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The IMF’s Position in a Fragmented Global Economy

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Ten years ago Cambridge University Press published my book, The IMF and Global Financial crises: Phoenix Rising? I had written a series of journal papers on the IMF and used the format of a book to summarize what I had learned about the Fund. I also made some evaluations and projections about the IMF and its reputation; a decade later, how has the IMF done?

The book reviewed the history of the IMF from its founding at Bretton Woods through the global financial crisis. One of the theses of the book was that the IMF had paid a high price for its handling of the Asian financial crisis. The Fund had formulated programs for Indonesia, South Korea, and Thailand that proved to be controversial. Among the charges levied against the Fund was:

  • Condemnation for imposing harsh macro policies in the conditions of the programs;
  • Criticism for including inappropriate structural conditions;
  • Blame for indirectly precipitating the crisis through its support of capital decontrol.

In the aftermath of the Asian crisis as well as subsequent crises in Russia, Turkey and Argentina, the global economy entered a period of steady real growth and moderate inflation rates. The demand for the Fund’s assistance declined, and the IMF used the occurrence of relative stability to undertake post-mortem reviews and changes in its recommended policies. These included a retreat from its advocacy of full capital decontrol, and a reassessment of the purposes and scope of conditionality.

When the global financial crisis of 2008-09 occurred, it was an opportunity for the IMF to show that it had learned the lessons of the previous crisis and could adapt its playbook.  The IMF set up 17 Stand-By arrangements during the period of September 2008 through the following summer. The policy conditions attached to these programs were based on an understanding that the contractions in economic activity in the program countries were the result of falling international trade that followed the financial collapse in the advanced economies. Subsequent reviews of the programs found that credit was disbursed more quickly and in larger amounts than in past crises.

In addition to providing financial resources, the IMF called for a coordinated response to the crisis and the use of fiscal stimulus to offset its effects. The Fund’s economists completed its turnaround in its position on capital account regulation and acknowledged that capital controls could mitigate financial fragility. The IMF’s activist stance was acknowledged by the newly formed Group of 20, which approved an increase of the IMF’s financial resources, and called upon it to institute surveillance of their economies.

The IMF, therefore, came out of the global financial crisis with its reputation as a crisis manager restored. The whimsical subtitle of my book came from a line in Don Quixote that referred to a phoenix that rose from the ashes of a fure.  How the IMF used its reputation and handled new crises, however, could only be revealed with the passage of time.

The IMF does much more than serve as a crisis lender. The results of its surveillance of the global economy are published in reports such as the World Economic Outlook, and updates to its economic forecasts are widely reported. The IMF’s Managing Director, Kristalina Georgieva, has a high public profile, and speaks out a range of global issues. The research of its economists has grown to include work done on income inequality, gender and climate change.

The next major challenge the IMF faced was the Greek debt crisis, when it joined the “troika” of the European Central Bank and European governments in arranging a resolution. The loans extended to Greece were controversial because of the conditions the Greek government had to implment. As the crisis deepened, the IMF differed from its troika partners in advocating for debt relief. Greece eventually repaid its loans from the IMF two years earlier than planned, but in retrospect the IMF’s inclusion in the troika constrained its ability to set sustainable debt levels.

More recently, during the pandemic the IMF was active in providing financial assistance to its poorest members. Some of its funds were given through new facilities, such as the Rapid Credit Facility and the Rapid Financing Instrument, with (at most) minimal conditionality. Brad Setser of the Council of Foreign Relations pointed out that lending from the IMF and the World Bank to lower middle-income countries rose just as private credit flows fell. Setser observed:

“Such a surge made financial sense, and was a moral imperative as well. The Bank and the IMF, and thus President Malpass and Managing Director Kristalina Georgieva, deserve credit for making it a reality. The system, in a sense, worked. Low income countries had to struggle through the pandemic, but they didn’t lose access to new financing at the same time.”

But not all agree that such lending by the IMF is consistent with its core missions. Kenneth Rogoff of Harvard, who was chief economist at the IMF from 2002 to 2003, points out that the Fund, unlike the World Bank, is not an aid agency. It uses conditionality in part to ensure that it is repaid so that it can continue to lend.  He also argues that “forceful IMF conditionality is essential to establish financial stability and ensure that its resources do not end up financing capital flight, repayments to foreign creditors, or domestic corruption.”

More recently the IMF has become involved with a number of developing nations that can not meet their debt obligations, including Egypt, Sri Lanka and Pakistan. According to The Economist, this work is likely to escalate:

“Debt loads across poorer countries stand at the highest levels in decades. Squeezed by the high cost of food and energy, a slowing global economy and a sharp increase in interest rates around the world, emerging economies are entering an era of intense macroeconomic pain… All told, 53 countries look most vulnerable: they either are judged by the imf to have unsustainable debts (or to be at high risk of having them); have defaulted on some debts already; or have bonds trading at distressed levels.”                                                 The Economist, 7/20/2022

The Fund recently published a Staff Discussion Note on “Geoeconomic Fragmentation and the Future of Multilateralism.” The authors of the Note point out that the pace of globalization slowed notably after the global financial crisis, and geopolitical tensions have led to a reversal of economic integration. They examine the consequences of fragmentation on international trade, the diffusion of technology and the international monetary system.

Could the IMF be replaced? It is difficult to imagine how a new global organization could be organized. On the other hand, regional blocs may become more widespread. For example, the IMF’s Note on fragmentation notes that global liquidity has four sources: central bank reserves, bilateral swap agreements, regional financial arrangements, and the IMF. Bilateral swap lines and regional arrangements have grown rapidly, leaving  the Fund as the only provider of universal coverage. Further growth of regional arrangements based on geopolitical blocs would increase their coverage, but it would be uneven across blocks and could be inadequate to deal with large shocks.

I argued in my book that it is crucial to remember that the IMF is an agent for its 190 principals. Its ability to address global challenges depends on the willingness of the sovereign members to use the IMF to organize responses to the challenges. A world that is divided by U.S.-China frictions gives the IMF limited scope to play the role it seeks to have.

China and the Debt Crisis

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Sri Lanka is not the first developing economy to default on its foreign debt, and certainly won’t be the last. The Economist has identified 53 countries as most vulnerable to a combination of “heavy debt burdens, slowing global growth and tightening financial conditions.” The response of China to what will be a rolling series of restructurings and write-downs will reveal much about its position in the 21st century international financial system.

Debt crises are (unfortunately) perennial events. In the 1970s many developing countries, particularly in Latin America, borrowed from international banks to pay energy bills that had escalated after oil price increases enacted by the Organization of Petroleum Countries (OPEC). Repaying those loans became more difficult after the Federal Reserve raised interest rates in 1979 to combat U.S. inflation. Mexico announced that it could no longer make debt payments in August 1982, and other governments soon followed (see here for more detail).

