Feb 22, 2010 - 3:51:40 AM
IMF staff paper says controls on capital could be useful part of policy toolkit - - radical change from conventional wisdom
By Michael Hennigan, Founder and Editor of Finfacts
Feb 19, 2010 - 5:02:44 AM
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An IMF paper published today, says sudden surges in capital can pose economic and financial challenges for countries and controls on inflows of foreign capital can be one tool in the broad policy toolkit. However, countries’ should take account of the impact of controls on other countries. The view is a radical change from the stance of the Fund in recent decades and on Monday in Mumbai, Lord Adair Turner, chairman of the UK Financial Services Authority, said a dominant conventional wisdom of economy theory and policy - - the Washington Consensus as it was labelled - - has assumed and asserted that an increase in the financial intensity of the economy is beneficial. Turner said short-term capital flows can under some circumstances be harmful: and complex financial innovation in developed countries has produced few demonstrable benefits and resulted in an increased risk of financial instability.
With the global economy recovering, capital is flowing back to emerging market economies - - a welcome development, according to Fund staff, in that it provides additional financing for productive investment, opportunities for risk diversification, and scope for consumption smoothing. However, some countries facing sudden and temporary spikes in different forms of foreign capital flows are worried about the possible problems this can cause for economic management or the health of the financial system.
Controls on foreign capital into emerging economies can be part of the policy options available to governments to counter the potential negative economic and financial effects of sudden surges in capital, the IMF staff said.
The global banking industry group, the Institute of International Finance, says inflows to emerging economies will rise to $721.6 billion in 2010 from $435.2 billion last year.
In recent months, Brazil has put a 2% tax on speculative inflows and Taiwan has banned foreigners from putting money into time deposits.
Speaking at the Reserve Bank of India organised 14th C.D. Deshmukh Memorial Lecture on February 15, 2010 in Mumbai, Lord Turner said policy makers should openly consider policy options which were rejected by the dominant conventional wisdom of the last two decades:
- While it is very difficult in a globalised economy to impose comprehensive controls on short-term capital flows, and while some categories of capital flow are beneficial, policy instruments (such as taxes) which place constraints on short-term speculative inflows may have an important role to play in some emerging economies.
- A variety of policy levers focused on ‘putting sand in the wheels’ of short-term speculative trading should be openly considered. Financial transaction taxes have theoretical attractions which need to be balanced against practical implementation challenges. Increases in capital requirements against trading activity are a key priority, and leverage constraints need to be applicable to non-bank as well as bank trading activities. Reductions in trading activity in markets of uncertain economic value (such as carry trade foreign exchange speculation on credit derivatives trading unrelated to underlying credit extension) would be acceptable consequences.
- Developed countries should consider macro-prudential tools which directly address the level and pattern of credit extension as key economic variables, constraining credit extension in the upswing, particularly where credit extension can drive asset price bubbles such as in commercial real estate. This constraint may be achieved via discretionary countercyclical variation in capital or liquidity requirements. This implies moving away from a sole reliance on the interest rate lever to steer the economy.
John Maynard Keynes’s insight that increased market liquidity can bring disadvantages as well as benefits needs to be rediscovered.
Turner said Keynes believed that "Of the maxims of orthodox finance, none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of institutional investors to concentrate their resources upon the holding of 'liquid' securities.' And scepticism about the limitless benefits of market liquidity and of the speculation required to make it possible, is justified on two grounds:
- First, the fact that the benefits of market liquidity must, as already discussed, be subject to declining marginal utility. The benefits deliverable by the extra liquidity which derives from flash and algorithmic trading, exploiting price divergences present for a fraction of a second, are clearly of minimal value compared with the provision of reasonable liquidity on a day-by-day basis.
- And second, the fact that, to a degree which is difficult to predict and unstable over time, greater market liquidity and a greater role for speculators can produce destabilising and harmful herd and momentum effects.
In a new Staff Position Paper “Capital Inflows: The Role of Controls,” issued on Friday, February 19th, IMF staff discuss the circumstances under which controls on capital inflows to emerging market economies can usefully form part of the policy toolkit to address the economic or financial concerns surrounding sudden surges in capital. The paper is part of work underway by the staff of the 186 member international institution that reassesses the macroeconomic and financial policy framework in the wake of the devastating crisis.
Controls part of a policy package
- There are a number of policy choices governments can make when faced with a short-term or sudden surge in foreign capital, IMF staff said. These include:
- Allowing the currency to appreciate
- Accumulating more reserves
- Changing fiscal and monetary policy
- Strengthening rules to prevent excessive risk in the financial system
- Capital controls
In some circumstances, capital controls may complement the use of economic or prudential remedies to more effectively address the problem.
“There may be circumstances in which capital controls are a legitimate component of the policy response to surges in capital inflows,”the paper says, while noting controls would normally be temporary, as a means to counter surges. In particular, the paper notes: “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 is justified as one element of the policy toolkit to manage inflows.”
Nevertheless, evidence to date on the relative effectiveness of capital controls is ambiguous, according to the paper. Controls appear to work better in countries with existing restrictions, or with strong administrative capacity. Evidence also suggests that controls have more effect on the composition of capital flows than on their volume.
Not all capital inflows created equal
The analysis found that certain types of capital inflows can make a country more vulnerable to financial crisis. One example is debt versus equity flows, in which the latter allows for greater risk-sharing between creditor and borrower.
Capital inflows might also fuel domestic lending booms, according to IMF staff, which is especially dangerous if extended to unhedged borrowers, such as households, rather than to exporters.
Drawing on evidence from the recent global financial crisis, the paper also found that countries with larger initial stocks of debt liabilities and higher foreign direct investment in the financial sector fared worse in the crisis.
This is because both are linked to credit booms and foreign-exchange lending by the domestic banking system inside the country, which can make the financial sector more vulnerable, the paper said. IMF staff also found evidence that controls on capital inflows that were in place before the crisis helped improve growth resilience during this crisis.
Global effects of controls
Any country’s policies to control the inflow of capital will need to take into account the global effect, particularly as economies recover and countries look for new sources of growth, IMF staff said.
Controls would be inappropriate in cases where the exchange rate was undervalued from a multilateral perspective since this could frustrate needed rebalancing of global demand and the sources of growth in individual countries, and could redirect capital to countries less able to absorb it.
The paper says controls should also not become a substitute for more fundamental - - but perhaps more difficult - - policy changes, as this could lead to adverse effects that could undercut the longer-term benefits from financial integration and globalization.
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