Name: Fatima
Section: B
Ass#1
The economic crisis that began in 2008 created tight links due to financial globalization
across countries. Firstly, there were large capital outflows when the crisis was at its peak and
this created funding problems. However, the second point of view is that the environment
since the crisis created problems coming instead from large capital inflows. e.g for developed
economies, especially the United States, AAA assets created and held by banks need to have
the appropriate capital charge if they are built on the basis of the law of large numbers and
hence are exposed to systemic risk. E.g For decades capital outflows from Brazil were
banned. As a result, a black market for hard currency developed outside the boundaries of the
law, and the money which was taken out of the country was not taxed. This resulted in a need
for more capital-account management.
Capital flow during the financial crisis that began in 2008, shows that it can create new
exposures and bring new risks. So there needs to be a combination of policies such as
• Exchange-rate flexibility with some degree of management,
• A relatively open capital account, but with some degree of management and controls.
In general, capital controls are not seen as a permanent solution to problems. Capital account
management tools need to be applied in a context that is clearly prudential. They should not,
however, be used to support undervalued currencies, in a mercantilist fashion. Therefore, in
practice, this means capital account policies must be judged according to their objectives and
not by the tools used in their implementation.
The Asian crisis has suggested that the impossible trinity can be managed. Firstly it suggests
that the exchange rate should be largely market-determined and flexible but still managed to a
certain extent. Second, the capital account should be largely open but not fully open, with
some degree of management including the exercise of control. Thirdly, as they were not at the
ends of the trinity they can and have a certain degree of management of the capital account.
Clearly, the record of capital volatility is stark over the last couple of decades. The jumps in
net capital flow in emerging markets from the U.S. $190 billion in 1995 to $200 billion in
2008 have indeed been due to the record of huge volatility in capital flows. It is a little
difficult to imagine what would happen if capital-account management were not resorted to
in active fashion in these countries. Moreover, there is an inflation and interest rate
differential that allows trade on an enduring basis. In addition, there is volatility in the
monetary policies of advanced economies which have given rise to capital flow volatility. As
the policies of advanced economies are driven by their own domestic needs, emerging
markets need to take adequate defensive action. Overall, there is a huge incentive for high
capital flows, which then lead to large exchange-rate appreciation, credit booms, and
asset-price booms, followed eventually by higher trade and current-account deficits over
time. This requires adequate capital management as markets can sometimes be irrational for
extended time periods.
Overall, the crisis has made it important to consider capital-account management in its broad
form and make it part of the overall toolkit for macroeconomic management to ensure price
and financial stability. Also, capital-account management is not only needed when domestic
financial markets are not developed enough but otherwise also. Capital account management
cannot be examined in isolation. It must be part of an overall toolkit with sound
macroeconomic policies, both fiscal and monetary.
If a country follows a flexible exchange rate and its currency appreciates, it is likely to cause
high capital inflows but the long-run health of the economy will be compromised by a
sustained appreciation. This can be because of the pecuniary externality that arises as the
export sector is not able to ride a temporary capital inflow. Capital inflow-domestic
expenditure increases-appreciation of the real exchange rate.
Since the Asian crisis emerging markets have followed greater flexibility in exchange rates
with some degree of management to avoid the extremes of prevailing orthodoxy. After all, a
world crisis is likely to require widespread exchange rate adjustments as different countries
are affected in different ways and have different capacities to weather the shocks.