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IMF concerns on surging capital inflows – Justified?

Emerging markets look very attractive to investors, especially given the lagging effects of the financial crisis and uncertainty around regulatory oversight in developed markets. As inflows of capital is rising into these economies the local authorities are wary of “hot money” floating in and out of their financial markets. The developing markets are learning from the experience of mature economies and heeding the lessons.

The International Monetary Fund is getting apprehensive, fearing a set of restrictions on capital movements in some of the faster growth countries. IMF, traditionally a proponent of unrestrained capital flows across sovereign borders, has reason to re-examine the modus operandi if the ultimate
goal is to promote global financial stability.

There is a certain capacity in any economy to assimilate additional capital and deploy them for productive use to generate new wealth. Any excess capital may find its way into more speculative uses and contribute to waste and instability. The crises in Russia, Korea and Southeast Asia over the last two decades all resulted in significant loss of wealth following asset inflation and decline in GDP when capital seeking quick arbitrage opportunities was left unregulated.

The proposition that an economy can be managed for growth by stimulating domestic demand through easy credit while securing foreign capital inflows with higher returns to outside investors has not been validated in the history of developing countries.

To the contrary, foreign capital seeks short-term returns through asset turnover, especially in unsupervised emerging financial markets. The near bankruptcy of Dubai, with inbound oil revenues flooding into luxury real estate merits a close look as case study.

The experience and evidence defy official IMF dogma. Capital must flow at a pace that allows for emerging markets to invest new funds locally and create jobs that help reduce the wealth gap rather than pursue asset arbitrage opportunities. Rapid in-and-out streams of capital raise merely illusions of liquidity. They do not expand available credit to support real growth.

As each government develops policies to promote real growth in their domestic economy capital flows will be subject to tighter scrutiny. Smarter regulation in fast growing markets may help stabilize the international financial system, as liquidity in their physical economy becomes more predictable.

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