## ppea2022008 - EXECUTIVE SUMMARY ## Source details **Canonical URL:** [ppea2022008 - EXECUTIVE SUMMARY](https://www.imf.org/-/media/files/publications/pp/2022/english/ppea2022008.pdf) ## Other formats - [Markdown version](/-/media/files/publications/pp/2022/english/ppea2022008.pdf.md) - [Structured JSON version](/-/media/files/publications/pp/2022/english/ppea2022008.pdf.json) --- ### Purpose and context - The Institutional View (IV) on the Liberalization and Management of Capital Flows, adopted in 2012, remains the basis for consistent advice and assessments on policies related to capital flows. - This paper reviews the IV drawing on: - advances in research (notably work on the Integrated Policy Framework, IPF), - the 2020 evaluation by the Independent Evaluation Office (IEO) on IMF Advice on Capital Flows, - staff experience with IV implementation and an earlier 2016 review. - Core premises retained: - capital flows are desirable and can bring substantial benefits; - CFMs can be useful in certain circumstances but should not substitute for warranted macroeconomic adjustment; - objective: help countries reap benefits while managing risks to preserve macroeconomic and financial stability and avoid significant negative outward spillovers. ### Proposed policy changes (high level) - Two primary changes: - Allow for preemptive CFM/MPMs on inflows in some circumstances. - Establish special treatment (no IV appropriateness assessment) for certain categories of measures by nature. ### Preemptive CFM/MPMs on inflows — rationale and scope - Rationale: - Based on IPF insights, CFM/MPMs (measures that are both capital flow management measures and macro-prudential measures) on inflows may be useful preemptively to address financial stability risks arising from buildup of stock vulnerabilities, notably FX mismatches. - Scope and limits: - IV would recognize preemptive inflow CFM/MPMs may be appropriate in certain circumstances while minimizing risk of unintended effects or inappropriate use. - Preemptive CFM/MPMs may be imposed on FX debt inflows to address systemic financial risks from FX mismatches; in narrower cases, on local-currency debt inflows. ### Special treatment for certain measures (no IV appropriateness assessment) - Four categories proposed to not be assessed under the IV: - Measures introduced solely for national or international security reasons. - Certain measures adopted pursuant to internationally agreed prudential frameworks (including reciprocity agreements). - AML/CFT measures implemented consistently with international standards (FATF). - Measures arising from certain international cooperation standards against avoidance or evasion of taxes (Inclusive Framework on BEPS and tax transparency standards). ### Elements retained and operational clarifications under the IV - Retains IV advice on: - Capital flow liberalization. - Management of capital inflow surges. - Management of disruptive outflows. - Additional operational guidance: - Macro-criticality: - CFMs are discussed in Fund surveillance if macro-critical — i.e., they significantly influence present or prospective domestic or balance of payments stability. - Proposed practical criteria: economy-wide significance of the sector, capital flows targeted, expected impact of CFMs. - Capital inflow surges: - Discusses quantitative methods and indicators to identify surges and finetune assessment of macroeconomic/financial stability challenges. - Imminent crises: - Use of indicators and analytical tools to identify imminent crisis circumstances under which outflow CFMs may be useful as part of an overall policy package. - Premature liberalization: - Severe deterioration of macro-financial stability after removal of CFMs may warrant temporary reintroduction until conditions for safe liberalization are met. ### Implementation and operational clarifications (selected) - CFMs that are also exchange restrictions or multiple currency practices (MCPs): - Proposed to be assessed solely under the respective Article VIII policy, and not under the IV, except MCPs that apply solely to capital transactions and are CFMs — these remain assessed only under the IV. - Measures not activated/enforced or with parameters set at zero: - Classified as CFMs and assessed only when activated, enforced, or parameters tightened. - Measures on FX purchases and transactions between residents: - Can be classified as CFMs if designed to limit capital flows. - Tax measures: - Measures that discriminate based on tax residency as defined in tax law frameworks should not automatically be assessed as CFMs; assessment focuses on whether they are designed to limit capital flows. - Differential treatment based on tax residency (e.g., 183 days) will not automatically be deemed residency-based CFMs. ### Implementation and review background - Review informed by: - IPF research, - 2020 IEO evaluation on IMF Advice on Capital Flows, - staff implementation experience. - Prepared by interdepartmental staff team from LEG, MCM, RES, and SPR. --- ### PREEMPTIVE CFM/MPMs ON INFLOWS — DETAILED FRAMEWORK ### Conceptual rationale and conditions - FX mismatches can be: - overall FX balance sheet mismatch across remaining maturities, or - FX maturity mismatch at shorter horizons, or both. - FX mismatches may build gradually without a surge; large FX mismatches raise probability that reversals and depreciations generate costly balance sheet effects and severe output collapses. - Conventional policy instruments can be limited during reversals (exchange rate, monetary policy trade-offs, limited FX liquidity/ reserves). - Preemptive CFM/MPMs on FX debt inflows can prevent further accumulation of elevated FX mismatches and associated systemic risks. - Preemptive measures on local-currency debt inflows are justified only in narrow, exceptional circumstances. ### Risks and mitigation when using preemptive measures - Potential adverse side-effects: - substituting for warranted macroeconomic policy adjustments or MPMs; - substituting for structural policies to develop markets; - misallocation of resources, rent seeking; - maintaining or exacerbating a stronger-than-warranted external position (currency undervaluation); - time needed to reduce existing stock vulnerabilities. - Mitigation: careful design, calibration, targeting, transparency, limitation to temporary use, periodic reassessment. ### Appropriateness criteria (three key considerations) - Necessary conditions: - Are systemic financial risks elevated? - Is the preemptive CFM/MPM needed to address these risks (i.e., MPMs unavailable or insufficient)? - Would the preemptive CFM/MPM help maintain or exacerbate a stronger-than-warranted external position that is mostly caused by domestic policy gaps? - The preemptive CFM/MPM is inappropriate if it would help maintain or exacerbate such an external position and the country is not taking policy actions to address the gaps; or if the extent and duration of the external strength are large relative to systemic risks and expected policy effectiveness. ### Assessment of FX mismatches and systemic financial risks - Preemptive CFM/MPMs on FX debt inflows appropriate only if systemic financial risks are elevated due to FX mismatches. - Assess FX mismatches using: - (a) sectoral and economy-wide private sector FX debt and asset positions (external and domestic); - (b) whether FX debt is hedged at relevant maturities (natural hedges, FX assets, contracts in deep hedging markets). - Evaluate amplifying/mitigating factors: FX leverage, asset price bubbles, FX buffers including central bank swap lines. - Use IMF macroprudential framework and stress tests where feasible. ### Exceptional case for local-currency debt inflow measures (joint conditions) - Preemptive CFM/MPMs on local-currency debt inflows may be justified only if all joint conditions are satisfied: - (i) local currency debt and FX markets are sufficiently shallow so outflows by some foreign investors are unlikely to be offset by others; - (ii) a large depreciation is costly due to FX mismatches or de-anchoring of inflation expectations and costs outweigh depreciation benefits; - (iii) domestic monetary policy is constrained and FX reserves are low; - (iv) other ex-post policy instruments (local-currency lender-of-last-resort and liquidity facilities) are substantially impeded or unavailable. ### Design principles and calibration - Measures must be both CFMs and MPMs: primary objective to safeguard financial stability, identifiable source of systemic risk, and reasonable expectation that the measure mitigates those risks. - Target debt inflows in the specific sector causing risk and calibrate to minimize costs and side-effects. - Avoid overbroad coverage or miscalibration that exceeds necessity. - Favor temporary, transparent, and periodically reassessed measures; prefer instruments that increase resilience (capital/liquidity requirements, maturity-dependent levies, targeted reserve requirements). ### Interaction with MPMs, macroeconomic and structural policy - Preemptive CFM/MPMs should not be used if MPMs alone would suffice. - Should not substitute for warranted macroeconomic adjustments; where immediate adjustment is unduly costly/slow, temporary CFM/MPMs may be appropriate alongside a commitment to corrective policy adjustments. - Should not substitute for market development or structural reforms; ideally combined with reforms (develop local currency bond markets; boost macro credibility; strengthen supervision). ### Exchange rate regime and spillover considerations - Fixed exchange rate regimes may strengthen the case for preemptive CFM/MPMs due to tighter policy constraints, but measures must not sustain unsustainable pegs. - Policy advice should consider spillovers via exchange rate, external position, or international financial flows; follow ISD guidance to discuss outward spillovers and alternative policies to minimize negative spillovers. ### Periodic review and removal - Review periodically (e.g., during Article IV consultations) for continued appropriateness: - whether MPMs have become available; - whether measure substitutes for warranted macro adjustment; - progress on reforms; - whether exchange rate has depreciated significantly or external position strengthened; - authorities’ actions to address domestic policy gaps. - Remove immediately if feasible without jeopardizing stability; otherwise phase out with appropriate speed linked to feasible policy adjustments. --- ### PRACTICAL TOOLS, SURGE IDENTIFICATION, AND RISK ASSESSMENT ### Identifying capital inflow surges — quantitative methods - Five quantitative approaches recommended (complement staff judgment): - Threshold analysis: flows within top 30th percentile of country's own distribution and sample distribution. - Trend analysis: - HP filter: Deviation from long-term trend by one historical standard deviation. - Hamilton filter: Asymmetric OLS regression filter. - Rolling window: Annual increase in inflows by more than one standard deviation above the five-year rolling average. - Cluster analysis: Partition inflows into k-clusters minimizing within-cluster sum of squared differences. - Apply to net and gross flows and to sectoral/asset-class flows (e.g., portfolio debt and equity). ### Stepwise surge assessment procedure - Step 1: Use set of quantitative methods and heatmap to count how many methods identify a surge; when two or more methods signal a surge, interpret as a possible threshold that a surge is taking place. - Step 2: Compare with comparator economies using same methods; if comparators also have surges, that supports the signal. - Step 3: Analyze macro-financial variables via heatmap: - Macroeconomic: real GDP growth, current account, inflation, external position. - Financial market: credit-to-GDP gap, interest rates, house prices, exchange rate, debt spreads, uncovered interest parity premia. - Structural indicators: governance, regulatory practices, financial development. - Sectoral surges: focus on relevant narrower indicators and sectoral data; surges large in a particular sector with systemic linkages can be disruptive. ### Identifying imminent crisis circumstances (outflow CFMs) - Outflow CFMs remain constrained to crises or imminent crisis circumstances. - Features associated with crises: excessive currency depreciation (often post-overvaluation), depletion of FX reserves, large declines in aggregate demand, rapid reversal of current account deficits, sharp increases in interest rates and spreads. - High-frequency indicators and qualitative information (sharp exchange rate moves, rapid reserve declines, tightening financial conditions, abrupt financing rollovers) inform imminent crisis identification. ### Premature liberalization — identification and response - Premature liberalization: removal of CFMs that outpaces economy’s capacity to handle resulting flows, evidenced by severe deterioration in macro-financial stability indicators after liberalization. - Policy responses: - Temporary reimposition of CFMs on some flow types until progress made on macroeconomic, financial, and structural policies recommended by integrated approach. - Reimposition may be alongside liberalization of other flow types if conditions met. - Subsequent monitoring of policy action; lack of corrective action suggests CFMs are managing flows rather than enabling safe liberalization. ### Assessing systemic risks from FX mismatches — two-step approach - Step 1: Identify elevated FX mismatches at relevant remaining maturities using: - stock of FX liabilities, - denomination of assets and availability of hedges, - maturity structure of balance sheets. - Use multiple indicators and data sources; proceed to Step 2 if mismatches are high for at least one macro-critical sector or if intermediate range (err on side of caution). - Step 2: Assess systemic risks with granular solvency and liquidity stress tests (preferred) or deepened narrative analysis: - Solvency stress tests: calibrated depreciation scenarios and default implications on bank solvency. - Liquidity stress tests: calibrate depreciation and withdrawal of FX funding; trace contagion and reserve drawdown. - Data sources and coverage (end-2019 examples): - IDS, LBS, MFS, QEDS, IIP, BSA and country-specific accounts; reported coverage examples: Households: 145 countries from IDS, 186 from LBS, 156 from MFS; Banks: 78 from IDS, 180 from LBS, 114 from QEDS, 156 from MFS. - Practical triage: if data gaps, use authority-provided unpublished data and staff judgment. ### Illustrative hypothetical country (Box 1 findings) - Sectoral FX debt stocks (shares of GDP): - NFCs: about 6 percent of GDP from external sources; about 25 percent of GDP from domestic sources. - Banks: cross-border borrowing in FX about 19 percent of GDP. - Households and NBFIs: FX liabilities low. - Maturity composition: - Short-term debt share about 40 percent for banks; about 30 percent for other sectors. - Conclusion: publicly available data warranted proceeding to Step 2 given judged elevated FX mismatches. ### Annex I — local-currency debt inflow assessment (summary) - Two-step assessment analogous to FX case for local-currency debt inflows; preconditions from paragraph 16 (i–iv) must be jointly satisfied before beginning assessment. --- ### COSTS, CONSTRAINTS, AND DESIGN CONSIDERATIONS ### Costs and cautions limiting use of CFMs and CFM/MPMs - Distortion of productive investment and competition; disproportionate burden on smaller firms. - Incentives for rent-seeking and corruption; governance risks. - Reduced impetus for reforms and perpetuation of market frictions. - Reduced long-term investor attractiveness if poorly designed/communicated. - Compliance costs and policy uncertainty from frequent changes. - Broader scope and longer duration increase distortionary costs and entrenchment risks. - Risk of beggar-thy-neighbor spillovers if used to manipulate terms of trade. ### Design, enforcement, and institutional considerations - Structural constraints: enforcement capacity, legal frameworks, administrative infrastructure. - Enforcement considerations inform tool choice: price-based (reserve requirements, levies) vs. quantity-based; marginal reserve requirements on new flows vs. measures applied to stocks (phase-in to reduce adjustment costs). - Preference for non-discriminatory MPMs when sufficient; CFM/MPMs only when MPMs unavailable or insufficient. - Complementary policies recommended to reduce long‑run reliance: develop domestic financial markets, local-currency instruments, hedging markets, strengthen macro frameworks and lender-of-last-resort functions. --- *Source: EXECUTIVE SUMMARY of ppea2022008 - REVIEW OF THE INSTITUTIONAL VIEW ON THE LIBERALIZATION AND MANAGEMENT OF CAPITAL FLOWS (February 22, 2022).