|The IMF and Capital Controls: The End of an Era?|
In February 2010, the IMF reversed its long-held position on capital controls by admitting that they constitute a “legitimate component” of the policymakers’ toolkit. Is this a sign of waning Fund support for uncontrolled finance?
12th March 2010
11th March 2010 - Dani Rodrik, Project Syndicate
In the world of economics and finance, revolutions occur rarely and are often detected only in hindsight. But what happened on February 19 can safely be called the end of an era in global finance.
On that day, the International Monetary Fund published a policy note that reversed its long-held position on capital controls. Taxes and other restrictions on capital inflows, the IMF’s economists wrote, can be helpful, and they constitute a “legitimate part” of policymakers’ toolkit.
Rediscovering the common sense that had strangely eluded the Fund for two decades, the report noted: “logic suggests that appropriately designed controls on capital inflows could usefully complement” other policies. As late as November of last year, IMF Managing Director Dominique Strauss-Kahn had thrown cold water on Brazil’s efforts to stem inflows of speculative “hot money,” and said that he would not recommend such controls “as a standard prescription.”
So February’s policy note is a stunning reversal – as close as an institution can come to recanting without saying, “Sorry, we messed up.” But it parallels a general shift in economists’ opinion. It is telling, for example, that Simon Johnson, the IMF’s chief economist during 2007-2008, has turned into one of the most ardent supporters of strict controls on domestic and international finance.
The IMF’s policy note makes clear that controls on cross-border financial flows can be not only desirable, but also effective. This is important, because the traditional argument of last resort against capital controls has been that they could not be made to stick. Financial markets would always outsmart the policymakers.
Even if true, evading the controls requires incurring additional costs to move funds in and out of a country – which is precisely what the controls aim to achieve. Otherwise, why would investors and speculators cry bloody murder whenever capital controls are mentioned as a possibility? If they really couldn’t care less, then they shouldn’t care at all.
One justification for capital controls is to prevent inflows of hot money from boosting the value of the home currency excessively, thereby undermining competitiveness. Another is to reduce vulnerability to sudden changes in financial-market sentiment, which can wreak havoc with domestic growth and employment. To its credit, the IMF not only acknowledges this, but it also provides evidence that developing countries with capital controls were hit less badly by the fallout from the sub-prime mortgage meltdown.
The IMF’s change of heart is important, but it needs to be followed by further action. We currently don’t know much about designing capital-control regimes. The taboo that has attached to capital controls has discouraged practical, policy-oriented work that would help governments to manage capital flows directly. There is some empirical research on the consequences of capital controls in countries such as Chile, Colombia, and Malaysia, but very little systematic research on the appropriate menu of options. The IMF can help to fill the gap.
Emerging markets have resorted to a variety of instruments to limit private-sector borrowing abroad: taxes, unremunerated reserve requirements, quantitative restrictions, and verbal persuasion. In view of the sophisticated nature of financial markets, the devil is often in the details – and what works in one setting is unlikely to work well in others.
For example, Taiwan’s use of administrative measures that rely heavily on close monitoring of flows may be inappropriate in settings where bureaucratic capacity is more limited. Similarly, Chilean-style unremunerated reserve requirements may be easier to evade in countries with extensive trading in sophisticated derivatives.
With the stigma on capital controls gone, the IMF should now get to work on developing guidelines on what kind of controls work best and under what circumstances. The IMF provides countries with technical assistance in a wide range of areas: monetary policy, bank regulation, and fiscal consolidation. It is time to add managing the capital account to this list.
With this battle won, the next worthy goal is a global financial transaction tax. Set at a very low level – 0.05% is a commonly mentioned rate – such a tax would raise hundreds of billions of dollars for global public goods while discouraging short-term speculative activities in financial markets.
Support for a global financial-transaction tax is growing. A group of NGOs have rechristened it the “Robin Hood tax,” and have launched a global campaign to promote it, complete with a deliciously biting video clip featuring British actor Bill Nighy (www.robinhoodtax.org). Significantly, the European Union has thrown its weight behind the tax and urged the IMF to pursue it. The only major holdout is the United States, where Treasury Secretary Tim Geithner has made his distaste for the proposal clear.
What made finance so lethal in the past was the combination of economists’ ideas with the political power of banks. The bad news is that big banks retain significant political power. The good news is that the intellectual climate has shifted decisively against them. Shorn of support from economists, the financial industry will have a much harder time preventing the fetish of free finance from being tossed into the dustbin of history.
1st March 2010 - Kevin Gallagher, The Guardian
In 1942, when working to establish the International Monetary Fund, John Maynard Keynes said the "control of capital movements, both inward and outward, should be a permanent feature of the post-war system."
In his new book Capital Ideas: The IMF and the Rise of Financial Liberalization, Jeffrey Chwieroth argues that despite the fact that the economics profession largely maintained their support of Keynes's position, by the late 1990s the IMF motioned to change its articles of agreement in order to outlaw capital controls across the world.
The about-face in IMF thinking, according to Chwieroth, was due to a change of position among IMF staff. In yet another about-face, the IMF staff just released a position paper where they retract their rejection of Keynes ideas. Now it's time to practise what they preach.
The movement to outlaw capital controls lost steam given that premature capital account liberalisation in part caused the Asian Crisis of 1997-8 and that nations such as Malaysia used capital controls to avoid the worst of that crisis. Behind the scenes however, the IMF still advised nations to liberalise their capital accounts and steer clear of capital controls.
Indeed as recently as November 2009, in response to Brazil's announcement of a temporary tax on inflows of speculative capital, IMF head Dominique Strauss-Kahn said "the problem is that most of the time it does not work".
