Damming Capital

NEW YORK – Capital-account regulations have been at the center of global financial debates for two years. The reasons are clear: since the world has experienced a “multi-speed recovery,” as the International Monetary Fund puts it, slow-growth advanced countries are maintaining very low interest rates and other expansionary monetary policies, while fast-growth emerging economies are unwinding the expansionary policies that they adopted during the recession. This asymmetry has spurred huge capital flows from the former to the latter, which are likely to continue.

Emerging economies fear that this flood of capital will drive up their currencies’ exchange rates, in addition to fueling current-account deficits and asset bubbles, which past experience has taught them is a sure recipe for future crises. The problem is compounded by the fact that one of the countries undertaking expansionary policies is the United States, which has the world’s largest financial sector and issues the paramount global currency.

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Small wonder, then, that several emerging economies are using capital controls to try to manage the flood. This, of course, contradicts the wisdom that the IMF and others have preached in the past – that emerging economies should free their capital accounts as part of a broader process of financial liberalization.

The G-20 recognized in 2008 that unfettered finance can generate costly crises; thus, it decided to re-regulate finance. But it left cross-border capital flows entirely off the agenda, as if they were not a part of finance. Furthermore, by a twist of language, regulations affecting capital flows are pejoratively called “controls,” rather than their correct name.

This is why it is so important that the IMF has taken steps to address the issue. In early April, the Fund made public two documents, one presented to the Board and a more technical “staff note,” together with a statement by Managing Director Dominique Strauss-Kahn. These followed another technical note issued a year ago.

The basic conclusion of all of these documents is that regulations of cross-border capital flows can complement macroeconomic policy and so-called “macro-prudential” financial regulations. Indeed, it has been shown that countries that used such regulations were hit less severely by the recent global financial crisis, and many economists argue that this was also true of the 1997-1998 Asian financial crisis.

We know from experience that there are many regulations that make sense, not just those now sanctioned by the IMF. One of them is a reserve requirement on cross-border flows – successfully implemented in Chile, Colombia, and elsewhere – or, even better, on cross-border liabilities. Taxes on inflows can play a similar role, as can minimum-stay periods for capital inflows.

Prohibition of certain transactions for prudential reasons also makes sense, particularly for borrowing in foreign currencies by economic agents that do not have revenues in those currencies. Alternatively, if those economic actors borrow from domestic financial institutions, regulations could resemble recent measures adopted in Brazil and South Korea, which include high capital and provision requirements for the associated liabilities.

In the recent IMF document, the Fund proposes a set of guidelines that countries should use for capital-account regulations (which they call “capital-flow management measures,” or CFMs). The guidelines correctly emphasize that these regulations should complement, not replace, counter-cyclical macroeconomic policies. But they make CFMs seem like an intervention of last resort, to be used only after everything else has been tried: exchange-rate adjustments, reserve accumulation, and restrictive macroeconomic policies. In fact, CFMs should play an integral part in avoiding excessive exchange-rate appreciation and reserve accumulation in the first place.

The IMF also prefers CFMs to be temporary. But this runs counter to “strengthening the institutional framework on an ongoing basis,” another recommendation of the guidelines. An institutional framework implies that CFMs should be part of a country’s permanent policy toolkit, and that regulations are strengthened or weakened depending on the phase of the business cycle. Temporary, improvised measures have had reduced effectiveness in many countries.

Moreover (and again counter to the guidelines), CFMs, almost by definition, require some discrimination between residents and non-residents. After all, we live in a global system in which different countries use different currencies, which implies that residents and non-residents have asymmetric demands for assets issued in those currencies.

Most importantly, a policy framework issued by international institutions like the IMF should include a clear mechanism to cooperate with countries using these policies. But none is to be found in the IMF’s guidelines, even though it recognizes that capital-account volatility is in a sense a negative externality inflicted upon recipient countries.

In fact, implementing the IMF’s guidelines may require eliminating provisions in several free-trade agreements (particularly those signed by the US) that restrict the use of capital-account regulations. More importantly, countries could use similar instruments, as part of a true international regulatory regime, to increase the effectiveness of their expansionary monetary policies.

Finally, any regulation in this area should recognize that capital-account convertibility is not obligatory for the IMF’s “clients.” This issue was settled in 1997, when then IMF Managing Director Michel Camdessus tried to include some commitment to capital-account liberalization in the Fund’s Articles of Agreement. The failure of that effort is implicitly recognized in the guidelines, which indicate that they do not imply any new obligations under IMF surveillance.

In other words, the new IMF framework is welcome, but countries will need the freedom to manage their capital account more than ever in the years ahead.