Are capital inflows expansionary or contractionary? One would think that the question was settled long ago. But, in fact, it is not. And there is a striking schizophrenia. Standard models, along Mundell-Fleming lines or more recent incarnations, give one answer. For a given monetary policy rate, inflows lead to an appreciation, and thus to a contraction in net exports – and a decrease in output. Only if the policy rate is decreased sufficiently can capital inflows be expansionary. Symmetrically, using a model along these lines, Paul Krugman argued in his 2013 Mundell-Fleming lecture that capital outflows are expansionary (Krugman 2014).
Emerging-market policymakers, however, have a completely different view. They see capital inflows as leading to increases in credit and output unless they are offset by an increase in the policy rate. They also point to a dilemma, however: while the direct effect of an increase in the policy rate is to limit the output boom, it is likely to engender even more capital inflows. The net result of an increase in the policy rate may even be pro-cyclical, calling forth recourse to heterodox instruments such as capital controls to overcome the dilemma (Ostry et al. 2012a).
The evidence appears to support the perception of policymakers. Capital inflows appear to be typically associated with currency appreciations, credit booms, and output increases.
Reconciling theory and reality
How can we reconcile the models and reality? The answer we offer in some recent work (Blanchard et al. 2015a) relies on extending the set of assets in the economic model, by allowing for both ‘bonds’ (the rate on which can be thought of as the policy rate) and ‘non-bonds’, i.e. assets such as equities and bank liabilities which are imperfect substitutes for bonds. In this case, even if the policy rate – which we take to be the rate on bonds – is given, capital inflows may decrease the rate on non-bonds and reduce the cost of financial intermediation. The positive effect of these lower rates on domestic demand may then offset the adverse effects of currency appreciation on external demand. Capital inflows may in this case be expansionary even for a given policy rate. In emerging markets, with a relatively underdeveloped financial system, the effect of a reduction in the cost of financial intermediation may dominate, leading to a credit boom and an output increase despite the appreciation. In more advanced economies, the appreciation may dominate, and capital inflows (even into non-bonds) may be contractionary (e.g. the Swiss case).
Several implications follow from this simple setup. The first is that the macroeconomic effects of capital inflows depend very much on their nature. For a given policy rate, bond inflows lead only to a currency appreciation and are contractionary. In contrast, non-bond inflows lead both to an appreciation and a decrease in their rate of return: depending on which effect dominates, such inflows may be expansionary. There is thus a tentative reconciliation between the Mundell-Fleming model and policymakers’ views.
Policies for managing inflows
A second implication is that the appropriate policies vis-à-vis capital inflows depend very much on the nature of the inflows.
Sterilised foreign exchange (FX) market intervention, if done through bonds (as is usually the case), can fully offset the effects of bond inflows, leaving both the exchange rate and interest rates unchanged. In effect, the central bank takes the opposite position of foreigners: as foreigners decrease their holdings of foreign assets and increase their demand for domestic bonds, the central bank decreases its demand for domestic bonds and increases its holdings of foreign assets. When, however, sterilised foreign exchange intervention is used in response to non-bond inflows, it can avoid a currency appreciation (see Blanchard et al. 2015b), but only at the cost of a larger decrease in the rate of return on non-bonds. Indeed, as a capital flow management tool, FX intervention leads to a paradoxical outcome: by reducing upward pressure on the currency (presumably the intended purpose), intervention actually increases capital inflows, and thus increases the effects of inflows on credit and the financial system.
A similar distinction applies to capital controls. Capital controls can be aimed at bond inflows, at non-bond inflows, or at both. If aimed at both and if successful, they can reduce or even eliminate all inflows, and thus by construction eliminate the effects on the exchange rate and the rate of return (in contrast to FX intervention that reduces the first, but amplifies the second).
Of greater interest are the effects of capital controls aimed primarily at bonds or non-bonds. Targeted controls affect the mix of inflows. Capital controls on bond inflows reduce or eliminate bond inflows, but increase the effects of non-bond inflows, both on the exchange rate and on the rate of return on non-bonds. Conversely, if capital controls are targeted to eliminate non-bond inflows, the effect of bond inflows on the exchange rate is magnified. In both cases, targeted capital controls reduce upward pressure on the currency which in turn increases the “spillover” effects from the non-targeted inflow on the exchange rate, the rate of return, or both.
What about the effects of monetary policy? The central bank might have one of two objectives (apart from its output/inflation mandate): stabilise the exchange rate or stabilise the rate of return on non-bonds (or put another way, limit credit expansion). If it targets the former, it will lower the policy rate, while if it targets the latter it will increase the policy rate. This is the form the ‘policy dilemma’ takes in our framework, whether to stabilise the exchange rate and accept a larger decline in the rate on non-bonds, or stabilise the rate of return and accept a larger appreciation. This is a false dilemma, however, as a combination of instruments can – at least in principle – avoid such a trade-off. To this we now turn.
