Inflation is defined as the debasement of a currency, especially as compared to the prices of the goods and services that currency is used to purchase. Capital inflow represents the investment in a country, often a developing country, from outside institutions, often in different currency zones. Although developing countries want outside investment, they are often wary of the capital inflow it entails, fearing inflationary consequences.
Too Much Money
One catchphrase often used to explain inflation is "too much money chasing too few goods." Capital inflow causes an increase in the foreign reserve accounts at domestic institutions. Over time, these reserves will be employed to buy the local currency, possibly expanding the local currency base without a corresponding increase in production. In the late 1980s and 1990s this situation arose in several countries, including Chile, Columbia, Indonesia, Korea, Spain and Thailand.
Sterilization
In principle, capital inflow need not lead to inflation. It may be "sterilized" by the right domestic monetary policies, as noted in a March 1997 report on the subject for the International Monetary Fund. The report, by Jang-Yung Lee, noted that sterilization often takes place through "the use of open market operations, that is, selling Treasury bills and other instruments to reduce the domestic component of the monetary base."
Difficulties with Open-Market Sterlization
One problem with an open-market sterilization policy is that it can prove too successful and self-defeating. It can raise interest rates to a degree that stimulates further capital inflows. Capital inflow often takes the form of a "carry trade," in which international investors borrow money where interest rates are low and lend that money out again in countries where the interest rates are high, pocketing the spread. The robust carry trades of recent years have meant that inflows can increase almost immediately upon any rise in rates stimulated by a country's central bank.
Other Tools
The sterilization of capital inflows can be approached differently. The central bank might increase the reserve requirement -- the amount of capital that domestic banks have to hold in readiness. This effectively reduces the money supply and may compensate for the inflow without stimulating more inflow. Some countries have varied the reserve requirements depending on the degree to which the domestic institution is involved in borrowing from foreign institutions. This is considered an indirect form of capital control. A more draconian move is simply to impose direct capital controls; governments sometimes simply tell their regulated institutions not to borrow as much cash from foreigners. This can backfire, though, hurting development.
