capital inflows analysis

8/10/2019 Capital Inflows analysis

http://slidepdf.com/reader/full/capital-inflows-analysis 1/25

MACROECONOMIC ADJUSTMENTTO CAPITAL INFLOWS: LESSONSFROM RECENT LATIN AMERICANAND EAST ASIAN EXPERIENCE

Vittorio CorboLeonardo Hernandez

Capital inflows to some developing countries have increased sharply in re-cent years. Impelled by better economic prospects in those countries, lower

international interest rates, and a slowdown of economic activity in the capital-exporting countries, the inflows have furnished financing much needed toincrease the use of existing capacity and to stimulate investm ent. Bu t capitalinflows can bring with them their own problems. Typical macroeconomicrepercussions have been appreciation of the real exchange rate, expansion ofnontrada bles at the expen se of tradables, larger trade deficits, and, in re-gimes with a fixed exchange rate, higher inflation and an accumulation offoreign reserves.

Should government intervene to limit some of these side effects—and ifso, ho w? The question is especially pressing in the wake of the Mexica ncrisis of December 1994. This article looks for answers in the experience offour L atin American and five East Asian countries between 1986 and 1993,

examining the effects of the capital inflows on the economy and comparingthe different ways in which these countries responded to the problem of too much capital.

T he debt crisis of 1982 was precipitated by a sudden reduction in capitalinflows at a time when highly indebted developing countries were facinga slowdown of the world economy, a large increase in international in-

terest rates, and a sharp loss in terms of trade. Weak economic policies andinstitutions in many developing countries exacerbated the effects of these shocks.The cutoff of capital inflows forced a quick and steep increase in the size of the

net external transfer—translating, in the short run, into sharply reduced domes-

The World Bank Research Observer, vol. 11 , no. 1 (February 1996) , pp. 61 -8 5© 1996 The International Bank for Reconstruction and Development / THE WORLD BANK 6 1

76555



tic expenditures and imports and, in the longer run, inpo damage to investmrates and economic growth.

During the decade following the initial shock, most of the highly indebcountries set about adjusting their policies and institutions to the new situaof severely restricted external financing. The goal of adjustment was to restosustainable balance of payments, at the same time laying firm foundationsgrow th. Some countries expected to return to international capital marketsto rely this time less on debt and more on direct foreign investment and polio investment.

For the first few years after the debt crisis, most lending to these counttook the form of official loans from international financial institutions to port the policy and institutional reforms necessary to achieve these goals. Ocountries began to make progress in their adjustment efforts, private capinflows tow ard them increased significantly—financed in part by the repation of the capital that had fled these countries in the early 1980s. In fact,capital account surplus (including net errors and omissions) for all develocountries increased from $48.7 billion in 1987, to a record level of $162.9lion in 1993, before easing to $142.2 billion in 1994 (IMF 1995).1 The new in-flows came from commercial bank lending, foreign direct investment, and pfolio capital (investment in stocks and bonds). Portfolio investment, whincreased from $11.9 billion in 1987 to $58.9 billion in 1994 (IMF 1995),been motivated by the potential for providing risk-sharing capital financinexpand the private sector. Host countries have encouraged foreign direct invment, with its promise of access to new technologies and markets, by dismtling restrictions and improving the macroeconomic environment by introing market-oriented reforms. Other incentives to capital inflows have beenintroduction of restrictive monetary policy in conjunction with some typeintervention in the exchange rate market. In any case, much of this inflowan endogenous response to a change in policies and prospects in the recipcountry.

The increase in capital inflows has relaxed the severe financial constraint host countries faced during much of the 1980s. And the new wave of capital haan added advantage over earlier inflows in that the resources are going toprivate sector and are predominantly in the form of equity capital rather debt financing.

But—paradoxically, with the debt crisis so close in time—the early 1990s havrevealed a downside to the inflows: the negative effects of receiving too mucapita l. One example is hot money —short-term, highly volatile inflows ally attrac ted by market imperfections or policy mistakes that create a largebetween domestic and foreign interest rates, the latter adjusted by expectatof devaluation. This type of inflow can be the source of undue or excessive vtility in rates of inflation and in nominal and real exchange rates. These flu

tions can have important economic costs. For example, imperfections in camarkets and barriers to entry in the export and import-competing sectors

62 Th e World Bank Research Observer, vol. 11, no. 1 (February 1996)



lead to an inadequ ate supply of capital and shortages in traded g oods. Real costsof bankruptcy and reallocation of resources can similarly generate economic costs.So in many countries the economic au thorities have tried to discourage hot m oneyby correcting the imperfections and policy mistakes that encouraged such in-flows in the first place or by controlling som e of the side effects of capital inflowsthrough different types of intervention.

Even predictable capital inflows can cause cyclical fluctuations in the realexchange rate, which in turn might affect the tradab le sectors and macroecon omicmanagement as a whole. Admittedly, more stable and lasting capital inflows,elicited by better prospects in the host country rather than by market imperfec-tions, will also set in motion a macroeconomic adjustment process similar to thetraditional Dutch disease (that is, the advers e effect on other sectors when anincrease in the price or volume of an exp ort generates an appreciation of the real .exchange rate, thereby reducing incomes in tradable goods sectors except forthe booming sector itself). There is no apparent economic reason to interferewith that adjustment process, except to smooth it over time.

This article first reviews the m acroeconomic and othe r relate d effects of capi-tal inflows as a basis for discussing why a country could be concerned aboutreceiving too mu ch capital and for analyzing the different econo mic policiesthat countries can use to deal with the side effects of capital inflows. Froman examination of the principal mechanism s used for this purpose by nine devel-oping countries, four Latin American and five East Asian, some conclusionsare drawn on how to manage capital inflows to minimize their detrimentaleffects.

The issues are highly relevant for potential recipient countries, particularly inthe wake of the Mexican crisis of December 1994. Indeed, the Mexican pesocrisis highlights the critical importance of establishing sound macroeconomicfundamentals and avoiding large curren t acco unt deficits w ith their asso ciatedappreciation of the real exchange ra te.2 The postcrisis effects also illustrate howfundamentals in the host country matter: the so-called tequila effect (the im-pact of the Me xican crisis on other countries) was uneven and caused less dis-tress in those economies with a stronger set of fundamentals, such as Chile, theRepublic of Korea, Malaysia, and Thailand.

Macroeconomic and Other Related Effects of Capital Inflows

Capital inflows tend to reduce interest rates and boost domestic expendi-ture. Increased domestic spending puts in motion a price adjustment pro-cess. For the purpose of analysis, suppose that a country produces and con-sumes three types of goods: an exportable, an importable, and a nontradable.The importable and exportable goods, assuming that the terms of trade be-

tween them are fixed, can be grouped into a single category—tradable. Givena pattern of demand for these two categories—tradable and nontradable—if

Vittorio C orbo and Leonardo Hernandez 63



expenditure increases owing to reduced interest rates resulting from the capinflow, pa rt of the increase will go into tradables and part into nontradabThe increased spending on tradable goods will increase the size of the trdeficit and in this way will accommodate the capital inflow. If this were alladjustment would be easy. In particular, no real appreciation would result. only concern about capital inflows would be about their sustainability andcountry's solvency.

