Alternate instruments to manage the capital flow conundrum: A study of selected Asian economies

• Author: Rajeswari Sengupta,Abhijit Sen Gupta
• DOI: http://doi.org/10.1111/1468-0106.12296
• Published date: 01 May 2019
• Date: 01 May 2019

ORIGINAL MANUSCRIPT

Alternate instruments to manage the capital flow

conundrum: A study of selected Asian economies

*

Rajeswari Sengupta

1

| Abhijit Sen Gupta

2

1

Department of Economics, Indira Gandhi

Institute of Development Research,

Mumbai, India

2

India Resident Mission, Asian

Development Bank, New Delhi, India

Correspondence

Rajeswari Sengupta, Indira Gandhi Institute

of Development Research (IGIDR),

Film City Road, Goregaon East, Mumbai,

Maharashtra 400065, India.

Email: rajeswari@igidr.ac.in

Abstract

Capital inflows to and outflows from emerging market

economies (EME) have increased significantly since 2000.

This rapid increase, accompanied by a sharp rise in volatil-

ity, has amplified the complexity of macroeconomic man-

agement in EME. While foreign capital provides additional

financing for productive investment and offers avenues for

risk diversification, unbridled flows exacerbate financial

and macroeconomic instability. In this paper, we focus on

the experience of six emerging Asian economies (EAE) in

dealing with capital flows. Using quarterlydata, we identify

the waves of capital flows experienced by these EAE and

the efficacy of the various policy measures taken. The pol-

icy choices include negotiating the trilemma (i.e. balancing

the need for monetary policy autonomy, exchange rate flex-

ibility and capital account openness), as per the demands of

the macroeconomic situation. The paper also analyses the

extent to which intervention in the foreign exchange market

and imposition of short-term capital flow management mea-

sures have aided countries to negotiate the trilemma. The

efficacy of these responses have been varied across coun-

tries, implying thata judicious mix of these measures, along

with improvement in financial and institutional develop-

ment, is required to effectively counter the vagaries of capi-

tal flows.

*We thank Ramkishen S. Rajan and participants at the Conference on Current Account Balances, Capital Flows, and

International Reserves held in City University of Hong Kong, Hong Kong on 4–5 May 2018 for their helpful comments. The

authors also thank Utso Pal Mustafi for excellent research assistance. The views expressed in this paper are those of the

authors and do not necessarily reflect the views and policies of the Asian Development Bank (ADB) or its Board of Governors

or the governments they represent.

Received: 25 February 2019 Accepted: 25 February 2019

DOI: 10.1111/1468-0106.12296

Pac Econ Rev. 2019;24:241–268. wileyonlinelibrary.com/journal/paer © 2019 John Wiley & Sons Australia, Ltd 241

KEYWORDS

asymmetric intervention, capital controls, capital flows, exchange

market pressure, trilemma

1|INTRODUCTION

Emerging economies have witnessed a sharp increase in capital flows over the past two and a half

decades. After fluctuating between 2.0 and 4.0% of GDP during 2000 to 2002, gross capital inflows

started to pick up from 2003 and reached a peak of 11.5% of GDP in the third quarter of 2007. These

inflows collapsed dramatically with the onset of the global financial crisis (GFC) and fell to −5.4%

of GDP in the fourth quarter of 2008 (Bluedorn, Duttagupta, Guajardo, & Topalova, 2013).

1

The

slew of measures introduced by several countries in the aftermath of the GFC to bolster aggregate

demand, including the unconventional monetary policies adopted by key advanced economies,

resulted in a resurgence of capital into the emerging market economies (EME). Gross capital inflows

rose rapidly in the second half of 2009 and 2010, and by the third quarter of 2010 these inflows to

EME exceeded the pre-crisis peak and reached almost 15% of GDP. The situation reversed again by

the end of 2011, with worsening of the global economic outlook driven by the sovereign debt rating

downgrade of the United States in August 2011 and exacerbation of the eurozone crisis. This resulted

in capital flows receding rapidly, with gross inflows falling below 3.0% of GDP in the last quarter of

2011 and eroding the recent exchange rate gains and reserve accumulation. While there was some

recovery in the subsequent quarters, the signal by the Federal Reserve Bank in May 2013 that it

would taper its bond-buying programme precipitated a sharp drop in capital flows.

This heightened volatility in capital flows created various macroeconomic challenges and finan-

cial stability concerns for EME, and forced them to undertake capital account management and mac-

roprudential measures to stem the flow of capital. These measures were adopted to address multiple

objectives, such as preventing excessive appreciation of the domestic currencies presumably to pre-

serve export competitiveness, guarding against asset price bubbles, maintaining monetary policy

autonomy, managing pressure on the exchange rate, and reducing financial sector vulnerability to

contagion.

Our paper focuses on the trend of capital inflows and outflows in selected emerging Asian econo-

mies (EAE) by analysing the “waves”in capital flows. Subsequently, the response of the host coun-

tries to these waves is analysed, focusing primarily on the capital account management measures.

These policy responses have involved dealing with volatile capital flows within the context of

balancing the trade-offs presented by the trilemma.

2

Faced with rising and volatile capital flows,

EAE had the option of negotiating the trilemma by: (i) intervening in the foreign exchange market to

stabilize the domestic currency and, hence, give up monetary policy autonomy; (ii) imposing capital

controls to stem the inflow of particular types of foreign capital to prevent currency fluctuations and

preserve monetary independence; or (iii) letting the exchange rate absorb the external shocks.

Finally, the paper attempts to evaluate the efficacy of these measures by analysing if these measures

achieved their desired goals.

In recent times, especially in the aftermath of the GFC, there has been a significant amount of

empirical work analysing the evolution of the trilemma trade-offs in EME. Han and Wei (2014) find

that a flexible exchange rate by itself does not convey monetary policy autonomy. It is possible that

when faced with international monetary policy spillovers (as was the case during the years of

242 SENGUPTA AND SEN GUPTA