Global financial cycle and liquidity management

BIS Working Papers  |  No 1069  | 
25 January 2023



The global financial cycle exposes emerging market economies to large fluctuations in capital inflows that tend to destabilise asset prices and macroeconomic conditions. In recent years, an influential line of research has advocated using capital controls to reduce the volatility of capital inflows and enhance macroeconomic resilience.


In this paper, we provide a different perspective on how emerging market economies can protect themselves from the ebb and flows of the global financial cycle. Our analysis is motivated by the observation that advanced economies also experience highly volatile capital inflows but are more resilient to them because of offsetting movements in capital outflows. In other words, when foreigners invest in advanced economies, local residents invest money abroad. And when foreign investors leave advanced economies, local residents repatriate their funds from abroad.


Our model sheds light on the reasons that underpin offsetting movements between capital inflows and outflows. When foreign capital moves into a country, asset prices increase. This provides an opportunity for local residents to sell domestic assets at high valuations and re-invest the proceeds abroad. When foreign capital leaves the country, local residents can repatriate their funds and buy back domestic assets at cheaper prices. By doing so, local residents make a profit and stabilise domestic asset prices. To enhance macroeconomic resilience, policymakers can thus encourage offsetting movements in capital flows rather than rely on capital controls to restrict capital inflows. More specifically, policymakers can subsidise the private accumulation of foreign liquidity when global financial conditions are buoyant or engage in foreign exchange intervention, particularly in countries that are less financially developed.


We use a tractable model to show that emerging markets can protect themselves from the global financial cycle by expanding (rather than restricting) capital flows. This involves accumulating foreign liquid assets when global liquidity is high to then buy back domestic assets at a discount when global financial conditions tighten. Since the private sector does not internalize how this buffering mechanism reduces international borrowing costs, a social planner increases the size of capital flows relative to the laissez-faire equilibrium. The model also shows that foreign exchange interventions may be preferable to capital controls in less financially developed countries.

JEL classification: F31, F32, F36, F38

Keywords: capital flows, foreign exchange reserves, sudden stop, capital flow management, capital controls