Its reiterative use would make it loose effectiveness as a stabilizing tool, in addition to eroding the hedging incentives I mentioned before. Furthermore, it could encourage arbitrage against the monetary authority, which could destabilize the foreign exchange market. A circumstance is deemed exceptional and worthy of an intervention if one can foresee an overreaction in the foreign exchange market that is pushing the real exchange rate significantly away from its fundamentals. It is important that the intervention is consistent with the inflationary objectives, because otherwise it might hurt the credibility of monetary policy. Although interventions can be either sterilized or not, the inflation targeting regime together with the exceptional nature of the intervention means that, generally, a foreign exchange intervention must be sterilized. Therefore, monetary policy decisions can be made independently of the exceptional intervention. In addition, the purpose of the intervention should be to stabilize the foreign exchange market without pursuing a specific level for the exchange rate. In a context of capital mobility, sterilized interventions can influence the exchange rate via the portfolio channel and interest rate differentials. This occurs because it affects the relative supply of assets in domestic currency in the local market, signals future interest rate movements, or provides information about policy makers’ perception on the fundamental value of the exchange rate. In Chile, after the elimination – in December 1999 – of the exchange rate band and the adoption of the inflation-targeting regime, the Central Bank stated that exceptional circumstances may require an intervention in the foreign exchange market.

It is hard to conceive a general rule governing the use of capital controls to deal with massive capital inflows, but it is certainly more difficult to apply such controls in economies highly integrated to the world markets. Something that the evidence seems to suggest is that capital controls affect mainly the composition of the flows, not necessarily their magnitude. In that case, in order to affect the composition of international liabilities, in particular those intermediated by the banking sector, it would be more efficient to direct the eye toward financial regulation rather than to capital controls. In addition, macro-prudential regulations should be used to mitigate the procyclicality of capital flows. These measures could include BIS Review 72/2010  5  liquidity management policies, for instance imposing differentiated liquidity requirements for short-term and long-term financing flowing to banks or to other financial agents. Final remarks To conclude, we must first emphasize that global financial integration entails extensive benefits, as it allows to smooth expenditure fluctuations and to obtain resources to finance investments in countries with capital shortage. However, we have also learned that capital flows can be destabilizing, particularly when financial systems are fragile and macroeconomic policies inconsistent. Long-lasting boom periods have always presented challenges to macroeconomic policy making. Sadly, the passing from economic boom to a costly recession is a too recurrent experience for emerging economies, especially in Latin America.