The U.S. government supported negotiations that brought together the governments unable to make payments, the banks that had made the loans, and the International Monetary Fund. The banks were willing to restructure the debt while the IMF lent funds to the governments that allowed them to keep up their interest payments while staving off acknowledging their inability to pay off the debt. But this only delayed a final resolution of the crisis and led to a “lost decade” in Latin America. In 1989 Secretary of the Treasury Nicholas Brady proposed a plan that led to reductions of the loan principals in return for the issuance of “Brady bonds” by the debtor governments.

The U.S. allowed the IMF to take the lead during subsequent crises, including the East Asian crisis of 1997-98, Russia in 1998 and Argentina in 2000. As the member with the largest quota, the U.S. could influence the design and implementation of the IMF’s programs. It also took a more active role when U.S. interests were directly affected, as it did with Mexico in 1994-95. While U.S. attention was focused on its own crisis in 2008-09, the IMF took on the task of lending to middle- and low-income countries that were caught up in the economic shock waves of the financial collapse. The Federal Reserve, however, established currency swap lines with the central banks of other advanced economies as well as those of four emerging markets: Brazil, South Korea, Mexico and Singapore.  The Fed reactivated the swap lines in March 2020 in response to the disruption in international credit markets caused by the pandemic and also set up a new facility to provide dollar funding to foreign official institutions.

China has taken a different position with regards to the debt of developing nations. Its state-owned banks have made bilateral loans as part of the Belt and Road initiative, with many of these loans made to African governments for infrastructure projects. But the amount of lending and the terms have not always been made transparent. Sebastian Horn of the University of Munich, Carmen Reinhart, currently Chief Economist at the World Bank while on leave from Harvard University’s Kennedy School, and Christoph Trebesch of the Kiel Institute for the World Economy developed a database of Chinese lending over the period of 1949-2017 which they published in a 2021 NBER paper, “China’s Overseas Lending.” They found “…that a substantial portion of China’s overseas lending goes unreported and that the volume of “hidden” lending has grown to more than 200 billion USD as of 2016.” Another study from AidData, a research lab at William & Mary, also documented Chinese lending to low- and middle-income countries, and found that many loans are collateralized against future commodity export receipts.

Some of these loans have already been restructured, with China pushing back repayment dates. If there is a systemic wave of defaults, the Chinese government must decide whether it will continue to negotiate directly with the governments that borrowed, or whether it will join the governments that belong to the Paris Club, a group of official creditors that attempt to devise sustainable solutions to debt problems, in designing a mechanism to reduce the volume of debt.

In 2020, the Group of 30 working with the IMF and the World Bank instituted the Debt Service Initiative (DSSI), which suspended debt service payments from low-income countries to official creditors, including China. Forty-eight countries participated in the program, which ended in December 2021.  The DSSI has been followed by the Common Framework, which brings together official creditors and low-income borrowers to provide some form of assistance to insolvent nations. However, private lenders have not agreed to participate and only three nations have requested relief through the Common Framework. There are concerns about the process, and there will undoubtedly be calls for broad-based debt cancellation as countries with mounting food and energy bills seek relief.

The decisions that China makes regarding its participation in new initiatives have implications for its future role in the international financial system. The government has sought to enhance the role of its currency, the renminbi, and its share in the foreign exchange reserves of central banks has risen as trade with China has grown. Serkan Arslanalp of the IMF, Barry Eichengreen of UC-Berkeley and Chima Simpson-Bell, also of the IMF, have documented the decline in the relative share of dollar-denominated foreign reserves and the increase in renminbi-denominated reserves in “The Stealth Erosion of Dollar Dominance and the Rise of Nontraditional Reserve Currencies” in the Journal of International Economics (working paper here). They find, however, that the changes in the composition of foreign reserves involve more than the Chinese currency, and show increases in the relative shares of the Australian dollar, the Canadian dollar, the Korean won, the Singapore dollar and the Swedish krona as wells. They attribute these changes in part to more active management of reserves by central bankers and also the existence of more liquid foreign exchange markets that facilitate non-dollar trading.

The use of the dollar-based international financial system as a financial weapon against Russia, including seizure of more than $300 billion of its central bank assets, could be an opportunity for another system to take its place, and there has been much speculation about the emergence of a Chinese-based rival. But Adam Tooze of Columbia University has pointed out that

“It (the dollar system) is a sprawling, resilient network of state-backed, commercially driven, profit-orientated transactions, lubricated by the easy availability of dollars, interwoven with American geopolitical influence, a repeated game in which intelligent players continuously gauge their advantages and disadvantages and the (very few) alternatives open to them and then, when all is said and done, again and again come back for more.”

A new system would take years to establish. Whether China’s government wants to allow its financial markets to become enmeshed in a global system by removing the remaining capital controls is unclear. The combination of drought, COVID-19 and its real estate crisis fully occupy the attention of the Chinese government. It may have to deal with a debt crisis among the developing nations however, and its response will be monitored for signs of how it sees its position within the global financial network of rules and institutions.

The IMF’s Proposed Policies on the Management of Capital Flows

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The IMF’s views on the advantages and drawbacks of capital flows have substantially evolved over time. The Fund reversed its opposition to capital controls in the wake of the global financial crisis of 2007-09, when it adopted the “Institutional View on the Liberalization and Management of Capital Flows.” That framework included capital flows measures (CFMs) as one of the policy measures available to a government facing surges of capital inflows, i.e., large inflows that could destabilize an economy. The Fund has now moved further in the direction of using CFMs, proposing that they can be used in a preemptive manner to avoid future instability.

The IMF had advocated the removal of capital controls before the Asian financial crisis of 1997-98, so that developing economies could benefit from capital flows. That crisis demonstrated the volatility of capital flows and the catastrophic impact of “sudden stops” on economic activity. Subsequently, the Fund refined its position on deregulation, advising governments to implement adequate supervisory and regulatory regimes before liberalizing their capital accounts, and to begin with opening to foreign direct investment before allowing short-term capital. The IMF moved further during the global financial crisis when it allowed Iceland to implement controls. The Institutional View was adopted in 2012, when countries such as Brazil used CFMs to manage the inflows of foreign capital seeking higher yields than those available in the U.S. The CFMs were part of a toolkit that also includes Macroprudential Prudential Measures (MPMs), which are designed to limit systemic risks. CFM/MPMs are measures designed to limit such risk by controlling capital flows.

The IMF’s new proposals are presented in an IMF Policy Paper, “Review of the Institutional View on the Liberalization and Management of Capital Flows.”  The first proposal extends the Institutional View by allowing the preemptive use of CFM/MPMs on foreign currency debt inflows in order to address the systemic risk that could result from foreign exchange mismatches on balance sheets. Such mismatches can occur slowly, and not just following surges. They increase the probability of capital flow reversals and exchange rate depreciations that disrupt economic activity and could not be adequately addressed with conventional policy tools.