* ### EXECUTIVE SUMMARY ### ppea2022008 - EXECUTIVE SUMMARY ### Purpose and context - The Institutional View (IV) on the Liberalization and Management of Capital Flows, adopted in 2012, provides the basis for consistent advice, and where relevant, assessments on policies related to capital flows. - This paper reviews the IV, informed by advances in research (notably work on the Integrated Policy Framework, IPF), the findings of the 2020 evaluation by the Independent Evaluation Office (IEO) on IMF Advice on Capital Flows, and staff’s experience with IV implementation. - The IV’s core premises and objectives remain unchanged: capital flows are desirable and can bring substantial benefits; CFMs can be useful in certain circumstances but should not substitute for warranted macroeconomic adjustment. - The IV aims to help countries reap benefits of capital flows while managing associated risks in a way that preserves macroeconomic and financial stability and does not generate significant negative outward spillovers. ### Proposed policy changes (high level) - Two primary changes are proposed: - Allow for preemptive CFM/MPMs on inflows in some circumstances. - Establish a special treatment for certain categories of measures that, because of their nature, should not be assessed under the IV’s standard appropriateness criteria. ### Preemptive CFM/MPMs on inflows — rationale and scope - Rationale: - Based on IPF insights, CFM/MPMs (measures that are both capital flow management measures and macro-prudential measures) on inflows may be useful to address financial stability risks in a preemptive manner (i.e., in the absence of a capital inflow surge). - These risks could arise from the buildup of stock vulnerabilities, notably currency mismatches, which conventional policy instruments may not effectively address during a capital flow reversal. - Proposed scope and limits: - The IV would recognize that preemptive inflow CFM/MPMs may be appropriate in certain circumstances, in a manner that minimizes the risk of unintended effects or inappropriate use, including to gain an unfair competitiveness advantage. - Such preemptive CFM/MPMs may be imposed on FX debt inflows to address systemic financial risks stemming from FX mismatches; in narrower cases, they may be imposed on local-currency debt inflows. ### Special treatment for certain measures - The review proposes not to assess the appropriateness under the IV for four categories of measures: - Measures introduced solely for national or international security reasons. - Certain measures adopted pursuant to internationally agreed prudential frameworks (including reciprocity agreements). - AML/CFT measures implemented consistently with international standards. - Measures arising from certain international cooperation standards against the avoidance or evasion of taxes. ### Elements retained and elaborated under the IV - The review maintains the IV’s existing policy advice on: - Capital flow liberalization. - Management of capital inflow surges. - Management of disruptive outflows. - Additional guidance is offered on key concepts and operational issues to support policy advice under the IV: - Macro-criticality: - CFMs are to be discussed in Fund surveillance if macro-critical, i.e., if they significantly influence present or prospective domestic or balance of payments stability. - The review proposes criteria for assessing macro-criticality in practice, focusing on the economy-wide significance of the sector, the capital flows targeted by the CFMs, and the expected impact of the CFMs. - Capital inflow surges: - Identifying inflow surges is an important step to determine policy advice under the IV. - The review discusses quantitative methods to help identify inflow surges and indicators to finetune the assessment of whether inflows pose macroeconomic and/or financial stability challenges. - Imminent crises: - The review discusses the use of indicators and analytical tools to identify imminent crisis circumstances, under which CFMs on outflows may be useful as part of an overall policy package that tackles underlying macroeconomic imbalances. - Premature liberalization: - Indications of premature liberalization can include a severe deterioration of macro-financial stability following the removal of CFMs. - These may warrant the temporary reintroduction of certain CFMs until the conditions for safe liberalization are met as guided by the IV’s integrated approach. ### Other implementation and operational clarifications - CFMs that are also exchange restrictions or multiple currency practices (MCPs): - Proposed to be assessed solely under the respective Article VIII policy, and not under the IV. - MCPs that apply solely to capital transactions and are also CFMs are proposed to be assessed only under the IV. - Measures not activated or enforced, or with parameters set at zero: - Proposed to be classified as CFMs and assessed only when activated, enforced, or their parameters are tightened. - Measures on FX purchases and other transactions between residents: - Can be classified as CFMs if they are designed to limit capital flows. - Clarification is provided on when a tax measure constitutes a CFM. ### Implementation and review background - The review is informed by: - Research on the Integrated Policy Framework (IPF). - The 2020 IEO evaluation on IMF Advice on Capital Flows. - Staff experience with IV implementation, including an earlier 2016 review that found the IV broadly appropriate but identified issues for further research and clarification. - The paper was prepared by an interdepartmental staff team from Legal (LEG), Monetary and Capital Markets (MCM), Research (RES), and Strategy, Policy and Review (SPR). *Source: EXECUTIVE SUMMARY of ppea2022008 - REVIEW OF THE INSTITUTIONAL VIEW ON THE LIBERALIZATION AND MANAGEMENT OF CAPITAL FLOWS (February 22, 2022).* ### 7. Some other topics, while important, are not tackled in this review, because the ### 7. Some other topics, while important, are not tackled in this review, because the ### Topics excluded from this review - Use of CFMs for social or political objectives. - Distributional effects of capital flow liberalization. - Use of outflow CFMs outside of (imminent) crisis circumstances. - Effects of digitalization and climate change on capital flows. - Rationale: "the analytical foundation to propose policy changes is insufficient at this time" and "Establishing this foundation will require additional time and research." ### Organization of the paper (structure overview) - Section II: case for preemptive CFM/MPMs on certain inflows and an assessment process for their appropriate use, building on the insights of the IPF. - Section III: proposed modifications to the IV’s treatment for certain categories of measures. - Section IV: elaboration of concepts and policies important for IV implementation. - Section V: other operational issues in the application of the IV. ### Revised Institutional View—Key elements regarding preemptive CFM/MPMs on inflows - Preemptive CFM/MPMs on debt inflows (primarily in FX) may be useful when private sector debt stock vulnerabilities (primarily FX mismatches) are present and MPMs cannot sufficiently address them. - Stock vulnerabilities can accumulate during prior inflow surges or gradually over time without a surge. - Preemptive inflow CFM/MPMs should be: - targeted, - transparent, - potentially longer-lasting but temporary, - recalibrated or removed as the vulnerabilities that led to adoption subside, or if an effective MPM (that is not designed to limit capital flows) becomes available. - In inflow surge contexts, inflow CFM/MPMs may be useful to address financial stability risks arising from the surge. - Decision logic (high-level): assess FX mismatches, systemic financial risks, monetary-autonomy/macro-destabilization considerations, and adjust fiscal/monetary/structural policies and exchange rate flexibility as warranted; remove CFMs/MPMs when the inflow surge abates or vulnerabilities dissipate. ### Institutional View—unchanged elements and international roles - Role of source countries: - Source country policies have a role in mitigating multilateral risks associated with capital flows. - Surges in cross-border flows may indicate need for adjustment in both recipient and source countries. - Cross-border policy coordination between source and recipient countries helps mitigate undesired spillover effects. - Spillovers and coordination are addressed via the Fund’s multilateral and bilateral surveillance, consistent with the Integrated Surveillance Decision (ISD). - International cooperation: - The IV does not alter members’ rights and obligations under other international agreements. - The IV fosters a global dialogue and promotes a consistent approach to handling capital flows within bilateral, regional, and multilateral agreements. - Encourages collaboration with organizations such as the OECD, BIS, FSB, and Standard Setting Bodies (SSBs). - Fund contributes to international efforts to reduce volatility of cross-border flows, including participation in FSB work on nonbank financial intermediation and crypto assets. - Steps to collaborate further with OECD, FSB, and SSBs are contemplated as part of the Management Implementation Plan responding to IEO recommendations. ### Proposed policy change: the case for preemptive inflow CFM/MPMs — conceptual rationale - FX mismatches can arise from: - overall FX balance sheet mismatch across remaining maturities, or - FX maturity mismatch at shorter horizons, or both (paragraph 9). - FX mismatches may build gradually in financial, household, or corporate sectors and pose systemic risks even without an inflow surge. - Large FX mismatches increase the probability that capital flow reversals and currency depreciations generate costly balance sheet effects and severe output collapses. - During capital flow reversals, conventional policy instruments may be limited: - Currency depreciation may tighten external borrowing constraints by reducing FX value of local-currency assets/collateral relative to FX debt. - Monetary policy trade-off: raising interest rates tightens domestic conditions; lowering rates can lead to further depreciation. - Capacity to provide FX liquidity (government/central bank) may be limited by insufficient FX reserves or other FX funding sources. - Therefore, CFM/MPMs on FX debt inflows may be useful preemptively (in absence of inflow surge) to prevent further accumulation of already-elevated FX mismatches and associated systemic risks (paragraphs 10–11). - Accumulation of external debt in local currency can pose vulnerabilities, but typically a wider set of policy tools (MPMs, monetary policy, lender-of-last-resort in local currency) is available to address them; preemptive CFM/MPMs for local-currency debt are warranted only in narrow exceptional circumstances (paragraph 12). ### Risks and mitigation when using preemptive inflow CFM/MPMs - Potential adverse side-effects: - May substitute for warranted macroeconomic policy adjustments or MPMs. - May substitute for structural policies to develop financial markets. - May cause misallocation of resources and rent seeking. - May maintain or exacerbate a stronger-than-warranted external position (currency could become or stay undervalued absent surge-related appreciation pressures). - May take time to reduce existing stock vulnerabilities. - Essential to minimize adverse side-effects through careful design and calibration (paragraph 13). ### Proposed policy change — criteria for appropriateness (three key considerations) - Are systemic financial risks elevated? - Is the preemptive CFM/MPM needed to address these risks? - Would the preemptive CFM/MPM help maintain or exacerbate a stronger-than-warranted external position that is mostly caused by domestic policy gaps? - Paragraphs 15–22 provide criteria and discussion to make these judgments (paragraph 14). ### Assessment of systemic financial risks and FX mismatches (criteria and indicators) - Preemptive CFM/MPMs on FX debt inflows are appropriate only if systemic financial risks are elevated due to FX mismatches (paragraph 15). - To assess FX mismatches, analyze (subject to data availability): - (a) sectoral and economy-wide private sector FX debt and asset positions (external and domestic); - (b) whether FX debt is hedged at relevant maturities, naturally or via FX assets or financial contracts in deep hedging markets. - Evaluate systemic risks from FX mismatches accounting for amplifying/mitigating factors such as: - FX leverage; - asset price bubbles fueled by external FX borrowing; - FX buffers held by the central bank or government, including access to other FX liquidity (e.g., central bank swap lines). - Use IMF macroprudential framework (IMF, 2013b and 2014a) and stress tests where feasible; align with 2021 Comprehensive Surveillance Review calls for strengthening systemic risk analysis in Article IV consultations. ### Exceptional case for preemptive measures on local-currency debt inflows (conditions) - Preemptive CFM/MPMs on local-currency debt inflows may be justified only in narrow and exceptional circumstances, e.g., high foreign investor participation amplifying maturity mismatches, fueling asset-price increases, or generating excessive leverage (paragraph 16). - Joint conditions expected to be satisfied for such justification in a disruptive reversal: - (i) local currency debt and FX markets are sufficiently shallow so outflows by some foreign investors are unlikely to be offset by others; - (ii) a large depreciation is costly due to FX mismatches or other reasons (e.g., if it de-anchors inflation expectations) and these costs outweigh depreciation benefits; - (iii) domestic monetary policy is constrained and FX reserves are low; - (iv) other ex-post policy instruments (local-currency lender-of-last-resort and liquidity facilities) are substantially impeded or unavailable. ### Is the preemptive CFM/MPM needed and how should it be designed? - The measure should be both a CFM and an MPM: - Primary objective: safeguard financial stability. - Identify source of systemic financial risks. - The CFM can reasonably be expected to mitigate such risks (Box 2 and paragraph 17). - For FX mismatch-driven risks, the measure should: - reduce existing FX mismatches, - prevent further increases in FX mismatches from already-elevated levels, or - increase resilience to FX mismatches by requiring capital or liquidity for external FX borrowing. - For local-currency external debt stock vulnerabilities, the measure should lower those stock vulnerabilities by reducing such inflows. - Measures should target debt inflows in the specific sector causing risk as closely as possible and be calibrated to address risks effectively while minimizing costs and side effects. - Overbroad coverage or miscalibration that goes beyond what is necessary renders the measure inappropriate. ### Box 2 — Definition of CFMs, MPMs, and CFM/MPMs (classification principles) - CFMs: measures designed to limit capital flows. - MPMs: prudential tools designed to limit systemic financial risks. - CFM/MPMs: measures designed to limit systemic financial risks stemming from capital flows (IMF, 2012b, 2013b, 2017). - Classification requires careful assessment of design, objectives, and circumstances; an interdepartmental group works with country teams for consistent classification. - Practical indicators: - Measures that affect international financial transactions and discriminate based on residency have been assessed as CFMs. - Non-discriminatory measures may also be CFMs if designed to limit capital flows given the context. - To classify a CFM as an MPM three conditions must be fulfilled: - (i) primary objective is to safeguard financial stability; - (ii) a source of systemic financial risks can be identified; - (iii) the CFM can reasonably be expected to mitigate such risks. - Notes: - Currency-based measures may often be MPMs, but can be CFMs if designed to limit capital flows. - CFMs are not labeled CFM/MPMs if design/context suggest primary objective is not financial stability or they are unlikely to limit systemic risks. - CFMs that mainly operate through the exchange rate receive extra scrutiny and may not qualify as MPMs. *Source: IMF staff — REVIEW OF THE INSTITUTIONAL VIEW ON THE LIBERALIZATION AND MANAGEMENT OF CAPITAL FLOWS (selected excerpts).