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EXECUTIVE SUMMARY

HOW TO RESPOND TO CAPITAL INFLOW EPISODES

1. Do nothing and allow/accept the currency appreciation accompanying these inflows

2. Unsterilized FX intervention to prevent a nominal appreciation

3. Sterilized intervention to prevent a nominal and real appreciation

4. Controls on inflows of foreign capital (capital controls)

5. Fiscal tightening and public asset and liabilities management

6. Macro-prudential regulation/supervision of banks and financial institutions

7. Massive large-scale long-term sterilized FX intervention

SUMMARY OF THE POLICY IMPLICATIONS: DIFFICULT POLICY TRADEOFF

IMPLICATIONS FOR ASSET PRICES IN EMERGING MARKET ECONOMIES

EXECUTIVE SUMMARY

Capital flows to emerging market economies (EMs) have been going through a cycle of boom and bust for

decades. In the past year, especially since the middle of 2010, we have seen another boom with massive flows

of capital—FDI, portfolio equity investments and fixed-income investments—going to EMs, especially those

perceived by market participants as having stronger macro, policy and financial fundamentals.

The question is how should policy makers respond to these inflows? Do nothing and allow their currencies to

appreciate and thus risk real currency overvaluation, loss of competitiveness and growth? Aggressively

intervene to prevent appreciation in an unsterilized way and thus feed monetary and credit growth, economic

overheating, inflation and asset/credit bubbles? Intervene in a sterilized way and thus feed further capital

inflows as the interest rate differentials and undervaluation that trigger the inflows are maintained? Impose

capital controls on short-term money that affects the short-term/long-term composition of inflows, but risks not

preventing appreciation as the controls don’t affect the overall amount of inflows? Tighten fiscal policy to

reduce domestic rates and inflows at the risk of feeding further inflows if fiscal discipline is associated with

lower sovereign risk? Impose credit control and macro-prudential supervision and regulation of the banking

system to reduce the chance of credit and asset bubbles at the risk that the inflows will bypass the banking

system and go directly to domestic capital markets, and thus still feed asset bubbles? Massively intervene for a

long time in a sterilized way to satisfy the long-term secular demand by international investors for the assets of

EMs?





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These difficult policy choices and trade-offs are driven by one of the key principles of international macro-

finance: the Inconsistent Trinity (or the Impossible Trinity). This principle says that economies can never have

all three of the following features at the same time: fixed or semi-fixed exchange rates, an independent

monetary/credit policy and perfect capital mobility unconstrained by capital controls. Only two of these three

objectives can be achieved at any one point in time: if there are no capital controls and a country wants an

independent monetary policy, it needs to give up on fixed exchange rates in favor of a flexible regime; if there

are no capital controls and the policy makers want fixed or semi-fixed exchange rates, they lose monetary/credit

policy independence; and, if policy makers want to maintain monetary independence while maintaining fixed or

semi-fixed exchange rates, they need to sacrifice capital mobility and use capital controls (on inflows or

outflows, depending on whether they are trying to manage a capital inflow episode or a case of capital flight).

HOW TO RESPOND TO CAPITAL INFLOW EPISODES

So, how should policy makers respond to these massive inflows and prevent them from destabilizing the

domestic economy and financial markets? Before considering specific policy options, one should note that such

inflows are driven both by short-term cyclical factors (interest rate differentials and a wall of liquidity chasing

assets as more quantitative easing in weakly growing advanced economies becomes the norm, with risk-on

periods of falling global risk aversion) and longer-term secular factors: long-term growth differentials relative to

advanced economies; global investors who are less biased toward their home markets, with related

diversification to EMs and higher long-term expected returns on EM assets; the expectation of long-term

nominal/real appreciation of EM currencies; and the realization that financial and sovereign debt crises can

occur in advanced economies as well as in EMs, and therefore that volatility in advanced economies can be as

high or higher than in EMs. The long-term secular factors are important as investors in advanced economies are

diversifying their portfolios internationally and discovering that they are long-term underweight in EM assets.

Thus, many of these inflows are not the classic short-term ―hot money‖ inflows that can flow out within a few

months, but rather are usually permanent and long term.

The policy options for EMs receiving these inflows can be organized into seven groups.

1. Do nothing and allow/accept the currency appreciation accompanying these inflows

The first and initial option for policy makers is to do nothing and allow whatever nominal and real appreciation

that is triggered by such inflows. The arguments for preventing this nominal appreciation are well known: if the

appreciation is excessive, the currency could become overvalued in real terms and the external balance worsen

excessively, with a rapidly shrinking current account surplus or even a growing current account deficit. The

resulting loss of competitiveness would hurt economic growth and eventually even trigger a financial crisis if

the current account deficit becomes excessive and unsustainable.

But there are also plenty of counter-arguments that suggest that a significant nominal and real appreciation is

necessary, driven by fundamentals and desirable.

First, the currency appreciation could be driven by fundamental factors such as a previously undervalued

currency that had weakened too much in a previous financial crisis or episode of global risk aversion. Or the

country may be running a large current account surplus (possibly also driven by currency undervaluation) that

leads to fundamental appreciation pressures on the economy. Or the country’s currency may be strengthening as

its terms of trade are improving following, for example, a rise in the real price of the commodities that it

exports.





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Second, nominal and real appreciation can be desirable as it: leads to a reduction in inflationary pressures;

reduces the cost of imported foreign currency-denominated commodities and intermediate inputs (with respect

to commodities, this is mainly about their currency value relative to the U.S. dollar—the currency in which

most commodities are traded globally); increases the purchasing power of domestic importers, especially

households; and can even improve the country’s terms of trade—and thus increase real income—by reducing

the relative price of imported goods.

Third, if the nominal appreciation that these inflows induce is prevented via sterilized intervention in the FX

markets, capital inflows driven by carry trade considerations—interest rate differentials—will keep on coming

and exert further upward pressure on the currency that is expected to appreciate. If, instead, the currency is

allowed to appreciate from an undervalued level to a fairly valued level, the inflows will stop and the

appreciation pressures will subside as the necessary, desirable and fundamentally driven appreciation is

accommodated rather than resisted. It is better to let a step or gradual appreciation occur until the currency is

not regarded by global investors as undervalued to ensure that capital inflows stop coming. Moreover, if the

nominal appreciation is resisted through unsterilized FX intervention, the resulting fundamental real

appreciation of the currency will occur via a rise in inflation rather than a nominal appreciation (as in Mexico,

Brazil and Argentina in the 1990s or Russia in 1990s and again in the 2000-08 period). In the long term, you

cannot fight a fundamental real appreciation.

Fourth, those capital inflows and the induced alteration of nominal and real exchange rates will change the

domestic allocation of resources toward booming sectors—such as commodities if an increase in the price of

commodities is the initial driver of the capital inflows and currency strengthening—and away from declining

sectors (such as other export sectors or import-competing sectors subject to import competition). Fighting this

necessary and desirable reallocation of resources that will occur anyhow in the long term to preserve the

competitiveness of declining sectors may be a mistake as markets and price signals—the capital inflows and the

resulting appreciation—suggest that a reallocation of resources is desirable, optimal and eventually

unavoidable.

However, there are many arguments against doing nothing and allowing currencies to appreciate. First, markets

are often wrong and capital inflows may be excessive and driven by factors that do not depend on fundamentals;

they can be driven by irrational exuberance—investors’ temporary fads for EMs that eventually get reversed.

Second, if flows driven by factors other than fundamentals lead to excessive appreciation, the economy will

eventually be damaged: the current account balance will worsen; there is a resulting loss of competiveness; and

growth could slow sharply.

Third, in some extreme cases, excessive inflows may eventually lead to excessive outflows and financial crises:

if the currency becomes so overvalued that the current account turns into a large and growing deficit that is

increasingly financed with short-term and foreign currency debt, a financial crisis driven by an unsustainable

current account deficit and an external debt sustainability problem could eventually take place (see Mexico in

1994-95, East Asia in 1997-98, Turkey and Argentina in 2001 and many other episodes of financial crises in

EMs).

Fourth, excessive real appreciation driven by the rise in the price of the export goods of a country—traditionally

commodities and resources in abundant supply in the country—leads to a Dutch Disease: non-traditional

exports such as manufacturing goods and other commodities not subject to a price increase lose competitiveness

and are crowded out. Thus, import-competing sectors can be destroyed and non-traditional exports can also be





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damaged. While one could argue that the decline of such sectors may be desirable if relative prices and flows of

capital suggest reallocation of resources toward sectors such as commodities whose prices are rising and away

from declining sectors, this reallocation can become problematic: if the inflows are partly a bubble not driven

by long-term fundamentals, you end up destroying sectors that would have been viable if that excessive real

appreciation had not occurred. Also, the economy becomes less diversified if most of the production gets

concentrated in the booming commodity sectors and is thus then at risk of long-term output volatility if the

country’s terms of trade become hostage to the whims of externally determined commodity prices.

