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This chapter examines the determinants and nature of China's capital inflows. Section 11.2 presents a detailed picture of the evolution of China's capital inflows. Section 11.3 examines the evolution of the balance of payments and dissects the recent surge in the pace of accumulation of international reserves. Section 11.4 discusses the broader composition of China's capital inflows in the context of the burgeoning literature on financial globalization. Section 11.5 examines various hypotheses that have been put forward to explain why China has its inflows so heavily tilted toward foreign direct investment (FDI). In this context, a detailed description of China's capital account restrictions and how these have evolved over time are provided. While controls on non-FDI inflows as well as tax and other incentives appear to be proximate factors for explaining the FDI-heavy composition of inflows, other factors may also have contributed to this outcome. It is not straightforward to disentangle the quantitative relevance of alternative hypotheses. It is argued that at least a few of the hypotheses — including some mercantilist-type arguments that have been advanced recently — are not consistent with the facts.

As private capital inflows resurged in Latin America during the later part of the 1980s, Chile was one of the first countries to attract such foreign capital flows and was also the one to attract the largest supply. Although the reemergence of such was in a way embraced because it relaxed the foreign exchange constraint, the composition and the large amount of new capital flows posed certain problems for the unprepared recipient countries. Such countries were faced with problems of domestic absorption since capital inflows are supposed to result in increases in the investment rate. Policy makers were also faced with dilemmas since the absence of regulations causes the real exchange rate to appreciate but intervention would lead to an increased money supply and inflation control. This chapter examines how massive capital inflows were dealt with in Chile during the 1990s, the policy responses, and the effects that were imposed on the domestic economy.

This chapter explores the effects of ex ante capital controls. In contrast to ex post controls, ex ante controls should not jeopardize the emerging market country's reputation, as they are included in contracts with foreign investors prior to their investing. The chapter analyzes the effectiveness of inflow controls to limit short-term capital and modify the composition of financial inflows. Several authors have suggested controls on capital inflows as an economic policy measure for managing excessive capital inflows into emerging markets. In periods of greater liquidity and low international risk aversion, it is common for substantial financial flows to move into Latin America and Asia. The years from 2004 to 2006 were classic examples: “dollar weakness,” or expectations of greater depreciation of the United States dollar due to forecasts that the U.S. current account deficit had to be reversed, together with low base interest rates in developed countries.

Examines the evolution of monetary policy rules and exchange rate regimes in the Philippines over the past two decades. It highlights the importance of recognizing the interdependence of exchange rate and monetary policies in a small open economy, and argues that failure to appreciate this has yielded undesirable consequences. To illustrate, it discusses the macroeconomic performance following regime shifts for various periods: (1) the eighties to early nineties when observed money growth not commensurate with growth in foreign reserve assets under exchange rate targeting caused episodes of peso collapse; (2) capital account liberalization – culminating in full peso convertibility in 1992 – which compromised the ability to conduct an independent monetary policy; and (3) the financial crisis years when it became apparent that fixing the exchange rate in a world of capital mobility was futile. The paper concludes by raising institutional issues and reviewing the conduct of monetary policy in the more recent postcrisis period.

This chapter investigates the patterns of international capital flows using data for 1970–2000. The data reveals that the quality of institutions plays an important role in explaining the direction and magnitude of capital flows in the 1970–2000 period. It also indicates that the quality of institutions and economic policy have contributed in the determination of the (relatively) high degree of capital flow volatility to the emerging markets in the 1970–2000 period. In addition, it shows that, despite the dramatic increase in capital flows, most capital flows to rich countries. A country that enhances institutions, decreases capital controls, and increases its growth is going to receive more capital inflows. Historical legal origins have a direct effect on capital inflows during the period 1970–2000.

This chapter summarizes how thinking about capital flows and their management has evolved in both policymaking and academic circles. Many advanced economies used restrictions on capital inflows for prudential purposes—even as they pursued financial liberalization more broadly—until the 1980s, when capital account restrictions began to be swept away as part of broader liberalization efforts. Likewise, many emerging markets that had inflow controls for prudential reasons dismantled them when liberalizing domestic financial markets and controls over outflows. That the use of capital controls as a means of managing inflows is often viewed with suspicion may be partly a “guilt by association” with outflow controls and exchange restrictions. Historically, these have been more prevalent and more intensive, and their purpose has been to prop up authoritarian regimes or poor macroeconomic policies, often affecting both current and capital transactions.

