Moderating Fluctuations in Capital Flows to Emerging Market Economies

• Author: Michael Mussa, Alexander Swoboda, Jeromin Zettelmeyer, and Olivier Jeanne
• Position: Economic Counsellor of the IMF and Director of the IMF's Research Department/Senior Policy Advisor in the IMF's Research Department/Economist in the Developing Country Studies Division of the IMF's Research Department/Economist in the Economic Modeling and External Adjustment Division of the IMF's Research Department

What challenges and constraints face proposals to moderate and cope with volatility in international capital flows, and how can international public intervention and regulation help to forestall and mitigate future crises?

The emerging market crises of the 1990s-in particular, the Asian crisis-have generated a perception of deep inadequacies in the international financial system and an intense debate on global financial reform, particularly regarding capital flows to emerging markets. It is now widely accepted that these crises resulted from both domestic policy failures-exacerbated in some cases by adverse external and political shocks-and weaknesses in the international financial system.

Policy failures included traditional macroeconomic imbalances, such as overvalued currencies and current account or fiscal deficits, particularly in Latin America and Russia. In addition, microeconomic weaknesses-themselves a result of inadequate regulation, poor risk management, and implicit or explicit government guarantees-played an important role, taking center stage in the Asian crisis. These weaknesses manifested themselves in the increasing vulnerability of corporations and financial institutions to higher interest rates or a depreciated exchange rate, or both, on top of signs of insolvency in the corporate and banking sectors even before the crisis. For instance, the rate of nonperforming loans was more than 15 percent in Indonesia, Korea, Malaysia, and Thailand. In Korea, 8 of the 30 largest conglomerates were either actually or effectively bankrupt by mid-1997 (Corsetti, Pesenti, and Roubini, 1998).

It is difficult, however, to explain the crises of the 1990s solely in terms of weak domestic fundamentals and adverse shocks. The Asian crisis was preceded by a rising tide of finance at declining emerging market spreads right up to the devaluation of the Thai baht (see chart), notwithstanding public discussion before the crisis of many of the fundamental deficiencies now widely diagnosed as having contributed to recent crises. Moreover, the virulence of the capital outflow once the crisis erupted is impossible to attribute to any single set of "bad news" and had the typical features of a financial run: investors fled because, given that other investors were fleeing, this was a rational way of limiting losses. Finally, the crisis spread quickly, including to countries and regions that were distant in terms of geography and trade linkages. This phenomenon, which became known as "contagion," affected even countries with strong fundamentals and that had little in common with the countries in which the crisis originally erupted.

[ SEE THE GRAPHIC AT THE ATTACHED RTF ]

In line with this analysis, two kinds of reform proposals can be distinguished. The first includes improvements in domestic policies and increased transparency. This would both reduce the fundamental weaknesses that make countries vulnerable to financial crises and make it less likely that existing weaknesses could build up unnoticed for substantial periods. The second includes measures to address systemic risks and contain crises more directly, such as improving international institutions, rules for debt workouts, and the regulation of certain types of international capital flows.

Domestic reform, supervision, and standards

There is wide agreement that emerging markets could reduce their vulnerability to crises and encourage high-quality growth by strengthening financial regulation, improving the legal framework governing relations between creditors and debtors, enhancing data dissemination, doing away with implicit and explicit guarantees, and-in some cases-strengthening macroeconomic...