## _031312

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### I. Main messages (Introduction)
- The appropriate degree of liberalization depends on country-specific circumstances, notably whether thresholds on financial development have been reached.
- Full liberalization is not expected to be appropriate for all countries at all times; orderly further liberalization can benefit countries with extensive restrictions.
- Managing financial stability risks from capital flows requires stronger policies and cross-country cooperation; CFMs may be temporarily reintroduced consistent with policy frameworks without compromising liberalization.
- In systemically important EMEs (China and India) with extensive capital controls, liberalization should be carefully planned and sequenced; further liberalization would be beneficial contingent on implementation of authorities’ liberalization plans and progress on supporting reforms, particularly in the financial sector.
- Capital outflows should be managed primarily by macroeconomic and financial sector policies; temporary CFMs on outflows can be useful mainly in crisis or near-crisis conditions as a supplement to other policies to prevent a free fall of the exchange rate and depletion of international reserves.
- Effectiveness of CFMs on outflows depends on macroeconomic policies, initial conditions, CFM design, and implementation capacity; effectiveness may erode quickly and CFMs should be lifted when risks recede.
- A stronger global safety net would facilitate further liberalization of capital flows.

### II. Scope, purpose, and organization
- Purpose:
  - Develop a “comprehensive, flexible, and balanced approach for the management of capital flows, drawing on country experiences,” and provide an up-to-date operational framework for policy advice on liberalizing capital flows and managing capital outflows.
- Organization (high level):
  - Section II: trends in liberalization; Fund’s role; literature review; proposed IMF policy framework; country experiences; implications for China and India.
  - Section III: CFMs on outflows and IMF policy framework for outflows.
  - Section IV: issues for discussion.

### III. Recent trends, measures, and empirical findings
- De facto / de jure openness and dynamics:
  - De facto liberalization significant mainly for advanced economies and emerging Europe.
  - De facto openness declined for EMDCs in Africa and the Middle East (especially after 2007); broadly unchanged for EMDCs in Asia and the Western Hemisphere.
  - Flows were volatile: increased during 2003–07 then contracted sharply after the global financial crisis.
  - De jure measures show only modest liberalization globally in the past decade:
    - In 2010, 93 out of 185 countries were largely open, and 62 were largely closed.
    - In the mid-1990s, 78 out of 184 countries were largely open, and 65 were largely closed.
  - Some modest liberalization across all income groups until mid-2000s, partially reversed after the crisis; upper middle and high income EMEs introduced controls on financial instruments and credit operations.
  - By region, de jure openness increased significantly only for EMDCs in Europe.
- Changes in policy measures since 2000:
  - Since the crisis, pace of both tightening and easing measures picked up.
  - Tightening measures concentrated in emerging middle-income countries.
  - Examples:
    - Broad controls affecting all portfolio investment and financial credit: Brazil, Colombia.
    - More selective controls: Croatia, Indonesia, Thailand.
    - Easing measures to ease domestic liquidity: Croatia, India, Malaysia.
- Benefits and costs of liberalization:
  - Theoretical benefits: improved resource allocation, risk diversification, reduced financing costs, competitive gains, and faster domestic financial development.
  - Empirical evidence mixed: about an equal number of studies find a significant effect on growth as find no effect.
  - Longer-term: more open EMEs have tended to grow relatively faster when China and India are excluded; with China and India included, average growth rates are not higher for more open economies though median growth rates remain higher.
  - Principal costs: vulnerability to financial crises from sudden stops, currency and maturity mismatches, and increased systemic risk-taking; association between inflow surges and likelihood of debt, banking, and currency crises depends on financial sector development, institutional quality, macro policy, and trade openness.
- Measurement notes:
  - De facto openness measured as BIS foreign claims over GDP and assets plus liabilities over GDP.
  - De jure openness measured using the Chinn-Ito index (similar results using staff’s narrow restrictiveness index covering 21 types of capital transactions).
  - “Largely open” = de jure restrictiveness index ≤ 0.33; “largely closed” = index ≥ 0.67 (staff’s narrow restrictiveness index).
  - Data from 2005 onward affected by methodological changes harmonizing AREAER and OECD Code entries.
  - After 2007, Milesi-Ferretti index not adjusted for valuation and may overstate decline in openness.

### IV. Proposed IMF policy framework for liberalizing capital flows (Box 2 — Integrated approach, modified)
- Core orientation:
  - Liberalization set within macroeconomic and financial system stability; timed and sequenced with macro and prudential policies; tailored to country circumstances.
  - No preset timetable for full liberalization; some countries may liberalize quickly while many require slower paths.
  - Structural policies to develop financial systems and macroprudential policies are important complements.
  - For low-income economies, initial liberalization focus on FDI recommended, with other flows liberalized later (example: Moldova).
- General principles (high level):
  - 1. Degree of liberalization depends on financial and institutional development thresholds.
  - 2. No expectation that full liberalization is appropriate for all countries at all times; orderly further liberalization likely beneficial for countries with extensive restrictions.
  - 3. Liberalization should proceed per the integrated approach, modified to reflect recent research and experience: cautious approach warranted; CFMs may need reimposition in certain circumstances; consider CFMs broadly; pay greater attention to multilateral effects; modify technical sequencing.
- The integrated approach — ten guiding principles:
  - (1) Liberalization best undertaken against sound and sustainable macroeconomic policies.
  - (2) Financial sector reforms that support macro stabilization should be priority.
  - (3) Operationally linked financial reforms should be implemented together.
  - (4) Prudential regulation, supervision, and restructuring should complement reforms to enhance competitive efficiency and market development.
  - (5) Sequencing by instruments/sectors should account for concomitant risks.
  - (6) Pace should consider financial structure of nonfinancial corporations (debt-equity ratios, foreign currency exposure) and effects on loan portfolios and banks’ capital base.
  - (7) Reforms requiring lead time for technical preparation and capacity building should start early.
  - (8) Reforms need to consider effectiveness of existing capital controls.
  - (9) Pace, timing, sequencing should reflect political and regional considerations.
  - (10) Operational and institutional arrangements for policy transparency and data disclosure need adaptation to support capital account opening.
- Sequencing considerations:
  - Assess macro and financial vulnerabilities; institution and market development; design/effectiveness of existing controls; capacity to manage large and volatile flows; authorities’ capacity to enforce controls.
- Three-stage stylized liberalization plan:
  - Stage I:
    - Liberalize FDI inflows; lay groundwork (international accounting standards, national statistics); strengthen monetary framework and financial sector regulation.
  - Stage II:
    - Liberalize FDI outflows and long-term portfolio flows; liberalize some short-term flows.
  - Stage III:
    - Eliminate remaining controls after developing financial markets and strengthening prudential regulation and supervision.
- Reimposition cautions:
  - CFMs may be temporarily reimposed in inflow surges or if liberalization outstrips capacity; prefer cautious liberalization to avoid on-off policy that creates moral hazard and damages investor confidence.
  - Temporary CFMs on outflows may be needed in crisis.
  - Pay attention to multilateral effects: relaxation by large EMEs could substantially increase gross capital flows; complete international regulatory and supervisory reforms to mitigate cross-border risks.
- Technical sequencing lessons:
  - Some short-term transactions may need liberalization ahead of long-term ones (e.g., short-term trade-related bank transactions).
  - Cross-border banking transactions should be liberalized no later than when nonfinancial sector is allowed to borrow abroad to avoid disintermediation.
  - Deposit interest rates should be liberalized before corresponding outflow controls.
  - Liberalization of outflows can help with inflow surges (examples: Korea, the Philippines, Thailand) but outflow CFMs should be removed only with adequate prudential regulation and supervision.
  - Transactions with similar economic content/maturity should be liberalized together to avoid arbitrage (examples: Chile, Malta, Slovak Republic).

