Monthly Archives: May 2015

Morality Tales and Capital Flows

When the Federal Reserve finally raises its interest rate target, it will be one of the most widely anticipated policy moves since the Fed responded to the global financial crisis. The impact on emerging markets, which have already begun to see reversals of the inflows of capital they received when yields in the U.S. were depressed, has been discussed and analyzed in depth.  But the morality tale of errant policymakers being punished for their transgressions may place too much responsibility for downturns on the emerging markets and not enough on the volatile capital flows that can overwhelm their financial markets.

Capital outflows—particularly those large outflows known as “sudden stops”—are often attributed to weak economic “fundamentals,” such as rising fiscal deficits and public debt, and anemic growth rates. Concerns about such flows resulted in the “taper tantrums” of 2013 when then-Federal Reserve Chair Ben Bernanke stated that the Fed would reduce its purchases of assets through its Quantitative Easing program once the domestic employment situation improved. The “fragile five” of Brazil, India, Indonesia, South Africa and Turkey suffered large declines in currency values and domestic asset prices. Their current account deficits and low growth rates were blamed for their vulnerability to capital outflows. There have been subsequent updates of conditions in these countries, with India now seen as in stronger shape because of a declining current account deficit and lower inflation rate, whereas Brazil’s situation has deteriorated for the opposite reasons.

But this assignment of blame is too simplistic. Barry Eichengreen of UC-Berkeley and Poonam Gupta of the World Bank investigated conditions in the emerging markets after Bernanke’s announcement. The countries with largest current account deficits also recorded the largest combination of currency depreciations, reserve losses, and stock market declines. But Eichengreen and Gupta found little evidence that countries with stronger policy fundamentals escaped foreign sector instability. On the other hand, the size of their financial markets as measured by capital inflows in the period before 2013 did contribute to the adverse response to Bernanke’s statement. The co-authors interpreted this result as showing that foreign investors withdrew funds from the financial markets where they could most easily sell assets.

These results are consistent with work done by Manuel R. Agosin of the University of Chile and Franklin Huaita of Peru’s Ministry of Economics and Finance. They reported that the best predictor of a “sudden stop” was a previous capital inflow, or “surge.” Sudden stops are more likely to occur when the capital inflow had consisted largely of portfolio investments and cross-border lending.  Moreover, they claimed, capital surges worsen the current account deficits that precede sudden stops (see also here).

Stijn Claessens of the IMF and Swait Ghosh of the World Bank also looked at the impact of capital flows on emerging markets. They found that capital flows to these countries are usually large relative to their domestic financial systems. Capital inflows contribute to the pro-cyclicality of their business cycles by providing funding for increased bank lending, which are dominant in the financial systems of emerging markets. The foreign money also puts pressures on exchange rates and asset prices, and can lead to higher debt ratios. All these lead to buildups in macroeconomic and financial vulnerabilities, which are manifested when there is negative shock, either in the form of a domestic cyclical downturn or a global shock.

What can the emerging market counties do to protect themselves from the effects of volatile capital inflows? Claessens and Ghosh recommend a combination of macroeconomic measures, such as monetary and fiscal tightening; macro prudential policies that include limits on bank credit; and capital flow management measures, i.e., capital controls. However, they point out that the best combination of these policy tools has yet to be ascertained.

Hélène Rey of the London Business School has written about the global financial cycle, which can lead to excessive credit growth that is not aligned with a country’s economic conditions, and subsequent financial booms and busts. The lesson she draws is that in today’s world Mundell’s “trilemma” has become a “dilemma”: “independent monetary policies are possible if and only if the capital account is managed, directly or indirectly, regardless of the exchange-rate regime.” Joshua Aizenman of the University of Southern California, Menzie Chinn of the La Folette School of Public Affairs at the University of Wisconsin-Madison and Hiro Ito of Portland State University, however, report evidence that exchange rate regimes do matter in the international transmission of monetary policies.

Whether or not flexible exchange rates can provide some protection from foreign shocks, the capital controls that have been implemented in recent years will receive a “stress test” once the Federal Reserve does raise its interest rate target. Policymakers will be forced to make difficult decisions regarding exchange rates and monetary policies. Moreover, this tale of financial volatility may have a different moral than the usual one: bad things can happen even to those who follow the rules.