The proposal would also allow CFM/MPMs in the case of high foreign investor participation in local-currency debt markets. In these cases, the danger is a “sudden stop” by foreign investors, which would have particularly adverse consequences if there were illiquid capital markets. Other domestic measures may be unavailable, and the CFM is a second-best solution.

The second proposed policy change exempts certain types of capital control measures that are enacted by governments for specific purposes from review. These include: first, measures adopted for national or international security; second, measures based on international prudential standards, such as those related to the Basel Framework on banking; third, measures designed to deal with money laundering and the combating of financial terrorism; and fourth, measures related to international cooperation standards related to the avoidance or evasion of taxes.

The usefulness of preemptive policies has been demonstrated in a new NBER working paper, “Preemptive Policies and Risk-Off Shocks in Emerging Markets” by Mitali Das and Gita Gopinath of the IMF and Sebnem Kalemli-Özcan of the University of Maryland. The authors investigate the impact of preemptive CFMs on the external finance premia in 56 emerging markets and developing economies during the Taper Tantrum and the COVID-19 shocks. The premia are measured by deviations from uncovered interest rate parity. They consider the impact of CFMs on inflows and outflows, as well as the effect of domestic MPMs.

The paper’s authors report that countries with preemptive CFMs on inflows in place during the five-year period preceding the shocks experienced lower premia and exchange rate volatility. They infer that use of the CFMs provide enhanced access to international capital markets during volatile periods. CFMs on outflows, on the other hand, had a positive effect on the UIP premiums, which may reflect the demand by foreign investors for higher returns to compensate for the CFMs in outflows.

The IMF’s capital flow policies under the Institutional View had been reviewed by the IMF’s Independent Evaluation Office (IEO) in its 2020 report , “IMF Advice on Capital Flows.” The report praised the IMF for the changes in its policy stance, and called the adoption of the Institutional View “a major step forward.” The IEO’s report, however, also called for further changes, including revisiting the Institutional View to take into account recent experience with capital flows, building up the monitoring, analysis and research of capital acccount issues, and strengthening multilateral cooperation on policy issues.

Anton Korinek of the University of Virginia, who wrote a briefing paper for the IEO report, Prakash Loungani, assistant director of the IEO and co-leader of the 2020 report, and Jonathan Ostry of Georgetown University, who was at the IMF when it issued the Institutional View, have written a review of the IMF’s latest policy proposals, “The IMF’s Updated View on Capital Controls: Welcome Fixes but Major Rethinking Is Still Needed.” While welcoming the new measures, they bring up several additional issues that should be addressed. These include the use of capital controls for domestic objectives, such as the impact of capital flows on income inequality and also real estate prices. Such a move would in many ways be consistent with the original aims of the Bretton Woods agreements.

The authors point out that the targets for the IMF’s capital policies are the host countries that receive capital inflows. But challenges associated with capital flows should also involve the countries that are the source of the capital flows. Since these are usually the advanced economies which have a major role in the IMF’s governance, such a move would require the cooperation of the IMF’s most influential members.

Korinek, Loungani and Ostry also urge the IMF to investigate the use of controls on capital outflows. The Fund’s current policy stance only approves the use of such measures during crises. Given the current economic and financial situation (see, for example, here), governments of developing countries are concerned about a repeat of the outflows of March and April 2020. The IMF should be working with these policymakers now to minimize the turbulence that large capital outflows would bring.

The Restructuring of Sovereign Debt

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The economic repercussions of Russia’s invasion of Ukraine will be devastating for many countries that have yet to recover from the pandemic. Higher prices for commodities, particularly energy and food, will increase inflation rates and widen trade deficits for those nations that import those items. Increases in interest rates will raise the cost of debt financing and hamper the ability of borrowers to meet their obligations or refinance existing debt.

Carmen Reinhart, Chief Economist of the World Bank, warned that the pandemic had exacerbated existing financial weaknesses in her Mundell-Fleming Lecture, “From Health Crisis to Financial Distress,” which has been published in the IMF Economic Review. She points out that economic and financial crises, including banking, currency, debt, etc., often occur together. The resulting “conglomerate crisis” can lead to a severe economic downturn. She warns that initial attempts to arrange a “shallow” restructuring of sovereign debt that does not reduce the intertemporal value of the debt may be followed by one or more subsequent restructurings, exacerbating the impact of the crisis.

Governments that need to restructure debt may be able to lessen the resulting impact if they act early. Tamon Asonuma, Marcos Chamon, Aitor Erce and Akira Sasahara have examined the consequences of debt restructurings in an IMF Working Paper, “Costs of Sovereign Defaults: Restructuring Strategies, Bank Distress and the Capital Inflow-Credit Channel.” The authors looked at 179 restructurings of the sovereign debt held by private holders over the period of 1978-2010. They divided the sample into three categories: “strictly preemptive,” where no payments were missed; “weakly preemptive,” where some payments were missed but only temporarily and only after the start of negotiations with creditors; and “post-default,” which occurred when payments were missed and without agreement with the creditors.

They reported that banking crises and severe declines of credit and net capital inflow occurred more frequently following post-default restructurings. They also found that contractions of GDP and investment spending were substantial in post-default restructurings, less severe in weakly preemptive restructurings and did not occur in the case of strictly preemptive cases. Private credit and capital inflows remained below the pre-crisis levels and interest rates rose after post-default restructurings. Their results indicate that governments that can restructure without missing payments will avoid some of the costs associated with restructurings. The authors acknowledge that large shocks can force a halt in payments, but even in those cases collaboration with creditors is more advantageous than unilateral actions.

The IMF reviewed the institutional mechanisms that address sovereign debt restructurings in 2020 policy paper, The International Architecture for Resolving Sovereign Debt Involving Private-Sector Creditors—Recent Developments, Challenges, And Reform Options. The review found that recent restructurings of sovereign debt had been much smoother than those in previous periods. It attributed this change to several factors, including the increased use of collective action clauses which allow a majority of the creditors to override a minority that oppose a restructuring. The paper’s authors called for more contractual reforms as well as an increase in debt transparency, and also recommended that the international financial institutions support debt restructurings financially when appropriate. But the report  warned that the pandemic could engender a widespread crisis that could overwhelm existing procedures:

“Should a COVID-related systemic sovereign debt crisis requiring multiple deep restructurings materialize, the current resolution toolkit may not be adequate in addressing the crisis effectively and additional instruments may need to be activated at short notice.”

The IMF sought to establish new instruments in 2020 when it joined the Group of 20 nations to create an institutional mechanism for low-income countries with unsustainable debt loads called the “Common Framework” (see here). The initiative sought to bring together official creditors, including the traditional lenders such as the U.S. and France, with more recent lenders, such as China and India, to coordinate debt relief efforts. Private creditors were to use comparable terms in their negotiations.

But the Framework has not been widely adopted because of reluctance by some lenders and borrowers. Chinese lending has been funneled through several institutions, and they are not always willing to join other creditors. The governments of the nations with the debt loads have been reluctant to signal that they may need relief, in part because of a negative signaling effect. The IMF has called for reorganizing and expanding the Common Framework.

