Can Emerging Markets Stabilize Capital Flows?

Since the early 2000s, policymakers in emerging markets have been concerned about “waves” of international capital flows into their countries. As Kristin Forbes, a professor at MIT’s Sloan School of Management, pointed out at the Investing in Emerging Markets 2012 conference, “Volatility of capital flows is here to stay, and there are no magic bullets.”

Forbes noted that traditional solutions in the policy toolkit are not working well today and are costly in the current low-interest-rate environment. She went on to show how the frustration of policymakers has led to increased experimentation with new solutions or new uses for older policies — such as exchange-rate targeting (Switzerland), lowering interest rates (Turkey), prudential regulations (Korea), and capital controls (Brazil) — in an attempt to stabilize flows.

For years, capital controls, the most controversial approach, have been hotly debated by economists. “Keynes and White were debating this issue at Bretton Woods after World War II, and if you read the transcripts, their discussions were very similar to the ones we’re having today,” Forbes said. Several “market-oriented” countries including Brazil, Colombia, Peru, and Thailand have adopted capital controls, but the existing evidence on their effectiveness is mixed. Overall, enforcement is difficult and controls become less effective over time.

In her presentation, Forbes presented new evidence showing how equity and debt investors adjusted their portfolios in response to capital controls applied by Brazil from 2006–2011, finding that investors significantly reduced the share of their portfolios allocated to Brazil as controls were implemented. Much of the effect was through “signaling” — that is, equity investors reduced holdings in response to higher taxes on debt securities.

When faced with Brazil’s capital controls, investors also reduced holdings in countries viewed as “friendly” to capital controls, and some investors increased allocations to other countries in Latin America or to other “dragon plays” that hoped to benefit from growth in China. Forbes called this the “Bubble Thy Neighbor” effect, saying that “this means there is an important role for multilateral institutions and cross-border cooperation.”

Forbes concluded with a new framework for analysis: In her 2011 paper with Darden Professor Frank Warnock, she examined capital flows — specifically the “surges” and “stops” in inflows driven by foreigners and the “flight” and “retrenchment” in outflows by domestic investors. “Most people focus on net capital inflows, but it gives a more complete picture to separate foreign and domestic flows,” Forbes said.

Forbes and Warnock tested a number of possible factors that could influence capital flows and found that global factors (especially global risk) were most important in driving waves of capital flows. As global risk increased, investors either stopped investing abroad and retrenched to their home country markets or left their home country markets (flight), usually for hard currency markets. Contagion contributed to slowdowns in capital flows, while domestic factors played a minimal role. Interestingly, capital controls had no significant effect on the probability of having a surge or stop of capital flows from abroad.

Ultimately, Forbes advised emerging market economies to focus less on trying to manage external influences beyond their control in favor of developing the internal resources necessary to cope with them. “Countries have limited ability to stop the waves of capital flows,” Forbes concluded. “Countries should focus on strengthening their domestic economy and financial systems to handle volatility, rather than trying to stabilize underlying flows.”