## INTRODUCTION ## Source details **Canonical URL:** [INTRODUCTION](https://www.imf.org/-/media/files/publications/pp/2022/english/ppea2022009.pdf) ## Other formats - [Markdown version](/-/media/files/publications/pp/2022/english/ppea2022009.pdf.md) - [Structured JSON version](/-/media/files/publications/pp/2022/english/ppea2022009.pdf.json) --- ### Key Messages - 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 in 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. - 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 through technology transfer, greater innovation and competition, and contributes 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 arise from multiple flow types: - Not only FDI to non-financial sectors, but also portfolio and debt flows, and foreign bank presence, contribute to growth and real-wage outcomes. - 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, benefiting high-productivity firms. - Foreign bank subsidiaries can alleviate financial constraints, facilitate growth and exports, provide FX liquidity, and help stabilize credit provision during crises. - Indirect/collateral benefits: - Capital flows help increase the depth and liquidity of securities markets, promote domestic capital market development, increase innovation, improve informational efficiency and stock liquidity, and can enhance corporate governance. - Foreign bank presence can improve financial service quality via competition; banks’ foreign expansion can provide diversification and reduce risks to home countries. - Country characteristics matter: - 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 around political uncertainty, and reap greater growth benefits. - Countries with weaker institutions are typically less diversified internationally, reducing risk-sharing benefits. - Less developed financial markets and tighter credit constraints lead to 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 amplification by frictions: - Capital flows can heighten macroeconomic volatility and vulnerability to crises by exposing financially open economies to external shocks and shifts in foreign investor sentiment. - 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 from contractionary global credit supply shocks than flexible regimes. - Frictions in domestic and international financial markets, including weaknesses in domestic 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 (Basu and others, 2020 aka the IPF conceptual model; IMF, 2020b). - In the IPF conceptual model, a positive foreign appetite shock (a non-fundamental and transitory shock unrelated to domestic conditions) leads to a surge in local currency inflows and a reduction in 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 FX intervention (FXI) (to counter the change in the UIP premia) is more effective 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 domestic price pressures. - Constraints on monetary policy (e.g., poorly anchored medium-term inflation expectations, liquidity traps, fixed exchange rate regimes) can strengthen the case for FXI and CFMs for macroeconomic management. - Inflow surges can magnify real or financial frictions, creating another potential case for CFMs: reallocation away from tradable sectors due to appreciation can be costly where tradeable sectors have learning-by-doing externalities; differing degrees of financial frictions across sectors can lead to overheating in low-friction sectors and misallocation of resources (e.g., over-investment in real estate), producing feedback loops between liquidity inflows, asset prices, and collateral values and potentially irreversible sectoral destruction. - B. CFMs/MPMs for Managing Financial Stability Risks - 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. - The early warning literature finds that increases in the ratio of a broad measure of credit (including bank, non-bank, and foreign sources) 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 exchange rate appreciation, contribute to increases in the credit gap, justifying the use of MPMs and potentially CFM/MPMs. - Surges can be associated with increases in wholesale-funded credit, heightening liquidity risks—particularly where supervisory and regulatory environments are weak—underlining the case for strengthening supervision and regulation. - Countries with less flexible exchange rate regimes experience a greater expansion in bank credit and a shift toward credit in FX during surges, suggesting larger benefits from CFM/MPMs in those contexts. - Capital inflow surges can fuel housing booms and domestic leverage, creating a feedback loop: mortgage leverage and housing booms increase financial fragility, and capital flows have been an important driver of housing vulnerabilities in advanced and emerging markets. - Real estate lending backed by non-tradable real estate collateral creates a pecuniary externality when agents ignore the impact of borrowing on collateral values, leading to feedback loops between credit and house prices and vulnerabilities to reversals from both direct non-resident purchases and foreign borrowing. - When high debt stocks generate systemic