A wave of restructuring may be triggered by a Russian default on its dollar-denominated bonds. The credit rating agencies have downgraded the Russian bonds to junk bond status (“C” in the case of Fitch’s rating). President Putin has stated that the bond payments will be paid in rubles, but the Russian currency has lost its international value. A default would hasten the collapse of the Russian economy. It would also lead to a reassessment of the solvency of other governments and their ability to fulfill their debt obligations. Foreign bondholders could decide to cut their losses by selling the bonds of the emerging markets and developing economies. A wave of such selling that occurs at the same time as the Federal Reserve raises interest rates will almost certainly lead to a new debt crisis for many countries. The IMF and World Bank will be hard-pressed to coordinate relief efforts across so many borrowers and lenders.

Will A Rise in Interest Rates Lead to a New Debt Crisis?

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The question of when the Federal Reserve will begin to reverse its loose policy stance continues to be a topic of widespread speculation. At last month’s meeting of the Federal Open Market Committee, its members showed a willingness to cut back on asset purchases in 2022 and to raise interest rates in 2023, but kept monetary policy on its current setting due to slower growth in employment than desired. The latest inflation reading may bring forward the Fed’s tightening measures. If and when interest rates do rise in the U.S. and other advaneced economies, what will be the impact for holders of foreign assets?

There is a split in opinions on the vulnerability of emerging market economies (EMEs) to rising interest rates. In an interview with Finance & Development, Richard House of Allianz Global Investors and David Lubin of Citibank played down the chances of a disruption of foreign markets when the Federal Reserve begins its reversal. They cite the increase in foreign exchange reserves and the decrease in the number of countries with fixed exchange rates as reasons why systemic crises can be avoided. In the same issue, however, Şebnem Kalemli-Özcan of the University of Maryland points out that country-dependent risk will affect the response to a new external environment. Many EMEs used monetary policy to finance their fiscal spending in response to the pandemic. There is a concern that their bond purchases and monetary creation could lead to higher inflation that will raise the cost of new financing at the same time as the U.S. is raising its interest rates.  

The author of the Buttonwood column of The Economist, however, notes that the central banks in several EMEs have already raised their policy rates in response to concerns of rising inflation following currency depreciations. Higher rates attract capital from foreign investors looking for higher yields, which strengthens the currency. An appreciating currency keeps down import prices and inflation in check.

Jasper Hoek and Emre Yoldas of the Federal Reserve Board and Steve Kamin of the American Enterprise Institute show that the response of emerging market economies to rising U.S. interest rates will depend in part on the reasons for the increase. If rates rise because of favorable economic growth in the U.S., then the EMEs should benefit from the increase in U.S. demand for their goods and increased investor confidence. If, on the other hand, the higher rates are due to higher inflation that requires a marked tightening of the U.S. policy stance, then interest rates on the debt of EME issuers will rise as their currencies fall in value.

The response to the pandemic in the EMEs is the biggest challenge those nations face.  While firms in the U.S. and Europe are busy meeting surging consumer demand, the virus continues to spread in Africa, South American and South Asia. The response in advanced economies to a recovery that brings with it higher inflation may threaten the ability of the EMEs’ policymakers to maintain their accommodative stance. Agustín Carstens, General Manager of the Bank for International Settlements, warns: “… it could be hard for EME policymakers to maintain accommodative policy stances should global financial conditions tighten materially. But tighter policy will make economic recovery even more difficult.”

The record of responses to Federal Reserve policy retrenchment is not encouraging. In May 2013, then Fed Chair Ben Bernanke responded to a question at a Congressional committee meeting about future Fed policy by noting that “If we see continued improvement and we have confidence that that’s going to be sustained then we could in the next few meetings … take a step down in our pace of purchases.” This innocuous remark led to turbulence in the financial markets, which became known as the “taper tantrum.” Increases in the Federal Funds Rate in 2018 under Fed Chair Jerome Powell met widespread criticism and concerns about their impact on slow economic growth, and the Federal Reserve reversed course in 2019.

Economists can always provide well-reasoned narratives as to how and why financial markets respond to events. Unfortunately, market volatility is almost always unanticipated. No matter how careful policymakers are with their statements, there is the potential for an unforeseen response. The continuation of the pandemic heightens the uncertainty, and the current elevated levels of stock prices and the increase in debt leaves asset markets vulnerable to a “Minsky moment” when an initial reversal leads to a demand for liquidity and cascading falls in financial markets. The EMEs will become part of the collateral damage of such a collapse.

The IMF and the Coronavirus

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A global threat such as the coronavirus should be met with a global response. National governments, however, have generally not coordinated their efforts, with the exception of those that belong to the European Union, and even there the distribution of vaccines has not gone smoothly. International agencies, on the other hand, such as the International Monetary Fund have responded more quickly. Moreover, the IMF has shown a willingness to play an active role in preparing for the post-pandemic world and to take on issues outside its usual remit.

The IMF’s past attempts to resolve financial crises have not always been successful (for an account see here). The IMF’s policy prescriptions at the outset of the East Asian crisis of 1997-98 included contractionary fiscal policy conditions for the governments that adopted IMF programs, as well as higher interest rates. There were  also structural conditions that dealt with the privatization of government-owned enterprises. While such policies may have been appropriate for a crisis that was due to expansionary macroeconomic policies, fiscal and monetary measures did not precipitate the East Asian crisis. Capital inflows had fueled bank lending and asset prices had soared, while central banks were committed to fixed exchange rates. Once foreign investors became alarmed about the exposure of private borrowers to currency and maturity mismatches, they began to exit, provoking a “sudden stop” of capital and currency devaluations.

The IMF faced criticism not only from the East Asian governments but from economists outside Asia. The macroeconomic policy conditions were inappropriate for a crisis that originated in private capital flows, and were based on overly optimistic projections of growth. Structural conditions were viewed as unnecessary and diverted attention from the measures that need to be undertaken. The IMF was also blamed for indirectly provoking the crisis through its advocacy of the removal of capital controls before the crisis. The IMF subsequently relaxed many of its program conditions as the nature of the crisis became more clear, but the damage to its reputation was enormous.

A decade later the IMF again faced a widespread financial crisis, and this time its response was very different. The global financial crisis of 2008-09 showed some similarities in its background with the Asian crisis. Inflows of capital to the U.S. and several European countries had fueled increases in asset prices and distorted expenditures. Once the bubbles in housing prices burst, financial institutions sought to unload mortgage-backed securities, forcing their prices down further. The rapid nature of the collapse in asset values and the lack of liquidity in financial markets exposed the fragility of the financial sector.

