Managing Capital Flows in Emerging Markets

IMF News, May 25, 2011

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The topic has long history at the IMF, dating to debates between John Maynard Keynes and Harry Dexter White around the Fund’s founding.
Both Keynes and White recognized benefits of capital flows for investment and growth, and also the risks of inflow surges and sudden stops.
White argued for the possibility of "some measure of the intelligent* control of the volume and direction of foreign investments" and that "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."
IMF work since the fall of 2009 includes: a first paper in early 2010, a Staff Discussion Note in 2011, country and regional studies, and a paper laying out a possible framework for considering capital flow management.

Policy interventions should be as closely aligned to the problem at hand as possible (including removing home-grown distortions that amplify inflows).
The magnitude of interventions should be commensurate with the distortions they are trying to address.
Countries should take into account spillovers and multilateral consequences when setting policies.

Countries should first exhaust macro policy options:
- 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.
Rationale for macro-first approach:
- reap benefits of capital flows while safeguarding against risks;
- stem inflow pressures by reducing incentives for capital to cross borders;
- ensure external adjustment that may be necessary from national or multilateral perspectives is not avoided.

Prudential measures that target the risks associated with capital inflow surges are generally preferred to capital controls that target flows themselves.
The appropriate choice between discriminatory prudential measures and capital controls depends on:
- the nature of the risks posed by the capital inflows;
- whether flows are intermediated through the domestically regulated banking system;
- other country-specific characteristics that affect distortion and effectiveness of instruments.
Prudential measures that improve financial sector functioning and resilience should be part of ongoing structural reforms and may need to be stepped up during surges.

Current circumstances make the IMF’s policy advice especially pertinent for emerging market economies in Latin America because:
- history suggests the unusually favorable external environment is conducive to very high domestic demand growth and a buildup of vulnerabilities in the region;
- the region benefits from easy financing conditions and high terms of trade—very strong commodity exports create issues of overheating and managing good times similar to capital inflows;
- 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;
- the region’s capital accounts tend to be more open and are subject to larger swings in capital flows.
Implication: Latin America needs to work particularly hard and on different fronts to contain the risk of boom-bust cycles.

The IMF is analyzing outward spillovers from the five largest economies—China, the Euro Area, Japan, the United Kingdom, and the United States—through a series of Spillover Reports to be discussed alongside each country’s Article IV report.
The goal is to shed light on how one country or region’s policies affect others and to facilitate policy choices that serve both national and global interests.
The IMF emphasizes the mutual benefits of coordinated attention to policies that affect capital flows, echoing White’s view that "prosperous neighbors are the best neighbors."

Brazil received $100 billion in portfolio and FDI flows in 2010, and a further $37 billion in the first quarter of this year.
Emerging market countries account for:
- some 40 percent of global GDP;
- 30 percent of international trade;
- almost 20 percent of world external savings.

Source: Managing Capital Flows in Emerging Markets, May 25, 2011 — Min Zhu, Special Advisor to the Managing Director, International Monetary Fund