Impacts of Capital inflows on Emerging markets
Capital Inflow is the actual increase in the available funds from foreign sources to aid in foreign development. It has led to international globalization where thus facilitating capital mobility from developed nations to the capital deficiency third world nations. In 2010, the United States (US) monetary authorities resorted to an unconventional monetary policy (Quantitative Easing-QE2) with the sole aim of stimulating its giant economy (the world’s largest economy).
This followed after its conventional monetary policy proved ineffective. In this scenario, the Central Bank of a country creates extra money to purchase bonds together with other financial assets for increasing the supply of money and the excess reserves in the banking system. It also leads to acceleration of prices of financial assets. US neither was the first country nor was it its first time to use such a policy. In early 2000s, Bank of Japan (BOJ) used such a policy to contain its increasing domestic deflation.
During the 2007-2010, the United Kingdom and US used had used the policy again as their interbank interest rates were close to zero.One of the risks associated with this policy is that it can lead to inflation especially if the banks are reluctant to lend the money to the needy investors (Jeanne, 2010).
While some scholars do advocate much for the acceptance of financial globalization, some countries have not yet seen or felt its benefits. To them, the word has lacked any meaningful definition. Financial globalization entails various world financial transactions, international trade, and accessibility of global financial services and encompasses all the nations across the globe, both developed and developing ones. Therefore, capital mobility should be encouraged and the idea of its restriction must be done away with in order to promote trade liberalization (Jeanne, 2010).
The flow of capital from one country to another is due to investment motives. Mostly the capitalinflows are to the third world countries that have been blamed for their failure to exploit the resources in their home countries. Capital inflows bring with them adverse effects to the emerging markets in which they occur. Though some economists argue that the negative impacts associated with capital inflows are cushioned out by the potential benefits (Fischer, 1997, p. 16), these effects have indeed far-reaching consequences on the economic status of the affected countries.
Capital inflows lead to the appreciation of domestic currency.Subsequently the profitability of investment in tradables goes down. Upon the appreciation of the currency, the exporters suffer since they gain little from their exported goods. Currency appreciation discourages private investors from committing their funds in investment projects.
Therefore, despite the fact that capital inflows boosts consumption, their impact on growth and investment is unbearable. This is very evident from the developing countries that for a long time have relied on capital inflows, as their countries’ economic growths remain stagnant (BIS, 2010).
Unless a nation has an appropriate mechanism to counteract the effects of domestic currency depreciation, the capital inflows can cause a nation very great mess. Countries that have managed to prevent real exchange appreciation like Chile, China and India have successfully had relatively stable economies and this was due to their aggressive capital controls (Akyüz, 2008).
Another impact of capital inflows is that the government capacities in the emerging markets are limited. Bearing in mind these countries desperately need thesecapital inflows, they have to comply with conditions imposed by the foreigners. For instance, the attainment of strong financial regulation and good governance in most cases is a prerequisite condition that has to be fulfilled by these emerging markets.
The countries that are capital-deficiency find themselves in uncompromising financial situations and because they need funds to finance their projects, they have to rely on these capital inflows. Eventually these countries end up operating on soft budget constraints for them to pay their debts which results from international finance accessibility (Akyüz, 2008).
Increased asset prices results from capital inflows. The cost of assets may be influenced by three variables namely: foremost is the inflows of exterior portfolio can influence the assets’ demand. For example, stock markets investment inflows consequently influencing the stocks’ values. Increased capital inflow in stock markets leads to their increased prices and anticipated returns on stocks decrease.
Subsequently, investors opt to channel their funds in other market assets like real estate and bonds thus increasing the prices of other asset prices. Secondly, swell in money supply because of capital or investment inflows improves asset prices’ investment. Thirdly, capital inflows may lead to an economic boom.
Decrease in world interest rates encourages consumption and investment as well as keeping down domestic interest rates that in turn may accelerate investment. These benefits the debtor country as it will induce income and substitution effects, which may lead to increased consumption (Rodrik & Subramanian, 2009)
Generally, the policy adopted by the US-Quantitative Easing is the same as capital inflow and the overall result is the increased money supply, which in most incidences the repercussions are more severe than the benefits. It is a temporary measure, which should be resorted to only as the last resort though it may not be applicable by the emerging markets from fewer developing countries. The most affected in these countries may be the final consumer of the manufactured goods who will suffer from inflationary effects, insufficient provision of some consumer goods (BIS, 2010).
