IMF, ADB warn against capital flow surges

Capital flows can benefit recipient economies, but economic managers must guard against surges that could lead to large foreign exchange swings and asset prices spiraling up and down, the International Monetary Fund (IMF) said on Tuesday. The Asian Development Bank also warned against capital flows to "developing Asia," as it set a 7.5-percent growth forecast for the region this year in its Asian Development Outlook 2010 released on Tuesday. "[Capital flows] benefits include providing additional financing to countries with limited savings, allowing risk diversification, and contributing to the depth and development of financial markets," the Washington-based lender said in its Global Financial Stability Report. But it noted that the low interest rates in developed economies and high global liquidity, economies with a stronger growth outlook or relatively higher interest rates risk attracting excessive flows that could lead to swings in the exchange rate and booms in domestic demand to the point of overheating economies. Inflation could accelerate and deficit could widen, it added. Surges in capital flows may also lead to asset bubbles and increase systemic risks for the financial system, it added. Analysts have been saying that Asia is most vulnerable to capital flow surges since it is expected to lead global recovery this year. Interest rates in the region also remain higher than in developed economies, which are still recovering from a recession. The Philippines has received these flows, which have boosted local share prices and the peso. To counter excessive capital flows, monetary authorities accumulate reserves to keep the exchange rate at the current level, slowing the local currency’s appreciation, the IMF said. Foreign exchange intervention, however, could be expensive. These can also lower local interest rates, cutting the interest rate gap with a similar interest-bearing asset abroad. This, however, is not advisable in countries facing inflation problems. The IMF said lower government spending could counter a capital surge since this reduces a country’s financing needs, which also leads to lower interest rates. "Fiscal austerity could also mitigate asset bubbles directly by lowering aggregate demand growth and supporting a capital account adjustment, thereby cushioning the cost of a sudden reversal in inflows," it added. The IMF added that imposing prudential ratios in the financial sector could also contain the inflow gush. "Tweaking liquidity ratios, which differentiate according to currencies, or reserve requirements that vary according to maturity, can provide a useful tool for dealing with capital inflow surges and their financial risks," it said. Capital controls on inflows are also available in case policy options and prudential measures are inadequate to stem the surge. "However, if the inflows are not temporary, but are driven by more fundamental factors, policymakers should adjust their macroeconomic policies to address the root causes, instead of mitigating the effects of inflows or attempting to limit them through various measures," the IMF said. Meanwhile, the ADB urged Asia and Pacific economies to coordinate in withdrawing stimulus measures and in freeing up exchange rates. "The region’s early recovery is attracting large capital flows, the perils of which were made clear in the 1997/1998 Asian financial crisis; volatile capital flows could again have serious implications for exchange rates and money supply," the ADB said. "Moreover, the quick return to high growth could accelerate the increase in consumer and asset prices," it said, adding that the surge of foreign money could complicate domestic policy. The ADB said more flexible exchange rates would help manage capital flows, and as economies move towards them, it is acceptable to place some limits on foreign money flows. "More flexible exchange rate systems are in the region’s own interest, and carefully designed capital controls that mitigate disruptive capital inflows may be desirable during the transition to greater flexibility, at least in the short run," it added. Governments and central banks also needed to pull back their support and allow businesses and consumers to sustain the recovery. Central bank officials earlier said capital flows were not yet a cause for concern, noting that the stock market rise is within expectations, while rising property prices have mostly been due to fundamentals. — Don Gil K. Carreon and Reuters