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

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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.

Assigned Readings: February 8, 2014

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Based on a dataset of 112 emerging economies and developing countries, this paper addresses two key questions regarding the accumulation of international reserves: first, has the accumulation of reserves effectively protected countries during the 2008-09 financial crisis? And second, what explains the pattern of reserve accumulation observed during and after the crisis? More specifically, the paper investigates the relation between international reserves and the existence of capital controls. We find that the level of reserves matters: countries with high reserves relative to short-term debt suffered less from the crisis, particularly if associated with a less open capital account. In the immediate aftermath of the crisis, countries that depleted foreign reserves during the crisis quickly rebuilt their stocks. This rapid rebuilding has, however, been followed by a deceleration in the pace of accumulation. The timing of this deceleration roughly coincides with the point when reserves reached their pre-crisis level and may be related to the fact that short-term debt accumulation has also decelerated in most countries over this period.

We explore the role of financial openness – capital account openness and gross capital inflows – and a newly constructed gravity‐based contagion index to assess the importance of these factors in the run‐up to currency crises. Using a quarterly data set of 46 advanced and emerging market economies (EMEs) during the period 1975Q1‐2011Q4, we estimate a multi‐variable probit model including in the post‐Lehman period. Our key findings are as follows. First, capital account openness is a robust indicator, reducing the probability of currency crisis for advanced economies, but less so for EMEs. Second, surges in gross (but not net) capital inflows in general increase the risk of a currency crisis, but looking at a disaggregated level, gross portfolio flows increase the risk of a currency crisis for advanced economies, whereas gross FDI inflows decrease the risk of a crisis for EMEs. Third, contagion has a very strong impact, consistent with the past literature, especially during the post‐ Lehman shock episode. Last, our model performs well out‐of‐sample, confirming that early warning models were helpful in judging relative vulnerability of countries during and since the Lehman crisis.

This paper revisits the bipolar prescription for exchange rate regime choice and asks two questions: are the poles of hard pegs and pure floats still safer than the middle? And where to draw the line between safe floats and risky intermediate regimes? Our findings, based on a sample of 50 EMEs over 1980-2011, show that macroeconomic and financial vulnerabilities are significantly greater under less flexible intermediate regimes—including hard pegs—as compared to floats. While not especially susceptible to banking or currency crises, hard pegs are significantly more prone to growth collapses, suggesting that the security of the hard end of the prescription is largely illusory. Intermediate regimes as a class are the most susceptible to crises, but “managed floats”—a subclass within such regimes—behave much more like pure floats, with significantly lower risks and fewer crises. “Managed floating,” however, is a nebulous concept; a characterization of more crisis prone regimes suggests no simple dividing line between safe floats and risky intermediate regimes.

This paper examines the effectiveness of capital outflow restrictions in a sample of 37 emerging market economies during the period 1995-2010, using a panel vector autoregression approach with interaction terms. Specifically, it examines whether a tightening of outflow restrictions helps reduce net capital outflows. We find that such tightening is effective if it is supported by strong macroeconomic fundamentals or good institutions, or if existing restrictions are already fairly comprehensive. When none of these three conditions is fulfilled, a tightening of restrictions fails to reduce net outflows as it provokes a sizeable decline in gross inflows, mainly driven by foreign investors.

Desperate Times, Desperate Measures

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The selloff of emerging market currencies and equities continued last week. A Bank of America report noted that investors withdrew $6.4 billion last week from emerging market stock funds, while bond investors are also showing signs of retreating. Moreover, the declines in currency values have expanded outside the “Fragile Five” of Brazil, India, Indonesia, South Africa and Turkey to include Argentina and Russia. What can policymakers do to offset the declines?

Kristin J. Forbes and Michael W. Klein have examined the policy options available to governments that face crises due to contracting capital flows and their impact on GDP growth, inflation and unemployment. The measures include a rise in interest rates, currency depreciation, the sale of foreign exchange reserves and new controls on capital outflows. They report that currency depreciations and reserve sales will provide support for GDP growth, while increases in interest rates and or imposing capital controls do not. But the beneficial impacts of the first two sets of policies appear with a lag and may generate higher inflation. None of the measures improve unemployment.

Christian Saborowski, Sarah Sanya, Hans Weisfeld and Juan Yepez of the IMF also looked at the effectiveness of capital outflow restrictions. They report that controls on outflows can be effective in reducing net outflows only when countries have good macroeconomic fundamentals, as measured by their records of GDP growth, inflation, fiscal policy and their current account balances, or good institutions. Iceland’s use of controls in 2008 is cited as a recent example of a successful use of controls. Of course, an economy with strong macroeconomic conditions is less likely to face substantial outflows.

