Managing Volatile Capital Inflows: The Experience of the 1990s

Abstract

The paper aims at deriving lessons for macroeconomic policy in developing countries in response to heavy temporary capital inflows as witnessed in the early 1990s. First, after spelling out the major reasons why policymakers should be concerned about cyclical inflows, the volatility of different capital-account items {bank lending, foreign direct investment, and portfolio flows} is assessed. Second, the recent capital flows are compared between Asia and Latin America for similarities and differences. Third, the paper discusses for 13 heavy capital importers in Asia and Latin America the extent to which they met the prerequisites postulated by the sequencing literature to avoid macroeconomic complications of heavy capital inflows, and how they used these external savings in light of the debt cycle theory. Finally, the paper draws five policy lessons for the next episode of heavy capital inflows: identify the origin of rising foreign exchange reserves; identify the limits of foreign debt; discourage above-limit, short-term inflows; observe the tradeoff between price stability and competitiveness; and design policies to target monetary aggregates and exchange rates, including fiscal policy, sterilized intervention, reserve requirements, and exchange rate management.