vulnerabilities—primarily FX mismatches—this may justify preemptive CFM/MPMs (Basu and others, 2020 aka IPF conceptual model; IMF, 2020b). - The IPF conceptual model emphasizes overborrowing in FX by private agents who do not internalize future market stress; preemptive CFM/MPMs can moderate FX borrowing and reduce financial stability risks from FX mismatches. - 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, particularly in emerging and developing economies, and is associated with higher output losses during such episodes; high stocks of external debt liabilities likely to be short-term or in FX are among the strongest predictors of capital inflow reversal episodes with large growth impact. ### Case for preemptive CFM/MPMs when FX debt is short-term - Short remaining maturity of FX debt creates a mismatch between short-term FX liabilities and FX liquid assets, exposing borrowers to rollover risk that can compound solvency pressures from a depreciation (Hur and Kondo, 2016; IMF, 2017; Brunnermeier and Sannikov, 2015).7 - Empirical evidence: external crisis risks tend to increase more strongly with short-term and maturing external debt (Basu and others, 2020). - Endogenous effects: 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 (Benmelech and Dvir, 2013; Brunnermeier and Oemhke, 2012; Bocola and Lorenzoni, 2020; Converse, 2018). - Footnote evidence: Bleakley and Cowan (2010) using balance sheet data from publicly listed firms in emerging markets do not find an impact of maturity mismatch on firm investment during sudden stops but find that firms exposed to short-term debt pay higher financing costs.7 ### Complementary role of CFM/MPMs with MPMs - Macroprudential measures (MPMs) play the primary role in reducing systemic vulnerabilities and tail risks to output (Brandao and others, 2020). - Evidence indicates MPMs on domestic lending can increase cross-border borrowing (borrowing directly from abroad or from foreign branches), justifying complementary use of residency-based measures to contain such “leakage” in certain circumstances (Nier and others, 2020; Ahnert and others, 2020). ### Considerations that caution against the use of CFMs and CFM/MPMs - 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, hindering investment in technology (Varela, 2017). - Smaller and external-finance-dependent firms can be disproportionately burdened (Alfaro and others, 2017); alternative financing (e.g., issuing international depository receipts) is relatively more expensive for such firms. Banks’ reduced profitability or reduced bank financing can further harm these firms (Forbes, 2007). - Differential impacts across firms add to the costs of CFMs given the role of small and medium enterprises in job growth and investment. - Incentives for rent-seeking and corruption: - CFMs and CFM/MPMs can create interest groups that incentivize 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: - Reliance on CFMs and CFM/MPMs can hinder development of domestic FX and local currency securities markets and perpetuate frictions (Aghion and others, 2013; Bena and others, 2017; Bae and others, 2012; He and others, 2013; Ng and others, 2016; Liu and others, 2020).8 - Such reliance can reduce urgency for reforms in market depth or fiscal frameworks and can substitute or delay warranted macroeconomic adjustment (Aizenman and Pasricha, 2013; Reinhardt and Sbrancia, 2015). - Potential to reduce longer-term attractiveness to investors: - Poorly designed or poorly communicated CFMs/CFM/MPMs may be interpreted as “anti-investor bias,” generating adverse market reactions and reducing future willingness to invest (Forbes and others, 2016). - Frequent reliance can reduce transparency and investor protection perceptions, affecting long-term attractiveness. - Compliance costs and policy uncertainty: - Compliance costs can be significant for businesses and financial institutions that implement CFMs; institutions may need complex systems, increasing operating costs and reducing profitability and competitiveness. - Frequent changes in measures increase compliance costs and policy uncertainty; transparency about overall policy strategy could help mitigate costs and uncertainty (IMF, 2014). - Costs increase with breadth and duration: - Broader application and longer duration of CFMs and CFM/MPMs raise distortive costs and entrench interests and evasion structures, arguing for periodic reassessments of benefits and costs. - CFMs used for macroeconomic management may need broader scope to plug leakages, increasing likely costs relative to often more targeted CFM/MPMs. - Inflow CFM/MPMs may need to remain in place longer than inflow CFMs used for macroeconomic management. ### Complementary policies and global spillovers - Need for complementary policies to reduce long-run reliance on CFMs/CFM/MPMs: - Structural and financial policies can reduce incentives to borrow in FX (Levy-Yeyati, 2021). - Examples: 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: - Use of inflow CFMs or CFM/MPMs to manipulate terms of trade can have adverse spillovers and reduce global welfare. - Empirical literature suggests trade competitiveness motivations