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

TL;DR: In the early 1990s, there has been a large trend increase in the volume of private capital fl ows to and from emerging market economies (EMEs). This increase can be attributed to EMEs' growing degree of fi nancial openness, the perception of continuing strong growth prospects, increasing productivity, growth in the overall profi tability of fi rms, positive interest diff erentials in favor of these economies and, sometimes, the expectation of continuing currency appreciation.

Abstract: Since the early 1990s, there has been a large trend increase in the volume of private capital fl ows to and from emerging market economies (EMEs). This increase can be attributed to EMEs’ growing degree of fi nancial openness, the perception of continuing strong growth prospects, increasing productivity, growth in the overall profi tability of fi rms, positive interest diff erentials in favor of these economies and, sometimes, the expectation of continuing currency appreciation. However, capital fl ows are not necessarily the outcome of domestic developments alone in recipient countries; they also refl ect the role of push factors emanating from source countries. The stance of monetary policy and the state of fi nancial markets in major advanced economies have led to the emergence of comparatively low interest rates and overall low returns in these economies, giving rise to the search for yields. These factors again came to the fore in 2010 following unprecedented quantitative easing by the central banks in major advanced economies and the likelihood of such policies being pursued for an extended period of time. With near zero interest rates in these countries likely to continue into 2011, EMEs are attracting large capital fl ows. The consequent rapid appreciation of exchange rates has generated concerns over potential ‘currency wars’, with a number of EMEs resorting to capital controls. Issues related to capital fl ows and their management have, therefore, re- emerged as a key concern for EMEs. The traditional pattern of capital fl ows to EMEs has been the result of the need to fi nance current account defi cits. However, during recent years, even as capital fl ows to EMEs have increased manyfold, current account balances, in aggregate, have actually moved from modest defi cits to substantial surpluses. These surpluses have led to increasing foreign reserves in these countries. The external fi nancing constraint that existed