Developing Countries’ Policy Responses to Large Private Capital Inflows: Control or Liberalize?

Although the influx of large private capital inflows provides developing countries with substantial macroeconomic benefits, the integration process carries some difficult macroeconomic challenges. This paper examines the implications of large private capital inflows episodes on the macroeconomic fundamentals of highly integrated developing countries under the two policy regimes. We begin by classifying developing countries according to their degree of capital account openness. Then, we exploit large capital inflow episodes to measure their short-run effects on key domestic macroeconomic fundamentals for a sub-sample of highly integrated countries that adopted the two policy regimes using a VAR framework. The results indicate that countries experiencing more volatile macroeconomic fluctuations, including a sharp reversal of inflows, tend to have higher current account deficits and experience stronger increases in both aggregate demand and the real value of the currency during the period of large capital inflows. In this respect, countries with a liberalized capital account usually witness an expansion of economic activity. However, such an effect is not likely to last indefinitely, and the boom phase may tend to reverse itself as the economy reaches its potential. Meanwhile, countries that adopt tightening capital controls on capital inflows experience more moderate GDP growth following the surge in inflows. Nonetheless, capital controls don’t completely insulate countries against external disturbances, as the real exchange rate is more vulnerable to shocks.