Capital account liberalization represents a frequent decision taken by the emergent countries in their integration process to the global economy. For the European Union members states, this is a necessary measure. If the capital flows assures the necessarfinancial stability, capital flows, transsmition channels of vulnerabilities, central bank.

Albulescu Claudiu Tiberiu

Coroiu Sorina Ioana

English

Research Papers in Economics

527 
 
THE CAPITAL FLOWS IMPACT ON THE STABILITY OF THE FINANCIAL 
SYSTEMS 
 
Coroiu Sorina Ioana 
University of Oradea, Faculty of Economics, No. 1, University Street, Oradea, Bihor County, 
Romania, E-mail: sorina_coroiu@yahoo.com, Phone: 0040740027103 
Albulescu Claudiu Tiberiu 
Ecological University "Traian" Deva, Faculty of Economy and Business Administration, No.16, 1 
Decembrie Street, Deva, Hunedoara County, Romania, E-mail: claudiual@yahoo.com, Phone: 
0040743089759  
 
Capital account liberalization represents a frequent decision taken by the emergent countries in their 
integration process to the global economy. For the European Union members states, this is a necessary 
measure.  If  the  capital  flows  assures  the  necessary  reserves  for  the  development  of  economical  and 
financial sectors of these states, it could occur negative effects, also (to see the financial crises of the ’90). 
For this reason, it requires some conditions, so that the potential negative impact of these capital flows on 
financial stability to be lower. On one hand, the paper presents how take place the transsmition of the 
financial vulnerabilities through the intermedium of the Central and Eastern Europe’s capital flows, and 
on the other hand, presents what is the report between financial stability and prices stability, in the context 
of capital flows liberalization.  
 
Keywords: financial stability, capital flows, transsmition channels of vulnerabilities, Central Bank.  
 
JEL Code: E58, F21, F36. 
 
In the context of financial globalization, the permanent preoccupation of all central banks is 
represented by the assurance of financial stability.  
There are several definitions, but there is not yet a common point of view regarding the content 
of the concept ˝financial stability˝. The Bank of England used this term for the first time in 1994, 
to appoint those objectives which didn´t represent prices stability or the functioning of financial 
system efficience.  
Romania´s National Bank considers that the notion of ˝financial stability doesn´t benefit, for the 
moment,  neither  by  an  acknowledged  definition,  nor  by  a  model  or  a  standard  analytic 
framework of evaluation. The financial stability can be observed in case no systematic crisis is 
manifested. At the same time, one can appreciate whether a financial system is stable when this is 
able  to  assign  efficient  economic  resources  (spatial  and  temporal),  to  evaluate  and  manage 
adequately the financial risks and to autocorrect when it is affected by exogenous impacts. That 
is, the financial system is stable when it becomes able to exercise the intermediation function, 
facilitating thus the performances of an economy and to absorb the impacts by correcting the 
imbalances appearing as a result of some adverse evolutions˝. (www.bnr.ro). 
The capital flows liberalization contributed to the increase of financial instability in the world, on 
the background of the financial markets development with asymmetric information, leading to 
the ˝herd behaviour˝, to speculations and multiple balances.  
If the external savings (the entrances of foreign capitals) don´t eliminate completely the internal 
savings, the process is favourable for the country receiving the capital: new work places are 
created; the local work force productivity grows by the capital usage and by the learning of some 
superior techniques of production and management; the state collects more taxes (or incomes 
from privatization) and is able to offer more public goods (infrastructure, health and education 
services);  on  the  whole,  the  increase  is  sustained  and  poverty  is  controlled.  Moreover,  the 
opening of capital account would impose more discipline on the internal capital market through 528 
 