But this is not all. At the existing relative price between tradable nontradable goods, the increase in demand for nontradable goods cannotfulfilled. That excess demand will result, independently of the exchange regime, in an increase in the relative price of nontradable goods—in other woa real exchange rate appreciation. That appreciation, which makes tradacheaper, will, in turn, create incentives to reallocate factors from the producof tradables toward the production of nontradables, and to switch consuexpenditure from nontradable to tradable goods. The final result is a real apciation, a larger nontradable sector, a smaller tradable sector, and a larger tdeficit. The real appreciation occurs either through an appreciation of the nonal exchange rate (under a floating exchange rate system) or through ancrease in the nominal price of the nontradable good (in a fixed or preannounexchange rate system).3

The real appreciation is the price mechanism at work. The increase in domtic expenditures, made possible by the initial capital inflow, puts the whole cess in motion and, together with the real appreciation and the demand supply characteristics for both types of goods, determines the final size oftrade deficit. This is the standard macroeconomics of the transfer problem. same sort of process will be set in motion by any capital inflows that end ulower domestic interest rates or by a relaxation of a domestic credit constrA similar adjustment process would result from a mineral discovery or a pernen t increase in the terms of trade. The only difference is that in the latter the export good that benefits from the price increase will end up with ancrease in production, while the rest of the tradable sector will lose resourcethe expanding export sector and most likely also to the nontradable sector. Tis the well-known Dutch disease problem referred to earlier (see Corden Neary 1982 and Corden 1984).

Two outcomes of capital inflows other than the macroeconomic effects described are important to consider. First, the larger amount of capital b rouinto the country will expand the volume of funds being intermediated throthe domestic financial system and hence the volume of domestic financial aand liabilities. Second, in a fixed or predetermined exchange rate system,monetization of large capital inflows will temporarily increase inflation th rothe rise in the price of nontradable goods tha t is part of the real appreciatFurthermore, in countries where wages and prices in general are indexed to

inflation levels, indexation causes prices to increase for a period of time so the temporary increase in inflation could be quite long lasting.

64 Th e World Bank R esearch O bserver, vol. 11, no. 1 (February 1996)



Why Should More C apital Be a Cause for Concern?

Th e effects of increased capital inflows a re far reaching, with im plications formost economic sectors. For this reason governments do well to take account ofa large increase in capital inflows, even if they are caused by better economicprospec ts in the host country. Because of its particular features, portfolio invest-ment is singled out here for more detailed discussion.

Implications for the Economy in General

Recipient countries are usually concerned about a large increase in capitalinflows for several reasons. First, in countries th at have recently reformed or arereforming their trade policies to increase their integration into the wo rld economy,the trade reform would bring an initial real depreciation accompanied thereaf-ter by a fairly stable real exchange rate adjusted for fundamentals (Thomas,M atin, and N ash 1990). The real exchange rate appreciation that accompaniescapital inflows wou ld counter the real depreciation, delaying the supply responseof export-oriented sectors and increasing the competition for the import-competing sectors. Thus, for countries that have initiated a trade reform, thereal appreciation effect of the capital inflow—particularly of cyclical capitalinflows—could work at cross purpo ses with the liberalization of trade an d couldundermine the credibility of the reform. A related consequence for countrieswith a more flexible exchange rate system could be excessive volatility in thenominal and real exchange rates, particularly in the case of hot money.

Second, in countries tha t are pursuing a stabilization pro gram with a fixed orpreann ounce d nom inal exchange rate as an anch or for domestic prices, or wh ereprice stability is an objective, the authorities could be concerned about moneti-zation effects. The expansion in high-powered money caused by large capitalinflows w ill have a temporary inflationary effect thr oug h the increased price ofnontradable goods (assuming that the increase in the supply of money exceedsthe increased demand arising from lower interest rates and accelerated eco-nomic activity).

Third, for those countries with weak banks (that is, banks with low or nega-tive net wo rth and a low ratio of capital to risk-adjusted assets) and p oor super-vision of the banking and financial system, the larger amount of funds to beintermediated may exacerbate the typical moral hazard problems associatedwi th deposit insurance. That is, lenders may take on riskier projects, which couldresult in a financial bubble and eventually lead to a crisis.

Fourth, if capital inflows are volatile or temporary, their reversibility canhave real adjustment costs that derive from resource reallocation, bankruptcies,hysterisis (meaning the asymmetrical problems resulting from the fact that it iseasier to exit a business than to enter it), or other market imperfections. If thecapital inflows are largely temporary, and if the authorities perceive that theprivate sector is making decisions based on the assumption that the flows are

Vittorio Corbo and Leonardo Hernandez 65



permanent, governments may try to avoid the adjustment process entirely, siit will have to be reversed later—an expensive process when irreversible care involved.

Fifth is the concern about maintaining a sustainable current account def(as a ratio of gross domestic product GDP) in the long run. Too sudden an in-crease in this deficit, particularly if it comes with a consumption boom, coraise the country's risk premium, restrict its future access to international ctal markets, and entail important adjustment costs if the flow is reversed folling negative political or economic developments at home or abroad.

Finally, there is a political economy argument. Many governments are sject to strong political pressure from interest groups in the exporting import-competing sectors to avoid or limit the real exchange rate appreciaassociated with the capital inflows. In such cases many governments willforced to take actions to protect the real exchange rate.

Portfolio Investment: A Special Case

The previous discussion applies to capital inflows in general, not distingu

ing among the different types. Portfolio investment (bonds and equity) has ticular features, raising specific macroeconomic issues that warrant more tailed analysis.

VOLATILITY. Th e mo st outstand ing feature of portfolio investment—opp osed , for instance, to foreign direct investment, borro wi ng from internatifinancial institutions, or long-term bank loans—is that, like hot money, it canreversed in a very sho rt tim e: foreign investors may sudde nly decide to leavecou ntry in wh ich they are investing. The volatility tha t this risk of flow-revemay cause in exchange rates, asset (stocks) prices, or interest rates can be vharmful.4 W hen capital inflows of this type have found their way into the b anksystem and have pushed up domestic expenditures and increased the curr

acco unt deficit, their reversal can affect th e domestic econom y throu gh a decrin asset prices, a jump in interest rates, liquidity problems in the banking seor a devaluation of the currency. Furthermore, if the central bank does not rquickly enough and the stock of international reserves is low, the reversal mcause a balance of payments crisis.

Negative shocks—a crisis in another country, a drop in the price of the mexpo rtable go od, a rise in the price of the main im porta ble good , a sharp incrin international interest rates, or a change in taxes affecting returns from inflows—may induce foreign investors to take their money out of the countrto kee p it there only if a higher re turn is provided . Either w ay, they will reacselling their domestic stock holdings and buying foreign currency with the ceeds. That will cause a fall in the general stock price index and, depending

the exchange rate system, either a loss of international reserves and an incrin domestic interest rates, or a depreciation of the nominal exchange rate, or b

66 The World B ank Research Observer, vol. 11, no. 1 (February 1996)



All these price movements can create considerable uncertainty, discouraginginvestment, whether foreign or domestic. At the same time, they can be verydamaging for the economy as a whole if interest rates, asset prices, or exchangerates fluctuate too widely—because of bankruptcies and hysterisis effects wheninterest rates increase and, in the case of exporting and import-competing sec-tors, when the exchange rate appreciates.