All that changed on Friday 19 February when Strauss-Kahn's own economists published a staff position note empirically showing that capital controls not only work but "were associated with avoiding some of the worst growth outcomes" of the current economic crisis. The paper concludes that the "use of capital controls – in addition to both prudential and macroeconomic policy – is justified as part of the policy toolkit."
The new IMF report singles out measures such as taxes on short-term debt (like Brazil's) or requirements whereby inflows of short-term debt need to be accompanied by a deposit to be placed in the central bank for a certain period of time (as practised by nations such as Chile, Colombia, and Thailand). The goal of these measures – which are often turned on when capital flows start to overheat and turned off when things cool – is to prevent massive inflows of hot money that can appreciate the exchange rate and threaten the macroeconomic stability of a nation.
The IMF's findings couldn't come at a better time. The carry trade is again bringing speculative capital to developing countries that could disrupt their recovery from the crisis. To make the proper deployment of capital controls effective however, at least three obstacles need to be overcome.
First, speculative capital can still wreak havoc because hot money blazes by countries that successfully deploy controls to nations that don't. Second, after a while investors creatively evade capital controls through derivatives and other instruments. Third, US trade and investment agreements make capital controls illegal.
Former IMF economist Arvind Subramanian proposes a solution to the first two problems. First, full-fledged co-ordinated capital controls among all emerging market economies. To solve the problem of capital control evasion, he says, the IMF should aid nations in regulating capital controls and see to it that controls are not evaded.
The third problem may be the biggest obstacle. If a nation has a trade agreement with the US, capital controls are illegal. Chile is renown for its measures to stem inflows but the Bush-era US-Chile Free Trade Agreement the US effectively forces Chile to literally pay the consequences (pdf) if Chile tries to use capital controls again.
The pending US-Colombia Free Trade Agreement, also negotiated under Bush, outlaws that country's use of controls on capital inflows. Democrats – who were against the Bush administration's rejection of capital controls in trade agreements – have pledged a new model for trade policy. US trade representative Ron Kirk is said to be unveiling the new model US trade agreement on Wednesday.
It's time to practise what economists have preached at least since Keynes: capital controls should be part of the toolkit. Developing economies should contemplate co-ordinated capital controls and the IMF lend its expertise to ensure such controls are not evaded. On Wednesday, Kirk should heed the new findings of the IMF and the positions of his own party by enabling nations to deploy capital controls to prevent and mitigate financial crises under US trade agreements. In Keynes's words: "It would not be foolish to contemplate the possibility of a far greater progress still."
19th February 2010 - IMF Survey
With the global economy recovering, capital is flowing back to emerging market economies—a welcome development, according to IMF staff, in that it provides additional financing for productive investment, opportunities for risk diversification, and scope for consumption smoothing.
But some countries facing sudden and temporary spikes in different forms of foreign capital flows are worried about the possible problems this can cause for economic management or the health of the financial system.
Controls on foreign capital into emerging economies can be part of the policy options available to governments to counter the potential negative economic and financial effects of sudden surges in capital, the IMF staff said.
In a new Staff Position Paper “Capital Inflows: The Role of Controls,” issued on February 19, IMF staff discusses the circumstances under which controls on capital inflows to emerging market economies can usefully form part of the policy toolkit to address the economic or financial concerns surrounding sudden surges in capital. The paper is part of work under way by the staff of the 186-member international institution that reassesses the macroeconomic and financial policy framework in the wake of the devastating global financial crisis.
Controls Part of a Policy Package
There are a number of policy choices governments can make when faced with a short-term or sudden surge in foreign capital, IMF staff said. These include
• Allowing the currency to appreciate
• Accumulating more reserves
• Changing fiscal and monetary policy
• Strengthening rules to prevent excessive risk in the financial system, and
• Capital controls.
In some circumstances, capital controls may complement the use of economic or prudential remedies to more effectively address the problem.
“There may be circumstances in which capital controls are a legitimate component of the policy response to surges in capital inflows,” the paper says, while noting controls would normally be temporary, as a means to counter surges. In particular, the paper notes: “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 one element of the policy toolkit to manage inflows.”
Nevertheless, evidence to date on the relative effectiveness of capital controls is ambiguous, according to the paper. Controls appear to work better in countries with existing restrictions, or with strong administrative capacity. Evidence also suggests that controls have more effect on the composition of capital flows than on their volume.
Not All Capital Inflows Created Equal
The analysis found that certain types of capital inflows can make a country more vulnerable to financial crisis. One example is debt versus equity flows, in which the latter allows for greater risk-sharing between creditor and borrower.
Capital inflows might also fuel domestic lending booms, according to IMF staff, which is especially dangerous if extended to unhedged borrowers, such as households, rather than to exporters.
Drawing on evidence from the recent global financial crisis, the paper also found that countries with larger initial stocks of debt liabilities and higher foreign direct investment in the financial sector fared worse in the crisis.
This is because both are linked to credit booms and foreign-exchange lending by the domestic banking system inside the country, which can make the financial sector more vulnerable, the paper said. IMF staff also found evidence that controls on capital inflows that were in place before the crisis helped improve growth resilience during this crisis.
Global Effects of Controls
Any country’s policies to control the inflow of capital will need to take into account the global effect, particularly as economies recover and countries look for new sources of growth, IMF staff said.
Controls would be inappropriate in cases where the exchange rate was undervalued from a multilateral perspective since this could frustrate needed rebalancing of global demand and the sources of growth in individual countries, and could redirect capital to countries less able to absorb it.
Controls should also not become a substitute for more fundamental—but perhaps more difficult—policy changes, as this could lead to adverse effects that could undercut the longer-term benefits from financial integration and globalization.
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