by Joseph Joyce
The IMF’s Proposed Policies on the Management of Capital Flows
The IMF’s views on the advantages and drawbacks of capital flows have substantially evolved over time. The Fund reversed its opposition to capital controls in the wake of the global financial crisis of 2007-09, when it adopted the “Institutional View on the Liberalization and Management of Capital Flows.” That framework included capital flows measures (CFMs) as one of the policy measures available to a government facing surges of capital inflows, i.e., large inflows that could destabilize an economy. The Fund has now moved further in the direction of using CFMs, proposing that they can be used in a preemptive manner to avoid future instability.
The IMF had advocated the removal of capital controls before the Asian financial crisis of 1997-98, so that developing economies could benefit from capital flows. That crisis demonstrated the volatility of capital flows and the catastrophic impact of “sudden stops” on economic activity. Subsequently, the Fund refined its position on deregulation, advising governments to implement adequate supervisory and regulatory regimes before liberalizing their capital accounts, and to begin with opening to foreign direct investment before allowing short-term capital. The IMF moved further during the global financial crisis when it allowed Iceland to implement controls. The Institutional View was adopted in 2012, when countries such as Brazil used CFMs to manage the inflows of foreign capital seeking higher yields than those available in the U.S. The CFMs were part of a toolkit that also includes Macroprudential Prudential Measures (MPMs), which are designed to limit systemic risks. CFM/MPMs are measures designed to limit such risk by controlling capital flows.
The IMF’s new proposals are presented in an IMF Policy Paper, “Review of the Institutional View on the Liberalization and Management of Capital Flows.” The first proposal extends the Institutional View by allowing the preemptive use of CFM/MPMs on foreign currency debt inflows in order to address the systemic risk that could result from foreign exchange mismatches on balance sheets. Such mismatches can occur slowly, and not just following surges. They increase the probability of capital flow reversals and exchange rate depreciations that disrupt economic activity and could not be adequately addressed with conventional policy tools.
The proposal would also allow CFM/MPMs in the case of high foreign investor participation in local-currency debt markets. In these cases, the danger is a “sudden stop” by foreign investors, which would have particularly adverse consequences if there were illiquid capital markets. Other domestic measures may be unavailable, and the CFM is a second-best solution.
The second proposed policy change exempts certain types of capital control measures that are enacted by governments for specific purposes from review. These include: first, measures adopted for national or international security; second, measures based on international prudential standards, such as those related to the Basel Framework on banking; third, measures designed to deal with money laundering and the combating of financial terrorism; and fourth, measures related to international cooperation standards related to the avoidance or evasion of taxes.
The usefulness of preemptive policies has been demonstrated in a new NBER working paper, “Preemptive Policies and Risk-Off Shocks in Emerging Markets” by Mitali Das and Gita Gopinath of the IMF and Sebnem Kalemli-Özcan of the University of Maryland. The authors investigate the impact of preemptive CFMs on the external finance premia in 56 emerging markets and developing economies during the Taper Tantrum and the COVID-19 shocks. The premia are measured by deviations from uncovered interest rate parity. They consider the impact of CFMs on inflows and outflows, as well as the effect of domestic MPMs.
The paper’s authors report that countries with preemptive CFMs on inflows in place during the five-year period preceding the shocks experienced lower premia and exchange rate volatility. They infer that use of the CFMs provides enhanced access to international capital markets during volatile periods. CFMs on outflows, on the other hand, had a positive effect on the UIP premiums, which may reflect the demand by foreign investors for higher returns to compensate for the CFMs in outflows.
The IMF’s capital flow policies under the Institutional View had been reviewed by the IMF’s Independent Evaluation Office (IEO) in its 2020 report , “IMF Advice on Capital Flows.” The report praised the IMF for the changes in its policy stance, and called the adoption of the Institutional View “a major step forward.” The IEO’s report, however, also called for further changes, including revisiting the Institutional View to take into account recent experience with capital flows, building up the monitoring, analysis and research of capital acccount issues, and strengthening multilateral cooperation on policy issues.
Anton Korinek of the University of Virginia, who wrote a briefing paper for the IEO report, Prakash Loungani, assistant director of the IEO and co-leader of the 2020 report, and Jonathan Ostry of Georgetown University, who was at the IMF when it issued the Institutional View, have written a review of the IMF’s latest policy proposals, “The IMF’s Updated View on Capital Controls: Welcome Fixes but Major Rethinking Is Still Needed.” While welcoming the new measures, they bring up several additional issues that should be addressed. These include the use of capital controls for domestic objectives, such as the impact of capital flows on income inequality and also real estate prices. Such a move would in many ways be consistent with the original aims of the Bretton Woods agreements.
The authors point out that the targets for the IMF’s capital policies are the host countries that receive capital inflows. But challenges associated with capital flows should also involve the countries that are the source of the capital flows. Since these are usually the advanced economies that have a major role in the IMF’s governance, such a move would require the cooperation of the IMF’s most influential members.
Korinek, Loungani and Ostry also urge the IMF to investigate the use of controls on capital outflows. The Fund’s current policy stance only approves the use of such measures during crises. Given the current economic and financial situation (see, for example, here), governments of developing countries are concerned about a repeat of the outflows of March and April 2020. The IMF should be working with these policymakers now to minimize the turbulence that large capital outflows would bring.