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.