* ### 18. Preemptive CFM/MPMs should not be used if MPMs alone would be sufficient to ### 18. Preemptive CFM/MPMs should not be used if MPMs alone would be sufficient to ### Role of MPMs vs preemptive CFM/MPMs - MPMs are typically able to contribute substantially to managing risks from FX borrowing (e.g., IMF, 2014b, and IMF, 2017), and preemptive CFM/MPMs should not be used if MPMs alone would be sufficient to address the risks. - Preemptive CFM/MPMs may be warranted only when MPMs are unavailable or insufficient to address the risks in question. - When necessary, a pre-emptive CFM/MPM—either alone, or to reinforce MPMs—may be the least distortive way to address the risks effectively. ### Interaction with macroeconomic policy - The preemptive inflow CFM/MPM should not be used to substitute for warranted adjustments in macroeconomic policies. - If monetary policy, exchange rates, or fiscal policy are at inappropriate settings, and correcting them would eliminate the systemic risks, these policies should be adjusted instead of using CFM/MPMs. - If immediate adjustment is unduly costly or slow to have effect, CFM/MPMs may be temporarily appropriate alongside a commitment to a plan to undertake the warranted policy adjustments recommended in Article IV consultations. - If correcting macroeconomic policies would have only a small or partial effect on systemic risks, a temporary CFM/MPM may be appropriate alongside correction of macroeconomic policies. ### Interaction with market development and structural policies - The preemptive CFM/MPM should not substitute for market development or structural policies that could reduce the underlying frictions, nor undermine such policies. - Example: if a preemptive CFM/MPM is used to reduce FX mismatches, it should not prevent the development of markets which could provide funding in local currency. - Structural policies may address frictions without adverse side-effects and should be pursued; preemptive CFM/MPMs may be appropriate in the interim unless they undermine reform efforts. - If preemptive CFM/MPMs are used, it would be desirable to combine them with reforms to address the underlying frictions, which may include: - developing local currency bond markets, - boosting the credibility of the macroeconomic policy framework, - developing sound financial supervision and regulation. ### Assessment of effects on a stronger-than-warranted external position - Key question: Would the preemptive CFM/MPM help maintain or exacerbate a stronger-than-warranted external position that is mostly caused by domestic policy gaps? If so, is the country taking sufficient actions to address its external position? - The External Sector Assessment (ESA) categorizes external positions; the term “stronger-than-warranted external position” corresponds to ESA categories “moderately stronger,” “stronger,” or “substantially stronger.” The ESA builds on staff judgment, country-specific circumstances, and estimates from the External Balance Assessment (EBA) and EBA-lite models. Country-specific knowledge and other analytical work may identify other distortions not included in the models. - Factors determining whether a preemptive CFM/MPM would help maintain or exacerbate a stronger-than-warranted external position: - The strength of the external position and the contribution of domestic policies. If the external position is stronger than warranted and policy gaps are mostly domestic, use of preemptive CFM/MPMs could add to the domestic policies generating the external imbalance. - The expected effect of the preemptive CFM/MPM on the external position. Relative to the counterfactual of no CFM/MPM use, inflow CFM/MPMs would be expected to depreciate the currency and strengthen the external position, unless a case can be made that its impact on the currency would not be economically significant.11 - Policy actions to address a stronger-than-warranted external position. If the country is undertaking corrective policy actions or committed to them, this mitigates concern; absence of such actions raises concern that the preemptive CFM/MPM could exacerbate the external imbalance. ### Putting it all together: overall assessment criteria - Necessary conditions for appropriateness: - 1. Systemic financial risks are elevated - 2. The preemptive CFM/MPM is needed to address systemic financial risks - 3. The preemptive CFM/MPM would help maintain or exacerbate a stronger-than-warranted external position mostly caused by domestic policy gaps and... - and unless - a.... the country is not taking policy actions to address the gaps - b.... the country is taking some policy actions to reduce the gaps, but the extent and duration of the strength of the external position are large relative to the systemic financial risks and the effectiveness of policy actions - The preemptive CFM/MPM is inappropriate if: - it would help maintain or exacerbate a stronger-than-warranted external position mostly caused by domestic policy gaps, and the country is not taking policy actions to address these gaps. - it would help maintain or exacerbate such an external position despite the country undertaking or committing to undertake corrective actions, if the extent and duration of the strength of the external position are large relative to the systemic financial risks and relative to the expected effectiveness of the policy actions. ### Exchange rate regime considerations - Countries with fixed exchange rate regimes may face tighter policy constraints that may strengthen the case for preemptive CFM/MPMs, because: - they face tighter constraints in the use of monetary policy and/or in allowing nominal exchange rate flexibility during capital flow reversals; - their ability to provide local currency liquidity support may be limited. - Caveat: measures should not substitute for warranted macroeconomic and structural adjustments or help maintain unsustainable currency pegs. ### Spillovers and surveillance - Policy advice on preemptive CFM/MPMs should take spillovers into account, which may arise via effects on the exchange rate, the external position, or international financial flows (e.g., contagion effects). - If the use of the CFM/MPM is assessed as appropriate under the IV, treatment of spillovers should follow ISD guidance: staff should discuss outward spillovers from members’ policies if they significantly influence the effective operation of the IMS. Staff should examine whether alternative policy actions could achieve domestic objectives while minimizing negative spillovers. - Consistent with the ISD, if policies promote the member’s own domestic and balance of payments stability, the authorities would not be obliged to act on staff recommendations. Staff may discuss outward spillovers that have important implications for other members but not for global stability. ### Periodic review and removal - The preemptive CFM/MPM should be reviewed periodically to assess whether its use continues to be appropriate, for example during Article IV consultations. - Evaluations should follow up on new information since the measure’s introduction, including: - whether MPMs have become available to address the risk; - whether the measure has become a substitute for warranted macroeconomic adjustment; - whether there has been progress on reforms to diminish the need for the CFM/MPM; - whether the measure has caused the exchange rate to depreciate significantly; - whether the external position has become stronger than warranted following the introduction of the measure; - whether the authorities have taken measures to address the domestic policy gaps underpinning the strength of the external position. - If any conditions required for appropriateness are no longer met, the CFM/MPM should be removed—immediately if feasible without jeopardizing macroeconomic or financial stability; or in a phased manner with appropriate phasing speed depending on feasible time paths for needed macroeconomic, financial, and structural policy adjustments. *Source: IMF staff.* ### 31. This review proposes that certain CFM/MPMs implemented in line with internationally ### ppea2022008 - 31. This review proposes that certain CFM/MPMs implemented in line with internationally ### Revisions proposed regarding CFM/MPMs and Basel/reciprocity arrangements - Paragraph 31: Proposal that certain CFM/MPMs implemented in line with internationally agreed prudential standards, including mutually agreed reciprocity arrangements, will not be assessed for their appropriateness under the IV. Revisions aim to mitigate the risk that measures implemented in accordance with the Basel Framework 23 and international agreements on reciprocation of certain prudential measures may be assessed as inconsistent with the Fund’s framework for capital flow management. - Paragraph 32: Specific tensions between Basel reforms and the IV may arise: - The reciprocity of the countercyclical capital buffer (CCyB) could be considered a residency-based outflow CFM under the existing IV. 24 The framework also allows home authorities to require that the banks they supervise maintain higher CCyB levels if they judge the host authorities’ buffer to be insufficient. 25 - D-SIB surcharges and charges set on banks identified by the FSB as G-SIBs have a cross-jurisdictional element in their calibration and could be considered CFMs by virtue of their design. - LCR and NSFR guidance provides leeway to use residency-based discrimination in limited circumstances (for example, higher run-off rates for nonresident deposits where a history of volatile deposit funding from nonresidents exists); such measures may be considered CFMs. - Paragraph 33: Mutually agreed reciprocity arrangements building on Basel standards could also be assessed as outflow CFMs. Example: European legislation establishing regional mechanisms operated by the ESRB to expand reciprocity to all exposure-based measures among EU member countries (i.e., beyond the CCyB and including all exposure-based tools). - Paragraph 34: Staff would refrain from assessing the appropriateness of measures implemented in accordance with the Basel prudential standards outlined in paragraph 32 under the IV. Staff would also not assess the appropriateness under the IV of multilateral, regional, or bilateral agreements among countries to reciprocate macroprudential measures as outlined in paragraph 33, where a country implements a macroprudential measure that is the same, or substantially the same, as the measure in effect in another country to address a financial stability risk related to specific exposures in the other country. 26 - Paragraph 35: Safeguards limiting inappropriate use in practice: - The measure must be in line with the mutually agreed-upon international prudential standards referenced above. - The interdepartmental group will work with country teams to assess whether any measure falls outside those agreements, drawing on Fund expertise and the Fund’s macroprudential policy framework. ### AML/CFT measures and IV assessment - Paragraph 36: AML/CFT measures can impact cross-border capital flows and constitute CFMs under the IV. The international standards (i.e., FATF standards 27) call for global implementation to prevent and combat money laundering and related predicate offenses 28, terrorist financing and proliferation financing, 29 and are principally designed to manage illicit flows. In an interconnected world, illicit capital flows can trigger negative spillovers in transit and recipient countries and affect the integrity and stability of the international financial system. 30 Many AML/CFT measures that limit capital flows would be considered discriminatory under the IV because residency and nationality are among risk factors that can trigger enhanced due diligence. AML/CFT measures are generally required on an ongoing basis, while CFMs are generally justified by temporary capital flow episodes; thus, IV criteria for CFMs are not suitable for assessing AML/CFT measures. - Paragraph 37: International standards require AML/CFT measures to be applied on a risk-sensitive basis to all transactions, including capital transactions. When ML/TF risk is moderate or high, implementation can result in additional controls, increased processing time and cost, or restrictions on transactions (e.g., with customers in countries identified by the FATF as having strategic AML/CFT deficiencies). AML/CFT implementation is required globally and does not depend on countries’ needs to manage capital flows or undertake macroeconomic adjustments. - Paragraph 38: Staff proposes that measures that are considered CFMs but are implemented in accordance with FATF standards should not be assessed under the IV. The Fund recognizes the need for an effective AML/CFT regime implemented commensurately with ML/TF risks. Such a regime relies on: - a robust legal framework in line with the AML/CFT standard, - strong institutions (including supervisory and law enforcement agencies) with adequate powers and procedures to operate and cooperate, - measures ensuring appropriate transparency over beneficial ownership of legal entities and arrangements. Measures considered CFMs but implemented in accordance with the FATF standards referenced in paragraph 36 will not be assessed for appropriateness under the IV. ### Measures arising from international cooperation on tax avoidance/evasion - Paragraph 39: Measures that levy discriminatory taxes consistent with certain international cooperation standards against avoidance or evasion of taxes will not be assessed for appropriateness under the IV. Post-GFC international collaboration to tackle tax avoidance (e.g., G20/OECD BEPS initiative) has led countries to introduce or propose discriminatory tax measures targeted at flows to objectively determined non-cooperative jurisdictions for tax purposes, which could be residency-based CFMs under the IV. - Rationale: Considering such measures inappropriate under the IV would be inconsistent with the Fund’s longstanding participation in international efforts to combat tax avoidance. Measures based on and implemented in accordance with certain international cooperation standards (i.e., existing minimum standards of the Inclusive Framework on BEPS, and established tax transparency standards on exchange of information 31) that constitute CFMs and are designed to prevent avoidance or evasion of taxes, including measures to enhance tax compliance, are proposed not to be assessed under the IV. 32 - Note on consistency: Whether a tax measure based on international cooperation standards is consistent with those standards is determined by legal design and substance rather than solely by implementation modality; implementation consistent with bilateral or multilateral obligations under a tax-related instrument is more likely to be consistent with international cooperation standards. ### Elaboration of important concepts and policies — Macro-criticality - Paragraph 40: Section introduces concepts relevant for IV implementation: macro-criticality, capital inflow surges, imminent crisis situations, and premature liberalization. No policy changes proposed to the IV’s framework in these areas. - Paragraph 41: Policy measures are discussed in Fund bilateral surveillance when they are macro-critical. 33 A measure may be a CFM but need not be discussed if not macro-critical. 