The Shifting Consensus on Capital Controls: Gallagher’s “Ruling Capital”

Among the many consequences of the global financial crisis of 2007-09 was a shift in the IMF’s stance on capital controls. The IMF, which once urged developing economies to emulate the advanced economies in deregulating the capital account, now acknowledges the need to include controls in the tool kit of policymakers. Kevin Gallagher of Boston University explains how this transformation was achieved in his new book, Ruling Capital: Emerging Markets and the Reregulation of Cross-Border Finance.

By the 1990s the Fund had long abandoned the Bretton Woods solution to the trilemma: fixed exchange rates and the use of capital controls to allow monetary autonomy. Instead, the IMF encouraged developing economies to open their borders to capital flows that would increase investment and achieve a more efficient allocation of savings (see Chapter 5 here). IMF officials proposed an amendment to its Articles of Agreement that would establish capital account liberalization as a goal for its members, but the amendment was shelved after the Asian financial crisis of 1997-98. The IMF subsequently continued to recommend capital account liberalization as a suitable long-term goal, but acknowledged the need to implement deregulation sequentially, beginning with long-term foreign direct investment before opening up to portfolio flows and bank loans.

The IMF’s position evolved further, however, as the full scale of the global crisis became apparent. First, the IMF allowed Iceland to use controls as part of its financial stabilization program. Then, in the aftermath of the crisis, Fund economists reported in a Staff Position Note that there was  “…a negative association between capital controls that were in place prior to the global financial crisis and the output declines suffered during the crisis…” The next stage came in 2012 when the IMF announced a new view–named the institutional view–of capital flows.  This doctrine acknowledged that capital flows can be volatile and pose a threat to financial stability.  Under these circumstances, controls, now named “capital flow management measures” (CFMs), can be used with other macroeconomic policies to minimize the effects of the capital volatility. Moreover, the responses to disruptive flows should include actions by the countries where the capital flows originate as well as the recipients.

Gallagher explains that these changes were due to both intellectual and political currents. IMF economists had been among those researchers who found little empirical evidence supporting the proposition that capital flows contributed to increased growth rates. This was not a surprise to those influenced by the work of economists such as Ragnar Nurske or Hyman Minsky, who were outside the mainstream. But new theoretical advances by Anton Korinek and Fund economists, including Olivier Jeanne and Jonathan Ostry, showed that the costs of volatile capital flows could be analyzed using the accepted tools of welfare economics. The adverse impact on financial stability of capital outflows can be considered as an externality that private agents ignore in their decision-making. Prudential controls seek to correct these market distortions.

Gallagher points out that at the same time as this new theoretical work was being disseminated, representatives of the emerging markets were lobbying the IMF to allow their governments the freedom to implement measures that they found necessary to offset destabilizing capital flows. The BRICS (Brazil, Russia, India, China, South Africa) coalition, which had worked together to promote reform of the IMF’s governance procedures, joined their efforts to resist any position on capital flows that could restrict their flexibility to limit them. They used the new theoretical perspectives to buttress their arguments in favor of the use of controls, and made similar arguments in other forums such as the meetings of the Group of 20. The BRICS representatives also urged the IMF to pay equal attention to the policies of the upper-income nations where capital flows originated.

The IMF’s Independent Evaluation Office has issued a report updating its 2005 evaluation of the Fund’s approach to capital account liberalization. The IEO describes the discussions leading up to the adoption of the institutional view as “contentious,” and the final document as reflecting a “fragile consensus” among the Executive Directors regarding the merits of full capital account liberalization and the proper use of CFMs. The IEO also reports that the new view seems to have influenced the IMF’s policy advice on capital account liberalization as well as its bilateral surveillance. However, the report cautioned that it is too early to tell whether the adoption of the institutional view will lead to greater consistency in the IMF’s advice on the use of CFMs.

Gallagher shows, moreover, that the battle over the use of capital controls has not ended, but shifted to new arenas. Free-trade agreements (FTAs) and bilateral investment treaties (BITs) signed with the U.S., for example, generally allow governments much less freedom to regulate financial flows. Similarly, the IEO report finds that there is “…a patchwork of bilateral, regional and international agreements regulating cross-border capital flows…” Moreover, the IMF’s attempts to promote international cooperation to reduce volatility due to capital flows have been unsuccessful.

There will be more developments in the story of the (re)regulation of capital. There are still disagreements on the side-effects of capital controls, and a rise in interest rates in the U.S. will test the effectiveness of controls on outflows. Until then, Gallagher’s book serves as a valuable account and analysis of the most recent changes.