While the central banks of the advanced economies coordinated their responses, the IMF assisted emerging market economies that were caught up in the economic downturn precipitated by the financial collapse. The Fund lent to 17 countries, with the largest amounts of credit going to Hungary, Pakistan, Romania, and the Ukraine. Moreover, the policy conditions attached to the programs reflected an awareness of the origin and severity of the global contraction. Fiscal policy in the program countries was utilized to respond to falling private demand, although their governments avoided the large deficits that occurred in the advanced economies. Interest rate increases designed to prevent runs on currencies were limited and exchange rates did stabilize. Moreover, the IMF allowed the use of capital controls. Overall, the IMF received high marks for its initiatives during the global financial crisis.

In retrospect, the post-crisis recovery did not go as smoothly as it should have. Many countries felt compelled to reverse the expansionary policies of the crisis period because of fears of excessive debt. This contractionary trend was exacerbated by a sovereign debt crisis in Greece. Other European governments sought the inclusion of the IMF in addressing the crisis, and for the first time the Fund had partners: the European Central Bank and the European Commission. The initial macro policy changes imposed by this “troika” sought to restore fiscal balance, but their contractionary effects kept tax revenues below their anticipated levels, which led to further cutbacks. The IMF differed with the European governments over the sustainability of Greece’s debt burden and the need for debt forgiveness. Eventually the Greek economy began a recovery, but in retrospect the austerity policies there and elsewhere led to a slower recovery that there could have been.

The IMF has drawn upon these past experiences in formulating its response to the pandemic. The Fund has again responded quickly to assist its members, approving emergency financing  through its Rapid Credit Facility and its Rapid Financing Instrument to 80 countries and assistance under other arrangements to another five nations. It has extended debt service relief to 29 of its poorest members that have obligations to the IMF. The Fund and the World Bank have called on bilateral lenders to suspend debt service payments from the poorest countries, and the governments of the Group of 20  agreed to do so for official debt. The agencies have called for private lenders to implement similar measures.

The IMF has also sought to prepare countries for the post-pandemic world. Kristalina Georgieva, the current Managing Director of the IMF and the first from a East European country (Bulgaria), has supported policy initiatives in areas that traditionally do not fall under the IMF’s purview. She has supported national policies that seek to address different forms of inequality, including income and wealth inequality as well as gender and generational inequality. She has also called for including climate related risk in the IMF’s economic and financial assessments , and using fiscal expenditures to target “…climate-resilient infrastructure and expanding green public transportation, renewable energy, and smart electricity grids.”

Will the IMF be able to engineer such broad changes? The IMF is an agent responsible to 190 principals, the sovereign governments that are the IMF’s members and oversee its activities. Some of these may feel that Georgieva’s policy agenda is too ambitious and/or expensive. There are also disagreements over how to finance the IMF’s assistance to its poorest members. Proposals to issue more Special Drawing Rights (SDRS) have faced opposition from the U.S. On the other hand, differences amongst its principals may allow the IMF more freedom to expand the scope of its mandate. There is also the danger that a wave of debt crises following the wave of public borrowing by emerging maket governments may force the IMF to focus on debt restructuring.

The IMF, and Georgieva in particular, deserve credit for bringing forward issues that traditionally have not been addressed in discussions of international macroeconomic concerns. Monetary and fiscal policies, for example, have impacts on racial and gender inequality that have been overlooked. Climate change will constrain the actions of the governments of the most vulnerable countries. Whether the IMF is successful in actually steering governmental actions towards these areas will depend on the willingness of its members to adopt wider and inclusive approaches in their responses to the coronavirus

[I had the opportunity of interviewing Ms. Georgieva for the Madeleine Korbel Albright Institute of Wellesley College. The transcript of the interview can be found here.]

Portfolio Capital Flows to Emerging Markets amid the Pandemic

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Among the most notable economic responses to the COVID-19 pandemic has been the turnaround in capital flows to emerging markets. A sudden reversal in portfolio flows of over $100 billion to these countries in March has been offset by a surge of capital this fall. But many of these countries have accumulated debt burdens that will affect their ability to recover from the pandemic.

The IMF examined portfolio flows to these economies in last April’s issue of the Global Financial Stability Report (see also here). The report showed that prior to the pandemic, bond portfolio inflows had been larger than equity portfolio flows, with cumulative flows since 2005 of approximately $2.5 trillion for bonds vs. about $1 trillion for equity. The bonds included both bonds denominated in foreign currency as well as local currency debt. These flows had constituted significant amounts of finance in the emerging and frontier markets’ debt and equity markets.

The authors of the report analyzed the determinants of the different types of portfolio flows. They reported that changes in global conditions (or “push factors”) are largely responsible for debt inflows. Among these factors are the VIX index, a measure of global risk appetite, the U.S. Treasury bond yield, and the foreign exchange value of the dollar. Equity flows are also influenced by foreign conditions, but domestic economic growth (a “pull” factor) is a larger factor in raising the likelihood of capital inflows. This reflects the dependency of the returns on portfolio equity on profitable business operations.

These results explain a large part of the retreat from portfolio securities last March. When the extent of the pandemic became clear, the VIX measure rose while the dollar initially appreciated as investors sought a “safe harbor.” These developments contributed to the reversal of foreign holdings of debt securities. The rapid deterioration in the prospects for economic growth in the emerging markets influenced the turnaround of portfolio equity flows.

But capital inflows were flowing back to the emerging markets by the summer and continued to rise this fall. The Institute for International Finance (IIF) reported inflows of $76.5 billion in November alone, with $39.8 billion for emerging market equities and $37.7 billion for bonds and other debt. For the fourth quarter the IIF expected the strongest level of inflows since the first quarter of 2013.

The turnaround reflects several factors. First, the Federal Reserve’s strong response to stabilize financial markets has been successful, and market volatility has dropped. At the same time, the Fed’s lowering of the Federal Funds rate caused investors to look elsewhere for yields. Finally, the announcements of successful vaccines offers the prospect of an economic recovery in 2021.

However, there are concerns that the desire for the higher yield on riskier debt is fostering the issuance of bonds by borrowers who may not be able to fulfill their obligations. The ability of many of the governments and firms in the emerging market economies to meet their debt obligations is very much open to question. In December, S&P Global Ratings noted that “short-term risks still loom large” in the emerging markets.  Moreover, the agency stated that  “Debt overhang among governments and pressure on corporate earnings would constrain an economic recovery.” Five of the 16 key emerging market sovereign bonds that S&P rates carry negative outlooks: Chile, Colombia, Mexico, Indonesia and Malaysia.

The dangers of government spending in emerging markets financed by debt have been noted by Michael Spence of Stanford and Danny Leipziger in “The Pandemic Public-Debt Dilemma.” While the current cost of debt financing is relatively cheap, Spence and Leipziger pointed out that “a country’s citizens are not well-served when their government becomes more indebted in order to spend imprudently.” They warn that “borrowing in hard currencies when exports are depressed and their own exchange rates are under duress simply makes future debt re-scheduling more likely…”

Similarly, Raghuram G. Rajan of the University of Chicago and former governor of the Reserve Bank of India also questions how much debt a government can issue in “How Much Debt Is Too Much?” While some governments can roll over existing debt, Rajan claims that ”… investors will buy that new debt only if they are confident that the government can repay all its debt from its prospective revenues.” He warns that “Many an emerging market has faced a debt “sudden stop” well before it reached full employment, triggered by evaporating market confidence in its ability to roll over debt.”

