The first important to note with regard to capital flows is that they can be influenced by external factors, such as low interest rates abroad and also recession, and internal factors such as high margins of capital productivity domestically, reforms in structures, as well as better credit worthiness that may be induced by good macroeconomic policies.
With regard to current account imbalance, when capital flows are inwards as a result of the internal or pull factors there will be no imbalances. On the other hand, when capital flows are influenced by the external factors, the likely outcome is that it will cause current account imbalances. The reason for this outcome is that there are four policy responses that may influence how the current account is impacted by the capital inflows. These policy responses are sterilization, the fiscal policies, the exchange rate policies, and capital control policies (Yan, 2008). Because there are time frames and political influence in the implementation of each of these policies, sterilization is the mostly commonly used one because the other three, are not very easy to implement on the basis of time and politics.
In the event of excess capital inflows, the monetary authority in a nation will either apply full, partial, or even no sterilization. In the case of no sterilization or partial sterilization, inflation will most likely increase and the result could be a deteriorated current account, hence an imbalance. It is good to note that in case of excess capital inflows and there is full sterilization, the current account will remain unchanged hence imbalances on the current account as a result of capital inflows happens mainly when there is partial or no sterilization because of the monetary expansion within the economy.
Yan, H. (2008). Foreign Capital Inflows and the Current Account Imbalance: Which Causality Direction? Journal of Economic Integration, 23(2), 434-461.