Friday, May 18, 2012

Capital Controls: Evolution of the IMF and Conventional Wisdom

Back when I was first being doused with economics in the late 1970s and early 1980s,  the idea that a country might impose controls on the inflow or outflow of international capital had a sort of fusty, past-the-expiration-date odor around it. Sure, such control had existed back before World War II, and persisted for some years after the war. But wasn't it already time, or slightly past time, to phase them out? Not coincidentally, this was also the position of the IMF at around this time. But when the IMF was founded back in the late 1940s, it accepted the necessity for capital controls, and now, the IMF is returning to an acceptance of capital controls--but with a twist. Let me walk through this evolution.

At the founding of the IMF back in the late 1940s,  "almost all members maintained comprehensive capital controls that the drafters of the Articles assumed would remain in place for the foreseeable future," reports the IMF in a 2010 paper on "The IMF's Role Regarding Cross-Border Capital Flows." The perspective was that "bodies such as the General Agreement on Tariffs and Trade (GATT—now the World Trade Organization, WTO) wereto be responsible for the liberalization of trade in goods and now services, while the Fund would ensure that members liberalized the payments and transfers associated with such trade." However, while the IMF would encourage liberalizing payments for trade, it would not especially encourage international capital flows for purposes of financial investment, based on a "rather negative view of capital flows that then prevailed, premised on the belief that speculative capital movements had contributed to the instability of the prewar system and that it was necessary to control such movements."

By the 1970s, the position of the IMF (and many mainstream economists) had changed. "Many advanced economies were liberalizing their capital accounts and it was recognized that international capital movements had begun to play an important role in the functioning of the international monetary system ..."
The IMF began to actively encourage countries to allow free movement of capital for investment purposes, although it stopped short of requiring such a change as a condition for loans. The general tenor of the IMF advice was that if there were problems with international capital flows, they could typically be resolved in other ways, like though flexibility of exchange rates or alterations in fiscal and monetary policy. By the 1990s, the IMF was proposing that all of its countries should gradually but surely remove all capital controls.
For more details on the IMF history with respect to capital controls, see the April 2005 report from the IMF's Independent Evaluation Office, Report on the Evaluation of the IMF's Approach to Capital Account Liberalization.

But this proposal never took effect, and one big reason was the East Asian financial crisis of 1997-98. The east Asian "tiger" economy like South Korea, Thailand, Malaysia, Indonesia and Taiwan had been growing ferociously in the 1980s and into the 1990s. They were viewed as genuine economic success stories: growing with rapid productivity growth, and fairly well-managed in their fiscal and monetary policies. But they attracted a wave of international investment capital in the early 1990s that pumped up their currencies and stock markets to unsustainable levels, and when the bubble burst and the international financial capital rushed out, it left behind a financial crisis and a deep recession. Of course, the recent difficulties in small European economies like Greece, Ireland, Portugal and Spain follow a similar pattern: international financial capital rushed in, promoted a boom, and then rushed out, leaving financial crisis and recession.

If you are in an economy that is small by global standards--which is most of them--then international capital markets have a tendency to dramatically overreact. It's like if when I said "I'm hungry," someone dumped a bathtub full of spaghetti over my head, and then when I said "that's too much," they starved me for a week. When small national economies look like a good place to invest, international money floods in and can lead to price bubbles and unsustainable booms. When the economic problems become apparent, then at some point a "sudden stop" occurs and international money floods out, leading to financial and economic crises.

Even before the east Asian crisis hit, some folks in the IMF and many outside it were rethink its notion that capital controls should only be viewed as obstructions to be removed, and began trying to develop a more nuanced view. The most recent IMF effort along these lines is a series of papers on "capital flows and the policies that affect them." The first paper in the series is the 2010 paper cited above. The fourth paper came out in March 2012, called  "Liberalizing Capital Flows and Managing Outflows." Here are a few highlights (references to figures and citations omitted):

Removing capital controls has theoretical benefits, but in the real world often has costs
"In perfect markets with full information and no externalities, liberalization of capital flows can benefit both source and recipient countries by improving resource allocation. The more efficient global allocation of savings can facilitate investment in capital-scarce countries. In addition, liberalization of capital flows can promote risk diversification, reduce financing costs, generate competitive gains from entry of foreign investors, and accelerate the development of domestic financial systems."

The main cost of removing capital controls is the risk of sudden stops
"The principal cost of capital account openness stems from the vulnerability to financial crises triggered by sudden stops in capital flows, and from currency and maturity mismatches. Systemic risk-taking can increase investment, leading to higher growth but also to a greater incidence of crises. Many empirical studies have established the strong association between surges in capital inflows (and their composition) and the likelihood of debt, banking, and currency crises in emerging market countries. Other studies, however, do not find a systematic association between crises and capital account openness, but find that the relationship hinges on the level of financial sector development, institutional quality, macroeconomic policy, and trade openness ... "

The main policy recommendations still propose a gradual movement toward fewer restrictions on capital movements, but this recommendation now comes hedged about with qualifications. Three of these seem especially important to me.

1) "In low-income countries, the benefits of capital flows arise mainly from foreign direct investment (FDI). In many countries, FDI has helped to boost investment, employment, and growth. Low-income countries generally need to strengthen their institutions and markets in order to safely absorb most other types of capital flows, which carry substantial risks until such thresholds are met." A common recommendation is that countries should allow foreign direct investment, and then gradually open up to international investment in equity markets, and then gradually open up to international lending and borrowing.

2) The pace at which this gradual opening-up to international capital happens should depend on the prior development of a nation's economic conditions and political institutions.

3) When using capital constraints, focus more on limiting international inflows than on outflows. This recommendation is a reversal from the early days of IMF, when constraints on capital outflows were common, but constraints on inflows were almost unheard of. But the recommendation makes sense. Limits on capital outflows are very hard to enforce in an interconnected modern world economy, and they are only needed when the financial crisis has already occurred. Limits on capital inflows, like encouraging foreign direct investment but discouraging dependence on short-term capital inflows from abroad, helps to prevent a financial bubble from inflating in the first place.

This advice seems sensible to me, if perhaps difficult to implement After all, would it have been politically or economically possible for Greece or Ireland or Spain to have restricted inflows of international financial capital back in 2007 or 2008? In response to such questions it's worth repeating an honest confession from up near the front of the March 2012 IMF report. "[T]he theoretical and practical understanding of capital flows remains incomplete. Capital flows are a financial phenomenon, and many of the unresolved analytical and policy questions related to the financial sector carry over to capital flows."