CGFS report on capital flows and emerging market economies

Press release  | 
03 February 2009

The Committee on the Global Financial System (CGFS)1 today released Capital flows and emerging market economies, a report prepared by a working group chaired by Dr Rakesh Mohan, Deputy Governor of the Reserve Bank of India.

In principle, the flow of capital between nations brings benefits to both capital-importing and capital-exporting countries. However, very large flows can also create new exposures and risks. This has become apparent with the extraordinary surge in capital flows - total capital inflows reached $1,900 billion in 2007, four times as large as in the period before the Asian crisis - and the subsequent very large reversal of foreign investment in emerging market assets in 2008.

The failure to analyse and understand the risks, excessive haste in liberalising the capital account and inadequate prudential buffers to cope with the excessive volatility in more market-based forms of capital allocation have the potential to compromise financial or monetary stability in many emerging market economies. On the other hand, rigidities in capital account management can also lead to difficulties in macroeconomic and monetary management. 

Against this background, the report takes stock of the policy debate on this complex subject over the past 20 years. While many questions remain unsettled, Dr Mohan believes that the current global financial crisis provides and identifies vulnerabilities - especially those related to foreign currency exposures. These are well analysed in the report. 

He draws attention to four key points discussed in the report:

  • There is a "financial stability hierarchy" of capital flows. Many crises have clearly demonstrated that reliance on short-term, foreign currency denominated inflows can increase a country's vulnerability. Countries have often been led to rely on short-term foreign currency debt because their long-term intermediation capacities in the local currency were limited. During periods of low rates and easy credit availability, with inadequate appreciation of currency and liquidity risks, foreign lenders have also been keen to extend short-term foreign currency lending to emerging market economies.
  • Large foreign currency inflows have had major consequences for the liquidity of domestic financial systems. The report discusses the advantages and drawbacks of central banks' market and non-market instruments. It notes the complex interrelations between monetary policy, exchange rate objectives, forex intervention and domestic financial balance sheets.
  • There is a strong two-way link between capital flows and the resilience of the financial system. Capital flows do most good and least harm when domestic financial markets are developed and local financial firms are strong. At the same time, the greater presence of foreign investors should improve the operation of local financial markets.
  • The impact of the greater role of foreign banks. The shift from cross-border, short-term foreign currency lending to more sustained local currency lending through local financial subsidiaries has improved financial stability. However, if the source of funding for local subsidiaries continues to be borrowing in foreign currency from the international markets/the parent bank, rather than domestic currency deposits, risks to financial stability remain. Local supervisors need to be particularly vigilant with new and rapidly developing market instruments - especially where they allow opaque leveraged positions to be built up.

The main chapters of the report discuss:

  • Macroeconomic context of capital flows
  • Composition of capital flows and financial stability
  • Intervention, sterilisation and domestic financial intermediation
  • Capital flows and domestic financial markets
  • Banks and capital flows
  • Intermediation of private outflows of portfolio capital
  • Preliminary assessment of the global financial crisis and capital flows in 2008

The conclusion provides a summary of the report arguing that a combination of policies - sound macroeconomic policies, prudent debt management, exchange rate flexibility, the effective management of the capital account, the accumulation of appropriate levels of reserves as self-insurance and the development of resilient domestic financial markets - provides the optimal response to the large and volatile capital flows to the EMEs. How these elements are best combined will depend on the country and on the period: there is no "one size fits all".

Specific questions regarding the Report may be sent to the Committee on the Global Financial System by e-mail ( or fax (+41 61 280 9100). For further information or to request a printed copy, please e-mail

1 The CGFS was established by the Governors of the G10 central banks to monitor and examine broad issues relating to financial markets and systems with a view to ensuring monetary and financial stability. The Committee is chaired by Donald L Kohn, Vice Chairman of the Board of Governors of the Federal Reserve System.