Are there ‘intelligent’ capital controls?

Author: Jonathan D. Ostry, IMF

The debate over how to manage capital flows to emerging market economies ebbs and flows, much like the flows themselves.

But, it’s a hot topic in the news again for good reason. Short-term fluctuations in capital flows are occurring against the backdrop of a structural trend increase. Investors have woken up to the higher risk-adjusted returns these economies are likely to continue to offer.

With flows rebounding in the aftermath of the global crisis, and the prospect of continued divergent fundamentals between advanced and emerging markets, the IMF has been giving renewed thought to how to manage inflows. Two papers I had the privilege of co-authoring in 2010 and 2011 provided analytical backing for an institutional paper issued earlier this year.

These issues have been controversial, but they are gradually moving into the mainstream policy discussion. What is important is that they are debated actively and inclusively by policymakers, academics, and multilateral agencies like the IMF. While views within the IMF have naturally evolved over time, my sense is that we have become more open-minded on this issue.

Contrary to perceptions, pragmatism on this issue isn’t entirely new to the IMF (see also an earlier review by our Independent Evaluation Office in 2005). You can go back a ways in history to see why. Take the IMF’s two founding fathers, John Maynard Keynes and Harry Dexter White. An important tenet for Keynes was that the post-war system should ‘facilitate the restoration of international loans and credits for legitimate purposes’ while also advocating a role for controls on capital movements in some circumstances. White took the view that, while desirable to encourage ‘the flow of productive capital to areas where it can be most profitably employed’, there should be ‘some measure of the intelligent control of the volume and direction of foreign investments.’ Both Keynes and White held nuanced views of the balance between free capital markets and ‘intelligent’ policies to mitigate the risks associated with fluctuations in flows.

Open capital markets confer many benefits. They enable countries to take advantage of new investment and growth opportunities — particularly important for emerging market countries with large infrastructure investment needs. Other benefits flow from foreign technology and know-how, competition in financial services, and risk sharing and consumption-smoothing.

But, as Jagdish Bhagwati pointed out some years ago, trade in financial assets is not quite the same as trade in widgets. Sudden, large, and volatile surges can pose formidable challenges for macroeconomic policy management and financial stability.

So, how do we see the issue of appropriate policy responses or ‘intelligent’ controls? Three broad principles are essential:

1)    align interventions as closely as possible to the problem;

2)    make sure the magnitude of interventions is commensurate with the distortion one is trying to mitigate; and

3)    take account of the impact on other countries.

What are the concrete implications of these principles?

Macroeconomic policy adjustments — greater exchange rate flexibility, official reserves accumulation, and changes in the policy mix — should be the primary response for macroeconomic concerns. Strengthening the macroprudential framework should be the primary response to financial-stability risks. But sometimes these tools will not be sufficient or appropriate.

Think of an overheating economy, whose currency is on the strong side, foreign exchange reserves are more than adequate for country-insurance purposes, and public debt is on a path consistent with both internal balance and fiscal sustainability. It would not make sense to allow a further strengthening of the currency, or accumulate more reserves, or adjust the macroeconomic policy mix further.

In such circumstances, capital controls may be needed to contain macroeconomic risks. They may also be needed to address financial stability risks arising from flows that bypass regulated financial institutions (either because the perimeter of regulation cannot be adjusted fast enough, or because of direct borrowing from abroad by nonfinancial entities).

First, however, macro policies have to be adjusted. Why? Because macro adjustments — especially the exchange rate — are essential to help discourage excessive inflows. And, not to do so, could drive flows toward countries less able to absorb them, effectively akin to a beggar–thy-neighbour policy and frustrating the global adjustment of external imbalances.

I have focused here on policy adjustments in recipient countries. But there is shared global responsibility also involving the source, or capital exporting, countries to ensure that countries reap the benefits from financial integration without incurring excessive risks, an issue that the Fund is taking up concurrently as part of its global surveillance program.

