Going against the flow: Dealing with capital flows to emerging markets
by Anton Korinek, via VoxEU
22 December 2010
Capital flows to emerging markets are controversial territory. This column argues that they create externalities that make the recipient economies more vulnerable to financial fragility and crises. It adds that policymakers can make their economies better off by regulating and discouraging the use of risky forms of external finance – in particular short-term dollar-denominated debts.
Two years after the most severe global financial crisis in decades, financial markets are flush with liquidity, aided by ample monetary stimulus from central banks around the world. Emerging market economies are experiencing large inflows of capital that drive up their exchange rates and inflate asset prices.
Policymakers in the affected economies are justifiably worried about the consequences. Indeed, as Reinhart and Reinhart (2008) have pointed out, such “capital flow bonanzas” are all too often followed by severe crashes that impose massive social costs. A growing chorus of academics, perhaps most famously represented by Stiglitz (2002), has argued that capital flows to emerging markets should therefore be regulated. Country after country, from Brazil to Indonesia, Korea, Peru, Taiwan and Thailand, has followed their advice in recent months. In a notable reversal on earlier policies, the IMF has given its blessing to capital controls under certain circumstances (Ostry et al. 2010).
Externalities of capital flows
In a recent research paper (Korinek 2010b), I make the welfare theoretic case for regulating capital flows based on the notion that such flows impose externalities on the recipient countries. Just as environmental pollution produces externalities that reduce societal wellbeing if unregulated, capital inflows to emerging markets produce externalities that make such economies more prone to financial instability and crises. By implication policymakers can make everybody better off (i.e. achieve a Pareto-improvement) by regulating and discouraging the use of risky forms of external finance, in particular of foreign currency-denominated debts.
Risky forms of capital inflows create externalities because individual borrowers find it optimal to ignore the effects of their financing decisions on aggregate financial stability. They take the risk of financial crisis in their economy as given and do not recognise that their individual actions contribute to this risk. In a way they face a “prisoners’ dilemma”; if they could all agree to use less risky financing instruments and less external finance overall, the economy as a whole would become more stable and everybody would be better off. This creates a natural role for policy intervention.
Mechanism of financial crises
The economic rationale for capital flow regulations derives from a specific market imperfection that plays a crucial role during emerging market financial crises. International investors typically demand explicit or implicit collateral when providing finance. However, the value of most of a country’s collateral depends on exchange rates. When an emerging economy is hit by an adverse economic shock, its exchange rate depreciates, the value of its domestic collateral declines, and international investors become reluctant to roll over their debts. The resulting capital outflows depreciate the exchange rate even further and trigger an adverse feedback cycle of declining collateral values, capital outflows, and falling exchange rates (see Figure 1).
Figure 1. Feedback loops during emerging market crises
This financial feedback loop, sometimes referred to as Fisherian debt deflation or simply as deleveraging cycle, can amplify economic shocks so that a relatively small initial shock leads to large declines in exchange rates, borrowing capacity and economic activity coupled with large capital outflows (see e.g. Mendoza, 2006). As shown in Korinek (2010b), rational private agents do not internalise their contribution to such feedback loops and therefore impose externalities on the rest of the economy.