### V. Managing capital outflows (Box 7 and Section 58)
- Guiding premise:
  - Once capital flows are substantially liberalized, some outflow volatility is normal; primary management should be via macroeconomic, structural, and financial sector policies.
  - CFMs on inflows can be preventive during inflow surges, consistent with Fund framework.
- When CFMs on outflows can be considered:
  - In crisis or near-crisis conditions to prevent free fall of the exchange rate and depletion of reserves.
  - When shocks cannot be handled by macroeconomic adjustment or financial sector policies alone, or where shock size/duration is highly uncertain.
  - CFMs should be part of a broader policy package and serve as breathing space while adjustments are implemented.
- Effectiveness and limitations:
  - Effectiveness can erode quickly unless backed by credible macro and financial sector policies.
  - Reinforcement may be needed to close loopholes; weigh benefits versus distortions including investor expectations and how long CFMs will buy time.
  - Widespread adoption may have multilateral effects similar to inflow CFMs; temporary and limited use reduces multilateral effects.
- Design and duration principles:
  - CFMs in crisis often need to be comprehensive but temporary; lift when:
    - (i) macroeconomic stability (exchange rate and debt sustainability),
    - (ii) confidence in domestic assets,
    - (iii) access to international capital markets,
    - (iv) financial system stability,
    - (v) adequate reserves.
  - Prefer non-residency-discriminatory measures (e.g., currency-based).
  - Design CFMs considering administrative/regulatory capacity and preexisting openness; measures commensurate to concern; tax-like measures may suffice.
- Types of CFMs on outflows (examples):
  - Residency-based: limits on residents’ investments abroad (Iceland); waiting periods for nonresidents to transfer proceeds (Ukraine); minimum holding periods (Chile); taxes on transfer of proceeds (Malaysia).
  - Non-residency-based: prohibitions on conversion/transfer of domestic currency assets (Iceland); limits on deposit withdrawals (Argentina).
  - Restrictions on nonresidents’ access to local-currency funding to make currency speculation more difficult.
- Box 6 policy responses by underlying factor (high level):
  - External shock: allow depreciation to new equilibrium; intervene to prevent overshooting; defend credible peg if temporary and reserves sufficient; consider discrete devaluation otherwise.
  - Inconsistent macroeconomic policies: implement macro adjustment; CFMs can be temporary breathing space.
  - Financial fragility: strengthen prudential regulation/supervision, deposit guarantees, liquidity support; CFMs can provide time.
  - Global conditions: if outflows reflect temporary increased risk aversion, adjust policy mix (allow depreciation, increase policy rates while easing fiscal stance).

### VI. Evidence on effectiveness of outflow CFMs and historical cases
- Academic/empirical evidence:
  - Limited academic research; mainly case studies.
  - Magud, Reinhart, and Rogoff (2011) survey finds only weak evidence of effectiveness of outflow controls except possibly Malaysia in 1998.
  - Staff analysis of 31 EMEs (1995–2010):
    - In countries with better-than-median macro conditions, tightening outflow controls increased net inflows for one year and allowed policymakers to reduce interest rates somewhat without exchange rate depreciation.
    - In full sample, effectiveness of outflow controls could not be confirmed.
  - Binici and others (2010): outflow controls are somewhat effective and more effective in advanced economies than others, partly due to higher institutional/regulatory quality.
- Historical tightening of outflow controls: uncommon over the past decade with notable cases:
  - Argentina (2001–02).
  - Iceland (2008).
  - Ukraine (2008).
- Selected country case highlights and exact figures from Table 1:
  - Argentina 2001–02:
    - peso devalued by 40 percent in early 2002; imposed Corralito and restrictions on transfers and loans in foreign currency; foreign currency deposits converted into domestic currency deposits at a specific exchange rate; freeze on bank deposits in 2002.
  - Iceland 2008:
    - very large short-term liabilities to foreign investors: 600 percent of GDP;
    - krona depreciated about 30 percent between December 2007 and March 2008;
    - net foreign asset position: -112 percent of GDP in 2007 to -629 percent in 2010;
    - controls prevented conversion of krona assets to foreign currency upon maturity; about ISK 600 billion kept in Iceland initially.
  - Latvia 2008–09:
    - output declined almost 25 percent cumulatively between 2008 and 2009;
    - Parex Banka had a market share of about 20 percent; government took a 51 percent stake in October 2008 (later increased to 85 percent); partial deposit withdrawal restrictions expired at end-2011.
  - Malaysia 1998:
    - September 1998 measures: limits on offshore swap operations, ban on short-selling, repatriation of ringgit held offshore, 12-month waiting period for nonresidents to sell profits from Malaysian securities (later replaced by a tax then phased out within a year).
  - Russia 1998:
    - exchange rate depreciated by about 50 percent in September 1998; inflation rose to 40 percent; capital outflows in second half of 1998 reached about US$17 billion.
  - Russia 2008:
    - outflows reached US$130 billion (or 8 percent of annual GDP) in the fourth quarter of 2008;
    - ruble depreciated by about 30 percent against the euro-dollar currency basket (and 15 percent in real effective terms) during December 2008–January 2009;
    - authorities did not use capital controls; relied on large-scale foreign exchange interventions and massive liquidity support to banks.
  - Turkey 2001:
    - inflation 70 percent in 2001; fiscal deficit reached 17 percent of GDP; public debt in excess of 90 percent; capital outflows amounted to about US$70 billion; exchange rate depreciated as much as 50 percent.
  - Ukraine 2008:
    - inflows averaged 7 percent of GDP in the four quarters leading up to the peak; outflows were 13 percent of GDP in the following four quarters;
    - hryvnia depreciated by some 35 percent in late-2008;
    - regulatory measures included revision of banks’ open foreign exchange position methodology, limits on early withdrawal of time deposits, ban on foreign exchange forward transactions, and mandatory five-day waiting period before local currency can be converted to foreign exchange for investment transactions.
  - Uruguay 2002:
    - by mid-2002 about 35 percent of deposits had been withdrawn; peg abandoned and Uruguayan peso depreciated by about 25 percent; five-day bank holiday declared.

### VII. Country experiences and vignettes
- Korea (Box 3):
  - Liberalization aligned with integrated approach: sound macro policies, sequencing of financial reforms, and development of domestic currency funding sources.
  - Outcomes: smooth overall transition despite capital flow surges; pre-crisis buildup of foreign-currency short-term debt and high leverage in banks led to rollover difficulties during the global crisis.
  - Policy response post-crisis (starting 2010): measures introduced to avoid renewed financial sector vulnerabilities and limit macro volatility.
- Central and Eastern Europe (CEE):
  - Many CEE countries sequenced liberalization with financial reform and macro stabilization, but later experienced rapid credit growth fueled by large inflows culminating in financial sector instability during the crisis.
  - Instability largely stemmed from prudential regulation and supervision not keeping up with inflow challenges and liquidity/regulatory conditions in source countries.
- Adverse experiences highlighted where incomplete support by macro/financial policies led to crises (examples: CEE countries; Mexico 1994; Turkey 1994 and 2000–01).

### VIII. Systemically important EMEs: China and India (risks, sequencing, and regulatory details)
- China — risks from liberalization:
  - Identified risks: asset bubbles; capital flight; currency and maturity mismatches in bank and corporate balance sheets.
  - Historical precedent: liberalizing while maintaining relatively fixed exchange rate contributed to crises (Mexico 1994–95; Asia, Brazil, Russia 1997–98).
  - Benefits of exchange rate flexibility: better handling of increased capital flows, improved macro control by reducing liquidity injections associated with surpluses, reduced vulnerabilities, addressing external imbalances, incentives for FX market and currency risk management.
- China — sequencing and reforms recommended:
  - Move to monetary policy more independent and interest-rate reliant; stronger supervisory and regulatory frameworks; broader financing/saving vehicles; deeper/liquid markets; liberalized loan and deposit interest rates; greater exchange rate flexibility.
  - Internationalization path: remove restrictions on more stable long-term financing like direct investment; expand QFII/QDII quotas judiciously toward eventual nonbinding quotas and removal.
- India — benefits and risks, sequencing:
  - Benefits: greater access to foreign capital for infrastructure; risk diversification; development of government and corporate bond markets; additional long-term financing; shift of large-project financing to capital markets freeing banks for SME and household lending.
  - Risks: exacerbation by high fiscal deficits and distortions; increased foreign participation in government bond market could raise pro-cyclicality, volatility of bond yields; faster opening to debt flows could transmit international volatility.
  - Sequencing emphasized by authorities: liberalize FDI first (no major distinction inflows/outflows), then equity, and finally debt; long-term flows liberalized ahead of short-term flows.
  - Practical details and limits:
    - FDI liberalized over time but 10 sectors remain prohibited.
    - FII debt limits raised substantially to US$45 billion in total (corporate and infrastructure bonds) but low utilization due to low bond liquidity.
    - Smaller FII limit on government bonds is US$15 billion and more fully utilized.
  - Preconditions: as fiscal consolidation advances, FII debt limits can increase faster; liberalization should be accompanied by liberalizing deposit rates, introducing new instruments, fostering exchange rate flexibility, strengthening fiscal discipline, and relaxing restrictions on domestic institutional investors to foster capital market development.