For example, the nominal appreciation of the Brazilian real and Chilean peso today is partly justified by the rise

of agricultural, oil and energy prices (for Brazil) and the rise of copper prices for Chile. But, based on a number

of indicators, the real exchange rate of Brazil’s currency is already way overvalued and the Chilean peso is

becoming overvalued. Thus, import-competing sectors and non-commodity manufactured goods export firms in

Brazil are hurting, while in Chile, non-traditional exporters—of wine, salmon and other agricultural goods –

may be pushed to the brink by the excessively strong currency. If the inflows are excessive and the real

appreciation excessive, the damage to or destruction of these other traded goods sectors will—in the medium to

long term—damage the economy, especially if it is driven by excessive short-term inflows that cause

excessively overvalued currencies. Once certain traded goods sectors have declined or are gone, the damage

will be permanent as such sectors will not come back. Certainly, it would not be in the interest of Chile to

become a quasi ―banana republic,‖ producing only a single highly volatile commodity such as copper.

It is also important to emphasize the difference between a diversified commodity-producing nation versus a

non-diversified one. Brazil, as an example, is the global leader in sugar production, a large and diversified net

exporter of metals and foodstuffs and a small net importer of energy products. It benefits overall from relative

commodity price movements, as energy has rallied only slightly in the past year against metals and agricultural

prices. Alternatively, Mexico benefits marginally from higher oil prices, but is a large net importer of higher-

priced agriculture-related commodities. Leaders that fail to diversify their economies could see investments

succeeding largely because their rising currency stunts growth in other sectors such as manufacturing and

tourism. The end result is that they are more susceptible to boom and bust cycles, high income inequality and

labor unrest.

Also, suggested policy responses other than preventing a currency appreciation—such as allowing these

exporters to hedge the currency risk or helping them by providing them with lower cost of capital or quasi-

export subsidies—are merely palliatives or band aids that don’t prevent a long-term decline triggered by

excessive appreciation: currency hedging cannot hedge against long-term currency movements and long-term

changes in relative prices; subsidies on the cost of capital are too small to make a difference; and quasi-export

subsidies are constrained by the fact that policy actions closer to export subsidies are severely restricted by

WTO rules.

But, what if such inflows and appreciation pressures are persistent and long term, rather than short term? Should

the reallocation of resources from declining sectors to booming sectors not be facilitated, rather than prevented

or resisted? Over a long time period, countries like Korea, Taiwan and Japan experienced tremendous

appreciation as they transitioned from being relatively poor states to economic powerhouses. While the case for

allowing sectoral reallocation is stronger if the flows and relative price movements are driven by fundamentals

rather than fickle bubbles, there are still important caveats. Crucially, in the short run, it is very hard to tell

whether such inflows are permanent and driven by fundamental factors, and thus the nominal and real

appreciation is fundamentally driven and not caused by over-valuation. Therefore, given that the risk of





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significant damage to the competitiveness of a country from short-term overvaluation (the risk of the loss of

important traded goods sectors and of an external deficit that might eventually cause a currency and financial

crisis) is serious if the inflows end up—ex-post—as excessive and driven by fads and bubbles, a prudent

approach to managing these inflows would be to try to resist excessive appreciation by intervening in the FX

markets and preventing excessive nominal and real appreciation.

Also, as the reallocation of resources across sectors is negative for growth in the short run—production and

employment in declining sectors falls faster than production and employment in emerging sectors can grow—it

may be sensible to slow this reallocation process, especially if there is uncertainty about how long-lasting and

fundamentally driven the nominal and real appreciation is. A faster nominal and real appreciation should be

allowed only if the inflows are more permanent, if the appreciation pressures are driven by fundamentals rather

than fads and bubbles and if the reallocation of labor and capital from less competitive and declining sectors to

more competitive and emerging/booming sectors can occur faster (i.e. if short-term reallocation costs and

frictions are smaller).

The role of China and the “China issue” in the competitive depreciation wars

The current debate on whether EMs should allow their currencies to appreciate or not given the massive inflows

of capital to these economies is complicated by the role that China is playing in preventing its undervalued

currency from appreciating at a fast enough pace.

Coordination problems: Many EMs recognize that their currencies are undervalued: they are running large

current account surpluses; their currencies fell sharply during their own financial and currency crises and they

have not been allowed to appreciate back to a stronger fundamental value since then; and many of these

currencies were further weakened during the global financial crisis of 2007-09 and have not appreciated back to

pre-crisis levels. However, many of these EMs are resisting excessively fast nominal appreciation of their

currencies—and many in Asia and Latin America have already allowed some significant nominal appreciation

to occur since the lows of 2009—because of the behavior of China. If China prevents its undervalued currency

from appreciating enough, other EMs in Asia and Latin America, and also in Africa (South Africa), would be

wary of letting their currencies appreciate significantly further as they would be worried about losing

competitiveness to China.

These concerns about Chinese currency policy are three-fold. First, other EMs worry about losing market share

relative to China in third markets (such as Europe, U.S., Japan and other advanced economies) if/when they

compete against China in exporting labor-intensive manufactured goods. Second, since China exports labor-

intensive manufactured goods to its own domestic markets, excessive real appreciation will damage the

competitiveness of import-competing manufactured goods sectors. Even a relatively closed economy (as a share

of GDP) like India worries about Chinese manufactured goods being dumped in India and hurting import-

competing sectors if the rupee is allowed—as it has been—to strengthen too much while the RMB is not; thus,

much more open economies than India in Asia and other EMs all over the world—all the way to South Africa—

do worry about the competitiveness of their import-competing sectors being damaged or destroyed by a flood of

cheap Chinese goods. Third, many EMs—especially Asian countries such as Korea, Taiwan, etc.—sell

intermediate inputs (such as inputs for consumer electronics) to China, which assembles them into final goods

for export to advanced economies. If the currency of one of these economies is allowed to appreciate too much

while another one doesn’t allow its currency to appreciate to the same degree—say, Korea compared with

Taiwan—then the former economy loses competitiveness relative to the latter in the Chinese market.





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For all of these reasons, Chinese currency policy is a major constraint on the willingness of other EMs to allow

their currencies to appreciate at a faster pace. China and many of these other EMs have large current account

surpluses and undervalued currencies. And in some of these EMs, the current account balance is already in a

deficit—namely Brazil, South Africa, India—given increasingly overvalued currencies and/or the strength of

domestic demand. But if China doesn’t move its currency value much relative to the U.S. dollar while another

EM does, the latter’s competitiveness would be weakened in absolute terms and relative to the trading and

export juggernaut that is China. Greater and faster currency appreciation in EMs would take place if China were

to allow its currency to appreciate at a faster rate. This is the reason why countries such as India, Brazil, South

Africa, Korea and others have started to complain vocally about Chinese currency policy; and countries such as

Malaysia, Thailand and others in Asia—which are wary of criticizing China in public given the power of this

large economy—are expressing similar concerns in private.

Global Imbalances: The undervalued currency issue is also relevant for China and for other economies with

large current account surpluses and undervalued currencies. China and these other EMs have followed a model

of a weak undervalued currency and export-led industrialization and growth. But this growth model relied on

the U.S. and a few other deficit countries being willing and able to be the consumers of first and last resort,

spending more than their income and running ever larger current account deficits so that China, emerging Asia,

a few other EMs (as well as Germany and Japan among the advanced economies) could be the producers of first

and last resort, spending less than their income and selling the surplus of domestic production over national

spending in the form of ever larger current account surpluses.

That traditional model of growth is now challenged if not broken as the over-spending deficit countries—which

are now over-leveraged—need to spend less, consume less, import less and reduce their current account deficits,

as indeed they are doing. Thus, while a nominal and real currency appreciation in China and other EMs leads—

over time—to a lowering of their current account surpluses, these economies can maintain their high growth

rates—despite shrinking external surpluses—by boosting domestic demand, especially consumption demand in

economies like China where consumption (as a share of GDP) is depressingly low and saving rates excessively

high.

In this context, allowing faster currency appreciation is beneficial for the process of switching demand away

from net exports toward domestic consumption as a weak and undervalued currency makes imported

consumption goods expensive, reduces the purchasing power of households’ incomes and leads to lower

consumption and higher savings. Thus, the switch in demand from net exports toward consumption can be

accelerated by a faster rate of currency appreciation. While that currency appreciation hurts export firms in

export markets and import competing firms, it also leads to higher domestic demand and consumption that can

then sustain similar levels of economic growth: trade sector firms will produce more for the domestic market

and less for foreign markets. Therefore, a more rapid currency appreciation can facilitate the necessary

reallocation of resources and demand from external demand to domestic demand.

Of course, if the Chinese currency were to be allowed to appreciate while maintaining loose monetary and

credit policies, the risk would be one of dangerous asset bubbles; but a necessary condition for being able to

tighten monetary and credit policies is a stronger currency value that would allow China to exit from the

Inconsistent Trinity trap.

