Global Economy
International Monetary Fund reverses decades old policy on capital controls
By Finfacts Team
Apr 6, 2011 - 2:17 AM

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The International Monetary Fund on Tuesday reversed a decades old policy, which opposed inter-country capital flow controls, when it endorsed guidelines for countries to use restrictions in some circumstances to protect their economies.

The Fund's executive board said on Tuesday that "capital flows have returned with the ebbing of the global financial crisis, bringing investment and growth benefits to recipient countries, but also important macroeconomic and financial stability challenges. Improved fundamentals and growth prospects in emerging markets and loose monetary policy in advanced economies are among the main pull and push factors behind the recent wave of inflows to emerging markets."

It reviewed a staff paper on the experience of selected countries in dealing with capital inflows, which suggests a possible framework for Fund policy advice on the spectrum of measures available to policymakers to manage inflows, including macroeconomic policies, prudential measures, and capital controls. The board said:
"Illustrative applications of this framework suggest that it may be appropriate for several countries, based on their current circumstances, to consider prudential measures or capital controls in response to capital inflows."

A majority of directors supported the change.

IMF managing director Dominique Strauss-Kahn said the fund is taking a "very pragmatic" view of capital controls, the use of taxes, interest rates or other policy tools to curb flows of cash in and out of countries.

"It cannot be a substitute for the right economic policies, but when the right economic policies are in place, then it can be necessary, on a temporary basis, to use this kind of tool," he said.

Several countries including Brazil, South Korea and Turkey have placed limits on capital flows in an effort to control inflation, limit the rise in their own currencies or prevent bubbles in their stock and property markets.

The Fund released two studies this week: Recent Experiences in Managing Capital Inflows—Cross-Cutting Themes and Possible Policy Framework, (pdf) which looks at country cases and suggests a framework of measures available to manage inflows, including macroeconomic policies, tax and prudential measures, and capital controls. The second paper, Managing Capital Inflows: What Tools to Use, (pdf), provides analytical underpinning to the Fund’s research on the topic.

This work on capital flows is part of a broader work agenda to enhance the coverage, candour, and evenhandedness of IMF policy advice. In the process, the Fund says it is looking at ways to strengthen how it evaluates advanced economies, where the global crisis began.

The IMF is studying the originators of capital flows, known as the “push” forces. Reports on the effects that policies in one country or group of countries might have on others, known as spillovers, are being prepared for the world’s five largest systemic economies - - China, the Eurozone, Japan, the UK, and the United States.

Net private capital flows to developing countries rose 44% in 2010 to about $753bn, according to the World Bank. The nine countries that attracted the most capital flows were Brazil, China, India, Indonesia, Malaysia, Mexico, South Africa, Thailand and Turkey, the bank said in January.

Brazil’s currency, the real, has jumped 42% against the dollar since the beginning of 2009. The Indonesian rupiah has risen 25%, while the South Korean won is up 14%. 

Choices, choices, choices

While capital flows are generally beneficial for receiving countries, surges in inflows carry risks for their economies and financial systems. IMF research finds that policy responses to inflows have varied considerably, in part because of the differences between countries and the nature of the capital inflows in each case.

Surges in inflows can pose challenges such as rapid currency appreciation and a buildup in financial sector fragilities, such as those stemming from asset price bubbles or rapid credit growth, or the risk of a sudden stop or reversal of inflows.

The management of capital inflows “covers a whole swath of economic policies,” said Strauss-Kahn in his statement (pdf) to the executive board. These issues are central to the role of the IMF.

IMF research: common ground and lessons

The following key principles form the foundation of an organizing framework around which national authorities can formulate policies:

1. No “one-size-fits-all”. The right policy mix will depend on each country’s circumstances, including the state of the domestic economy and the nature and magnitude of the capital inflows.

2. Structural reforms are always encouraged. Policies designed to increase the capacity of the economy to absorb capital inflows for example, by creating deeper domestic capital markets should be pursued under all circumstances.

3. There are no substitutes for the right macro policies. Any response has to give primacy to macroeconomic policies. Measures specifically designed to influence inflows cannot be a substitute for the implementation of appropriate macroeconomic policies.

4. Capital controls are part of the policy toolkit. As outlined recently by Strauss-Kahn, capital controls can be used on a case-by-case basis, in appropriate circumstances.

5. Design the medicine to treat the ailment. Capital flow management measures should match the specific macroeconomic or financial stability concerns in question. In general, these measures should maximize efficiency and minimize distortions, and should be withdrawn when risks recede.

6. Think of others. Policies that might affect the external stability of other countries and, by extension, global financial stability or growth prospects, should be discouraged. In this regard, the framework suggests giving preference to measures that do not discriminate on a residency basis. This reflects the Fund’s multilateral mandate to promote systemic stability and foster global policy coordination.

The effectiveness of the policy framework will be analyzed and adjusted over time, particularly in light of the impact that policies in one country or group of countries might have on others.

Country experiences in managing capital flows will also be covered in forthcoming IMF research and in the upcoming Regional Economic Outlooks, to be issued in late April and May this year.

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