Another day, another IMF U turn, this time in a ‘Staff Position Note’ on capital controls by Ostry, Ghosh, Habermeier, Chamon, Qureshi, and Reinhardt (they seem to prefer writing by committee at the Fund – personally, I’m with Sartre: ‘hell is other people’). This comes hard on the heels of its recent rethink on inflation, part of a laudable institutional journey of reflection, prompted by the financial meltdown. Don’t think this one needs subtitles, so here are the highlights, plus some comments from me.
First the intro, which drives a wedge between the case for liberalizing trade and that for opening up capital markets, and summarizes the concerns of emerging market economies (EMEs) on the latter.
‘The benefits from a free flow of capital across borders are similar to the benefits from free trade, and imposing restrictions on capital mobility means foregoing, at least in part, these benefits. Notwithstanding these benefits, many EMEs are concerned that the recent surge in capital inflows could cause problems for their economies. A concern has been that massive inflows can lead to exchange rate overshooting (or merely strong appreciations that significantly complicate economic management) or inflate asset price bubbles, which can amplify financial fragility and crisis risk. More broadly, following the crisis, policymakers are again reconsidering the view that unfettered capital flows are a fundamentally benign phenomenon and that all financial flows are the result of rational investing/borrowing/lending decisions. Concerns that foreign investors may be subject to herd behavior, and suffer from excessive optimism, have grown stronger.
The question is thus how best to handle surges in inflows. The tools are well known and include fiscal policy, monetary policy, exchange rate policy, foreign exchange market intervention, domestic prudential regulation, and capital controls.’
And the findings?
‘If the economy is operating near potential, if the level of reserves is adequate, if the exchange rate is not undervalued, and if the flows are likely to be transitory, then use of capital controls is justified as part of the policy toolkit to manage inflows. Such controls, moreover, can retain potency even if investors devise strategies to bypass them, provided such strategies are more costly than the expected return from the transaction: the cost of circumvention strategies acts as “sand in the wheels.”
A key issue of course is whether capital controls have worked in practice. Our sense is that the jury is still out on this. Controls seem to be quite effective in countries that maintain extensive systems of restrictions on most categories of flows, [got that? – the IMF is saying that capital controls work best when they’re comprehensive!] but the present context relates mainly to the reimposition of controls by countries that already have largely open capital accounts. The evidence appears to be stronger for capital controls to have an effect on the composition of inflows than on the aggregate volume. For example, in the case of Chile and Colombia, controls do appear to have had some success in tilting the composition of inflows toward less vulnerable liability structures.
Looking at the current crisis, our own empirical results suggest that controls aimed at achieving a less risky external liability structure paid dividends as far as reducing financial fragility. An interesting twist is that some foreign direct investment (FDI) flows may be less safe than usually thought. In particular, some items recorded as financial sector FDI may be disguising a buildup in intragroup debt in the financial sector and will thus be more akin to debt in terms of riskiness.’
A few caveats, which largely seem to be about not encouraging China to see capital controls as an alternative to devaluing its currency (a political hot topic in Washington and elsewhere):
‘Global recovery is dependent on macroeconomic policy adjustment in EMEs, which could be undercut by capital controls, notably in cases where currencies are undervalued. In addition, controls imposed by some countries may lead other countries to adopt them also: widespread adoption of controls could have a chilling longer-term impact on financial integration and globalization.’
The caveats are weaker, and the U turn more pronounced than in the paper on inflation I reviewed last week. That’s partly because this is a journey that began over a decade ago. On the eve of the Asian financial crisis of 1997/8, the Fund was on the verge of amending its Articles of Association to enshrine capital account liberalization as one of its explicit aims. The Asia crisis started a rethink, which has continued with the latest trauma. But I’ll only believe that the Fund has really changed when we see its staff out there advising developing countries on the best ways to introduce capital controls.
And anyway, a rethink at the Fund may not be enough. The push for capital account deregulation has been locked in in several regional and bilateral trade agreements. In its bilateral trade agreements with Chile and Singapore, the US government insisted on the elimination of precisely some of those ‘speed bump’ controls now recognized by the Fund as useful tools to help economies navigate the turbulent seas of international capital.
So a long way to go to make capital markets work for development, but this is at least a welcome step. More coverage in the Economist and the New York Times.