2. Unsterilized FX intervention to prevent a nominal appreciation





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Suppose that excessive or excessively fast nominal appreciation of the currency driven by capital inflows is

considered to be undesirable and damaging, either because such inflows may be partly excessive and driven by

non-fundamental fads or bubbles that would damage the competitiveness of the traded goods sectors in the

event of the currency appreciating too much or because the Chinese resistance to faster appreciation forces other

EMs to go slower. Then, what is the second policy option if doing nothing and allowing the currency to

appreciate is not optimal? The country could resist the currency appreciation by intervening in the FX market,

and purchasing the foreign currency coming from the current account surplus and/or from the net capital

inflows. This FX intervention could be unsterilized or sterilized. Let us consider first the option of unsterilized

intervention.

Unsterilized intervention is FX intervention that allows the open market operation that leads to the central

bank’s purchase of foreign currency to increase base money, as it would automatically if a sterilization

operation is not added to the intervention to prevent the increase in base money. The benefit of unsterilized

intervention is that, by pushing domestic interest rates lower (as it is equivalent to an open market operation that

increases base money and reduces the economy’s policy rate), it causes domestic overheating: if the growth rate

of the economy was already too high, such unsterilized intervention would exacerbate that overheating and lead

to wage and price inflation. Also, since base money is allowed to grow and nominal and real interest rates stay

too low, there is also a risk of a credit bubble—as the money multiplier generates excessive credit growth when

there is excessive base money growth—and the risk of dangerous asset bubbles. So, unsterilized intervention

that prevents a nominal currency appreciation causes significant collateral damage to the economy.

Note also that an alternative to unsterilized intervention—effectively equivalent to such unsterilized

intervention—is a delay in monetary policy rate normalization that fast-growing EMs may decide to use if they

are worried about their currencies appreciating too much. The recovery of growth in most EMs is V-shaped,

rather than U-shaped in advanced economies. Thus, EMs should increase their policy rates—which were

reduced during the crisis when their economies slowed sharply or experienced outright recessions—at a faster

rate than slowly recovering advanced economies. But these EMs are now slowing the speed at which they are

increasing their policy rates and normalizing them given their faster growth, because they are worried that

excessively fast normalization will lead to carry trade-driven capital inflows (as policy rate differentials are

rising during this normalization) that will lead to excessive currency appreciation. So, it does not matter whether

these economies slow their rate of currency appreciation via unsterilized intervention or through delays in

policy rate normalization: in either case, base money is growing too fast and policy rates are too low for too

long, leading to overheating, excessive growth above potential, rising goods and services inflation, and

dangerous credit and asset bubbles.

Note also that unsterilized intervention can prevent a nominal appreciation of the currency, but cannot prevent

an eventual real appreciation. Indeed, if the fundamental real appreciation of an undervalued currency is

prevented via unsterilized intervention that slows or altogether prevents a nominal appreciation, the resulting

overheating of the economy will cause an increase in the inflation rate that will then lead to a real appreciation

through the inflation channel rather than through the nominal currency appreciation channel. And the rise in

inflation can increase expected inflation and become sticky, which can damage the central bank’s credibility.

So, if a fundamental real appreciation—which, ultimately, is the real driver, more than the nominal exchange

rate, of movements in the current account balance—cannot be prevented via unsterilized intervention, because

of the ensuing rise in inflation, it makes more sense to achieve such real appreciation through nominal

appreciation rather than via higher inflation. Indeed, the eventual result is the same in terms of the amount of





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real appreciation; however, in one case, that outcome is achieved with lower inflation (when the nominal

exchange rate is allowed to appreciate), while in the other case the same outcome is achieved with a higher and

more costly inflation rate.

3. Sterilized intervention to prevent a nominal and real appreciation

The third option is a sterilized FX intervention: the central bank intervenes in the FX market by purchasing the

foreign currency surplus deriving from a current account surplus and/or a capital account surplus driven by

large-scale capital inflows; but at the same time it sterilizes the effect of such FX intervention on the domestic

monetary base through a matching open market operation (repo operations or issuance of central bank bills) that

reduces the money supply back to the level prior to the FX intervention. Traditionally, FX intervention in most

economies is sterilized because, if it was not, it would amount to a domestic monetary policy rate target change

given that unsterilized intervention changes the money supply and leads to a change in short-term policy rates.

Thus, to prevent a change in the policy rate—whose target is usually determined by domestic considerations

about growth and inflation—FX intervention is traditionally sterilized via open market operations that raise

short-term interest rates or prevent them from falling. The potential benefit of sterilized intervention is that, not

only does it prevent the currency from appreciating in nominal terms, but it may also prevent the overheating of

the economy and the rise in inflation that unsterilized intervention would induce.

But there is a serious problem with sterilized intervention: it is ineffective in stopping the capital inflow and

leads to successive and persistent inflows of capital that force further and repeated intervention. The reason why

sterilized intervention does not work is the Inconsistent Trinity principle: unsterilized intervention stops the

capital inflows because it reduces the interest rate differentials that were causing the carry trade-driven inflows.

Sterilized intervention, instead, feeds the beast of capital inflows rather than starving it: by maintaining—via

sterilization—the interest rate differentials that were triggering the inflow in the first place. Sterilized

intervention induces further capital inflows and thus requires further intervention and further sterilization, which

becomes self defeating: the main drivers of the inflow—the interest rate differential and/or undervalued

currency—are not allowed to shrink when sterilization occurs. Thus, sterilized intervention feeds continued

capital inflows that can last for long periods of time and lead to an ever-rising accumulation of excessive

foreign currency reserves.

Sterilized intervention is usually also fiscally very expensive as the central bank earns a lower interest rate on

the foreign currency reserves that it purchases than it pays on the sterilization bonds (or domestic bonds) that

are issued in the sterilization process. These quasi-fiscal costs (equal to the interest rate differential between the

domestic economy and the foreign economy multiplied by the increase in FX reserves) can be very high for a

typical EM with large stocks of foreign reserves. Sterilized intervention also has other drawbacks: the central

bank could run out of the domestic bonds needed to do the sterilization and thus be forced to issue central bank

sterilization bonds to continue the sterilization. Also, full and perfect sterilization of FX intervention is—for a

number of technical reasons—hard to achieve; thus, partially sterilized intervention has similar qualitative

effects to unsterilized intervention (although of a smaller magnitude): it eventually leads to excessive base

money growth, too low interest rates, overheating, inflation and asset and credit bubbles.

Sterilized intervention can be closer to being full than partial if it is accompanied by capital controls on inflows

(a policy option we will discuss later); in that case, the capital inflow is reduced even if large interest rate

differentials are maintained. Thus, the perverse effects of continued inflows triggered by sterilized intervention

can be partially controlled. Sterilized intervention that is close to full can prevent, for a while, not only a





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nominal appreciation, but also a real appreciation of the currency. Indeed, if domestic overheating of the

economy is prevented via sterilized intervention, the increase in inflation that would follow an unsterilized

intervention is somewhat prevented or slowed down.

Of course, no country can prevent forever a real appreciation of its currency that is driven by fundamental

factors; if this real appreciation is delayed in nominal terms via intervention and in real terms via sterilized

intervention, it will eventually occur through a slower and more gradual rise in the inflation rate for traded

goods or via a rise in the relative price of non-traded goods. But, for a while, as the example of China shows,

partially sterilized FX intervention together with capital controls and other domestic credit controls (to be

discussed below) can slow such fundamental real appreciation.

However, preventing or delaying a necessary real appreciation via sterilized intervention has other serious and

damaging consequences when one considers the global general equilibrium of current account balances and

currency values. Specifically, over-spending countries—such as the U.S. and other adherents of the ―Anglo-

Saxon model‖—spent the past decade over-leveraging, running current account deficits and eventually

experiencing an economic and financial crisis that has now forced them to save more and spend less on

domestic demand to reduce their debts and leverage. To maintain growth at even an anemic rate—let alone a

robust one—these current account deficit countries and highly indebted economies now need a nominal and real

depreciation of their currency to reduce their trade deficits and grow more via net export growth. Meanwhile,

over-saving countries—China, other EMs and the export powers Japan and Germany, all of which ran current

account surpluses during the same period—are now resisting nominal appreciation of their currencies that

would reduce their current account surpluses. And many of them are resisting a real appreciation via sterilized

intervention. They feel they are unable or are unwilling to reduce their savings and increase their domestic

consumption demand to sustain their growth via greater domestic rather than foreign demand.

But if China, emerging markets and other surplus countries prevent their nominal currency appreciation via

intervention and successfully prevent even a real appreciation via sterilization of this intervention (that prevents

a rise in domestic inflation), the only way deficit countries can achieve a real depreciation is via persistent

deflation that leads to a double-dip recession, debt deflation of private and public debts and even larger and

unsustainable fiscal deficits and debt. This third mechanism for achieving exchange rate equilibrium is thus far

more dangerous and damaging than EM currencies appreciating through nominal currency moves or inflation.

