“What used to be heresy is now endorsed as orthodox,” remarked John Maynard Keynes in 1944 after he helped convince world leaders that the newly established International Monetary Fund (IMF) should have the regulation of international financial flows as a core right. By the 1970s however, the IMF and Western powers began to dismantle the theory and practice of regulating global capital. In the 1990s, the IMF went so far as to try and change its articles of agreement to manage the deregulation of cross-border finance.
This week, the IMF grabbed headlines for seemingly going back to its more sensible roots. While the IMF has taken a step in the right direction, it still insists on the eventual deregulation of global financial flows and a “one size fits all” approach to how nations should manage volatile speculation.
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Last week, the IMF released a new “institutional view” on the management of cross-border financial flows. The IMF remains wedded to the eventual liberalisation of a country’s capital account, but it now recognises that the idea of free transfers of investments rests on much weaker ground than does the case for free trade. The IMF now sees that nations need to cross a certain institutional threshold first, one that many emerging markets and developing countries have not yet reached.
What is more, the IMF now acknowledges that there are risks as well as benefits to cross-border financial flows. Capital flows are particularly prone to sharp inflow surges followed by sudden stops that can cause a great deal of financial instability.
‘One size fits all’ approach
All the headlines noted that the new IMF view says nations could even use “capital controls”, reframed as “Capital Flow Management Measures (CFMs)”, on previously deregulated portions of their capital account if done alongside other macroeconomic policies such as: Interest rate and fiscal policy management, the accumulation of foreign exchange reserves and macroprudential financial regulations. Even under such circumstances, capital controls should generally not discriminate on the basis of currency.
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On top of this, this month the IMF’s Independent Evaluation Office (IEO) also released an assessment of IMF policy on reserve accumulation. The IEO report implies that the IMF still has a “one size fits all” approach to reserve accumulation. Many in the emerging markets feel that the accumulation of foreign exchange reserves during the 2000s was a strategic way to ensure that they could manage exchange rate volatility and export competitiveness – yet the IEO report says the IMF pinned significant blame of global financial instability on emerging market reserve accumulation.
In recent years, many emerging markets and developing countries have been busy re-regulating financial globalisation in order to promote financial stability so as to enhance domestic priorities. They have been watching the IMF’s “rethink” on these issues very closely because they have decades of experience with the management and mismanagement of capital flows.
Nations such as South Korea and Brazil were flooded with hot money from 2009 to 2011, so much so that it accentuated currency appreciation and asset bubbles. The arena for the “tsunami” of inflows was the low interest rates and quantitative easing in industrialised countries and relatively higher rates in the emerging world. When the eurozone panic ensued in July of 2011, financial flows came to a halt and did an aboutface to the “safety” of the United States, Switzerland, and beyond.
Countries across the emerging world accumulated foreign reserves and regulated cross border capital flows during surges and eased such measures to prevent and mitigate sudden stops. Reserve accumulation helps temper a surge in financial flows by reducing pressure on the exchange rate. And perhaps more importantly, those reserves can be there to protect a currency in the event of a sudden reversal. Capital controls, say like Brazil’s recent taxes on inflows and regulations on foreign currency derivatives, helped temper capital inflows to the country as well, and were relaxed last week when there was less pressure on Brazil’s financial systems.
Unfortunately, the IMF’s new position is summarised in one small text box in its report that proscribes a one-size fits all approach to all countries that is out of touch with prudent thinking and practice.
Capital account liberalisation
Despite the academic evidence and country experience to the contrary, the IMF’s new “institutional view” remains stubbornly wedded to the idea of capital account liberalisation. In a new study that surveys and updates the economics literature recently published by the Peterson Institute for International Economics, Arvind Subramanian, Olivier Jeanne and John Williamson conclude that “the international community should not seek to promote totally free trade in assets – even over the long run – because (as we show in this book) free capital mobility seems to have little benefit in terms of long run growth”.
The IMF recommendation to use capital controls only after a set of policies such as interest rate adjustment, reserve accumulation, and prudential regulations have been in place, is out of step with theory and evidence as well. New work in economic theory shows that capital controls can actually be the optimal policy choice. The new welfare economics of capital controls views unstable capital flows as negative externalities on recipient countries. Therefore regulations on cross-border capital flows are optimal tools to correct for market failures that can make markets work better and enhance growth, not worsen it.
Indeed, the IMF’s own research showed that those nations that deployed such policies were among the least hard hit during the global financial crisis. In the nations studied, capital controls were often deployed first or at least alongside a host of other macroprudential measures, and many were not market based or temporary.
The IMF also fails to fully appreciate that capital flows should be regulated at “both ends” or at least that industrialised nation regulations won’t make matters worse. IMF research [PDF] over the last year outlined circumstances where industrialised countries should also take part in regulating global capital flows. But the new view also shows that industrialised country trade and investment treaties may prohibit the regulation of cross border finance.
The good news is that Article VI of the IMF Articles of Agreement still stands: “Members may exercise such controls as are necessary to regulate international capital movements.” The IMF is making strides in the right direction, but the lead will have to continue to come from the example of many emerging markets. Developing countries remain the best judges of their own economies and should look at the new IMF advice on financial globalisation with great scrutiny.
Kevin P Gallagher is associate professor at Boston University and co-chair of the Pardee Task Force on Regulating Global Capital Flows for Development.