The form that these flows take in many countries, short-term and foreign-currency based, further contributes to the building up of financial mismatches with potentially severe financial and macroeconomic consequences. Moreover, even before a  BIS central bankers’ speeches  3  crisis occurs, capital surges have macroeconomic impacts through the expansions in activity resulting from credit growth, the factor reallocations that may be associated with persistent exchange rate movements, and the inflationary or deflationary pressures that may arise from the combination of exchange rate pass-through and aggregate demand expansions. In cases where capital flows are not excessive and driven by fundamentals, the pursuit of macro and financial stability can be consistent with the inflation targeting framework and exchange rate flexibility, even though it may be accompanied by moderate exchange rate volatility and real exchange rate appreciation. Under these conditions, exchange rate flexibility helps the efficient reallocation of resources and thus becomes the first line of defense in avoiding the building up of risks. For example, the delayed appreciation of exchange rates to improved domestic conditions could be a factor that accelerates capital inflows to take advantage of artificially low asset prices. Therefore, a flexible macroeconomic framework geared to avoiding the buildup of overheating and that allows prompt asset price adjustment should be the main way to avoid excessive, especially speculative, capital inflows. But even if flows are not “excessive”, agents may undertake exposures that could be privately efficient, such as currency and maturity mismatches, but result in aggregate vulnerabilities.

All considered, the pursuit of macro and financial stability in the context of an inflation target regime may call for some exceptional departure from a fully floating exchange rate and a highly integrated international financial market. This can take different forms, as they may require the use of non-interestrate policy, such as reserve requirements on bank deposits instead of the conventional interest rate policy; a temporary reduction of the degree of financial integration, through the use of some sort of capital controls; or it can allow some exchange rate intervention, through the accumulation of international reserves in order to avoid excessive exchange-rate appreciation. I will comment on each of these options next. Using alternative monetary policy instruments to deal with inflationary pressures, such as reserve requirements on bank deposits, may prevent the undesired credit growth associated with capital inflows without affecting interest rate differentials. This seems to be the case of Turkey, Peru, Brazil, China and India, which have used extensive reserve requirements to deal with inflationary pressures in the current scenario. Other alternative is imposing a levy on foreign exchange borrowing by banks, as the one implemented in South Korea. However, this road is more appropriate when inflationary pressures come from excessive bank credit related to capital inflows than in other cases. When the surge in inflows comes not only from  4  BIS central bankers’ speeches  the banking system, these measures may only create disintermediation and the allocation of excessive risk in other parts of the financial system.