Capital inflows bring significant real and financial benefits, risks can be managed: report

• An increasing share of foreign capital is channelled through portfolio investors and other non-bank financial intermediaries, shifting the risks associated with capital flows.
• Improvements in emerging market economies' fundamentals increased the importance of cyclical factors as drivers of capital flows.
• While macro-prudential measures, occasional foreign exchange intervention and liquidity provision can help mitigate risks, they are no substitute for structural reforms. 

Richer data and more sophisticated methods of analysis show capital flows offer clear benefits for most countries and that the risks posed, while significant in some cases, can be managed using policy tools, a new report finds.

The report by the Committee on the Global Financial System, which monitors financial sector developments for central bank Governors, said macro prudential measures, occasional foreign exchange intervention and liquidity provision mechanisms are no substitute for structural reforms, however.

Changing Patterns of Capital Flows shows how risks have evolved over the past decade due to the rising importance of portfolio investors and other changes in the institutions and infrastructure through which capital flows are channelled, shifting from bank-based to market-based funding. 

The decade following the Great Financial Crisis of 2007-09 saw significant changes in the volume and composition of capital flows, including in the pipes that channel them.

In many countries, portfolio investors have surpassed banks as the largest source of foreign credit. Other changes include the international expansion of banks and investors based in emerging market economies (EMEs), which has also broadened the role of public sector investors in international capital markets.

The report, prepared by a Working Group chaired by Gerardo García López (Bank of Mexico) and Livio Stracca (European Central Bank), also assesses the effectiveness of policy tools for managing the risks associated with extreme shifts in capital flows.

It looks into the impact of the Covid-19 crisis, when portfolio flows to EMEs initially reversed with unprecedented speed and magnitude, and finds many EMEs had enough policy leeway to implement countercyclical policies to smooth the adjustment to the shock.

The Covid-19 crisis highlighted the critical role played by the global financial safety net, as well as the importance of developing a better understanding of the joint impact that policy tools have on capital flows.