the  appearance  of  some  reference  levels  for  different  prices  and  through  the  increase  of 
competition in the bank area. 
Beside the bestowed advantages, the capital entrances may represent a serious threat for the 
macroeconomic  stability  and  the  external  competitivity,  generating  an  overheating  of  the 
economy in case its volume exceeds its capacity to absorb them.  
The main channels leading to the overheating of the emergent economies are: the credit channel 
and the exchange channel.  
The credit channel  must benefits of a major importance, in the conditions in which the banks 
occupy a dominant position in the financial system and the accessible capital volume, after the 
elimination of restrictions concerning the capital account, is much higher. According to Backé, 
Égert  i Zumer (2006), the banks own 85% of all the financial actives, while the capital markets 
have a more reduced importance.  
The quick increase of the credit represents a risk on the financial stability because: it stimulates 
the  generating  set  of  demand,  if  it  grows  much  more  than  the  production;  leading  thus  to 
inflationist pressures; encourage the import, contributing to the increase of deficit of the current 
account; it proliferates the exchange risk and it increases the credit risk. 
The consequences of a boom credit are often associated to the macroeconomic and financial 
crises, as a result of the macroeconomic imbalances and the worsening of financial situation in 
the  bank  area.  G.  Kaminsky,  S.  Lizondo   i  C.  Reinhart
  (2007)  shows  that  over  80%  of the 
published papers have the conclusion that credit growth is an important factor that contributes to 
the banking/monetary crisis. M. Goldstein (2001) and an important study of IMF reveals the 
vulnerabilities of the credit boom for the countries with an emergent or in transition economy, 
too. These papers reveals the fact that, a strong credit increase determine almost automatically a 
fast growth of investments, a decrease of valutary reserves, a real appreciation of the money and 
finally, a decrease of production. So, the credit boom almost always determine banking and/or 
monetary crisis. 
The macroeconomic disequilibrium can decrease the economic activity: the payment capacity of 
the debtor decrease, the volum of the bad debts increase, there is a bigger vulnerability of the 
credit channel and exchange channel. When the financial instability appears into a vulnerable 
system, the macroeconomical disequilibrium can be bigger, because the credit institutions and the 
other  financial  institutions  decrease  the  lending  activity  and  appears  the  situation  when  an 
economic agent cannot finance anymore their activity.  
The increase volume of the credits determine the overdemand of  the credit risk management 
system, so, the quality of the credit portofolio decrease. 
Another  risk  factor  is  caused  by  the  practices  of  currency  credit  lending,  so  that  there  is  a 
decrease  of  currency  risk,  liquidity  risk,  insolvability  risk,  because  these  credits  are  mainly 
financed  through  other  types  of  resources  (not  only  through  the  deposits  attracted  from  the 
clients), especially through the external credit lines. In this situation, the unexpected decrease of 
the exchange rate agravate more the vulnerability of the banking system.   
That´s  why  the  authorities  must  maintain  a  viable  balance  between  the  assurance  of 
macroeconomic and financial stability and the expansion of the credit that contributes to the 
economic increase and the efficience of resources allocation.  
The decisions to be taken, must base on the economic objectives of the respective country and to 
take into account the regime of the exchange value, the institutional constraints, as well as the 
determinatives and the structure of the capital entrances. On many occasions, the decisions base 
on incomplete information, especially in the incipient stage of capital inflows when it is still 
difficult to evaluate the nature of these entrances and whether these are temporary or permanent.  
The identification of some viable solutions which can temper the quick credit increase is difficult. 
The increase of the interest rate in order to limit the inflationist pressures: (i) could encourage 
even more the credit in foreign currency (inclusively, due to the possible efect of appreciation of 529 
 
