Lately, the “dark side” of financial integration has increasingly come into focus. The global financial crisis was a vivid demonstration of what happens when the system flips over from stable to instability. And the prescribed treatment has created increasingly serious side-effects ever since. With monetary policy in advanced economies having been kept at ultra loose levels for over 5 years and still further unconventional monetary stimulus being embarked upon in some cases, the repercussions on the rest of the world are testing the limits of macroeconomic management, especially for emerging market countries. Large capital inflows have lowered long-term yields and compressed risk spreads across a wide range of asset classes, contributing to increased risk-taking. The marked rise in the co-movement of asset prices across countries, particularly in bond yields, is making it harder for policies to achieve desired financial conditions domestically. At the same time, upward pressure on exchange rates risks undermining export competitiveness, complicating the trade-offs between macroeconomic stabilization and financial stability. And should inflows reverse abruptly, the resulting asset price and exchange rate swings could induce broad contagion effects that prove disruptive to economic activity. In all this, the underlying concern is that integration has amplified the vulnerability of domestic financial conditions to external shocks, while limiting the effectiveness of the tools that policymakers have for addressing those shocks. This is not solely an emerging market problem. Indeed, the degree of co-movement in bond yields appears to be even stronger for advanced economies.

The need and benefits of living on reclaimed land have been accepted and the focus is on strengthening the infrastructure to sustain this. Similarly, financial integration is a choice. Countries decide to become financially integrated because the perceived benefits of doing so outweigh the costs. Moving forward sustainably requires going beyond coping with capital flows to living with them. This involves developing and leveraging on fundamental economic strengths to enhance countries’ resilience to external shocks. A diversified export base focused on high value-added products and services translates into higher margins and pricing power, and hence less sensitivity to swings in the exchange rate. At the same time, developing a firm domestic consumer base will solidify economies’ internal strength and lessen the dependence on external demand. Much can also be done on the financial side. Deep and liquid markets would help to absorb swings in capital flows without overly large price movements. The availability and widespread usage of risk management instruments, particularly foreign currency hedging, would mitigate the negative repercussions from asset price volatility. Outward capital flows by domestic investors can enhance stability as international asset holdings can provide an important buffer during periods of volatility. Last, but not least, limiting leverage in the banking system can go a long way in cushioning the economy from external shocks. In most cases, exchange rate flexibility will be an indispensible part of living with capital flows.