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Capital controls or cooperation?

Capital controls or cooperation?

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Since the 2007/8 financial crisis, there has been considerable discussion about the role of capital flows in the formation of asset bubbles and their subsequent collapse, and about strategies for managing the movements of "hot money" from country to country in search of yield and/or safety. It is fair to say that there is far from a consensus: government policies around the world currently range from the extremely controlling to the totally laissez-faire.

 The outflows of capital from emerging markets arising from the Fed’s tapering of QE have raised again the question of whether capital controls would be appropriate as a short-term measure to calm markets and prevent currency collapse. So far, no country has adopted outright controls, though several are intervening in markets to support their currencies: as I write, the Turkish finance minister (on Twitter) has just ruled out any use of capital controls or transaction taxes. But it is not beyond the bounds of possibility that, faced with currency collapse and/or unsustainable rises in debt burdens, some countries may resort to direct restrictions on capital movements. Would this be an appropriate course of action?

 Ten years ago, the institutional view would have been “No”. Capital flows were widely regarded as beneficial under all circumstances. Free movement of capital was an important principle in the Washington Consensus: the IMF enthusiastically promoted liberalisation of capital flows and in some cases made that a condition of financial assistance. And the European Union was built upon the binding principle of free movement of capital and labour between all member states.

 But since then, two major financial crises have forced these institutions to reconsider. Capital controls were successfully used by Iceland in 2008 when its banks collapsed, and by Cyprus after the collapse of its two biggest banks in March 2013. This last is particularly bizarre as Cyprus is a member of the Euro. How on earth capital controls can be compatible with membership of a single currency is a mystery, but somehow the EU managed to tweak its treaties to allow it to happen and Cyprus’s capital controls have protected it from serious loss of financial assets.

 In November 2012 the IMF produced a paper that appeared to suggest capital controls might be a good thing after all. This prompted a collective gasp of astonishment from the world's press. Headline after headline announced that the IMF had relaxed its historic opposition to capital controls. People campaigning for tax havens to be closed down rejoiced, because capital controls would limit or prevent capital flight to tax havens. Various economic forums promoting worldwide capital controls and an end to globalisation started to believe that maybe, just maybe, the IMF was moving in their direction.

 They are totally mistaken. The IMF has not changed its fundamental position on capital flows at all. It remains committed to the ideal of free worldwide movement of capital. What the IMF is trying to do in this paper is reconcile that fundamental position with the reality of capital controls in today's turbulent world and the political nature of the debate about their use. This is like walking a tightrope over a raging torrent.

 The Fund’s general position is that even quite extreme capital flows can be beneficial, and capital controls should be a last resort only. Therefore the first focus should be on improving macroeconomic and macroprudential policy-making, and establishing sound fiscal management:

“Rapid capital inflow surges or disruptive outflows can create policy challenges. Appropriate policy responses comprise a range of measures, and involve bothcountries that are recipients of capital flows and those from which flows originate. For countries that have to manage the macroeconomic and financial stability risks associated with inflow surges or disruptive outflows, a key role needs to be played by macroeconomic policies, including monetary, fiscal, and exchange rate management, as well as by sound financial supervision and regulation and strong institutions. In certain circumstances, capital flow management measures can be useful. They should not, however, substitute for warranted macroeconomic adjustment.”

So countries should retain discipline over monetary and fiscal policy even when there are apparently beneficial inflows of capital. Rather than welcoming these flows as a means of generating economic growth, countries should treat them with caution and act to dampen their expansionary effect.

This unfortunately creates a problem. The whole point of free flows of capital is that inward investment is supposed to create economic growth. If countries have to regard inflows as possibly damaging and take steps to dampen their effect, what on earth is the point of having free flows?

The problem really is where the flows go. If they go into new business development, creating jobs and economic activity that eventually is self-sustaining – sort of “priming the pump” – then they are to be welcomed. But if they go into real estate and/or construction (whether housing or infrastructure), or into funding consumer or government spending, then they could be creating sustainable economic growth - or they could be blowing up potentially damaging bubbles. So the challenge is to determine when inward flows are helpful and when they are not. And this is not easy for governments to do.

It is very easy for even supposedly responsible governments to make the mistake of confusing inflows of hot money due to investors reaching for yield or safety with genuine foreign direct investment. In my view this mistake is currently being made by the UK government, which is hanging both its economic and its election strategy on house price appreciation driven by demand for high-end London property by overseas investors, most of whom have no intention of living in the UK and are simply treating prime residential real estate as a safe high-yield investment. They have no commitment to the UK and will sell up when better opportunities come along – and when they do, the housing market will collapse. The right-wing think-tank Civitas has proposed a mechanism for restricting sales of prime residential property to overseas investors. It should be taken seriously.

Nor is the UK government the only one to make the mistake of confusing unstable capital flows with genuine inward investment. The same mistake has been made by Eurozone periphery countries and by emerging market economies.

