Managing capital inflows

The recent IMF policy discussion paper-“Capital Inflows and Balance of Payments Pressures—Tailoring Policy Responses in Emerging Market Economies (EMEs).” prepared by Atish Ghosh, Manuela Goretti, Bikas Joshi, Uma Ramakrishnan, Alun Thomas, and Juan Zalduendo dated  June 2008  raises some of the very issue that we have been discussing recently on the appropriate policy responses to the surge in capital inflows.

Over the past three years, many emerging market and developing countries have experienced historically high levels of positive capital flows. The rise in net flows to emerging markets has been building up for some time but it accelerated markedly with record levels since 2005 and it is expected to be maintained at such high levels despite the worldwide financial market turbulence.

Net Private Capital Inflows to Emerging Markets

 

 

We note a more or less similar trend in the flows of FDI to Mauritius; inflows to Hotels, IRS and real estate accounted for an average of 70% of the total FDI, exclusive of the inflows to the banking sector, over the past two years.

Thus much of the pick up in the growth momentum is explained by the abundant global liquidity that has flooded many emerging markets including Mauritius in search of higher returns. The large capital inflows were associated with an acceleration of GDP growth and large swings in aggregate demand and in the current account balance that may deteriorate during the inflow period.

 

 

While these surges of net private capital inflows are generally beneficial to recipient countries, they also create important policy challenges, especially substantial short-term macroeconomic challenges in managing the heavy foreign exchange inflows. Most policymakers face, what Maurice Obstfeld and Alan M. Taylor back in 2003 had termed the macroeconomic trilemma or the “impossible trinity”: the impossibility of having simultaneously three typically desirable, yet contradictory, objectives: a stable exchange rate, independent monetary policy and free international capital mobility. Because only two out of the three objectives can be mutually consistent, policymakers must decide which one to give up. This is the trilemma.

A surge in net foreign exchange inflows can lead to rapid credit growth, an overheated economy, and a build up in inflationary pressures. If the exchange rate is allowed to appreciate, this will provide some degree of monetary control -increasing direct control over the monetary base –and reduce the incentives to arbitrage interest rate differentials, but it can lead to a loss of competitiveness and limit export opportunities and potentially reducing economic growth. In the case of a current account deficit, the real appreciation could exacerbate the external imbalance. To counter these effects, the authorities may decide to intervene by building up foreign reserves to keep the exchange rate from appreciating and this leads to excessively loose monetary conditions and hikes up inflation. Even if the authorities are able to prevent nominal exchange rate appreciation, real appreciation could occur through higher domestic inflation. Sterilization is not only ineffective for it raises interest rates which further encourages capital inflows, thus perpetuating the problem, it also  however entails substantial costs because it generally involves the central bank exchanging high-yield domestic assets for low-yield reserves.

The evidence shows that the recent wave of capital inflows has been associated with strong exchange market pressures in all regions. These have been resisted through the accumulation of foreign reserves while also allowing some upward movement in exchange rates. But the desire to limit the extent of exchange rate appreciation was quite widespread. There was also an aggressive sterilization effort at the beginning when capital began to pour in but it tapered off as the authorities became increasingly conscious of its cost. The higher degree of resistance to exchange rate changes during the inflow period and sterilized intervention were unable to prevent real appreciation.  A greater increase in nominal interest rates was strongly linked to greater real appreciation as the higher returns on domestic assets ended up attracting more capital inflows and fueling upward pressures on the currency. Thus a policy of resistance to nominal exchange rate appreciation has not been successful in preventing real appreciation and that restrictions on capital inflows have in general not facilitated lower real appreciation. In contrast, fiscal policy in the form of slower growth in government expenditure is strongly associated with lower real appreciation.

So what should be the design of policy responses in the face of the large capital inflows and what is the effect of policy responses on the behaviour of the real exchange rate? In the IMF paper , referring to the  cases of the countries that have a current account deficit and where the net total capital flows exceed this deficit, the recommended policy response is a) to allow limited nominal exchange rate appreciation (whereas a large appreciation, by making investment in the country more expensive, would deter further inflows.); b) do  not sterilize reserves accumulation for it will hike up interest rates that will encourage  continued capital inflows;  c) Do not tighten monetary policy because the resulting higher interest rates are likely to exacerbate the capital inflow problem; d) tighten fiscal policy, especially if there are inflationary pressures; allow the nominal exchange rate to appreciate and the tightening of fiscal policy will lower interest rates and reduce inflows and e) Relax controls on capital outflows and possibly impose controls on inflows.

            Fiscal restraint in the face of strong capital inflows helps reduce pressures on the real exchange rate. The evidence suggests “that countries facing strong output growth and capital inflows would benefit from greater fiscal restraint, by saving a larger share of buoyant revenues, rather than allowing public spending to soar or prematurely cutting taxes.” This is exactly what some local economists have been saying about the recent budget. « Commentant le financement in toto des recommendations du rapport du PRB,…ll aurait dû se servir de cet argent pour reduire le deficit budgetaire ou financer des projets de dévelopment, mais c’est clair qu’il a fait un choix politique. »

In this context, back in March of this year, the Governor of the BOM had acknowledged “l’utilisation du taux d’intérêt comme instrument de contrôle ou celle de l’ajustement du taux de change comme solution temporaire”. He had called for greater coordination between monetary and fiscal policy.  «  Le gouverneur de la Bank of Mauritius (BoM), Rundheersing Bheenick, demande l’aide de l’État mauricien pour la maîtrise du flux de capitaux étrangers à court terme qui submergent le pays. À travers son budget, mais également à travers les institutions sous son contrôle, l’État est exhorté à faire un plus gros effort afin d’aider à annihiler les effets néfastes. ». He does not seem to have been heard; instead in the recent budget, despite a falling tax revenue to GDP ratio and an increasing reliance on grants, recurrent expenditure to GDP has been increased to 22% of GDP.  We seem to doubt whether the conversion to fiscal rectitude was genuine and that the efforts at fiscal consolidation may have gone waste.

 

	2006/07	2007/08	2008/09
As a % of GDP	Actual	Revised
Tax Revenue	17.4	18.8	18.1
Grants	0.1	0.3	1.4
Total  Revenue	19.2	21.1	21.9
Current Expenditure	20.1	19.8	21.6
o/w interest payments	4.1	4.4	3.9
TOTAL EXPENDITURE	23.5	24.9	25.2
OVERALL BALANCE	-4.3	-3.8	-3.3