This depressionary and deflationary bias is exacerbated for the PIIGS (Portugal, Ireland, Italy, Greece and

Spain), which badly need a nominal and real depreciation of the euro. Instead, the monetary policy of the ECB

and the tight fiscal policy of Germany strengthens the euro and encourages more recessionary deflation in the

PIIGS, which are already slumping. This deflationary dilemma is even worse for stagnating Japan, which faces

more deflation and thus needs a weaker yen, yet runs a large current account surplus that tends to lead to a

stronger yen.

At the end, if nominal and real depreciation (appreciation) of the deficit (surplus) countries doesn't occur, the

falling domestic demand of deficit countries and the failure to reduce savings and increase consumption in the

surplus countries will lead to a global lack of aggregate demand at the time of a glut of capacity.

Indeed, a serious asymmetry exists in the adjustment process for global imbalances in the international

monetary system: current account deficit countries eventually must adjust as they run out of FX reserves and/or

bond vigilantes impose market discipline (a partial exception being the U.S., which has so far benefitted from





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its "exorbitant privilege."). But surplus countries feel little pressure to adjust, reduce their current account

surpluses or stop intervening to prevent their currencies from appreciating. So, the international monetary

system has a serious asymmetry flaw: this situation leads to a lack of global aggregate demand when

imbalances fester for too long. Since deficit countries spend less and save more when they are forced to adjust,

while surplus countries cannot be forced to reduce their savings and pump up consumption, more global

aggregate demand can be lacking following the burst of bubbles that forced debtor countries to deleverage. This

was a problem in the 1930s, which the IMF’s founding document, the 1945 Articles of Agreement, failed to

resolve. To this day, the IMF has no leverage on the surplus countries and/or on the large deficit countries (the

U.S.) that don't need its financial support.

Therefore, following the bursting of their asset bubbles (especially in housing), which has forced deficit

countries to de-leverage, a depressionary and deflationary bias could develop in the global economy. The real

depreciation of the deficit countries may occur via deflation rather than nominal depreciation if surplus

countries successfully resist a nominal and real appreciation: this eventually causes more global deflation and

private and public debt defaults (or coercive debt restructurings) in debtor countries that end up suffering from

debt deflation; these debt defaults and/or restructurings ultimately hurt the growth and wealth of saving and

creditor countries.

4. Controls on inflows of foreign capital (capital controls)

The Inconsistent Trinity principle implies that, in the absence of capital controls, allowing a currency to

appreciate excessively may be damaging to the real economy; but at the same time preventing a currency from

appreciating is also problematic as the monetary authority loses control of monetary and credit policy and

causes dangerous overheating, as well as assets and goods inflation. So, how to maintain some degree of

monetary and credit policy independence while either pegging the currency value or heavily managing its value

to prevent excessive appreciation? The Inconsistent Trinity principle suggests that the only way to achieve some

monetary autonomy while at the same time heavily managing the exchange rate is by breaking the third pillar of

the trinity: perfect capital mobility needs to be restricted via capital controls (on inflows if the country is

experiencing excessive capital inflows that would otherwise lead to excessive currency appreciation). Indeed,

capital controls on inflows allow an economy to maintain domestic interest rates at a higher level and one more

appropriate to prevent domestic growth overheating and excessive inflation, while at the same time slowing

down the amount of capital inflows driven by carry trade interest rate differentials, thus allowing an economy to

slow the appreciation pressures that derive from such excessive inflows. Hence, a country can manage its

currency value and prevent excessive appreciation while at the same time maintaining monetary autonomy and

choosing domestic policy rates consistent with its growth and inflation goals.

Indeed, historically, economies that have experienced episodes of sudden and excessive capital inflows have

resorted to capital controls on inflows, starting with Chile, Brazil and Colombia in the 1990s. And, in the most

recent current episode of capital inflows to EMs, capital controls on inflows—that had fallen out of fashion in

the previous few years—came back into vogue: Brazil, Thailand and many other EMs have introduced (or

reintroduced) them, while other economies in Asia and Latin America are seriously considering introducing

them. Of course, capital controls on inflows have existed for a long time in China, which tightly controls—or

tries to control—both capital inflows and capital outflows.

So, are capital controls a partial or full solution to the problem of excessive capital inflows? The answer is that

they are at best a very partial solution. First, note that capital controls can take many forms: they can restrict





11

only short-term capital inflows, such as when a country is worried about short-term hot money inflows; they can

restrict overall inflows to fixed-income instruments, but not restrict FDI or portfolio inflows to equity markets;

they can discriminate between domestic and foreign currency borrowing by domestic agents (banks, other

financial institutions and corporate firms); or they can impose restrictions on all capital inflows regardless of

their maturity, currency composition or debt-versus-equity nature. Traditionally, EMs have imposed controls on

short-term hot money inflows under the assumption that such inflows—being short term, volatile and fickle—

are more risky than long-term flows. Also, at times, restrictions are greater on fixed-income investments, as

equity investments (whether FDI or portfolio inflows into the equity market) are considered to be more

beneficial to the country.

Some of the problems with capital controls relate to their enforcement and the incentives to avoid them, given

the differential between domestic and foreign rates that such controls induce (with that wedge being the purpose

of the controls in the first place): derivative instruments and the creative invoicing of exports and imports can

lead to leaks in these capital controls. Also, defining what is short term and long term can lead to capital control

avoidance: in the 1990s Chile restricted short-term hot money inflows (investment with a horizon of less than

one year) via an un-remunerated forced deposit of a fraction of such inflows, only to discover that some

unrestricted and untaxed ―FDI‖ took the form of foreign firms creating firms in Chile—technically FDI—whose

only purpose and investments were short-term fixed-income instruments; thus, forcing Chile to further tighten

its capital controls to prevent such avoidance of inflow controls.

The experience with capital controls on short-term hot money inflows—based on the Chilean situation—is that

such inflows affect the composition of the capital inflows between short-term and longer-term flows (reducing

the share of inflows that are short term), but they do not reduce the overall size of such inflows. This result is

important because, if the objective of the policy makers is to reduce ―risky‖, ―volatile‖ short-term hot money

flows, one could argue that such controls on short-term flows have been effective. But, if the total amount of

inflows is not affected by controls on short-term money (only its composition is affected), then controls have

not been able to reduce the appreciation pressures on the domestic currency that policy makers were worrying

would lead to excessive nominal and real appreciation.

Preventing short-term hot money could be of little or no comfort if what a country is worrying about is not just

short-term hot money, but rather an excessive appreciation of its currency that leads to a Dutch Disease loss of

competitiveness. So, if this last round of controls on capital inflows—which has mostly taken the form of

controls on short-term inflows—is driven by the desire to slow down excessive currency appreciation rather

than only preventing hot money, it is likely that such controls will not do the job. This is especially the case if

the latest round of capital inflows is not just cyclical and driven by carry trades based on short-term interest rate

differentials, but rather is driven by a more structural and secular increase in international investors’ demand for

EM assets. This secular and long-term shift of capital to EMs will not be stalled by controls on short-term flows

as these flows are mostly long term and permanent (as international investors reduce the home bias in their asset

portfolios and permanently move assets to EMs).

Controls on all capital inflows—regardless of their maturity—could be more effective in reducing the overall

flow of capital to EMs and thus reduce the appreciation pressures on a currency. However, the recent batch of

capital controls concentrates on controls on hot money, not overall inflows, in part because policy makers don’t

want to discourage FDI and portfolio inflows into equity markets. One could concentrate capital controls on

fixed-income instruments and exclude equity investments (whether FDI or portfolio ones), but equity

investments can be as fickle, volatile and hot money in their nature as fixed-income investments.





12

Thus, probably the most effective capital controls on inflows that would reduce overall appreciation pressures

on a currency would be those that exclude only FDI and that apply both to short- and long-term flows of capital.

But the current batch of controls on inflows—leaving aside the fact that the implicit or explicit tax on inflows

that is imposed is often still too low to prevent most inflows of any type or maturity—is not of this form: it is

either on short-term flows only or on short-term fixed-income investments or on overall fixed-income

investments. Thus, this type of inflow control does little to prevent significant appreciation pressures on these

EM currencies.

In conclusion, properly designed and comprehensive capital controls on inflows of capital—regardless of their

maturity—can slow down currency appreciation pressures. And the use of capital controls will become more

popular and widespread as EMs increasingly need to manage inflows that are considered to be excessive. But

the current batch of inflow controls in EMs doesn’t fit such criteria, and so is unlikely to prevent structural,

secular inflows of capital that are leading to longer-term appreciation pressures in many EMs.

Controls on capital inflows used to be a ―dirty word‖ in the world of the ―Washington Consensus,‖ even if a

less dirty word than capital controls on outflows. But, given the difficulties in properly managing excessive

capital inflows to EMs, such controls have become more popular in recent years among policy makers in EMs.

