Policy Issues in Market Based and Non Market Based Measures to Control the Volatility of Portfolio Investment

Valpy FitzGerald

QEH Working Papers from Queen Elizabeth House, University of Oxford

Abstract: The wave of financial crises in emerging markets since 1995 has led to increasing concern as to the consequences of the instability of international portfolio capital flows. The leading industrial countries are in the process of constructing a new 'global financial architecture'. The causes of the growth and volatility of short term portfolio capital flows towards emerging markets are to be found in systemic characteristics of global financial markets, particularly the way in which investment funds are managed in order to confront uncertainty. Securities markets in developing countries are both narrow and shallow, leading to considerable instability in the face of foreign capital flows. Developing countries have maintained and adopted measures to control the volatility of portfolio flows. These controls are based on 'price' measures, particularly taxes, which act by changing the incentives to market participants. In contrast, 'quantity' measures have become less common. The use of complex financial instruments and offshore financial centres has made these controls less difficult to evade. None the less, the empirical evidence shows that marked-based measures are an effective means of balance of payments stabilization when combined with active monetary intervention. Open-market operations have proved quite successful in this regard, and can be complemented by the active use of reserve requirements and public sector deposits. Domestic regulatory systems may also be important supportive factors. The stabilization of portfolio flows and the lengthening of maturities cannot be achieved by individual developing countries acting in isolation. The existing 'international financial architecture' is mainly designed to prevent international bank failures; greater coordination between securities authorities is required due to the systemic instability of global capital markets. This could be supported by appropriate multilateral investment disciplines and cooperation between tax authorities.

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