### IX. Annex 1 — Regulatory framework comparison for China and India (selected rules and exact limits)
- FDI:
  - China:
    - Only foreign investors in good standing 1/ may invest in excess of 10 percent of the company’s shares up to sector-specific limits.
    - A three-year mandatory holding period applies for foreign strategic investors.
    - Outflow: companies may purchase and transfer foreign exchange for outward FDI subject to registration only and can use renminbi in countries that accept such settlement.
  - India:
    - FDI allowed under automatic and government approval routes.
    - Several sectors allow up to 100 percent; 10 sectors prohibited.
    - Outflow: Indian companies and registered partnerships may invest up to 400 percent of their net worth without approval (ceiling not applicable where investment is from Exchange Earners' Foreign Currency account or ADRs/GDRs; lower limits/additional conditions for unregistered partnerships/proprietorships).
- Portfolio equity:
  - China:
    - Inflow: Only QFIIs may invest in “A” shares; caps on foreign ownership: 10 percent for a single foreign investor, 20 percent for all foreign investors.
    - QFIIs have individual quota limits; mandatory principal lock-in periods of 3 months or 1 year depending on QFII type; other transfers subject to State Administration of Foreign Exchange approval.
    - Outflow: Only QDIIs may invest in equities abroad within purchase and FX quotas and regulatory limits.
  - India:
    - Inflow: Registered FIIs allowed; overall ceiling for FIIs is 24 percent of paid up capital (can be raised to sectoral cap via board/general body special resolution); 20 percent limit for public sector banks.
    - NRIs/PIOs allowed up to 10 percent (raisable to 24 percent via resolution); Overseas Citizenship holders have same rights as NRIs (except agricultural land).
    - Outflow: residents’ investments in companies listed abroad capped at US$200,000 a year; resident corporations may invest up to 50 percent of net worth in shares of listed companies abroad; Indian Mutual Funds allowed within overall cap of US$ 7 billion.
- Portfolio bonds:
  - China:
    - Inflow: Only QFIIs may invest in bonds on stock exchanges; select foreign banks/central banks may invest in inter-bank bond market with renminbi subject to limits; no minimum holding period.
    - Outflow: QDIIs subject to overall ceilings and regulatory limits.
  - India:
    - Inflow: Registered FIIs may invest in corporate debt with overall limit US$20 billion, plus US$25 billion for infrastructure bonds and US$15 billion for government securities; infrastructure bonds have mandatory holding periods; different limits for NRIs.
    - Outflow: resident individuals may invest in debt securities abroad subject to yearly limit of US$200,000.
- Money market:
  - China:
    - Inflow: Only QFIIs may invest in money market funds subject to lock-in periods and limits; select foreign entities may invest in renminbi money market subject to limits.
    - Outflow: only QDIIs may invest in money market instruments within FX quotas/limits.
  - India:
    - Inflow: Only NRIs may invest in money market mutual funds.
    - Outflow: residents may purchase these instruments abroad without RBI approval according to norms.
- Derivatives:
  - China:
    - Inflow: not allowed.
    - Outflow: generally subject to approval and limits.
  - India:
    - Inflow: generally subject to limits and approval; hedging of nonresidents’ investments allowed.
    - Outflow: commercial banks may purchase for ALM; resident companies may use derivatives to hedge commodity price and FX debt exposures.
- Loans / external borrowing:
  - China:
    - Inflow: short-term borrowing subject to individual limits; maturities > one year subject to approval; loans to enterprises with foreign participation limited to total investment minus registered capital; all loans must be registered; rules vary by sector/instrument.
    - Outflow: lending abroad generally subject to approval; banks may lend abroad per banking and relevant regulations.
  - India:
    - Inflow: external commercial borrowing allowed via automatic and approval routes.
    - Automatic route limits: US$20 million for minimum three-year average maturity and US$750 million for minimum five-year average maturity.
    - Approval route can be higher than US$750 million; loans subject to all-in-cost ceiling and end-use restrictions.
    - Outflow: lending abroad generally subject to approval except certain trade credits and lending to foreign subsidiaries.
- Domestic currency accounts of nonresidents:
  - China: nonresident nonbank institutions with renminbi from trade may deposit renminbi in correspondent accounts with mainland banks; limited trade financing allowed through correspondent accounts.
  - India: only NRIs and nonresident PIOs may maintain rupee accounts.
- Repatriation / surrender:
  - China: proceeds generally repatriated within 180 days of exportation; may be deposited with foreign exchange domestic banks or abroad; conditions regulated by balance of payments status and FX management needs.
  - India: proceeds must be repatriated within 12 months of shipment and may be deposited in domestic bank accounts; these accounts do not earn interest.

### X. Issues for discussion (as presented)
- Do Directors agree that the modified integrated approach provides a suitable framework for policy advice on liberalizing capital flows (Box 2 and paragraphs 21–29)?
- Do Directors support extending the definition of CFMs to include measures designed to affect capital outflows?
- Do Directors support the proposed framework for managing capital outflows (Box 7 and paragraphs 58–64)?

*Source: _031312 - References (IMF chapter/section excerpts as provided).*

### References .............................................................................................................

### _031312 - References

### I. Main messages (from Introduction)
- First, the appropriate degree of liberalization for a country would depend on its specific circumstances, notably on whether it has reached certain thresholds with respect to financial development. There is no expectation that full liberalization is an appropriate goal for all countries at all times. Nonetheless, countries with extensive restrictions on capital flows are likely to benefit from further liberalization, in an orderly manner. Meanwhile, as the global crisis has made clear, managing the financial stability risks associated with capital flows requires stronger policies and cooperation across countries. CFMs may be temporarily reintroduced in accordance with the relevant policy frameworks, without compromising the overall process of liberalization. A stronger global safety net would facilitate further liberalization of capital flows.
- Second, in systemically important EMEs such as China and India, which have extensive capital controls, liberalization should be carefully planned and sequenced as it could have potentially significant domestic and multilateral effects. Further liberalization would be beneficial for these countries based on implementation of the authorities’ liberalization plans and more rapid progress on supporting reforms, particularly in the financial sector.
- Third, while capital outflows should be managed primarily by macroeconomic and financial sector policies, the temporary reimposition of CFMs on capital outflows can be useful mainly in crisis or near crisis conditions but only as a supplement to other policies in response to large outflows typically associated with crises. The objective of such CFMs is to prevent a free fall of the exchange rate and depletion of international reserves. CFMs can, in particular, buy time for adjusting fiscal and other policies and stabilizing the financial sector. However, the effectiveness of CFMs on outflows depends on a number of factors, notably macroeconomic policies, initial conditions, the design of the CFMs, and implementation capacity. Even where CFMs are initially effective, their effectiveness may erode quickly. As CFMs can give rise to significant distortions, they should be lifted when the risks they were designed to address recede.

### II. Scope, purpose, and organization of the paper
- Purpose: To develop a “comprehensive, flexible, and balanced approach for the management of capital flows, drawing on country experiences,” and to provide an up-to-date and operational framework for policy advice on liberalizing capital flows and on the management of capital outflows.
- Organization:
  - Section II: Overview of recent trends in liberalization of capital flows; the Fund’s role; review of literature on pros and cons of liberalizing cross-border capital flows; proposed IMF policy framework for liberalization; country experiences; implications for systemically important EMEs (China and India).
  - Section III: Examination of CFMs on outflows and proposed IMF policy framework for managing capital outflows.
  - Section IV: Issues for discussion.

### III. Definitions, concepts, and legal context
- Definition and interpretation:
  - “Liberalization” of capital flows has varied interpretations; this paper uses the term instead of “capital account liberalization.”
  - The Fund has embraced a broader concept of restrictions on inflows (CFMs) that includes both residency-based measures (capital controls) and other measures (including some prudential measures) designed to affect capital inflows.
  - Full convertibility often understood as absence of any limitation on capital flows, including both the transaction and related payments and transfers.
  - OECD concept: focuses on elimination of residency-based measures on cross-border capital movements.
  - EU concept: broader, generally prohibits all restrictions on the movement of capital, even if not residency-discriminatory.
- Legal framework highlights:
  - Article VI, Section 3: members are free to “exercise such controls as are necessary to regulate international capital movements.”
  - Members’ rights to regulate capital movements cannot be exercised in a manner inconsistent with obligations under Article IV.
  - Article VI, Section 1: prohibits members’ use of the Fund’s general resources to meet a large or sustained outflow of capital and allows the Fund to require that a member impose controls on capital movements to prevent such use.
  - Article VIII, Section 2(a): requires members to refrain from imposing restrictions on current international payments and transfers without the Fund’s prior approval; thus, controls under Article VI that would constitute exchange restrictions under Article VIII, Section 2(a) require Fund approval.
- Purpose of the proposed frameworks: to inform policy discussions with and advice to Fund members; not intended to provide guidance on the scope of members’ obligations under Article IV.