remain relevant in the use of CFMs; inflow controls can increase trade surplus or persist undervaluation (Choi and Taylor, 2017; Montecino, 2018; Pasricha, 2020).9 - The literature supports prudence: consider CFMs during surges only when the currency is overvalued (as in the IV), and weigh additional considerations to avoid measures that could lead to or exacerbate undervaluation. ### Considerations that can inform the use or design of CFMs and CFM/MPMs - Structural constraints and design guidance: - Structural country characteristics can reduce need for CFMs or inform design; some characteristics reduce need, others (e.g., enforcement capacity) shape feasible designs. - Administrative and legal infrastructure requirements: - Imposition requires infrastructure to impose, monitor, enforce, and plug leakages; establishing such infrastructure can be onerous and outweigh benefits in some countries. - Legislation should allow a designated authority to flexibly introduce and adjust CFMs in response to changing macroeconomic conditions. - Tool-specific enforcement considerations: - 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 where primary legislation is required to change them; URRs are easier for central banks to implement but may be hard to calibrate effectively. - Targeted vs. broad-based tools: targeted controls may be less distortionary but are more vulnerable to leakages, especially in well-developed financial systems, potentially necessitating broader coverage and increasing distortions (Ostry and others, 2011). - International obligations and prior experiences: - Commitments (e.g., OECD Codes of Liberalization) or prior negative experiences can prevent countries from implementing CFMs even when appropriate under the IV. - Resident-held foreign asset positions: - Larger 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 appear to act 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 without changes in net flows (order flow matters).10 - Domestic financial market development: - Well-developed domestic securities markets can mitigate price impact of foreign appetite shocks and reduce need for CFMs (IMF, 2014b). - Development of local investor base for local currency bonds can help cushion shocks; deeper domestic markets improve outlook for FX and local currency portfolio inflows and limit likelihood of negative or weak flows (IMF, 2020a). *Source: Background Note: Capital Flows and CFMs—Benefits and Costs (excerpts).* ### INTRODUCTION________________________________________________________________________________ 2 ### INTRODUCTION ### Key Messages - 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 in 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. - 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 through technology transfer, greater innovation and competition, and contributes 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 arise from multiple flow types: - Not only FDI to non-financial sectors, but also portfolio and debt flows, and foreign bank presence, contribute to growth and real-wage outcomes. - 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, benefiting high-productivity firms. - Foreign bank subsidiaries can alleviate financial constraints, facilitate growth and exports, provide FX liquidity, and help stabilize credit provision during crises. - Indirect/collateral benefits: - Capital flows help increase the depth and liquidity of securities markets, promote domestic capital market development, increase innovation, improve informational efficiency and stock liquidity, and can enhance corporate governance. - Foreign bank presence can improve financial service quality via competition; banks’ foreign expansion can provide diversification and reduce risks to home countries. - Country characteristics matter: - 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 around political uncertainty, and reap greater growth benefits. - Countries with weaker institutions are typically less diversified internationally, reducing risk-sharing benefits. - Less developed financial markets and tighter credit constraints lead to 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 amplification by frictions: - Capital flows can heighten macroeconomic volatility and vulnerability to crises by exposing financially open economies to external shocks and shifts in foreign investor sentiment. - 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 from contractionary global credit supply shocks than flexible regimes. - Frictions in domestic and international financial markets, including weaknesses in domestic 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 (Basu and others, 2020 aka the IPF conceptual model; IMF, 2020b). - In the IPF conceptual model, a positive foreign appetite shock (a non-fundamental and transitory shock unrelated to domestic conditions) leads to a surge in local currency inflows and a reduction in 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 FX intervention (FXI) (to counter the change in the UIP premia) is more effective 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 domestic price pressures. - Constraints on monetary