IMF new view on capital flows: “landmark” but still only a “baby-step forward”

6 December 2012

The IMF’s new “institutional view” on capital flows, despite being more flexible than its previous stances, has nonetheless angered developing countries who blame rich country policies for volatility in financial movements.

The IMF has been preparing the new institutional view on capital flows for over a year (Update 82, 81, 79. Before the final policy paper was discussed at the board, Brazilian finance minister Guido Mantega launched a broadside against the Fund’s approach in his statement to the annual meetings in mid October. He said “experience has shown that the free flow of capital is not necessarily the preferable option in all circumstances. We reaffirm the need for a more balanced approach within the IMF on how to limit excessive short-term capital flows.”

Despite Brazil’s outspoken position on the issue, the IMF agreed a new policy in mid November. It required two full board meetings, because the original discussion in early November did not produce enough agreement. After a long discussion of the benefits and potential risks of capital flows, the paper says: “there is no presumption that full liberalisation is an appropriate goal for all countries at all times,” but still argues that “countries with extensive and long-standing measures to limit capital flows are likely to benefit from further liberalisation in an orderly manner.”

A key concern of some developing countries was over the language in box 3 in the document, which “summarise[d] the main elements of the proposed institutional view on capital flow liberalisation and management”. It crystallised the paper as saying that capital flow regulations “should be targeted, transparent, and generally temporary – being lifted once the surge abates, in light of their costs.” Further, it says that regulations “should not be used to substitute for or avoid warranted macroeconomic adjustment”. The text of the policy paper clarifies that in response to inflow surges, a number of macroeconomic adjustments should be considered, including altering interest rates, allowing exchange rate changes or accumulating reserves. However, the summary of the executive board discussion, released early December, commits the Fund to avoiding lending conditionality on capital account regulations, saying those regulations “maintained outside of the proposed institutional view would not be considered measures that the Fund could require members to eliminate as a condition for the use of Fund resources.”

The summary also made clear that divisions remain on the board. It said that: “A few directors noted … that adopting an institutional view at this stage would seem premature and would have preferred further work and discussion.” Opposition to parts of the final paper came principally of the executive directors from Brazil, Argentina and India.

The board summary states that “many directors”, in IMF terminology meaning between 10 and 15 of a total of 24, “emphasised that the role of source countries in capital flows should be adequately integrated into the institutional view”, revealing one of the main bones of contention. While the paper says “source countries should better internalise the spillovers from their monetary and prudential policies, because push factors, including changes in global liquidity conditions, also contribute importantly to capital flows,” it includes little detail on how the IMF would act differently towards those rich countries. Deputy governor of the Peoples Bank of China, Yi Gang, commented in his statement to the annual meetings that the “surveillance of macroeconomic, financial sector policies, and capital flow volatilities originating from major reserve currency-issuing economies should be accorded with greater priority.”

Kevin Gallagher of Boston University called the IMF’s new position “truly landmark” but went on to say “the IMF decree does not go far enough. The IMF is still biased toward the eventual liberalisation and deregulation of capital flows, despite academic evidence that premature liberalisation can be harmful to financial stability. What is more, the IMF allows for a very narrow band of circumstances for the use of capital controls, despite the fact that its own research has shown that such measures have worked under a broader set of circumstances. Finally, the IMF puts the majority of the burden for regulating capital flows on emerging market and developing countries, not the industrialised nations that are the source of the speculative finance in the first place. The IMF’s baby-step forward may amount to a big step backward in the broader debate and discussion on the management of capital flows.”

Kavaljit Singh of Indian think tank Public Interest Research Group argued that “its strict adherence to a particular theoretical framework is very much evident in the policy paper which strongly argues that capital flow liberalisation is generally more beneficial and can spur financial and institutional development. In the post-crisis world, there is overwhelming evidence which suggests that pro-cyclical capital flows engender both macroeconomic and financial instability, and even countries with strong macroeconomic fundamentals cannot cope with volatile capital flows. … A major departure from its theoretical positions on capital flows could have added to the credibility and legitimacy of the IMF as an unbiased policy advisor to member countries. Alas, the IMF has lost this opportunity.”

It’s all in the implementation

During a visit to the Philippines shortly after the board discussion, IMF managing director Christine Lagarde faced awkward questions. Deputy governor of the central bank Diwa Guinigundo told journalists that “unique individual country circumstances should be considered” and that the IMF should, “when warranted, by all means endorse” capital flow regulations, including any implemented by the Philippines.

The IMF will face considerable scrutiny as it begins to implement its new institutional view. Martin Rapetti of Argentine think tank Centro de Estudios de Estado y Sociedad (CEDES) argued in mid-November that for Latin America, the main threat from volatile capital flows is no longer financial crises. “Capital inflows have led to a pronounced appreciation of the real exchange rates (RERs) in the region, especially in South America. … Current RER levels are unlikely to trigger a sudden stop and consequently do not represent a threat in terms of external and financial crises. They do, however, pose a threat in terms of development prospects.” That is because a rising exchange rate inhibits growth via its “impact … on the tradable sector, especially on manufactures and knowledge-intensive tradable services.”

Rapetti recommends that capital account policy should be one tool for targeting exchange rates in order to stimulate economic development. Given that the new IMF policy only provides limited space for using capital account measures, the policy recommended by Rapetti would be considered off limits by the Fund.