34 Determination of macro-criticality assesses whether a CFM limits capital flows such that it significantly influences the member’s present or prospective domestic or balance of payments stability. Channels include impacts on international reserves, exchange rates, financial system stability, fiscal sustainability, or economic efficiency and growth. - Paragraph 42: Assessing macro-criticality requires country-specific consideration; no universal indicator or numerical threshold exists. Assessment is case-by-case, considering design, types of flows affected, context, country circumstances, and transmission channels. Staff judgment is important. - Paragraph 43: Macro-criticality can be analyzed at different levels: sector(s), specific flows (target), and expected impact on the target. If a sector is not macro-critical, further assessment is obviated. - Paragraph 44: General guidance and qualifications on determining macro-criticality: - Both current and prospective expected impacts must be assessed; a CFM with small current effect may be macro-critical prospectively. - Measures with high discretion in application may require focus on macro-criticality of the target itself. - When CFMs are introduced as a package, assess macro-criticality of the package rather than each component if proximity in time, objectives, and geography suggest a package. - A macro-critical CFM remains macro-critical even if subsequent marginal changes are small. - Table 1 (illustrative examples summarized): - Sector not macro-critical → no need for further assessment (example: high surrender requirement on private sector exports where public sector exports dominate) — Not macro-critical. - Target not macro-critical → no need for further assessment (example: tax on inflows into a marginal segment of housing market) — Not macro-critical. - Broad measures targeting a significant share of a macro-critical sector (example: sizable tax on inflows to all residential real estate or major urban centers) — Macro-critical. - Measures expected to have significant impact on target and/or macro variables (example: repatriation/surrender requirement to central bank on all exports) — Macro-critical. - Small changes to already identified macro-critical measures merit discussion (examples: small change to macro-critical taxes on banks’ external assets; small change to macro-critical limit on nonresidents’ holdings of domestic bonds) — Macro-critical. - If impact on target cannot be determined ex ante, assessment should focus on the target (example: FDI screening in mining; electric energy; gas and petroleum industries) — Macro-critical. *Source: Excerpt from ppea2022008 (IMF Review of the Institutional View on the Liberalization and Management of Capital Flows), paragraphs 31–44.* ### 45. Identifying capital inflow surges is an important step to determine policy advice under ### ppea2022008 - 45. Identifying capital inflow surges is an important step to determine policy advice under ### Identifying capital inflow surges: definition and risks - A capital inflow surge is an episode of exceptionally high capital inflows that can overwhelm the capacity of the economy and/or its financial system to absorb the inflows without endangering macroeconomic or financial stability, including by constraining the space for policies to adjust. - Surges may lead to the build-up of macroeconomic imbalances and/or financial vulnerabilities and increase risks of subsequent capital flow reversals or crises. - Surges do not need to be large economy-wide to pose risks; surges sizeable in a particular sector with systemic linkages can be disruptive. - Under the IV, in the context of inflow surges and under certain circumstances, inflow CFMs or CFM/MPMs may be useful to mitigate these risks. ### Quantitative approaches to identify inflow surges - Objective: provide additional guidance and tools (not replace staff judgment) to identify inflow surges and assess whether they pose macroeconomic and/or financial stability challenges. - Five quantitative approaches cited: - Threshold analysis: Flows within top 30th percentile of country's own distribution and sample distribution. - Trend analysis: - HP filter: Deviation from long-term trend by one historical standard deviation. - Hamilton filter: An asymmetric ordinary least squares (OLS) regression filter. - Rolling window: Annual increase in inflows by more than one standard deviation above the five-year rolling average. - Cluster analysis: Partitioning inflows into k-clusters with the nearest mean (minimizing within-cluster sum of squared differences). - These methods can be applied to net and gross capital flows and to sectoral/asset-class flows (e.g., portfolio debt and equity flows). ### Stepwise procedure to assess surges and related challenges - Step 1: Use a set of quantitative methods to obtain a signal on whether the economy (or sector) is experiencing a surge in the volume of capital inflows. - Compare results via a heatmap that portrays how many methods identify a surge (Panel A in Figure 6). - When two or more methods signal a surge, interpret as a possible threshold for when a surge is taking place. - Complement lagged balance of payments data with high-frequency capital flows data and sectoral information (e.g., nonresidents’ share in real estate purchases). - Heatmap also reveals how prone a country is to surges. - Step 2: Consider whether inflow surges are taking place in comparator economies using the same method and summarize in a heatmap (Panel B in Figure 6). - If comparator countries are experiencing inflow surges, the country is more likely to be facing a surge. - Step 3: Analyze a range of macro-financial variables to assess absorption capacity and whether macroeconomic or financial stability challenges are arising. - Use a heatmap (Panel C in Figure 6) summarizing: - Macroeconomic variables: real GDP growth, current account, inflation developments, external position. - Financial market indicators: credit-to-GDP gap, interest rates, house prices, exchange rate, debt spreads, uncovered interest parity premia. - Structural indicators: governance, regulatory practices, financial development. - For sectoral surges, consider a narrower set of variables. - An inflow surge is more likely to pose challenges when some variables exceed their historical trends or levels. ### Identifying imminent crisis circumstances (outflow CFMs) - Current policy: CFMs on outflows should be used only in crises or imminent crisis situations; this remains appropriate. - Crises are difficult to predict; the IV considers an economy with inadequate FX reserves, undervalued exchange rate or high balance sheet FX exposure, and stagnating economy as likely to be in crisis or imminent crisis. - Balance of payments crises often involve banking, sovereign, or real economy crises, or asset price bubbles, and may follow prolonged booms partly fueled by capital inflows. - Features associated with crises: excessive currency depreciation (often following overvaluation), depletion of FX reserves, large declines in aggregate demand, rapid reversal of current account deficits, sharp increases in interest rates and spreads. - High-frequency data and qualitative information can help identify imminent crisis circumstances that may justify outflow CFMs: - Relevant high-frequency and qualitative indicators include sharp exchange rate depreciation, rapid decrease of reserves, sharply tightening financial conditions, swiftly declining economic activity, abrupt changes in FX market participation or the rollover of external debt. - Findings from models and analytical tools on reversal of inflows and bursting asset bubbles should be combined with these indicators and judgment. ### Premature liberalization: identification and response - The IV guidance emphasizes that liberalization is more beneficial and less risky if countries have reached certain levels/thresholds of financial and institutional development; liberalization needs to be well planned, timed, and sequenced. - There is no presumption that full liberalization is appropriate for all countries at all times. - If liberalization is assessed to have been premature, CFMs can be reimposed temporarily until conditions for safe liberalization are in place. - Identifying premature liberalization requires assessing whether removal of CFMs has outpaced the economy’s or financial system’s capacity to handle resulting flows: - Examine whether large changes in capital inflows or outflows followed liberalization and whether severe deterioration in macro-financial stability indicators emerged shortly after CFMs were removed or subsequently when exposure to sizable flows or the global financial cycle occurred for the first time. - Recognize that some costs of greater openness may take time to appear. - Examples of premature liberalization: - Liberalization of short-term flows without necessary prudential, supervisory, and monitoring frameworks. - Relaxation of outflow CFMs in response to temporary inflow increases without supporting reforms, producing sustained or accelerated outflows and unstable macroeconomic conditions. - Distinction from episodic overwhelm: premature liberalization implies sustained lack of capacity at the current development level, increasing likelihood of recurring costly episodes; by contrast, even well-sequenced liberalizers can be temporarily overwhelmed by exceptionally large shocks. - Policy response when premature liberalization is signaled: - Reimposition of CFMs on some types of flows may be appropriate until sufficient progress is made on macroeconomic, financial, and structural policies recommended by the integrated approach. - Reimposition may be implemented alongside liberalization of other flow types if conditions for those are met. - Subsequent assessment should identify necessary policy actions and monitor progress; lack of policy action suggests CFMs may be managing flows rather than supporting safe liberalization. ### Measures that are also exchange restrictions or multiple currency practices - Fund Articles of Agreement prohibit members from restricting current international payments and transfers and introducing discriminatory and multiple currency practices (MCPs) without Fund approval (Article VIII, Section 2(a) and Section 3). - The Fund’s policy on exchange restrictions allows temporary approval of exchange restrictions maintained for balance of payments reasons; the MCP policy allows temporary approval of MCPs maintained for both balance of payments and non-balance of payments reasons. - Some measures affecting capital transactions are subject to Article VIII because the Articles define certain transactions as “current”; such measures can also be considered CFMs on outflows under the IV. - An overlap can arise between the Article VIII framework and the IV because approval criteria differ; a measure could be approved under exchange restrictions or MCP policy while considered not appropriate under the IV. - CFMs that are also MCPs and applicable solely to capital transactions are not subject to Fund approval under Article VIII but are subject to the IV; where such MCPs are macro-critical, they are assessed only under the IV. *Source: IMF staff.* ### 63. Staff proposes that measures that are both CFMs and also exchange restrictions ### 63. Staff proposes that measures that are both CFMs and also exchange restrictions ### Assessment approach for measures that are both CFMs and exchange restrictions / MCPs - Staff proposes that measures that are both CFMs and also exchange restrictions and/or MCPs because they relate to transactions that are capital in nature but considered as current under the Fund’s Articles are assessed solely under Article VIII. - Approval of those measures would be granted on the basis of the approval criteria under the relevant Article VIII policy. - Given that the Board has decided not to assert jurisdiction over MCPs that apply solely to capital transactions, such measures, if they are also considered to be CFMs, will be assessed only under the Fund’s IV as per standing practice. - This approach eliminates potential inconsistencies that may undermine the coherence of the Fund’s policy advice on matters of its jurisdiction and under the IV. - Footnotes and decisions referenced in the text: “Current transactions” are defined in Article XXX(d) of the Fund’s Articles of Agreement. Decision No. 1034-(60/27). Decision No. 6790-(81/43) (as amended). See IMF (2012b), footnote 85. While Article VIII sets obligations for members, assessments under the IV constitute only recommendations. The result of this policy is that MCPs that relate solely to capital account transactions are not subject to Fund approval. Decision No. 8648-(87/104), July 17, 1987 explicitly states that the phrase “multiple currency practices” in decisions of the Fund relating to the use of the Fund’s resources does not, except as otherwise provided, include multiple currency practices applying solely to capital transactions. However, under the IV, those measures can be considered CFMs. - Note: This notwithstanding, they would continue to also be identified as MCPs in staff reports. ### Other operational issues (paragraphs 64–65) - There could be CFMs that are part of a country’s policy framework or regulations but are not activated or enforced. Such measures typically are: - (i) safeguard/contingency measures whose introduction is conditional on the materialization of exceptional circumstances (e.g., in crisis situations); - (ii) measures that could be CFMs but have current quantitative parameters set at zero; and - (iii) CFMs that are not enforced, for example due to low enforcement capacity. - Staff proposes the following treatment of these measures when they are macro-critical: - Safeguard/contingency measures: - While safeguard/contingency frameworks themselves do not constitute CFMs, newly introduced or revised frameworks will be reviewed, and advice will be provided on their use consistent with the IV. - When, based on the framework, measures are activated, they will be assessed under the IV. - Footnote: Some members or international agreements refer to contingency measures as “safeguard” measures. - Measures that could be CFMs but have current quantitative parameters set at zero: - Will not be classified as CFMs. - They will be assessed under the IV, and classified as CFMs if appropriate, if/when their quantitative parameters are tightened. - Unenforced CFMs: - Such measures will be assessed when they are tightened or enforced. - Measures on FX purchases and transactions between residents (paragraph 65): - The IV is primarily concerned with transactions between residents and nonresidents, i.e., balance of payments flows. - In some cases, countries may restrict certain transactions among residents, for example by limiting deposit withdrawals and/or restricting FX purchases. - When such measures between residents are put in place to arrest depreciation pressures in the context of capital outflows or a sudden stop, these measures would be deemed to have been designed to limit capital outflows, and as such will be considered CFMs and assessed under the IV. ### Tax measures (paragraph 66) - Staff propose to align the assessment of tax measures under the IV with internationally established legal principles of taxation. - Staff propose that measures that discriminate based on tax residency as defined in tax law frameworks should not be automatically assessed as CFMs because of their presumed discriminatory design. - Internationally accepted norms on taxation, including those enshrined under tax treaties, permit treating tax residents and non-residents differently. - Such measures are considered non-discriminatory because they seek to achieve an equivalent treatment between persons in “like circumstances,” thereby seeking to create a level-playing field. - An example would be withholding taxes that commonly apply differently to residents and non-residents to appropriately reflect their objective and factual differences. - Differential treatment based solely on tax residency conforming to international standards (for instance, based on the number of days physically present in a jurisdiction such as 183 days or more) will not be automatically considered residency-based CFMs; rather they will be assessed as to whether they are designed to limit capital flows. - This approach to the assessment of tax measures would be applied to both income and transactional tax measures. - Footnotes and references in this section: See the OECD and UN Model Tax Conventions. For example, Article 24 prohibits discrimination based on nationality but does not apply where a different tax treatment results from factors other than nationality, such as tax residence. Tax residency is commonly defined under the domestic tax law of a country or state and determines a person’s liability to tax in that country or state by reason of their domicile, physical presence, or any other criterion of a similar nature. Withholding tax regimes commonly treat non-residents differently compared to tax residents, both formally and substantially, to ensure effective collection and to reflect key differences in the tax base. This approach is also consistent with the OECD Codes, which state that “apparently discriminatory taxes levied in accordance with widely accepted principles of international tax law are not considered as equivalent to a restriction under the Codes.” ### Issues for discussion (paragraph 67) - Do Directors endorse the proposed change to the Institutional View to consider preemptive inflow CFM/MPMs subject to the considerations discussed in Section II? - Do Directors agree with the proposals in Section III on the special treatment of measures introduced solely for national or international security reasons, certain measures adopted pursuant to internationally agreed frameworks on financial stability, AML/CFT measures implemented consistently with international standards, and measures arising from certain international cooperation agreements against the avoidance or evasion of taxes? *Source: ppea2022008 - 63. Staff proposes that measures that are both CFMs and also exchange restrictions (excerpt).