### IV. Box 1 — The Concept of Full Liberalization of Capital Flows (summary of key points)
- No uniform definition of full liberalization; broadest sense = absence of any regulatory or other measure that would impede cross-border movements of capital, covering underlying capital transactions and related payments/transfers.
- OECD Capital Code and Code of Liberalization of Current Invisible Operations: comprehensive framework covering almost all current and capital international transactions and related payments/transfers; liberalization obligation applies only to measures that discriminate between residents and nonresidents.
  - Capital Code established Lists A and B:
    - List A: transactions of longer maturity, generally considered less volatile and essential—stronger liberalization obligations apply; subject to standstill principles (no new restrictions).
    - List B: includes more limited, generally short-term, potentially volatile transactions—restrictions can be reintroduced at any time.
- EU Treaty: generally prohibits all restrictions on movement of capital, including nondiscriminatory measures; recognized prudential or public policy measures are not considered restrictions if not arbitrary or disguised discrimination. EU members outside euro area may resort to restrictions under balance of payments difficulties in certain circumstances.
- Bilateral/regional agreements: may include liberalization obligations with limited flexibility; could create challenges for managing capital flows and may lack safeguards or sequencing. Broader international coordination, including with the Fund, would contribute to a more consistent framework.

### V. Recent trends in capital flows (opening of Section II.A)
- During the past decade, gross capital flows increased substantially on a global basis, mainly among advanced economies, but also for some EMEs.
- Drivers cited:
  - Growing real and financial interconnectedness;
  - Structural factors such as financial innovation, better access to information, declining home bias, differential expectations of growth between advanced and emerging economies, aging populations in advanced economies;
  - Global liquidity conditions, which at times led to a “search for yield;”
  - Global recycling of resource earnings and foreign reserves;
  - Some reduction in regulatory barriers.

### VI. Metadata excerpts (lists of content types referenced)
- Tables: Selected Country Cases with Significant Capital Outflows (Table 1).
- Figures: De Jure Restrictiveness and De Facto Openness to Capital Flows; Liberalization of Capital Flows, 1997 and 2010; Evolution of Controls on Capital Inflows and Outflows, 2000–2010; Changes in Capital Controls, 2000–2010; Real GDP in Emerging Market Countries Excluding China and India, 1990–2011; Stylized Representation of a Broad Liberalization Plan; Financial Openness of IMF Members, 2010.
- Boxes: The Concept of Full Liberalization of Capital Flows; Suggested Policy Framework for Liberalizing Capital Flows; Capital Flow Liberalization in Korea; Liberalization and its Aftermath in Central and Eastern European Countries; Liberalization of Capital Flows in China and India—The Authorities’ View; Capital Outflows—Underlying Factors and Potential Policy Responses; Suggested Policy Framework for Managing Capital Outflows.
- Annexes: Regulatory Framework for Capital Transactions in China and India.
- Glossary acronyms listed include AREAER, BIS, CEE, CFM, EMDC, EME, EU, FDI, FII, IEO, IMFC, NRI, OECD, QDII, QFII.

*Source: _031312 - References (sections and excerpts as provided) *

### 12.      Liberalization played a role in increased flows, although perhaps a modest one.

### 12. Liberalization played a role in increased flows, although perhaps a modest one.

### De facto and de jure openness: patterns and recent dynamics
- De facto measures of openness indicate significant liberalization only for advanced economies and emerging Europe (Figure 1).
- De facto openness declined for emerging markets and developing countries (EMDCs) in Africa and the Middle East (for the latter, especially after 2007).
- De facto openness remained broadly unchanged for EMDCs in Asia and the Western Hemisphere.
- Flows were volatile, increasing during 2003–07 before contracting sharply in the aftermath of the global financial crisis.
- De jure measures of restrictiveness indicate only modest liberalization globally over the past decade.
  - On a de jure basis, 93 out of 185 countries were largely open, and 62 were largely closed in 2010 (Figure 2).
  - By comparison, in the mid-1990s, 78 out of 184 countries were largely open, and 65 were largely closed.
- Among country-income groups:
  - Some modest liberalization occurred across all income groups until the mid-2000s, with low and middle income countries liberalizing the most.
  - This modest liberalization has been partially reversed following the onset of the global crisis (Figure 3).
  - Some upper middle and high income EMEs introduced controls on financial instruments and credit operations.
  - An increasing number of countries have begun to regulate foreign investment by institutional investors.
- By region, de jure openness increased significantly only for EMDCs in Europe.

### Changes in policy measures since 2000
- With the onset of the global crisis, the pace of both tightening and easing measures has picked up (Figure 4).
  - The tightening and easing measure differs from the restrictiveness index: it shows the number of regulatory changes countries introduced to ease or tighten restrictions on capital transactions in a year.
- Over the entire period since 2000, tightening measures were concentrated in emerging middle-income countries, primarily reflecting concerns about the effect of more volatile capital flows on financial stability.
  - Some countries imposed broad based controls that affected all portfolio investment and financial credit (Brazil, Colombia).
  - Others implemented more selective controls (Croatia, Indonesia, Thailand).
- Easing measures (Croatia, India, Malaysia) were taken to help ease domestic liquidity conditions, mainly by reducing controls on cross border credit.

### Benefits and costs of liberalizing capital flows
- Theoretical benefits (perfect markets, full information, no externalities):
  - Improves resource allocation by facilitating investment in capital-scarce countries.
  - Promotes risk diversification, reduces financing costs, generates competitive gains from entry of foreign investors, and accelerates development of domestic financial systems.
- Empirical evidence is mixed; benefits depend on country thresholds and characteristics:
  - About an equal number of studies find a significant effect of liberalization on growth as find no such effect (see Background Paper, Section I and II).
  - A new literature on the welfare theory of capital controls argues that full capital mobility may not be desirable under certain circumstances.
  - Lack of consensus reflects differences in sample coverage and estimation methodology.
- Longer-term growth evidence:
  - Over the longer term, more open EMEs have tended to grow relatively faster, although the evidence is not conclusive.
  - When China and India are excluded, on average open economies have grown faster over the last two decades, regardless of which index of openness to capital flows is used (Figure 5).
  - When China and India are included, average growth rates are not higher for more open economies, although median growth rates remain higher.
- Principal costs:
  - Vulnerability to financial crises triggered by sudden stops in capital flows, and from currency and maturity mismatches.
  - Systemic risk-taking can increase investment and growth but also the incidence of crises.
  - Many empirical studies show a strong association between surges in capital inflows (and their composition) and likelihood of debt, banking, and currency crises in emerging market countries.
  - Other studies find the relationship hinges on financial sector development, institutional quality, macroeconomic policy, and trade openness.

### Experience during the global financial crisis and heterogeneity across countries
- During the global financial crisis, EMEs with significant cross-border bank flows and pre-crisis inflow surges suffered larger output losses.
  - De facto measures of openness (primarily bank-intermediated flows) were significant predictors of growth declines, as were banks’ pre-crisis leverage and credit growth.
  - EMEs with greater restrictions on capital inflows (especially on debt liabilities) fared better during the recent global crisis (Ostry and others, 2010; Ostry and others, 2011).
  - Among EMEs that experienced earlier crises, those with higher economy-wide capital inflow restrictions in pre-crisis years experienced smaller growth declines when crises occurred (Ostry and others, 2011).
  - Further work is needed to assess how differences in prudential policies would affect these results.
- Low-income countries:
  - Benefits of capital flows arise mainly from foreign direct investment (FDI), which has helped boost investment, employment, and growth.
  - Low-income countries generally need to strengthen institutions and markets to safely absorb most other types of capital flows; FDI liberalization should typically come first, with other flows liberalized later based on institutional and market development (as was done in Moldova).

### Measurement notes and definitions
- De facto openness is measured as Bank for International Settlements (BIS) foreign claims over GDP and assets plus liabilities over GDP.
- De jure openness is measured using the Chinn-Ito index (similar results obtained using staff’s narrow restrictiveness index, which comprises controls on 21 types of capital transactions).
- “Largely open” means a de jure restrictiveness index smaller than or equal to 0.33, and “largely closed” an index greater than or equal to 0.67 based on staff’s narrow restrictiveness index.
- Data for 2005 onward are affected by methodological changes implemented in 2005 that harmonized the AREAER capital control entries and the OECD Code of Liberalization of Capital Movements.
- After 2007, the Milesi-Ferretti index is not adjusted for valuation, and may thus overstate the decline in openness following the crisis.

