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Message from ADB's President Contributors Acknowledgements Executive Summary and Recommendations Jeffrey D. Sachs, Masahiro Kawai, Jong-Wha Lee, and Wing Thye Woo Paper Summaries (full papers downloadable) International Monetary Advisory Group Global Financial Crisis, its Impact on India and the Policy Response Nirupam Bajpai To What Extent Should Capital Flows be Regulated? Maria Socorro Gochoco-Bautista The Case for a Further Global Coordinated Fiscal Stimulus Willem Buiter Managing a Multiple Reserve Currency World Barry Eichengreen From the Chiang Mai Initiative to an Asian Monetary Fund Masahiro Kawai An Asian Currency Unit for Asian Monetary Integration Masahiro Kawai The International Monetary System at a Crossroad Felipe Larrain B. Towards a New Global Reserve System Joseph Stiglitz A Realistic Vision of Asian Economic Integration Wing Thye Woo An Asian Monetary Unit? Charles Wyplosz Will US fiscal Deficits Undermine the Role of the Dollar as Global Reserve Currency? If So, Should US Fiscal Policy be geared to Preserving the International Role of the Dollar? Yongding Yu International Monetary Working Group International Reserves and Swap Lines: the Recent Experience Joshua Aizenman, Donghyun Park and Yothin Jinjarak The Future of the Global Reserve System Daniel Gros, Cinzia Alcidi, Anton Brender, and Florence Pisani Renminbi Policy and the Global Currency System Yiping Huang Will the Renminbi Emerge as an International Reserve Currency? Jong-Wha Lee Asia's Sovereign Wealth Funds and Reform of the Global Reserve System Donghyun Park and Andrew Rozanov Reforming International Monetary System Kanhaiya Singh Designing a Regional Surveillance Mechanism for East Asia: Lessons from IMF Surveillance Shinji Takagi

2. To What Extent Should Capital Flows be Regulated?

Maria Socorro Gochoco-Bautista

Stylized facts regarding capital flows in the last two decades show that the potential for crisis is great, given pro-cyclical capital flows. The global crisis and the resulting recession and low interest rates in advanced economies will increase the potential for more pro-cyclical carry trade flows to emerging market economies (EMEs). Both the volume and volatility of capital flows have increased, with “sudden starts” of capital outflows becoming more prominent in the recent period, in contrast with “sudden stops” of capital inflows which characterized crises in the past. Emerging market economies have become important players in international banking and capital markets as financial globalization proceeds. But they have become more vulnerable to changes in investor appetites and portfolio changes from mature economies as equity flows and short-term flows become more important than banking flows as was the case in the past.

Capital flows need to be regulated because unfettered trade in financial assets in the presence of distortions is not necessarily welfare-improving. To what extent they need to be regulated depends on the degree of distortions present in an economy and whether it is easier to remove these distortions and allow capital flows versus the difficulty of dealing with the distortions which makes such regulation necessary. It also depends on complementary policies that can be adopted to make capital more productive in an economy to increase welfare obtainable from capital flows. The fact is that many EMEs today are running current account surpluses rather than deficits as in the past means that there is less of a need for external finance. There remains the problem of recycling such surpluses to advanced economies such as the US that need them, which then return to EMEs in search of higher returns.

Having embraced economic liberalization, however, should not preclude efforts to find ways to reduce the potential damage from pro-cyclical capital flows through their regulation. Unfortunately, while capital regulation has worked in some cases, for example, to lengthen the maturity of flows, there is little evidence that such regulation alters the composition of flows nor work over extended periods of time. There is also little evidence that EMEs can be spared the effects of a large externally-initiated financial crisis no matter what they do. The lack of success in regulating capital flows by individual countries underscores the need for international cooperation in the design and implementation of such regulation of capital flows.

Under the current predominantly US dollar standard, there is a huge incremental demand for “safe” dollar assets that are reflected in perverse flows from the EMEs to the US and advanced economies. There is also little incentive for the US to weaken the dollar to correct its large deficit. However, as the reserve currency of the world, authorities in the US need to, and the rest of the world expect them to, maintain the strength of the dollar. The dollar standard also exacerbates pro-cyclical capital flows to EMEs such as those under carry trade. The adjustment burden tends to be shifted onto surplus countries to either continue to recycle their surpluses to the US and advanced economies and maintain the status quo, or to take on riskier assets for global adjustment to occur.

The radical solution to the problems of pro-cyclical capital flows and systemic crises would be to reform the global reserve system through the adoption of a supranational global reserve currency. Absent this, regulating capital flows may be regarded as a second-best solution. To be effective, such regulation should try to increase the policy space for countercyclical policy and requires international cooperation to raise the chance of success of measures adopted to regulate capital flows. To the extent that reforming the global US dollar-based reserve system could take time, and given continuing financial globalization, regulating capital flows becomes a necessary collective challenge.