Question

The mobility of international capital flows is causing emerging market nations experience instability in their economies. With free floating exchange rate market is beyond the control of the country's central bank or government. The economic results are likely to be an independent monetary policy, free movement of capital, but less stability in the exchange rates.

What would you advise governments under such circumstances concerning improvements in their monetary system, if they want to provide more stable political, economic and social environment?

Answer 1

With the intensification of economic globalization and greater integration of world economies in post-cold war era, there have arisen issues related to flow of hot money into emerging market economies and sudden withdrawal, causing a lot of instability. Emerging market economies like India, become attractive destination for Foreign Portfolio Investment as the interest rates available in these countries are generally higher than the ones available in advanced economies.

Under free floating market exchange rates, the central bank is not allowed to manage the foreign exchange rate and is completely determined by the laws of demand and supply. In such scenario, the exchange rates become volatile as per the inflow or outflow of hot money.

The government in these countries in order to maintain stable environment have to ensure the stability of financial markets and foreign exchange market. The right kind of monetary policies have to be adopted for the same.

• Countries can rationally judge if the full capital account convertibility be allowed or not. The criteria like, stable rate of inflation, low Fiscal and Current Account Deficit should be taken into consideration before going for full capital account convertibility. This will ensure averting too much risk.
• More pro-active regulatory role of financial market regulators and central bank
• In long run, these countries can discuss and negotiate on the ideas like Tobin tax that will tax short term trading in foreign exchange market
• Central bank can exercise the policy of sterilisation where it will offset the inflationary impact of inflow by sucking up the extra liquidity by selling government securities
• With prudence, countries can also strengthen their domestic monetary policy by better adjustment to economic cycles and optimum interest rate adoption

Though the globalisation of capitalist economy has brought capital and investment to capital hungry emerging economies but at the same time these often lead to instability and crisis, which needs cautious policy calibration to be handled.