Info Service on Finance and Development (Dec12/01)
Small door for capital controls, but maintains primacy of financial
Fund’s “institutional view” supports regulation measures, albeit
with several imposing caveats such as the temporary and limited extent
to which regulations can be introduced and a strong emphasis on macroeconomic
prerequisites and financial reforms.
The paper stems from the directive of the International Monetary and Financial Committee (IMFC) in its 24th meeting communiqué on September 24, 2011, to conduct “further work on a comprehensive, flexible, and balanced approach for the management of capital flows, drawing on country experiences.” The IMF’s Independent Evaluation Office (IEO) also saw a need for a consistent IMF view on capital flows that ensures policy advice is even-handed and appropriate for individual country experiences.
The summary report of the IMF Board’s discussions states that a few Directors argued that adopting an “institutional view” at this stage seems premature and they would have preferred further work and discussion.
The Directors also stressed that this “institutional view” would need to remain flexible and evolve over time to incorporate new experience and insights, take into account specific country circumstances and be reviewed periodically.
The main elements of the IMF’s position on capital account liberalization and capital controls is organized in two broad sections. The first section broadly discusses liberalization of money flows and its benefits and risks. The second section discusses the regulation of capital flows, with specific attention to both inflow surges and disruptive outflows.
The basics of the IMF view on capital control measures
The Fund’s view paves an inroad, albeit a narrow one, for capital control measures in stating that they can be “useful in managing inflows” when “macroeconomic conditions are highly uncertain” and when the “room for macroeconomic policy adjustment is limited, or appropriate policies take undue time to be effective.” The IMF’s position however admits that capital controls, especially to limit the volume of inflows, can safeguard financial stability when inflow surges create systemic financial risks.
Two key statements in the IMF’s institutional view are that the “degree of liberalization that is appropriate for a country at a given time depends on its specific circumstances, notably its financial and institutional development,” and that the IMF makes “no presumption that full liberalization of capital flows is an appropriate goal for all countries at all times.”
However, the IMF frames capital control measures as a “limited and temporary imposition” which is permissible when it is “consistent with an overall strategy of capital flow liberalization.”
A significant caveat to even limited and temporary capital control regulations is that macroeconomic policies, namely monetary, fiscal and exchange rate management, should be addressed before regulation is attempted. The IMF view underscores that capital control measures should not be used to “substitute for or avoid warranted macroeconomic adjustment,” which includes fiscal tightening and lowering interest rates, for example.
The emphasis on macroeconomic prerequisites reinforces the assertions of a 2011 IMF paper, “Recent Experiences in Managing Capital Inflows.” This report said that capital account regulations should be used only after countries build up foreign exchange reserves, let currencies appreciate and cut budget deficits.
The cautious and hesitant approach of the Fund is demonstrable in the importance given to considering alternatives to regulation: “Their usefulness relative to their costs needs to be evaluated on an ongoing basis, including by assessing whether there are alternative ways to address the prudential concerns that are not designed to limit capital flows.” In this vein, strengthening financial regulation, deepening financial markets and improving institutional capacity should also be prioritized before or simultaneous to regulations to manage inflows.
The Fund rationalizes their tepid institutional approach to permitting capital controls in that it would undermining investor confidence, moral hazard and weakening the incentives of financial institutions to develop proper risk management.
The paper takes on a much more rigid approach to managing outflows, relative to inflows. In the event of capital outflows, which has historically triggered currency devaluations and financial instability that leads to financial crisis and contagion, the Fund says that regulation should “be used only in crisis situations or when a crisis is considered to be imminent. They should be temporary, being lifted once crisis conditions abate, and may need to be adjusted on an ongoing basis in order to remain effective.”
The scope for long-term capital controls is possible only if they are not adopted for “balance of payments purposes and that there are no less distortive measures available that are effective.” However, Directors on the IMF Board concurred that certain capital account regulations safeguard financial stability over the long-term.
The IMF maintains that capital control measures should not discriminate on the basis of residence, in that regulations should be the same for both foreign and domestic investors. The Fund also upholds that the least discriminatory measure that is effective should be preferred.
While most of the Board Directors expressed a preference for avoiding discrimination between residents and non-residents, a few Directors emphasized that residency-based measures may be justified when the failure to differentiate between residents and non-residents would render the policy ineffective.
