IMFs new stance on capital controls

Updated: Dec 5 2012, 07:25am hrs
In recent decades, there has been a gradual trend toward liberalisation of capital flows, both inward and outward, among member countries. The trend has been particularly pronounced in emerging Europe, although systemically important emerging economies (including, for example, China and India) have also announced plans for further liberalisation. The pace of liberalisation moderated slightly in the wake of the global crisis, but the general trend across the world remains one of increasing openness to cross-border capital flows. Where authorities have intervened to influence capital flows, they have generally done so not by re-regulating permanently significant parts of the capital account but by targeting temporarily specific types of flows.

It is recognised that CFMs can impose costs on the economy. They can reduce discipline in financial markets and public finances, tighten financing constraints by restricting the availability of foreign capital, and limit residents options for diversifying their assets. They can also be costly to monitor and enforce, promote rent-seeking behaviour and corruption, and facilitate repression of the financial sector, impeding financial development and distorting the allocation of capital.

The move toward liberalisation reflects countries recognition of the benefits of capital flows under the right conditions. At a microeconomic level, capital flows can enhance the efficiency of resource allocation and the competitiveness of the domestic financial sector. Moreover, as countries develop they require more advanced financial systems, which often go hand in hand with greater cross-border capital flows. In addition, capital flows can facilitate the transfer of technology and management practices, particularly through foreign direct investment (FDI). Capital flow liberalisation can have indirect or collateral benefits for intermediate objectives, such as financial sector development, macroeconomic policy discipline, trade, and economic efficiency. At a macroeconomic level, capital flows enable countries to fund welfare-enhancing current account imbalances. Moreover, they can enable beneficial portfolio diversification. The empirical relationship between capital flows and growth is well documented for FDI and other non-debt flows, including for low-income countries, but it is less clear cut for debt-creating flows.

Well-designed capital flow liberalisation can help countries realise the benefits of capital flows, forgo the costs of CFMs, and support key economic objectives. At the same time, some countries have sustained rapid growth rates notwithstanding relatively closed capital accounts, with China and India being notable examples. Capital flows have, nonetheless, played a role in growth in some cases; in China, for example, large inward FDI flows over several decades have contributed to capital, technology, and managerial expertise. In any event, building on their progress with respect to reforms (such as financial sector reform) that support liberalisation, several large emerging economies are now moving in the direction of further capital flow liberalisation.

The benefits of capital flow liberalisation are largest when countries have achieved certain levels of financial and institutional development. In particular, in order to strengthen countries capacity to absorb and manage inflows and outflows, their financial systems need to be able to mediate flows safely, allow firms to access capital to finance productive investment, and give households and firms the ability to diversify their portfolios while managing the risks. Their institutions need to bolster the resilience of financial, corporate, and household balance sheets. Country experiences suggest that capital flow liberalisation is more likely to be successful if it is supported by sound fiscal, monetary, and exchange rate policies, and exchange rate flexibility can help cushion the real economy against the effects of capital flow volatility. Greater trade openness can support capital flow liberalisation by raising countries ability to attract foreign capital and by supplementing domestic demand with external demand, which can mitigate the growth and financial effects of crises.

At the same time, capital flow liberalisation carries risks, which are magnified when countries have yet to attain sufficient levels of financial and institutional development. The risks include heightened macroeconomic volatility and vulnerability to crises. In the absence of adequate financial regulation and supervision, financial openness can create incentives for financial institutions to take excessive risks, leading to more volatile flows that are prone to sudden reversal. Historically, capital flow liberalisation has often been followed by financial crises, and, during the recent crisis, financially open economies experienced larger output losses. While causality is difficult to ascertain owing to econometric concerns in estimation, these experiences highlight the risks associated with liberalisation in advance of basic prerequisites being met. Countries where CFMs were already in place, or were re-imposed, have also experienced contagion. Moreover, macroeconomic and financial policies could play a key role in precipitating crises.

Against this background, there is no presumption that full liberalisation is an appropriate goal for all countries at all times. The degree of liberalisation appropriate for a country at a given time depends on its specific circumstances, notably its financial and institutional development. Careful liberalisation of capital flows can provide significant benefits, which countries could usefully work toward realising over the long run. Moreover, a country could make progress toward greater capital flow liberalisation before reaching all of the necessary thresholds for financial and institutional development, and indeed doing so may itself spur progress in these dimensions. At the same time, liberalisation needs to be managed particularly cautiously if the threshold conditions are not yet met, as the risks are higher. Nevertheless, exceeding key thresholds for financial and institutional development does not eliminate the risks associated with capital flows.

Indeed, as the recent global financial crisis has shown, large and volatile capital flows can pose risks even for countries that have long been open and drawn benefits from capital flows and that have highly developed financial markets. For example, in several advanced economies, financial supervision and regulation failed to prevent unsustainable asset bubbles and booms in domestic demand from developing that were partly fueled by cheap external financing. Rather than favouring closed capital accounts, these experiences highlight the need for policymakers to remain vigilant to the risks. In particular, there is a constant need for sound prudential frameworks to manage the risks that capital inflows can give rise to, which may be exacerbated by financial innovation.

Several countries with long-standing and extensive CFMs would, however, likely benefit from careful further liberalisation. Among emerging economies, for example, significant progress has been made with respect to the pre-conditions for liberalisation. Macroeconomic cushions are ample with strong growth, low inflation, and high foreign reserves; the composition of external flows includes a relatively large share of FDI and equity flows; financial development is reflected in growing financial market depth and enhanced regulation and supervision; institutional quality and governance are deemed by investors to be improving; and trade openness has increased over time. Liberalisation by larger economies could substantially affect gross global capital flows, just as limited liberalisation or new CFMs in some economies could divert flows toward those with more open markets. Evidence on the magnitude of these multilateral effects is, however, unclear.

Extracted from the IMF paper The Liberalisation and Management of Capital Flows: An Institutional View