Combining the policy instruments
How should policymakers choose amongst the different policy instruments? The policymaker may have several objectives in mind – with respect to credit growth (given the risk of financial crisis); the currency (given the risk of Dutch disease); and output (given nominal rigidities in the system). The issue is really one of matching the policy instrument (there are three) to deliver on the most important objectives, without too much cost in terms of the other objectives. We recognise of course that no instrument works perfectly: this applies as much to monetary policy and foreign exchange market intervention as to macroprudential tools and capital controls.
Our approach suggests that, if the central bank is worried about both appreciation and unhealthy or excessive credit growth, FX intervention or capital controls are preferable to the use of the policy rate in response to an increase in bond inflows (since a policy rate reduction will lead to a larger reduction in the rate of return on non-bonds). In response to non-bond inflows, our framework suggests that if the goal is to maintain exchange rate stability with minimum impact on the return to non-bonds, capital controls do the job best, followed by FX intervention, followed by a move in the policy rate.
Given a range of potential goals and tools, policy instruments can be combined in interesting ways. Against the backdrop of debates over policy dilemmas and trilemmas, it is notable that monetary policy and FX intervention can, in principle, offset the effect of inflows on both exchange rates and the rate of return to non-bonds without a need for capital controls (see Ostry et al. 2012b). This is a more optimistic conclusion than the proposition of Rey (2013) viz. that, short of using macroprudential tools or capital controls, countries cannot divorce themselves from global financial flows.
Some empirical evidence
So much for theory; what about the evidence? An empirical exploration faces many challenges, including the fact that capital flows in reality reflect both push and pull factors, whereas the theoretical arguments above relate to the effects of exogenous flows (and thus the empirics must in turn look at the effects of the exogenous component of flows only). This challenge requires the use of instruments, namely variables that affect the inflows but are plausibly not caused by events within the country. Our approach is to use global flows to all emerging market countries together with the VIX as instruments, on the assumption that these are unlikely to be correlated with developments in any particular emerging market country. In addition, countries to varying degrees make use of different policy instruments to cancel the effects of the flows, something that must be controlled for in the empirical approach. With these caveats in mind, our empirical results are broadly supportive of the theory. We find that, while bond inflows have a negative effect on economic activity, non-bond inflows have a significant and positive effect. We also find that non-bond inflows (excluding FDI) have a strong positive effect on credit, much stronger than bond flows, highlighting the key channel we think is at play in the output effects of capital flows. FDI inflows, while they increase output, have a negative impact on credit, perhaps because some of the intermediation which would have taken place through banks is replaced by FDI financing.
To conclude: theory suggests that, for a given policy rate, bond inflows lead to currency appreciation and are contractionary, while non-bond inflows lead to an appreciation but also to a decrease in the cost of borrowing, and thus may be expansionary. The empirical evidence is broadly supportive. Exogenous bond inflows appear to have on average small negative effects on output, while exogenous non-bond inflows appear to have a positive effect. Our analysis, if correct, has important implications for the use of policy tools to deal with inflows. Different combinations of tools must be used depending on the nature of the flows.
Blanchard, O., J. Ostry, A.R. Ghosh, and M. Chamon (2015a), “Are Capital Inflows Expansionary or Contractionary? Theory, Policy Implications, and Some Evidence”, CEPR Discussion Paper 10909.
Blanchard, O., G. Adler, and I. de Carvalho Filho (2015b), “Can Foreign Exchange Intervention Stem Exchange Rate Pressures from Global Capital Flow Shocks?”, NBER Working Paper 21427.
Fleming, J. M. (1962), “Domestic financial policies under fixed and floating exchange rates”, IMF Staff Papers 9, pp. 369–379.
Krugman, P. (2014), “Currency Regimes, Capital Flows, and Crises”, IMF Economic Review 62(4).
Mundell, R. (1963), “Capital mobility and stabilisation policy under fixed and flexible exchange rates”, Canadian Journal of Economics and Political Science 29, pp. 475–85.
Ostry, J. D., A. R. Ghosh, M. Chamon, and M. S. Qureshi (2012a), “Tools for managing financial-stability risks from capital inflows”, Journal of International Economics 88(2), pp. 407–421.
Ostry, J. D., A. R. Ghosh, M. Chamon (2012b), “Two Targets, Two Instruments: Monetary and Exchange Rate Policies in Emerging Market Economies”, IMF Staff Discussion Note No. 12/1.
Rey, H. (2013), “Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy
Independence”, Jackson Hole 2013.