* ### 2. Since the IV was adopted, a growing literature has provided additional insights into ### ppea2022008 - 2. Since the IV was adopted, a growing literature has provided additional insights into ### Key Messages (Box 1) - Capital flows offer many benefits for open economies: - A range of direct and indirect benefits stem not only from FDI inflows but also from other types of flows. However, country characteristics—particularly domestic institutional and financial development—determine the extent to which a country reaps these benefits. - Inflow CFMs and CFM/MPMs can help manage the risks from excessively large or volatile capital flows: - Capital flows can be excessively large, thereby overwhelming a country’s capacity to safely manage them, and volatile, posing risks of costly reversals. These risks are heightened in the presence of domestic and international frictions. - A key role in managing capital flows should be played by macroeconomic policies, as well as by sound financial supervision and regulation and strong institutions. In certain circumstances, CFMs can be useful. They should not, however, substitute for warranted macroeconomic adjustment. - Inflow CFMs during surges can enhance monetary autonomy and avoid costly macroeconomic adjustments due to overvaluation, particularly in countries with existing real or financial frictions. - CFM/MPMs can help manage the financial stability risks from increases in credit, leverage, reliance on volatile funding structures, FX mismatches, and asset prices during inflow surges. - When stock vulnerabilities, primarily foreign currency (FX) mismatches, have grown large, they can increase the likelihood and severity of crises, justifying a preemptive approach to managing risks. - Several considerations caution against CFMs and CFM/MPMs and argue for a limited use—only under the well-defined circumstances described in this review: - Frequent use of CFMs and CFM/MPMs can generate compliance costs, policy uncertainty, and governance problems. CFMs and CFM/MPMs can also burden smaller firms disproportionately, may hinder the development of domestic markets, and can reduce the impetus for reforms. - CFMs used for macroeconomic management may need to have broad coverage, potentially increasing their costs. CFM/MPMs may be more narrowly targeted, but may need to stay in place for longer, potentially also increasing costs. - Use of inflow CFMs or CFM/MPMs to manipulate the country’s terms of trade can have adverse beggar-thy-neighbor spillovers and can reduce global welfare. - Even when the circumstances described in this review are met, enforcement considerations and structural characteristics can inform the use or design of CFMs and CFM/MPMs: - Use of CFMs and CFM/MPMs, or their design, may be constrained by the lack of an enabling legal framework or the administrative infrastructure to enforce and flexibly adjust them, or by international obligations. - Accumulated resident-held foreign asset positions may increase resilience to adverse foreign appetite shocks and mitigate the need to use inflow CFMs during surges. - Domestic financial market development—beyond FX market depth—may be important for determining the need to use CFMs and CFM/MPMs. ### Benefits of Capital Flows: Recent Evidence - Direct benefits documented by recent empirical literature: - Capital flows allow for a more efficient global allocation of resources, by letting capital move from where it is less productive to where it is more productive, benefitting both source and recipient countries. - Capital flows can lower financing costs, incentivize technology upgrades, improve the allocation of resources across firms, and improve efficiency in production, thereby boosting aggregate productivity. - Foreign direct investment boosts efficiency in production through technology transfer, and greater innovation and competition, while contributing to greater resilience of enterprises during crises. - Capital flows permit greater risk-sharing between countries, allowing countries to smooth consumption through international borrowing and lending. - Benefits beyond FDI: - Portfolio and debt flows, as well as foreign bank presence, contribute to benefits. - Stock market liberalization and greater portfolio inflows have been found to contribute to higher real wage growth in the manufacturing sector, as well as greater investment and GDP growth. - Banks with access to foreign borrowing, particularly larger and more capitalized banks, can increase local credit supply and benefit high-productivity firms. - Presence of foreign bank subsidiaries can alleviate financial constraints, facilitate economic growth and exports, provide FX liquidity, and help stabilize credit provision during crises. - Indirect (collateral) benefits: - Capital flows can increase the depth and liquidity of securities markets and promote development of domestic capital markets. - Greater foreign institutional ownership leads to significant increases in innovation, more informationally-efficient stock prices in emerging markets, and improvements in stock liquidity. - Financial liberalization can enhance corporate governance in response to foreign competition and demands from international investors. - Presence of foreign bank subsidiaries can improve quality of financial services via competition; banks’ foreign expansion can provide diversification and reduce individual and systemic risks to home countries. - Heterogeneity by country characteristics: - Countries with stronger institutions and domestic policy frameworks attract a greater share of safer capital flows (FDI, equity flows, and local currency and longer-term debt), experience lower volatility in these flows around periods of political uncertainty, and reap greater growth benefits overall. - Countries with weaker institutions are typically less diversified internationally, reducing risk-sharing benefits. - Countries with less developed financial markets and tighter credit constraints experience greater volatility in private investment and consumption responses to exogenous uncertainty shocks. ### The Case for CFMs and CFM/MPMs to Manage Risks from Capital Flows - Risks from capital flows and amplifying frictions: - Financially open economies are more exposed to external shocks and shifts in foreign investor sentiment, heightening macroeconomic volatility and vulnerability to crises. - A global financial cycle driven by monetary policy in a center country can contribute to macroeconomic volatility, particularly in economies with weak monetary policy credibility. - Fixed exchange rate regimes are more sensitive to center country conditions and experience greater negative real effects of contractionary global credit supply shocks than flexible exchange rate regimes. - Frictions in domestic and international financial markets (including weaknesses in domestic financial regulation and supervision) can fuel systemic vulnerabilities: excessive leverage, asset price inflation, FX mismatches, and liquidity risks when flows are short-term. - A. CFMs for Macroeconomic Management - Inflow CFMs can enhance monetary autonomy in countries with shallow FX markets in certain circumstances: - In the IPF conceptual model, a positive foreign appetite shock leads to a surge in local currency inflows and a reduction in the uncovered interest parity (UIP) premia in countries with a shallow FX market, which can spur overborrowing. - A combination of inflow CFMs (to counter the surge and further borrowing) and FXI (to counter the change in the UIP premia) is a more effective response than changing the policy rate, under both dominant currency pricing (DCP) and producer currency pricing (PCP). - Inflow CFMs and FXI can help stabilize domestic aggregate demand, and allow monetary policy to focus on addressing domestic sources of price pressures. - Constraints on monetary policy strengthen the case for FXI and CFMs: - When medium-term inflation expectations are poorly anchored and can be destabilized by pass-through from appreciation, countercyclical use of FXI and CFMs can improve the output-inflation tradeoffs faced by monetary policy. - Presence of a liquidity trap or fixed exchange rate regime could justify the use of CFMs for macroeconomic management as the economy cannot fully adjust through use of monetary policy alone. - Inflow surges can magnify existing real or financial frictions: - Reallocation away from tradable sectors driven by currency appreciation during surges can be costly when the tradable sector has learning-by-doing externalities not internalized by agents. - If financial frictions differ across sectors, inflow surges can overheat the sector with lower frictions, crowding out liquidity from the sector with more frictions, potentially leading to misallocation (e.g., over-investment in real estate), feedback effects between liquidity inflows, asset prices and collateral values, and irreversible destruction of sectors with tighter financial constraints. - B. CFMs/MPMs for Managing the Financial Stability Risks from Capital Flows - Inflow surges and banking crisis risk: - Capital inflow surges are associated with a greater probability of future banking crises in countries that see a buildup of macro-financial vulnerabilities in boom times. - Increases in the ratio of a broad measure of credit to GDP relative to its trend (the credit gap) is the single most powerful predictor of banking crises in advanced and emerging markets. - Capital inflow surges, especially when composed of offshore borrowing and associated with appreciation in exchange rates, contribute to increases in the credit gap, justifying the use of MPMs as well as potentially CFM/MPMs. - Surges in inflows can be associated with increases in wholesale-funded credit, heightening liquidity risks, particularly where supervisory and regulatory environments are weak. - During surges, countries with less flexible exchange rate regimes experience a greater expansion in bank credit and a shift towards credit in FX, suggesting greater benefit from CFM/MPMs. - Housing booms, leverage, and feedback loops: - Mortgage leverage and housing booms increase financial fragility; capital flows have been an important driver of housing vulnerabilities in advanced and emerging market economies. - Real estate lending backed by non-tradable real estate assets creates a pecuniary externality: agents do not consider the impact of their borrowing on collateral values, leading to feedback loops between credit and house prices and vulnerabilities to reversals. - Preemptive CFM/MPMs when stock vulnerabilities are large: - When high debt stocks create systemic vulnerabilities, primarily FX mismatches, preemptive CFM/MPMs may be justified. - Private agents may overborrow in FX because they do not internalize the impact of their decisions on future market stress when foreign lending conditions tighten, currencies depreciate, and balance sheets weaken; preemptive CFM/MPMs can moderate further borrowing in FX and reduce financial stability risks. - Empirically, a high existing stock of external debt liabilities in FX increases the likelihood of sovereign external debt default, debt restructuring, or an IMF program, and is associated with higher output losses during such episodes; high stocks of external debt liabilities that are likely to be short-term or in FX are among the strongest predictors of capital inflow reversal episodes with large growth impact. - Importance of debt maturity: - The case for preemptive CFM/MPMs is strongest when the remaining maturity of FX debt is short term. - A mismatch between short-term FX liabilities and FX liquid assets exposes borrowers to rollover risk, compounding solvency pressures from a depreciation. - Empirically, external crisis risks tend to increase more strongly with short-term and maturing external debt. Where default risk is greater, short-term borrowing can arise endogenously and increase the risk of fire sales and premature liquidation of assets, ultimately increasing volatility of output, investment, and total factor productivity. *International Monetary Fund — BACKGROUND NOTE: CAPITAL FLOWS AND CFMS—BENEFITS AND COSTS (pp. 3–8)* ### 16. While MPMs play the primary role in reducing systemic vulnerabilities, CFM/MPMs ### 16. While MPMs play the primary role in reducing systemic vulnerabilities, CFM/MPMs ### Role and interaction of MPMs and CFM/MPMs - MPMs (macroprudential measures) play the primary role in reducing systemic vulnerabilities and tail risks to output (Brandao and others, 2020). - Evidence indicates that use of MPMs on domestic lending can increase cross-border borrowing (borrowing directly from abroad or from foreign branches), creating “leakage” that can justify complementary use of residency-based measures in certain circumstances (Nier and others, 2020; Ahnert and others, 2020). ### Considerations that caution against the use of CFMs and CFM/MPMs - General caution: Recent literature and experience suggest limiting use of CFMs and CFM/MPMs to well-described circumstances (see IV and this review). - Distortion of productive investment and competition: - CFMs and CFM/MPMs can distort resource allocation across firms and reduce aggregate productivity (Andreasen and others, 2019; Andreasen and others, 2021). - They may affect market structure and competition and hinder investment in technology (Varela, 2017). - Controls can disproportionately burden smaller and external-finance-dependent firms (Alfaro and others 2017); alternative financing (e.g., issuing international depository receipts) can be relatively more expensive for these firms. - Smaller firms may be more affected if controls reduce bank financing they rely on (Forbes, 2007). - Differential impacts across firms add to costs because small and medium enterprises are a significant source of job growth and investment. - Incentives for rent-seeking and corruption: - CFMs and CFM/MPMs can create interest groups that benefit or lose, encouraging rent-seeking and corruption, e.g., trade mis-invoicing or bribery (Das and Biswas, 2020). - Adverse effects may be larger in countries with greater political fragmentation (Chanda, 2005). - Some evidence that countries with more corrupt bureaucracies are more likely to impose capital controls (Wei and Bai, 2016). - Reduced impetus for reform and perpetuation of frictions: - Reliance on CFMs/CFM-embedded MPMs can hinder development of domestic FX and local currency securities markets, perpetuating frictions that necessitate their use (Aghion and others, 2013; Bena and others, 2017; Bae and others, 2012; He and others, 2013; Ng and others, 2016; Liu and others, 2020). - CFMs or CFM/MPMs can reduce urgency for reforms to deepen markets or improve fiscal frameworks; if CFMs are designed as taxes, they can bring revenue and substitute or delay warranted macroeconomic adjustment (Aizenman and Pasricha, 2013; Reinhardt and Sbrancia, 2015). - Reduced long-term attractiveness to investors: - Poorly designed or poorly communicated CFMs/CFM-embedded MPMs can generate adverse market reactions and be interpreted as an “anti-investor bias,” reducing future willingness to invest. - Adverse reactions are more likely when CFMs substitute for warranted macroeconomic and policy adjustments, and less likely when objectives are well communicated (Forbes and others, 2016). - Investors invest less in countries with less transparency and weak investor protection; frequent reliance on CFMs/CFM-embedded MPMs may harm long-term attractiveness. - Compliance costs and policy uncertainty: - Compliance costs can be significant for businesses and financial institutions required to implement and verify CFMs; institutions may need complex systems, increasing operating costs and reducing profitability and