With the purpose of increasing their liquidity safeguards and stabilizing real exchange rates, official reserves in emerging economies, accumulated through sterilized interventions, precluded current account adjustment, artificially boosting tradable sector growth. This led to global imbalances and, so the argument goes, facilitated (or even caused) global financial unrest. BIS Review 124/2010  1  The above argument depends on whether capital inflows to emerging economies, which were indeed substantial in 2006–2008 (see Figure 1), are driven primarily by interest rate differentials or by medium term growth prospects. It is noteworthy to see how these interest rate differentials have evolved over time. Figure 2 plots (simple) average monetary policy rates for a group of developed and emerging economies, as well as Chile. It is striking that, whereas on average it stood at 440 basis points (bp) between January 2006 and July 2008, now it is barely 50 bp lower (390 bp). Intriguingly, market expectations for interest rate differentials hover between 400 bp and 450 bp over the next year. It would require substantial sensitiveness to interest rate differentials to make the argument that these are the main drivers of capital inflows. Moreover, the decade from 1996 to 2005 witnessed an average differential above 1000 bp, affected of course by risk premia, but still indicates that crude short-term interest rate differentials by themselves are not suggestive of substantial capital inflows. In terms of growth prospects, the picture is markedly different. Figure 3 presents IMF’s past data and forecasts for economic growth in developed and emerging economies.

Naturally, a booming economy, with a widening current account deficit, persistent appreciation and low inflation may need some stabilization if the expansion is deemed to be unsustainable. Fiscal policy could help, but unfortunately it is not always available, especially in countries with a weak fiscal history. Another tool, with weak evidence supporting its  2  For further discussion on the use of monetary policy to affect asset prices, in particular in the context of inflation targeting in open economies, see De Gregorio (2010b). 3  In economies following inflation targets is important that the intervention be coherent with the inflation outlook to avoid undermining credibility. Intervention can also be part of unconventional policies to reach the inflation target when interest rates are close to the zero lower bound. BIS Review 124/2010  3  effectiveness, is capital controls. 4 Regardless of whether they are effective or not, they may hide policy distortions. For example, policymakers thinking that capital controls are effective at insulating the economy from capital inflows, may tighten monetary policy to slowdown the expansion, but instead induce further inflows that look for loopholes to avoid the controls. For this reason I think that a more promising avenue is to look at the impact of capital inflows on financial stability. Indeed, many of the booms in asset prices and activity that come with capital inflows are caused and amplified in the financial system. Capital inflows and financial stability From the macro point of view, I have emphasized currency risks associated to capital inflows.