MACROECONOMIC FLUCTUATIONS. Another important characteristic of portfolioinvestment, as opposed to other forms of capital flows such as bank loans, is itsbehavior during different phases of the macroeconomic cycle. In fact, it has beenargued tha t bank borro win g reinforces the up- and dow nswin gs in economic activitythat characterize the cycle. This is because banks are willing to lend more duringupswings—the expansionary and recovery phases of the cycle—than duringrecessionary down swing s. Private portfolio investors, on the oth er han d, will refrainfrom selling every time stock prices are too low (or buying every time they are to ohigh) because they do not w ant to realize capital losses. This behavior will result inan endogenous smoothing of the cycle. Of course, this reasoning applies only whendomestic and foreign assets are not perfect substitutes.

Dealing with the Side Effects

For countries with a well-functioning banking system, long-term capital in-flows arising from improved economic prospects in the host countries are bestaccomm odated by letting the transfer system w ork th rough a combination of alarger current account deficit and a real appreciation.

But if the current account deficit and real appreciation arising from long-term inflows appear too large to accommodate smoothly, the authorities maydecide to intervene. In general, governments have been more inclined to inter-vene when capital inflows are short term or are associated with distortions orimperfections in the domestic economy, because the size or composition of theinflows is liable to create macroeco nom ic prob lem s of the type discussed earlier.One type of distortion that encourages short-term capital inflows is providingfree deposit insurance to weak, poorly regulated ba nks. Another d istortion tha tcould encourage such inflows is offering free currency risk insurance through aswap facility at the central bank (this happened, for example, in Chile until1990). In such cases, governments should start by trying to eliminate the imper-fection that is causing the inflow.

Similarly, short-term speculative capital inflows— hot money—could also beencouraged by a restrictive monetary policy introduced to compensate for anexpansionary fiscal policy in a fixed or preannounced exchange rate system. Inthis case, changing the policy mix toward a more restrictive fiscal policy and a

less restrictive monetary policy, by reducing domestic interest rates to a levelcloser to parity, reduces the incentives for the kind of inflows attracted by inter-

Vittorio Corbo and Leonardo Hernandez O /



est rate differentials or the expectation of falling domestic interest rates—is , ban k loans and portfolio investment.

If the cause of disruptive inflows cannot be eliminated, governments instead attempt, by direct or indirect methods, to control the extent andimpact of the flow.

Direct MethodsDirect methods of restricting capital inflows work either through the cos

bringing them in or through a quantity constraint—measures such as ceilingbanks' foreign borrowing, minimum reserve requirements on foreign loanceilings on foreign direct investment. G overnm ents can also try to reduceinflows by imposing a Tobin's interest-rate equalization tax (requiring foreers to pay a tax on the interest paym ents they receive from funds invested ab roBut the increasing integration of world capital markets has made it much eto g et aroun d capital co ntrol s; at best, they retain some effectiveness in the srun (Mathieson and Rojas-Suarez 1993 ; Schadler and others 1993).

Indirect MethodsIndirect methods of dealing with the effects of capital inflows comprise

eign exchange intervention, fiscal adjustment, liberalization of the currentcount and of capital outflows, and floating the exchange rate.

Foreign exchange intervention—the purchase of foreign currency by the cetral bank (with accumulation of foreign reserves) to support the nominalchange rate—takes two forms: sterilized and nonsterilized. Sterilized intertion involves open market operations carried out by the central bank to mothe liquidity created by the initial purchase of foreign excha nge, thus avoidinincrease in domestic expenditures and a temporary increase in inflation. Stization can also be achieved through other restrictions that reduce the momultiplier—examples are an increase in the required reserves for commebanks or a ceiling on their total credit. These restrictions also help avoidmonetization effect of the purchase of foreign currency—that is, they limiincrease in the m oney su pply. But the scope for action is limited by the degresubstitution between foreign and domestic assets. Moreover, sterilization pcies have other costs. G enerally, the more open the capital accoun t and the hithe degree of substitution between domestic and foreign assets, the less effethe sterilization. It also usually increases the quasi-fiscal deficit of the ceban k, and the introd uction of higher reserve requirements on bank depositsceilings on banks' credit increases the cost of financial intermediation andcourages informal financial activities. (For a recent review of the basic ecoics of capital inflows using a simple macroeconomic model, see Frankel 1

for central bank intervention, see Edison 1993; and for the policy issues asated with capital inflows, see Calvo, Leiderman, and Reinhart 1993 and 19

68 Th e World Bank Research Observer, vol. 11 , no. 1 (February 1996)



The drawback of intervening without sterilization is that interest rates falland credit expands, leading to an increase in domestic expenditures. Thus, toprevent the economy from overheating, governments in countries with a level ofoutput close to full employment usually augment nonsterilized intervention withanother policy to restrain aggregate demand.

Fiscal policy is used for its macroeconomic effect, as well as for the way itaffects how money is spent (the expenditure composition effect). The first ef-

fect, other things being equal, is part of the policy mix aimed at counteractingthe inflationary impact of an expansion in the money supply arising from pur-chases of foreign exchange inflows. The second effect is a higher (less appreci-ated) equilibrium real exchange rate, achieved by shifting the composition ofaggregate expenditures away from government consumption and toward pri-vate expenditure. The reduction in appreciation occurs inasmuch as govern-men t consump tion is more intensive in nontrad able goods and private expe ndi-tures are more intensive in tradable goods.

Liberalizing the current account helps to ease the pressure on the domesticeconomy by shifting expenditure toward tradable goods. Like a restrictive fiscalpolicy, it has a comp osition effect th at helps to achieve a higher equilibrium realexchan ge ra te than o the rwise . Tar i ff chan ges should be used for. the i r

microeconom ic, resource allocation role, however, rather than as a mecha nismfor macroeconomic control.Liberalizing capital outflows may induce domestic investors, such as pension

funds, to take their capital abroad. This may partially compensate for the ef-fects of capital inflows, although this result is uncertain: some models predict alarger capital inflow arising from liberalization of capital outflows (Laban andLarrain 1993).

Any move toward a floating exchange rate regime—for instance, by estab-lishing or widening the band within which a fixed exchange rate is allowed tofluctuate—increases the exchange rate risk that market participants face, withcorrespondingly less incentive for short-term capital inflows.

Dealing with Volatility

The policies just discussed mainly affect the real exchange rate, the currentaccount, and temporary inflation problems that can arise from a surge in capitalinflows. The discussion that follows focuses on measures to counteract the vola-tility associated with portfolio investment.

