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IMF Says Local Investors Can Curb Capital Flow Volatility

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.

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 today. That showed policy makers have 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 U.S. Federal Reserve phases out its monetary stimulus. The Fed’s surprise decision earlier this month not to pare its $85 billion in monthly asset buying for now is leaving these nations 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 called “The Yin and Yang of Capital Flow Management: Balancing Capital Inflows with Capital Outflows.”

Foreign Assets

“Rather, as international capital flows dried up, domestic residents stepped in to replace them by drawing down their own foreign assets,” according to the IMF.

Today’s report focused on Chile, Malaysia and the Czech Republic, showing how they learned from past crises to adopt new policies enabling what the report called “stabilizing financial adjustment.”

In Chile, private pension funds, which hold about 40 of their assets abroad, repatriated some during the global turmoil, helping offset the reduction in foreign investors’ inflows, according to the report. In Malaysia, bond markets remained stable thanks to purchases by well-capitalized institutional investors, it said.

Common features of resilient countries include credible fiscal and monetary policies and financial regulation that limits excessive risk taking, according to the report.

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

Heavily Managed

“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 U.S. 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 Sept. 18 decision 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 at a press conference in Washington today. “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.”

Synchronized Output

In a separate chapter, the IMF said that countries’ outputs were the most synchronized since World War II during the 2008 turmoil.

“Spikes in regional and global output correlations tend to occur during financial crises, but when the crisis occurs in an economy like the United States -- which is both large and a global financial hub -- the effects on global output synchronization are disproportionately large,” according to the report.

While the correlation has now returned to pre-crisis levels, “a large financial shock could again induce the world’s economies to rise and fall in tandem,” according to the fund.

A global financial institution could still fail as progress on making the system safer is yet incomplete, it said.

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