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Summary
This briefing explores the impact of capital account policy on international development. The liberalisation of capital accounts in developing countries has been promoted by international economic and financial institutions. However, with evidence showing the damaging economic, social and human consequences of unrestricted capital movement, tools to manage capital flows are increasingly being embraced by policy makers and academics.
Developing countries have been particularly affected by the loss of monetary autonomy, risky capital inflows and sudden outflows, as well as exchange rate volatility that accompanies capital account liberalisation. The resultant financial crises bring increases in poverty and inequality.
Capital controls can help promote sustainable growth, employment, living standards, and stability in developing countries by supporting long-term private-sector investments and at the same time lowering the risk of economic crises.
Background
With G20 members Indonesia and South Korea recently adopting instruments to manage money flows in and out of their economies, the debate about capital controls has revitalised. While regulation of capital flows was seen as a legitimate policy tool during post-war economic restructuring, since the 1980s, it has been frowned upon by advanced industrialised economies and international financial institutions. Recent policy practices and academic positions indicate that the image of capital controls might have changed again in the wake of the global financial crisis. While provoking fear of protectionism for some, others welcome the potential for enhancing global financial stability and development prospects. What is at stake for developing countries in this debate?
Advanced industrial economies’ responses to the global financial crisis have intensified the struggles of many developing countries to cope with huge capital inflows from overseas. With interest rates in North America and Europe being held at record lows of close to zero per cent, large amounts of short-term portfolio investment continue to flow to developing economies, where the risks of inflation and asset bubbles keep interest rates high. The Institute for International Finance (IIF) estimates a rise of capital inflows to emerging markets from £281 billion in 2009 to £459 billion in 2010.i
Reconsidering capital management
Advocates of capital account liberalisation have argued that the free movement of capital around the globe enhances economic growth and paves the way for poor countries’ development. According to this theory, if capital flows are unrestricted, then resources would be allocated efficiently and move from rich counties, where yields are low due to capital abundance, to countries where capital scarcity promises high returns on investments. Consequently, increased credit availability in developing economies would enhance domestic production and consumption and lead to economic growth, which would contribute to poverty reduction. Free capital movement is presumed to increase investment stability by allowing poor countries to diversify their income sources and thus become more independent of donors.
Empirical experience, however, contradicts this theory. Capital account liberalisation had significant distributional implications and was at the root of highly destructive financial and economic crises in the past, especially in the developing world. The November 2008 study Lessons from World Bank research on financial crisies examines financial crises’ impacts on poverty, inequality and human development. For example, the 1995 Peso crisis in Mexico resulted in a 9 per cent decline in GDP, in that year, causing a considerable increase in poverty. Similarly, the Argentinean financial crisis in 2002 was found to have dramatic effects on real incomes of workers and households, “with 63 per cent of urban households experiencing real income falls of 20 per cent or more between October 2001 and October 2002”. Wealth transfers in times of crisis, despite being “quite complex”, are generally found to take place from the poor to the rich. Moreover, research on Indonesia’s financial and economic crisis of 1998 found sharp and “geographically uneven increases in the poverty rate”. While there exists cross-country variation on human development during crisis, “in the poorest developing countries, however, both health and education outcomes deteriorate during economic crises.”ii
Internationally distinguished economists including Nobel-prize winner Joseph Stiglitz and Harvard professor Kenneth Rogoff, international organisations such as the United Nations, as well as policy makers in developing countries have long argued for active capital flow management. In a February 2010 staff position note Capital inflows: the role of controls, International Monetary Fund (IMF) economists reviewed the impact of capital controls on economic performance during the recent financial crisis and found that “the use of capital controls was associated with avoiding some of the worst growth outcomes associated with financial fragility.”iii
Policy achievements
There are a number of reasons why capital controls are used, directly relating to and going beyond crisis management. To maintain independence over their monetary policy, the implementation of capital controls is often the only option available to developing countries. Economists Robert Mundell and Marcus Flemming won a Nobel prize for describing the “trilemma” of international macroeconomics that a country cannot simultaneously maintain free capital movement with an independent monetary policy and stable exchange rates. For developing countries that link their currency to more stable currencies, this ‘unholy trinity’ necessitates capital controls to ensure monetary autonomy. Giving up sovereignty over monetary policy has recently created problems in the Eurozone, and far more severe effects on poverty were seen in developing economies during the last two decades. Monetary dependence on external developments creates public spending instability, harming poor people most.iv
Another major rationale for developing countries to adopt capital controls is to shift the composition of capital flows towards long-term investment, particularly investment in new projects or businesses. Whereas portfolio investment, mostly in the form of short-term stock market investments and short-term debt, is inherently pro-cyclical and creates volatility; stable, long-term private sector investment is a critically important contributor to economic development. For example, Chile’s central bank re-imposed restrictions on selective capital inflows in 1991 on a long-term basis. Investors are required to deposit an unremunerated reserve at the central bank for a period of one year on liabilities in foreign currencies. Former IMF chief economist Kenneth Rogoff and others have found that Chile’s active capital management was successful in changing its foreign liabilities towards longer-term maturities, making the country more resistant to external shocks.v Colombia, India and China have also shifted investment composition by using capital controls.