Restrictions on capital outflows are sometime s used to reduce the risk of aflow reversal by limiting the amount of capital that foreign investors areallowed to take out of the host country within a given period of time. Al-though this policy can be effective in reducing the potential damage of asudde n capital ou tflow, it is also likely to reduce the am oun t of capital inflow inthe first place, limiting the economic benefits of access to external sources of

finance.

Vittorio Cor bo and L eonardo Hernandez 6



The opposite policy—lifting restrictions on outflows to enable domestic resi-dents to invest in foreign assets—has two different effects: first, inflows mayincrease as foreigners perceive less risk of getting their investment stuck in thecountry; second, because domestic assets will be better diversified internationally, the effects of a negative shock will be less severe in the first place. Thepolicy, if credible, will make a flow reversal less likely.

For similar reasons, opening the current account may limit the effects of a

negative shock. The opening usually means tha t the host country's real econwill be more diversified, so that damage to one productive sector is less likely tospread through the economy as a whole.

The ultimate purpose of any measure to tackle volatility should be to build aneconomy more resilient to external shock s, so that foreign investors will be lessinclined to flee if a shock occurs. Maintaining long-term fiscal and monetarytargets has the added advantage of sending positive signals about the economyto foreign investors. In addition, it is essential to sustain a balanced budget inthe short and medium terms to avoid an increase in inflation when a negativeshock does occur, and to build a large stock of international reserves because ofits buffer effect.

One policy tool that may prove useful in the short run is to mandate that the

central bank exercise greater discretionary power over the allocation of resou rces.For example, requiring that private savings—such as pension funds—be invein government bonds (or in foreign assets) may help to sterilize the expansion inhigh-powered money caused by a sudden capital inflow. Alternatively, restricing the amou nt of government bonds that domestic investors can hold may copensate for a sudden capital outflow that sharply reduces liquidity. This type ofpolicy, however, may not be pursued in the long run because of its costs in termsof efficiency and distribution.

In sum, the risk of a reversal in flows of portfolio investment is better dealtwith through mechanisms that absorb negative shocks and minimize their ef-fects on the economy, rather than by restricting capital outflows.

Dea ling with Capital Inflows: Some Recent Experiences

The typical response of recipient countries when capital inflows resumedin the late 1980s and early 1990s was, first, to absorb them into the economythrough the price mechanism described earlier, and later to intervene whenthe movements in liquidity, exchange rate, interest rates, and current ac-count balances became worrisome. This section reviews the interventionsused in the nine countries that (apart from China) have received most of thecapital inflows in recent years: four in Latin America (Argentina, Chile, Co-lombia, and Mexico) and five in East Asia (Indonesia, the Republic of Ko-rea, Malaysia, the Philippines, and Thailand). The inflows for each countryare plotted in figure 1.

70 Th e World Bank Research Observer, vol. 11, no. 1 (February 1996)



Figure 1. Capital Flows, 1986-93

Millions of U.S. dollars100,000-

20 000

Percentage of GDP

•10

Thailand ChileMalaysia

2Philippines Argentina Rep. of .

Mexico Indonesia Colombia Korea0

a. Weighted average (ratio of the sum of capital flows an d GDP for 1986-93).b. Total flows are the sum of current account an d change in reserves for 1986-93-c. Korea started receiving capital inflows in 1990. Flows for 1990-93 totaled US$20 billion, o r1.7 percent of GDP.Source: IMF, International Financi al Statistics.

The responses are grouped in eight categories: (1) moves toward a more flex-ible exchange rate ; (2) fiscal restra int; (3) sterilization by means of open market

operations that offset the inflows; (4) sterilization to restrict the growth in moneysupply by using other offsetting means; (5) restrictions on capital inflows; (6)liberalization of the current account; (7) selective liberalization of the capitalaccount (capital outflows); and (8) strengthening of the domestic financial sys-tem (table 1).

The specific policies are analyzed under these eight headings with a focuson those policies related to the way countries responded to the surge in capi-tal inflows. Some of the policies, in particular those implemented by Argen-tina, Mexico, and the Philippines in the late 1980s and by the rest earlier inthe decade, are also part of structural and stabilization programs undertakenprimarily to foster economic growth. (Note that where these policies arepa rt of a broader package of reforms, they are not identified with an x intable 1.)

Vittorio Corbo and Leonardo H ernandez 71



Table 1. Major

Country

ArgentinaChileColombiaIndonesiaR e p of KoreaMalaysiaMexicoPhilippinesThailand

Economic MeasuresMoves toward a

m o r e f l e x i l eexchange

rate*

X

X

XX

X

X

X

Employed

Fiscalrestraint*

X

XX

X

X

X

X

Sterilizationby openmarket

operations

X

X

XX

X

X

X

X

Sterilizationby other means6

X

X

X

X

X

Restrictions oncapital inflows

X

XX

X

X

X

X

Liberalizing thecurrent account1

X

X

X

XX

X

X

X

X

Selectiveliberalization of

the capitalaccount*

X

X

X

X

X

Strengtheningthe domestic

financialsystem*

X

X

X

a. Progress toward a floating exchang e rate, including widening o f the band within which the rate may fluctuate, limiting use of swap facilities, and pegginga basket of currencies.

b Includes expenditure reduction, expenditure switching tow ard public investment, and accelerated repayment of public debt.c. Conve ntional sterilization through issuing government or central bank debt, or both, to absorb domes tic liquidity.d. Includes increase in banks' reserve requirements, increase in banks' capitalization, and depositing of public sector cash balances at central bank.e. Includes taxes on capital inflows , minimum reserve requirements on foreign loans, and ceilings on foreign borro wing.f. Includes tariff reductions.g. Includes removing restrictions on overseas investments by residents.h. Includes raising banks' risk-adjusted capital adequacy requirements to the levels set out in the Basle agreement.Source: Authors' analysis.



Moves toward a More Flexible Exchange Rate

Of the countries in our sam ple, Argentina has retained its fixed exchang e ratesystem (introduced as the main anchor for its stabilization program in April of1991). Colombia has maintained its crawling peg policy but widened the bandwithin which the nominal exchange rate is permitted to fluctuate, while Malay-sia has kept its policy of pegging to a basket of currencies and also allowed agreater variability of the spot rate . Korea pegs its currency to the U.S. dollar andmaintains a nar row b and within which the exchange rate can fluctuate on intradaytrading according to market forces. In October 1993 Korea widened this rangein response to pressures on the exchange rate from inflows, effectively introduc-ing greater exchange rate risk for market participants.

As part of a broader package of reforms, the Philippines in September 1992eliminated all restrictions on the use of foreign currency for both current andcapital account transactions, lifted restrictions on access to dollar loans fromoffshore accounts, liberalized off-floor trading, and extended the trading hoursof the foreign exchange market. As a result the value of the Philippine peso isnow essentially market-determined but with greater variability. Chile has had acrawling peg policy in place since the middle of the 1980s. Initially pegging to

the dollar and within a narrow band, Chile adjusted its exchange rate policy toincrease the uncertainty of exchange rate movements and to accommodate areal appreciation of the exchange rate. To this end the Chilean authorities haveappreciated the central parity rate on several occasions, widened the band aroun dthe central parity, and changed the peg from the dollar to a basket of currencies.

