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In recent centuries the world has see-sawed between globalisation and de-globalisation of finance, with wildly different outcomes. A long-term historical view shows that the current system of relative ease and freedom for money to flow across borders without regulation is more historical anomaly than the normal state of affairs. The liberalisation of international financial flows should be viewed as an unusual and significant intervention, as finance has normally been largely domestic and regulated.
In the wake of the financial collapse of 2008, the role of cross-border capital flows, which can have both good and potentially devastating consequences, is again being questioned. The countries that fared the worst in the crisis were those with the most deregulated and liberalised policies towards capital inflows. This report explains the drawbacks, especially for development, of policies to deregulate the movement of money across borders, and makes suggestions for a new pragmatic approach to regulation of financial flows to ensure stability and development.
Since 2009, many developing and emerging economies have increased regulation of and control over financial inflows to manage surges from overseas. They have done this in an environment of increasing and more volatile flows to developing countries, with 2010 flows reaching $1.095 trillion, the second highest ever after a peak of $1.65 trillion hit in 2007.
However, the empirical evidence shows that movement of money on this scale and speed is becoming increasingly problematic. Capital flows impose a number of risks, such as currency risk, flight risk, fragility risk, contagion risk, and sovereignty risk. There is considerable consensus in the economic literature that capital flow surges and stops contribute to financial and banking crises. And these crises are more than just headline grabbing events, but have wide-ranging negative social impacts. The way in which financial flows are managed impacts on wealth distribution, poverty, children’s well being, women’s economic advancement and unemployment. These impacts are not generated only by a crisis, as boom periods can also bring problems of inequality and de-industrialisation. Having a fully liberalised capital account also facilitates tax avoidance and tax evasion.
On the opposite side, economic history shows that countries that have successfully developed have used foreign capital to do so, but that this foreign capital did not arrive through fully open capital accounts. In general, investment that is of a longer duration and provides additional benefits or spillovers is more desirable. Better and more pragmatic management of the capital account could also contribute to reducing global macroeconomic imbalances through reducing the demand for precautionary foreign exchange reserves, improving the ability of countries to run independent monetary and fiscal policies, and potentially managing large outflows and inflows.
Developing countries are already attempting to exert more influence over surges of capital inflows, and there has been significant debate over the effectiveness of the tools being used. It should be clear that no macroeconomic tool will ever be perfect. Capital account regulations can be effective in lengthening the expected investment horizon and changing the composition of incoming financial flows, while there is mixed evidence over their impact on flow volumes and exchange rate appreciation. Some of the most effective country policy stances are in India and China, which maintain extensive controls over the capital account and remain some of the fastest growing economies. Across the world a range of measures have been used successfully by different countries, including: limits on foreign direct investment, foreign exchange restrictions, quantitative controls on inflows, outflow controls, taxes on inflows, banking regulation, and limits on the issuance of derivatives.
Despite the grave social risks involved in not regulating financial flows, international provisions for dealing with capital account management are scattered and a comprehensive overarching global framework does not exist. The extensive liberalisation of capital accounts, witnessed over the past three decades, has been furthered by a broad range of international pressures, including from the International Monetary Fund, under the World Trade Organisation, from bilateral trade and investment agreements and through the Organisation for Economic Cooperation and Development and the European Union. These institutions present significant hurdles to more effective use of pragmatic capital account regulations, and politically powerful interest groups, particularly in rich countries, have a stake in trying to prevent regulation.
While most capital account regulations are available for unilateral implementation, there are constraints on the effectiveness of these tools for some countries, particularly small developing countries. Potential unwanted domestic side effects can be managed with public policy and public investment focussed on ensuring domestic financial intermediation and financial institutions meet the needs of the poor and work towards sustainable development. Impacts on third countries from implementing regulations appear moderate and could be managed with better regional coordination of regulation.
Even more effective would be policies in rich countries to tackle the risks from capital flows at their source. This includes better overall financial regulation, but consideration should be given to specific capital flows policy in source country. More regional and international coordination on capital account regulation, particularly enforcement of rules, would help developing countries deal with financial flows more effectively. Ultimately, a more ambitious global framework agreement could reinforce mutually consistent management techniques across source and destination countries.
Developing and developed countries would benefit and stability would be enhanced by a more hard-headed approach to macroeconomic policy and cross-border financial flows. It is time for a new consensus, one in favour of pragmatic policies that will seek to channel financial flows for the benefit of people, especially those in developing countries. Given the occurrences of the last few years, it is clear that while the hurdles may be high, achieving finance that works for development is not beyond our reach. Civil society organisations and social movements are vital pressure points to see political change, but their action should be complemented by new thinking among responsible financial actors and policy makers.
In the short term:
- Civil society groups need to recognise that reforms to the management of international financial flows and the underlying structure of the international financial system are important to the achievement of development goals and demand change.
- Policy makers in developing countries should not fear regulation of the capital account and need to think more proactively about the costs as well as the benefits of different kinds of capital flows.
- The IMF needs to accept that capital account regulations can be desirable at any time. Once it has accepted this and demonstrated a more pragmatic approach, it can work with countries to help them design the best techniques to fit their desired policy goals.
- Policy makers and relevant international institutions need to create a system of international data sharing and analysis to help police existing and new measures to regulate financial flows.
In the medium-term:
- Rich and developing countries need to coordinate to remove the policy hurdles resulting from investment treaties and free trade agreements.
- Developing country policy makers need to be encouraged, especially by their own citizens, to begin working in regional configurations to coordinate capital account management.
- Rich countries need to commence serious discussions with developing countries, at the IMF or elsewhere, on how source countries can effectively contribute to the stability of financial flows that enhance development prospects.
- Existing treaties such as the Lisbon Treaty in the EU, which already looks like it needs to be renegotiated, should be amended to remove requirements for capital account liberalisation.
Time for a new consensus: Regulating financial flows for stability and development
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Le temps est venu d’un nouveau consensus: Réguler les flux financiers pour parvenir à la stabilité et au développement
Ha llegado la hora de un nuevo consenso: Regular los flujos financieros para la estabilidad y el desarrollo
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