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

Capital flows to Emerging Market Economies (EMEs) have been characterised by high volatility over the past couple of decades. In recent years although gross capital flows have increased greatly overall net capital flows have flowed uphill from EMEs to advanced economies. This has challenged the conventional view that capital flows to EMEs are always beneficial through augmentation of their resources leading to greater investment. Full capital account liberalisation can impart avoidable volatility and have an adverse impact on growth prospects of the EMEs. Available evidence is strongly in favour of a calibrated and well-sequenced approach to opening up of the capital account and its active management, along with complementary reforms in other sectors. Greater caution is necessitated in the liberalisation of debt flows. In order to cushion their economies from undue volatility, despite much advice to the contrary, most EMEs manage their capital accounts actively, including interventions in the foreign exchange markets accompanied by sterilization. Sound macroeconomic and financial policies, accompanied by prudent capital account management, greater exchange rate flexibility, purposive use of prudential regulation, along with continued financial market development, as practised by the Asian EMEs over the past decade have cushioned their economies from the current global financial crisis. They have successfully achieved a virtuous circle of high growth, low 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 great premium on the skill of policymakers and can run the risk of markets perceiving central bank actions to become uncomfortably unpredictable. Such risk is mitigated by a record of successful management.