China, now a large supplier of capital to the rest of the world, has benefited enormously from direct capital inflow in the modernisation of its industrial structure. Asia more generally has benefited immensely from the openness of the international capital market.

But the scale and volatility of international capital movements facilitated by the innovative instruments that have been developed to take advantage of openings for arbitrage in international financial markets have also exposed the international economy to risks often beyond national control. In the 1990s, the East Asian economies became the darlings of burgeoning international capital markets. They were ill-prepared to manage the ‘hot’ inflows and rapid exodus of international capital when their economies lost their shine. Their currencies and economies fell in a heap in the Asian financial crisis. In the global financial crisis, the collapse of unrestrained ‘shadow banking’ in the American and international capital market, wreaked havoc in many economies around the world. Bhagwati’s warning (that the belief that unrestrained movement of international capital was entirely beneficial and without serious risk had ‘been created by what one might christen the Wall Street-Treasury complex’) was prescient in the wake of what happened during the global financial crisis.

International capital flows are now beginning to rebound, and the prospect is for continued divergence between the fundamental growth prospects of advanced and emerging markets. The G20 has been grappling with how to manage capital flows as it seeks to reconstruct the international financial system after the global financial crisis. The IMF, an earlier proponent of international capital mobility and capital account liberalisation as a priority in economic reform agendas, has swung in behind this international effort to re-think the principles that should guide the approach to regulation of international capital flows.

This week’s lead essay by Jonathan Ostry reflects the present focus on re-thinking the approach to controls on international capital flows. Drawing on the ideas of both John Maynard Keynes and Henry Dexter White (the IMF’s founding intellectual fathers) Ostry (quoting White) advocates ‘some measure of the intelligent control of the volume and direction of foreign investments.’

But what principles should guide the use of controls over international capital flows?

This is a highly contested issue. Ostry provides perspective on it.

Large inflows can complicate macroeconomic policy management, leading to exchange rate appreciation pressures or overshooting, and loss of monetary policy independence. Particularly if the inflows turn out to be temporary, they may require a costly reallocation of productive resources back to the tradable sector as inflows retreat and the exchange rate is brought down. Whether inflows are temporary or more permanent, a sudden surge can overwhelm the prudential management of domestic financial markets, and wind up fuelling asset price bubbles rather than financing worthwhile investments. The right policy response to a surge in capital inflows will need to include both macroeconomic and prudential elements.

As Ostry notes, 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). These considerations are particularly important for small, capital importing economies with thin financial and international currency markets. The first line of defence (which avoids scaring away productive long term capital inflow) is the right mix of macro-economic policies. Macroeconomic policy adjustments, especially through a flexible exchange rate, help discourage excessive inflows and avoid their distortive effects.  There is also growing consensus that capital exporting countries share responsibility to ensure that countries are able to reap the benefits from financial integration without incurring excessive risks. The debate about when and how the application of capital controls might be justified is thus entirely appropriate. But it should not obscure the imperative of capital account liberalisation and reform in the major emerging economies in Asia.

Under the surface, China is grappling with the urgency of capital account liberalisation (making the movement of capital into and out of the country freer). There are already large hot capital flows into China that can easily dodge the regulation and go undetected. The huge the interaction of the Chinese economy, including the government, business and even households, with the international economy now demands reform of the Chinese capital account if China is to both get most benefit from it as well as reduce the imbalances in its dealings with the rest of the world. Reform of its international capital account is crucial for strengthening China’s macroeconomic policy regime, as well as its financial markets and their integration into global markets, increasing the flexibility of the Chinese exchange rate and allowing the Chinese currency assume its rightful and necessary role in the international monetary system as an international transactions and reserve currency.

In his K R Narayanan lecture in Canberra this week, Dr Duvvuri Subbarao, Governor of the Reserve Bank of India, said that ‘capital controls were an unavoidable’ instrument in international macro-economic management. But again, as the trajectory of India’s growth portends a similar role for India to that of China in the world economy, the trend should be towards a more open approach to managing its interaction with international capital markets.

China and India are destined to be still larger players in the global economy and they will fulfil that destiny in significant part only through fuller participation in strong and open international capital markets.

Peter Drysdale