Jeremy Bulow of Stanford, Carmen M. Reinhart, currently chief economist of the World Bank Group, Kenneth Rogoff of Harvard and Christoph Trebesch of the Kiel Institute for the World economy foresee a need to plan measures to deal with debt problems in “The Debt Pandemic.” They warn of debt restructurings on a scale not seen since the debt crisis of the 1980s. They view the pandemic as “…a once-in-a-century shock that merits a generous response from official and private creditors toward emerging market and developing economies.” Among the measures they suggest is new legislation to support orderly restructurings.

The need for policy measures to deal with debt restructuring is also expressed by Kristalina Georgieva, Managing Director of the IMF, Ceyla Pazarbasioglu,  Director of the IMF’s Strategy, Policy, and Review Department, and Rhoda Weeks-Brown,  General Counsel and Director of the IMF’s Legal Department. They specifically call for strengthening provisions that minimize economic disruption when debtors are in distress. These could include lower debt payments or the automatic suspension of  debt service. They also ask for increased debt transparency and agreement by creditor governments that are part of the Paris Club on a common approach to restructuring.  The latter two steps are aimed in part at China, which has become the largest bilateral creditor for many developing countries. There is considerable uncertainty over the size and conditions of debt owed to China, and how China will respond to the inability of debtor governments to make payments on the debt.

The IMF itself has pledged to provide debt service relief to its poorest members, while working with the Group of 20 on its Debt Service Suspension Initiative. Under this program, the governments of the G20 have offered to suspend the payments of government-to-government debt for 73 developing economies. The G20 also called on private lenders to offer similar relief, but there has been little response.

The onset of a debt crisis among the emerging market countries has been foreseen.  The widespread borrowing to deal with pandemic, however, has exacerbated the debt overhang. The pandemic will continue to affect financial stability and economic performance even as medical measures are implemented to deal with the virus .

The Guardians of the Financial Galaxy

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The rapid expansion of the pandemic and the ensuing economic and financial collapses brought about responses by policymakers, including actions undertaken on an international basis. The Federal Reserve acted together with other central banks to ensure that an adequate supply of dollars was available to support dollar-based financing outside the U.S. Similarly, the IMF moved rapidly to provide financial support to its members. These national and international institutions constitute a “two tier” system in international finance that occupies the role of lender of last resort.

International cooperation has occurred before, and Michael Bordo of Rutgers University gives an account of these efforts in a new NBER working paper, “Monetary Policy Coordination an Global Financial Crises in Historical Perspective.” During the Bretton Woods era, central banks cooperated to sustain the fixed exchange rate system. In 1962, the U.S. established bilateral currency swaps with foreign central banks, which provided dollars to be used in support of their exchange rates.

The swaps continued in the 1970s after the termination of the Bretton Woods regime as policymakers sought to control the volatility of exchange rates. During the early and mid-1980s there were episodes of coordination of foreign exchange market intervention by central banks as governments in the advanced economies sought to stabilize the value of the dollar. But these occurred less frequently in the late 1980s as inflation fell in most of these countries and foreign exchange market intervention became less common.

The outbreak of crises in emerging markets in the 1990s required a joint response, and the IMF took on the role of crisis manager. During the Asian crisis of 1997-98, for example, the Fund provided credit to the governments of the countries in crisis. Their programs included conditions that required included cutbacks in government spending and credit creation, and frequently a currency devaluation. However, the IMF’s policies came under immediate criticism as inappropriate and overly severe. These were not crises based on excessive government spending, but rather financial collapses. The IMF paid a high price in its reputation for its handling of the Asian crisis, but learned a valuable lesson: financial instability can impose a serious cost.

The financial crisis of 2007-09 provided another major challenge to global financial stability and the need for a coordinated response. Banks in Europe and Japan had borrowed dollars to acquire dollar-denominated assets, such as mortgage-based securities. Their access to dollar funding was threatened as the interbank markets for dollars came under strain. In December of 2007, the Federal Reserve announced that it was establishing swap lines with the European Central Bank and the Swiss National Bank. At the crisis escalated in 2008, the Federal Reserve set up similar arrangements with the central banks of Australia, Canada, Denmark, England, Japan, New Zealand, Norway, and Sweden. It also arranged swap arrangements with the central banks of Brazil, Mexico, Korea and Singapore, emerging market economies with substantial exposure to dollar-based financing. The Federal Reserve and the foreign central banks exchanged currencies, and the foreign central banks lent the dollars to its domestic banks that needed them. At the conclusion of the swap period, the currency exchanges were reversed using the same exchange rate, and the central banks would pay the Fed a fee based on what it had charged their own banks.

These arrangements differed from previous efforts in that they were designed to address financial instability, not exchange rate values. The dollar had become the primary global funding currency, so a decrease in dollar liquidity would have had widespread effects. The joint activities of the Federal Reserve and its partner central banks were successful in bringing down the cost of dollar lending in the foreign markets and avoiding the collapse of foreign institutions with dollar liabilities.

The IMF was also active during the crisis. Not all central banks were able to exchange currencies with the Federal Reserve, and the IMF served as an alternative source of financing. During the period from September 2008 through the following summer, the IMF instituted 17 Stand-By Arrangements. The economic policies that were part of these programs reflected an awareness of the origin and severity of the global downturn. Credit was disbursed more quickly and in larger amounts than had occurred in the past and there were fewer conditions attached to the programs. Consequently, the IMF’s record during the great recession was very different from that of the Asian financial crisis.

During the current crisis, central banks and the IMF have built upon and expanded the policies they undertook in 2008-09. Once again, global dollar financing came under strain. In March the Federal Reserve renewed or set up swap facilities with the central banks of 14 countries. In addition, it established a repurchase facility for foreign and international monetary authorities (FIMA) that would allow them to temporarily exchange their holdings of U.S. Treasury securities for dollars.

These efforts were successful in preventing a collapse of dollar financing. Nicola Cetorelli, Linda S. Goldberg and Fabiola Ravazzolo of the Federal Reserve Bank of New York investigated the impact of the Federal Reserve’s facilities by comparing the foreign exchange swap basis spreads of currencies covered by the agreements with those on other currencies. They found that  ”… the swap lines have been an important factor helping to improve market conditions and expand access to dollar liquidity during the period of peak strains in global U.S. dollar funding markets.” They added that the Federal Reserve was engaging in a wide range of other actions that could also have impacted this market.

The central banks that obtained the dollars were able to use them to support banks that provided dollars to other parties in their countries. For example, Gianluca Persi of the European Central Bank showed that the Eurosystems’s use of the swap lines”…not only helped banks to satisfy their immediate U.S. dollar funding needs but also supported market activity.” He concludes that “The swap lines between central banks therefore helped to mitigate the effects of the strains in the U.S. dollar funding market.”

