Over the past 20 years, emerging market economies have experienced three large waves of net capital inflows. The first wave of net capital inflows started in the early 1990s and concluded with the Asian financial crisis in 1997.
The second wave began in 2003 and ended in 2008 when the global financial crisis began. The third wave resumed surprisingly quickly in early 2009. In Asia, thanks to low interest rates around the world, capital ran to high-return economies with the flows exceeding the pre-crisis level by early 2010.
Capital inflows deliver economic benefits and are highly welcome in emerging economies. They lower the costs of funding and improve living standards. Nonetheless, capital inflows often come with many undesired effects.
First, they can push up the real exchange rate, making it harder for a country to compete on exports because its products become more expensive. Second, they can lead the economy to overheat, generating inflationary pressures when the central bank comes in to moderate exchange rate appreciation through loose monetary policy.
Third, they can set off asset price bubbles, with prices divorced from fundamental forces of supply and demand and intensifying financial vulnerability.
The ebb and flow of capital inflows in recent years did indeed drive cycles of boom and bust in emerging economies. Capital flows in as a result of rich-country fiscal deficits and loose monetary policies, producing unreasonably high asset prices.
After the collapse of Lehman Brothers on Sept 15, 2008, stock indices in many Asian economies plunged. However, with the revival of capital inflows in early 2009, stock indices in many countries today have reached new heights with some even doubling.
For instance, in March 2009, Singapore’s Straits Times Index was 1,456 but last week was trading around 3,260. Similarly, the Hang Seng index in Hong Kong was around 11,015 in March 2009 and is around 22,600 today. Stock indices of other economies, such as South Korea and Australia, have behaved likewise.
Capital inflows also pushed up real-estate prices. In Singapore, home prices rose more than 15% in one quarter, the fastest in 28 years. In Hong Kong, high-end real-estate prices are soaring. Korean and Australian real-estate markets have also heated up. Average home prices in many countries are expected to double over the next 10 to 12 years.
Capital inflows as a result of rich-country fiscal deficits and loose monetary policies will fuel a substantial appreciation of exchange rates.
Exchange rate appreciation, if sustained, can be beneficial to small and medium-sized enterprises that are importers, but harmful to exporters as rising currency values make it harder to export. Different countries have different monetary policy responses to capital inflows as a result.
In conventional macroeconomics, the “impossible trinity” paradigm suggests that, without direct capital controls, countries that experience large capital inflows need to choose between rising currency values and inflation.
Without any form of intervention in the foreign-exchange market, currency values rise. This makes it harder for countries to compete in exports because their products become more expensive, worsening current account deficits, intensifying external imbalances, and heightening the vulnerability to a sharp reversal of capital inflows.
Countries facing large capital inflows can choose to resist pressures for the currency to appreciate by intervening in the foreign exchange market.
Maintaining a currency board in Hong Kong and the managed exchange rate in Singapore can lead to the accumulation of foreign reserves and loosen monetary conditions, creating potential for overheating and inflation.
Many other Asian central banks including the Bank of Korea, however, are not willing to tighten monetary policy, fearing that a wider return differential relative to mature economies would attract even larger capital inflows. Policymakers can also try to restrict the inflows of capital by imposing controls on capital inflows or by removing controls on capital outflows.
With such control measures, countries want to achieve multiple policy goals at once, including discouraging capital inflows to reduce upward pressures on exchange rate, reducing the risk associated with the sudden reversal of inflows and maintaining some degree of monetary policy independence.
Scholars and policymakers, however, have yet to agree on the role of capital controls in helping countries withstand external shocks and avoiding extreme exchange rate fluctuations. Control on capital inflows may also be seen a less responsible policy option as it actually pushes undesirable flows to other locations.
Policies thus far are not ideal. Another instrument available is a policy mix of loose monetary policy and countercyclical fiscal policy. Such options could potentially mitigate the effects of overheating and exchange rate appreciation as a result of surge in capital inflows.
Greater self-control on government expenditure in the midst of capital inflows has several benefits. First, countercyclical fiscal policy not only dampens aggregate demand but also reduces return differentials and hence the incentive for inflows. Second, fiscal restraint helps to moderate exchange rate appreciation. Third, an improving fiscal position during the period of high inflows may provide greater scope for countercyclical fiscal response to cushion economic performance when the inflows stop.
To battle bubbles, macroeconomic policies alone are not enough. Dampening property prices using macroeconomic policies alone is certainly too blunt an instrument to be applied in non-crisis periods. Macroprudential regulations, which are aimed at mitigating the risk of the financial system as a whole, become relevant.
Tightening mortgage requirements and pledging to provide more land for development are sensible policy options to cool real estate markets.
Perhaps the next step is to aim at reducing the likelihood of a sudden stop. Empirical evidence has shown that the likelihood of sudden stops declines as financial vulnerabilities are lowered. To reduce such likelihood, countercyclical banking regulations that impose limits on non-deposit bank liabilities can be an option.
The writer is an assistant professor of economics at Nanyang Technological University and acknowledges the contribution of NTU student Poh Wen Eng for this article. The article was first published in Business Times (Singapore).
About the author
Writer: Chia Wai Mun