The IMF view addresses countries from which capital flows originate, or “source countries,” only in the sense of vigilance and internalization of “spillovers”, rather than regulatory measures where source countries take responsibility for the sometimes adverse effects of their capital flows on recipient countries.
The paper states, “Policymakers in all countries, including those that generate capital flows, should take into account how their policies affect others. Source countries should better internalize the spillovers from their monetary and prudential policies, because push factors, including changes in global liquidity conditions, also contribute importantly to capital flows, in addition to pull factors.”
Most Directors on the IMF Board agreed that policies in source countries play an important role in promoting the stability of the international monetary system—(an indirect reference to the quantitative easing monetary policies of the US Federal Reserve, which as led to high volumes of capital flowing into emerging market economies in search of higher returns than in the US and Europe).
Accordingly, the Directors said that policymakers in source countries should seek to better internalize the risks associated with their policies.
According to a staffperson in the IMF team that produced the paper, the emphasis is on “soft coordination rather than something hard.” The Fund staffperson explained that while both source and recipient countries should address capital flows together, the Fund does “not have an idea of any sort of explicit and hard policy coordination.”
While the “interest of source countries in bearing some of the costs of recipient countries is not completely obvious, but there are some important channels. Whenever there’s a crisis in recipient countries it also affects source countries,” said the IMF staffperson.
According to the Fund, the adverse risks imposed by source country policies can be addressed through stronger regulations and supervision by “systemically important financial institutions and nonbank financial institutions,” (such as big global banks and Financial Stability Board, for example).
On the scope of multilateral coordination of regulatory measures, the paper states that “cross-border coordination of policies” involving multiple countries would help to “better harness the benefits of capital flows, mitigate the multilateral risks, and encourage the implementation of policies that are conducive to the effective operation of the international monetary system.”
The Board Directors also called on IMF staff to continue to strengthen collaboration with other international organizations and institutions involved in the design and promotion of international frameworks in the area of capital flows, including on data issues.
IMF rationale on avoiding financial risk and crisis
While the central message of the IMF to its member countries is to “harness the benefits of liberalization while managing the risks,” historical examples of countries enduring financial crises as a result of capital flow liberalization are also cited. Examples cited as a footnote in the paper include Mexico (1994-95 crisis), Turkey (1994 and 2000 crisis), Korea (1997 twin crisis), Russia (1998 crisis), the Asian crisis of 1997-1998, and Estonia, Iceland, Ireland, Latvia, Lithuania, and others during the recent global financial crisis.
The Fund underscores that the reason for this is the absence of adequate financial regulation and supervision while opening financial flows. Without meeting “basic prerequisites” financial liberalization creates incentives for excessive risk-taking by financial institutions, which, as the world has seen, creates financial volatility marked by the threat of imminent capital flight. At the same time, countries where capital controls were already in place, or were re-imposed, have also experienced financial crisis.
But to the IMF, risks and volatility can be avoided or managed with timed and sequenced financial liberalization that is underpinned by macroeconomic adjustments and financial regulation.
Examples of this are the development of capital markets, including pension funds, restructuring financial and corporate sectors, strengthening prudential regulation, supervision and risk management, strengthening systemic liquidity arrangements and related monetary and exchange operations, improving accounting and statistics and revising financial legal frameworks.
Such reforms can then facilitate the “substantial benefits” of financial liberalization, which include “financial sector competitiveness, greater productive investment and consumption smoothing.”
At the same time, the IMF position makes a clear admission that “There is, however, no presumption that full liberalization is an appropriate goal for all countries at all times.” Executive Directors from developing countries agreed with this admission and cautioned that the risks associated with the size and volatility of capital flows with premature liberalization should be clearly recognized.
An “integrated approach”
IMF position is organized around the theory of an “integrated approach”
to financial liberalization, meaning that financial and institutional
developments through some of the above cited reforms take place simultaneous
to liberalization. The integrated approach is based on “successive
and sometimes overlapping phases.”
the IMF attributes adverse outcomes to countries not following or
only partly following the “integrated approach” of supporting liberalization
with financial sector and macroeconomic reforms, although there are