Pigs Will Fly: IMF Now OKs Capital Controls

♠ Posted by Emmanuel in ,, at 4/07/2010 11:52:00 PM
Big man, pig man, ha ha charade you are
You well-heeled big wheel, ha ha charade you are

Pink Floyd fans like your truly should be very familiar with the Storm Thorgerson / Hypgnosis cover of the band's 1977 album, Animals. It, of course, is a twist on George Orwell's dystopian novel Animal Farm. Living in the shadow of nearby Battersea Power Station--the building you see on the cover belching smoke that has since been deactivated--I reflected on how pigs may fly as I was reading a recent report on the IMF effectively making yet another mea culpa for championing Washington Consensus-style neoliberal orthodoxy for so long. A few weeks ago, the IMF issued a policy paper more or less disavowing its previously cherished tenet of budgetary responsibility by encouraging higher inflation targets and countercyclical public spending during crisis situations (at least if you can afford them). Over a year ago, I spotted this hypocrisy in IMF prescriptions as it apparently believed that poor countries hit by crisis needed to heed conditionalities advocating belt tightening and fiscal austerity while rich countries like the US could spend as it pleased. Let no one forget who still calls the shots at the IMF.

Dani Rodrik
now points us in the direction of yet another IMF policy paper that signals the very end of another cherished Washington Consensus idea: unrestricted capital mobility. Many like yours truly have faulted the IMF for advocating that Asian countries hit by contagion in 1997/98 remove capital controls. Instead of spurring long-term investment, inflows from footloose global capital tended to be speculative in nature, leaving at the first sign of trouble. Given that the financial infrastructures of developing countries had, by that time, not sufficiently developed enough sophistication to channel these inflows, they proved detrimental to economic performance overall.

Apparently, the IMF is now coming around to a similar point of view and, wonder of wonders, now suggests that prudential use of capital controls to keep investment in these countries for a longer period of time and discourage "hot money" could just be the right thing to do. As Blightly's own fearless leader said, perhaps the old Washington Consensus really is over. What follows is the introductory portion of the report, though the rest is of course well worth reading for dedicated development and IPE followers -

Capital Inflows: The Role of Controls

With the global economy beginning to emerge from the financial crisis, capital is flowing back to emerging market economies (EMEs). These flows, and capital mobility more generally, allow countries with limited savings to attract financing for productive investment projects, foster the diversification of investment risk, promote intertemporal trade, and contribute to the development of financial markets. In this sense, the benefits from a free flow of capital across borders are similar to the benefits from free trade, and imposing restrictions on capital mobility means foregoing, at least in part, these benefits, owing to the distortions and resource misallocation that controls give rise to.

Notwithstanding these benefits, many EMEs are concerned that the recent surge in capital inflows could cause problems for their economies. Many of the flows are perceived to be temporary, reflecting interest rate differentials, which may be at least partially reversed when policy interest rates in advanced economies return to more normal levels. Against this backdrop, capital controls are again in the news. A concern has been that massive inflows can lead to exchange rate overshooting (or merely strong appreciations that significantly complicate economic management) or inflate asset price bubbles, which can amplify financial fragility and crisis risk. More broadly, following the crisis, policymakers are again reconsidering the view that unfettered capital flows are a fundamentally benign phenomenon and that all financial flows are the result of rational investing/borrowing/lending decisions. Concerns that foreign investors may be subject to herd behavior, and suffer from excessive optimism, have grown stronger; and even when flows are fundamentally sound, it is recognized that they may contribute to collateral damage, including bubbles and asset booms and busts.

The question is thus how best to handle surges in inflows that may pose both prudential and macroeconomic policy challenges. The tools are well known and include fiscal policy, monetary policy, exchange rate policy, foreign exchange market intervention, domestic prudential regulation, and capital controls. Clearly, the appropriate policy mix is likely to depend on the state of the economy (i.e., how close it is to potential); the level of reserves (is further accumulation desirable/appropriate?); the quality of existing prudential regulation (can prudential tools effectively tackle the boom/bust credit/asset price cycle); the scope to allow the currency to strengthen (is the currency already overvalued?); and the likely persistence of the inflows (with permanent inflows less likely to warrant a policy response than transitory inflows).

This paper reviews the arguments on the appropriate management of inflow surges and focuses in particular on the conditions under which controls may be justified. A key conclusion is that, if the economy is operating near potential, if the level of reserves is adequate, if the exchange rate is not undervalued, and if the flows are likely to be transitory, then use of capital controls—in addition to both prudential and macroeconomic policy—is justified as part of the policy toolkit to manage inflows. Such controls, moreover, can retain potency even if investors devise strategies to bypass them, provided such strategies are more costly than the expected return from the transaction: the cost of circumvention strategies acts as “sand in the wheels.”

A key issue of course is whether capital controls have worked in practice. Our sense is that the jury is still out on this, and it is difficult to get the data to speak loudly on the issue. Controls seem to be quite effective in countries that maintain extensive systems of restrictions on most categories of flows, but the present context relates mainly to the reimposition of controls by countries that already have largely open capital accounts. The evidence appears to be stronger for capital controls to have an effect on the composition of inflows than on the aggregate volume (though empirical models linking aggregate inflows to controls are frequently subject to a host of objections, most obviously, simultaneity bias). For example, in the case of Chile and Colombia, controls do appear to have had some success in tilting the composition of inflows toward less vulnerable liability structures.

Looking at the current crisis, our own empirical results suggest that controls aimed at achieving a less risky external liability structure paid dividends as far as reducing financial fragility. An interesting twist is that some foreign direct investment (FDI) flows may be less safe than usually thought. In particular, some items recorded as financial sector FDI may be disguising a buildup in intragroup debt in the financial sector and will thus be more akin to debt in terms of riskiness. This point resonates well with the experience of emerging Europe during the recent crisis.

A significant caveat, however, to the use of capital controls by individual countries, relates to the potential for adverse multilateral consequences. In the present circumstances, global recovery is dependent on macroeconomic policy adjustment in EMEs, which could be undercut by capital controls, notably in cases where currencies are undervalued. Widespread adoption of controls by EMEs could exacerbate global imbalances and slow other needed reforms—a critical concern at present, when sustained global recovery hinges on a rebalancing of global demand and the sources of growth in individual countries. In addition, controls imposed by some countries may lead other countries to adopt them also: widespread adoption of controls could have a chilling longer-term impact on financial integration and globalization, with significant output and welfare losses. Multilateral dimensions clearly need to be taken into account in assessing the merits of controls at the individual country level.