Financial Contagion and Volatile Capital Flows

Liberalized capital accounts and financial integration can enrich a country’s welfare as long as they are appropriately coordinated with the adequate strengthening of policy frameworks. Otherwise, volatile capital flows and financial contagion, promulgated by capital account liberalization and financial integration may lead to domestic macroeconomic and financial challenges via the transmission of international shocks into an economy that is highly vulnerable to external shocks. Thus, economies face a key challenge as to how to reap the maximum benefits from using capital inflows to enhance economic growth while minimizing their associated risks. Obviously, both financial contagion and volatile capital flows should not be seen as primary reasons for countries to de-liberalize their capital accounts. Instead, policy frameworks should be strengthened to better manage volatile capital flows. Although there are no magic solutions to effectively manage capital flow surges, countries need a conceptual framework to manage volatile capital flows to enhance their resilience to external shocks. The “capital flow management” framework may include a package of available policy options including macroeconomic policies, prudential measures and capital controls. Macroeconomic policies have to be the primary response to volatile capital flows. Since capital flows are commonly pro-cyclical and much more volatile, counter cyclical macro policies can essentially smooth out the business cycle. Beyond macroeconomic policies, authorities have available conventional prudential regulations and capital controls to manage the risks from volatile capital flows. When financial sector supervision is efficient and effective, prudential measures are the obvious choice. Capital controls are an essential component of the policy toolkit in dealing with capital flows in certain circumstances. In all circumstances, structural reforms to improve the capability of the economy to absorb capital inflows by deepening domestic financial markets, are always to be encouraged.