Policy issues surrounding the management of capital flows are saddled with a legacy of ideological overtones, but as a recent conference organised by the Brazilian authorities and the Fund last month suggested, they are foremost highly technical issues that need to be analysed thoroughly. And a lot of work is still needed. The debate on how to design ‘intelligent’ controls that reflect the needs of different countries at different times will continue; the IMF is the logical forum to host ― and dare I say lead ― this debate.

Jonathan D. Ostry is deputy director of the Research Department at the International Monetary Fund.

Views expressed herein are those of the author and should not be attributed to the IMF, its Executive Board, or its management.


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  • Andrew Elek


    This is a welcome article and I look forward to reading the papers you have published.

    There may be an inconsistency between two of your paragraphs on the example you use.

    You say:
    It would not make sense to allow a further strengthening of the currency, or accumulate more reserves, or adjust the macroeconomic policy mix further.

    First, however, macro policies have to be adjusted.

    Please clarify.

    Andrew Elek

  • Dr Exmond DeCruz

    My, my how the world, or rather should I say the IMF, has been changing…
    It wasn’t that long ago when the Malaysians were accused of economic apostasy when they challenged the prevailing orthodoxy by imposing selective capital controls. What was little known then was that Malaysian PM Dr Mahathir had tapped into the advice of a former currency market speculator and manipulator to learn of the mindset of the hedge fund speculators whom he mistakenly accused of manipulating and wrecking the Thai and Malaysian currencies for personal gain. Paul Krugman, who was then universally derided for his controversial support of this idea was, without his knowledge, partly responsible for the Malaysians taking heart to challenge the prevailing orthodoxy and assuming that not inconsiderable risk of being cast as an international pariah. Nevertheless, it was debatable in the end whether such drastic actions had been required, given that all of the stricken Asian economies eventually recovered.

    Whilst Mahathir’s ideas of a grand conspiracy were fuelled by his own paranoia and had little basis in fact, what the maverick did successfully demonstrate was that capital controls could be used, but only in parallel with serious internal reforms, without fears of economic Armageddon. Not long thereafter, the IMF’s Michel Camdessus grudgingly conceded that perhaps the IMF needed to re-examine its blanket opposition to capital controls, citing that their temporary applications during a crisis may indeed have merit, but only in conjunction with improvements in domestic macroeconomic policies and regulatory and supervisory systems. And this is the point – temporary application– as a tool against the blind panic and hysteria that occasionally grips markets and which left unconstrained, can wreck entire economies and endanger the whole system.

    It is indeed now comforting to know that the GFC has re-focused minds keenly on the topic of international capital controls because this is a vital debate. During the 1997 Asian Financial Crisis, the consensus had been that the markets had suddenly woken up to the structural weaknesses inherent in the Asian economies. As capital took flight, wise sages throughout the rest of the world pointed knowingly at the flaws in the so-called “tiger” economies, and conceded that the markets had finally delivered a long-overdue “verdict”. This was baldly stated, despite the fact that these same economies had enjoyed rich, opportunistic inflows of capital for more than two decades from those very same markets.

    The idea of international markets operating autonomously and guided by a benign, invisible hand delivering beneficient growth and development all around and occasionally delivering well-earned kicks to the backsides of poorly managed economies is almost an article of faith bordering on religious fervor amongst mainstream economists. There is no doubting that the international financial system of open capital markets has worked brilliantly in lifting billions of people out of poverty at a scale thoroughly unprecedented in our global history.

    However capital markets are still driven in the end by human greed and when the panic-stricken, herd mentality of investors and speculators fearing financial oblivion takes over, as it did during the recent GFC, no economy well-managed or otherwise could survive the shellacking from a determined stampede. “Intelligent” controls, properly guided and formulated and palatable as a last option, may afford vulnerable developing economies much needed temporary armoury during a crisis.

    Australia may take pride on having escaped fall-out from the GFC, pointing as is our wont to our prudent financial regulation as the key, but there is no mistaking the fact that our economic fortunes are inextricably tied with that of the gargantuan and ever-effervescent Chinese economy and that, far more than anything else, may have contributed to insulating us from the mayhem.