We can use the indicators used in the IMF study to assess macroeconomic conditions in the countries in the headlines last week. The data are from 2013:

GDP Growth Inflation Fiscal Budget/GDP Current Acct/GDP
Argentina 5.1% ? -3.3% -0.6%
Brazil 2.2% 6.2% -2.7% -3.7%
India 4.9% 10.1% -5.1% -3.1%
Indonesia 5.6% 7.0% -3.3% -3.9%
Russia 1.5% 6.8% -0.5% +2.3%
South Africa 1.9% 5.8% -4.8% -6.5%
Turkey 3.9% 7.5% -1.2% -7.5%

All the countries had rising inflation rates, with India’s hitting double digits. The current account deficits were particularly high for South Africa and Turkey, while India and South Africa had fiscal deficits of about 5%.  Russia’s growth rate was the lowest in this group.

And then there is Argentina. No one believes the inflation rate that the government reports; unofficial estimates place it at around 28%. The government has sought to restrict capital flows while also pegging the exchange rate. But foreign exchange market intervention by the central bank has not stopped an unofficial market from springing up. Last week the central bank, which saw its foreign exchange reserves shrinking precipitously, stepped back and allowed the peso to fall by more than 15%. The government also enacted a partial liberalization of the controls on the purchase of foreign exchange. But there are no signs of a response to inflation, and President Cristina Fernandez de Kirchner, who faces a term limit, has little incentive to take measures that in the short-term could further anger Argentine citizens.

Turkey’s central bank also acknowledged the strength of the forces arrayed against it when it announced a sharp rise in interest rates.  But foreign investors are concerned about corruption and political instability, and the Turkish currency has continued to slump. The Prime Minister’s opposition to the higher interest rates was not reassuring.

When will the withdrawals of money from the emerging markets end, and how will all this play out? The governments of the affected countries are using combinations of all the measures that Forbes and Klein list. But the most diligent central bank can not neutralize the impact of a weak or conflicted government. The financial volatility will continue until some sort of resolution is found to the political volatility.

Who’s In Control?

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In the post-financial crisis world, capital controls have become viewed in many quarters as an acceptable policy tool. A number of studies have investigated how controls may affect macroeconomic and financial performance. But how controls are implemented is also a topic of interest, in part because the inopportune use of these measures may exacerbate the conditions they are intended to ameliorate.

Charles Collyns of the Institute of International Finance presents a classification of the use of controls to deal with capital inflows. The first template is the “Classical Chinese”: the capital account is largely closed except for FDI flows, the exchange rate is fixed and there is a repressed domestic financial system.  But China itself is moving away from this method, as are many low-income countries. The second model is the “Textbook” pre-2008 IMF model: flexible exchange rates with the long-run goal of capital account liberalization. This model showed itself vulnerable to financial shocks in 2008. The third scheme is the “Brazilian Defense”: a floating exchange rate and the use of macroprudential and tax tools to restarin capital flows. This approach has also been utilized by India and Turkey. The fourth classification is dubbed by Collyns the “New Orthodoxy,” and is defined by a commitment to both an open capital account and the development of domestic financial markets. Mexico is offered as an example country that uses such an approach.

If the “Classical Chinese” and the “Textbook” models are being discarded, then one popular alternative is the discretionary use of capital controls. But are capital controls used to avoid inflows that lead to credit bubbles and a boom-bust cycle? A new paper by Andrés Fernández, Alessandro Rebucci and Martín Uribe examines whether policymakers use capital controls in a macroprudential manner. If they were, we would expect to see a tightening of controls on inflows and a relaxation of restrictions on outflows during expansions, and the opposite pattern of policy measures during downturns.

The authors use three indicators—the output gap, the cyclical component of the real exchange rate, and the cyclical component of the current account—to date their boom-and-bust episodes. They update Schindler’s index of capital controls, which distinguishes among controls on inflows and outflows on six types of assets. The authors report that over the period of 2005-2011 there was no correspondence of changes in capital controls and macroeconomic conditions. Controls were not responsive to economic expansions or contractions, over- or undervaluations of the real exchange rate or large current account imbalances.

They offer two interpretations for their results. One is that theory has outrun practice, and controls will become increasingly used in a macroprudential fashion as policymakers become accustomed to using them in this fashion. The second interpretation is that there are other factors that determine the cyclical properties of the usage of capital controls. But what?

There was a literature on the political and economic determinants of capital account liberalization in the 1980s and 1990s, summarized by Eichengreen. Among the factors found to contribute to decontrol were the deregulation of domestic financial markets, the abandonment of exchange rate pegs, and a trend towards democratization in many developing countries. But Eichengreen cautioned that there might have been other factors that were difficult to measure but nonetheless significant. The latest contributions to the literature on the use of capital controls indicate that there are still unanswered questions regarding their implementation.