Data Spotlight: Coping with Capital Inflow Surges

• Position: Prepared by of the IMF's Monetary and Capital Markets Department.

ONE of the effects of the recent global crisis has been a surge in capital flows to emerging markets, particularly to those with strong growth prospects. Capital inflows have well known benefits—by supplementing domestic savings in financing economic growth, fostering the diversification of investment risk, and contributing to the development of financial markets. Still, a sudden surge of incoming capital can complicate economic management, lead to asset price bubbles, and increase systemic risk in the financial sector. In addition to the traditional policy responses—exchange rate changes, adjustments in fiscal and monetary policies, foreign exchange intervention, reserve accumulation, and prudential measures—emerging economies often use capital controls—tightening controls on inflows, easing controls on outflows, or both—to try to mitigate risks associated with fluctuations in international capital flows.

Before the recent global crisis, many emerging markets followed the advanced economies by opening up their economies to foreign investment and allowing domestic investors to put their money abroad. As a result, cross-border capital flows—from advanced economies to emerging economies and between emerging economies—increased over the past two decades. But some emerging economies responded by placing restrictions on these flows. For example, Argentina, Thailand, and Colombia implemented unremunerated reserve requirements on most types of capital inflows in the second half of the 2000s. Thailand also actively liberalized outflow controls to balance part of the capital inflows by allowing residents to invest abroad. To address the large increase in credit expansion, Croatia applied a mix of prudential measures and capital controls on banks’ foreign borrowing. While both India and China pursued a gradual liberalization of the capital account, controls were tightened on specific capital inflows in 2007. More recently, Brazil introduced a tax on some foreign exchange transactions at the end of 2009 and supplemented it with another tax on certain equity inflows in 2010.

But the evidence on the effectiveness of capital controls is mixed. They generally cannot reduce the total volume of inflows or reduce exchange...