Indeed, there is greater sympathy for controls on inflows of capital than for controls on outflows of capital even

if recent IMF research on capital account liberalization suggests that the correlation between capital account

liberalization—on inflows and/or outflows—and economic growth is extremely weak or non-existent. Thus, the

case for aggressive and front-loaded capital account liberalization in EMs is quite weak, especially when the

supervision and regulation of domestic financial institutions is weak and thus the liberalization of capital

controls risks leading to excessive and risky inflows that eventually cause a currency and financial crisis (with

the East Asian financial crisis of 1997-98 being the poster child of the tragic risks of botched capital account

liberalization).

One should also note that there is a degree of effective equivalence between controls on capital inflows and

measures that go under the rubric of macro-prudential regulation and supervision of the banking and financial

system. Thus, sound supervision of the financial system—that is consistent with the Washington Consensus

view—and capital controls have some significant effective overlap; hence, the more accepting attitude that even

the IMF has recently taken toward these tools to control inflows of capital.

Still, another formal constraint on the imposition of controls on inflows derives from bilateral investment

treaties (or BITs) that the U.S. has already signed with a number of EMs, including Chile. Driven by a

misguided and ideological bias against any capital controls—regardless of whether they were controls on

outflows or more harmless and possibly beneficial controls on inflows—the U.S. aggressively pushed clauses

into these BITs that severely restrict the ability of EMs to impose even prudential controls on excessive capital

inflows; the U.S. effectively threatened these economies with losing the benefits of having a BIT with the U.S.

if restrictions to even potentially beneficial inflow controls were requested by an EM. For example, the U.S.

BIT with Chile allows that country to impose such controls on inflows only as an emergency and for a

maximum period of two years.

This bilateral approach to capital account liberalization—like other misguided bilateral and regional trade

agreements that at times cause more trade diversion than trade creation—is damaging since rules about capital

mobility and controls should be agreed at the multilateral level rather than being shoved (under undue pressure)

down the throat of EMs at the bilateral level.





13

A final observation: one way to reduce upward currency pressures is to liberalize controls on capital outflows

rather than introducing controls on inflows. This is, for example, the route that South Africa has taken to

contain appreciation pressures. Indeed, inducing domestic residents—households, financial institutions,

corporate firms—to accumulate foreign assets is a way to compensate for upward pressures on the currency

coming from capital inflows. Reductions in capital outflow restrictions can take many forms including all sorts

of restrictions on private agents holding foreign assets. One particular form of this—which is relevant for

countries such as China—is the requirement that exporters repatriate the foreign currency receipts of their

exports; phasing out such a restriction could lead exporters to keep more of those export receipts abroad in the

form of foreign assets, a type of capital outflow. While reducing controls on outflows is a good idea, it is

unlikely that phasing out such restrictions would—in the short run—lead to significant capital outflows: the

inflows are driven by relative interest and growth differentials, expectations of currency appreciation and

expectations of higher returns on domestic equities and fixed-income assets. Thus, domestic investors may be

slow to diversify their assets abroad in an environment in which the expected returns on domestic assets are—

for the time being—higher than those on foreign assets.

5. Fiscal tightening and public asset and liabilities management

It has been suggested that one of the ways in which an EM can reduce capital inflows and the resulting

appreciation pressures on its currency is to tighten its fiscal balance, i.e. reduce its budget deficit or increase its

budget surplus. The logic of the argument is as follows: first, fiscal deficits lead to currency appreciation in two

ways—they tend to increase domestic interest rates and attract capital flows triggered by interest rate

differentials; second, fiscal deficits—especially those driven by government spending—tend to increase the

relative price of non-traded goods and services (as most government spending falls on non-traded goods and

services) and the ensuing increase in the relative price of non-traded to traded goods is one of the ways in which

real currency appreciation takes place. Thus, tighter fiscal policy leads to nominal and real depreciation—or

reduces appreciation pressures—as it leads to lower interest rates and to a fall in the relative price of non-traded

goods.

The argument for using fiscal policy to prevent excessive capital inflows and appreciation pressures is only

partially valid. First, given the political economy of fiscal policy, actively using fiscal policy to prevent capital

inflows may be hard: telling a parliament that fiscal discipline is necessary to induce lower inflows is a wonky

argument that may not have traction in actual political systems even if the argument may have conceptual

validity. Second, for many reasons, it is not obvious that fiscal discipline leads to less capital inflows and less

appreciation pressures. It can actually lead to more appreciation pressures. Indeed, lower fiscal deficits are

associated with smaller current account deficits or larger current account surpluses; thus a lower fiscal deficit

may strengthen the currency as it leads to a better external balance. Also, the arguments that a larger fiscal

deficit leads to a stronger currency may not be valid for most EMs: a larger deficit can weaken the currency as it

may lead to expectations of the monetization of such a deficit or an increase in the country’s sovereign risk.

Conversely, more fiscal austerity is more likely to strengthen a currency as it leads to lower risk of monetization

and/or to lower sovereign risk and sovereign spreads, a reduction that induces more inflows to fixed-income

instruments with lower credit risk.

So the outcome of a larger degree of fiscal discipline can be a stronger currency value rather than the reverse,

thus defeating the goal of using fiscal policy to prevent excessive inflows and excessive appreciation.





14

Another way in which fiscal policy affects the value of a country’s currency is via its management of public

sector assets and liabilities. In some EMs, such as Chile, that have accumulated large long-term stocks of of

foreign currency assets—during ―good times‖ of budget surpluses or small deficits—as buffers of savings to be

used in ―bad times‖ (recessions), a fraction of these foreign currency assets are used every year to finance the

government budget: i.e., for any given fiscal balance, the government decides to run down some of these large

assets rather than increase its public debt liabilities—to finance part of its spending. This is a rational and

sensible—if cautious—use of large stocks of foreign assets accumulated over time. But using even a few billion

dollars of foreign assets to finance one’s public spending has the collateral effect of causing currency

appreciation: when the government sells these foreign currency assets to convert them into domestic currency to

use them to pay for domestic currency expenses, it causes a currency appreciation that can be damaging to

competitiveness.

In principle, the central bank could intervene when the government sells foreign assets and prevent such

appreciation through FX intervention that, if sterilized, doesn’t cause any inflationary increase in base money.

But central banks—such as the one in Chile—have been wary and have resisted pressures from national

treasuries to purchase such foreign currency assets when treasuries convert them into domestic currency and

thus cause appreciation pressures. While this sterilized intervention would not cause monetary easing, central

banks have correctly observed that this form of intervention swaps foreign currency assets in the hands of the

public sector for a transfer of such assets to the central bank and a matching increase in the private sector

holdings of domestic public debt (as a result of the sterilization). But the same result could be achieved if the

treasury were not to run down its foreign currency assets, but rather finance itself for its marginal spending

needs by issuing more domestic currency public debt. Thus, the lessons for governments—that are sitting on a

pile of foreign currency assets and are worried about the appreciation pressures that selling such assets on the

open market could induce—are that they would be well advised to finance their marginal spending needs not

via a reduction of such foreign currency assets, but rather by issuing more domestic currency debt.

The two alternative financing options have the same effect on the net worth of the government sector—one

reducing its assets and the other increasing its liabilities—but the latter option has the advantage of causing less

appreciation pressures on the currency. Thus, sound asset and liabilities management can reduce appreciation

pressures for a government concerned that its financing policies might lead to excessive currency appreciation.

Still, unless a government never runs down its stock of foreign assets—something that may not be feasible or

optimal—this strategy only delays the eventual appreciation that the currency would experience when such

assets are eventually run down.

6. Macro-prudential regulation/supervision of banks and financial institutions

FX intervention that prevents or slows down currency appreciation risks causing domestic overheating, rising

inflation, credit and asset bubbles. This is certainly the case when the intervention is not sterilized, but also

when it is sterilized as sterilization is never full and perfect; in most cases—including the experience of China,

which has somewhat binding capital controls that should reduce capital inflow pressures—FX intervention is

only partially sterilized, thus leading to excessive monetary and credit growth. Hence, any economy that

intervenes in FX markets to prevent or slow down currency appreciation should be worried about the risk of

asset and credit bubbles and rising inflation.

Therefore, one of the additional policy options available to EMs trying to manage capital inflows is to use

prudential regulation and supervision of their financial system to try to control and prevent credit and asset





15

bubbles. Indeed, in the past year, EMs that have experienced froth in their housing markets (for example, China,

Hong Kong, Singapore and others), in part because of large-scale capital inflows, have used direct credit

controls and other supervision tools to avoid credit and asset bubbles.

These policy tools can include direct credit controls in markets where excesses are occurring (such as

commercial and residential real estate where, for example, underwriting standards can be tightened and

suggested loan-to-value ratios reduced); the use of reserve requirements for banks to reduce the money and

credit multiplier and ensure that any growth in base money leads to smaller growth in credit growth; and

reducing currency mismatches in banks assets by imposing limits on the net foreign currency exposure of the

banking system.

