The IMF’s statement today on capital controls (here and here) on the surface would seem to be a substantial shift towards a more accommodating position on their use, and is drawing attention.
Over the last two years, Fund staff has put out a number of good papers (from 2010, 2011, and 2012) on the issue. My take away from that work is that controls can make sense, but only in those cases where other policies don’t work or need time to become effective. Consider the following scenario. If a country’s currency is overvalued, then the Fund would understand that the capital inflows take the exchange rate in the wrong direction. If it already has adequate reserves, coping with inflows by building reserves further may seem wasteful. Also, capital inflows may worsen problems of overheating when there isn’t scope for fiscal tightening to relieve the pressure. When these conditions hold, capital controls may be the only answer. Similarly, for a country facing a capital surge while liberalizing the financial sector, temporary controls buy breathing space for policies to take effect and for the prudential framework to be strengthened. What it shouldn’t be is an excuse to preserve an undervalued exchange rate, or to defer adjustment of a weak external position.
Thinking back to my time on the Fund staff more than a decade ago, I don’t think the advice was really much different then. Yes, the Fund’s public statements were strongly anti-capital controls and highlighted the damage that controls could cause. However, in discussions with countries there was always recognition that, while a liberalized capital account was a medium-term goal, timing and sequencing were important. And certainly many countries in good standing with the Fund have had controls.
So what is new today?
For the first time, the IMF Board has endorsed this framework and made it an official position. Compared to past statements, the presumption that full liberalization is always the right long-term goal has been abandoned, and there is now a greater recognition of the risks to financial stability from boom and busts in capital flows. It is also a more positive assessment of the experience with controls, which makes sense given the success of some countries using controls in the recent crisis. Perhaps the Fund will now feel more comfortable suggesting controls and living with them where they exist, but whether that will matter depends on how the principles are applied, so we will have to wait and see.
My concern with the Fund announcement today is that it seems designed to signal a broad comfort with controls beyond what the analysis supports. Having opened the door, the Fund shouldn’t be surprised if the countries that walk through it are not the ones with the strongest case. For countries inclined to protect against flows, their exchange rate will always feel overvalued, reserves always inadequate, their fiscal and regulatory polices top notch, if just given enough time.
Certainly I understand the desire of the Fund to take a “comprehensive, flexible, and balanced” approach. If a more nuanced view allows the Fund to be more engaged with countries, that can be a good thing as well. That said, given the importance of the Fund in signaling and endorsing policies and establishing the rules of the road, there is a risk with this new approach.
This piece is cross-posted from Macro and Markets with permission.