Reducing the overall volumes of capital flows is an additional objective for developing countries to regulate their capital accounts. Painful experiences during the 1990s raised awareness of the destructive effects of asset bubbles and credit booms triggered by extensive uncontrolled inflows of foreign capital into developing economies. The economic transition of Central and Eastern Europe has resulted in a rapid opening to foreign capital. Until 2008, large amounts of money flowed from advanced industrialised economies eastwards, particularly to banks in the region. In turn, banks extended private, foreign-currency loans on an unprecedented scale. Without bearing any relation to the economic fundamentals of these countries, the massive capital inflows led to large macroeconomic imbalances and fuelled credit booms and asset bubbles. In the long run this type of development is not sustainable. In emerging Europe, the bust which severely destabilised the region’s economic and social development was initiated by the outbreak of the global financial crisis. A 2009 World Bank report details the vast decline in living standards through spiking unemployment and poverty rates in Eastern Europe after September 2008.vi
In other cases, capital controls are employed to reduce real exchange rate pressure. Former World Bank chief economist Joseph Stiglitz has long promoted capital controls’ positive effects on containing currency crises.vii A large scale and unsustainable appreciation of the Icelandic kroner came in the wake of Iceland opening its capital account. Capital controls were, however, only adopted when the crisis broke out and Iceland’s currency collapsed in September 2008. Restrictions on outflows were aimed at preventing even worse economic outcomes and constituted the key response of the emergency package introduced under the oversight of the IMF. Due to its damaging effects on private investment in the manufacturing sector, exchange rate volatility causes particular economic and social risks to developing economies.
Apart from individual circumstances of domestic economies, capital controls might be employed to contain the risk of contagion. Herd behaviour by international investors exposes developing countries to the risk of financial crises even if they have solid economic fundamentals. Despite its healthy economy, OECD member South Korea first experienced the devastating effects of sharp reversals in capital flows during the Asian financial crisis in 1997 which started in Thailand and then spread throughout the region. The Asian financial crisis decimated the economies of the region, destroying businesses, jobs, and economic growth. Contagion also played a significant role for South Korea during the recent crisis starting in the United States. In June, the Korean government adopted restrictions to contain foreign borrowing. Short-term external debt had caused serious distress when lenders rapidly withdrew from the Korean economy in late 2008.viii
Current hurdles for capital controls
Despite widening acknowledgement of the positive impacts on economic stability and development by economists and policy makers, sovereign management of capital flows continues to face significant hurdles. Apart from positions of single staff members, the IMF still fails to formally endorse the use of capital controls, especially longer-term controls. In July, IMF managing director Dominique Strauss-Kahn announced his sympathy towards emerging countries imposing controls temporarily during times of crisis, but warned against permanent instruments to manage money flows.ix
One significant area where the skepticism towards capital controls materialises is international trade policy. Many bilateral and multilateral trade agreements do not allow for an active management of capital flows. In December 2007, the Caribbean was the first region to conclude a full Economic Partnership Agreement with Europe. The agreement includes provisions on trade in services and investment requiring the parties to remove “a variety of instruments that are commonly used to limit or screen foreign investment”.x Similarly, under the World Trade Organisation (WTO), countries that grant market access are often required to fully liberalise their capital accounts. Capital account liberalisation is also considered a cornerstone of the WTO agreement currently under negotiations in the Doha Round.xi
What can be done?
Significant hurdles for short and long-term capital management techniques persist. The G20 summit chaired by South Korea in November this year could make an important contribution to making capital account policy work for development by:
- Opening the policy space for developing countries to pursue independent monetary policy which can help promote economic growth and public spending stability to reduce poverty and inequality.
- Allowing developing countries to actively influence the composition of foreign capital coming into their economy. Capital controls constitute a tool to support long-term private sector investment in developing economies and help to enhance employment rates and living standards. At the same time they are able to prevent volatile types of investment that bring high risks of generating financial crises in developing economies.
- Containing developing economies’ vulnerability to crises and associated economic and social costs. Large capital inflows, sharp reversals of money flows, exchange rate pressure and contagion associated with open capital accounts are all causes of financial crises which in turn have devastating impacts on the world’s poorest.
