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Coping with too much of a good thing : policy responses for large capital inflows in developing countries

Author

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  • Goldstein, Morris

Abstract

In discussing the causes and consequences of large capital inflows to developing countries, the author emphasizes two things. First, although there are legitimate grounds for an optimistic long-term outlook on private capital flows to developing countries, there is little to suggest that the volatility of capital flows will end. In designing policy strategies to accommodate this volatility, a premium should be put on credibility, resilience, and flexibility. Second, country differences notwithstanding, host countries need to respect the basics of adjustment and finance in designing their policy response to large inflows. Host countries that want to keep using the nominal exchange rate as their key nominal anchor and that do not want to accept much appreciation in their real exchange rate must be prepared to tighten fiscal policy. This is the most reliable way to reduce aggregate demand, keep inflation in check, and limit deterioration of the current account. Regarding sterilization policy, domestic interest rates will be higher and the size of the inflow will be larger with sterilization than without it. Not that sterilization necessarily need be avoided; in the early stages of inflow, it can help moderate or even offset the induced expansion of domestic credit. But with high capital mobility, sterilization becomes more expensive and less effective the longer it is used. Effective regulation and supervision are important in ensuring the best use of large inflows of foreign resources. It makes a big difference, for example, if banks use their higher reserves to lend for productive investment and human capital formation than if they use them to fund speculative activities that eventually translate into nonperforming loans (and perhaps a large public sector liability as well). Careful assessment of credit risk and of maturity mismatches are essential if banks are to help the private sector earn a rate of return greater than the cost of capital. Similarly, good disclosure and accounting standards are essential for accurate pricing of risk in both banking and securities markets. These and similar measures are worth implementing even without large capital inflows. Beyond dealing with surges in capital inflows, host countries must decide the optimal speed at which they wish to move toward full capital account liberalization.

Suggested Citation

  • Goldstein, Morris, 1995. "Coping with too much of a good thing : policy responses for large capital inflows in developing countries," Policy Research Working Paper Series 1507, The World Bank.
  • Handle: RePEc:wbk:wbrwps:1507
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Bernardo S. de M. Carvalho & Márcio G. P. Garcia, 2008. "Ineffective Controls on Capital Inflows under Sophisticated Financial Markets: Brazil in the Nineties," NBER Chapters,in: Financial Markets Volatility and Performance in Emerging Markets, pages 29-96 National Bureau of Economic Research, Inc.
    2. Goopu, Sudarshan, 1996. "The analysis of emerging policy issues in development finance," Policy Research Working Paper Series 1589, The World Bank.
    3. Gooptu, Sudarshan, 1996. "Emerging policy issues in development finance," The Quarterly Review of Economics and Finance, Elsevier, vol. 36(Supplemen), pages 85-100.
    4. Ying, Yung-Hsiang & Kuan, Chung-Ming & Tung, Chris Y. & Chang, Koyin, 2013. "“Capital mobility in East Asian Countries is not so high”: Examining the impact of sterilization on capital flows," China Economic Review, Elsevier, vol. 24(C), pages 55-64.
    5. Lensink, Robert & White, Howard, 1998. "Does the Revival of International Private Capital Flows Mean the End of Aid?: An Analysis of Developing Countries' Access to Private Capital," World Development, Elsevier, vol. 26(7), pages 1221-1234, July.
    6. Sadik, Ali T. & Bolbol, Ali A., 2001. "Capital Flows, FDI, and Technology Spillovers: Evidence from Arab Countries," World Development, Elsevier, vol. 29(12), pages 2111-2125, December.
    7. Lim Choon-Seng, 1999. "Extent and Efficacy of Monetary Sterilisation in the SEACEN Countries," Research Studies, South East Asian Central Banks (SEACEN) Research and Training Centre, number rp40, April.
    8. Frankel, Jeffrey A & Okongwu, Chudozie, 1996. "Liberalized Portfolio Capital Inflows in Emerging Markets: Sterilization, Expectations, and the Incompleteness of Interest Rate Convergence," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 1(1), pages 1-23, January.
    9. Christiane Nickel & Günter Schmidt & Georg Stadtmann & Michael Frenkel, 2001. "The Effects of Capital Controls on Exchange Rate Volatility and Output," IMF Working Papers 01/187, International Monetary Fund.
    10. Jeffrey A. Frankel & Chudozie Okongwu, 1995. "Liberalized Portfolio Capital Inflows in Emerging Capital Markets: Sterilization, Expectations, and the Incompleteness of Interest Rate Convergence," NBER Working Papers 5156, National Bureau of Economic Research, Inc.
    11. M. Frenkel & G. Shimidt & G. Stadtmann & Nickle Christiane, 2002. "The Effects of Capital Controls on Exchange Rate Volatility and Output," International Economic Journal, Taylor & Francis Journals, vol. 16(4), pages 27-51.
    12. Heike Joebges, 2000. "Ursachen für die Häufung von "Zwillingskrisen" in Schwellenländern," Vierteljahrshefte zur Wirtschaftsforschung / Quarterly Journal of Economic Research, DIW Berlin, German Institute for Economic Research, vol. 69(1), pages 38-52.

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