Managing Capital Flows in Emerging Markets

May 25, 2011

Min Zhu, Special Advisor to the Managing Director,
International Monetary Fund
Rio de Janeiro, Brazil, May 26, 2011

As prepared for delivery

It is my distinct pleasure to be in the great city of Rio de Janeiro in order to open today’s conference, co-hosted with our Brazilian friends, on Managing Capital Flows in Emerging Market Economies.

This is, of course, a very topical subject—not least here in Brazil which, like many other emerging market economies (EMEs), has been contending with large capital inflows over the past couple of years. While the subject is topical, it is by no means ephemeral or new. Investors worldwide have woken up to the exciting growth opportunities in emerging market countries, and despite fluctuations from time to time, robust capital flows to EMEs will likely be a structural characteristic of the global financial markets for many years to come.

And I need hardly remind this audience of eminent policy makers, academics, and practioners, that this subject has a long history to which, indeed, many of you have made critical contributions. What I would like to do in my remarks this morning is to give a brief overview of some of the thinking at the Fund on this issue, what it means for emerging market economies in Latin America, and how we hope to take the work agenda forward.

Some History

First, a little history. Since I am still relatively new to the Fund—having assumed my duties just over a year ago—I began reading up on what the Fund has been saying over the years about managing capital flows. While the subject has, at times, been contentious, my own sense is that, by and large, the Fund has tended to be open minded and pragmatic, rather than dogmatic, on this topic.1

The issues, in fact, have been discussed since the very earliest days of the Fund. This year happens to be the seventieth anniversary of the debate between John Maynard Keynes and Harry Dexter White, which is perhaps a natural starting point for us. It makes for fascinating reading.2 It is often assumed for example that Keynes favored capital controls, White opposed them, and that the Fund’s Articles of Agreement are an uneasy compromise between these two great minds. But that is too simplistic a reading of history. In fact, both men recognized that capital flows can bring tremendous benefits for investment and growth—but also that inflow surges and sudden stops can bring risks of economic dislocation.

Since Keynes’ views are generally known, I will not linger on them except to remark that, when drawing up his Plan for the IMF in 1941, Keynes went out of his way to emphasize the need for the post-war system to “greatly facilitate the restoration of international loans and credits for legitimate purposes.”

White, the American, took as his starting point that “the desirability of encouraging the flow of productive capital to areas where it can be most profitably employed needs no emphasis.”

But he was also open to the idea of some controls under specific circumstances. When submitting his doctoral dissertation to Harvard University in 1930, White had written that “some measure of the intelligent* control of the volume and direction of foreign investments is desirable.”

In his Plan for the IMF, White developed the argument further, writing that:

“There has been too easy an acceptance of the view that an enlightened trade and monetary policy requires complete* abandonment of controls over international economic transactions. There is a tendency to regard foreign exchange controls, or any interference with the free movement of funds as, ipso facto, bad ... [But] there are times when it is in the best economic interest of a country to impose restrictions on movements of capital…[and] there are periods when failure to impose controls…have led to serious economic disruption.”

Therefore, White concluded “the task before us is not to prohibit instruments of control but to develop those measures of control, those policies of administering such control, as will be the most effective in obtaining the objectives of world-wide sustained prosperity.”*3

It is very much in this spirit that we, at the Fund, have been working over the past couple of years to develop our policy advice on how best to manage capital flows.

Toward an intelligent response to capital flows

Recognizing that once the global financial crisis had passed, capital flows would resume rapidly, researchers at the IMF started thinking about these issues in the fall of 2009, publishing a first paper in early 2010,4 followed by further analytical work in a Staff Discussion Note5 early this year (which Mr. Ostry will discuss tomorrow), as well as papers looking more closely at, and drawing upon, country and regional experiences6. These various strands fed into a paper that carries the institution’s imprimatur and lays out a possible framework for considering these issues.7

I hope that this framework, and the analytical thinking that underpins it, while preliminary, will give us a good basis for providing policy advice to emerging market countries facing surges of capital inflows. It meets, I think, White’s criteria of an “intelligent” response, and of helping to develop measures that “will be the most effective in obtaining the objectives of world-wide sustained prosperity.”

The basic ideas are grounded in sound economic principles, namely:

• Policy interventions should be as closely aligned to the problem at hand as possible, (which may, at times, mean removing home-grown distortions that amplify inflows);

• The magnitude of the interventions should be commensurate with distortions they are trying to address;

• In setting policies, each country also needs to take into account the spillovers and multilateral consequences of its actions.

In the context of managing capital flows, this means that countries will want to first exhaust their macro policy options, which include:

• allowing the exchange rate to appreciate unless it is overvalued and/or external stability is at risk;

• accumulating reserves in line with country insurance metrics;

• adjusting the monetary/fiscal policy mix by tightening fiscal policy to maintain a sustainable pace of demand growth and, if conditions permit, lowering policy interest rates

These steps need to be taken before imposing capital controls or prudential measures that may act as capital controls (together referred to as capital flow management measures). This logical primacy of the macroeconomic response helps countries: (i) reap the benefits of capital flows while safeguarding against the risks; (ii) stem the inflow pressures by reducing the incentives for capital to cross the border; and (iii) ensure they are not avoiding external adjustment that may be necessary from a national or multilateral perspective.