Mexico introduced an exchange rate band, which was subsequently widened.In December 1994 the central parity was devalued and immediately after that,the exchange rate was allowed to float. Indonesia, which maintains a managedfloat against the U.S. dollar, imposed limits on the use of facilities for currencyswaps to discourage foreign borrowing, but it also widened the spot market bid-ask spread offered by the Bank of Indonesia to encourage more trading amongmarket participants. Since the late 1980s, Thailand has pegged the baht to a

basket of currencies, a significant component of which is the U.S. dollar, withthe Bank of Thailand setting a day-to-day exchange rate. From 1993 a series ofsteps was taken to further liberalize the exchange rate system, particularly trans -actions and volumes of the capital account.

Fiscal R estraint

Several countries in the sample explicitly used fiscal adjustment to coun teractthe effects of the capital inflow in expanding expenditure and causing the realexchange rate to appreciate. Argentina reduced the fiscal deficit as part of itsstabilization program and, following the reversal in capital inflows associatedwi th the tequila effect, introdu ced a major fiscal adjustment prog ram . In In-donesia the timetable for implementing several public investment programs was

Vittorio Corbo and Leonardo Hernandez 73



extended to improve the fiscal position. Korea's fiscal accounts, driven morthe level of domestic activity and tax revenues to avoid an overheating ofeconomy than by attempts to compensate for the effects of capital inflows, been streng thened since 199 1. Malaysia system atically reversed its public sedeficit of 11 percent of gross national product in 1986, to a surplus of 0.2 cent of GNP in 1993. In the process, expenditures were oriented toward invment, particularly in infrastructure, while fiscal surpluses were used to acc

ate repayment of external public debt.In the early 1980s M exico strengthened its fiscal accoun ts but relaxed them a

in 1 99 4. The Philippines reduced its public sector deficit from 5.5 percent of GDP in199 0, to 1.7 percent in 1992. Thailand's fiscal adjustment was even more impsive, moving from a public sector deficit of percent of GDP in 19 84-8 5 to a surpluof 5 percent in 19 89 -90 , with most of the turnaro und coming from reduced govment consumption. Coupled with improvements in efficiency and changes totax system, which have made Thai government revenues and expenditures msensitive to the Tha i business cycle, fiscal balances hav e deteriorated in recent yto a deficit in 199 4 of 0.8 p ercent of GDP, reflecting heightened emphasis on reing income inequalities across rural and ur ban areas.

Sterilization by Open Market Operations

All the countries in the sample except Argentina intervened to sterilize—thaoffset—the inflows. Chile used the policy quite intensively to avoid a sharp apciation of the nominal exchange rate within the band, offsetting the increase inmoney supply from growing foreign reserves by issuing central bank bonds offerent maturities. Colombia's sterilization took the form of placing central bbonds denominated in foreign currency at market-determined rates. Indonestrategy was to mop up the liquidity associated with the foreign reserve accumtion by increasing the interest rate on Bank of Indonesia certificates to make tmo re attractive to domestic financial institutions.

Since 198 6, when big current accoun t surpluses bro ught large accum ulatof foreign reserves to Korea, the government's policy has been to place forexchang e and mo netary stabilization bond s. Similarly, Malaysia, where forreserves have accumulated at the rate of 4.3 percent of G DP a year since 1986,has sterilized the resulting monetization in part through placing governmbo nd s. Mexico issued bonds from 19 90 until Janu ary 1994 denominated b otpesos and do llars; in Thailand the Bank of Thailand issued its own b onds; anthe Philippines, the central bank issued substantial numbers of its own securto m op up some of the liquidity brought by the foreign exchange accu mula t

Sterilization by Other Means

Three countries in the sample—Colombia, Malaysia, and the Philippinehave increased reserve requirements along with sterilization to restrict the gr

74 Th e World Bank R esearch Observer, vol. 11 , no. 1 (February 1996)



of money supply brought by the foreign reserve accumulation. In addition, Co-lombia forced commercial banks to invest in dollar-denominated instrumentsand the Philippines increased treasury deposits in the central bank. Malaysiarestricted lending by commercial banks for credit cards and the purchase ofspecific consumer products and transferred the deposits of the Employee Provi-dent Fund (a government-administered pension fund) to designated accounts inthe central bank.

Among the other countries, Indonesia required public enterprises to shift de-posits from commercial banks to the Bank of Indonesia, reducing net domesticcredit to compensate for the expansion in high-powered money, and Thailandtightened monetary policy by imposing voluntary limits on commercial banklending to nonp rodu ctive activities, such as consumer loans, mortgage loans,and the construction of luxury condominiums. Since 1989 Thailand has alsobeen reducing the scope of its preferential credit system for priority sectors,decreasing lending amounts and increasing interest rates.

Restrictions on Capital Inflows

Several of the sample countries have imposed controls on capital inflows thatvary considerably in type and exten t. Chile introduced a compulsory noninterest-bearing deposit at the central bank for a whole year (or a paid-in-cash tax equiva-lent to the interest cost of a deposit for the same amount). This compulsorydeposit, which started at a level of 20 percent of the inflow and then increasedto 3 0 percent, applies to all investment except foreign direct investment in projectspreviously screened by the app ropriate authorities. In September 1993 Colom -bia introduced a 47 percent unremunerated reserve requirement on short-term(up to eighteen months) external borrowing by firms. Mexico restricted foreigncurrency liabilities of commercial banks to 10 percent of total liabilities andthen introduced a reserve requirement of 15 percent on all foreign-denominatedexternal borrowing.

Indonesia limited external borrowing by commercial banks and imposed ceil-ings on annual foreign borrowing by public enterprises. The Philippines intro-duced some restrictions on foreign loans in late 1994. Thailand reintroduced a10 percent tax on interest payments on foreign borrow ing in March 1990 . Dur-ing the first half of 19 94 , Malays ia imposed ceilings on the external liabilities ofcommercial banks tha t were no t related to trade or investment, prohibited resi-dents from selling short-term monetary instruments to nonresidents, and re-quired commercial banks to deposit the ringgit funds of foreign banking institu-tions in noninterest-bearing acco unts of the central bank.

Liberalizing the Current Account

All countries in the sample continued to liberalize their trade regimes, in partto counterbalance the real exchange rate appreciation associated with inflows.

