Emerging economies should avoid capital controls

BASEL, Switzerland (Reuters) - Emerging market economies (EMEs) should rely more on exchange rate flexibility and tighter monetary policy than capital controls to help achieve balanced global growth, the Bank for International Settlement said.

In an annual report published on Monday, the BIS said many EMEs are facing policy challenges as their strongly recovering economies attract capital inflows looking for higher returns.

This has created the temptation for policymakers to rely heavily on capital controls to limit the destabilising effects that some volatile inflows, or hot money, can cause.

But the BIS warned many forms of capital controls offered only temporary relief.

"Moreover, to the extent that they are effective, capital controls reduce competition in the financial system and distort the efficient allocation of capital and inhibit economic growth," the report said.

There is also little evidence that showed capital controls can help make an economy less susceptible to crises or reduce the real cost of such crises, it said.

The BIS said macroprudential measures can help limit the vulnerability of the financial system to volatile capital flows and alleviate some important policy dilemmas.

"A more promising and durable approach to addressing volatile EME capital inflows would be to strengthen the ability of the financial system and the economy to withstand them," the report said.

But in the end, in view of these policy challenges, the BIS said there may be no effective alternative to raising interest rates, allowing greater flexibility in exchange rates and reducing reliance on foreign exchange intervention.

"This approach is also essential in order to achieve an orderly medium-term macroeconomic adjustment and ultimately, balanced global growth."

The BIS said EMEs need to work with advanced economies on strengthening international monetary arrangements to ensure there is a sufficient supply of an international currency in the event of any subsequent crisis.

That international currency is almost certain to remain the U.S. dollar for the foreseeable future, it said.

(Reporting by Ian Chua; Editing by Toby Chopra)