If the exchange rate level that is intended to be defended is inconsistent with economic fundamentals, massive inflows can be created that will sooner or later appreciate the domestic currency in real terms. Investors take advantage of a relatively cheap currency to enter capitals before the appreciation occurs, and get a significant capital gain. Hence, within a framework of capital mobility, foreign exchange flexibility avoids one-sided bets over the exchange rate. 2  BIS Review 72/2010  Furthermore, an inflation targeting regime with a floating exchange rate provides a good buffer to smooth the impact of changes in capital flow cycles. The same monetary policy reaction to a currency appreciation that reduces inflationary pressures, allows limiting the currency appreciation process by narrowing interest rate differentials. A second line of defense is a symmetrical opening of the financial account. Many countries have approached financial integration by opening their economies to capital inflows, still holding on to their constraints to local capital outflows, especially from institutional investors. After a while, and as a reaction to massive capital inflows, restrictions on outflows are allowed to become less stringent. However, this is normally done too late and signals fear of capital inflows. In fact it can even reinforce the phenomenon, particularly when the exchange rate has reached unsustainable levels. Having a well regulated and developed financial system is a requisite for properly accommodating exchange rate and capital movements. This is because it makes it easier to prevent exchange rate fluctuations from destabilizing financial conditions.

In the future, given the weaker cyclical behavior of developed economies, these differentials will probably increase, providing renewed incentives for capital flows to emerging economies. In this case, the appearance of short-term interest rate differentials would be a symptom of cyclical divergence between developed and emerging economies. Furthermore, in the coming years, the fundamentals of economic growth across economic zones, together with the deleveraging process in the developed world, could also encourage more capital flows into emerging economies, even if short-term turbulences in financial markets delay or push back its occurrence. The fact that capitals are flowing into emerging economies with renewed vigor does not mean that all such flows are being absorbed in net terms. If inflows are counteracted by comparable outflows, no significant impact should be felt either by output or the exchange BIS Review 72/2010  1  rate. Thus, for the purposes of analyzing the exchange rate, it is important to examine net capital flows. Given the balance of payments identity, net capital inflows must equal the current account deficit plus the hoarding of international reserves, the latter being equivalent to capital outflows conducted by the central bank. In any case, the prices of assets in the economy may be affected by gross flows depending on their composition, which matters from a financial stability point of view. More complex scenarios are those where capital inflows trigger a credit and a domestic spending boom by financing the leveraging of households, firms or government.