competitiveness. - Frequent changes create additional compliance costs and policy uncertainty for firms. - Transparency about overall policy strategy could mitigate costs and uncertainty, as with macroprudential tools (IMF, 2014). - Potential adjustment costs for financial and productive sectors argue for limited use of CFMs—only in well-defined circumstances. - Broader scope and longer duration increase costs: - Broader and longer-lasting CFMs/CFM-embedded MPMs raise distortionary costs and risks of entrenched interests and evasion structures. - CFMs used for macroeconomic management may need broader scope to address leakages, increasing likely costs from resource allocation distortions compared with often more targeted CFM/MPMs. - Inflow CFM/MPMs may need to remain in place longer than inflow CFMs used for macroeconomic management. - These dynamics argue for periodic reassessment of benefits and costs. - Need for complementary policies to reduce long-run reliance: - Private-sector preference to borrow in FX often reflects deeper structural causes; unaddressed, these persist (Levy-Yeyati, 2021). - Consider complementing CFMs/CFM-embedded MPMs with structural and financial policies to reduce FX borrowing incentives: developing domestic financial systems, local currency securities and hedging markets, monetary and fiscal frameworks, crisis preparedness, and lender-of-last-resort functions of central banks (Hale and others, 2020; IMF, 2021b; Hofman and others, 2021). - Risk of beggar-thy-neighbor spillovers from inflow measures: - Using inflow CFMs or CFM/MPMs to manipulate terms of trade can produce adverse spillovers and reduce global welfare. - Empirical literature suggests trade-competitiveness motivations remain relevant in use of CFMs; inflow controls can increase trade surplus or persistence of undervaluation (Choi and Taylor, 2017; Montecino, 2018; Pasricha, 2020). - The literature supports prudence: consider CFMs during surges only when the currency is overvalued (as in the IV), and weigh additional considerations for preemptive CFM/MPMs that could lead to or exacerbate undervaluation. ### Considerations that can inform the use or design of CFMs and CFM/MPMs - Structural characteristics constrain or inform design: - Some country characteristics reduce the need to use these tools; others (e.g., enforcement capacity) inform tool design. - Decision to use CFMs/CFM-embedded MPMs can depend on circumstances beyond IV appropriateness. - Administrative infrastructure and legal framework: - Imposition requires infrastructure to impose, monitor, enforce, and plug leakages; establishing such infrastructure can be onerous and may outweigh benefits for some countries. - To implement CFMs in response to changing macroeconomic conditions, countries need legislation allowing a designated authority to flexibly introduce and adjust measures. - Enforcement entails significant administrative costs for authorities and compliance costs for targeted sectors. - Enforcement considerations informing tool choice: - Price-based vs. other tools: - Price-based controls are more transparent, but countries often use tools already in their legal arsenal. - Tax-like CFMs may be difficult to enact or modify where changes require primary legislation. - URRs (unremunerated reserve requirements) are easier for central banks to implement, but effective calibration can be challenging. - Countries may prefer familiar tools to reduce implementation costs for agents assisting compliance (e.g., banks). - Targeted vs. broad-based tools: - Targeted controls may be less distortionary with fewer unintended consequences. - Targeted measures may be subject to leakages in well-developed financial systems, possibly necessitating broader coverage and increasing distortions (Ostry and others, 2011). - International obligations and prior experience: - Commitments to OECD Codes of Liberalization or other international agreements may constrain use of CFMs for macroeconomic management. - Prior negative experiences with CFMs can reduce willingness to use them. - Resident foreign asset positions: - Accumulated resident-held foreign asset positions increase resilience to adverse foreign appetite shocks and can mitigate need to use inflow CFMs during surges (Agosin and others, 2019; Broner and others, 2013; Goel and Miyajima, 2021). - Resident flows have acted as shock-absorbers rather than shock-amplifiers even in emerging markets during the global financial crisis (IMF WEO, 2013). - Movements in gross flows can affect exchange rates and monetary policy autonomy even without changes in net flows (order flow effects). - Countries with larger and more liquid resident foreign asset positions may face less need to tighten inflow CFMs during surges. - Domestic financial market development: - Development of domestic securities markets beyond FX depth mitigates price impact of foreign appetite shocks and reduces need for CFMs (IMF, 2014b). - More developed local currency instruments reduce currency mismatches (Caballero and Krishnamurthy, 2003). - Development of a local investor base for local currency bonds can help cushion shocks. - Using a capital-flows-at-risk framework, deeper domestic financial markets improve outlook for FX and local currency portfolio inflows and significantly limit likelihood of negative or weak flows (IMF, 2020a). *Background Note: Capital Flows and CFMs — Benefits and Costs (excerpt)* ### References ### ppea2022008 - References ### Integrated Policy Framework and IMF analytical work - Adrian, T., Erceg, C., Linde, J., Zabczyk, and P., Zhou, J., 2020. “A Quantitative Model for the Integrated Policy Framework,” IMF Working Paper No. 20/122, International Monetary Fund, Washington, D.C. - Basu, S., Boz, E., Gopinath, G., Roch, F., and Unsal, F., 2020. “A Conceptual Model for the Integrated Policy Framework,” IMF Working Paper No. 12/21, International Monetary Fund, Washington, D.C. - Brandao-Marques, L., Gelos, R. G., Narita, M., Nier, E., 2020. “Leaning Against the Wind: A Cost-Benefit Analysis for an Integrated Policy Framework” IMF Working Paper No. 20/123, International Monetary Fund, Washington, D.C. - _________________, 2020b. “Toward an Integrated Policy Framework,” Policy Paper No. 2020/046, International Monetary Fund, Washington, D.C. ### IMF policy, guidance, and applied country-risk work - International Monetary Fund (IMF), 2013. World Economic Outlook: Transition and Tensions, Washington, D.C., October. - _________________, 2014. “Staff Guidance Note on Macroprudential Policy,” IMF Staff Guidance Note, International Monetary Fund, Washington, D.C. - _________________, 2015. Global Financial Stability Report: Navigating Monetary Policy Challenges and Managing Risks, Washington, D.C., April - _______________, 2017. “Increasing Resilience to Large and Volatile Capital Flows—The Role of Macroprudential Policies,” IMF Policy Paper, International Monetary Fund, Washington, D.C. - _______________, 2020a. Global Financial Stability Report: Markets in the Time of COVID-19, Washington, D.C., April. - _______________, 2020c. External Sector Report: Global Imbalances and the COVID-19 Crisis, International Monetary Fund, Washington, D.C., August. - _______________, 2021a. “How to Assess Country Risk,” IMF Technical Notes and Manuals no. 2021/003, International Monetary Fund, Washington, D.C. - _______________, 2021b. “Guidance Note for Developing Government Local Currency Bond Markets,” IMF Analytical Notes no. 2021/001, International Monetary Fund, Washington, D.C. - Goel, R., and Miyajima, K., 2021. “Analyzing Capital Flow Drivers Using the ‘At-Risk’ Framework: South Africa’s Case,” IMF Working Paper No. 2021/253, International Monetary Fund, Washington, D.C. - Nier, E., Olafsson, T., Rollinson, Y., 2020. “Exchange Rates and Domestic Credit—Can Macroprudential Policy Reduce the Link?” IMF Working Paper No. 20/187, International Monetary Fund, Washington, D.C. - Pasricha, G., 2020. “Estimated Policy Rules for Capital Controls,” IMF Working Paper No. 20/80, International Monetary Fund, Washington, D.C. - Yepez, J., 2021. “Unintended Consequences of U.S. Monetary Policy Shocks: Dutch Disease and Capital Flow Measures in Emerging Markets and Development Economies,” IMF Working Paper No. 2021/209, International Monetary Fund, Washington, D.C. ### Capital flows, capital controls, and policy instruments - Agosin, M., Dias, J., and Karnani, M., 2019. “Sudden Stops of Capital Flows: Do Foreign Assets Behave Differently from Foreign Liabilities?” Journal of International Money and Finance, vol. 96, pp. 28-36. - Aizenman, J. and Pasricha, G.K., 2013. "Why do emerging markets liberalize capital outflow controls? Fiscal versus net capital flow concerns," Journal of International Money and Finance, Elsevier, vol. 39(C), pages 28-64. - Alfaro, L., Chari, A., and Kanczuk, A., 2017. “The Real Effects of Capital Controls: Firm-Level Evidence from a Policy Experiment,” Journal of International Economics, vol. 108, issue C, pp. 191-210. - Andreasen, E., Bauducco, S., and Dardati, E., 2019. "Capital Controls and Firm Performance," Working Papers of Central Bank of Chile, no. 852, Central Bank of Chile, Santiago. - Andreasen, E., Bauducco, S., and Dardati, E., 2021. “Beware the Side Effects: Capital Controls Cause Misallocation and Reduce Welfare,” Paper presented at conference “S1 2021 International Finance & Macroeconomics” Sponsored by NBER, Cambridge, MA. - Benigno, G., Chen, H., Trok, C., Rebucci, A., and Young, E., 2016. “Optimal Capital Controls and Real Exchange Rate Policies: A Pecuniary Externality Perspective,” NBER Working Paper 22224, National Bureau of Economic Research, Inc., Cambridge, MA. - Erten, B., Korinek, A., and Ocampo, J. A., 2019. “Capital Controls: Theory and Evidence,” NBER Working Paper 26447, National Bureau of Economic Research, Inc., Cambridge, MA. - Korinek, A., 2018. “Regulating Capital Flows to Emerging Markets: An Externality View,” Journal of International Economics, vol. 111, pp. 61-80. - Korinek, A., 2020. “Managing Capital Flows: Theoretical Advances and IMF Policy Frameworks,” IEO Background Paper BP/20-01-01, Independent Evaluation Office of the International Monetary Fund, Washington, D.C. - Korinek, A., and Sandri, D., 2016. “Capital Controls or Macroprudential Regulation?” Journal of International Economics, vol. 99, supp. 1, pp. S27-S42. - Ostry, J., Ghosh, A., Habermeier, K., Laeven, L., Chamon, M., Qureshi, Kokenyne, A., 2011. “Managing Capital Flows: What Tools to Use?” IMF Staff Discussion Note 11/06, International Monetary Fund, Washington, D.C. - Pasricha, G., Falagiarda, M., Bijsterbosch, M., Aizenman, J., 2018. “Domestic and Multilateral Effects of Capital Controls in Emerging Markets,” Journal of International Economics, vol. 115, pp. 48–58. - Rebucci, A., and Ma, C., 2019. “Capital Controls: A Survey of the New Literature” NBER Working Paper 26558, National Bureau of Economic Research, Inc., Cambridge, MA. - Montiel, Peter, 2020. “The IMF’s Advice on Capital Flows: How Well is it Supported by Empirical Evidence?” Internal Evaluation Office (IEO) Background Paper No. BP/20-02/02 for IEO evaluation of IMF Advice on Capital Flows, International Monetary Fund, Washington, D.C. ### Financial integration, foreign ownership, and firm-level effects - Aghion, P., Van Reenen, and J., Zingales, L., 2013. “Innovation and Institutional Ownership,” American Economic Review, vol. 103, no. 1, pp. 227-304. - Aggarwal, R., Erel, I., Ferreira, M., and Matos, P., 2011. “Does Governance Travel Around the World? Evidence from Institutional Investors,” Journal of Financial Economics, vol. 100, issue 1, pp. 154-181. - Alfaro, L., and Chen, M., 2012. “Surviving the Global Financial Crisis: Foreign Ownership and Establishment Performance,” American Economic Journal: Economic Policy, vol. 4, no. 3, pp. 30-55. - Alfaro, L., and Chen, M., 2018. “Selection and Market Reallocation: Productivity Gains from Multinational Production,” American Economic Journal: Economic Policy, vol. 10, no. 2, pp. 1‑38. - Bena, J., Ferreira, M., Matos, P., and Pires, P., 2017. “Are Foreign Investors Locusts? The Long-Term Effects of Foreign Institutional Ownership,” Journal of Financial Economics, vol. 126, issue 1, pp. 122-146. - Bruno, V., and Hauswald, R., 2014. “The Real Effect of Foreign Banks,” Review of Finance, vol. 18, issue 5, pp. 1683-1716. - Desai, M., Foley, C. F., and Hines, J., 2009. “Domestic Effects of the Foreign Activities of US Multinationals,” American Economic Journal: Economic Policy, vol. 1, no. 1, pp. 181-203. - Gelos, R. G., Gornicka, L., Koepke, R., Sahay, R., and Sgherri, S., 2019. “Capital Flows at Risk: Taming the Ebbs and Flows” IMF Working Paper No. 19/279, International Monetary Fund, Washington, D.C. - Larrain, M., and Stumpner, S., 2017. “Capital Account Liberalization and Aggregate Productivity: The Role of Firm Capital Allocation,” Journal of Finance, vol. 72, issue 4, pp. 1825-1858. - Varela, L., 2017. “Reallocation, Competition, and Productivity: Evidence from a Financial Liberalization Episode,” The Review of Economic Studies, vol. 85, issue 2, pp.1279–1313. - Liu, X., Wie, S., and Zhou, Y. 2020. “A Liberalization Spillover: From Equities to Loans” NBER Working Papers 27305, , National Bureau of Economic Research, Inc., Cambridge, MA. - Ma, C., Wei, S. J., 2020. “International Equity and Debt Flows: Composition, Crisis, and Controls” NBER Working Papers 27129, National Bureau of Economic Research, Inc., Cambridge, MA. ### Macrofinancial linkages, credit, maturity, and crisis dynamics - Bianchi, J., 2011. “Overborrowing and Systemic Externalities in the Business Cycle,” American Economic Review, vol. 101, no. 7, pp. 3400-3426. - Bleakley, H., and Cowan, K., 2010. “Maturity Mismatch and Financial Crises: Evidence from Emerging Market Corporations,” Journal of Development Economics, vol. 93, issue 2, pp. 189‑205. - Brunnermeier, M., and Oehmke, M., 2012. “The Maturity Rat Race,” The Journal of Finance, vol. 68, issue 2, pp. 483-521. - Brunnermeier, M., and Sannikov, Y., 2015. “International Credit Flows and Pecuniary Externalities,” American Economic Journal: Macroeconomics, vol. 7, no. 1, pp. 297-338. - Caballero, J., 2014. “Do Surges in International Capital Inflows Influence the Likelihood of Banking Crises,” The Economic Journal, vol, 126, issue 591, pp. 281-316. - Caballero, R. J., and Krishnamurthy, A., 2003. “Excessive Dollar Debt: Financial Development and Underinsurance,” Journal of Finance, vol. 58, issue 2, pp. 867-893. - Caballero, R. J., and Lorenzoni, G., 2014. "Persistent Appreciations and Overshooting: A Normative Analysis," IMF Economic Review vol. 62, no. 1, pages 1-47, April., Palgrave Macmillan; International Monetary Fund. - Jotikasthira, C., Lundblad, C., and Ramadorai, T., 2012. “Asset Fire Sales and Purchases and the International Transmission of Funding Shocks,” The Journal of Finance, vol. 67, issue 6, pp. 2015-2050. - Hur, S., and Kondo, I., 2016. “A Theory of Rollover Risk, Sudden Stops, and Foreign Reserves,” Journal of International Economics, vol. 103, pp. 44-63. - Broner, F., Didier, T., Erce, A., and Shmuckler, S., 2013. “Gross Capital Flows: Dynamics and Crises,” Journal of Monetary Economics, vol. 60, issue 1, pp. 113-133. - Bianchi, J., and Mendoza, E., 2020. “A Fisherian Approach to Financial Crises: Lessons from the Sudden Stops Literature,” Review of Economic Dynamics, vol. 37, supp. 1, pp. S254-S283. ### Exchange rates, international monetary spillovers, and the global financial cycle - Aizenman, J., Chinn, M., and Ito, H., 2016. “Monetary Policy Spillovers and the Trilemma in the New Normal: Periphery Country Sensitivity to Core Country Conditions,” Journal of International Money and Finance, vol. 68, pp. 298-330. - Rey, H., 2013. "Dilemma Not Trilemma: The Global Financial Cycle and Monetary Policy Independence," Proceedings Economic Policy Symposium: Jackson Hole, Federal Reserve of Kansas City Economic Symposium, p 285-333. - Carrière-Swallow, Y., Gruss, B., Magud, N., and Valencia, F., 2021. “Monetary Policy Credibility and Exchange Rate Pass-Through,” International Journal of Central Banking, vol. 17, no. 3, pp. 61-94. - Hale, G., Jones, P., and Spegel, M., 2020. “Home Currency Issuance in International Bond Markets,” Journal of International Economics, vol. 122, no. 103256. - Du, W., Pflueger, C., and Schreger, J. 2020. “Sovereign Debt Portfolios, Bond Risks, and the Credibility of Monetary Policy,” The Journal of Finance, vol. 75, issue 6, pp. 