Capital Flows: Shocks or shock absorbers?

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Financial crises often arise from a sudden stop to capital flows. One way to limit this danger is to restrict capital flows. Another approach would be to structure the financial market in such a way that the damage from a sudden stop is limited. Capital controls (also called capital-flow management measures, or CFMs) and macro-prudential measures (MPMs) are complements rather than substitutes. Both can be employed alongside standard macroeconomic policies, like monetary or exchange rate policies. The optimal mixture depends on the available policy space and the objectives pursued in individual countries and their suitability at a given time in the business/financial cycles. CFMs and MPMs can overlap when large capital flows become a potential source of systemic risk (e.g. capital inflows into the domestic banking sector that can fuel a housing bubble – limits on the credit for real estate transactions). Both capital controls and MPMs should take into account that non-bank financial institutions will continue to gain importance in financial intermediation, and also that digitalisation of financial services may significantly change the configuration of capital flows. Continued vigilance was thus required. The availability of data could be improved in terms of the timeliness, scope and granularity of data on capital flows. A comprehensive database stored at a one-stop at a one-stop information hub for MPMs should be considered.

Monetary policy in the advanced economies might have side effects on overall flows to emerging economies. Should this be taken into account when setting policy? Moreover, changes in controls on outflow by source countries could also increase or reduce the funding available for savings-deficient emerging markets. There are thus ample reasons to coordinate capital flow measures. The same also holds true for macro-prudential policies. Emerging economies should benefit if advanced economies would dampen their own cycle.There was need for more organised/transparent discussion between source and recipient countries about their choice of policy tools and their preferred composition of flows (trade-off financial stability and growth). Different fora, the G20, the IMF and the OECD (with its code of conduct) all covered part of the agenda. What could be the objective of global coordination on capital account measures and their liberation? To many, a reduction in the volatility of capital flows appears desirable, but some volatility over the cycles seems unavoidable. Increasing the resilience of the financial system to this volatility needs to be also part of the response.

Cosmina Amariei is Researcher at European Capital Markets Institute (ECMI).