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Abstract

We have now witnessed more than half a decade of relatively heavy capital inflows to a large group of highly heterogeneous developing countries and economies in transition in Asia, Eastern Europe, the Former Soviet Union, Latin America, and parts of Africa and the Middle East—in effect, we have already seen the reversal of these flows in a number of cases. In light of the richness of the country experiences and the continued relevance of the topic in a world of increasingly integrated capital markets, our aim in this paper is threefold: first, to chronicle the policies adopted in a broad range of countries, so as to document who did what and when; second, to try to assess to what extent such policies achieved their intended objectives and; lastly following from the previous two points, to draw lessons about which policies appeared to have been the most successful tools in coping with surging capital inflows, with emphasis on the 'policy mix' and how individual measures interact. In this retrospective review of the policy response to the surge in capital inflows we find crucial importance of the interaction of policies to either magnify or reduce the volume of inflows, affect their composition, and/or alter their macroeconomic consequences. For example, a combination of little or no short-term exchange rate uncertainty (as is the case when there is an implicit or explicit peg), sterilized intervention, which tends to prevent domestic short-term interest rates from converging toward international levels, and no binding impediments to capital inflows (through either taxation or quantitative constraints) is likely to maximize the volume of short-term capital inflows a country receives (this policy mix characterizes the Mexican experience during 1990-93 reasonably well). The pairing of little or no short-term exchange rate risk and relatively high domestic interest rates favors the short-term investor; for the long-term investor, there is always exchange rate risk since over longer horizons the probability of a realignment of the peg or a change in the exchange rate regime increases. Further, longer-term investments (such as foreign direct investment) tend to be less interest sensitive. Hence, it would not be surprising to see that if such a policy mix remains in place for any extended period of time it may end up skewing the composition of inflows toward the short end of the maturity spectrum. Similarly, it could be argued that the mix of sterilized intervention and controls on inflows may undermine the 'individual effectiveness' of these policies. The comparatively high interest rate differentials that usually accompany sterilization may act as an inducement to circumvent the capital controls (i.e. firms and banks may find ways of borrowing offshore). To the extent that they are successful in dodging the controls, this tends to offset some of the contractionary effects of the sterilization efforts (this is case of Brazil in 1994-95). Along the same lines, liberalizing controls on outflows as a policy aimed at reducing net capital inflows may backfire if domestic interest rates are high relative to international levels and/or if it is interpreted a positive signal of the future economic/policy environment. Indeed, several countries (Chile, Malaysia, and Thailand) liberalized outflows while at the same time engaging in substantive sterilization efforts.

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