As previously pointed out, some of these policy actions that go under the rubric of macro-prudential supervision

of the financial system are effectively equivalent to capital controls on inflows of capital. The difference

between controls on short-term foreign currency lending by foreigners to domestic agents (especially financial

institutions)—a form of capital control—and prudential limits on currency mismatches of the financial

system—a form of prudential supervision of banks—is effectively only semantic. Thus, there is a strong

analogy between some forms of capital controls on inflows and other actions that are usually defined as macro-

financial prudential supervision of the financial system.

However, one should note that, for this prudential supervision to be effective at preventing credit and asset

bubbles, such supervision cannot be limited to banks and other supervised financial institutions. If the foreign-

based capital inflows go directly into financial markets—stock markets and fixed-income instruments—rather

than being intermediated directly through the banking system, asset bubbles can occur even if banks and other

financial institutions are properly supervised. The direct foreign currency borrowings of the corporate sector

should also be considered and supervised in the proper assessment of systemic risks in the economy. The

activities and foreign transactions of unregulated and unsupervised—or poorly regulated and supervised—

financial institutions (such as a variety of shadow banking financial institutions) should also be properly

supervised as excessive capital inflows may directly go to these weakly regulated and supervised institutions.

The overall prudential supervision of financial institutions and of the other agents in the private sector

(corporate firms and households’ balance sheets) is usually always beneficial to prevent the build-up of balance-

sheet vulnerabilities that lead to excessive risk taking, debt and leverage and that can eventually trigger

systemic risk events. But such a holistic approach to systemic risk is particularly important when large-scale

capital inflows enter a small and open EM and risk leading not just to excessive currency appreciation, but also

the further build up of balance-sheet risks, mismatches and vulnerabilities.

7. Massive large-scale long-term sterilized FX intervention

We have previously discussed why sterilized intervention to prevent a currency’s appreciation may not be

effective in stopping capital inflows: if domestic and foreign assets are perfectly substitutable and there are no

capital controls, such inflows will be driven by interest rate differentials for any given expectation of currency

appreciation. Thus, as long as the intervention is sterilized and the interest rate differential driving the inflows

maintained, the inflows will keep on coming and the appreciation pressures will remain, thus defeating the

intervention attempts.

The traditional argument that sterilized intervention is ineffective in stopping capital inflows and appreciation

pressures is predicated on two important assumptions: domestic and foreign assets are perfectly substitutable;





16

the investors’ demands for domestic and foreign assets are given and stable over time. Both assumptions are not

fully correct in the case of EMs.

Regarding the assumption of perfect asset substitutability, it is obviously incorrect as assets in EMs are

imperfectly substitutable with those of advanced economies. This is certainly the case for equities and corporate

bonds, but is also true for foreign currency and especially local currency government bonds, as the credit risk,

liquidity, volatility and market risks for these EM instruments are quite different to those of similar instruments

for advanced economies. Thus, sterilized intervention that changes the relative supply in international investors’

assets portfolios between domestic assets and EM assets may eventually be successful in stopping capital

inflows as changes in the relative market supply of domestic and foreign (EM) assets change credit and liquidity

risks so as to satisfy the demand for domestic and EM assets at either unchanged exchange rates or more

modestly changed exchange rates. Hence, aggressive sterilized intervention can eventually slow and/or stop

capital inflows by satisfying the demand for domestic and foreign assets for any given interest rate differential

and currency value.

The second assumption, that the demand for domestic and foreign (EM) assets by international investors

(especially those in advanced economies) is stable and given over time, is also obviously incorrect. If more

investors in advanced economies have now discovered EMs, have reduced their home bias and have decided to

increase their long-term secular portfolio allocation share to EMs—for any given level of interest rate

differential—this represent a permanent shift in these investors’ demand—for any given expected relative

returns—from domestic assets toward EM assets. In this case, large-scale massive sterilized intervention does

the job of satisfying this extra demand for the assets of EMs by increasing the supply of these assets to satisfy

the additional stock demand. Thus, once this increased stock demand has been satisfied via an increase in the

supply, the inflows will slow or stop at relatively unchanged exchange rates, even if the interest rate

differentials that sterilized intervention imply persist over time.

Think of it this way: international investors want to reduce the share in their portfolios of domestic advanced

economies assets and increase their share of EM assets. Then, central banks in EMs that intervene in the FX

markets to prevent their currency from appreciating—or equivalently sovereign wealth funds (SWFs) that are

diversifying into the assets of advanced economies—acquire the advanced economies assets that are being sold

by international investors and provide to such investors—via the sterilization operation—the interest rate-

bearing assets that international investors desire. Once this swap of assets has occurred and international

investors have successfully diversified their portfolios from advanced economies to EM assets, the drive for

further inflows is diminished and the appreciation pressures vanish, even if the interest rate differentials

between advanced economies and EMs remain. There is a significant difference between these types of flows

and hot money speculative flows and cross-border bank lending used to finance credit booms and consumption;

but these are not always so easy to disentangle without the benefit of hindsight.

Thus, large-scale sterilized FX intervention—of the order of several percentage points of GDP and continued

for a number of years—can be effective in preventing excessive currency appreciation in EMs while, at the

same time, satisfying the desire of international investors to permanently increase the share of their portfolio of

assets invested in EM assets. If this argument is correct, intervention needs to be sterilized, but on a massive

scale; not a few billion dollars here or there, but rather a large and persistent and long-term increase in the FX

reserves of EMs experiencing a large persistent and secular flow of capital to their economies. So,

paradoxically, the optimal response of EMs to large-scale secular inflows of capital to their economies may be

massive sterilized intervention.





17

There are a few objections to this argument for the desirability of massive sterilized intervention as a solution to

the capital inflow problem. First, the assets that international investors are seeking in EMs are a combination of

short- and long-term government bonds, corporate bonds, equity portfolio investments and real assets (FDI in

the corporate sector and in the natural resources and real estate of EMs). Instead, the central bank sterilized

intervention provides these investors only with short- and long-term government bonds, not the other fixed-

income assets, equity and FDI-related real assets. Thus, the capital inflow will—through a substitution effect

away from the government fixed-income assets toward other debt and equity instruments—increase the price of

(and reduce the yield on) corporate bonds and equities.

This increase in the asset prices of risky private assets in EMs—as well some reduction in the government

short- and long-term debt’s credit and liquidity spreads if the foreign demand for such assets partly exceeds the

supply provided by the central bank intervention—is one of the side effects of the capital inflow: currency

movements in EMs are somewhat dampened through the intervention, but the capital inflow leads to an increase

in the prices of private and public fixed-income instruments and in the price of equities.

The additional foreign investors’ demand for equities and real assets (FDI) in EM can then be further satisfied

via government privatization of state-owned enterprises and assets and/or private firms’ issuance of more equity

and/or M&A and private equity transactions by foreign investors acquiring EM firms and/or the creation of the

real capital assets (greenfield investments) that the FDI triggers. So, demand for EM private equity and fixed-

income instruments by foreign investors is satisfied in a number of ways once the sterilized intervention does

occur.

What about the argument that sterilized intervention leaves the central bank of an EM with a large stock of

relatively low-return assets—usually short-term and longer-term government bonds—of the advanced

economies, while allowing foreign investors to acquire higher-return private and public debt and equity

instruments in these EMs? Even this potentially negative side effect of the sterilized FX intervention can be

avoided.

Indeed, in most EMs that have accumulated foreign reserves well in excess of what is needed to deal with

liquidity/rollover risk, the excess reserves of central banks have been transferred to SWFs that have the task of

investing such liquid low-return reserves into longer-term and higher-return fixed-income and equity

instruments in the rest of the world, including advanced economies and other EMs. These investments of SWFs

run the gamut of equity investments (passive portfolio investment, controlling equity stakes, FDI, private

equity), commodities and resource investments, and fixed-income instruments (public and private corporate

bonds and other fixed-income and structured finance investments).

Investors in advanced economies invest and diversify more into EM assets, while investors in EMs also reduce

their home bias and invest in a wide range of foreign assets, including those of advanced economies and other

EMs. At the end of the process, home bias is reduced both in advanced economies and EMs. And, as long as

part of the reserves of central banks are managed and invested by these countries’ SWFs, the upward pressures

on the currency values of these EMs are eventually somewhat reduced.

In EMs where capital controls on outflows are still persistent—such as China—the international diversification

of private sector portfolios is restricted by such controls. Thus, the actions of central banks and of SWFs are a

substitute for the limited and restricted diversification of private households, firms and financial institutions. Of

course, over time, it is preferable for such private sector agents to directly accumulate foreign assets and reduce

their portfolio home bias, once controls on capital outflows are liberalized; but as long as such controls on





18

outflows still persist—as they do in China and some other EMs—the foreign asset accumulation by central

banks and SWFs becomes a substitute for the private sector’s foreign asset accumulation and diversification.

