
a strong case for adjusting fiscal policy,
which usually is set on the basis of me-
dium-
or
long-term considerations, in re-
sponse to what may turn out to be short-
term fluctuations in capital flows. How-
CALVO
et
al.:
THE CAPITAL INFLOWS PROBLEM-CONCEPTS AND ISSUES
65
ever, if the authorities envision a tighten-
ing of the fiscal stance, the presence of cap-
ital inflow may call for earlier action in
this respect.
C.
Trade Policy
Trade policy measures can help to in-
sulate the export sector from real exchange
rate appreciation. A possibility is to in-
crease both export subsidies
and
import
tariffs in the same proportion
so
as to avoid
creating further relative discrepancies be-
tween internal to external terms of trade
and
to announce that those subsidies/ tar-
iffs will be phased out in the future. In-
deed, if the private sector perceives these
measures as transitory, agents are likely
to substitute future for present expendi-
ture, thereby cooling off the economy and
attenuating the real exchange rate appre-
ciation. The fiscal cost
of
this package need
not be large, and static distortions do not
increase, since such a trade policy does
not change initial relative price distortions
between exports and imports. However,
one can criticize this policy on several
grounds. First, its effectiveness depends on
the private sector’s believing that those
subsidies/ tariffs will be phased out in the
future. Second, these policies deviate from
the worldwide trend towards commercial
opening. As past experience shows, such
protectionist moves often lead to retalia-
tion and welfare reductions.
D.
Banking Regulation and Supervision
As
discussed earlier, attempting to in-
sulate the banking system from short-term
capital flows is an attractive goal in cases
where most of the inflows take the form
of
increased short-term bank deposits.
Regulation limiting banks’ exposure to the
volatility in equity and real estate markets
could help insulate the banking system
from the bubbles associated with sizable
capital inflows. In this vein, risk-based
capital requirements in conjunction with
adequate banking supervision that en-
sures compliance could help insulate the
domestic banking system from the vagar-
ies of capital flows.
VII.
FINAL
WORDS
Emphasizing the risks associated with
capital inflows may be too pessimistic. The
overall picture is less bleak. The analysis
here points
out
that several Asian coun-
tries have experienced capital inflows sim-
ilar to those in Latin America without as-
sociated sizable appreciations of the real
exchange rate-perhaps, in part, because
a large share of capital flows into these
Asian countries has taken the form of di-
rect investment. This finding renders moot
many policy concerns. However, the key
question is how to achieve this favorable
composition of capital flows.
No
policy
”tricks” can do the job. In order to induce
investors to bolt down their capital, poli-
cymakers must muster a high degree of
credibility and support clear, simple, and
market-oriented policies. Even then, sub-
stantive direct investment may not occur
for sometime.
Until credibility is achieved, countries
are well advised to be cautious about the
intermediation of capital flows, especially
if these flows are perceived to be primarily
short-term and easily reversible. Countries
that have successfully managed (to date)
the surge in inflows have not relied on a
single policy measure. The approach has
been eclectic, combining a number of the
policy options. Thus, a reasonable se-
quencing of policies involves initially lim-
iting the intermediation of those flows by
combining sterilized intervention, greater
exchange rate flexibility, and possibly in-
creased marginal reserve requirements.
Policymakers could then adopt measures
to gradually monetize these flows (non-
sterilized intervention) and perhaps ap-
preciate the currency.
66 CONTEMPORARY ECONOMIC POLICY
El-Erian, M. A., "Restoration of Access
to
Voluntary
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