It is fair to say that some emerging market countries are better able to cope with the present market turbulence than others, and this is directly related to the soundness of their macroeconomic and fiscal policies in the last few years. Those countries that have used the QE-driven inflows of capital since 2008 as an excuse to pursue highly expansionary monetary and fiscal policies are already facing the possibility of severe economic contraction, inflation and even debt default as their currencies collapse:

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Because the countries that are suffering the most are those with the worst economic policies, US policymakers (and others) claim that the problems experienced by emerging market countries due to the capital outflows arising from QE tapering are nothing to do with the Fed. If only emerging market countries had implemented tighter monetary policy and structural reforms, the story goes, they would have been able to cope. So it’s all their own fault, apparently – even for those emerging market countries that have not been guilty of economic mismanagement on the scale of Argentina or Venezuela.

But that’s not what the IMF’s paper says. Yes, countries at risk from large capital flows generated by the policies of other countries should pursue sound macroeconomic and fiscal policies to mitigate the disruptive effect. But those who cause large capital movements also bear some responsibility (my emphasis):

“Policymakers in all countries, including countries that generate large capital flows, should take into account how their policies may affect global economic and financial stability. Cross-border coordination of policies would help to mitigate the riskiness of capital flows.”

In other words, the Fed should not “go it alone” on monetary policy decisions if those decisions would cause disruptive capital movements and place at risk global financial and economic stability. Yes, there are basket case economies out there:  no-one is suggesting that the Fed should construct policy to help them avoid the consequences of their stupidity. But if the Fed’s policy puts the global economy or financial system at risk, the US will be behaving even worse than Argentina and Venezuela. After all, their stupidity only places themselves at risk. The US’s “self-determination” could place the entire world at risk.

The IMF warned the US that tapering QE would make the financial system riskier, and that policymakers in other countries might have to intervene to protect their economies. And there have been calls from the World Bank as well as from central bankers and finance ministers in significant emerging market economies for co-operation between central banks as suggested in the IMF’s paper. So far this has fallen on deaf ears.

If the damaging capital flows arising from the Fed’s monetary policy continue, there is a risk that this could escalate into an emerging market crisis similar to that in the late 1990s. To prevent this, emerging market economies may have to impose capital controls. This would undoubtedly be better than another financial crisis, but it is certainly not the best solution: free movement of capital has generally been economically beneficial, and as Iceland has discovered, capital controls once imposed are difficult to remove. It would be a real shame if governments worldwide were forced to impose capital controls because central banks’ failure to coordinate monetary policy threatened the stability of the global financial system.

I seriously hope the US reconsiders its “go it alone” approach to monetary policy. “Our currency, your problem” is no longer appropriate in the era of globalisation.


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Countries can protect themselves against predatory hot money by imposing high taxes on interest income that is taken out of the country. That eliminates the benefit of exploiting interest rate arbitrage which is a primary attractor of hot money. The hot money is almost invariably US$, the global payments and reserve currency. When dollars flood in to buy local currencies in order to buy hogh interest investments in those currencies, the hot fx demand inflates the fx value of the local currencies. When local currencies are later exchanged for dollars as the hot money flows out, the outflow only deflates the local currency by the amount the inflow had inflated it. So the hot money causes some fx volatility, but no real damage.

It is when interest income leaves the local economies that the financial damage is done. Financial investments like buying stocks (only the money earned from IPOs is actually "invested" into the company whose stocks are being bought), and buying any kind of debt instrument like mortgages or government bonds, add zero economic value into the local economy. But financial investments suck money out of the local economy as interest payments. And short term money that is invested in long term debt can cause serious financial turmoil -- a shortage of money to roll over debt -- when it floods in then floods out of local currencies. That's where we get "financial crises" in the affected currencies.

Large selloffs of stocks by foreigners merely deflates the nominal share price without affecting the operations of the company whose shares are being traded; and earning dividends by buying stock in profitable companies is a non-predatory way to earn income in a foregin country. But if foreigners are going to be allowed to buy a nation's debts, the nations should impose high taxes on taking interest earnings out of the country. National banking systems can print money if their government or real estate markets need more money, and this will reduce the fx value of their currency, which makes their exports cheaper, so internal money supply inflation is kind of a self-corrective cure for national financial profligacy. But borrowing in foregin currencies is a recipe for national financial disaster.

Great article as per usual Frances. The literature around this subject has been ongoing for many years now. Ken Rogoff at Harvard was debating this exact issue back in 1999: International Institutions for Reducing Global Financial Instability - The Journal of Economic Perspectives, Vol. 13, No. 4. (Autumn, 1999), pp. 21-42. However, the discussion always reverts back towards the paradox of allowing free movement of funds vs capital controls when in need. The IMF as you rightly point out have always adopted the position of free flowing capital on such countries as Turkey and Korea, and note this happened because they did not have the correct macro-prudential controls in place at the point 'hot money' came rushing in. Rogoff notes that when free flowing money arrives it should ideally be invested as equity in companies rather than short term bonds looking for a quick in and out to make a speculative profit. One way to deal with this is to tax short term speculative hot money, and encourage longer term funding. Alternatively, full capital controls do not need to last forever, for those countries affected, and to protect bank runs, temporary controls can be placed on positions so as not to paralyse or collapse the financial system. Such calls inevitably raise the idea of a global crisis manager, or an international regulator, however countries such as the US, UK, Germany, Japan et al are not going to like a breach of sovereign and domestic governance - however I think it is required due to the disparate take up of global macro-prudential policy which brings about such crisis and almost encourages speculation rather than genuine investment in a countries future. Big ideas for crisis times, perhaps now is the time to reopen the debate and aim for international governance.

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