the  national  currency)  and  (ii)  could  affect  those  who  have  already  a  service  of  high  debt. 
Another solution could arise from the credit institutions, that is the rythm of the credit increase 
must be in accordance with the capacity of managing this phenomenon (inclusively, according to 
the  results  of  stress-testing)  and  the  present  and  future  level  of  the  capital  and  of  the 
commissions.  
The exchange channel occupies an important role in the transmission of monetary policy. The 
capital inflows increase the efficience of this channel, assuring a low rate of inflation in an 
extremely short period of time, both directly, through the lower of import prices, and indirectly, 
through the effects on the net exports, and implicitely, on the generating set of demand. However, 
though it is favourable on short term, the excessive usage of this mechanism of transmission risks 
to become a double-edged weapon, because it may aggravate the external imbalances and may 
increase  the  vulnerability  to  the  capital  flows  reversibility  which  may  take  place  sometimes 
through the simple changing of the investors feelings. Thus, there may exist situations in which 
the lower of interest rates may face the sudden appreciation of the exchangerate, but such a 
monetary policy act would be incompatible with the inflation target (Isărescu 2008). 
In the conditions of some massive entrances of capital, the currency will continue to appreciate 
and the external competition of the economy will erode. The imports will increase in a quicker 
rythm than the exports, contributing thus to the expansion of the generating set of demand. The 
current account deficit may reach unsustainable levels, as a reflection of the generating set of 
demand. In case these evolutions are not counteracted in time through the implemementation of 
some reinforcing measures of fiscal policies and incomes, the investors feelings may modify 
which will determine the retreat of foreign capital. There has been observed that the scale of the 
capital exits may exceed the authorities capacity to protect the value of national currency and 
may be equivalent to a sudden correction in the sense of depreciation, respectively exchange 
crisis.  
In the context of a dis-inflationist process and of an economic increase, there cannot exists at the 
same time free capital movements, a fixed rate of exchange and an independent monetary policy. 
This is what in literature is called the triangle of incompatibilities.  
If the reduction of the inflation is desired and a fixed rate of exchange is adopted, the monetary 
policy is efficient only if the capital movements are limited. Otherwise, the entrances and exits of 
capital undermine the effort of liquidities control and impede the usage of rate of exchange as an 
instrument of monetary policy. (Cerna et al., 2008). 
If a fixed rate of exchange is adopted and the capital movements are liberalized, then one must 
give up to the monetary policy autonomy (as it happens, for example, in the case of a small 
country that ties its national currency to the currency of another country). 
If it is chosen a fluctuating rate of exchange, then the monetary policy autonomy and a high level 
of capital movement liberalization can be maintained.  
Different  schemes  of  these  three  caractheristics  dominated  the  monetary  arrangements  of 
different areas in a certain period of time. In the monetary system based on the gold standard, in 
the 19th century, most of the countries have chosen the benefits of capital free movement and the 
stability of fixed relation between the currency and gold. In the Bretton Woods system, created at 
the end of the Second World War, several countries gave up to the capital mobility, in order to 
obtain  both a regime  of  fixed rate of exchange  and  an independent  monetary  policy.  In  the 
present, at least in the case of the majority of industrial regions, has been chosen a regime which 
gives up to the fixed rate of exchange in favour of the two other caractheristics. 
In  the  ex-communist  countries,  it  is  specific  the  “Tošovský  dilemma”.  The  continuous 
appreciation in real terms of the national currencies of the countries in transition from Central 
and Eastern Europe may attract – if the internal interest rates are maintained at a relatively low 
level – excessive capital entrances which follows the valuation of interest rate differential. On the 
other hand, the authorities must promote the sufficiently high interest rates, in order to assure a 530 
 
balance between the internal savings and the investments. In these conditions, the dilemma of the 
monetary policy consists of the fact that a too high or a too low level of interest rate determine 
the inflation increase and the increase of the deficit of the current account.  
˝The vicious circle˝ of the monetary policy may be represented in the following way:   
 
Figure no. 1: ˝The vicious circle˝ of the monetary policy 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
                                    
 
 
 
 
 
Source: Cerna coord., 2008; 
 
In the context of economic globalization, the opening of contemporary economies generates a 
potential conflict between the prices stability and the financial stability. The masive entrances of 
capital  aggravate  the  vulnerabilities  and  the  existent  macroeconomic  imbalances  in  the  host 
economies, existing the risk to generate both inflation and financial instability.  
The intrance of capital flows can generate vulnerabilities for the price stability and the financial 
stability, as in this figure: 
 
   
 
High interest rates: 
high interest rate differential 
 
Increase of monetary policy 
interest rate 
 
Capital entrances 
Intervention sterilization: 
absorption of supplementary 
liquidities 
 
Appreciation pressures of 
national currency 
 
Inflationist pressures 
Interventions on the 
markets: 
currency purchase 
 
Increase of monetary base and 
monetary generating set 531 
 
Figure no. 2: The  vulnerabilities for the price stability and the financial stability induced by 
the capital flows 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Source: Isărescu (2006); 
 
In the conditions of some massive entrances of capital, the currency will continue to appreciate 
and the external competition of the economy will erode. The imports will increase in a quicker 
rhythm than the exports, contributing thus to the expansion of the generating set of demand. The 
current account deficit may reach unsustainable levels, as a reflection of the generating set of 
demand. In case these evolutions are not counteracted in time through the implementation of 
some reinforcing measures of fiscal policies and incomes, the investors feelings may modify, 
which will determine the retreat of foreign capital. There has been observed that the scale of the 
capital exits may exceed the authorities capacity to protect the value of national currency and 
may be equivalent to a sudden correction in the sense of depreciation, respectively exchange 
crisis.  
It is evident the way in which the sudden depreciation influences the prices stability – the effect 
is both direct, through the import prices, and indirect, through the inflationist expectations. It is 
similarly evident the reaction of monetary policy, the major objective of which represents the 
prices stability. A more restrictive behavior of monetary policy will lead to a compression of the 
generating set of demand, generating economic recession and unemployment.  
Capital inputs  
Capital 
account 
liberalization 
 
