The unrenumerated reserve and net capital flows: Chile in the 1990s

Abstract

In the 1990s, Chile suffered the effects of a surge in external capital inflows that canie to a sudden stop towards the end of the decade, despite its concentration in flows considered to be stable, implying that an appropriate composition of capital flows is not by itself adequate protection against capital flow volatility. The surge in capital flows responded to push factors associated with the supply of foreign financing that narrowed the spread between domestic and external returns. The unremunerated reserve requirement (known as encaje) helped to offset the push factors by widening the spread and restraining net capital inflows, particularly short-term, thus gaining additional room for monetary-policy manoeuvre. An early elimination of the encaje during the capital inflow surge would have boosted the inflows still further, thus aggravating macroeconomic imbalances. An intensification of the encaje, however, would have had limited marginal effectiveness due to circumvention and the bound imposed by short-term inflows, already close to zero. A more effective strategy would have been to apply the encaje on a wider basis, thus avoiding circumvention, or to complement its application with additional restraint on fiscal policy.