Potential Causes of Capital Inflow
The causes of capital inflow are categorized into three: autonomous upward shifting of the domestic demand money function; increased productivity of domestic capital; and other foreign factors such as reduction of global interest rates. In the event that the recipient country’s exchange rate is flexible, the injection of foreign capital in that nation will end up bringing about appreciation of its currency.
This will make imported goods relatively cheaper, consumption will shift away from non-tradable and all of them will be aiming to eradicate inflationary pressures. Nevertheless, this may not happen within a country with fixed exchange rate that is not determined by the forces of demand but rather fixed by the monetary authorities of the nation in question. Holding all other things constant and having a more flexible exchange rate is not likely to experience inflation effects because of capital inflows (BIS, 2010).
Capital inflows due to sustained increase in demand for money will not be inflationary. However, if the increase is due to other reasons, the accumulation of external exchange reserves will cause the expansion of the monetary base, increased inflationary pressures and destabilization of the foreign position.
Slight asset price movements may be used in identifying the causes of capital inflow in countries with stable financial and stock markets. Increase in money demand lead to falling prices of domestic bonds; equities etc. and investors may change their investment portfolios. Inflows caused by decreased global interest rates or accelerating domestic production of capital will lead to increased prices of real and financial assets.
Capital inflows triggered by demand of money will be associated with increased money balances and not increasing inflation. Domestic prices respond slowly in countries with high inflation than the ones with low inflation. An upward shift in the domestic money demand will lead to the decline of foreign currency deposits when global interest rates go down. The capital inflows cause the recipient countries so many uncountable problems (Jeanne, 2010).
Problems caused by Capital Inflows
The major problem that can be caused by capital inflows is the destabilization of macroeconomic management. “This happens through the inflows that lead to the appreciation of country’s exchange rate system and the ones that lead to indebtness of the recipient country that has to be repaid continuously on the contractually agreed terms” (Hall &Levi, 2009, p. 131).
One more setback that is associated with inflows is that there may be assumptions in the stock market. One undesirable outcome of such speculation is decreased local savings. This is brought about by the emergence of uncertainties in the market.Inflows may also lead to the loss of local control and management of economic policies and decision making in economic forums.
This can even interfere with country’s sovereignty and independence because the recipient countries have to plead with investors or donors to get the much-needed inflows. Finally, some capital inflows are followed by the conditions for instance the privatization of state facilities which at times may be undesirable (Akyüz, 2008).
Policy responses to Capital inflows
Four policy measures can be adopted to combat the problems brought about by the inflows. They include exchange rate intervention, capital controls, sterilization and fiscal policy (IMF, 2010). Some are advantageous while others are disadvantageous. The first two are disadvantageous while the last two are advantageous.
Exchange rate intervention can be achieved by accumulation of foreign reserves required to prevent exchange rate from appreciating though this is not appropriate as it can lead to loose monetary conditions. Alternatively, a nation may decide to use its monetary authorities to maintain fixed exchange rate that still may not be advisable as it can sometimes lead to unfavorable economic conditions when laws of supply and demand are required to determine the exchange rate.
The second response that can be adopted is the capital control, which too is disadvantageous. This can be done by restricting the capital inflows, which may bring problems to the domestic nation if it does not have investment options or the required capital to invest due to constrained savings (Ostry, Et Al, 2010, p. 35). Sterilization and fiscal policies are appropriate response to adopt.
Sterilization involves the country’s Central Bank exchanging the domestic assets with high yields with the low yield reserves. Fiscal policy involves deliberate measures taken by the government to shift the production and consumption patterns in the domestic country to combat with the problems of increasing capital inflows. This is the most recommended policy measure, as it does not have adverse effects (Cardarelli, Elekdag & Ayhan, 2010).
Quantitative Easing is not an appropriate way of solving financial crisis. Though having been used by the United Kingdom, US and Japan at some times, it is not advisable for it tobe applied by the emerging markets. Empirical studies show that even the advanced nations have never relied on Capital inflows to achieve economic development.
Therefore, few developing countries can develop on their own to avoid the problems associated with these inflows. Again once encountered by these problems of capital inflows the application of suitable policies such as fiscal policies and capital controls is required.
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