Two recent IMF publications offer different perspectives on how policymakers should handle capital outflows. One outlines a tactical response to an unplanned reversal, while the second provides a strategy to prepare for volatility before it occurs.
The first approach appears in an IMF Policy Paper, Global Impact and Challenges of Unconventional Monetary Policies. Most of the paper deals with the effects of unconventional monetary policies (UMP) designed to restore the operations of financial markets and/or to support economic activity when the central bank’s policy rate has hit the lower bound. The measures include the purchase of bonds not usually bought by a central bank and forward guidance on interest rates. The paper draws upon the experiences of the Bank of England, the Bank of Japan, the European Central Bank, and the Federal Reserve.
The paper also deals with the possible challenges posed by the eventual winding down of the UMP both within the countries that have implemented them and in non-UMP countries. The authors of the report warn that ”In non-UMP countries, currencies will depreciate (to balance changes in relative bond returns) and bond yields might rise…” They further caution that “Some capital flow reversal and higher borrowing costs are to be expected, but further volatility could emerge, even if exit is well managed by UMP countries.” The report points to one source of volatility: “Further amplification could come from the financial system, where stability could be undermined as non-performing loans rise, capital buffers shrink, and funding evaporates.”
What can the non-UMP policymakers do to offset or least minimize this turbulence? Relatively little, according to the report. Central banks should maintain their credibility through appropriate monetary policies (always a good idea), allow some change in their exchange rates (but avoid disorderly adjustment!), and reverse measures that were implemented during periods of capital inflows (but only if this does not endanger financial stability!). The IMF offers to coordinate national policies to curtail negative spillovers, and promises to provide credit as needed. The IMF’s message for the non-UMP countries, therefore, seems to be: A storm is coming! It might be bad! Close the windows and doors, and place your faith in a higher power (conveniently located at 700 19th Street in Washington, DC)!
A different message comes from the authors of Chapter 4 of the IMF’s latest World Economic Outlook, entitled “The Yin and Yang of Capital Flow Management: Balancing Capital Inflows with Capital Outflows.” Its authors make the distinction between those emerging market countries that respond to capital inflows through a current account deterioration (a “real” adjustment) versus those with offsetting capital outflows (“financial” adjustment). They find that the latter group registered a smaller response to the 2008-09 global financial crisis, as manifested in changes in GDP, consumption and unemployment. The former group includes Argentina, India and Turkey, while the latter group includes Brazil, Mexico and Thailand. The authors attribute the better experience of those countries that experienced “financial adjustment” to several factors, including the repatriation by their residents of their foreign assets to smooth consumption in the face of a shock.
Of course, the withdrawal of assets from foreign countries is feasible only if those assets are relatively liquid. Evidence on this aspect of the financial crisis comes from Philip Lane in his authoritative account of the role of financial globalization in precipitating and propagating the global crisis, “Financial Globalisation and the Crisis,” which appeared in Open Economies Review (requires subscription). He reports that emerging economies were “long debt, short equity” in the period preceding the crisis. Their assets consisted of liquid foreign debt that they could draw upon if needed, while their liabilities were in the form of FDI and portfolio equity. The advanced economies, on the other hand, followed the opposite strategy of “long equity, short debt,” which was profitable but hazardous once the crisis hit.
There is another way, however, to evaluate the strategy of “financial adjustment.” Countries that match inflows with outflows have less exposure on a net basis, and net exposure may be tied to the occurrence of an external crisis. A recent IMF working paper by Luis A. V. Catão and Gian Maria Milesi-Ferretti, “External Liabilities and Crises,” reports that the risk of a crisis increases when net foreign liabilities rise above 50% of GDP and the NFL/GDP ratio rises 20% above a country’s historic mean. Moreover, when they examine exposure on different classes of liabilities, they find that the increase in crisis risk is linked to net debt liabilities.
Financial adjustment, therefore, was a successful strategy for minimizing the capital flow volatility for several reasons. The emerging market countries that implemented it lowered their international financial exposure and issued risk-sharing equity rather than debt. They were therefore less vulnerable than those countries with more liabilities that included relatively more debt. Given the cyclical nature of capital flows, such prophylactic measures should be enacted before the next storm arrives.