Managing Capital Accounts in Emerging Markets: Lessons from the Global Financial Crisis

Abstract

The global financial crisis forcefully highlighted the importance of curbing the impact of large and volatile capital inflows on growth and financial stability in developing countries. It led the IMF to reconsider its long-standing rejection of capital controls. Yet its new ‘macroeconomic policy first’ approach has to be reconciled with the hybrid nature of banking activity and its role in transmitting global shocks. A consideration of dominant actors and strategies of intermediating capital inflows offers distinct policy options, ranging from carefully designed central bank strategies to institutional changes that realign bank incentives towards longer horizons and sustainable growth models. Where capital inflows arise predominantly from official sources rather than cross-currency private investment strategies, central banks can combine a firm commitment to price stability with managed exchange rates and no concern for tight liquidity control, the opposite of IMF’s advice. Where domestic banks play an important role in the intermediation of capital inflows, policy attention is best focused on the relationship between domestic money market liquidity and cross-currency strategies. Indeed, an important policy lesson from the global financial crisis is that liquidity conditions are relevant not only in markets of the funding currencies, as in the common interpretation of carry-trade volatility, but also in target currencies.

Keywords: IMF, capital controls, financial crisis, international banking, short-term funding, shadow banking

JEL Classification: E58, E63, F3, G1, O11, O2