Capital flows to the emerging countries have been trending upwards since 2003, driven by the significantly greater growth potential of these countries relative to the developed countries.  Since spring 2009, indeed, capital inflows have recovered the peaks registered in 2007-2008, when they became so massive that several emerging countries took steps to regulate them more effectively. They exceeded even those peaks in the third quarter of 2010.

Emerging markets capital inflows are to a large extent reversible. The brutal halt to capital inflows between October 2008 and February 2009 offers a striking illustration of this, but they have remained volatile since that time. The pace and direction of these flows depend in particular on investors' risk tolerance. When risk aversion abates, capital once more starts flowing to the emerging markets due to their distinctly more attractive yields.

The instability of capital flows creates economic policy dilemmas for the emerging countries. In particular it puts constraints on the central banks in the conduct of their monetary policy. Recently observed capital inflows are also fuelling fears of asset price bubbles, overvalued exchange rates and/or ballooning currency reserves. These risks are at work, mainly in Asia and Latin America.

Brazil's imposition of a tax on short-term capital inflows (portfolio investments) in October 2009 has sparked a debate on the need for better regulation of capital flows. The International Monetary Fund (IMF) has recently shifted its stance on this issue, spelling out cases in which regulation may be appropriate, supplementing economic policy measures. In such cases, this may involve either stricter prudential regulation or capital controls, provided these do not compromise the open character of the financial account in the balance of payments, or a combination of these two options.

Trésor-Economics No. 85