The press was recently full of dramatic reports about the IMF changing its position on capital controls, recommending its use as an instrument of policy. For someone like me, who watched the news obsessively during the balance of payments crisis of the early 1990s, this ostensible change in the IMF?s position came as a big surprise.
Why is this important? Those who held the view that cross-border portfolio flows were unsavoury might find support in this about-face for policies that cause these flows to dry up. The costs of this should not be underestimated; capital flows, in theory, should allow the financing of investment projects when domestic savings are insufficient, and as the IMF points out in its report, ?foster the diversification of investment risk, promote inter-temporal trade, and contribute to the development of financial markets.?
Of course, the fine print is different from the headlines. But before we get into the specifics of what the IMF actually did say, it?s worth thinking about the debate about capital controls a bit more carefully. At least since the Asian crisis, international portfolio flows have been a controversial topic. At the time of that crisis, leaders of many affected countries held foreign investors responsible for the dramatic reductions in Asian equity prices and foreign exchange rates. Their statements were based on one observation followed by two assumptions.
The well-documented observation is that movements in countries? equity markets follow movements in portfolio flows to these countries. The first assumption is that portfolio flows generate these movements in returns, because foreign speculators have deep pockets and move markets when they trade. Second, that portfolio flows are primarily driven by factors unrelated to fundamentals, that is, foreign speculators are subject to swings in their sentiment about markets, and this sentiment is what drives their investment decisions. When combined, these ingredients lead to the view that portfolio flows are ?hot money?, a pejorative term that is now commonly used to describe them.
There is at least one other interpretation of the observation that foreign portfolio flows predict declines in asset returns. This interpretation is that foreign investors are better informed than domestic investors about economic fundamentals. According to this view, foreign investors can predict movements in relevant fundamentals better than domestic investors and buy or sell assets accordingly. When these predicted events materialise, the prices of the assets adjust to their new levels. Note that according to this interpretation, portfolio flows aren?t ?hot money?, but rather the product of rational calculations by foreign investors. These investors are just better at reading the writing on the wall than their domestic counterparts.
Which view is correct? One can come up with plenty of reasons why domestic investors are better informed than foreign investors (local connections, a better understanding of domestic institutions, and so on). Just as easily, one can come up with reasons to believe that the opposite is true (foreign investors are experienced at investing in multiple countries, can spot patterns seen in different situations, possess more sophisticated investment technology, etc). What?s important here is that there is a real debate and there is evidence to support both the views. If you come down on the side that foreign portfolio flows during the Asian crisis came from rational investors anticipating troubles in these economies, then characterising them as ?hot money? and banning them seems unfair?like a punishment for being prescient.
Now coming back to the IMF report. On closer reading, there is a small amount of analysis in the report in which the declines in GDP growth rates of multiple countries, post crisis, are explained using the composition of inflows into these countries. The authors find weak evidence that the declines in growth rates are lower for countries with a larger share of non-financial FDI, and even weaker evidence of capital controls being associated with avoiding large GDP growth rate declines. However, there isn?t much evidence about what the levels of these growth rates were, to begin with. So, it is entirely possible that the countries imposing capital controls had low growth rates to begin with and low declines, post crisis. And the language in the report is very cautious: ?The perspective… is thus that capital controls are a legitimate part of the toolkit to manage capital inflows in certain circumstances, but that a decision on their use should reflect a comparison of the distortions and implementation costs that they may impose….? That?s a wise advice. It seems to me that much more work is required before we can think about the right circumstances in which capital controls might be appropriate.
The author is a financial economist at Sa?d Business School, University of Oxford