Capital Flow Volatility and Systemic Risk in Emerging Markets: The Policy Toolkit

As the global financial crisis has shown, reaping the benefits of financial development and international financial integration without incurring large risks remains a key challenge for many countries around the world. The financial system is inherently procyclical, that is, it tends to amplify the business cycle. Faced with a positive shock, financial institutions and markets can behave in the same manner, fuelling asset price and credit booms, and leading to a generalized expansion of economic activity. When the cycle turns, asset prices decline, credit gets reduced, and the economy can slow down. In the extreme, disturbances can lead to financial crises with major real sector dislocations and large fiscal costs. This procyclicality and risk of financial crises importantly relates to various aspects of international financial integration, with capital flows often being quite volatile. In advanced countries (ACs), the buildup in banking systems’ vulnerabilities prior to the recent crisis took place through complex chains of credit intermediation and involved large gross capital flows. Global banks (particularly European banks) were key players in this process, raising funds on U.S. wholesale markets and then lending these funds back to U.S. residents through purchases of securitized claims on U.S. borrowers, mostly related to residential mortgages (Shin 2012). Although net capital inflows—that is, the net of gross inflows and outflows—were relatively small, gross exposures ended up very large.1 The shock