CAN COUNTRIES INFLUENCE THE SIZE AND DIRECTION OF PRIvATE CAPITAL FLOWS?
If the balance of payments and current account balances still matter, how may national governments influence the size and direction of private capital flows, the key exogenous factor determining a country’s external position? As we suggested earlier, finding an instrument or set of instruments which could effectively perform such a task is not easy. Capital controls such as a ban on certain transactions, licence requirements to conduct them, and the taxation of capital flows (explicit or implicit, for example unremunerated reserve requirements) are formally unavailable for EU members and advanced candidates because such controls violate the acquis communitaire (one of the four Single Market basic freedoms). The non-EU countries which belong to the Organisation for Economic Co-operation and Development (OECD) are also constrained by the OECD Code of Liberalization of Capital Movements, although in a less rigorous way than in the case of the EU acquis (see OECD, 2012).
However, countries which are not constrained by international treaties and other formal obligations and which have tried capital controls have found those tools to be problematic. Individual instruments may have some, but rather a temporary, impact on the structure and maturity of capital flows (see Baba and Kokenyne, 2011). If a country has already reached an advanced degree of its economic openness and financial sector sophistication, capital movement restrictions could be quite easily circumvented through current account transactions, those capital account transactions which remained unrestricted, offshore markets and various kinds of derivatives. Thus the ultimate effect of capital controls is building various kinds of market distortions and decreasing transparency of capital flows rather than impacting upon their size and direction.
The effectiveness of monetary policy in terms of its influence on the size and direction of private capital flows is rather limited and depends on the underlying regime. There is no impact under a hard peg because there is no sovereign monetary policy at all. A flexible exchange rate allows for some accommodation of volatility in capital flows through either nominal appreciation or depreciation of a national currency and associated exchange rate risk premiums or adjustments of the central bank’s interest rates. However, if the exogenous changes in private capital flows are strong enough (as experienced in the period of 2004-2011) a country’s tolerance of exchange rate fluctuation can reach economic and political limits. In addition, in some circumstances both capital inflows and outflows may become self-accelerating under flexible exchange rates (speculation for currency appreciation or depreciation).
Adjusting interest rates in response to fluctuations in capital flows involves a risk of damaging domestic macroeconomic conditions with negative consequences for the real sector: interest rate cuts may cause the economy to overheat, whereas a radical increase in interest rates to stop capital outflow may trigger a downturn.
Hybrid monetary regimes, which target both exchange rate and interest rate or monetary aggregates, may try to sterilize both capital inflows and outflows. However, sterilization of capital inflows is usually costly and ineffective in the long term as it creates a one-way bet for the market players. In turn, sterilization of capital outflows may easily lead to a meltdown of international reserves and trigger a speculative attack against the country’s currency.
Fiscal policy may have some impact on the current account as it influences net national saving (a fiscal deficit decreases net national saving and a fiscal surplus increases it). However, one should take into account the offsetting effects in terms of net private financial flows. For example, fiscal contraction, which is widely considered as one of the measures to diminish current account imbalances, may not necessarily bring the expected results due to ‘crowding-in’ effects (Rostowski, 2001). Successful fiscal adjustment is usually perceived by investors as a factor decreasing country risk (i.e., increasing the expected rate of return) and boosts private capital inflows, thus leading to higher account deficits.
Fiscal policy may also have some microeconomic impact through various kinds of fiscal incentives and disincentives. For example, in some countries which experienced housing market booms and busts in the 2000s, special tax incentives artificially stimulated housing investments. However, in most cases such incentives or disincentives influence the structure of capital flows rather than their total volume. The same concerns micro-prudential financial regulations. They may have a benefit of their own by increasing the robustness of a financial sector. However, their impact on capital flows may concern their structure rather than the overall volume.
Finally, macro-prudential financial regulation may have some impact on both the volume and structure of capital flows. However, this is a relatively new regulatory concept and will very much depend on its practical operationalization: what kind of financial flows and variables will be monitored, by whom and according to which criteria, and what kind of preventive and corrective instruments can be adopted (see Macroprudential, 2011). Its early record looks mixed. In some countries it serves as a new label for the old practices of capital control.9 In others the debate on the concept, the analytical and institutional framework, and the instruments of macroprudential regulation is still in a relatively infant stage. It seems that more time and practical experience is required to assess its regulatory potential and effectiveness, including its impact on crossborder financial flows.
The above picture confirms, once again, my earlier view on the limited potential of national policies in small open economies to regulate the balance of payments, current account balances and the real exchange rate in a world of unrestricted capital movement. This means that prudent macroeconomic (especially fiscal) and regulatory policies at the national level may increase a country’s financial safety and its ability to withstand various exogenous BoP shocks but do not guarantee its full immunity against external turbulence and BoP crisis.