This chapter examines the volume and composition of capital flows in South Africa, distinguishing between net flows of foreign (non-resident) capital and net flows of domestic (resident) capital. Two key themes are the response of investors to capital account liberalization and the role of domestic capital markets in influencing the composition of flows. Section 2 assesses exchange control reform in South Africa, emphasizing the gradual nature of the liberalization strategy and the priority given to macroeconomic and financial sector stability. Section 3 examines the composition of foreign capital inflows, in particular the high levels of inward portfolio investment supported by developed local capital markets. Section 4 focuses on outward investment by South African residents in the form of institutional investors, companies, and individuals. Section 5 concludes with an assessment of the implications of the changes in the financial account since 1994 for the external balance sheet and for macroeconomic policy.

This chapter reviews some arguments on the appropriate management of capital inflow surges and examines, in particular, the conditions under which capital controls may be justified. A key conclusion is that if the economy is operating near potential, if the level of reserves is adequate, and if the exchange rate is not undervalued, then use of capital controls—in addition to both prudential and macroeconomic policy—is justified as part of the policy toolkit to manage the macroeconomic risks that inflow surges may bring. Such controls can moreover retain potency even if investors devise strategies to bypass them, provided such strategies are more costly than the expected return from the transaction.

This chapter discusses international spillovers, the multilateral impact of individual countries' policies, and the scope for international policy cooperation. Theory and empirics suggests that recipient countries would benefit from coordinating their policy responses to capital inflows. Specifically, because of spillovers of one country's measures on another, uncoordinated responses might result in barriers that—abstracting from terms of trade effects—are inefficiently high, reducing both global and recipient-country welfare. Theory also suggests that, under plausible conditions, it would be globally efficient if source and recipient countries could act “at both ends” in managing cross-border capital flows. For the recipient country, there would be a clear benefit if part of the distortive cost of capital controls could be shifted to the source country. Even though source countries might incur some economic or administrative cost in managing outflows, they would benefit from the terms of trade improvement.

While the Thai baht had lost about 55% of its value in terms of the US dollar by the end of January 1998 because it sold the majority of its international reserves in 1997, other currencies across Southeast Asia also experienced such declines since non-resident portfolios retreated from investment in economies that exuded similar characteristics with that of Thailand. The crisis experienced by both the Thai baht and the Indonesian rupiah are the most recent in the series of crises that have occurred recently throughout the developing region that are allegedly caused by a faulty domestic banking system and swelling capital inflows. This chapter emphasizes how the understanding of such crises should be given much attention because of the social costs involved. The chapter examines the various economic implications of these crises in developing countries particularly of those in Southeast Asia.

This chapter discusses a simple theoretical framework linking capital flows and various policy measures to macroeconomic outcomes. In the face of macroeconomic imbalances, policy makers need to decide whether to try to reduce the volume of flows or to tackle any collateral damage that they may cause. If the inflows are such that they bring little genuine benefit to the recipient country, then the obvious solution is to try to stop them entering the economy in the first place. But inasmuch as the capital inflow is considered to be beneficial, then dealing with any negative repercussion would naturally be the preferred option. To this end, the central bank—or national authorities more generally—have potentially three instruments at their disposal: the policy interest rate, foreign exchange (FX) intervention, and macroprudential measures. These instruments map naturally to maintaining price stability, curbing the appreciation of the currency, and safeguarding financial stability.

This chapter examines how emerging markets typically respond to capital inflows in practice. Confronted by an inflow surge, national authorities respond through a combination of policy instruments—both macroeconomic tools and less orthodox measures. While the thrust of the policy responses across countries is largely the same, there are differences in the specific instruments deployed that likely depend on economic, historical, and institutional characteristics. Central banks seem to use the policy interest rate to address inflation and overheating concerns associated with capital inflows, and to reduce currency appreciation. Most emerging market central banks intervene quite heavily in the face of inflows, nearly always sterilizing that intervention. Finally, emerging market economies also seem to be using capital controls and macroprudential measures in the face of large inflows, but capital controls appear less frequently, often acting as a backstop to other measures.

