Capital controls are in again
What’s at stake: The International Monetary Fund has shifted its long-held stance against capital controls as it seeks to help emerging economies protect themselves from future economic crises. In a new staff position note, confirming the change of stance we reported in November, IMF economists wrote that capital controls could be used in some cases by emerging market governments as a shield from unwanted capital flows.
The IMF staff position note argues that for both macroeconomic and prudential reasons there may be circumstances in which capital controls are a legitimate component of the policy response to surges in capital inflows. The note 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.” Multilateral dimensions, however, are integral to a balanced perspective on the appropriateness of using capital controls to manage inflows. While controls can be helpful to individual countries under certain conditions, their widespread use could have deleterious effects on the efficient allocation of investment across countries, and harm prospects for global recovery and growth.
William Cline argues that the new empirical evidence the IMF staff produces is seriously misleading. The authors rightly consider the recent global financial crisis to be a “natural experiment” to test whether capital controls substantially lessen the adverse impact of external shocks on emerging-market economies. According to their results more financially open economies fared worse in the global financial crisis. For 37 emerging-market economies, the authors find that severity of the growth decline from the 2003–07 average to 2008–09 was associated with larger stocks of debt liabilities relative to GDP, and larger stocks of foreign direct investment (FDI) in the financial sector relative to GDP. Moreover, there was a “negative association between capital controls that were in place prior to the global financial crisis and the output declines suffered during the crisis”. Unfortunately, it turns out that their results are driven almost entirely on evidence from a handful of small, unrepresentative economies: the three Baltic states and Iceland.
Marek Belka adds a European dimension to the discussion and points to the specific challenges facing the new member states, which are constrained in their ability to impose capital controls by the rules of the European Union. For some of these countries, greater use of prudential regulations – following Poland’s example – could be a first step. And given the broader debate underway on financial transactions taxes in international fora, such as the G-20 group of advanced and emerging economies, the new member states should consider whether this form of regulation would be appropriate for their economies and take part in the discussion.
Simon Johnson points to a recent lecture by Adair Turner, head of Britain’s Financial Services Authority delivered at the Reserve Bank of India in Mumbai where he addressed the issue of capital controls. Much of what Mr. Turner is arguing on these issues is not new — as he acknowledges, the general points have been made eloquently before, in various fashion, by scholars like Jagdish Bhagwati (in broad terms) and Arvind Subramanian (in specific form, with numerous co-authors). But Mr. Turner has a knack for bringing officials with him. He is ahead of the intellectual curve, but not so far divorced as to seem out of touch or irrelevant.
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