policy (e.g., poorly anchored medium-term inflation expectations, liquidity traps, fixed exchange rate regimes) can strengthen the case for FXI and CFMs for macroeconomic management. - Inflow surges can magnify real or financial frictions, creating another potential case for CFMs: reallocation away from tradable sectors due to appreciation can be costly where tradeable sectors have learning-by-doing externalities; differing degrees of financial frictions across sectors can lead to overheating in low-friction sectors and misallocation of resources (e.g., over-investment in real estate), producing feedback loops between liquidity inflows, asset prices, and collateral values and potentially irreversible sectoral destruction. - B. CFMs/MPMs for Managing Financial Stability Risks - 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. - The early warning literature finds that increases in the ratio of a broad measure of credit (including bank, non-bank, and foreign sources) 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 exchange rate appreciation, contribute to increases in the credit gap, justifying the use of MPMs and potentially CFM/MPMs. - Surges can be associated with increases in wholesale-funded credit, heightening liquidity risks—particularly where supervisory and regulatory environments are weak—underlining the case for strengthening supervision and regulation. - Countries with less flexible exchange rate regimes experience a greater expansion in bank credit and a shift toward credit in FX during surges, suggesting larger benefits from CFM/MPMs in those contexts. - Capital inflow surges can fuel housing booms and domestic leverage, creating a feedback loop: mortgage leverage and housing booms increase financial fragility, and capital flows have been an important driver of housing vulnerabilities in advanced and emerging markets. - Real estate lending backed by non-tradable real estate collateral creates a pecuniary externality when agents ignore the impact of borrowing on collateral values, leading to feedback loops between credit and house prices and vulnerabilities to reversals from both direct non-resident purchases and foreign borrowing. - When high debt stocks generate systemic vulnerabilities—primarily FX mismatches—this may justify preemptive CFM/MPMs (Basu and others, 2020 aka IPF conceptual model; IMF, 2020b). - The IPF conceptual model emphasizes overborrowing in FX by private agents who do not internalize future market stress; preemptive CFM/MPMs can moderate FX borrowing and reduce financial stability risks from FX mismatches. - 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, particularly in emerging and developing economies, and is associated with higher output losses during such episodes; high stocks of external debt liabilities likely to be short-term or in FX are among the strongest predictors of capital inflow reversal episodes with large growth impact. *Background Note 1: CAPITAL FLOWS AND CFMS—BENEFITS AND COSTS (February 18, 2022)* ### 15. The case for preemptive CFM/MPMs is strongest when the remaining maturity of FX ### 15. The case for preemptive CFM/MPMs is strongest when the remaining maturity of FX ### Case for preemptive CFM/MPMs when FX debt is short-term - Short remaining maturity of FX debt creates a mismatch between short-term FX liabilities and FX liquid assets, exposing borrowers to rollover risk that can compound solvency pressures from a depreciation (Hur and Kondo, 2016; IMF, 2017; Brunnermeier and Sannikov, 2015).7 - Empirical evidence: external crisis risks tend to increase more strongly with short-term and maturing external debt (Basu and others, 2020). - Endogenous effects: 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 (Benmelech and Dvir, 2013; Brunnermeier and Oemhke, 2012; Bocola and Lorenzoni, 2020; Converse, 2018). - Footnote evidence: Bleakley and Cowan (2010) using balance sheet data from publicly listed firms in emerging markets do not find an impact of maturity mismatch on firm investment during sudden stops but find that firms exposed to short-term debt pay higher financing costs.7 ### Complementary role of CFM/MPMs with MPMs - Macroprudential measures (MPMs) play the primary role in reducing systemic vulnerabilities and tail risks to output (Brandao and others, 2020). - Evidence indicates MPMs on domestic lending can increase cross-border borrowing (borrowing directly from abroad or from foreign branches), justifying complementary use of residency-based measures to contain such “leakage” in certain circumstances (Nier and others, 2020; Ahnert and others, 2020). ### Considerations that caution against the use of CFMs and CFM/MPMs - 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, hindering investment in technology (Varela, 2017). - Smaller and external-finance-dependent firms can be disproportionately burdened (Alfaro and others, 2017); alternative financing (e.g., issuing international depository receipts) is relatively more expensive for such firms. Banks’ reduced profitability or reduced bank financing can further harm these firms (Forbes, 2007). - Differential impacts across firms add to the costs of