3097-3138. - Zeev, N., 2019. “Global Credit Supply Shocks and Exchange Rate Regimes,” Journal of International Economics, vol. 116, pp. 1-32. - Magud, N., and Vesperoni, E., 2015. “Exchange Rate Flexibility and Credit During Capital Inflow Reversals: Purgatory...not Paradise,” Journal of International Money and Finance, vol. 55, pp. 88-110. - Bocola, L., and Lorenzoni, G., 2020. “Financial Crises, Dollarization, and Lending of Last Resort in Open Economies,” American Economic Review, vol. 110, no. 8, pp. 2524-2557. ### Financial markets, liquidity, and global banking - Buch, C., and Goldberg, L., 2020. “Global Banking: Toward and Assessment of Benefits and Costs,” Annual Review of Financial Economics, vol. 12, pp. 141-175. - Correa, R., Du, W., and Liao, G., 2020. “U.S. Banks and Global Liquidity” NBER Working Paper 27491, National Bureau of Economic Research, Inc., Cambridge, MA. - Morais, B., Peydró, J. L., Roldán-Peña, J., Ruiz-Ortega, C., 2018. “The International Bank Lending Channel of Monetary Policy Rates and QE: Credit Supply, Reach-for-Yield, and Real Effects,” Journal of Finance, vol. 74, issue 1, pp. 55-90. - Spiegel, M., 2021. “Monetary Policy Spillovers Under Covid-19: Evidence from U.S. Foreign Bank Subsidiaries,” Working Paper 2021-14, Federal Reserve Bank of San Francisco. - Committee on the Global Financial System (CGFS), 2021. “Changing Patterns of Capital Flows,” CGFS Papers, Bank for International Settlements, Basel. ### Uncertainty, misallocation, and productivity - Carrière-Swallow, Y., and Céspedes, L. F., 2013. “The Impact of Uncertainty Shocks in Emerging Economies,” Journal of International Economics, vol. 90, issue 2, pp. 316-325. - Cingano, F., and Hassan, F., 2020. “International Financial Flows and Misallocation,” CEP Discussion Paper No 1697, Center for Economic Performance, London. - Bau, N., and Matray, A., 2020. “Misallocation and Capital Market Integration: Evidence from India,” NBER Working Paper 27955, National Bureau of Economic Research, Inc., Cambridge, MA. - Bleck, A., and Liu, X., 2018. “Credit Expansion and Credit Misallocation,” Journal of Monetary Economics, vol. 94, pp. 27-40. - Forbes, K., 2007. "One Cost of the Chilean Capital Controls: Increased Financial Constraints for Smaller Traded Firms," Journal of International Economics, vol. 71(2), pp. 294-323. - Forbes, K., Fratzscher, M. & Kostka, T., and Straub, R., 2016. "Bubble Thy Neighbour: Portfolio Effects and Externalities from Capital Controls," Journal of International Economics, vol. 99, pp. 85-104. ### Selected empirical studies on capital flows, prices, and housing - Badarinza, C., and Ramadorai, T., 2018. “Home Away from Home? Foreign Demand and London House Prices,” Journal of Financial Economics, vol. 130, issue 3, pp. 532-555. - Gorback, C., and Keys, B., 2020. “Global Capital and Local Assets: House Prices, Quantities, and Elasticities,” NBER Working Paper 27370, National Bureau of Economic Research, Inc., Cambridge, MA. - Jorda, Ò., Schularick, M., and Taylor, M., 2015. “Betting the House,” Journal of International Economics, vol. 96, supp. 1, pp. S2-S18. - Fan, M., and Lyons, R., 2003. “Customer Trades and Extreme Events in Foreign Exchange,” in Monetary History, Exchange Rates and Financial Markets, Chapter 6, ed by Paul Mizen, Edward Elgar Publishing, Cheltenham, United Kingdom. *References section, ppea2022008.* ### 1. Step 1 Applied to a Hypothetical Country _____________________________________________________ 8 ### 1. Step 1 Applied to a Hypothetical Country ### Purpose and context - Illustrates the first step of a two-step approach to assess systemic financial stability risks stemming from foreign currency (FX) mismatches. - Step 1 focuses on assessing FX mismatches at the relevant remaining maturities to determine whether mismatches are high enough to warrant moving to Step 2 (systemic risk assessment taking amplifying and mitigating factors into account). - FX mismatch at any relevant remaining maturity is defined as "the stock of FX liabilities which is not covered by liquid FX assets or FX hedges (either natural hedges or financial contracts in deep hedging markets)." ### Sources and types of FX mismatch risks - Two principal vulnerability types from FX debt stocks: - FX balance sheet mismatches: assets and liabilities denominated in different currencies; solvency affected by exchange rate changes. - FX maturity mismatches: operations and/or long-term assets funded by short-term FX liabilities; creates rollover and FX liquidity risk. - FX liquidity risk is more concerning than local currency liquidity risk because the central bank’s ability to function as lender of last resort may be limited when the liquidity gap is in FX. - Amplifiers of FX-mismatch risks: - High leverage of domestic borrowers or lenders. - Overvalued asset prices. - Significant presence of foreign investors in local currency bond markets when these markets are not well developed. ### How FX mismatches generate systemic outcomes (examples) - FX balance sheet mismatch: - Depreciation increases the local currency value of FX liabilities while local-currency assets remain unchanged, pressuring solvency and increasing FX debt service burden. - Can lead to higher direct and indirect credit risk, defaults on FX and local currency debt, and macro‑financial feedback effects (e.g., cutbacks in expenditure). - FX maturity mismatch: - Short-maturity FX liabilities expose agents to rollover risk in the event of reversal of FX debt inflows. - Contingent claims (activation of FX credit lines, derivatives, covenants) can spike FX cash outflows, causing defaults or forced asset sales at fire‑sale prices, valuation losses, and higher funding costs. ### Relation between balance-sheet and maturity mismatches - Either type may be present without the other: - Rollover risk can exist without an overall balance sheet mismatch. - An overall balance sheet mismatch can exist even if liabilities are long-term. - Regulatory limits (e.g., open FX position limits, capital requirements based on market risk) may keep bank FX mismatches limited on balance sheet but do not prevent short-term FX funding for FX assets. ### Step 1: required components to assess FX mismatches at relevant maturities - Three components are needed: - (i) the stock of FX liabilities; - (ii) the denomination of assets and availability of hedges; - (iii) the maturity structure of the balance sheet (including FX liabilities, assets and hedges). - Multiple indicators should be used to assess each component, subject to data availability. ### Practical elements and data considerations for Step 1 - FX debt stocks: - Assess private sector FX debt both economy-wide and at sectoral level (households, non-financial corporations (NFCs), banks, non-bank financial institutions (NBFIs)). - Investigate heterogeneity within sectors (e.g., exporters, large corporates, offshore affiliates, trade credit, off-balance-sheet exposures, contingent liabilities). - FX assets and hedges: - Assess whether sector FX debt is hedged at relevant maturities through: - Natural hedges (e.g., export revenues net of FX expenses for corporates; remittances for households). - Holdings of liquid FX assets (short- and long-term maturities). - Financial contracts in deep hedging markets (note: non-deliverable instruments protect from valuation loss but do not provide FX liquidity at maturity). - Evaluate whether indebted entities are the holders of hedging instruments (requires granular data). - Consider whether hedging markets will remain deep and liquid under stress. - Maturity structure: - Breakdown FX debt stocks and assets by maturity to identify short-term FX exposures and mismatches between FX obligations and liquid FX assets. - Consider timing of FX income and maturity of hedges, and whether hedges must be rolled over. - Use proxies and soft information where granular maturity breakdowns are unavailable (e.g., external interbank debt as proxy for short-term FX debt; portfolio assets and other investment assets in the IIP or BSA as proxies for liquid asset components). - Consider reasonable proxies for the ratio of FX to local currency debt in short-term external debt series when direct data are missing. ### Data sources and reported data availability (end-2019) - Sectoral breakdowns and statistics sources: BIS Locational Banking Statistics (LBS), BIS International Debt Securities Statistics (IDS), BIS Quarterly External Debt Statistics (QEDS), IMF Monetary and Financial Statistics (MFS), IMF International Investment Position Statistics (IIP), Balance Sheet Approach (BSA) matrix data, and country-specific sectoral accounts. - Reported data availability for end-2019: - Households: 145 countries from IDS, 186 countries from LBS and 156 countries from MFS. - NFCs: 86 countries from IDS, 182 countries from LBS and 156 countries from MFS. - Non-Bank Financial Institutions: 76 countries from IDS, 147 countries from LBS. - Banks/deposit taking corporations: 78 countries from IDS, 180 countries from LBS, 114 countries from QEDS, and 156 countries from MFS. - Other sectors: 113 countries from QEDS. - IDS provides a breakdown by currency and sector and also by maturity: "short-term" (up to one year) and "long-term" (greater than one year). - QEDS provides a breakdown of external debt by maturity for deposit-taking corporations and other sectors for up to 114 countries, and by currency and maturity for up to 44 countries. ### Practical note on hedging market liquidity - Deep hedging market defined by ability to execute (large) transactions efficiently without significant price impact or increased counterparty risk. - Key measures of market illiquidity include price impact and price reversal; bid-ask spreads and effective spreads can capture market liquidity though high-frequency data may be unreliable in underdeveloped markets. *Background Note: Assessing Systemic Financial Stability Risks Due to FX Mismatches (February 22, 2022)* ### 13. Other country-specific information should be used to assess FX mismatches. While the ### ppea2022008 - 13. Other country-specific information should be used to assess FX mismatches. While the ### Step 1 — Identifying elevated FX mismatches - Primary data sources proposed provide coverage for a great majority of the Fund’s membership, but data gaps may be severe for some countries (e.g., country not included in dataset; datasets not measuring all external liabilities and assets). - Types of potentially large but undercovered FX liabilities to uncover (quantitative and qualitative): - FX loans from non-BIS-reporting institutions - Inter-company FX debts - Contingent FX liabilities - FX swaps - Other off-balance-sheet FX liabilities - Country authorities may have unpublished or “soft” information useful for assessment (e.g., unpublished data on FX mismatches; whether most borrowing is by FDI companies with parent guarantees or from parent companies). - Judgment is required to assess whether FX mismatches are elevated because: - Granular data on FX debt and hedges are often incomplete. - Country-specific factors affect functioning of hedging markets and appropriate sectoral aggregation. - A holistic assessment should consider available data, country-specific factors, historical trends, and peer comparisons. - Triage rule for proceeding to Step 2: - If FX mismatches at relevant maturities are judged high for at least one macro-critical sector, proceed to Step 2. - If FX mismatches are in an intermediate range, it is desirable to err on the side of caution and move to Step 2. - It is sufficient for FX mismatches to be elevated for one macro-critical sector; Step 2 should focus on identified sectors. ### Box 1 — Illustrative hypothetical country (key quantitative findings) - Sectoral FX debt observations (stocks, as shares of GDP): - Non-Financial Corporations (NFCs): - about 6 percent of GDP from external sources (internationally issued FX bonds and cross-border FX loans) - about 25 percent of GDP from domestic sources (domestic FX loans) - Banks: - cross-border borrowing in FX is high, at about 19 percent of GDP - Households and NBFIs: - FX liabilities as a share of GDP are both quite low (not quantified beyond “low”) - Time and peer comparisons: - NFCs’ domestic and cross-border FX liabilities have grown steadily over time. - NFCs’ cross-border borrowing in FX as a share of GDP is moderate relative to peers, but domestic FX debt is relatively high. - Assets vs liabilities: - Liquid FX and external assets (proxied by claims on domestic or foreign banks and portfolio assets) appear smaller than liabilities as a share of GDP. - Total external assets (available in BSA data) are larger, especially for NFCs. - Text Box Figure 4 caveat: does not include some private sector FX assets (FDI and trade credits) because liquidity is unclear. - Maturity composition: - Share of short-term debt in total external debt and in internationally-issued FX securities for banks or depository corporations remains significant at about 40 percent. - For other sectors, the share of short-term debt in total external debt is stable but significant at 30 percent. - Conclusion from hypothetical data: - Based on publicly available data shown, sufficient reason exists to judge FX mismatches are high enough to proceed to Step 2. ### Step 2 — Assessing systemic financial stability risks from elevated FX mismatches - Core idea: For any given level of FX mismatches, systemic risk depends on financial structure, macro-financial linkages, and mitigating/amplifying factors. Use multiple information sources and tools to trace shock transmission. - Preferred approach: granular stress tests of relevant sectors (solvency and liquidity dimensions). Stress tests can be available from past FSAPs or Article IV surveillance if data permit. - Solvency stress test: - Assess how an adverse macroeconomic scenario (including a calibrated depreciation) increases private sector defaults due to FX balance sheet mismatches and how that affects bank solvency. - Liquidity stress test: - Calibrate depreciation and withdrawal of FX funding to the private sector. - Include assumptions on liquidation of each sector’s FX assets and operation of FX hedging markets under stress. - Identify spillovers of FX shortfalls onto the rest of the economy, using structure of financial system, presence of elevated asset valuations, and availability of policy support. - Objective of stress tests: - Assess whether key sectors can withstand the shock. - Quantify size of domestic contagion. - Judge degree of FX policy support that may be needed. ### Box 2 — System-wide FX liquidity stress-testing tool (summary) - Tool concept: - Applies standard liquidity stress-testing approach for banks to other sectors: agents fall into FX liquidity stress when net FX cash outflows within a period exceed FX liquid asset buffers. - Three sources of cashflows: operations (imports/exports), investment income/expenses (interest/dividends), and financing (contractual flows, contingent flows like credit lines and covenant-triggered repayments, and new contracts including rollovers). - Transmission channels and contagion: - Example: capital outflows trigger FX liquidity shocks to NFCs with substantial external debt. - If NFCs’ FX liquid assets are global safe assets, they can be sold to foreign counterparts and domestic contagion is limited. - If FX liquid assets are FX deposits at local banks, NFCs’ liquidity stress transmits to banks. - If banks’ FX liquid assets are mostly reserve deposits and central bank paper, stress could transmit to central bank and cause a drawdown in international reserves. - Extent of contagion and reserve drawdown depends on maturity mismatches, composition/nature of liquid FX assets, and liquidation order. - Data and implementation: - Tool relies mostly on balance sheet approach matrix data (“who-to-whom” flow of funds by counterparty). - Can be implemented using BSA and typical WEO projections, with assumptions for missing information and drawing on staff judgment. - Relevant acronyms: Ext. = external; NFC = non-financial corporate; LC = local currency; global safe assets = currencies and sovereign securities of reserve currency issuers. ### Role of country authorities and alternative assessment approaches - Country authorities may provide: - Specific concerns shaping Step 2 analysis (e.g., stress scenario design). - Additional unpublished data (composition of foreign investor base, granular financial network data, NFC balance sheets, credit