Capital Controls: When Are Multilateral Considerations of the Essence?

IMF Blog, September 7, 2012

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One main argument against capital controls is that, though they may be in an individual country’s interest, they could be multilaterally destructive in the same way that tariffs on goods can be destructive.
A particular concern is that a country might impose controls to avoid necessary macroeconomic and external adjustment, in turn shifting the burden of adjustment onto other countries.
A proliferation of capital controls across countries may undercut warranted adjustments of exchange rates and imbalances across the globe, and in the logical extreme could lead to financial autarky or isolation, seriously damaging global welfare.
Central question posed: Should multilateral considerations trump national interests?

Exploitation of market power
- By restricting inflows (or outflows), debtors (or creditors) can manipulate the (intertemporal) terms of trade (the interest rate) in their favor.
- Market-power exercise is inherently zero-sum: what is good for the imposing country is bad for counterparties; thus deliberate terms-of-trade manipulation has no multilateral justification.
- Note: Some large players maintain capital controls (including creditors on outflows), and other measures (e.g., expansionary monetary policy) may materially impact the world interest rate.
Financial-stability externalities
- Foreign borrowing may amplify risks of a financial crisis, and such risks may not be taken into account in private borrowing-lending decisions.
- Capital controls allow authorities to price in the social risk inherent in private foreign borrowing so that the externality can be "internalized" in private decisions.
- Controls can deflect capital flows elsewhere; some countries may welcome additional flows, while others may face compounded financial-stability risks.
Externality in the production of exportables (learning-by-doing)
- The national first-best response to such an externality is a subsidy to producers.
- If the first-best subsidy is infeasible, a policy of currency undervaluation supported by capital controls (to limit inflows that would undo the undervaluation) may be used as an alternative.

Key crux (as argued by Ostry, Ghosh, and Korinek): whether the capital controls themselves carry a welfare cost.
- Costs can include bureaucracy, compliance, and especially "imperfect targeting" that keeps out desirable flows (e.g., foreign direct investment for start-up projects).
If controls have an identified cost, coordination is generally necessary to achieve global efficiency: each country should take into account impacts on others when choosing interventions.
In the case of simultaneous inflow surges across multiple recipient countries:
- Under laissez-faire, there will be a tendency for each country to impose inflow controls that are too high.
- Coordination across recipient countries would seek to de-escalate an inflow control war by accounting for “mutual deflection” of flows and the escalating responses of others.
- The efficient outcome is not zero controls, but lower controls than unilateral choices would produce.
Coordination complications when costs of controls rise at an increasing rate:
- If costs are rising, and plausibly rising at an increasing rate (example framing: a 10 percent tax is more than twice as distortionary as a 5 percent tax), solutions may require restraint by lenders on outflows.
- The lender’s incentive to exercise such restraint is not obvious, complicating coordination.

If the first-best subsidy response to learning-by-doing externalities is infeasible, a country may pursue currency undervaluation supported by capital controls.
From a theoretical perspective, this resembles the financial-stability case: spillovers to other countries are an inherent part of market functioning and, by this logic, the country could be allowed to proceed.
However, practical and normative concerns:
- High bar required to prevent mercantilist behavior disguised as infant-industry support or learning-by-doing.
- Currency undervaluation combined with capital controls has larger multilateral implications (trade balance, current account) than a production subsidy would.
- Such policies may frustrate other countries’ attempts to benefit from learning-by-doing in their tradables sectors.
Policy signal: In most cases, undervaluation supported by capital controls should raise red flags.
- Situations where countries adopt or sustain policies likely to have a substantial effect on capital inflows while currencies are undervalued—particularly when intent is to support undervaluation—would likely attract scrutiny.

Capital flows bring enormous benefits to borrowers and lenders alike but may require multilateral principles for safe management.
International cooperation can mitigate the severity of boom-bust cycles in capital flows—a notion tracing back to the IMF’s founding fathers.
Despite substantial global financial integration over six decades, multilateral oversight of both source and recipient countries to assist in managing capital flow volatility remains a worthy objective.
Such oversight is likely essential to safeguard the stability of the international monetary system—a core purpose of the IMF and its members.

Source: Capital Controls: When Are Multilateral Considerations of the Essence?, Jonathan D. Ostry, September 7, 2012 (IMF web page).

Staff Discussion Note
- Staff Discussion Note (Markdown version)
- Staff Discussion Note (PDF)