October/2012 n o. 32 research brief The International Policy Centre for Inclusive Growth is jointly supported by the Bureau for Development Policy, United Nations Development Programme and the Government of Brazil. By Raquel Almeida Ramos 1 Dealing with Exchange Rate Issues: Reserves or Capital Controls? 1. Introduction Developing countries’ positions regarding the capital account have changed significantly in the last decade. After a period of wide liberalisation, country authorities have now been constantly increasing their policy toolkit with new instruments to intervene in the capital account and limit the consequences of excessively volatile capital flows. This change is a response to the increasing size and volatility of capital flows, which is associated with the process of financialisation that has been taking place in recent decades, where financial actors and motives have assumed more important roles. The increasing magnitude and volatility of finance-related flows are clearly shown in Figure 1, which presents the net financial flows excluding Foreign Direct Investment (FDI) received by developing and emerging countries since 1990. 2 Figure 1 Net Private Financial Flows Excluding FDI: Emerging and Developing Economies, 1990–2011 (US$ billions) Source: UNCTAD 2011, updated. Based on IMF, World Economic Outlook, April 2011 database. The increases in the scale and volatility of financial flows have amplified their importance in determining exchange rates, compared to the impact of trade-related flows. This increased relative importance of finance-related flows has, however, brought important exchange rate problems: as these flows are more volatile and procyclical, issues of exchange rate volatility and misalignment have being happening more often. The exchange rates of developing countries already tend to experience higher volatility due to the specificities of finance-related flows to these countries, which flow in at periods of high liquidity internationally, but flow out at the smallest sign of crisis due to fear of facing important losses when re-converting the capital into the funding currency (the markedly different pattern of flows at times of crisis can also be seen in Figure 1). The impact of exchange rate volatility and of exchange rate misalignment also tend to be more important in developing countries due to features such as high exchange rate pass-through to inflation, high liability dollarisation, and higher reliance on the export of products whose competitiveness is price-based. Moreover, the impact of exchange rate volatility on the level of uncertainty—and, therefore, on economic activity—is higher in countries where there is greater volatility, such as developing countries. In this context of finance-related capital flows assuming an increasing role in determining exchange rates, and due to the problems of exchange rate volatility and misalignment, developing countries have been implementing different capital account policies. The following sections of this Policy Research Brief analyse two of these policies: the accumulation of reserves, and capital controls. 3 The final section presents concluding remarks. 0 1 2 3 4 5 6 7 8 9 10 ‐300 ‐200 ‐100 0 100 200 300 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Mexican crisis Crisis in East Asia, Brazil and Russia Argentinean crisis Rumours on interest rates in Japan Global financial crisis European debt turbulence