### Proposed IMF policy framework and guidance
- The Fund does not currently have a Board-endorsed framework for the liberalization of capital flows. Past staff advice relied heavily on the “integrated approach” (informal Board seminar, 2001), which was never formally adopted.
- This paper proposes endorsement of an updated version of the integrated approach as the basis for Fund policy advice on liberalization of capital flows (Box 2).
- Core features of the integrated approach (as retained and emphasized):
  - Sets liberalization of capital flows within the broader context of macroeconomic and financial system stability.
  - Removal of controls on cross-border capital movements should be properly timed and sequenced with other policies, notably macroeconomic and financial sector prudential policies.
  - Views capital flow liberalization and financial sector development as mutually supportive; recognizes broad linkage between domestic and cross-border financial liberalization.
  - Extent and pace of liberalization should be such that the economy and financial sector can handle resulting flows without undue risk.
  - Path and extent of liberalization must be tailored to each country’s circumstances and interests; some countries can liberalize quickly (the “big bang” approach), while many require slower liberalization.
  - The approach does not set a timetable for achieving full liberalization and recognizes that the appropriate degree of liberalization can differ across countries based on financial sector and institutional development.
- Modifications to the integrated approach:
  - Recent research and global developments suggest no certainty that full liberalization is appropriate for all countries at all times; a more cautious approach to liberalization is warranted.
  - Increased financial linkages, larger and more volatile capital flows, and the growing role of large internationally active complex financial groups heighten financial stability and macroeconomic risks.
  - Pace of liberalization needs to consider the capacity of the economy and financial system to safely handle capital flows.
  - Structural policies to develop the financial system, along with macroprudential policies to strengthen resilience to capital flow volatility, are important complements.
  - For low income economies, an initial focus on liberalizing FDI is recommended, with other flows liberalized later contingent on institutional and market development (example: Moldova).

*Source: IMF chapter section titled "12. Liberalization played a role in increased flows, although perhaps a modest one."*

### Box 2. Suggested Policy Framework for Liberalizing Capital Flows

### Box 2. Suggested Policy Framework for Liberalizing Capital Flows

### General principles
- 1. The appropriate degree of liberalization for a country would depend on its specific circumstances, notably on whether it has reached certain thresholds with respect to financial and institutional development.
- 2. There is no expectation that full liberalization is an appropriate goal for all countries at all times. Nonetheless, countries with extensive restrictions on capital movements are likely to benefit from further liberalization, in an orderly manner.
- 3. Liberalization should proceed in accordance with the staff’s integrated approach, modified to take account of recent research and experience:
  - A cautious approach to liberalization is warranted in view of the lessons learned from the global crisis:
  - Under certain circumstances, CFMs (including capital controls) may need to be reimposed as part of an overall process of liberalization.
  - Liberalization needs to consider CFMs more broadly, and not just capital controls.
  - Greater attention needs to be paid to the multilateral effects of policies, including liberalization of capital flows and changes in prudential measures.
  - Experience also suggests that a number of technical modifications are warranted to the sequence in which certain transactions are liberalized.

### Outline of the integrated approach
- The integrated approach establishes the following 10 principles to guide the liberalization process:
  - (1) lifting controls on international capital flows (and financial liberalization more generally) is best undertaken against a background of sound and sustainable macroeconomic policies;
  - (2) financial sector reforms that support and reinforce macroeconomic stabilization should be given priority;
  - (3) financial sector reforms that are operationally linked and mutually reinforcing should be implemented together;
  - (4) prudential regulation and supervision and financial restructuring policies should be implemented to complement other financial reforms aimed at enhancing competitive efficiency and market development;
  - (5) the liberalization of capital flows by instruments or sectors should be sequenced to take into account the concomitant risks;
  - (6) the pace of reforms should take into account the conditions relating to the financial structure of nonfinancial corporations and other entities (for example, debt-equity ratios and foreign currency exposure) and their effects on the quality of the loan portfolios and capital base of financial institutions;
  - (7) reforms that require substantial lead time for technical preparations and capacity building should be started early;
  - (8) reforms need to take account of the effectiveness of existing capital controls;
  - (9) the pace, timing, and sequencing of liberalization need to take account of political and regional considerations; and
  - (10) the operational and institutional arrangements for policy transparency and data disclosure—including monetary and financial policy transparency—need to be adapted to support capital account opening.
- Sequencing needs to be based on individual country circumstances, including:
  - macroeconomic and financial sector vulnerabilities;
  - the degree of development of institutions and markets;
  - the design and effectiveness of existing controls;
  - the ability of the financial and nonfinancial sector to deal with large and volatile capital flows and to manage the risks related to international capital flows and increased exchange rate flexibility;
  - the authorities’ capacity to efficiently administer and enforce controls.

### Three stages of liberalization (stylized plan)
- The integrated approach provides for three stages of the liberalization of capital flows:
  - Stage I:
    - Liberalize FDI inflows (FDI inflows considered more stable and growth‑contributing).
    - Lay groundwork: introduce international accounting standards and improve national statistics.
    - Strengthen monetary framework and financial sector regulation.
  - Stage II:
    - Liberalize FDI outflow and long-term portfolio flows.
    - Liberalize some short-term flows.
  - Stage III:
    - Eliminate all remaining controls after developing financial markets and further strengthening the financial sector by implementing adequate prudential regulations and supervision to ensure proper risk management of international capital flows.

### Reimposition of CFMs, cautious liberalization, and multilateral effects
- Under certain circumstances, CFMs (including capital controls) may need to be reimposed as part of an overall process of liberalization; for example, when a country faces a capital inflow surge it may be appropriate to temporarily reimpose or tighten CFMs on inflows.
- Cautions about reimposition:
  - Preferable to liberalize cautiously rather than reverse the process; an “on-off” policy can create moral hazard and undermine market discipline.
  - Reimposition of CFMs can adversely affect investor confidence for a considerable time.
  - Temporary CFMs on outflows may be needed in a crisis.
  - If liberalization proceeds too quickly and outstrips capacity to handle resulting flows, a limited and temporary reversal may be warranted.
- Greater attention should be paid to the multilateral effects of capital flow policies, including:
  - relaxation of restrictions by large EMEs could result in a substantial increase in gross capital flows as portfolios are adjusted;
  - prudential frameworks and their interactions across countries can have large effects on capital flows;
  - national and international regulatory and supervisory reforms should be urgently completed and fully implemented, and new prudential frameworks developed to mitigate cross-border risks.

### Technical modifications to sequencing of transactions
- Key technical lessons on sequencing:
  - While CFMs affecting long-term transactions should normally be removed earlier, some short-term transactions may need to be liberalized ahead of long-term transactions (for example, short-term trade-related bank transactions). About two-third of the countries that restrict FDI inflows liberalized transactions related to banks’ accounts abroad.
  - Removing CFMs in particular sectors should consider effects on other sectors and the broader economy. Cross-border banking transactions need to be liberalized no later than when the nonfinancial sector is allowed to borrow abroad to avoid disintermediation.
  - Deposit interest rates should be liberalized before corresponding outflow controls.
  - Liberalization of capital outflows can help deal with capital inflow surges (examples: Korea, the Philippines, and Thailand), but CFMs on outflows should be removed only if conditions such as adequate prudential regulation and supervision are present.
  - Transactions with similar economic content and maturity should be liberalized together to avoid regulatory arbitrage and minimize distortions (examples: Chile, Malta, Slovak Republic).

### Applying the integrated approach — country experiences
- Overview:
  - Most countries only partly followed the integrated approach, contributing to adverse outcomes in some cases.
  - Sequencing the lifting of capital controls is necessary but not sufficient; lifting controls must be fully and durably supported by financial sector and macroeconomic policies.
- Positive experiences:
  - Countries that mirrored the integrated approach generally avoided financial crises during or after liberalization, liberalizing against a background of sustained sound macroeconomic policies and a stable financial system (example: Korea).
  - Other examples of different successful approaches: gradual removal in line with sectoral capacity (Austria); rapid liberalization paired with continuous prudential upgrades in a strong financial system (United Kingdom); South Africa removed controls on inflows before outflows and lifted residents’ investment restrictions gradually to safeguard reserves and maintain banking stability.
- Adverse experiences:
  - Some countries experienced crises during or after liberalization owing to inconsistent macroeconomic or financial sector policies (examples: CEE countries; Mexico’s 1994 crisis linked to macroeconomic imbalances, tightly managed exchange rate, rapid credit growth fueled by short-term external borrowing, and gaps in financial supervision; Turkey’s 1994 and 2000–01 crises linked to excessive risk taking by a financial sector dominated by large state-owned banks combined with inconsistent macroeconomic and exchange rate policies).
- Sequencing of liberalization — observed practices:
  - Liberalization of short-term transactions has typically followed or accompanied that on long-term transactions (examples: Russia, Slovenia).
  - Countries have often liberalized all types of portfolio transactions simultaneously (equities, bonds, money market instruments, and collective investment securities) recognizing interchangeability (examples: Chile, Cyprus).
  - Practices vary on the sequence of lifting controls on FDI and portfolio investments; about half of the countries liberalized FDI earlier than portfolio investments, while the other half did the opposite.
  - Controls on inward real estate transactions are often maintained after other transactions have been liberalized (examples: Mexico, Switzerland, United States).
  - Liberalization often entailed gradually increasing ceilings on investments (examples: India, Kazakhstan, Philippines, South Africa), reducing administrative burdens (e.g., prior approval to registration/notification — Cyprus, Korea, Moldova), and expanding instruments or sectors open for investment (example: India).
  - Countries have sometimes liberalized by type of investor, removing controls on legal entities earlier than on other investors (examples: Moldova, Thailand) or on specific investor categories (examples: China, India).
  - Capital outflows usually remain controlled for longer than inflows, possibly to avoid capital flight.

