This Bretton Woods Project article highlights the IMF’s continued struggle with the idea of capital controls as acceptable policy instruments. Whether or not the struggle is more ideological than prudential is of little interest to countries that are experiencing large inflows of capital from investors seeking higher returns than they can get in “developed countries.” Their warranted fear is that the capital will be retrieved by investors as interest rates once again rise in Europe and the US. Countries that used controls during the financial crisis have better weathered the storm than those that did not - a statistic that suggests the IMF should reconsider more vocally.
In an early March IMF meeting to promote policies for financial stability, IMF deputy managing director Min Zhu said volatility in global financial markets is the Fund’s main concern. Zhu welcomed the expansion in Latin America of policies to mitigate risks in the financial system, also known as macro-prudential policies, which have “provided a crucial anchor for confidence during the recent global turmoil”. Policies include reserve requirements, limits to foreign exchange positions and measures to manage foreign credit risk. He also expressed that policy makers need to do more to identify potential risks, prepare to react quickly and work together with other countries to prevent asset bubbles fed by overseas credit market developments. These statements confirm the Fund’s gradual change of position in relation to capital flows regulations. The Fund began to accept these regulations, though in a limited way, after the 2008 global financial crisis (see Update 70, 46).
Regulations on capital inflows are also being supported by the World Bank. Hasan Tuluy, the Bank’s new vice-president for Latin America and the Caribbean, argued in a mid-March interview that selected capital controls can be beneficial as significant inflows have potentially damaging effects on foreign exchange and may generate asset bubbles.
Hot money
After a late March summit, the BRICS’ leaders issued a joint declaration urging developed countries “to adopt responsible macroeconomic and financial policies, [and] avoid creating excessive global liquidity.” Brazil has suffered the destabilising impact of surges of capital inflows more than others recently. To slow down destabilising flows, in early March, the government extended a 6 per cent transaction tax on short-term foreign loans to cover bonds with up to five years maturity (see Update 73). Guido Mantega, Brazil’s finance minister, said that until rich countries decide to cooperate and implement policies to absorb excess liquidity, Brazil will “take measures to impede the entry of this capital”.This follows two recent IMF publications analysing how policy developments in rich countries are increasing the amount and volatility of flows to emerging markets (see Update 79).
In late February, the People’s Bank of China released a report outlining a timetable for liberalisation of its capital account over the next 10 years. It explains that removal of capital controls will only happen after a series of other moves like liberalising the exchange rate, freeing interest rates and deepening its financial markets.
IMF, capital flows and exchange rates
A February IMF working paper, Capital inflows, exchange rate flexibility, and credit booms, argues that during capital inflow bonanzas, domestic credit grows more rapidly in economies with relatively inflexible exchange rate regimes. According to the paper, this effect on credit expansion might make inflexible exchange rate regimes more vulnerable to reversal of capital flows and a credit bust than flexible regimes. However, the authors do not suggest that less flexible regimes necessarily call for broader forms of capital controls but that they “may need to be ‘counteracted’ by carefully designed macro-prudential policies” targeting banks’ external funding and incentives to lend and borrow in foreign currency.
New framework for compiling data on financial flows
New alternative proposals
A March 2012 report by a task force of academics from across the globe, published by Boston University, presents alternatives. First, regulations shouldn’t be seen as interventions of last resort but as “part of the normal counter-cyclical packages, and particularly as tools to avoid excessive exchange rate appreciation and reserve accumulation.” Second, they should not be temporary but “part of the permanent toolkit of countries, which are strengthened or weakened in a counter-cyclical way.” Third, they also require “some discrimination between residents and non-residents, which reflects the segmentation that characterises financial markets in an international system”. Finally, the IMF policy framework should start “by designing mechanisms to cooperate with countries using these policies”.
The Fund might internalise these criticisms in a policy paper to be published in June, in which they will present a “comprehensive, balanced, and flexible Fund institutional view on policies affecting capital flows.”
BITs vs Capital flows regulation
Similarly, in late February a group of 100 economists signed a letter to the ministers negotiating a new trade agreement between the US and Pacific Rim countries called Trans-Pacific Partnership Agreement (TPPA), expressing their concerns that “if recent US treaties are used as the model for the TPPA, the agreement will unduly limit the authority of participating parties to prevent and mitigate financial crises.” The letter recommends that “the TPPA permit governments to deploy capital controls without being subject to investor lawsuits, as part of a broader menu of policy options to prevent and mitigate financial crises.” This comes just after US business associations and the US government rebuked a January letter by 250 economists calling the US “to recognise that capital controls are legitimate prudential financial regulations that should not be subject to investor claims under US trade and investment treaties.”