CFMs given the role of small and medium enterprises in job growth and investment. - Incentives for rent-seeking and corruption: - CFMs and CFM/MPMs can create interest groups that incentivize 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: - Reliance on CFMs and CFM/MPMs can hinder development of domestic FX and local currency securities markets and perpetuate frictions (Aghion and others, 2013; Bena and others, 2017; Bae and others, 2012; He and others, 2013; Ng and others, 2016; Liu and others, 2020).8 - Such reliance can reduce urgency for reforms in market depth or fiscal frameworks and can substitute or delay warranted macroeconomic adjustment (Aizenman and Pasricha, 2013; Reinhardt and Sbrancia, 2015). - Potential to reduce longer-term attractiveness to investors: - Poorly designed or poorly communicated CFMs/CFM/MPMs may be interpreted as “anti-investor bias,” generating adverse market reactions and reducing future willingness to invest (Forbes and others, 2016). - Frequent reliance can reduce transparency and investor protection perceptions, affecting long-term attractiveness. - Compliance costs and policy uncertainty: - Compliance costs can be significant for businesses and financial institutions that implement CFMs; institutions may need complex systems, increasing operating costs and reducing profitability and competitiveness. - Frequent changes in measures increase compliance costs and policy uncertainty; transparency about overall policy strategy could help mitigate costs and uncertainty (IMF, 2014). - Costs increase with breadth and duration: - Broader application and longer duration of CFMs and CFM/MPMs raise distortive costs and entrench interests and evasion structures, arguing for periodic reassessments of benefits and costs. - CFMs used for macroeconomic management may need broader scope to plug leakages, increasing likely costs relative to often more targeted CFM/MPMs. - Inflow CFM/MPMs may need to remain in place longer than inflow CFMs used for macroeconomic management. ### Complementary policies and global spillovers - Need for complementary policies to reduce long-run reliance on CFMs/CFM/MPMs: - Structural and financial policies can reduce incentives to borrow in FX (Levy-Yeyati, 2021). - Examples: 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: - Use of inflow CFMs or CFM/MPMs to manipulate terms of trade can have adverse spillovers and reduce global welfare. - Empirical literature suggests trade competitiveness motivations remain relevant in the use of CFMs; inflow controls can increase trade surplus or persist undervaluation (Choi and Taylor, 2017; Montecino, 2018; Pasricha, 2020).9 - The literature supports prudence: consider CFMs during surges only when the currency is overvalued (as in the IV), and weigh additional considerations to avoid measures that could lead to or exacerbate undervaluation. ### Considerations that can inform the use or design of CFMs and CFM/MPMs - Structural constraints and design guidance: - Structural country characteristics can reduce need for CFMs or inform design; some characteristics reduce need, others (e.g., enforcement capacity) shape feasible designs. - Administrative and legal infrastructure requirements: - Imposition requires infrastructure to impose, monitor, enforce, and plug leakages; establishing such infrastructure can be onerous and outweigh benefits in some countries. - Legislation should allow a designated authority to flexibly introduce and adjust CFMs in response to changing macroeconomic conditions. - Tool-specific enforcement considerations: - 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 where primary legislation is required to change them; URRs are easier for central banks to implement but may be hard to calibrate effectively. - Targeted vs. broad-based tools: targeted controls may be less distortionary but are more vulnerable to leakages, especially in well-developed financial systems, potentially necessitating broader coverage and increasing distortions (Ostry and others, 2011). - International obligations and prior experiences: - Commitments (e.g., OECD Codes of Liberalization) or prior negative experiences can prevent countries from implementing CFMs even when appropriate under the IV. - Resident-held foreign asset positions: - Larger 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 appear to act 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 without changes in net flows (order flow matters).10 - Domestic financial market development: - Well-developed domestic securities markets can mitigate price impact of foreign appetite shocks and reduce need for CFMs (IMF, 2014b). - Development of local investor base for local currency bonds can help cushion shocks; deeper domestic markets improve outlook for FX and local currency portfolio inflows and limit likelihood of negative or weak flows (IMF, 2020a). *Source: Background Note: Capital Flows and CFMs—Benefits and Costs (excerpts).* ### References ### ppea2022009 - References ### Models, Frameworks, and IMF Policy Papers - 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. 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