Will the IMF “make history” with a new view on capital flows?

22 June 2012

In October the Fund is expected to present an updated institutional view on capital account regulations. The most recent IMF paper on the topic received criticism for advocating for capital account liberalisation in China and India. Meanwhile emerging economies worry that the Fund’s prescriptions still constrain their capacity to cope with global financial volatility.

The last two years have seen a refining of the IMF’s approach to capital account management. In April the Fund published the fourth in a series of executive board papers since late 2010 (see Update 79, 75, 74) that will inform the Fund’s ‘institutional view’ on managing capital flows to be presented after the annual meetings in October.

The April paper, Liberalising Capital Flows and Managing Outflows, covers the issues of liberalisation of capital flows in systemically important emerging market economies, mainly China and India, and the management of capital outflows. It confirms the Fund’s view that regulations on capital flows “may be temporarily reintroduced in accordance with the relevant policy frameworks, without compromising the overall process of liberalization.”

the Fund's view should be put to rest

The paper aims to update the Fund’s “integrated approach” on liberalisation outlined in 2001 (see Update 24). The new approach still assumes capital market liberalisation as the end goal, however, it calls for more caution and argues that specific circumstances should be considered: “recent research suggests that there is no certainty that full liberalisation is an appropriate objective for all countries at all times, and that a more cautious approach to liberalisation is warranted.” More specifically it stresses that “the appropriate degree of liberalisation for a country would depend on whether it has reached certain thresholds with respect to financial development.” On managing capital outflows, the paper confirms that regulations on outflows “can be useful mainly in crisis or near crisis conditions, but only as a supplement to more fundamental policy adjustment.”

Gerald Epstein from the University Massachusetts observed that despite progress, the IMF is far from completely convinced that capital flows should be managed: “First, countries should have the option of making capital account regulations a permanent feature of their macroeconomic policy apparatus. Governments can then have a tool of dynamic capital account management that can be used more or less intensively depending on the current macroeconomic environment and goals. The IMF has not yet been willing to explicitly embrace this important idea. Secondly, as a related point, the IMF should more explicitly state that any notion of ‘best practices’ or ‘codes of conduct’ – if they are to be used at all – should explicitly state that countries have the right to choose their own package of capital regulations. There is no one size fits all. Finally, more of the burden of evidence should be placed on the advocates of financial liberalisation to demonstrate the value of less regulated financial systems, including less regulation with respect to capital flows. There is very little evidence that is clearly in support of broad capital account liberalisation.”

China and India

A great deal of the paper focuses on liberalisation of the capital account in China and India (see Update 80, 75, 66, 58). The paper argues that liberalisation would help to ease constraints on growth in India and rebalance growth in China, “toward a more sustainable pattern that relies less on exports and investment and more on consumption”.

The authors enumerate benefits and risks of liberalisation in China: “The benefits of liberalisation also include a better allocation of capital and risk diversification; and liberalisation would widen the use of the renminbi as an international currency [and] improve liquidity in domestic equity markets.” In order to avoid potential financial risks like asset bubbles, capital flight, and currency and maturity mismatches “capital flow liberalisation needs to move hand in hand with measures to address gaps in financial sector supervision and domestic capital market distortions.” In order to harness the benefits and mitigate risks liberalisation needs to be complemented with an “independent monetary policy”, “exchange rate flexibility”, “stronger supervisory and regulatory frameworks” and “deeper and more liquid financial markets”.

In the case of India the paper argues that “the main benefits of capital flow liberalisation would arise from greater access to foreign capital, including specialised financing for substantial infrastructure investment needs, as well as improved risk diversification. Increased foreign participation in the government bond market would provide an additional source of financing for the budget, but could also raise the risk of pro-cyclical fiscal policy and increase the volatility of bond yields. In addition, a faster opening up to debt flows could lead to greater transmission of financial volatility from international markets.” The Fund argues that in order to avoid risks liberalisation should occur in tandem with “strengthened fiscal discipline” and further bolstering of “the banking system and financial markets”, and should be carefully sequenced “first liberalising [foreign direct investment] flows (with no major distinction between inflows and outflows) then equity and, finally, debt flows”.

Epstein countered that capital account regulations insulated China and India “from the worst financial practices and products that contributed to the financial crisis in the US and Europe, including complex, opaque and toxic derivative products such as collateralized debt obligations and credit default swaps. In short, there are some types of financial products, including those that can be traded across national borders or in foreign currencies, that should not be allowed at all. It is not clear that the IMF has yet learned this key lesson of the current crisis.”

An April paper from the Levy Institute of Bard College by Sunanda Sen presents an alternative view of how the opening of the capital account is affecting China and India. The main conclusion of her paper is that in recent years China and India have sacrificed domestic goals of stability and development to comply with globally sanctioned norms of free capital flows.

Sen gives examples of how India’s “closer integration into global financial markets has thus not only constrained its monetary policies (which have been consistently side-tracking the interests of real growth), but has also changed the composition of public expenditure-away from distributional justice to the rentier interests.” Sen also argues that since implementing capital account and financial deregulation both countries have faced increasing volatility in financial asset, commodity, and real estate markets.

Institutional view

At the IMF spring meetings in April, Guido Mantega, Brazil’s finance minister, again argued that capital account regulations have yet to be fully accepted by the Fund and that “Brazil opposes any ‘guidelines’, ‘frameworks’ or ‘codes of conduct’ that attempt to constrain policy responses of countries facing surges in excessive and volatile capital inflows” (see Update 76, 73). He expressed concerns that the Fund has downplayed the role played by monetary policies in advanced countries and not supported the defensive measures deployed by some emerging economies, and expressed doubts on the Fund’s work: “they persist in offering unsolicited policy advice. We have doubts about the quality, consistency and evenhandedness of the ongoing work on capital flow management and urge the Fund to rethink its approach.”

At a side-event to the UNCTAD XIII Conference in late April, Cristina Pasin, a senior official from the Central Bank of Argentina, explained the limitations of only considering capital account regulations as temporary measures to be implemented in times of crisis: “by the time you have to implement such measures, it is by definition too late, and you have missed the chance to avert the crisis.”

The forthcoming agreement of a new IMF institutional view on capital flows regulations led Kevin Gallagher of Boston University and Stephany Griffith-Jones and José Antonio Ocampo of Columbia University, to argue that the Fund can make history. The authors explain that “there is still time for the IMF to further sharpen its view”. They emphasise that regulations should be permanent and applied in a counter-cyclical manner and that regulations on outflows from source countries would help to temper global volatility. They argue that since there is no clear association between capital account liberalisation, economic growth, and financial stability, the Fund’s view “that all nations should eventually completely deregulate cross-border finance should be put to rest.”