prevailing macroprudential regulation designed to tame purely domestic asset price booms. Furthermore, if capital inflow surges lead to prolonged far-from-equilibrium real exchange rates, they may have distortive and long-lasting effects on the domestic allocation of resources.<sup>**10**</sup> Magud and Reinhart (2006) pointed out four fears that motivate policy makers to be proactive in managing capital flows: fear of exchange rate appreciation, of hot money, of large inflows and of loss of monetary autonomy. Higher levels of the exchange rate could damage the competiveness of domestic industries. Sudden inflows of hot money pose risks of sudden reversals, increasing the volatility of exchange rates. “If capital controls and related macroprudential measures are seen not as instruments of exchange rate management but as part of a package of policies targeted at financial stability, then it is the _composition_ of capital flows that takes center stage rather than their volume” (CIEPR, 2011, p.11). However, sometimes the problem is not one of an undesirable composition of inflows, but their size. A surge in foreign capital poses risks of asset price or credit bubbles if the economy has limited capacity to absorb.<sup>**11**</sup> At the same time, cash-rich agents could be encouraged to excessive risk taking and herd behavior, what suggests that some restrictions or taxes on capital flows could be useful – including as a way to gain additional freedom in setting short-term interest rates.

A sequential approach to cope with surges of capital inflows is offered by Ostry et al (2010). As per macroeconomic concerns, policymakers should ask themselves whether the exchange rate is undervalued and should be allowed to float upwards, as a first step. If it is not the case, the country could start with a policy of accumulation of reserves, provided that increasing their levels is desirable. But if there is an inflationary concern, policy makers should sterilize these interventions.<sup>12</sup> If inflation is under control, another option would be simply to cut interest rates. As there are costs incurred by the sterilization process, there are limits beyond which it is no longer attractive to keep buying foreign currency. In this case, fiscal tightening may be an option to attenuate the external stimulus. If the scope for fiscal contraction is limited, then capital controls could be useful to deal with the situation.

In parallel, if capital inflows cause prudential concerns, the macroprudential toolkit may be more efficient and should be used before capital controls. If policy makers are able to identify the source of concern, a macroprudential measure could be better targeted than is the case for a broader restriction. As an illustration, if the concern is excessive borrowing from abroad or its impact on domestic credit growth,

> **10** Asset price booms and busts may be transmitted without actual capital flows, not only indirectly through synthetic operations that may not require cash transfers, but also through pure contagion of expectations and risk behavior. In the latter case, macro and microprudential tools as well as macroeconomic policies are obviously the means to deal with them.

> **11** Recently, e.g., “because the creation of new assets in developing countries will be slower than the increase in demand for them, the price of existing assets in those markets – equities, bonds, real estate, and human capital – are likely to overshoot their long-term equilibrium value. Recent history is full of examples of the negative side-effects that can arise” (Canuto, 2011b, p.1).

> **12** Garcia (2011) shows how sterilized interventions by the Central Bank in an inflation-targeting regime tend to have an expansionary effect on aggregate demand. This is e.g. the case when capital inflows correspond to a strong demand for domestic private assets. This means that full sterilization of domestic monetary impacts may ultimately need a local-currency bond purchase larger than the size of the original foreign exchange acquisition. See more on sterilization below.

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