This is general advice; of course, it must be tailored to country-specific characteristics. If I may nevertheless generalize a bit, I think that current circumstances make this policy advice especially pertinent for emerging market economies in Latin America:

• First, history suggests that the unusually favorable external environment is conducive to very high domestic demand growth and a buildup of vulnerabilities in the region.  

• Second, the region is also facing a second tailwind—it is benefiting not only from easy financing conditions but also high terms of trade. Very strong commodity exports create issues of overheating and managing good times that are in many ways similar to capital inflows.

• Third, unlike Asia, current accounts in Latin America are already in deficit and though these deficits have not reached dangerous levels they can rapidly move to vulnerable positions as domestic demand reacts exuberantly.

• Finally, the region’s capital accounts tend to be more open and are subject to larger swings in capital flows.  This all implies that Latin America needs to work particularly hard and on different fronts to contain the risk of boom bust cycles.

Beyond a macroeconomic response, prudential measures that improve the functioning and the resilience of the financial sector should be part of the countries’ on-going structural reform efforts, which may need to be stepped up in response to the additional risks that sudden surges of capital might bring.

I will not get into the choice between discriminatory prudential measures and capital controls as this will be discussed extensively during the conference. Suffice it to say that, in general, prudential measures that target the risks that capital inflow surges might bring are to be preferred to capital controls that, by their nature, target the flows themselves. However, the appropriate choice of tools will, in practice, depend on the circumstances, including the nature of the risks posed by the capital inflows, whether the flows are being intermediated through the domestically regulated banking system, and other characteristics that might make one instrument less distortionary and more effective than the other.

A Shared Responsibility

I have spoken at some length on how emerging market economies might respond to capital inflows in part given how pressing the issue is for these countries at the current juncture—Brazil, for example, received $100 billion in portfolio and FDI flows in 2010, and a further $37 billion in the first quarter of this year.

But a multilateral institution like the IMF obviously needs to consider the other side of the coin—namely, policies in capital-exporting countries. To this end, Fund staff are undertaking in-depth analysis of the outward spillovers, through capital flows and otherwise, from the five largest economies in the world—China, the Euro Area, Japan, the United Kingdom, and the United States. The findings will be presented in a series of Spillover Reports, to be discussed by our Board, alongside each country’s Article IV report, this July. By shedding light on the impact of one country—or region’s—policies on others, we hope to facilitate the process of finding policies that serve both the national and the global interest.

I do not wish to anticipate these reports—or their discussion by our Executive Board—but to quote the eloquent Mr. White once more: “It is true that rich and powerful countries can for long periods safely and easily ignore the interests of poorer or weaker neighbors or competitors, but by doing so they will imperil the future and reduce the potentiality of their own level of prosperity. The lesson that must be learned is that prosperous neighbors are the best neighbors; that a higher standard of living in one country begets higher standards in others; and that a high level of trade and business is most easily attained when generously and widely shared.”

I believe that White’s words are as true today as they were seventy years ago. What has changed since that time is the definition of “rich and powerful countries.” Today, emerging market countries account for some 40 percent of global GDP, 30 percent of international trade, and almost 20 percent of world external savings. Ensuring that, globally, countries reap the full benefits of capital flows is thus a shared responsibility between advanced and emerging market economies, between surplus and deficit countries, between capital-exporters and capital-importers. Key to this will be addressing structural impediments, on both the supply and demand sides, that may artificially distort the relative price of capital, and result in its less-than-globally optimal allocation.

The issues are not easy, either analytically or politically. Certainly, we at the Fund do not have all of the answers, and our thinking will surely continue to evolve. Yet we know that this is a pressing matter for our entire membership. That is why I would like to thank the Brazilian authorities for convening this conference with us, and it is why we are looking to you, the participants, to help us analyze the issues over the next couple of days through productive discussions and debates.

1 See, for example, the Independent Evaluation Office Report on the Evaluation of the IMF’s Approach to Capital Account Liberalization, 2005, available at:

2 The International Monetary Fund, 1945-65. Vol. III, Documents by Keith Horsefield, 1969, (Washington DC: International Monetary Fund).

3 * Emphasis added.

4 “Capital Inflows: The Role of Controls” by Jonathan D. Ostry, Atish R. Ghosh, Karl Habermeier, Marcos Chamon, Mahvash S. Qureshi, and Dennis Reinhardt, Staff Position Note 10/04 (2010), available at:

5 “Managing Capital Inflows: What Tools to Use?” by Jonathan D. Ostry, Atish R. Ghosh, Karl Habermeier, Luc Laeven, Marcos Chamon, Mahvash S. Qureshi, and Annamaria Kokenyne. Staff Discussion Note 11/06 (2011), available at:

6 “Managing Abundance to Avoid a Bust in Latin America” by Nicolás Eyzaguirre, Martin Kaufman, Steven Phillips, and Rodrigo Valdés. Staff Discussion Note 11/07 (2011), available at

7 Recent Experiences in Managing Capital Inflows—Cross-cutting Themes and Possible Policy Framework (2011), available at:


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