And even in EMs where capital controls on outflows are more limited, capital inflows dominate capital

outflows as the higher expected growth rates of EMs and the higher expected return on their financial assets

lead investors to prefer their local assets to those of the now sluggishly growing advanced economies. So, this

asymmetry in the degree of international portfolio diversification leads to persistent upward pressures on EM

currencies.

One should also note that China’s approximately US$1 billion per day reserve purchases, foreign currency

buying and physical commodities purchases (in addition to the more visible Treasurys) also include taking

direct or indirect ownership of foreign resource producers, allowing China to secure supplies and control more

of the supply chain. While this is a decade-long trend, it has come in a variety of forms, including making loans

in anticipation of opening markets (oil in Ghana), direct investments (iron ore in Mongolia), new technology

plays (shale gas in the U.S.) and outright bidding wars (fertilizers in Canada). Most EMs do not wield such

strategic power, based on size, weaker balance sheets, higher debt and restricted access to the capital markets;

but some of them do.

Another consideration to keep in mind is that, to avoid severe Dutch Disease and the crowding out of non-

traditional exports, some countries have set up a fiscal regime—i.e. a stabilization fund—that invests the

proceeds of traditional exports into foreign assets; this system avoids the adverse effects of excessive nominal

currency appreciation. This is what, for example, Chile has done with its copper fiscal surpluses, thus reducing

the pro-cyclical trends in its economy. This is also what oil and energy exporters in the Middle East are doing:

they maintain pegs to the U.S. dollar and they invest their foreign reserves and/or equivalently most of their

assets in SWFs and/or equivalently their fiscal surplus stabilization funds into foreign assets.

Moreover, in some economies, the growth rate and the returns in the stock markets are too concentrated in a few

sectors, for example copper in the case of Chile. The best policy may be to sell some of those copper mines to

non-residents as a way of achieving greater international risk sharing and reducing the volatility of GNP in the

face of the higher volatility of GDP. But if, for political reasons, this best policy choice is not easily

implementable, a second-best option for not putting all of your eggs into one basket (or into one mine) would be

a reduction of home bias by investing the fiscal surpluses of such copper mines into a diversified basket of

foreign assets.

In some sense, large-scale sterilized intervention by central banks, the accumulation of foreign assets by SWFs,

the creation of fiscal stabilization funds investing in foreign assets and inducing state-owned enterprises and

EM multinational corporations to invest in foreign assets are all variants of the same policy: the accumulation

by domestic agents—mostly public and at times private—of foreign assets that reduces upward pressure on the

domestic currency.

It should be noted that the arguments in this section for massive sterilized intervention as a way to manage

capital inflows to EMs and avoid excessive currency appreciation don’t imply that little or no appreciation

should occur over time: if currencies are massively undervalued—based on current account imbalances and

other long-term factors—such as differentials in relative productivity growth—that require a nominal and real

appreciation, eventually such movements in relative prices should not be prevented, but rather allowed to occur.





19

The argument for large-scale sterilized intervention is a different one: it is that the timing of the reduction in

home bias between advanced economy investors and EM investors is different. Specifically, advanced

economies investors are reducing their home bias and diversifying into EM assets faster than private investors

in EM are diversifying into advanced economies assets or into other EMs assets. This is due to the facts that:

capital controls on outflows are still pervasive in many EMs; and international portfolio diversification and

reduced home bias can take longer in lower per capita income EMs. Thus, the upward movements in nominal

and real exchange rates of EMs that this differential in the speed of home bias reduction implies may not be

optimal and may have to be smoothed out by central banks and SWFs. Eventually, reductions in capital controls

on outflows in EMs and other changes that reduce the home bias of EM private investors will lead to sustained

capital outflows that would tend to reduce the excessive appreciation pressures that EM currencies currently

face.

Of course, this strategy of large-scale sterilized intervention has its own risks. If there was a shock to the

system, say, originating in the EM universe, how would these cross-holdings unravel? If foreign investors were

to flee EMs, would EM central banks have to sell their higher-yielding and possibly less-liquid investments in

advanced economies? Would this not increase volatility in risk markets at such times? Also, does it make sense

to reduce the sterilization cost of central banks by investing more in higher-yielding, but more risky foreign

assets? And is this a role that SWFs should play? Should central banks and SWFs do the foreign asset

accumulation that the private sector would do in the absence of controls on outflows? These are legitimate

questions; but in a process where the degree of home bias is reduced over time both for advanced economies

investors and for the private and public sector investors of EMs, less home bias and greater international

portfolio diversification is actually highly beneficial.

It is true that when SWFs are used to offset the sterilization costs of central banks or to reduce the home bias of

private investors, since the inflows being sterilized are someone else's wealth (the private sector that had a

positive saving-investment balance and should have accumulated those foreign assets), the capital inflows are a

potentially short-term liability of the central bank. Thus, if in effect invested abroad in higher-return

instruments, such a surplus would presumably be less liquid and riskier. In this case, the hurdle rate of return

will be local versus global rate/yield differentials plus expected FX moves.

Clearly, if capital flows were to reverse themselves at an inopportune moment (as during the periods of global

risk aversion that regularly happen), then there would be a problem for the SWF, which would have to be

refilled from the central bank or the treasury. But since SWFs, central banks and treasuries are all different arms

of the public sector this would only be an inter-public sector wealth transfer. In effect, the public sector does the

international diversification that the private sector would do in a world where the latter is allowed to diversify

internationally. When the private sector is unwilling or unable to diversify internationally, there is a role for the

public sector to provide, for a while, such diversification services.

SUMMARY OF THE POLICY IMPLICATIONS: DIFFICULT POLICY TRADEOFF

The recent episode of capital inflows to EMs is both old and new. Old because cycles of capital inflows into

EMs followed by ―sudden stops‖ and capital outflows out of EMs have occurred repeatedly in the past few

decades as cyclical factors (the relatively cyclical stance of EMs compared with that of advanced economies

driving interest rate and growth differentials; and changes in global investors’ risk aversion, driven in part by

downside or upside risks to advanced economies’ economic and financial outlooks) sometimes lead to capital

inflows and sometimes to bouts of capital outflows.





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But it is also new as the structural reforms in most EMs after their own economic and financial crises have

made them more resilient and less at risk of major financial crisis. Also, given their higher potential growth

rates and lower levels of debt and leverage in the private and public sectors, most EMs will grow much faster

than advanced economies for a long period of time with the share of global GDP and its growth rate accounted

for by EMs rising further in the next two decades. This secular shift in relative output, trade and financial power

is leading investors in advanced economies to reduce their home bias and invest—on a secular long-term

basis—a larger fraction of their assets in EM.

Thus, the most recent episode of capital inflows to EMs is not just cyclical, but also secular, even if renewed

bouts of risk aversion and cyclical factors will—from time to time—lead capital to again flow out of EMs,

exerting downward pressure on their currencies and asset prices. But given that secular factors may dominate

the cyclical ones—as long as EMs maintain market-oriented and openness policies that maintain high growth—

these inflows of capital to EMs are not just transitory; they are rather persistent, long-term and permanent,

despite possible short-term volatility.

Thus, EMs need to manage these inflows properly. As discussed above, the option of doing nothing and allow

any currency appreciation that the market and capital inflows determine is not optimal for a number of good

reasons, including non-fundamental factors at times driving these flows. And, even if these flows are more

stable and permanent, excessively rapid nominal and real appreciation could be damaging for many EMs,

especially if China takes a much slower path regarding the appreciation of its undervalued currency. Thus, the

difficult options that EMs face are to somewhat limit the pace of such currency appreciation via sterilized

and/or unsterilized intervention, capital controls on inflows, fiscal policy discipline and proper public sector

asset and debt management, and prudential regulation and supervision of financial markets to prevent the credit

and asset bubbles that often follow these capital inflow episodes.

But this paper has also argued that the reduced home bias of advanced economy investors and their greater

demand for EM assets is also secular and occurring at a faster speed than the reduction in private sector agents’

home bias in EMs, in part because capital controls on outflows are still prevalent in EMs and in part because

such international portfolio diversification occurs at a more advanced stage in the development of economic and

financial markets. Thus, EMs facing massive capital inflows and differential in the rate of the reduction of home

bias may find it optimal to engage in large-scale persistent sterilized FX intervention to prevent excessive short-

term currency appreciation, to satisfy foreign investors’ demand for EM assets and to reduce the home bias of

the private sector via public sector accumulation of foreign assets on the part of central banks and SWFs.

IMPLICATIONS FOR ASSET PRICES IN EMERGING MARKET ECONOMIES

If the analysis in this paper correctly suggests that EM policy makers will increasingly resist the currency

appreciation pressures that their currencies will face, what are the implications for asset prices in EMs? Here are

10 implications of the analysis.

First, if currencies are allowed to appreciate less via unsterilized and/or sterilized intervention, more of the

capital inflow will manifest itself in the form of an increase in the prices of equity and fixed-income instruments

in these economies and less in the form of a currency appreciation.

