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How do we prevent future financial crisis in emerging markets?

As we learned as early as the late 1990s, international capital flows can create significant financial instability in emerging economies. Does this make it optimal to impose capital controls? Or should policymakers rely on domestic macroprudential regulation in their quest for greater financial stability?

Anton Korinek, Assistant Professor at the Department of Economics at Johns Hopkins University, shows that it is desirable to employ both instruments to mitigate contractionary exchange rate depreciations. Macroprudential regulation reduces the amount and riskiness of financial liabilities, no matter whether they are financed by domestic or foreign lenders, while capital controls increase the aggregate net worth of the economy by reducing net inflows. Both types of policy measures can make the economy more stable and reduce the incidence and severity of crises.

Korinek’s research suggests that it is optimal to impose capital controls and macroprudential regulation that amount to a 2% tax on debt flows, or equivalent quantity regulations. In advanced countries where the risk of contractionary exchange rate depreciations is more limited, the role for capital controls subsides. However, macroprudential regulation remains essential to mitigate booms and busts in asset prices.

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