The Challenge of Managing Global Capital Flows

• Author: Manuel Guitián
• Position: Director of the IMF's Monetary and Exchange Affairs Department

The financial crisis that erupted in Asia in 1997 vividly demonstrated the risks associated with free capital flows. But capital mobility is a goal worth pursuing, given the potential benefits. With the right policies, countries can manage the risks while increasing their access to global financial markets.

CAPITAL MOBILITY is generally a desirable aim. When private capital is allowed to flow freely across borders in search of the best investment opportunities, it can be channeled toward its most productive uses on a global scale. Developing countries, where domestic resources tend to be in short supply, stand to benefit particularly from capital account liberalization, which can lead to increased investment, faster economic growth, and improved standards of living, as well as contribute to the deepening and broadening of domestic financial markets.

But capital flows also expose countries to external disturbances and can have a destabilizing effect. The dangers of sudden outflows are well understood, but capital inflows also carry risks-they may create difficulties for monetary policy management and inflation control as well as for exchange rate stability and export competitiveness. This is particularly true in countries with vulnerable financial sectors and inappropriate macroeconomic policies.

The long-running debate about the desirability of unrestrained capital movements intensified in the wake of the financial crisis that rocked several Asian economies in 1997 and 1998 (see box). Do capital controls have a role in today's world economy? What other steps can be taken, at both the national and the international levels, to help countries minimize the potentially disruptive effects of capital flows on their economies?

Capital flows and the Asian crisis

The Asian countries hit hardest by the crisis of 1997 and 1998-Indonesia, Korea, and Thailand-had pursued diverse approaches to opening up their capital accounts. Although they achieved only partial liberalization, they all experienced significant growth in capital inflows (until the crisis, almost half of total capital inflows to developing countries went to Asia-nearly $100 billion in 1996).

Indonesia liberalized outflows relatively early and inflows only gradually. In 1989, it eliminated controls on foreign borrowing by banks but reintroduced them two years later because of concerns about excessive borrowing. It continued, however, to liberalize inflows to corporations, allowing borrowing for trade finance, sales of securities to nonresidents, and foreign investment in the domestic stock market. Korea took a gradualist approach. It liberalized outflows first and did not begin liberalizing inflows into its securities markets until the mid-1990s. In 1992, nonresidents were given limited access to the Korean stock market, and the types of securities that resident firms could issue abroad were expanded. Foreign exchange banks were authorized to borrow abroad, but direct foreign borrowing by corporations was controlled. In contrast, Thailand sought to attract foreign inflows, offering tax incentives to foreign investors, setting up a special facility (the Bangkok International Banking Facility) to channel inflows through the banking system, and allowing foreign investment in Thai securities markets. Capital outflows were liberalized gradually, however.

The impact of capital account liberalization ultimately depends on how efficiently capital flows are used. In all three countries, liberalization brought significant growth to capital inflows channeled through domestic banking systems that were inefficient and unsophisticated and that contributed to their short-term maturities. Excessive lending to interrelated entities distorted incentive structures. The rapid expansion of bank credit strained credit assessment capabilities, and funds flowed into unprofitable or speculative activities.

Policy weaknesses led to the accumulation of unsustainable levels of foreign debt by domestic firms. The three countries had pegged their currencies to the U.S. dollar, and the high domestic interest rates needed to sustain the pegs both attracted short-term inflows and encouraged domestic firms to borrow in foreign currencies. Much of this foreign borrowing was unhedged on expectations that the pegged exchange rates would be maintained indefinitely. Government guarantees, implicit as well as explicit, encouraged lending by foreign institutions and undue risk taking by...