Vittorio C orbo and Leonardo H ernandez 75



In Argentina the government accelerated and completed a major trade libization program that eliminated all export taxes and all quantitative restricon imports, except for automobiles, and reduced the maximum import tfrom 115 percent in 1988 to only 20 percent by 1992. Later on, as theexchange rate continued to appreciate, the authorities compensated exporimport-competing sectors by increasing a tax rebate applicable to exportsimposing an im port surcharge. The rationale here was to improve the rel

price of goods made by import-competing sectors withou t changing relative pricesbetween import-competing items and export goods.In Chile import tariffs were reduced from 15 percent to 11 percent in 1

and in early December 1995, the government was considering a further retion of the tariff as a way to increase the equilibrium rea l exchange rate. Colbia also accelerated its trade liberalization to counterbalance the appreciaeffects of the capital inflows, while Indonesia increased support programexporters and has recently accelerated liberalization, in particular by redu(and sometimes abolishing) import tariffs and removing import licensinstrictions. Malaysia reduced some import tariffs in 1989-90 and introducmore comprehensive trade liberalization program in 1993. Korea implemean im port liberalization program during 19 92-94, covering 133 items, withther liberalization scheduled for 1995-97. Following the recent liberalizaKorea's average weighted import tariff eased to 8 percent in 1994, frompercent in 1991 .

During the period under review, Mexico reduced its average import tari13 percent. In the Philippines the surge in capital inflows coincided with a pously announced gradual reduction of tariffs. Thailand also accelerated liberalization: tariffs on capital goods used in manufacturing were reduced 20 percent to 5 percent, and all exceptions were eliminated, with the net eof reducing the average tariff level to 9 percent in 1992, down two percenpoints from 1990.

Selective Liberalization of the Capital AccountThe selective opening of the capital account was generally intende

reduce the volume of net capital inflows, although liberalizing capital flows was sometimes part of a broader liberalization effort. For examArgentina reduced most restrictions on capital movem ents as part of its overallliberalization strategy, while Chile, as part of its strategy to avoid too sa real appreciation, allowed pension funds to invest some of their asabroad, liberalized investment outflows for selected private enterprises,progressively reduced (and most recently abolished) mandatory surrerequirements of Chilean exporters. In mid-1993 Colombia took steps tother liberalize its capital account, allowing residents to hold foreign aand permitting access to foreign credit, as well as removing all restricton foreign exchange transactions.

76 Th e World Bank R esearch Observer, vol. 11, no. 1 (February 1996)



Indonesia has had an open capital account all along that facilitated the diver-sification of assets. Korea selectively liberalized its capital account to facilitatecapital outflows by being more lenient when approving requests from firms forforeign direct investment, allowing small- and medium-sized domestic firms toraise capital abroad, and allowing domestic institutional investors and individu-als to make foreign po rtfolio inve stments. The P hilippines eliminated all restric-tions on foreign currency operations. Thailand allowed foreign exchange earn-

ers to open foreign exchange accounts with domestic banks and domestic investorsto transfer up to $5 million freely for direct investment. Although some restric-tive regulations were maintained, residents were readily allowed to invest inproperty and securities abroad, and requirements for approval to repatriate divi-dends and loan repayments were abolished. In Malaysia, the capital controlsadopted during the first half of 1994 were abolished in August of that year, andthe remaining controls on capital outflows were principally aimed at monitor-ing these flows. Those controls included a requirement that residents obtainpermission to borrow more than one million ringgit from abroad, a ban onoffshore borrowing of ringgit, and approval for nonresidents to gain access toringgit credit facilities.

Strengthening the Domestic Financial System

Argentina's method for strengthening the financial system was to increasecapital requirements for banks even above those outlined for all banks by theBasle agreement (an accord adopted by industrial countries that implies a capi-tal-asset ratio of 8 percent, adjusted for risk ). Some of the other countries in tro-duced a gradual increase in capital requirements as part of their strategy formoving to the Basle norm. G enerally, countries in the sample moved tow ardstrengthening commercial banks. Indonesia instituted more stringent capital andreserve requirements for banks, both to strengthen the financial system and toreduce credit ex pansion.

Colombia implemented the Basle agreement and went even further by requir-ing banks t o make special provisions on loan s to local governm ents. These loans,which were growing rapidly, were considered riskier than those covered understandard Basle rules. In addition, the government intensified its monitoring ofthe banking system to avoid the undue risk-taking made possible by the avail-ability of foreign loans.

Economic Policy: Some Observations and Lessons

The outcomes of the different policies implemented to compensate for them one tary and real effects of the recent surge in inflows of private capital canbe expressed in terms of a set of macroeconomic indicators of performance.Wh en these outcomes are tabulated (table 2), some im portant general obser-




Table 2. Selected Macroeconomic DataCountry and indicator 1986 1987 1988 1989 9 9 1991 1992 1993

ArgentinaOverall capital account balance*

As a percentage of GDPGovernment consumption1*Average inflation'Real effective exchange rated

Current account balance1*

hil

Overall capital account balance'As a percentage of GDP

Government consumption1 Average inflation0

Real effective exchange rated

Current account balance1

ColombiaOverall capital account balance*

As a percentage of GDPGovernment consumption11

Average inflation'Real effective exchange rated


IndonesiaOverall capital account balance*

As a percentage of GDPGovernment consumption1*Average inflation'Real effective exchange rated

Current account balance1*

2 304.02. 2n.a.

90.1121.3-2 .7

1 179.16. 7

12.619.599.7-6 .7

818.82. 39. 8

18.987.1

1.5

3 412.94. 3

11.05. 8

91.6-5 .4

3 134.02. 94. 9

131.3123.4-3 .9

947.64. 6

10.919.9

105.1-3 .6

-34 .1-0 .1

9.823.386.0-0 .2

4 074.15. 49. 49. 3

78.1-3 .3

3 318.52. 64. 3

343.0133.9-1 .2

955.74 .0

10.414.7

108.0-1 .0

615.31.6

10.128.189.3-0 .7

1 674.02. 09. 08. 0

82.3-2 .6

-2,995.2-3 .9

4 .53 079.8

88.11.4

1 234.14 .49. 9

17.0115.9

-2 .5

373.70 .9

10.625.887.9-0 .4

2 628.52. 89. 46. 4

83.4-2 .3

-1,590.0-1 .1

8. 42 314.0

184.53 .3

2 747.39. 09. 8

26.0127.9-1 .8

86.40 .2

10.329.186.5

1.4

5 637.05. 39. 07. 8

86.4- 3 . 4

1 806.31.08. 8

171.7256.4

-0 .2

1 032.13 .09. 5

21.8136.0

0 .3

-414 .7-1 .010.230.489.4

5. 5

6 144.65.39. 19. 9

89.7-3 .8

10,549.14. 69. 4

24.9308.2-2 .8

2 906.46. 89. 4

15.4151.3

-1 .6

490.21.0

10.727.094.7

1.5

3 898.93 .09. 55 .0

90.6-2 .1

11,179.44 .4n.a.10.6

338.1-2 .9

2 410.35. 39. 7

12.7152.9- 4 . 6

2 396.44 .4

11.922.6

102.2-4 .1

3 623.82 .59. 9

10.297.0-1 .9



Rep. of KoreaOverall capital account balance*

As a percentage of GDPG overnment consumption1 Average inflation0


Current account balance*1

MalaysiaOverall capital account balance*




MexicoOverall capital account balance*

As a percentage of GDPG overnment consumption1 Average inflation'Real effective exchange rated


