Destabilizing movements of short-term capital

If countries allow total freedom of movement of capital two options to control these movements are available: (a) the exchange rate can be set, in which case the country loses control of interest rates which would fluctuate in response to capital movements; (b) the interest rate can be set, in which case the exchange rate against the country's currency would fluctuate in response to capital movements into and out of that currency in search of the highest return. From this perspective countries cannot permit free movement of capital and expect to maintain control over both monetary instruments.

During the 1980s the international capital markets challenged national governments, insisting on ever higher real interest rates as the price for avoiding flight of capital and inflationary depreciation of a currency. These difficulties came to a head in the 1990s with speculation against the European Exchange Rate Mechanism run without exchange and capital controls.

The growth in trade flows between countries is dwarfed in value by the financial flows whose destabilizing growth has increased over recent years. In 1991, for example, $7 trillion worth of financial derivatives were traded in the world's money markets. This market scarcely existed at the beginning of the 1980s.

Developing countries are increasingly exposed to the movements of external financing which results from their progressive integration into international finance. In the case of Latin America, for example, one important influence on short-term borrowing has been interest-rate arbitrage between the USA dollar rates and generally substantially higher rates in these countries domestic financial markets. The resulting inflows also included portfolio equity investment, much of it speculative and thus, like the short-term borrowing, potentially subject to reversal. An influx of capital in response to interest rate differentials shifts the mood of markets and encourages a further influx, which then acquires further momentum by putting upward pressure on the exchange rate and thus enlarging opportunities for profitable arbitrage. Hence the capital inflow may prove unsustainable. If a worsening of the external accounts forces a depreciation of the currency, there is a risk of further depreciation through financial outflows as arbitrage profits, dependent in part on a high exchange rate, are eliminated. This threatens government ability to control key economic variables.