To shed light on the IMF’s evolving policy makeover, I discussed the first of the IMF’s two recent policy papers, titled “Rethinking Macroeconomic Policy.” Now I will review the second paper, titled “Capital Inflows: The Role of Controls,” which has much more relevance for Turkey than the first one, since it deals with the controversial issue of controls on foreign capital inflows to emerging market economies (EMEs).
This paper is timely because in its recent research note, titled “Capital Flows to Emerging Market Economies,” the Institute of International Finance (IIF) expects net private capital flows to EMEs, after rebounding through 2009, to increase further in 2010 and 2011, amid the most favorable global economic outlook ever for EME capital inflows, promising both higher return and less risk relative to developed countries. Net private capital flows to EMEs are expected to reach $722 billion in 2010, up from $349 billion in 2009 and $667 billion in 2008 (but still down from the 2007 peak of $1 trillion). Although the IIF sees limited risk of a short-term boom-bust cycle from this “famine to feast” recovery, based on what the EMEs, especially in emerging Europe (which includes Turkey), learned from their painful experiences, it still perceives significant medium-term risk of excess or another global financial bubble that has to be monitored.
Controls on either foreign capital inflows or outflows restrict financial account convertibility, the freedom with which either residents or non-residents can buy and sell a country’s currency for financial asset transactions. Any IMF member accepting the obligations of Article VIII of the IMF’s Articles of Agreement is expected to commit to current account convertibility, covering exports and imports of goods and services and unilateral transfers. IMF members are not required to have full, i.e., both current account and financial account convertibility. In fact, under Article VI, a member country may impose controls on international capital movements, i.e., restrict financial convertibility, without the IMF’s approval and may do so by discriminating among other member countries. Although most IMF members have current account convertibility, only a minority have full convertibility. The IMF had begun to explore requiring full convertibility in the early 1990s, but the East Asian financial crisis of 1997-1998, widely blamed on financial account liberalization, ended that exploration.
Viewed against this background, “Capital Inflows: The Role of Controls” is the most notable IMF policy paper on the subject since the publications of “The IMF and Recent Capital Account Crises: Indonesia, Korea, Brazil,” in 2003 and “The IMF’s Approach to Capital Account Liberalization” in 2005 by the IMF Independent Evaluation Office. Both reports had raised questions about the IMF’s earlier financial account liberalization position and policies.
This paper, co-authored by Jonathan Ostry, the IMF’s deputy director of research, fully recognizes the economic benefits of free international mobility of capital, similar to benefits of free international trade in goods and services. But, it argues, such mobility, especially surges in short-term capital inflows driven by interest-rate differentials, can be destabilizing for EMEs, causing “bubbles and asset booms and busts,” especially when foreign investors are “subject to herd behavior and suffer from excessive optimism.”
As available tools to cope with these potentially harmful effects it lists fiscal, monetary and exchange rate policies, foreign exchange market intervention, domestic prudential regulation and capital controls. It justifies capital controls under four conditions: (1) the economy is operating near its potential; (2) the level of reserves is adequate; (3) the exchange rate is not undervalued; and (4) the capital inflows are likely to be transitory. It considers at length the various potential economic but not the non-economic costs of even such temporary controls. It also raises the question of their effectiveness by reviewing the experiences of several EMEs with capital inflow controls.
Although the large body of empirical evidence, based on decades of research, is far from conclusive on the effectiveness of controls, it touts its own empirical evidence as supportive of controls. But William R. Cline of the Peterson Institute for International Economics has attacked, in a note titled “The IMF Staff’s Misleading New Evidence on Capital Controls,” that evidence, calling it “seriously misleading.”
Turkey began its financial liberalization in the mid-1980s, with the major step taken in 1989, but formally accepted Article VIII obligations in April 1990. It has moved since then to full convertibility through continued liberalization, with a series of amendments to Decree 32 under Law No. 1567 of the Protection of the Turkish Currency. Although some economists have blamed Turkey’s foreign exchange and banking crises in 1995 and 2000-2001 on speculative short-term foreign capital flows, enabled by the lira’s full convertibility, the ultimate causes of those crises were macroeconomic and regulatory policy mistakes of Turkish governments. Given Turkey’s chronic national saving deficiency and current account deficits -- and its still inadequate foreign exchange reserves -- controls on foreign capital inflows could restrict the country’s economic growth, especially in the face of serious external financing constraints.
Even before the emergence of the IMF’s sympathetic position, subject to many caveats, on capital controls, Brazil imposed last October a 2 percent financial operations tax on fixed income and portfolio equity inflows, aimed at surging foreign capital inflows that were blamed for the rapid appreciation of the Brazilian real. Although the tax did not apply to foreign direct investment, it did not distinguish between short-term and long-term inflows. So, it was not strictly speaking a Tobin tax, which was proposed in 1972 by the late Nobel Prize-winning US economist James Tobin, on short-term speculative currency trading to reduce excessive foreign exchange rate volatility.
It is unclear whether the Brazilian real’s recent relative stability is due to this tax or largely reflects other factors such as the central bank’s intervention in the foreign exchange market and exogenous global trends. Regardless, the debate on capital controls will continue. But financial globalization is already so entrenched that capital controls, whether effective or not, pose little threat of financial de-globalization. That is good news for those of us who oppose controls for philosophical and political as well as economic reasons.
