The current surge of capital flows to emerging markets continues to challenge the IMF’s historical position regarding capital account regulation and exchange rate policies, with the Fund’s policy framework being criticised by academics and emerging markets.

In an early March IMF meeting to promote policies for financial stability, IMF deputy managing director Min Zhu said volatility in global financial markets is the Fund’s main concern. Zhu welcomed the expansion in Latin America of policies to mitigate risks in the financial system, also known as macro-prudential policies, which have “provided a crucial anchor for confidence during the recent global turmoil”. Policies include reserve requirements, limits to foreign exchange positions and measures to manage foreign credit risk. He also expressed that policy makers need to do more to identify potential risks, prepare to react quickly and work together with other countries to prevent asset bubbles fed by overseas credit market developments. These statements confirm the Fund’s gradual change of position in relation to capital flows regulations. The Fund began to accept these regulations, though in a limited way, after the 2008 global financial crisis (see Update 70, 46).

Regulations on capital inflows are also being supported by the World Bank. Hasan Tuluy, the Bank’s new vice-president for Latin America and the Caribbean, argued in a mid-March interview that selected capital controls can be beneficial as significant inflows have potentially damaging effects on foreign exchange and may generate asset bubbles.

Hot money

The expansionary policies of central banks in developed countries are increasing liquidity and pushing cash towards emerging markets with higher interest rates and better growth prospects (see Update 79). Nicolas Eyzaguirre, director of the IMF Western Hemisphere department, explained at the mentioned IMF meeting that a combination of factors – high commodity prices, very strong growth in Asia and low levels of indebtedness in Latin America, coupled with reduced global risks – may create the conditions for capital to flow towards Latin America over the next two years, and argued that when these flows are persistent at important magnitudes, they “end up generating strong risk taking in the financial sector”.

After a late March summit, the BRICS’ leaders issued a joint declaration urging developed countries “to adopt responsible macroeconomic and financial policies, [and] avoid creating excessive global liquidity.” Brazil has suffered the destabilising impact of surges of capital inflows more than others recently. To slow down destabilising flows, in early March, the government extended a 6 per cent transaction tax on short-term foreign loans to cover bonds with up to five years maturity (see Update 73). Guido Mantega, Brazil’s finance minister, said that until rich countries decide to cooperate and implement policies to absorb excess liquidity, Brazil will “take measures to impede the entry of this capital”.This follows two recent IMF publications analysing how policy developments in rich countries are increasing the amount and volatility of flows to emerging markets (see Update 79).

In late February, the People’s Bank of China released a report outlining a timetable for liberalisation of its capital account over the next 10 years. It explains that removal of capital controls will only happen after a series of other moves like liberalising the exchange rate, freeing interest rates and deepening its financial markets.

IMF, capital flows and exchange rates

The implications of volatile capital flows are motivating the Fund to revise its own stance on exchange rate and monetary policies, which traditionally prioritised price stability over growth (see Update 72). An IMF staff discussion note released early March, Two targets, two instruments: Monetary and exchange rate policies in emerging market economies, argues that in order to avoid unwanted appreciation of the exchange rate, countries with inflation targeting schemes and free floating exchange rates should consider more seriously the use of foreign exchange interventions. If “a sudden surge in capital inflows leads to a large, temporary appreciation of the currency above its medium-term value, and that results in economic dislocation, then some intervention in the foreign exchange market is likely to be optimal even under an [inflation targeting] regime.” It also explains that “If two policy instruments are available (the policy interest rate and foreign exchange market intervention), then they should be used in tandem to achieve both price-stability and exchange-rate objectives.” This represents another small step away from the Fund’s historical preference for either pegged or fully flexible exchange rates.

A February IMF working paper, Capital inflows, exchange rate flexibility, and credit booms, argues that during capital inflow bonanzas, domestic credit grows more rapidly in economies with relatively inflexible exchange rate regimes. According to the paper, this effect on credit expansion might make inflexible exchange rate regimes more vulnerable to reversal of capital flows and a credit bust than flexible regimes. However, the authors do not suggest that less flexible regimes necessarily call for broader forms of capital controls but that they “may need to be ‘counteracted’ by carefully designed macro-prudential policies” targeting banks’ external funding and incentives to lend and borrow in foreign currency.

New alternative proposals

The Fund still maintains a code of conduct on the use of capital account regulations endorsed by the board in March 2011, and heavily criticised by emerging markets and academics for being too prescriptive, and for suggesting that regulations should only be used temporarily and as a last resort (see Update 76). The idea of a code of conduct was also rejected in an October statement by the G20 finance ministers, which emphasised that there is no one-size-fits-all approach to capital account regulations (see Update 78).

A March 2012 report by a task force of academics from across the globe, published by Boston University, presents alternatives. First, regulations shouldn’t be seen as interventions of last resort but as “part of the normal counter-cyclical packages, and particularly as tools to avoid excessive exchange rate appreciation and reserve accumulation.” Second, they should not be temporary but “part of the permanent toolkit of countries, which are strengthened or weakened in a counter-cyclical way.” Third, they also require “some discrimination between residents and non-residents, which reflects the segmentation that characterises financial markets in an international system”. Finally, the IMF policy framework should start “by designing mechanisms to cooperate with countries using these policies”.

The Fund might internalise these criticisms in a policy paper to be published in June, in which they will present a “comprehensive, balanced, and flexible Fund institutional view on policies affecting capital flows.”