### Country vignettes
- Korea:
  - Korea’s liberalization over the past decade or so corresponds in key respects with the integrated approach: sound and stable macroeconomic policies, appropriate sequencing of financial sector reforms, and high degree of financial integration achieved relatively smoothly despite bouts of capital flow surges.
  - During the run-up to the global financial crisis, Korean banks took on substantial foreign-currency-denominated short-term debt and experienced rollover difficulties when the crisis broke; in 2010–11 the authorities introduced measures to limit excessive risk taking in the banking sector.
- Central and Eastern Europe (CEE):
  - The experience of many CEE countries shows the need for liberalization to be fully and durably supported by financial stability policies.
  - Many CEE countries sequenced liberalization with financial sector reform and macroeconomic stabilization and had lifted controls by the middle of the past decade, but subsequently experienced rapid credit growth fueled by large capital inflows that culminated in financial sector instability during the global crisis.
  - The financial instability largely stemmed from prudential regulation and supervision not keeping up with inflow challenges and reflected liquidity and regulatory conditions in source countries.

*Box 2. Suggested Policy Framework for Liberalizing Capital Flows — source text.*

### Box 3. Capital Flow Liberalization in Korea

### Box 3. Capital Flow Liberalization in Korea

### Overview and strategy
- Over the past decade or so, the Korean authorities have significantly liberalized capital flows.
- Their approach corresponded to the integrated approach in several respects.
- The authorities recently introduced measures to reduce vulnerabilities in the banking sector.
- Starting in the early 1990s, the Korean authorities gradually eliminated many controls on capital transactions with a view to achieving a degree of openness associated with upper middle income OECD countries.

### How Korea’s liberalization matched the integrated approach
- Liberalization proceeded generally against a background of broadly sound, sustainable, and consistent macroeconomic policies (principle 1).
  - Examples: generally prudent fiscal policy; the introduction of a flexible exchange rate regime; and monetary policy that delivered stable prices.
- Priority given to financial sector reforms that supported and reinforced macroeconomic stabilization (principle 2).
  - Example: promotion of development of domestic currency funding sources, resulting in a deep and active corporate bond market.
- Financial market development proceeded through operationally linked and mutually reinforcing financial sector reforms (principle 3).
  - Examples: strengthened disclosure requirements to enhance transparency of the foreign exchange market; strengthening of accounting standards.
- Financial sector regulation was strengthened in preparation for, and during, capital flow liberalization (principle 4).
  - Example: strict liquidity requirements were put into place in the context of implementing Basel II rules.
- Less risky flows were liberalized before more risky ones (principle 5).
  - Example: gradual easing of controls that generally liberalized longer-term transactions such as FDI (except for certain sectors) or certain portfolio investments first.

### Outcomes and vulnerabilities
- The approach allowed Korea to achieve a smooth overall transition to increased financial integration, despite occasional capital inflow and outflow surges.
- Nevertheless, in the years leading up to the recent global financial crisis:
  - The banking system accumulated substantial foreign exchange forward positions and short-term external debt in the wholesale market.
  - The banking system became highly leveraged.
  - When the crisis hit, Korea experienced a sharp “sudden stop” as access to short-term external debt financing abruptly ended and banks experienced difficulty rolling over debt.

### Policy response after the crisis
- Having learned from this experience, starting in 2010 the authorities introduced measures to avoid a renewed buildup of financial sector vulnerabilities and limit the associated potential for macroeconomic volatility (see Section V of the Background Paper for detail).

*Source: Box 3. Capital Flow Liberalization in Korea*

### 44.      At the same time, an increased exposure to capital flows carries substantial risks

### _031312 - 44.      At the same time, an increased exposure to capital flows carries substantial risks

### Risks from increased exposure to capital flows (China focus)
- Capital flow liberalization carries substantial risks for China given the prevailing exchange regime and financial system.
- Identified risks:
  - Asset bubbles.
  - Capital flight.
  - Currency and maturity mismatches in bank and corporate balance sheets.
- Historical precedent: liberalizing capital flows while maintaining a relatively fixed exchange rate regime contributed to crises in:
  - Mexico (1994–95).
  - Asia, Brazil, and Russia (1997–98).
- By contrast, emerging economies with more flexible exchange regimes have generally fared better under external pressures: Chile, Peru, South Africa.

### Sequencing and supporting reforms for China
- Capital flow liberalization needs to be sequenced with measures to address gaps in financial sector supervision and domestic capital market distortions.
- Policy and institutional reforms recommended to accompany liberalization:
  - Move to a monetary policy that is more independent and more reliant on interest rates than administrative measures.
  - Stronger supervisory and regulatory frameworks.
  - A broader range of financing and saving vehicles.
  - Deeper and more liquid financial markets.
  - Liberalized loan and deposit interest rates.
  - Greater exchange rate flexibility.
- Benefits of exchange rate flexibility cited:
  - Better preparation to deal with the impact of increased capital flows.
  - Improved macroeconomic control by reducing ongoing liquidity injections associated with capital and current account surpluses.
  - Reduced vulnerabilities to shocks.
  - Help address external imbalances.
  - Stronger incentives for developing the foreign exchange market and for currency risk management by banks and corporates.
- Internationalization path:
  - With supporting reforms, China could liberalize capital flows, fully internationalize the renminbi, and move the currency toward being “freely usable.”
  - Early stages should focus on removing remaining restrictions on more stable, long-term sources of financing such as direct investment flows (both inward and outward).
  - Existing initiatives: Qualified Foreign- and Qualified Domestic Institutional Investor (QFII and QDII) could be useful, with quotas steadily expanded and judiciously targeted at particular asset classes; eventually quotas would become nonbinding and could be removed.

### India: benefits, risks, and sequencing
- Principal benefits of liberalization for India:
  - Greater access to foreign capital, including specialized financing for substantial infrastructure investment needs.
  - Improved risk diversification.
  - Positive effects on infrastructure investment that can spur growth.
  - Foreign investment in fixed income instruments would help develop government and corporate bond markets and provide additional long-term financing for infrastructure.
  - Greater foreign funding and specialized financing (e.g., take-out financing and credit enhancements) could reduce reliance on domestic banks and lower asset/liability mismatches and concentration risks on banks’ balance sheets.
  - Shifting large-project financing to capital markets could free banks to focus on small and medium enterprise and household lending, enhancing access to credit and financial inclusion.
- Risks for India:
  - Risks exacerbated by high fiscal deficits and economic distortions.
  - Increased foreign participation in the government bond market could:
    - Provide an additional source of financing for the budget.
    - Raise the risk of pro-cyclical fiscal policy.
    - Increase the volatility of bond yields.
  - Faster opening to debt flows could lead to greater transmission of financial volatility from international markets.
- Sequencing strategy emphasized by authorities:
  - Liberalize FDI flows first (no major distinction between inflows and outflows), then equity, and finally debt flows.
  - Long-term flows are being liberalized ahead of short-term flows.
  - In practice, FDI has been liberalized over time, but significant restrictions remain (only 10 sectors are prohibited).
  - Examples of remaining constraints: caps such as the one on insurance are low; some sectors (e.g., multi-brand retail) remain restricted.
- Debt market specifics and quantitative limits:
  - FII debt limits on corporate and infrastructure bonds have been increased substantially in recent years to US$45 billion in total, but these limits have had low utilization owing to low bond liquidity.
  - The smaller FII limit on government bonds is US$15 billion and is more fully utilized.
- Policy trade-offs and preconditions:
  - As fiscal consolidation advances, FII debt limits can increase faster.
  - Liberalization must weigh benefits to investment and market development against possible increases in asset price and interest rate volatility and impacts on fiscal incentives.
  - Liberalization should be accompanied by policies to bolster the banking system and financial markets:
    - Liberalize deposit rates and introduce new financial instruments.
    - Encourage exchange rate flexibility to act as a buffer to external shocks and to foster foreign exchange hedging instruments and a more transparent monetary policy framework.
    - Strengthen fiscal discipline to minimize risks and promote capital market development.
    - Relax financial restrictions on domestic institutional investors as fiscal consolidation proceeds, enabling greater foreign asset holdings and contributions to capital market development.

### Managing capital outflows: scope and concerns
- Large capital outflow surges can cause financial system stress and large output losses.
- Outflow surges drivers:
  - Domestic developments.
  - Global factors outside individual countries’ control: changes in global risk perception, liquidity, interest rates, and the outlook for global growth.
  - Contagion via trade and financial linkages.
- Definition note: capital outflows include residents’ investments and transfers abroad as well as the alienation and repatriation of nonresidents’ foreign currency investments in the country.