This chapter examines the ideas that shaped independent India's economic policy. Topics covered include Gandhi and Hind Swaraj, the rise of planning, agricultural growth, savings, capital inflows, investment, public sector growth, and industrial development.

This chapter provides concrete policy advice for dealing with capital inflows. In sum, once the monetary authorities have allowed the exchange rate to appreciate to a level that is not undervalued from a multilaterally consistent medium-term perspective, they may want to start intervening in the foreign exchange (FX) market to prevent further appreciation, sterilizing the intervention if there are inflationary pressures. If the economy shows signs of overheating, monetary and fiscal tightening might be necessary, together with macroprudential measures to contain excessive credit growth. To the extent these policies prove insufficient, the authorities need to consider bolstering them by imposing or tightening capital controls. At the same time, national authorities must be mindful of growing balance-sheet mismatches in the economy and should avail themselves of both prudential measures and capital controls to shift the composition of inflows toward less risky forms of liabilities.

This chapter investigates how monetary authorities responded to large and rapidly increasing capital inflows. It indirectly tests whether tight monetary policy measures—described broadly as “sterilization”—promoted additional capital inflows through keeping the level of interest rates high, by examining the effectiveness of sterilization in limiting the impact of reserve inflows on the growth of monetary aggregates. The chapter is organized as follows. Section 6.2 presents an overview of the capital inflow episode in the context of Indonesia, Korea, Malaysia, the Philippines, and Thailand, by emphasizing the relationship between the capital inflows and the growth of monetary aggregates. Section 6.3 summarizes the policy responses, collectively called “sterilization,” taken by the East Asian monetary authorities to limit the expansionary impact of reserve inflows on the growth of monetary aggregates. Section 6.4 tests for the effectiveness of sterilization in limiting the growth of monetary aggregates, by using both time series and structural approaches. Finally, Section 6.5 presents concluding remarks. Two commentaries are included at the end of the chapter.

This chapter focuses on external factors as the cause of currency and financial crises. It analyzes how the de facto dollar peg system adversely influenced capital inflows to the countries in crisis by studying the relationship between the de facto dollar peg system and the capital inflows to these countries. Focus is placed on countries that requested IMF financial support during the Asian crisis, namely, Thailand, Korea, and Indonesia. Estimated regression equations are used to conduct a simulation analysis of how capital inflows would have behaved had the monetary authorities of these countries adopted a currency basket peg system instead of the de facto dollar peg system. The simulation analysis generates the following results: A currency basket peg system would have had a depressing effect on capital inflows to Thailand and Korea during the analyzed period 1985–96. It would also have had a slightly depressing effect on capital inflows to Indonesia. Increases in foreign exchange risk against the U.S. dollar under a currency basket peg system would have contributed most to the depressing effect. This is because the estimated foreign exchange risk variable against the U.S. dollar is the most significant variable among the explanatory variables in the capital flow equation. Two commentaries are included at the end of the chapter.

This chapter reviews Brazil's experience with capital controls. In spite of the significant progress in terms of capital account liberalization and currency convertibility attained since the early 1990s, current regulations continue to be cumbersome and complex. The debt accumulation pattern and the profile of external financing substantially changed since liberalization of the capital account and the floating of the currency. Net financial flows have financed current account deficits. Moreover, sudden stops are more pronounced when the crisis is mostly domestically driven. The strong capital controls system did not prevent capital flight. Sudden stops involve both the interruption of capital inflows and an increase in outflows. Foreign direct investment (FDI) flows tend to be more stable and less correlated to the other flows. Liberalization of the capital account in the last fifteen years has provided more convertibility to the currency.

Critics and experts blamed structural weaknesses and misguided macroeconomic policies as the major causes of the 1997 financial crisis. These include financial sector frailties, weakness in the corporate and government sectors, a deteriorating external situation, and contagion. It is argued that neither the structural nor liquidity-panic view accounts for the causes and consequences of the crisis. East Asian countries had failed to reform and improve the efficiency of their financial and corporate sectors.