Policy Responses to Capital Flows in Emerging Markets: 11
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Household sector tools, such as LTV and DSTI, are the second-most-commonly used set of tools globally, even as they are less common in Western Hemisphere countries compared to most other regions. When we zoom in on household sector tools, we find that restrictions on loan-to-value and debt-service-to-income are most frequently used globally Figure These tools are especially common in Asia, Europe and the Middle East, with about half of countries in these regions maintaining this tool.
However, as we observed before, these tools are less commonly used in Western Hemisphere countries, where only about a quarter of countries reported using these tools. By contrast, tighter capital requirements on exposures to the household sector are common across all regions, including in the Western Hemisphere. For instance, Argentina applies a higher risk weight for loans at LTV ratios above 75 percent. Compared to household sector tools, measures to manage risks from exposures to the corporate sector are less common.
The most frequently used ones are additional capital requirements for loans to the corporate sector, including for exposures in FX, as well as caps on FX lending, which are quite common even in Latin America. There are some useful lessons from country experiences with macroprudential policy to date. One such lesson is that it is useful to adopt a portfolio approach: For instance, to address risks in housing markets, it is useful to combine limits on LTV, limits on DSTI and amortization requirements. In the absence of a DSTI limit, LTV limits can be circumvented by borrowers obtaining an unsecured loan to cover the down payment as has been the experience in Sweden and China.
A DSTI limit can counter this, and can also protect against additional sources of risk, such as shocks to income and interest rates. However, a DSTI limit may lead borrowers to prefer ever-longer-maturity loans, or loans that do not amortize, in order to keep debt service within the limit. This can reduce efficiency costs, when the bank assesses that the borrower is a good credit but would not otherwise be able to grant the loan. Third, it can be useful to take steps well before vulnerabilities have built up and before credit gaps widen measurably.
This is because we want to lock in the resilience benefit of macroprudential policy action early as has been the approach in Ireland and the United Kingdom, for instance. The IV recommends that:. In the context of capital-inflow surges, CFMs may play a useful role particularly when: The research I cited previously, by Nier, Olafsson and Rollinson, also examines the effectiveness of capital flow management measures in the context of credit booms [vii].
Let me focus on our findings for countries in the Western Hemisphere as they are of particular interest for us here today. We find that in general, Western Hemisphere countries vary in terms of their capital account openness as seen in the left panel in Figure But most of them have in common that they have not introduced new CFMs or adjusted their existing measures recently. The right panel of Figure 12 shows that, apart from the crisis measures in Argentina, only eight CFMs were introduced or adjusted over this close to six-year period — mostly in response to inflows by utilizing specific reserve requirements or taxes.
Intervention in foreign exchange markets is also a common response to capital inflows—including in emerging market countries with flexible exchange rate regimes. A key motivation for interventions cited by EM central banks is the concern about financial stability.
Such a concern often reflects the presence of substantial unhedged currency mismatches on private sector balance sheets, which can cause large losses in case of sharp currency movements. The desire to build foreign currency reserves is also a common driver of FX intervention. Financial stability aside, interventions can also be motivated by macroeconomic considerations.
Central banks may worry that exchange rate volatility has an undesirable impact on inflation, or that overly rapid exchange rate adjustment negatively affects growth. FX intervention is widely used in Latin America, although the frequency of interventions differs across countries.
Many countries in the region have accumulated reserves as they leaned against sustained capital inflows. In some cases, those reserves were also deployed at times of depreciation pressures. Figure 13 is taken from a forthcoming book that documents the Latin American experience with FX intervention [viii]. Portfolio flows to emerging markets have been under pressure recently.
Policy Responses to Capital Flows in Emerging Markets
These flows have fallen sharply but have remained positive year-to-date, as shown in Figure The decline has been driven mainly by retail flows, which turned negative during the selloff in the second and third quarter of Inflows from institutional investors are estimated to have declined as well but remained positive. Debt portfolio flows were particularly affected, after strong inflows in This is in part because, over the past year, market participants have substantially revised upward their expectations for the likely path of US interest rates, pricing in several additional policy rate hikes.
Looking ahead, emerging markets will probably continue to face reduced portfolio flows, given the ongoing U. Figure 15 shows the estimated cumulative impact of the U. This further reduction in inflows will pose challenges to countries that rely heavily on external financing.
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While global factors affected all countries, the overall spillovers across emerging markets have so far been relatively contained, and idiosyncratic factors have explained much of the outsized asset price moves. In credit markets, the widening of spreads on hard currency sovereign bonds has been more pronounced in lower-rated issuers Figure 16 , suggesting that investors have continued to differentiate between borrowers based on economic fundamentals and other country-specific factors.
Another important point to emphasize is that there is limited evidence of contagion so far, given strong global risk appetite. However, if global risk appetite were to weaken, the risk of contagion could rise. Facing external pressures, central banks in several emerging market economies responded with interest rate hikes Figure 18 and interventions in currency markets Figure Argentina and Turkey reacted by raising policy rates sharply, while countries already in a tightening cycle including Indonesia, Mexico, and the Philippines hiked rates by more than markets had expected.
Foreign exchange interventions were carried out in the spot market Argentina, Indonesia and via derivatives Argentina, Brazil, India, Turkey. Our main policy advice remains that exchange rate flexibility should be used as a key shock absorber.
Policy Responses to Capital Flows
Appropriate macroeconomic policies should always be the core of the policy response — coupled, if necessary, with macroprudential policies to contain systemic risk and FX interventions. Policy rate hikes should counter inflationary pressure from currency depreciation and market pressures from outflows.
However, if global risk appetite were to weaken, the risk of contagion could rise. Facing external pressures, central banks in several emerging market economies responded with interest rate hikes Figure 18 and interventions in currency markets Figure Managing the risks that stem from capital inflows, while maximizing their benefits, requires a careful calibration of policy responses, especially in an environment of large and volatile capital flows. Compared to household sector tools, measures to manage risks from exposures to the corporate sector are less common. We have no references for this item. The risks from capital flows, including heightened macroeconomic volatility and vulnerability to crises, are well known from the experiences of emerging markets EMs and other open economies. Cecchetti et al find that prolonged easing of monetary policy in the United States tends to fuel rising financial sector leverage in other countries Figure 8.
FX interventions can be used to prevent disorderly market conditions, if reserves are adequate. Capital Flow Measures can be implemented in certain situations — but they should not be used as substitutes for needed macroeconomic adjustment. Instead, they should be temporary, transparent, and part of a broader policy response.
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