Natural mappingWhile evidence suggests that EME policymakers responded to capital inflows through various tools, did the choice of policy instrument correspond with the nature of the risk posed by capital flows? In general, yes. The difference between the average real effective exchange rate (REER) appreciation in cases when FX intervention was used compared to when it was not used was significantly greater (about 5 percentage points). For monetary policy, the output gap mattered most, followed by the rate of domestic credit expansion, which were significantly larger when monetary policy was tightened.
Macroprudential measures were typically deployed in the face of rapid credit growth, while inflow controls were tightened when both credit growth and currency appreciation were a concern. On average, REER appreciation was 5 percentage points greater when both inflow controls and FX intervention were used compared to when FX intervention was used alone. Similarly, credit expansion was about 2 percentage points faster when both inflow controls and macroprudential measures were tightened than when the macroprudential measures were used alone. Moreover, inflow controls were generally used with at least one other instrument – suggesting that capital controls were deployed when countries were contending with multiple, and increased, risks that threatened financial and macroeconomic stability.
Figure 4 Policy Instruments and Risks, 2005Q1-2013Q4
Source: Authors’ estimates.
Note: Figures show the average year-on-year change in real domestic private credit growth and change in REER (in percent), output gap (in percent), and net capital flow/GDP (in percent) for the cases when policy instruments are used, and when they are not used. *, **, and *** indicate that the difference between the two group means is statistically significant at the 10, 5, and 1 percent levels, respectively.
Everything except fiscal tighteningWe conclude that policymakers in EMEs have responded to capital flows by deploying a combination of instruments. Central banks used the policy interest rate to address inflation and overheating concerns, and intervened heavily in the face of capital inflows. Beyond these policies, EMEs tightened macroprudential measures, capital controls and currency-based measures that affect capital inflows, while countries with relatively closed capital accounts tended to relax restrictions on capital outflows. Moreover, there has been some correspondence between the tool deployed and the nature of the risk – thus, central banks intervened when the real exchange rate was appreciating, tightened monetary policy when the economy was overheating, and used macroprudential tools when financial-stability concerns dominated. Inflow controls were typically used when there were many, aggravated, risks. The orthodox policy prescription to tighten fiscal policy in the face of capital inflows was the least used instrument in practice, with no strong evidence that EMEs systematically tightened fiscal policy in response to large capital flows.
Disclaimer: The views expressed in this column are those of the authors, and should not be attributed to the IMF, its Executive Board, or its management.
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