PhilippinesOverall capital account balance*




-4,411.0- 4 . 110.02. 8

101.44. 3

1,140.24. 1

16.90.7

96.9-0 .4

2,651.42.09.1

86.278.2-1 .3

243.20.88.00.8

92.04. 0

-8,615.0-6 .310.1

3.0112.0

7.2

-1,164.6-3 .715.4

0.3

99.68.3

3,979.02.88.8

131.880.5

2.1

-60 .0-0 .2

8.43.8

94.60.6

-11,001.5-6 .0

9.57.1

134.97.8

-2,883.1-8 .314.32.6

98.25.2

-3,310.1-1 .9

8.6114.2104.5-2 .2

530.31.49.08.8

100.30.8

-2,187.4-1 .010.2

5.7155.4

2. 3

1,000.02.6

14.42.8

97.60.7

6,540.93.28.5

20.0115.8-3 .0

2,000.64. 79.5

12.2109.2-3 .4

1,765.30.7

10.18.6

160.1-0 .9

2,908.76.8

14.02.6

100.4-2 .1

10,928.54. 58.4

26.7128.4-3 .1

2,597.45.9

10.114.1

111.5-6 .1

7,636.02.6

10.39.3

168.8-3 .0

5,355.211.414.24. 4

103.0-8 .9

22,725.07.88.9

22.7146.7-5 .1

3,284.67.29.9

18.7117.1-2 .3

7,942.92.6

10.96.2

168.5-1 .5

8,584.914.813.14.8

116.5-2 .8

25,923.47.89.9

15.5165.3-7 .4

2,653.35.09.78.9

137.4-1 .9

2,725.70.8

10.84. 8

171.70.1

11,632.418.012.6

3.5

119.4- 3 . 8

29,521.38.1

10.78.7

178.4-6 .4

4,144.47.6

10.17.6

139.0-6 .0

(Table continues on the following page.)



Table 2. continued)

Country and indicator

ThailandOverall capital account balance

As a percentage of GDPGovernment consumption1 Average inflation'Real effective exchange rated

Current account balance*1

1986

652.81.5

12.81.8

105.20.6

1987

1 546.03.1

11.32.5

110.2-0.7

1988

3 859.76.3

10.03.9

116.4-2.7

1989

6 978.09.79.55.4

120.7-3.5

1990

10 426.012.2

9.45.9

128.4-8.3

1991

12 075.912.2

9.35.7

136.1-7.5

1992

8 849.07.9

10.04.1

142.4-5.5

1993

14 188.511.410.3

3.6147.9

-S.S

a. In millions of U.S. dollarsb. As a percentage of GDP.c. Percent.d. 1985 100 .n.a. Not availableSource: IMF, International Financial Statistics; IMF, Balance of Payments Statistics.



vations and policy lessons emerge, along with conclusions specific to indi-vidual countries.

General Observations

• In all the countries the increase in inflation wa s brief. In fact, since the early1990s, inflation in Argentina, Chile, and Mexico has been decreasing and

has remained fairly stable in the other six countries.• The countries that received the largest capital inflows (as a percentage ofGDP, see figure 2) on average during 19 86 -9 3 are no t those that experiencedthe largest appreciation of the real exchange rate. Indeed, appreciation inthose countries (Chile, Malaysia, and Thailand) has been relatively low.

• Those countries—Chile, Indonesia, Malaysia, and Thailand—in whichgov ernm ent con sum ption has been decreasing as a percentage of GDP arealso those in which real exchange rate appreciation has been lower (seefigure 3).

• Those countries that did not employ a restrictive fiscal stance relative toG DP—Argentina, Korea , M exic o, and the Philippines—show the highest realexchange rate ap preciation, even though they were no t the largest recipients

of capital inflows.

Figure 2. apital Flows and hange in the Real Exchange Rate, 1986-93

Percentage change in the real exchange rate/ u -

6 0 -

5 0 -

4 0 -

3 0 -

2 0 -

10

o

Ret•

Argentina o

ublic of Korea3

——__ Philippines B

B Colombia

Indonesia B

I I I I

Mexico a

B Chile—

i i

Thailand a

Malaysia o

-1 2 3 4 5 6 7Capital flows as a percentage of GDP

10

a. Korea started receiving capital inflows in 1990. Flows for 1990-93 totaled US$20billion, or 1.7 percent of GDP.

Source: IMF, International Financial Statistics.

Vittorio Corbo and Leonardo Hemindez 81



Figure 3- Changes in G overnment Consumption and the Real Exchange Rate,1986-93

Percentage change in the real exchange rate/ u -

6 0 -

5 0 -

4 0 -

3 0 -

2 0 -

0 -

Chilea

Thailand • ^ ^ ^ * * ^ ^

M a l a y s ^ . ^ * - ^

Indonesia a

I I I I

Mexicoo

Republic of Ko

Argentina a

^

a Philippines

H Colombia

i i i

- 5 - 4 - 3 - 2 - 1 0 1 2 3 4 5Percentage points of change in government consumption as a share of GDP

Source: IMP International Fina ncial Statistics.

Country-Specific Conclusions

Overall, the evidence does not indicate any clear regional difference iway countries have responded to the surge of capital inflows, although argthe Asian countries (except for Korea and the Philippines) have tended tom ore o n restrictive fiscal policy than the Latin American grou p (other than CSome conclusions about economic policy specific to individual countrieshowever, be drawn from the cases studied:

• Th e experiences of Chile and Co lom bia clearly illustrate the difficultiea country faces in the more integrated and global capital markets o1990s wh en it wants to com bine a restrictive monetary policy intendcombat inflation with policies to manage the real exchange rate. The lis that, when restrictive monetary policy accompanies an exchangetarget, sterilized intervention tends to exacerbate, rather than ameliocapital inflows. That happens because sterilization tends to maintaieven increase the differential between domestic interest rates and expforeign interest rates (adjusted for expected devaluation). Furthermor

the experience in Chile and the Philippines also show s, sterilized in tervemay significantly worsen the quasi-fiscal deficit of the central bank.

82 The World ank Research Observer, vol. 11, no. 1 (February 19



• A com parison of the experiences of Indonesia, Malaysia, and Thailan d w iththose of Colombia, Korea, Mexico, and the Philippines suggests that, whereminimizing the real exchange rate appreciation is an objective, sterilizedintervention is most effective when accompanied by fiscal restraint. Theformer countries substantially tightened fiscal policy while implementingsterilized intervention, whereas fiscal adjustment in the latter group wasless severe.

Policy Lessons

The experiences of the nine countries examined in this study afford somepointers for policy.

The central bank can play at least a temporary role in averting some of theside effects of capital inflows.

In the long run a tight fiscal policy seems to be the most effective means ofminimizing the appreciation of the real exchange rate normally caused by acapital inflow. The resultant increase in public savings leaves more ro om for theinflows to finance investment in the private sector, and a firm fiscal stance in-creases the confidence of the international investor community.

A mixed policy seems preferable to a purely fiscal policy in the short runbecause fiscal policy is generally too inflexible to deal on its own with volatilecapital flows. Nevertheless, in the medium and long terms, the high volatility ofportfolio investment flows predicates a consistent fiscal policy aligned with fun-damentals.

