Managing Capital Flows and Exchange Rates
- KDI/EWC series on Economic Policy
Edited by Dongsoo Kang and Andrew Mason
Chapter 11: Facing volatile capital flows: the role of exchange rate flexibility and foreign assets
In the last two decades, international financial integration has increased substantially around the world. As a result, countries are now more exposed to both the positive and the negative effects of capital flows. The increased external financing has become a mixed blessing for developing economies. While providing an alternative source of funding, concerns arise about both monetary policy and financial stability. On the former, a highly open capital account leads to a loss of independence of monetary policy in a context of exchange rate flexibility (the so-called impossible trinity). On the financial stability side, concerns are associated with the volatility of flows. Boom–bust cycles in external financing may cause financial stability through currency mismatches. Also, if funds retrieved cannot be replaced, projects being financed may default. On the positive side, capital flows benefit growth, as they provide additional sources of funding for investment. In addition, easier access to credit can improve consumption smoothing, reducing macroeconomic volatility in the presence of transitory shocks. The volatility that accompanied increased flows in the 1990s led to the adoption of controls to capital flows in some countries and to a debate on their effectiveness. Although evidence of the 1990s pointed to the difficulty of administering controls effectively, in the sense of avoiding ways to circumvent them, they have come back into the debate when episodes of increased volatility of flows take place, as has been the case in recent years. Concerns involving the role of capital controls have been focused on avoiding transitory real exchange rate appreciation in the presence of a wave of capital inflows (i.e., Brazil).
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