The IMF has also been active in meeting the needs of its members. The IMF has used its rapid financial assistance programs (Rapid Financing Instrument, Rapid Credit Facility) to make loans to 76 countries. These loans do not require full programs or reviews, and carry little conditionality. The IMF is also adjusting existing programs to meet the need for health-related expenditures.

The IMF is making special efforts for its low-income members. It is providing grants to its poorest members to cover the IMF debt obligations. In March the IMF and World Bank called on official bilateral creditors to suspend debt service payments from low-income countries. The Group of 20 governments responded by agreeing to suspend repayment of official bilateral credit from these nations until the end of 2020. The IMF, the World Bank and the G20 also called for private sector creditors to participate in similar debt relief on comparable terms.

IMF Managing Director Kristalina Georgieva at the opening of this spring’s meeting pledged to use the Fund’s  $1 trillion lending capacity to support its members. She also urged governments to be active in addressing the needs of their citizens. In a speech at the London School of Economics on October 6, she pointed out that “flexible and forward-leaning fiscal policy will be critical for the recovery to take hold.” She also called for measures to deal with the debt of low-income countries, including “access to more grants, concessional credit and debt relief, combined with better debt management and transparency.”

A division of labor, therefore, has evolved between the Federal Reserve and the IMF during periods of widespread instability. The Federal Reserve provides dollars to other central banks in upper-income countries and selected emerging market economies to preserve stability in the global financial markets. Since the Federal Reserve lends to central banks, there is little concern about insolvency. In many ways it assumes the traditional role of lender of last resort as conceived by Bagehot and other nineteenth century economists.

In normal times the IMF lends to governments in middle- and low-income countries with balance of payments crises and possible insolvency. The Fund disburses credit in programs that operate over a time horizon at least a year and sometimes longer. However, during the global financial crisis and now the current crisis, the IMF ramps up its lending. It provides credit quickly at little if any cost, and its programs seek to stabilize economic activity. Moreover, the IMF takes public positions to advocate fiscal stimulus and debt relief.

Stanley Fischer, who served as First Deputy Managing Director of the IMF from 1994 to 2001, saw the need for an international lender of last resort for countries facing an external financial crisis, and claimed that the IMF had played that role in the 1980s and 1990s. In subsequent years it became clear that central bankers in advanced economies preferred to deal with each other and organize their own programs. There have been periodic calls for the IMF to become more involved in swap networks, but the central banks have shown no interest in involving the IMF in their networks. The two-tier system functioned relatively well in 2008-09 and to date has stabilized financial markets. But the number of coronavirus cases are surging, and there are concerns about another recession in the U.S. and Europe. The current system to back stop financial markets and institutions will be tested in new ways that may show its limitations.

The Coming Debt Crisis

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After the 2008-09 global financial crisis, economists were criticized for not predicting its coming. This charge was not totally justified, as there were some who were concerned about the run-up in asset prices. Robert Schiller of Yale, for example, had warned that housing prices had escalated to unsustainable levels. But the looming debt crisis in the emerging market economies has been foreseen by many, although the particular trigger—a pandemic—was not.

Last year the World Bank released Global Waves of Debt: Causes and Consequences, written by M. Ayhan Kose, Peter Nagle, Franziska Ohnsorge and Naotaka Sugawara. The authors examined a wave of debt buildup that began in 2010. By 2018 total debt in the emerging markets and developing economies (EMDE) had risen by 54 percentage points to 168% of GDP. Much of this increase reflected a rise in corporate debt in China, but even excluding China debt reached a near-record level of 107% of GDP in the remaining countries.

The book’s authors compare the recent rise in the EMDE’s debt to other waves of debt accumulation during the last fifty years. These include the debt issued by governments in the 1970s and 1980s, particularly in Latin America; a second wave from 1990 until the early 2000s that reflected borrowing by banks and firms in East Asia and governments in Europe and Central Asia; and a third run-up in private borrowing via bank loans in Europe and Central Asia in the early 2000s. All these previous waves ended in some form of crisis that adversely affected economic growth.

While the most recent increase in debt shares some features with the previous waves such as low global interest rates, the report’s authors state that it has been “…larger, faster, and more broad-based than in the three previous waves…” The sources of credit shifted away from global banks to the capital markets and regional banks. The buildup included a rise in government debt, particularly among commodity-exporting countries, as well as private debt. China’s private debt rise accounted for about four-fifths of the increase in private EMDE debt during this period. External debt rose, particularly in the EMDEs excluding China, and much of these liabilities were denominated in foreign currency.

The World Bank’s economists report that about half of all episodes of rapid debt accumulation in the EMDEs have been associated with financial crises. They (with Wee Chian Koh) further explore this subject in a recent World Bank Policy Research Paper, “Debt and Financial Crises.” They identify 256 episodes of rapid government debt accumulation and 263 episodes of rapid private debt accumulation in 100 EMDEs over the period of 1970-2018. They test their effect upon the occurrence of bank, sovereign debt and currency crises in an econometric model, and find that such accumulations do increase the likelihood of such crises. An increase of government debt of 30 percentage points of GDP raised the probability of a debt crisis to 2% from 1.4% in the absence of such a build-up, and of a currency crisis to 6.6% from 4.1%. Similarly, a 15% of GDP rise in private debt doubled the probability of a bank crisis to 4.8% if there were no accumulation, and of a currency crisis to 7.5% from 3.9%. (For earlier analyses of the impact of external debt on the occurrence of bank crises see here and here.)

Kristin J. Forbes of MIT and Francis E. Warnock of the University of Virginia’s Darden Business School looked at episodes of extreme capital flows in the period since the global financial crisis (GFC) in a recent NBER Working Paper, “Capital Flows Waves—or Ripples? Extreme Capital Flow Movements Since the Crisis.”  They update the results reported in their 2012 Journal of International Economics paper, in which they distinguished between surges, stops, flights and retrenchments. They reported that before the GFC global risk, global growth and regional contagion were associated with extreme capital flow episodes, while domestic factors were less important.

Forbes and Warnock update their data base in the new paper. They report that has been a lower incidence of extreme capital flow episodes since 2009 in their sample of 58 advanced and emerging market economies, and such episodes occur more as “ripples” than “waves.” They also find that as in the past the majority of episodes of extreme capital flows were debt-led. When they distinguish between bank versus portfolio debt, their results suggest a substantially larger role for bank flows in driving extreme capital flows.

Forbes and Warnock also repeat their earlier analysis of the determinants of extreme capital flows using data from the post-crisis period. They find less evidence of significant relationships of the global variables with the extreme capital flows. Global risk is significant only in the stop and retrenchment episodes, and contagion is significantly associated only with surges. They suggest that these results may reflect changes in the post-crisis global financial system, such as greater use of unconventional tools of monetary policy, as well as increased volatility in commodity prices.

