The International Monetary Fund (IMF) has just released a new policy paper on capital flows (IMF 2012). A recent editorial in the Financial Times describes it this way:
As far as intellectual shifts go, the U-turn by the International Monetary Fund on capital controls is remarkable. In the 1990s, the IMF came close to including the promotion of capital account liberalisation in its rule book. On Monday, after a thorough three-year review, the fund has accepted institutionally that direct controls can play a useful role in calming volatile, international capital flows. (Financial Times. 3 December 2012)
The background story to the IMF’s U-turn might begin with the 1997 Asian financial crisis. At that time, the IMF misinterpreted the central role of volatile capital flows in the crisis. Of course there were multiple factors involved, but even the most robust and mature economies could not have withstood the whipsaw of huge capital inflows that reversed suddenly when confidence was lost. Thailand, for instance, had capital inflows equal to 13% of GDP in 1996, which left the following year. More recently, during the 2008 global financial crisis, the reversals were smaller and the countries of East Asia were better prepared, but for policymakers in several economies this was a severely testing period. My recent ADBI working paper explains why the IMF’s long-standing reluctance to acknowledge any role for capital flow management has been inappropriate (Grenville 2012A). The IMF shared the common presumption that capital flows would be beneficial, analogous to the benefits from international trade. Capital flows would fund a larger volume of investment; foreign direct investment (FDI) would bring with it technology and managerial skills; inflows would allow “consumption smoothing” whereby consumers experiencing a temporarily negative income shock could maintain their expenditure by borrowing overseas; capital flows allow risks to be spread through portfolio diversification; and foreign flows might provide discipline on domestic macroeconomic policies. These benefits were of limited relevance to many East Asian countries. They were, generally, high-saving economies that had no need for the extra funding, although the FDI component did bring valuable skills transfer. Both risk transfer and consumption smoothing effects were perverse: the flows exacerbated the cycle (arriving when the economy was booming and leaving when it slowed) and risk was usually shifted to those who knew least about it and who would reverse their portfolio positions when adverse economic shocks arrived. The formal textbook models, which informed the IMF’s policies, did not reflect reality. The huge, two-way gross flows between advanced countries demonstrate that interest differentials are rarely an important explanation of flows. The portfolio lodestone of uncovered interest parity (UIP), which predicts that interest differentials will be closely related to exchange rate movements, has proved to be misleading in practice, with emerging countries able to sustain substantial interest differentials for decade-long periods (Grenville 2011). The common assumption of close substitutability between domestic and foreign assets is inappropriate for emerging economies because the attributes of financial assets are specific and unique to individual countries. Financial instruments are differentiated not only by different exchange rates and interest rates, but by the complex institutional environment of laws, practices, and perceptions. Foreign investors’ understanding of these attributes tends to be shallow and fragmentary. This creates a setting conducive to radical changes of investor sentiment, which are the driving force of the surges and reversals in capital flows. To incorporate this into the analytical framework simply as a “time-varying risk premium” leaves policymakers with no practical guidance. Emerging countries will often have significantly higher underlying equilibrium medium-term interest rates (reflecting higher profit opportunities as these countries converge toward the technological frontier). Thus when markets are confident, emerging countries will tend to receive excessive capital inflows, which put unwelcome upward pressure on exchange rates, reducing international competitiveness. To counter these excessive inflows, some recipients have built up large foreign exchange reserves, effectively reversing the flows so that capital is flowing “uphill” from the emerging economies to the mature economies. A strategy is needed that uses the potential benefits of capital “flowing downhill” (this would require these countries to run current account deficits) while at the same time protecting them from both the excessive inflows and the reversals. This strategy needs to take account not only of the fickle nature of the capital flows, but the structurally-higher profitability that is characteristic of emerging countries, which motivates the excessive inflows. This strategy would require more active management of exchange rates and capital flows than has been the accepted “best practice.” The IMF has shifted a long way on this issue. Over the past two years it has produced a series of discussion papers (listed in IMF 2012, footnote 3) which have noted the surges and reversals and explored the role that policy might play, but there has been little encouragement to see capital flow management as a normal policy tool (Grenville 2012B). Even with its revised position, the IMF sees management of capital flows as a last resort, after all conventional policy measures have been used. Among the alternative strategies, the IMF suggests that tighter fiscal policy will be an appropriate response, but in many cases the extra saving that comes with tighter fiscal policy will put unwelcome upward pressure on the exchange rate. Macro-prudential policies may help, but are appropriate only if the flows are threatening financial stability. In short, capital flow management should be higher on the list of possible policy responses than the IMF suggests, even after its “U-turn.” _____ References: Grenville, S. 2011. The Impossible Trinity and Capital Flows in East Asia. ADBI Working Paper Series. No. 319. Tokyo: Asian Development Bank Institute. Grenville, S. 2012A. Rethinking capital flows for emerging Asia. ADBI Working Paper Series. No. 362. Tokyo: Asian Development Bank Institute. www.adbi.org/working-paper/2012/06/22/5098.rethinking.capital.flows.emerging.east.asia/ Grenville, S. 2012B. Taming Volatile Capital Flows in Emerging Economies. Agenda. Volume 19, Number 2. http://epress.anu.edu.au/apps/bookworm/view/Agenda+-+Volume+19%2C+Number+2%2C+2012/10161/grenville.html#toc_marker-22 IMF. 2012. The liberalization and management of capital flows: an institutional view. Washington, DC. www.imf.org/external/np/pp/eng/2012/111412.pdf
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