Sterilized intervention has been ineffective in protecting the real exchangerate from appreciating. The policy may work in the short run, but the main-tained or even increased domestic interest rates that go along with it provideadditional incentives for capital inflows. Finally, this policy is not sustainableon its own in the long run because, in worsening the quasi-fiscal deficit ofthe central bank, it has an expansionary effect that eventually leads to realappreciation—which in turn may bring speculative attacks on the exchangerate.

Moving toward a floating exchange ra te and increasing the extent to which itis determined by m arket forces—a step taken by most of the sample coun tries—appears to be more successful than a fixed exchange rate regime: first, in sup-porting an effective monetary policy; second, in increasing the exchange raterisk faced by market participants and thus in discouraging, at least to someextent, speculative capital inflows; and, third, in relieving some of the upwardpressure on inflation that is stimulated by capital inflows.

Letting domestic interest rates fall to levels consistent with international in-terest rates (augmented by expected depreciation) seems necessary to abate theinflows of short-term, speculative capital. As the experiences of Colombia andIndonesia show, letting the domestic interest rate adjust reduces the incentivesfor capital inflows and elim inates the quasi-fiscal losses of the central ban k. T he




aggregate effects on demand of the lower interest rate need to be handled througha fiscal adjustment.

Quantitative constraints o r ceilings on foreign borrowing by banks or othlarge borrowers, or sterilization, through forcing large investors (pensiofunds or public enterprises) to purchase liabilities of central banks may peffective in the short run as long as domestic interest rates and capitalflows do not rise in the process. But given the worldwide integration

financial m arkets and the sophistication of financial intermediaries, such poli-cies do not seem to work in the long run, and they may also damage theconomy as a whole because of related pervasive effects on resource alltion and efficiency. These policies will probably also be a disincentivinternational investors.

In sum, the benefits for economic growth that capital inflows can brindeveloping countries—namely, relaxing the balance of payments constraintfacilitating investment—can be realized if the associated macroeconomic adment problems are properly handled. By the same token, mismanagement irecipient country can virtually eliminate the benefits and may even ultimacause a reversal of flows. The key to higher sustainable rates of investmentgrowth seems to be fiscal policy—not only because of the highly integrfinancial markets around the world, but also because monetary policy becoless effective whenever there is a nominal exchange rate target. This is parlarly true for those flows that are highly volatile, such as private portfolio inment. For more long-term capital inflows, the authorities should allowadjustment mechanism to work through a real appreciation, accompanied fiscal adjustment to reduce the size and smooth out the required appreciati

NotesVitto rio C orbo is professor of economics at the C atholic University of Chile, and Leon

Hernandez is on the staff of the International Economics Department of the World BThis article is a revised and expanded version of Corbo and Hernandez (1993), a ppresented at a World Bank conference on portfolio investment in developing countThe authors are extremely grateful to Alistair Boyd for his assistance in revising the pand to two anonymous referees for their helpful comments and suggestions.

1. All dollar am ounts are U.S. dollars.2. Another lesson from the Mexican crisis concerns the taking of undue risks in ma

ing internal and external debt. This issue, although extremely important, is not discuin this article.

3. The dynam ics of an economy with a floating exch ange ra te system are different the example given here, but the final outcome—a real exchange rate appreciatioremains; see Dornbusch 1976 and Calvo and Rodriguez 1977.

4. On an empirical basis, there is no conclusive evidence concerning the different deof volatility of the different types of foreign financing (see Claessens and others 1993

84 Th e World ank Research Observer, vol. 11, no. 1 (February 199



References

The word processed describes informally reproduced works that may not be com-monly available through library systems.Calvo, G uillermo, and Carlos Rodriguez. 1977. A Model of Exchange Rate Determina-

tion under Currency Substitution and Rational Expectations.Journal of PoliticalEconomy 85(3, June):617-25.

Calvo, G uillermo, Leonardo Leiderman, and Carmen Reinhart. 199 3. Capital Inflowsand Real Exchange Rate Appreciation in Latin America: The Role of External Factors.IMF Staff Papers 40:108-51.

. 1994. The Capital Inflows Problem: Concepts and Issues.Contemporary Eco-nomic Policy 12(July):54-66.

Claessens, Stijn, Michael P. Dooley, and Andrew War ner. 1 993 . Portfolio Capital Flows:Hot or Cool? In Stijn Claessens and Sudarshan G ooptu, eds., Portfolio Investment inDeveloping Countries. World Bank Discussion Paper 228. Washington, D.C.

Corb o, Vittorio, and Leonardo Hernandez. 1993. Macroeconom ic Adjustment to Portfo-lio Capital Inflows: Rationale and Some Recent Experiences. In Stijn Claessens andSudarshan G ooptu, eds., Portfolio Investment in Developing Countries. World BankDiscussion Paper 228. Washington, D.C.

Cord en, W. M. 1984. Booming Sector and Dutch Disease Economics: Survey and Co n-solidation. Oxford Economics Papers 36(November):359-80.

Corden, W. M., and J. P. Neary. 1982. Booming Sector and De-Industrialization in aSmall Open Economy. The Economic Journal 92(December):825—48.

Dornbusch, Rudiger. 1976. Expectations and Exchange Rate Dynamics.Journal of Po-litical Economy 84(6, December):1161-76.

Edison, Hali J. 19 93. The Effectiveness of Central Bank In tervention: A Survey of theLiterature after 1982. Special Papers in International Economics 18 (July). PrincetonUniversity, Princeton, N.J.

Frank el, Jeffrey A. 1994. Sterilization of Money Inflows: Difficult (Calvo) or Easy(Reisen)? IMF Working Paper W P / 9 4 / 1 5 9 . International Monetary Fund, Washington,D.C. Processed.

IMF (International Monetary Fund). Various issues. International Financial Statistics. Wash-ington, D.C.

. Various issues. Balance of Payments Statistics. Washington, D.C.

. 1992. Private Ma rket Financing for Developing Countries. World Economic

and Financial Surveys. Washington, D.C. Processed. December.. 1995. World Economic Outlook. Washington, D.C.Laban, Raul, and Felipe Larram. 1 993. Can a Liberalization of the Capital Outflows

Increase Net Capital Inflows? Working Paper 1 55. Instituto de Econom ia, PontificiaUniversidad Catolica de Chile, Santiago.

Mathieson, D. J., and L. Rojas-Suarez. 1993. Liberalization of the apital Account. Expe-riences and Issues. Occasional Paper 10 3. Washington, D .C : International M onetaryFund.

Schadler, Susan, Maria Carkovic, Adam Bennett, and Robert Kahn. 1993. Recent Experi-ences with Surges in Capital Inflows. Occasional Paper 108. Washington, D.C: Inter-national Monetary Fund.

Thom as, Vinod, Kazi M. M atin, and John D. Nash. 1990. Lessons in Trade Policy Re-forms. Policy and Research Series 10. World Bank, Washington, D.C. Processed.

Vittorio C orbo and Leonardo H ernandez 85

capital inflows analysis

Documents