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Liberalization and Regulation of Capital Flows : Lessons for Emerging Market Economies

  • Rakesh Mohan

    (Asian Development Bank Institute)

  • Muneesh Kapur
Registered author(s):

    Capital flows to emerging market economies (EMEs) have been characterized by high volatility since the 1980s. In recent years (especially since 2003), although gross as well as net capital flows to the EMEs have increased, they could not be absorbed domestically. Overall, savings have flowed uphill from EMEs to advanced economies, challenging the conventional view that capital flows to EMEs are always beneficial through augmentation of their resources leading to greater investment. Full capital account liberalization can impart avoidable volatility and have an adverse impact on growth prospects of EMEs. Available evidence is strongly in favor of a calibrated and well-sequenced approach to opening up the capital account and its active management, along with complementary reforms in other sectors. Greater caution is needed in the liberalization of debt flows. Despite much advice to the contrary, most EMEs manage their capital accounts actively to cushion their economies from undue volatility, including interventions in the foreign exchange markets accompanied by sterilization. Sound macroeconomic and financial policiesaccompanied by prudent capital account management, greater exchange rate flexibility, purposive use of prudential regulation, and continued financial market development practiced by most Asian EMEs over the past decadehave cushioned their economies from the current global financial crisis that started in 2007. They have successfully achieved a virtuous circle of continuing growth, low and stable inflation, and financial stability. How these elements can be best combined will depend on the country and on the period : There is no one size fits all. Such a discretionary approach does put a great premium on the skill of policymakers and can run the risk of markets perceiving central bank actions becoming uncomfortably unpredictable. Such risk is mitigated by a record of successful management.

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    File URL: http://www.eaber.org/node/22877
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    Paper provided by East Asian Bureau of Economic Research in its series Macroeconomics Working Papers with number 22877.

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    Date of creation: Jan 2010
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    Handle: RePEc:eab:macroe:22877
    Contact details of provider: Postal: JG Crawford Building #13, Asia Pacific School of Economics and Government, Australian National University, ACT 0200
    Web page: http://www.eaber.org

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