Second, some nominal currency appreciation will continue, but its size and speed will depend on how

undervalued a currency is (based on current account balances and other factors such as inflationary pressures)

and how large the inflationary pressures are in the economy. It will also critically depend on the speed at which





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China allows its currency appreciate and thus reduce the apprehension with which EMs regard the excessive

strength of their currencies if China continues to engage in beggar-thy-neighbor massive FX intervention to

prevent its undervalued currency from strengthening.

Third, in addition to aggressive sterilized intervention to prevent excessive appreciation, these EMs will also

increasingly use capital controls on inflows and domestic policies to restrict credit growth (under the rubric of

prudential supervision of the financial system) and in turn to prevent excessive asset bubbles. Still, froth in

equity and fixed-income markets is likely to result as intervention is only partially sterilized, while capital

controls and domestic credit controls are only partly effective.

Fourth, fixed-income instruments in EMs have only a modest spread reduction upside for several reasons:

spreads on foreign currency instruments—especially sovereign bonds—are already quite narrow given current

credit fundamentals; and the spread reduction on domestic currency bonds will be restricted by sterilization

policies, the slowdown in the pace of policy rate normalization and the fact that the sterilization of intervention

increases the supply of local currency government bonds available to satisfy the higher demand for such bonds

by foreign investors. On the other side, an important development that can provide support to local currency

EM debt and perhaps compress spreads more is the rise of EM pension funds, which are natural buyers of long-

term government debt. These EM pension funds can also be a vehicle—on top of central banks and SWFs—for

the reduction in home bias and greater cross-border portfolio diversification. Latin America is leading the way

with pension funds’ assets under management accounting on average for 20% of GDP and as high as 55% of

GDP in Chile.

Fifth, private sector fixed-income instruments—especially local currency corporate bonds—may experience a

larger increase in price and fall in spread compared with government bonds and also compared with foreign

currency bonds of corporates whose spreads are already low for high-grade issuers.

Sixth, the capital inflows to EMs will further increase equity prices in EMs on a cyclical and secular basis.

While this stock market outperformance will continue over time, there are some important caveats: the EM

investment trade in general and the EM equity trade in particular are becoming highly crowded trades. Every

week, one hears of new funds created in the U.S., Europe and Asia to invest in EM assets. Thus, equity

valuations are becoming excessive—based on price-to-earnings ratios—in many EM stock markets (and, in

fixed-income, bond yields are falling and risk becoming too low over time). Greater growth differential in EMs

compared with advanced economies does not necessarily lead to stock market outperformance as such a

differential has already been priced in many EM equity markets; and finding EMs where high-trend growth has

not been already been priced in is becoming increasingly hard. Thus, the risk of equity market reversals

becomes larger the longer this EM equity ―bubble‖ continues and leads to mispricing. Indeed, there is a serious

risk that, over time, a serious asset bubble will develop in EM equity and fixed-income markets. One should

also point out that equity market volatility in these EMs is likely to rise noticeably and stay high in the coming

years, especially versus volatility in FX and fixed-income markets.

Seventh, EMs cannot fully decouple from economic weakness in advanced economies. The debate on

decoupling versus recoupling is not a black and white, yes or no issue. No economy is an island and none can

decouple from global economic conditions, especially those in advanced economies; so it is a matter of degrees

of recoupling or decoupling depending on how severe and persistent is the slowdown in growth in advanced

economies. In fact, correlations between emerging and developed countries’ equities and currencies remain





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elevated, and are higher than the correlations between EMs themselves. Thus, recoupling of real economies will

be driven by factors such as trade channels, financial flow channels, and commodity and currency channels.

And, at the high frequency level, global investors’ risk aversion and the high correlation between advanced

economies and EM equity markets are a source of financial contagion and instant asset price recoupling. Indeed,

the bouts of global risk aversion in spring 2010—with the Greek and eurozone periphery crisis—and in the

summer of 2010—as the risk of a double-dip recession was rising in the U.S. —led to a very fast correction of

EM equity markets. This correction was as large (and in some cases larger) than that of advanced economies as,

when the risk is off, EM economies are still considered more risky than advanced economies and as their

markets are less liquid and thus any capital outflow leads to a stronger downside pressure on prices (given their

markets are less deep and liquid).

Eighth, a long-term and gradual diversification of portfolios toward EM assets makes sense; and the equity

market capitalization of EM will increase—both in absolute and relative terms compared with that of advanced

economies—over the next two decades. But too much new and unsophisticated capital is indiscriminately

chasing assets in EMs without proper due diligence and a realistic assessment of short- and longer-term

fundamentals and expected return in specific economies and markets. EMs are a very heterogeneous group of

countries with very different risk and return profiles. The risk is that the wall of liquidity coming from the

second round of quantitative easing in the U.S. (QE2) and weak growth in advanced economies will flood EMs

and lead over time to credit and asset bubbles. This risk is greater if EM policy makers indulge in unsterilized

intervention or, equivalently, postpone policy rate normalization at a time when overheating is becoming a

concern; the risk of overheating, rising inflation and asset/credit bubbles is significant even if intervention is

partially sterilized as the ensuing monetary and credit growth may not be fully controlled because of leaky and

not very binding capital controls on inflows and because of behind-the-curve supervisory policies to tighten

credit and avoid financial froth in such economies.

Ninth, it should be remembered that boom and bust cycles have occurred repeatedly in EMs in the past few

decades: the large boom and inflows of the 1970s leading to the Latin American debt crisis that started in 1982

and that caused a lost decade of growth; next, the resolution of the Latin American debt crisis led to another

massive episode of capital inflows to Latin America and Asian and other EMs that went bust first in 1994 in

Mexico, then in 1997-98 in East Asia (Thailand, Korea, Indonesia and Malaysia), and then in Brazil, Russia,

Turkey, Argentina, Uruguay, Pakistan, Ukraine and Ecuador between 1999 and 2003.

Then, another boom cycle in EMs started in 2003 with the global economic recovery and the housing and credit

bubbles in advanced economies (U.S., UK, Ireland, Iceland, Spain, Australia, New Zealand) and in some EMs

(especially those in Central, Eastern and Southern Europe) where current account and/or fiscal deficits and

overvalued currencies together with an unsustainable credit boom led to serious financial fragility. The ensuing

U.S. and global economic recession and financial crisis of 2008-09 following the bust of housing, subprime and

credit bubbles in advanced economies and financially fragile EMs led to another bust cycle in EMs: the stronger

among these experienced a sharp economic slowdown; some of those most exposed to trade with advanced

economies—with the exception of China—suffered a painful if short-lived recession; while those with greater

macro, financial and policy vulnerabilities—such as the most fragile economies in Emerging Europe—suffered

very severe recessions and serious distress in their financial markets, forcing many of them into the arms of the

IMF.





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The resumption of global economic growth in the spring of 2009 was V-shaped in EMs whose macro and

financial fundamentals were sounder at the onset of the global economic crisis: i.e. most of Asia, a good part of

Latin America and the Middle East; and weaker and U-shaped in the more fragile economies of Emerging

Europe. Their economies recovered rapidly and their asset prices sharply rose, in many cases faster and by more

than asset prices in advanced economies. But new bouts of global risk aversion—triggered by the PIIGS crisis

in the spring of 2010 and the markets’ worries about a U.S. double dip in the summer of 2010—led to sharp

corrections in EMs, especially in equity markets, only to see a resumption of capital inflows to EMs and asset

prices rallies when the risk-off mode turned into a risk-on mode and when the Fed and other advanced

economies’ central banks signaled QE2, which is creating a wall of liquidity chasing assets in EMs.

Tenth, the discussion above suggests that, while the lack of banking and financial crises in the stronger EMs

during the global recession and financial crisis of 2008-09 shows the resilience of these EMs and the structural

improvement of their macro, policy and financial fundamentals, this latest episode of capital inflows to EMs

may last longer and be more massive for both cyclical and structural/secular reasons.

Thus, if this new cycle of inflows is not properly managed, the ensuing credit and asset bubbles will lead to

excessive growth, an excessive increase in domestic demand, a rise in inflation and nominal and real

appreciation that, over time, will weaken external balances and turn current account surpluses into deficits

financed in a risky way—with short-term, foreign currency debt—and thus will plant the seed of another cycle

of currency and financial crises in EMs. We may still be a few years away from such a bust and crisis, but if the

latest round of capital inflows is not properly managed it will end in tears, just as with the devastating cycles of

the 1980s and 1990s.

Hopefully, most EMs will have learned the lessons of their previous cycles and now follow policies that could

prevent another destructive cycle of capital flows. But a happy ending cannot be taken for granted despite much

stronger fundamentals in most EMs today than in the recent past. Sound management of the latest inflow of

capital, which implies the difficult policy trade-offs discussed in this paper, will be necessary to prevent another

cycle that—like previous ones—leads to a painful currency and financial crisis.

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