Managing Capital Flows and Exchange Rates
KDI/EWC series on Economic Policy
Edited by Dongsoo Kang and Andrew Mason
Chapter 5: Irrational expectations, financial amplification and prudential capital controls
Capital market liberalization and integration into the global financial markets bring not only benefits but also costs into the emerging market economies. Empirical evidence (e.g., Reinhart and Rogoff, 2009) suggests a relationship between financial liberalization and financial instability that may impose high welfare costs, which are of great concern to economic agents and policy-makers. Responding to crises or for prudential purposes, a number of emerging market economies have imposed controls on international capital flows. Brazil, Colombia, Indonesia, Korea, Taiwan, Thailand and Peru either imposed new measures or extended existing ones in order to manage capital inflows from 2009 to 2011 (see Ostry et al., 2011). A recent and growing body of literature understands the financial crises in the emerging economies as incidences of financial amplification. Moreover, it argues that prudential controls on capital flows to emerging economies may be desirable from a welfare-theoretic perspective, because they reduce the costs from the financial crises. Figure 5.1 depicts such financial amplification effects. When negative shocks hit emerging economies, they experience a decline in aggregate demand, an ensuing depreciation of their exchange rates and also a decline in asset prices. This results in adverse balance sheet effects of a declining value of collateral and net worth, which constrain access to external finance and force further contraction in the aggregate demand. These balance sheet effects and financial amplifications occur in the presence of binding external borrowing constraints. Then, when does the external borrowing condition become constraining? Seeds may be sown through the opposite process of the previous vicious financial amplification. In good times, emerging market agents experience growing aggregate demand, increasing asset prices and exchange rate appreciations, which improve external borrowing capacity and accumulate external debt. Seeds of financial crises are sown in good times.
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