Capital mobility brings many benefits to an economy, but this can also create instability and worsen crisis, Taiwan central bank governor Fai-nan Perng wrote in an article released by the central bank on Monday.
In a number of countries, international capital flows have been closely linked to financial crisis, he said in the article that was published in The Banker magazine's September issue. While, capital movements in the form of foreign direct investment create a win-win situation for both investing and recipient nations, short-term capital is highly volatile, he noted.
"Large and sudden inflows of foreign capital lead to exchange rate overshooting, loss of trade competitiveness, domestic credit booms and asset price bubbles, all of which can elevate systemic risks and create financial fragility," Perng wrote. And once the economic and financial conditions start to deteriorate, money flows out with devastating consequences, he said.
The central banker urged Asian nations to set up a formal regional exchange-rate coordination mechanism so that a stable currency relationship can be established. "Regional exchange-rate stability is conducive to promoting economic and financial stability," Perng said. When exchange rates are stable, lower transaction costs and reduced uncertainty will boost growth in intra-regional trade and investment, he added.
For small economies with deregulated capital accounts, a better option would be to keep the nominal exchange rate flexible and permitting the real exchange rate to reflect economic fundamentals, said Perng.
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