registries, legal guidelines for asset liquidation). - Unpublished stress tests undertaken by the central bank. - Information to fill gaps on overlap between holders of domestic assets and FX borrowers, FX contingent liabilities of large corporates, and government access/willingness to draw down FX buffers. - If stress tests are not feasible: - Build on existing risk assessments in bilateral surveillance (Article IV reports). - FX-related systemic risk assessment should include: - Assessment of systemic risks (build on Article IV systemic risk analysis and deepen as needed). - Assessment of consequences of a capital inflow reversal for systemic financial stress. - Explanation of how amplifying/mitigating factors connect to FX mismatches (e.g., FX debt service as percentage of export revenues; elevated housing/stock valuations associated with leverage; presence of large FX contingent liabilities; functioning of FX hedging markets under stress; availability of FX buffers such as sovereign wealth funds, FX reserves, FX swap lines, and/or Fund arrangements). ### Conclusion - Two-step approach structures assessment of systemic financial stability risks from FX mismatches: - Step 1: identify elevated FX mismatches using available data and country-specific information. - Step 2: assess systemic risks using stress tests or deepened narrative analysis. - Emphasis on holistic assessment using all available data and judgment. - Question of whether elevated FX mismatches pose systemic risks is key for appropriateness of preemptive CFM/MPMs; other elements (e.g., that MPMs are not sufficient) must also be met. - Granular information from this risk assessment improves understanding of financial system structure and interlinkages and can inform bilateral surveillance. - Methodological and data innovations may evolve approaches over time. ### Annex I — Preemptive CFM/MPMs on local currency debt inflows (summary) - Preemptive CFM/MPMs on local currency debt inflows may be appropriate only in narrow and exceptional circumstances. - Two-step assessment for local currency debt inflows: - Step 1: assess whether elevated local currency leverage and/or maturity mismatches are fueled by local currency debt inflows. - Step 2: assess associated systemic risks. - Preconditions: - For CFM/MPMs on local currency debt inflows, it must be judged that conditions (i)-(iv) from paragraph 16 of the Board paper are jointly satisfied (these relate to functioning of FX and local currency markets under stress, effects of depreciation, and impairment of other policy instruments during crises). - If these conditions are satisfied, the risk assessment process begins; if not, the CFM/MPM would not be appropriate. - By contrast, these conditions do not need to be satisfied for the risk assessment process for preemptive CFM/MPMs on FX debt inflows to begin; thus circumstances for local currency measures are narrower and more exceptional. *Source: ppea2022008 - Background Note: Assessing Systemic Financial Stability Risks Due to FX Mismatches (excerpts).* ### 2. Once it is decided to begin the assessment process, Step 1 of the risk assessment ### 2. Once it is decided to begin the assessment process, Step 1 of the risk assessment ### Step 1 — Establish whether local currency leverage and maturity mismatches are elevated - Use data on local currency debt stocks, assets, and maturity structure to determine whether leverage and maturity mismatches are high enough in at least one macro-critical sector to proceed to Step 2. - Apply judgment where mismatches are ambiguous; if mismatches are neither clearly elevated nor clearly safe, err on the side of caution and proceed to Step 2. - If local currency vulnerabilities are substantial owing to local currency debt inflows and the narrow circumstances in the Annex apply, staff should use the risk assessment outlined in this Annex. If the main vulnerability is FX mismatch owing to FX debt inflows, staff should conduct the risk assessment outlined in Section III of the Background Note. ### Step 2 — Assess systemic risks related to local currency leverage and maturity mismatches - Preferred approach: granular stress tests of the relevant sectors to assess both solvency and liquidity risks (such as those already conducted in FSSAs). - Stress tests should build in the impairment of policy instruments during crises applicable to the specific country and that justified beginning the assessment (examples: the need for sharp increases in policy rates, or the inability of the central bank to provide liquidity support). - Build on existing risk assessments in Article IV reports (IMF, 2015; IMF, 2014). - Provide a narrative establishing whether systemic vulnerabilities arise from the local currency debt inflows. - Determine whether crisis risks would be accentuated in the event of a reversal in flows owing to FX mismatches or other factors (examples: elevated housing or stock price valuations associated with high leverage due to local currency debt inflows that, when unwound during a reversal, would lead to stress that could not be alleviated by central bank local currency liquidity support). ### Principles for design and implementation of preemptive CFM/MPMs to address FX mismatches - Align with the 2012 Institutional View and the Fund’s macroprudential policy framework: - Avoid using CFMs/MPMs as a substitute for necessary macroeconomic adjustment. - Use policy instruments that are the most effective, efficient, and direct, and the least distortive in addressing the policy objective. - Seek to treat residents and nonresidents in an evenhanded manner. - Ensure measures are transparent and generally temporary. - Preemptive CFM/MPMs should target systemic risks at source: - Identify magnitude and source of FX mismatches across financial sector, non-financial corporate sector, and household sector, and the underlying financial transactions (type and maturity). - Closely target specific sector(s) and transaction(s) that give rise to FX mismatches—on balance sheets overall, or at relevant shorter maturities. - Calibration principles: - Calibrate measures to address FX mismatches effectively while minimizing costs and distortions to capital flows, domestic credit, output, or market functioning. - Prefer instruments that are most efficient (minimize distortions and costs) among alternatives targeting the same risks. - Narrow targeting can reduce unintended side-effects and costs but may increase circumvention risk; aim to target risks closely without undermining effectiveness. - Price-based measures (example: higher reserve requirement on non-resident FX liabilities) can be easier to adjust and less distortionary than volume ceilings when well calibrated, but may face legislative or informational constraints. - Measures that target certain flows (example: short-term FX debt) and encourage shifts toward less risky flows (example: reserve requirement or levy that is higher for shorter maturities) may reduce systemic risks with limited effects on overall capital inflows and the exchange rate. - Ensure calibration is commensurate with policy objectives; avoid overly strict requirements (examples: credit rating requirements, all-in-cost ceilings, or hedging requirements) that preclude nearly all enterprises from borrowing abroad. ### Measures to increase resilience and reduce amplification - Design preemptive CFM/MPMs to build buffers for exposed sectors or institutions to limit adverse effects when borrowers reach solvency or debt repayment limits. - Examples of resilience-enhancing designs: - Maximum leverage limits (caps on borrowing relative to equity capital) for corporates based on external FX borrowing. - Levies on external liabilities in FX that feed a dedicated resource of liquid FX assets usable when rollover risk materializes. ### Implementation considerations and preferences - Consider adjustment costs: - Measures affecting new flows typically impose smaller adjustment costs than measures affecting the stock of existing FX liabilities. - Marginal reserve requirements or other tools applied to new flows can be calibrated to affect new flows strongly while avoiding adjustment costs from applying to existing liabilities. - If measures must be applied to existing stocks, mitigate adjustment costs via phase-in or stepwise tightening. - Prefer measures that do not discriminate by residency: - MPMs (non-discriminatory by residency and not designed to limit capital flows) are preferred when they can contain systemic risks from FX mismatches. - CFM/MPMs should be used only when MPMs are unavailable or insufficient. - Consider MPMs that incentivize hedging of FX mismatches to reduce underlying stock vulnerabilities. ### Illustrative measures by type/sector of vulnerabilities (non-exhaustive, drawn from Table 1) - Banks and NBFIs — FX balance sheet mismatch: Capital requirements based on the net open FX position; constraints on net open FX position; limits on FX derivatives positions; limits on banks’ lending in FX; caps on credit growth in FX; higher (marginal) reserve requirement on FX than local currency liabilities; sectoral capital requirements for banks’ FX lending to (unhedged) NFCs; tighter lending standards for (unhedged) FX lending. - NFCs — FX balance sheet mismatch: Requirements on NFCs to hedge FX exposures; liquidity requirements for NFCs borrowing (unhedged) in FX; limits and taxes on FX borrowing from abroad*; maximum leverage requirements based on NFC’s borrowing from abroad in FX*. - Households — FX balance sheet mismatch: Sectoral capital requirements for banks’ FX lending to (unhedged) HHs; tighter LTV, debt-to-income (DTI), and/or debt-service-to-income (DSTI) limits on (unhedged) FX mortgage loans; differentiated stamp duty rates on (unhedged) HHs with FX mortgage loans; limits and taxes on household borrowing from abroad*. - FX maturity mismatch measures (across sectors): FX liquidity coverage ratio (LCR); FX net stable funding ratio (NSFR); caps on FX loan-to-deposit (LTD) ratio; maturity-dependent levies on banks’ non-core FX liabilities; higher marginal reserve requirements on short-term than long-term FX liabilities; maturity-dependent constraints on external funding in FX*; unremunerated reserve requirements on short-term borrowing in FX from abroad*. - Note: Items marked with * in the table indicate measures that discriminate by residency and will always constitute CFMs or CFM/MPMs. The table is non-exhaustive; some measures may function as MPMs, CFMs, or CFM/MPMs depending on objectives and design. *ppea2022008 - 2. Once it is decided to begin the assessment process, Step 1 of the risk assessment (excerpt)* ### 7. Preemptive CFM/MPMs should be transparent. As stressed in both the IV and the ### 7. Preemptive CFM/MPMs should be transparent. As stressed in both the IV and the ### Transparency and communication - Clear communication of the policy objectives and the specific measures being used would help avoid disrupting market and public expectations. - A timely announcement of a well explained CFM/MPM would make it easier for the targeted sectors to understand the authorities’ intentions. - Clear communication would also make it possible to set accurate expectations regarding when and under what conditions the measures would be removed or adjusted. ### Periodic reassessment and recalibration - Preemptive CFM/MPMs should be reassessed periodically and recalibrated if possible, to minimize possible distortions and unintended side-effects that can arise over time. - The CFM/MPM should be recalibrated if the vulnerabilities that led to its adoption subside or an alternative, less distortionary, tool becomes available. - Addressing stock vulnerabilities may take time, creating scope for unintended effects and distortions (such as attempts at circumvention) to emerge and strengthen over time (Background Note 1). - The continued effectiveness of the measure and the potential emergence of circumvention and side effects should therefore be regularly reviewed. - Periodic evaluations can assess either: - whether an alternative measure can be found that is an MPM or a CFM/MPM that addresses the concern in a manner that does not discriminate by residency and/or is less distortive, or - whether the design of the existing CFM/MPM measure needs to be adjusted to counter the side-effects. ### Context from the Background Note: USING THE IPF ANALYTICAL TOOLKIT TO ENHANCE POLICY ASSESSMENTS - Purpose and scope: - The IPF examines the integrated use of all instruments (monetary policy, fiscal policy, FXI, MPMs, CFMs, and CFM/MPMs) to guide the appropriate policy mix during an inflow surge. - It recommends identifying the nature of the underlying shock (fundamental, non-fundamental, or a mix) and the country's characteristics to determine warranted macroeconomic adjustments and the appropriate policy mix. - Nature and composition of inflow surges: - Fundamental shocks (which may be persistent) include changes in global interest rates, productivity, and commodity prices. - Non-fundamental shocks include risk-on/risk-off episodes triggered by changes in investors' portfolio constraints that are not directly related to fundamentals. - The composition of inflows can vary; e.g., debt flows with short-term remaining maturity, in FX or domestic currency, can increase rollover risks when capital flows reverse. - Policy implications from IPF models: - If the shock is at least in part fundamental or persistent, adjustments to monetary, fiscal, and financial policies—and for flexible exchange rate regimes, to the nominal exchange rate—are likely warranted. - If the shock is predominantly or exclusively non-fundamental, it is not generally warranted to adjust macroeconomic policy settings away from levels consistent with inflation and growth objectives. - The assessment of warranted adjustments should be guided by indicators used in bilateral surveillance (e.g., inflation expectations, output gap, debt sustainability, the ESA, and reserve adequacy). - Frictions that hinder response using only macroeconomic policy and exchange rate adjustment: - Non-fundamental shocks combined with shallow FX markets increase the likelihood of overvaluation and overheating; shallow FX markets make premia on local currency debt more sensitive to shocks. - Weak monetary policy credibility can amplify overheating by causing excessive falls in medium-term inflation expectations alongside credit-driven output expansion. - Role of FXI and CFMs: - In the presence of overheating and overvaluation, FXI and CFMs can enhance monetary autonomy in certain circumstances without generating other distortions, particularly when reserves are adequate or more than adequate. - FXI and CFMs can reduce appreciation pressures and external funding to limit overvaluation and overheating, but their relative costs and benefits depend on country-specific factors. - FX reserve accumulation involves carry costs which may increase with the size of reserves. - FXI may create confusion about the nominal anchor, induce agents to increase FX risk exposure, and hinder FX market development. - CFMs require enforcement mechanisms and may be constrained by international agreements; the choice of CFMs is informed by the country's legal and administrative infrastructure. - Systemic financial risks from inflow surges identified by IPF models: - Domestic collateral constraints: bubbles in domestic asset prices (e.g., housing) may relax collateral constraints and lead to surges in local currency credit, increasing vulnerability to debt overhang and sharp deleveraging when inflows reverse. - FX mismatches: FX debt inflow surges may create elevated FX mismatches that become unsustainable when inflows reverse; the riskiest FX debt inflows tend to be short-term. - Interaction of MPMs and CFM/MPMs: - Staff should consider how the structure of the financial system affects the effectiveness and calibration of MPMs when assessing CFM/MPMs. - CFM/MPMs can complement MPMs in circumstances where agents borrow from abroad and risks cannot be addressed by MPMs alone. *BACKGROUND NOTE 4: USING THE IPF ANALYTICAL TOOLKIT TO ENHANCE POLICY ASSESSMENTS; Approved By Tobias Adrian, Pierre-Olivier Gourinchas, Ceyla Pazarbasioglu, and Rhoda Weeks-Brown; Prepared by: Marcin Kolasa and Gurnain K. Pasricha (both MCM), Suman Basu and Emine Boz (both RES), and Dimitre Milkov (SPR); February 22, 2022.* --- _Source: https://www.imf.org/-/media/files/publications/pp/2022/english/ppea2022008.pdf_