Navigating Capital Flows—An Integrated Approach

IMF Blog, December 9, 2020

Source details

Title: "Navigating Capital Flows—An Integrated Approach"
Authors: Tobias Adrian, Gita Gopinath, Ceyla Pazarbasioglu
Date: December 9, 2020
Context: Presents a new analytical macroeconomic framework—the Integrated Policy Framework (IPF)—to guide policy responses to volatile cross-border capital flows and to feed into the upcoming review of the IMF’s Institutional View on the Liberalization and Management of Capital Flows.
Core premise: "There is no “one-size-fits-all” response to capital flow volatility, nor is it a case of “anything goes” or that all policies are equally effective."

International capital flows:
- "Provide significant benefits for economic development but can also generate or amplify shocks."
- Pose long-standing policy challenges for many open economies.
Role of exchange rates:
- "Flexible exchange rates can act as a useful shock absorber in the face of capital flow volatility," but may be insufficient "in particular when access to global capital markets is interrupted or market depth is limited."
Heterogeneity matters:
- "Optimal policies depend on the nature of shocks and country characteristics."
- Examples of distinguishing country features: "less developed financial markets and large foreign currency debts" versus "countries that do not have foreign currency mismatches on their balance sheets" or those with "deep and liquid" markets.
When flexible exchange rates are appropriate:
- "In countries with flexible exchange rates, deep markets, and continuous market access, full exchange rate adjustment to shocks remains appropriate."
When complementary tools are useful:
- In presence of vulnerabilities such as "shallow markets, dollarization, or poorly anchored inflation expectations," tools like "macroprudential measures, foreign exchange intervention, and capital flow management measures" can enhance monetary policy autonomy and help contain inflation and promote stable growth.

Objective: "Brings together insights from new models, as well as empirical work and case studies and lays out a coherent framework for the use of multiple tools to achieve macroeconomic and financial stability."
Emphasis: Integrated use of "macroprudential measures, foreign exchange intervention, and capital flow management measures" alongside interest rate policy.
Precautionary application: "Precautionary capital flow management measures on capital inflows, applied before shocks hit—can also help lower financial stability risks."

Non-rationalization of misuse:
- "Our findings do not rationalize indiscriminate use of tools."
- IPF tools "should not be used to maintain an over- or undervalued exchange rate."
Complementarity—not substitution:
- "Most of the time they cannot fully offset underlying vulnerabilities. Thus, they are no substitute for deep markets, healthy balance sheets, and strong institutions."
- "Efforts to promote the development of markets and institutions remain important to complement sound macroeconomic policies."
Risks from prolonged or inappropriate use:
- Possible costs include "slower market development and increased risk-taking."
- Example: "Persistent interventions might feed a (false) sense of security about future exchange rate developments that leads firms or households to take on more foreign currency debt, thus increasing balance sheet vulnerabilities."
Potential misuse in practice:
- Tools might "support under/overvalued exchange rates, substitute for warranted macroeconomic adjustment, or impede price discovery and competition."

Long-term impacts:
- Need to balance benefits of IPF tools against "possible costs such as slower market development and increased risk-taking."
- Concern that "protracted reliance on some of the tools might perpetuate the very vulnerabilities that rationalize their use."
Fiscal aspects:
- "The fiscal stance and public debt levels matter for countries’ vulnerability to shocks," and models will be extended "to examine more closely the interaction between different fiscal policies and IPF tools."
Multilateral considerations:
- A country’s optimal policy mix "depends on the actions of other countries and global institutions."
- IPF tool use may have positive spillovers (if they "improve macroeconomic and financial stability, and facilitate trade") and negative spillovers (e.g., "capital flow management measures may deflect capital flows to other countries, where such flows may contribute to currency overvaluation and overheating").
Safeguards and metrics:
- Need to develop "suitable metrics for assessing" tool deployment to differentiate "appropriate and inappropriate deployment of IPF tools."
Process: "Work in each of these areas will advance in the period ahead and should result in improved policy guidance for countries facing volatile capital flows."

Source: Navigating Capital Flows—An Integrated Approach, Tobias Adrian, Gita Gopinath, Ceyla Pazarbasioglu, December 9, 2020.