such speculative flows are volatile by nature, they can impair the orderly functioning of the financial markets. when investors exit from securities markets abruptly in a herd, stock and bond prices get affected, and when investors take the redemption proceeds out of the country, the exchange rate gets affected. should the central bank intervene to stabilize the forex market, the resultant tightened liquidity can affect the money markets. thus, speculative flows affect all financial markets – the securities markets, the forex market, the money market and the credit market, with contagion spreading from one market to another rapidly. if not contained, these swift developments can threaten financial stability and lead to output and employment losses. managing capital flows 5. surely, capital flows are important to meet the investment needs of emes. problems arise when the flows are largely in excess of the economy ’ s absorptive capacity and also when they are highly speculative in nature. emes have responded to managing the adverse macro impact of volatile capital flows through a variety of policy actions. stylistically, these can be categorized into three options. the first option is to do nothing ( exchange rate option ) in which case the exchange rate will appreciate. the second is to allow the flows to come in but intervene in the forex market ( reserve accumulation option ). the third option is to deploy capital controls. typically, emes have adopted a mix of all the options. let me briefly discuss the implication of these options. the option of exchange rate adjustment 6. the most straight forward option for the central bank is to allow flows to come in without any intervention. however, when capital inflows are large, this can lead to currency appreciation unrelated to fundamentals and trigger a “ dutch disease ” syndrome. experience has shown that a flexible exchange rate system is prone to overshooting, and this has engendered the “ fear of floating ” among many countries. the option of reserve accumulation 7. the second option for a central bank, confronted with a surge of capital flows, is to intervene in the foreign exchange market to dampen disorderly movements of the exchange rate. this will result in accumulation of foreign exchange reserves and release of additional liquidity into the system. if left unsterilized, the additional liquidity so generated in the system will have potential inflationary implications. typically central banks have sterilized the flows, either partly or fully, using a variety of tools including open market operations, tightening the access of banks to the discount window,

is not yet complete and differences in views / perceptions / experiences need to be accommodated. within this advisory role, even - handed treatment, in the sense that sources of volatility and potential vulnerability are given as much emphasis as the issue of capital controls, is important. conclusion 25. in its january 28, 2010 issue, the economist said, “ capital, like water, tends to flow around such obstacles ( taxes ). try to dam its movements at one point, and slowly but remorselessly, it will find its way around. ” to learn to “ dam ” the flows so that the benefits of capital flows exceed their costs remains an intellectual and policy challenge for emes.