International capital flows—which represents the movement of money across borders for trade or investment—are crucial for economic development in Latin America. This is because they help bring in new technologies and managerial best practices, and supplement insufficient domestic savings to finance investment.
Yet, Latin American countries—as with many emerging market economies—are prone to boom–bust cycles, where fluctuating and volatile capital flows coming in and out of countries can disrupt business development and investment, and therefore create substantial economic costs.
Our latest research from the Regional Economic Outlook: Western Hemisphere report, finds that policies can help countries mitigate the costs and duration of sudden stops in capital inflows.
Recent trends in capital flows
Net capital flows (the difference between capital flowing in and capital flowing out) to Latin America have followed different dynamics compared with other emerging market economies over the last decade. While other emerging market economies saw a steady decline in net capital inflows as a share of GDP since 2007, capital flows to Latin America have declined much less, although they have been volatile. Between 2008 and 2018, net flows fell by less than 1 percentage point of GDP in the region, compared to more than 4 percentage points of GDP in other emerging market economies.
Changing dynamics
With the commodities price super-cycle over, other factors are playing a larger part in explaining capital inflows to the region. Our analysis finds that capital inflows to the region have become more sensitive over the last six years to changes in: global risk aversion; growth differentials relative to advanced economies, and U.S. interest rates . This change contrasts with those for other EMEs, where the sensitivity of flows to the different drivers has remained broadly stable.
Our research suggests that there is a higher likelihood that countries in the region may experience sudden stops in capital inflows going forward if economic growth continues to falter or if global financial conditions suddenly tighten. Moreover, the economic costs associated with sudden stops in capital inflows could be amplified by domestic vulnerabilities such as large fiscal imbalances.
Vulnerabilities to Sudden Stops
Although certain fundamentals such as levels of liability dollarization (i.e. levels of foreign currency-denominated debt), fiscal deficits, and public debt in most Latin American countries are currently weaker than they were prior to the sudden stop of capital flows in 2008-2009, these vulnerabilities remain broadly contained. Why? Because most countries in Latin America have adequate reserve buffers relative to their external financing requirements and moderate levels of liability dollarization. This helps protect countries from economic disruptions caused by volatile capital flows.
How to respond to a sudden stop?
Our analysis shows that policies can affect the duration and costs of sudden stops in capital inflows. Floating exchange rate regimes drastically reduce the duration and related output losses of sudden stops. The effects are quantitatively large: a flexible exchange rate regime increases the probability of exiting a sudden stop by at least 60 percent relative to a fixed exchange rate regime.
Monetary policy tightening also seems to help, with a rise in real interest rates of 1 percentage point reducing the duration of a sudden stop by close to 5 percent.
These results reinforce the view that exchange rate flexibility mitigates the impact of external shocks and do not support the idea that tightening monetary policy during crises is a bad idea.