High interest 
differential  
Capital inputs  
The 
vicious 
circle of 
monetary 
policy  
Nominal appreciation  
Macroeconomic 
Equilibrium 
Abrupt depreciation  
Capital outputs  
Deterioration of the 
investors’ perception  
Unsustainable 
external 
disequilibrium  
Fiscal 
disequilibri-
um  
Deterioration 
of external 
competition  
Economy 
overwarming  
Price stability  
Financial stability  
Inflation 
Restrictive monetary and  
fiscal policies  
Compression of  the 
aggregate demand; 
recession ; 
unemployment  
Decrease of the  
profitability of 
companies  
Accumulation 
of 
nonperforming 
credits  
Reduction of 
bank 
profitability  
Increased vulnerability 
on the exchange rate’s 
fluctuations 
Banking 
bankruptcy  
Expansion of the foreign 
exchange credit  532 
 
The financial stability may also be affected by exchange crisis, and the restrictive policies meant 
to rebuild the prices stability could have a contrary effect. In case the public opinion perceives 
the  appreciation  of  the  national  currency  as  a  phenomenon  of  long  term,  the  preference  for 
borrow in foreign currency becomes unavoidable and the monetary policy would not be anymore 
so  efficient.  However,  a  sudden  correction  in  the  sense  of  depreciation  could  lead  to  a 
deterioration of the balance situation in the households and in the companies, whose fortune will 
diminish.  
The financial area will also be affected because of the constraints in the real area. A great part of 
the bank loan would become nonperforming in the context of non-execution of due payments by 
the economic agencies. The problems regarding the maturity noncorrelation in the bank balances 
would be added to the major balance noncorrelations, already existing, from the perspective of 
the  designation  of  the  incomes  and  the  due  payments,  risking  to  transform  all  generalized 
financial crisis.  
Despite the vulnerability caused by the capital flows liberalization, we hope that the advantages 
conferred by them will have priority and the final effect will be a favorable one.     
 
References: 
1. Cerna, S., Donath, L.,  eulean, V., Herbei, M., Bărglăzan, D., Albulescu, C. and Boldea, B., 
Financial Stability, Editura Universită ii de Vest, West University Publishing House, Timi oara, 
2008; 
2. Backé, P., Égert B. and Zumer, T., Credit Growth in Central and Eastern Europe, ECB Woking 
Paper No. 687, 2006; 
3. Goldstein Morris, Global Financial Stability: Recent Achievements and Ongoing Challenges in 
Global public policies and programs: Implication for Financing an Evaluation. Proceedings from 
a World Bank Workshop edited by De Christopher D. Gerrard, Marco A. Ferroni, Ashoka Mody, 
2001; 
4. Isărescu M., Price stability and financial stability, Dissertation at the award of the title “Doctor 
Honoris Causa” of the University of Pite ti, December 8, 2006; 
5. Isărescu M., Problems of the monetary policy in emerging countries. The Romanian case., 
Barcelona, Publications of the Royal Academy of Economics and Finance, speech at the Royal 
Academy of Economics and Finance, on February 21, 2008; 
6.  Kaminsky  G.,  Lizondo  S.,  Reinhart  C.,  Short-Run  Pain,  Long-run  Gain:  The  Effects  of 
Financial Liberalization, World Bank Working Paper No. 2912; IMF Working Paper No. 0334, 
2007; 
7. www.bnr.ro 
 
   

Global Financial Stability: Recent Achievements and Ongoing Challenges in Global public policies and programs: Implication for Financing an Evaluation.

Long-run Gain: The Effects of Financial Liberalization, World Bank Working

Price stability and financial stability, Dissertation at the award of the title “Doctor Honoris Causa” of the University of Pite ti,

Problems of the monetary policy in emerging countries. The Romanian case.,

THE CAPITAL FLOWS IMPACT ON THE STABILITY OF THE FINANCIAL SYSTEMS

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THE CAPITAL FLOWS IMPACT ON THE STABILITY OF THE FINANCIAL SYSTEMS

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