Emerging market residents key to steady capital flows

Emerging markets can better resist capital flow volatility by taking measures to encourage their residents to invest abroad in good times and repatriate the funds when needed, according to a study by the International Monetary Fund (IMF).

Countries where a surge of capital inflows was offset by domestic residents' purchase of foreign assets fared better during the global financial crisis as international investors pulled out, the IMF said in a chapter of its World Economic Outlook, released on Monday. That showed policymakers had other options than capital controls or currency interventions, it said.

The fund's advice comes as countries from India to Indonesia brace for weaker capital flows once the US Federal Reserve phases out its monetary stimulus. The Fed's surprise decision last month not to pare its US$85 billion in monthly asset purchases for now gave them time to address domestic economic fragilities.

During the 2008 turmoil, "while some countries experienced the classical boom-and-bust cycle in response to volatile international capital flows, many did not", the IMF wrote in the study.

"Rather, as international capital flows dried up, domestic residents stepped in to replace them by drawing down their own foreign assets," it said.

The report focused on Chile, Malaysia and the Czech Republic, showing how they learned from past crises to adopt new policies that enabled what the report called "stabilising financial adjustment".

In Malaysia, bond markets remained stable, thanks to purchases by well-capitalised institutional investors, it said.

Common features of resilient countries included credible fiscal and monetary policies and financial regulation that limited excessive risk taking, the report said.

An open capital account enabling residents to move money in and out of the country and a flexible exchange rate regime also played a positive role, it said.

"A heavily managed exchange rate, on the other hand, may undermine residents' incentives to reduce outflows during sudden stops because an anticipated depreciation creates very strong incentives to send assets offshore, thereby exacerbating capital flow volatility," the IMF said.

The prospect of reduced US stimulus had forced central banks including those of Brazil, India, Indonesia and Turkey to raise interest rates or intervene in foreign exchange markets as their currencies plunged. Asian currencies rallied, led by Malaysia's ringgit and Thailand's baht, after the Fed's decision on September 18 to refrain from paring stimulus.

"[Malaysia] is much better prepared than it was during the Asian crisis," John Simon, the chapter's main author, said on Monday. "They had a very deliberate process of building up their institutions, their reserves and indeed they've been improving the ability of their financial institutions and their companies generally to go out and interact with the global economy."