But interest rates and exchange rates cannot shoulder entirely the burden of adjustment to large and volatile capital flows. Asian countries have been experimenting the use of so-called macroprudential tools to complement the more traditional macroeconomic tools in dealing with capital flows and asset price inflation. These include the use of loan-to-value ratios, taxes and stamp duties on asset market transactions, and minimum holding periods for assets, all of which serve to dampen demand for domestic assets. Asia needs to continue refining these tools, learning from experience and adapting to different circumstances. Deepening and broadening financial markets Third, Asia must deepen and broaden its financial markets. Asia must do a better job in effectively intermediating its considerable savings pool as well as capital inflows towards  BIS central bankers’ speeches  3  more productive investment in the region. Deeper financial markets will help to absorb or redeploy more effectively capital from abroad. Broader financial markets will help minimise the flow of capital to unproductive investments by offering a wide range of investment instruments. The ADB has estimated that some $ trillion will be needed in Asia to finance infrastructure projects through 2020. Capital markets provide an efficient way to intermediate flows and can reduce the cost of borrowing. In fact, the financing needs of Asia – in infrastructure and other high fixed capital investments – are particularly amenable to capital market solutions, given the size of the financing tranche and the need for credit risk diversification.
So, the phenomenon of large capital inflows into Asia is here to stay and we should learn how to handle it. Large capital inflows pose two risks. First, these flows can potentially overwhelm Asia’s ability to channel them to productive use, and create asset market bubbles – especially in real estate. Residential property prices in some Asian markets have increased by more than 50% since 2009, outpacing income growth. To be sure, there are underlying structural factors supporting housing demand, such as urbanisation, growing populations, and the rise of the middle class. But surplus liquidity and rapid credit expansion fuelled by low global interest rates and large capital inflows have exacerbated asset price inflation in Asia. The unwinding of asset bubbles can be rapid and extremely unpleasant. Second, large capital inflows can turn into sudden outflows. Sharp capital flow reversals can cause exchange rates to weaken, trigger panic in funding markets, and even result in destructive wealth effects. The unwinding of long positions in Asian markets as global investors sought to de-risk their portfolios was partly responsible for the sharp selloff in many Asian currencies in recent months. The most effective way to manage capital inflows is to allow interest rates or exchange rates to go up so that capital is priced appropriately. Indeed, as emerging Asia continues to grow, allowing the exchange rate to steadily appreciate over the medium term is vital to ensuring that capital inflows are moderated and allocated to productive investments.