Will Self-Protection Policies Safeguard Emerging Markets From Crises?

Abstract

This paper addresses the usefulness of several proposed domestic measures for protecting emerging market economies against financial crises. These new proposals go beyond traditional macroeconomic policies and include raising foreign currency reserves, establishing contingent lines of international credit, taxing short-term foreign capital flows, and instituting prudential capital controls. We primarily focus on the role of liquidity enhancing measures for managing readily reversible international capital flows and briefly discuss capital controls as an alternative or complementary policy to prevent financial crises. Our analysis relies on three premises. Financial crises may be a by-product of domestic financial reform and international capital market integration and not always the consequence of fundamental inconsistencies in macroeconomic policies. Freely floating exchange rates are difficult to achieve in practice. Near-term measures may be necessary for managing capital flow volatility in addition to sound fiscal and monetary policies during financial liberalization. We reach three main conclusions. Safeguards impose costs on the domestic economy either by raising the cost of capital or by reducing the flow of international capital that may be offset by the benefits of reducing the frequency or severity of financial crises. Liquidity enhancing measures are most appropriate when crises arise as one possibility among ‘‘multiple equilibria.’’ The design of self-protection policies is likely to involve a combination of measures that is country specific.