### Use and effectiveness of capital outflow controls (CFMs/capital controls)
- Historical tightening of outflow controls over the past decade was uncommon; notable cases include:
  - Argentina (2001–02).
  - Iceland (2008).
  - Ukraine (2008).
- Main causes of outflow surges in these cases:
  - Argentina: unsustainable macroeconomic policies triggering a currency crisis.
  - Iceland: collapse of an overgrown banking sector in the early stages of the global financial crisis.
  - Ukraine: full-fledged banking and currency crisis deepened by weak macroeconomic management.
- Evidence on effectiveness:
  - Relatively little academic research; mainly case studies.
  - A recent survey (Magud, Reinhart, and Rogoff, 2011) finds only weak evidence for effectiveness of outflow controls, except possibly Malaysia in 1998.
  - A staff analysis of 31 EMEs during 1995–2010:
    - In the subset of countries with better-than-median macroeconomic conditions, tightening outflow controls increased net inflows for one year and allowed policymakers to reduce interest rates somewhat without accepting exchange rate depreciation.
    - In the full sample of 31 countries, the effectiveness of outflow controls could not be confirmed.
  - Quantitative research (Binici and others, 2010) concludes outflow controls are somewhat effective and more effective in advanced economies than in other countries; attributed partly to higher institutional and regulatory quality in advanced economies.
- Conditions for potential effectiveness:
  - Controls need to be supported by coherent macroeconomic policies and favorable fundamentals.
  - In cases with inconsistent macroeconomic policies and conditions (e.g., Argentina 2001–02; Ukraine 2008), outflow controls will not make a lasting difference.
  - Well-designed and enforced controls, reinforced as needed and part of comprehensive macroeconomic adjustment (as in Iceland in 2008), can be effective for longer periods.

### Policy approach for managing capital outflows
- The section outlines an approach to guide the use of CFMs on outflows, focusing on countries that have liberalized capital flows fully or considerably and may need to reimpose CFMs for crisis prevention or management.
- The proposed policy framework for managing outflows can also apply to countries that still maintain a high degree of restrictions on capital flows.
- Recognized premise: in some instances, macroeconomic policies alone will not be sufficient in the short run, and the use of CFMs may be necessary.

*Source: _031312 - 44.      At the same time, an increased exposure to capital flows carries substantial risks*

### 58.      Once a country has substantially liberalized capital flows, a certain degree of

### _031312 - 58.      Once a country has substantially liberalized capital flows, a certain degree of

### Overview
- Once a country has substantially liberalized capital flows, a certain degree of capital outflow volatility is normal and does not in and of itself call for the use of CFMs.
- Outflows should primarily be managed using appropriate macroeconomic, structural, and financial sector policies.
- CFMs on inflows can be used as a crisis prevention measure during inflow surges in a manner consistent with the Fund’s framework for capital inflows.

### When CFMs on outflows can be considered
- CFMs on capital outflows can be considered in crisis or near crisis conditions to help prevent:
  - free fall of the exchange rate, and
  - depletion of international reserves.
- CFMs may be necessary when domestic or external shocks cannot be handled by macroeconomic adjustment or financial sector policies alone, or when the size or duration of shocks are highly uncertain.
- CFMs should always be part of a broader policy package that includes macroeconomic, financial sector, and structural adjustment; CFMs can provide breathing space while other policies are implemented.

### Effectiveness and limitations of CFMs on outflows
- The effectiveness of CFMs on outflows can erode quickly unless supported by credible macroeconomic and financial sector policies.
- It is often necessary to periodically reinforce CFMs to close loopholes.
- A judgment must be made whether the benefits outweigh distortions; factors include:
  - longer-term effects on investor expectations, and
  - the amount of time that CFMs will buy before being eroded.
- Widespread adoption of CFMs on outflows may have multilateral effects similar to those of CFMs on inflows, including on the distribution of flows across countries and on the global investment climate; temporary and limited use reduces likely multilateral effects.

### Design and duration principles
- CFMs on outflows adopted in a crisis will often need to be comprehensive, but they should be temporary and lifted as soon as conditions are met or the measures become ineffective.
- General conditions for lifting CFMs:
  - (i) macroeconomic stability (especially exchange rate and debt sustainability);
  - (ii) confidence in domestic assets;
  - (iii) access to international capital markets;
  - (iv) financial system stability;
  - (v) adequate reserves.
- CFMs should be removed if they become ineffective or when distortions outweigh benefits.
- Give precedence to measures that do not discriminate on the basis of residency, for example measures that discriminate on the basis of currency.
- In designing CFMs, consider country-specific circumstances (administrative/regulatory capacity, preexisting degree of openness). CFMs should be commensurate to the concern; often tax-like measures may be sufficient.

### Types of CFMs on outflows (examples)
- Residency-based CFMs:
  - limits on residents’ investments in financial instruments abroad (Iceland);
  - waiting periods for nonresidents to transfer proceeds from domestic securities (Ukraine);
  - minimum holding periods (Chile);
  - taxes on transfer of proceeds (Malaysia).
- Non-residency-based CFMs:
  - prohibitions on conversion and transfer of domestic currency assets (Iceland);
  - limits on deposit withdrawals (Argentina).
- Restrictions on nonresidents’ access to funding in local currency can be used to make currency speculation more difficult.

### Box 6 — Underlying factors driving capital outflows and policy responses
- External shock:
  - Allow exchange rate to depreciate to new equilibrium; intervene to prevent overshooting; defend a credible peg if shock is temporary and reserves are sufficient; consider discrete devaluation otherwise.
- Inconsistent macroeconomic policies:
  - Implement macroeconomic adjustment; CFMs on outflows can be temporary breathing space.
- Financial fragility:
  - Strengthen prudential regulation and supervision, improve deposit guarantees, provide liquidity support; CFMs can provide time for these measures.
- Global conditions:
  - If outflows reflect increased risk aversion or tighter monetary conditions abroad and are temporary, adjust macroeconomic policy mix (e.g., allow exchange rate depreciation, increase policy rates while easing the fiscal stance).

### Box 7 — Suggested policy framework for managing capital outflows (policy recommendations)
- Manage capital outflows primarily with macroeconomic and financial sector policies.
- Use CFMs on inflows as preventive measures to mitigate reversals of inflows, consistent with the Fund’s policy framework for capital inflows.
- Implement structural policies and macroprudential measures as crisis prevention to increase resilience of financial, corporate, and household sectors.
- Consider CFMs on outflows (i) in crisis or near crisis conditions; and (ii) to provide breathing space while more fundamental policy adjustment is implemented.
- Prefer non-residency-discriminatory measures (e.g., currency-based measures).
- Design CFMs taking into account administrative/regulatory capacity and preexisting openness; ensure measures are commensurate to the concern.
- Keep CFMs temporary and lift when removal conditions are met.
- Account for multilateral effects of CFMs on outflows.

### Country case highlights and key statistics from Table 1 (selected figures preserved exactly)
- Argentina 2001–02:
  - peso devalued by 40 percent in early 2002; imposed Corralito and restrictions on transfers and loans in foreign currency; foreign currency deposits converted into domestic currency deposits at a specific exchange rate; freeze on bank deposits in 2002.
- Iceland 2008:
  - very large short-term liabilities to foreign investors: 600 percent of GDP;
  - krona depreciated about 30 percent between December 2007 and March 2008;
  - net foreign asset position: -112 percent of GDP in 2007 to -629 percent in 2010;
  - controls prevented conversion of krona assets to foreign currency upon maturity; about ISK 600 billion kept in Iceland initially.
- Latvia 2008–09:
  - output declined almost 25 percent cumulatively between 2008 and 2009;
  - Parex Banka had a market share of about 20 percent; government took a 51 percent stake in October 2008 (later increased to 85 percent); partial deposit withdrawal restrictions expired at end-2011.
- Malaysia 1998:
  - September 1998 measures: limits on offshore swap operations, ban on short-selling, repatriation of ringgit held offshore, 12-month waiting period for nonresidents to sell profits from Malaysian securities (later replaced by a tax then phased out within a year).
- Russia 1998:
  - exchange rate depreciated by about 50 percent in September 1998; inflation rose to 40 percent; capital outflows in second half of 1998 reached about US$17 billion.
- Russia 2008:
  - outflows reached US$130 billion (or 8 percent of annual GDP) in the fourth quarter of 2008;
  - ruble depreciated by about 30 percent against the euro-dollar currency basket (and 15 percent in real effective terms) during December 2008–January 2009;
  - authorities did not use capital controls; relied on large-scale foreign exchange interventions and massive liquidity support to banks.
- Turkey 2001:
  - inflation 70 percent in 2001; fiscal deficit reached 17 percent of GDP; public debt in excess of 90 percent; capital outflows amounted to about US$70 billion; exchange rate depreciated as much as 50 percent.
- Ukraine 2008:
  - inflows averaged 7 percent of GDP in the four quarters leading up to the peak; outflows were 13 percent of GDP in the following four quarters;
  - hryvnia depreciated by some 35 percent in late-2008;
  - regulatory measures included revision of banks’ open foreign exchange position methodology, limits on early withdrawal of time deposits, ban on foreign exchange forward transactions, and mandatory five-day waiting period before local currency can be converted to foreign exchange for investment transactions.
- Uruguay 2002:
  - by mid-2002 about 35 percent of deposits had been withdrawn; peg abandoned and Uruguayan peso depreciated by about 25 percent; five-day bank holiday declared.