Corporations can respond to crises by changing how and where they raise funds. Juan J. Cortina, Tatiana Didier and Sergio L. Schmukler of the World Bank analyze these responses in another World Bank Policy Research Working paper, “Global Corporate Debt During Crises: Implications of Switching Borrowing across Markets.” They point out that firms can obtain funds either via bank syndicated lending or bonds, and they can borrow in international or domestic markets. They use data on 56,826 firms in advanced and emerging market economies with 183,732 issuances during the period 1991-2014, and focus on borrowing during the GFC and domestic banking crises. They point out that the total amounts of bonds and syndicated loans issued during this period increased almost 27-fold in the emerging market economies versus more than 7 times in the advanced economies.

Cortina, Didier and Schmukler found that the issuance of bonds relative to syndicated loans increased during the GFC by 9 percentage points from a baseline of 52% in the emerging markets, and by 6 percentage points in the advanced economies from a baseline probability of 28%. There was also an increase in the use of domestic debt markets relative to international ones during the GFC, particularly by emerging economy firms. During domestic banking crises, on the other hand, firms turned to the use of bonds in the international markets. When the authors used firm-level data, they found that this switching was done by larger firms.

The authors also report that the debt instruments have different characteristics. For example, the emerging market firms obtained smaller amounts of funds with bonds as compared to bank syndicated loans. Moreover, the debt of firms in emerging markets in international markets was more likely to be denominated in foreign currency, as opposed to the use of domestic currency in domestic markets.

Cortina, Didier and Schmukler also investigated how these characteristics changed during the GFC and domestic bank crises. While the volume of bond financing increased during the GFC relative to the pre-crisis years, syndicated bank loan financing fell, and these amounts in the emerging market economies fully compensated each other. In the advanced economies, on the other hand, total debt financing fell.

The global pandemic is disrupting all financial markets and institutions. The situation of banks in the advanced economies is stronger than it was during the GFC (but this could change), and the Federal Reserve is supporting the flow of credit. But the emerging markets corporations and governments that face falling exports, currency depreciations and enormous health expenditures will find it difficult to service their debt. Kristalina Georgieva, managing director of the IMF, has announced that the Fund will come to the assistance of these economies, and next week’s meeting of the IMF will address their needs. The fact that alarm bells about debt in emerging markets had been sounding will be of little comfort to those who have to deal with the collapse in financial flows.

Capital Controls in Theory and Practice

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It has been a decade since the global financial crisis effectively ended opposition to the use of capital controls. The IMF’s drive towards capital account deregulation had been blunted by the Asian financial crisis of 1997-98, but there was still a belief in some quarters that complete capital mobility was an appropriate long-run goal for emerging markets once their financial markets sufficiently matured. The meltdown in financial markets in advanced economies in 2008-09 ended that aspiration. Several recent papers have summarized subsequent research on the justification for capital controls and the evidence on their effectiveness.

Bilge Erten of Northeastern University, Anton Korinek of the University of Virginia and José Antonio Ocampo of Columbia University have a paper, “Capital Controls: Theory and Evidence,” that was prepared for the Journal of Economic Literature and summarizes recent work on this topic. In this literature, the micro-foundations for the use of capital controls to improve welfare are based on externalities that private agents do not internalize. The first type of externality is pecuniary, which can lead to a change in the value of collateral and a redistribution between agents. In such cases, private agents may borrow more than is optimal for society, which suffers the consequences in the event of a financial shock. Policymakers can restrict capital flows to limit financial fragility.

The second justification of capital controls is due to aggregate demand externalities, which are associated with unemployment. Private agents may borrow in international markets and fuel a domestic boom that leaves the domestic economy vulnerable to a downturn. If there are domestic frictions and constraints on the use of monetary policy that limit the response to an economic contraction, then capital controls may be useful in mitigating the downturn.

Alessandro Rebucci of Johns Hopkins and Chang Ma of Fudan University also summarize this literature in “Capital Controls: A Survey of the New Literature,” prepared for the Oxford Research Encyclopedia of Economics and Finance. They discuss the use capital controls in the case of both pecuniary and demand externalities, and capital controls in the context of the trilemma. In their review of the empirical literature on capital controls, they summarize two lines of research. The first deals with the actual use of capital controls, and the second their relative effectiveness.

Whether or not capital controls are used as a countercyclical instrument together with other macroprudential tools has been an issue of dispute.  Rebucci and Ma report there is recent evidence that indicates that such instruments have been utilized in this manner, as the recent theoretical literature proposes. There are also cross-country studies of capital control effectiveness that are consistent with the theoretical justification for the use of such measures. For example, capital controls can limit financial vulnerability by shifting the composition of a country’s external balance sheet away from debt.

Some recent papers from the IMF investigate the actual use of capital controls and other policy tools in emerging market economies. Atish R. Ghosh, Jonathan D. Ostry and Mahvash S. Qureshi of the IMF investigated the response of emerging markets to capital flows in a 2017 working paper, “Managing the Tide: How Do Emerging Markets Respond to Capital Flows?” They report that policymakers in a sample of 51 countries over the period of 2005-13 used a number of instruments to deal with capital flows. In addition to foreign exchange market intervention and central bank policy rates, capital controls were utilized, particularly when the inflows took the form of portfolio and other flows. Tightening of capital inflow controls was more likely during periods of credit growth and real exchange rate appreciation. The authors’ finding that several major emerging markets have used capital controls to deal with risks to financial and macroeconomic stability is consistent with the theoretical literature cited above. However, the authors caution that their results do not indicate whether managing capital flows actually prevents or dampens instability.

This subject has been addressed by Gaston Gelos, Lucyna Gornicka, Robin Koepke, Ratna Sahay and Silvia Sgherri  in their new IMF working paper, “Capital Flows at Risk: Taming the Ebbs and Flows.” They examine the policy responses to sharp portfolio flow movements in 35 emerging market and developing economies during the 1996-2018 period, using a rise in BBB-rated U.S. corporate bond yields as a global shock. The authors look at the structural characteristics and policy frameworks of the countries as well as their policy actions. Among their results they find that more open capital accounts at the time of the shock are associated with fewer large inflows after the shock. Moreover, a tightening of capital flow measures is linked to larger outflows in the short-run. They also find that monetary and macroprudential policies have limited effectiveness in shielding countries from the risks associated with global shocks.

Capital controls have become an important tool for many developing economies, and there are ample grounds to justify their implementation. Recent empirical literature seems to show that the actual implementation of such measures is undertaken in a manner that meets the criteria outlined in the theoretical literature. However, whether regulatory limits on capital mobility actually achieve their financial and macroeconomic goals is still not proven. The Federal Reserve has signaled its intention to maintain the Federal Funds Rate at its current level, but shocks can come from many sources. Policymakers may find themselves drawing upon all the tools available to them in the case of a new global disruption to capital flows.