Panel cautions against excessive haste in liberalising capital a/c

Panel cautions against excessive haste in liberalising capital a/c
S Kalyana Ramanathan / London February 03, 2009
The Committee on the Global Financial System (CGFS) in its report on "capital flows and emerging market economies" released today said that excessive haste in liberalising capital account has the potential to compromise financial or monetary stability in emerging market economies (EMEs).
The CGFS headed by Reserve Bank of India Deputy Governor Rakesh Mohan was, however, quick to add that excessive rigidities in capital account management can also lead to difficulties in macroeconomic and monetary management.
The CGFS concluded its one and a half year study of more than 20 emerging market economies, starting from the Asian economic crisis of 1997 to the recent credit squeeze in the global economy.
"In principle, the flow of capital between nations brings benefits to both capital-importing and capital-exporting countries. However, very large flows can also create new exposures and risks. This has become apparent with the extraordinary surge in capital flows - total capital inflows reached $1,900 billion in 2007, four times as large as in the period before the Asian crisis - and the subsequent very large reversal of foreign investment in emerging market assets in 2008," said a media release issued today by Bank for International Settlements under which the CGFS was constituted.
Large foreign currency inflows have had major consequences for the liquidity of domestic financial systems. The report discusses the advantages and drawbacks of central banks' market and non-market instruments. It notes the complex interrelations between monetary policy, exchange rate objectives, forex intervention and domestic financial balance sheets.
There is a strong two-way link between capital flows and the resilience of the financial system. Capital flows do most good and least harm when domestic financial markets are developed and local financial firms are strong. At the same time, the greater presence of foreign investors should improve the operation of local financial markets.
The report argues in favour of a combination of policies - sound macroeconomic policies, prudent debt management, exchange rate flexibility, effective management of the capital account, the accumulation of appropriate levels of reserves as self-insurance and the development of resilient domestic financial markets - provides the optimal response to the large and volatile capital flows to the EMEs. "How these elements are best combined will depend on the country and on the period: there is no "one size fits all," Mohan said.