### Issues for discussion (as posed in the source)
- Do Directors agree that the modified integrated approach provides a suitable framework for policy advice on liberalizing capital flows (Box 2 and paragraphs 21-29)?
- Do Directors support extending the definition of CFMs to include measures designed to affect capital outflows?
- Do Directors support the proposed framework for managing capital outflows (Box 7 and paragraphs 58-64)?

*Source: IMF content unit _031312 - 58. Once a country has substantially liberalized capital flows, a certain degree of (PDF chapter/section).*

### Chapter IX of Background Paper for People’s Republic of China: Spillover Report for

### Chapter IX of Background Paper for People’s Republic of China: Spillover Report for

### Annex 1. Regulatory Framework for Capital Transactions in China and India — Overview
- This annex compares regulatory rules across key capital transaction types between China and India, preserving the original categorizations and numeric limits.

### FDI (Foreign Direct Investment)
- China:
  - Only foreign investors in good standing 1/ may invest in excess of 10 percent of the company’s shares up to the limits determined for the specific sector.
  - A three-year mandatory holding period applies for those foreign strategic investors.
  - Outflow: Companies may purchase and transfer foreign exchange for outward FDI subject to registration only and they can also use renminbi in countries that accept such settlement.
- India:
  - FDI is allowed under two routes: automatic route and government approval route.
  - In several sectors, investment up to 100 percent is allowed, while a few other sectors have sector-specific caps and guidelines.
  - There are 10 sectors in which FDI is prohibited.
  - Outflow: Indian companies and registered partnerships may invest up to 400 percent of their net worth without approval. The ceiling, however, is not applicable where the investment is made out of balances held in Exchange Earners' Foreign Currency account or out of funds raised through ADRs/GDRs. Lower limits and additional conditions apply to unregistered partnership and proprietorship firms.

### Portfolio Equity Investments
- China:
  - Inflow: Only QFIIs 2/ may invest in “A” shares. Investments are subject to caps on foreign ownership in Chinese listed companies (10 percent of the shares of the company for a single foreign investor 20 percent for all foreign investors).
  - Every QFII has its own quota limit to invest in domestic securities.
  - A mandatory principal lock-in period of 3 months or 1 year applies depending on the type of QFII.
  - Other transfers, such as principal injections, repatriations and remitting revenues, are subject to State Administration of Foreign Exchange approval.
  - Foreign investors, including institutions and individuals, can also invest in “B” shares subject to foreign exchange management requirements.
  - Outflow: Only QDIIs 3/ may invest in equities abroad within their respective purchase and foreign exchange quotas and regulatory limits.
- India:
  - Inflow: Registered FIIs, such as pension funds, mutual funds, investment trusts, university funds, endowments, charitable trusts, and charitable societies are allowed to invest in equity.
  - The ceiling for overall investment for FIIs is 24 percent of the paid up capital of the Indian company, which can be raised up to the sectoral cap/statutory ceiling, subject to the approval of the board and the general body of the company passing a special resolution to that effect.
  - The limit is 20 percent of the paid up capital in the case of public sector banks.
  - Nonresident Indians (NRIs), and Persons of Indian Origin (PIOs) are also allowed to invest in equity with a limit of 10 percent of the paid up capital of the Indian company, which can be raised to 24 percent subject to the approval of the general body of the company passing a resolution to that effect.
  - Holders of Overseas Citizenship of India certificates have the same rights to invest in India as NRIs (except to invest in agricultural land or plantations).
  - The ceiling for FIIs is independent of the ceiling for NRIs/PIOs. However, there is no overall limit on such investments.
  - Outflow: The overall limit on residents’ investments in companies listed abroad is US$200,000 a year. Resident corporations may invest up to 50 percent of their net worth in shares of listed companies abroad.
  - Indian Mutual Funds are permitted to invest within an overall cap of US$ 7 billion.

### Portfolio Bond Investments
- China:
  - Inflow: Only QFIIs may invest in those bonds and similar securities traded on stock exchanges.
  - Foreign banks engaged in cross-border trade settlements in renminbi, Hong Kong SAR, and Macao SAR renminbi clearing banks, and foreign central banks and monetary authorities may invest in the inter-bank bond market with renminbi subject to limits, but there is no minimum holding period.
  - Outflow: QDIIs’ investments are subject to overall ceilings and regulatory limits on the type of security.
- India:
  - Inflow: Registered FIIs may invest in debt securities issued by Indian corporates with an overall limit of US$20 billion, with an additional limit of US$25 billion in infrastructure bonds and a US$15 billion limit on government securities.
  - Infrastructure bonds are subject to mandatory holding periods. Different limits apply to NRIs.
  - Outflow: Only resident individuals may invest in debt securities abroad subject to a yearly limit of US$200,000.

### Investments in the Money Market
- China:
  - Inflow: Only QFIIs may invest in money market funds subject to their prescribed minimum lock-in periods and limits, depending on the type of QFII (see “Portfolio Equity Investment” above).
  - Additionally, Hong Kong SAR, and Macao SAR renminbi clearing banks, and foreign central banks and monetary authorities may invest with renminbi in the money market subject to limits, but there is no minimum holding period.
  - Outflow: Only QDIIs may invest in money market instruments within their respective foreign exchange quotas and regulatory limits.
- India:
  - Inflow: Only NRIs may invest in money market mutual funds.
  - Outflow: Residents may purchase these instruments abroad without Reserve Bank of India approval according to the prescribed norms.

### Derivatives
- China:
  - Inflow: These transactions are not allowed.
  - Outflow: These transactions are generally subject to approval and limits.
- India:
  - Inflow: These transactions are generally subject to limits and approval. Hedging of nonresidents’ investments in India is allowed.
  - Outflow: Commercial banks may purchase such instruments for their own asset and liability management. Resident companies may use derivatives to hedge commodity price and foreign exchange debt exposures.

### Loans / External Borrowing
- China:
  - Inflow: Short-term borrowing is subject to individual limits. Borrowing for maturities in excess of one year is subject to approval.
  - Loans to enterprises with foreign participation are limited to the difference between total investment and registered capital. All loans must be registered.
  - Rules vary by sector and instrument; banks that attach derivatives to these loans (either buying or selling them) that are issued abroad would come under the jurisdiction of the relevant authorities.
  - Outflow: Lending abroad is generally subject to approval. Banks may lend abroad in accordance with banking regulations, as well as other relevant regulations such as compliance with rules governing derivatives transactions.
- India:
  - Inflow: External commercial borrowing is allowed through automatic and approval route.
  - External commercial borrowing through automatic route is subject to limits of US$20 million for a minimum three-year average maturity and US$750 million for a minimum five-year average maturity.
  - External commercial borrowing through approval route can be higher than US$750 million.
  - External loans are subject to an all-in-cost ceiling, which is adjusted occasionally, and also end-use restrictions.
  - Outflow: Lending abroad is generally subject to approval, except for certain trade credits and lending to foreign subsidiaries.

### Domestic Currency Accounts of Nonresidents
- China:
  - In addition to financial institutions in Hong Kong SAR, nonresident nonbank institutions with renminbi from trade transactions may deposit renminbi in correspondent accounts with Chinese mainland banks.
  - Limited trade financing is also allowed through the correspondent accounts.
- India:
  - Only NRIs and nonresident PIOs may maintain rupee accounts.

### Repatriation / Surrender Requirement
- China:
  - Proceeds must be generally repatriated within 180 days of exportation and may be deposited with in foreign exchange domestic banks or abroad.
  - The conditions for depositing abroad are regulated based on the balance of payments status and foreign exchange management needs.
- India:
  - Proceeds must be repatriated within 12 months of shipment and may be deposited in accounts with domestic banks. These accounts do not earn interest.

*Source: Annex 1, "Regulatory Framework for Capital Transactions in China and India," Chapter IX of Background Paper for People’s Republic of China: Spillover Report for the 2011 Article IV Consultation and Selected Issues.*

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