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50th Anniversary Special Address—Capital Flow Management and International Cooperation, Address by Naoyuki Shinohara, Deputy Managing Director, International Monetary Fund
November 20, 2014
As prepared for delivery
I welcome the opportunity to speak today about issues related to the management of capital flows. This is a crucial issue to the global financial system in an era where the volume of money crossing national borders continues to grow at a pace once unimaginable to policy makers and market participants.
Capital flow liberalization has been an important element of Asia’s economic success. But the size and volatility of capital flows also present policy challenges, particularly as short-term debt flows have grown in magnitude. The potential dangers have been underlined by the recent economic history of this region, and remain at the core of policy issues facing the global economy. For example, significant capital flows volatility was experienced in Asia in the wake of the May 2013 “tapering tantrum”, especially in India and Indonesia, where fundamentals were weaker at that time. An important challenge for policymakers is to devise a more coherent approach to deal with the liberalization and management of capital flows.
So today I would like to discuss the policy challenges of capital flows from the perspective of both national policies and multilateral cooperation. I will address how to mitigate risks, improve the effectiveness of policies, and strengthen the international monetary system. Let me begin by placing this discussion in the context of the current economic environment.
The Global Environment
In my remarks this morning, I presented the IMF’s analysis of the global economy, highlighting some of the key risks and policy challenges that must be addressed. One of the key challenges I discussed was the adjustment of advanced economy monetary policy, and the risk of sharp reversals of capital flows.
We saw last year how economies that depend more on external financing, or those with a large presence of foreign investors in their domestic financial markets, are more subject to the risk of capital flow reversals. More broadly, countries with weaker fundamentals—such as higher current account and fiscal deficits—are more likely to be targeted in times of stress. In addition, higher corporate leverage could amplify the adverse effect of higher interest rates, as was described in the IMF’s Asia-Pacific Regional Economic Outlook that was released last April.
All of this places great pressure on monetary authorities in this region. As I will discuss later in this presentation, recent IMF research shows that policymakers have increasingly relied on macroprudential policy tools to contain the systemic risks posed by capital inflows. These have often been associated with booming real-estate markets and rapid credit growth. But Asian economies have comparatively less-open financial accounts than other regions, and have been less active users of capital flow measures than their counterparts elsewhere. But they are facing increasingly complex policy challenges.
Context of Capital Flows
Before addressing these challenges, it would be useful to take some time to explore the issues surrounding capital flow management and related policies. The starting point of a capital flows policy must be appropriate national policies. Here, macroeconomic policies, sound financial supervision and regulation, and strong institutions are crucial.
As you know, the global trend towards liberalization of inward and outward capital flows is a recognition of the benefits of such flows under the right conditions. But, as you also know, capital flow liberalization carries risks that are magnified when countries have yet to attain sufficient levels of financial and institutional development. In the absence of adequate financial regulation and supervision, financial openness can create incentives for financial institutions to take excessive risks, leading to volatile flows that are prone to sudden reversal.
Against this background, there is no presumption that full liberalization is an appropriate goal for all countries at all times. As the recent Global Financial Crisis has shown, large and volatile capital flows can pose risks even for countries that have long been open and that have highly developed financial markets.
That said, several countries with long-standing and extensive capital flow management measures would likely benefit from further, careful liberalization. Some systemically important emerging economies (for example, China and India) have announced plans for further liberalization. Under these circumstances, liberalization needs to be well planned and sequenced to ensure that the benefits outweigh the costs.
Country experiences suggest that capital flow liberalization is more likely to be successful if it is supported by sound fiscal, monetary, and exchange rate policies. Among emerging economies—including in Asia—significant progress has been made with the preconditions for liberalization: Macroeconomic cushions are ample, with strong growth, low inflation, and high foreign reserves. The composition of capital flows is also favorable, with a relatively large share of FDI and equity investments. Financial development is reflected in growing financial market depth and enhanced regulation and supervision. Institutional quality and governance are regarded as improving, and trade openness has increased.
Managing Capital Flows
Rapid surges of capital inflows or disruptive outflows can create policy challenges. For countries that have to manage the macroeconomic and financial stability risks associated with such volatility, a key role needs to be played by macroeconomic policies. This includes monetary, fiscal, and exchange rate management, as well as sound financial supervision and regulation and strong institutions. In certain circumstances, capital flow management measures can be useful. They should not, however, substitute for warranted macroeconomic adjustment.
The IMF is well-placed to provide relevant advice and assessments to its members on the management of capital flows, in close cooperation with country authorities and other international organizations. In addition, the IMF’s approach on macroprudential policy tools has proven useful to many countries.
I have so far been discussing the policies of countries on the receiving side of capital flows. But the policies of source countries are also an essential part of the picture—as the ongoing discussion of monetary policy in advanced economies makes clear. Policy makers in these countries must take into account how their policies may affect global economic and financial stability. Clear and effective communication by advanced-economy central banks concerning exit from unconventional monetary support is important to reduce the risk of excessive market volatility.
But beyond monetary policy, advanced economies also need to address the macroeconomic and financial stability risks associated with cross-border activities of markets and institutions under their jurisdictions. They need to strengthen financial system regulation and supervision, including careful monitoring of the shadow banking sector. There is also a need for further progress on recovery and resolution planning for large institutions, including cross-border resolution.
International Cooperation
In addition to the national policies outlined above, international coordination would be helpful in mitigating undesired spillover effects of policies. Efforts in this area encompass a broad range of interactions, some of which are already in place.
They include better communication of advanced economy policies, and regular interaction among central bankers, supervisors and regulators to help reduce risks of cross-border liquidity and credit disruptions—for example, discussions with central bank governors and Ministers, including at the IMFC and G20; and interactions of the Joint IMF-Financial Stability Board, that was requested by the G20 to identify data gaps that masked key vulnerabilities in the run-up to the financial crisis. The IMF could also enhance its collaboration with the OECD and other relevant international organizations to coordinate their positions on capital flows.
Another important element at the current juncture would be to identify enhancements to the global financial safety net that could help support both advanced and emerging markets as the global economy transitions away from large-scale liquidity support. Such enhancements could include supporting central bank swap lines and cooperating with regional financial arrangements. Countries could also make greater use of IMF precautionary arrangements if more insurance is needed. In this regard, the recent completion of the expansion of the ASEAN+3 Chang Mai Multilateral Initiative is potentially a useful tool for regional cooperation in providing safety nets for countries that do not have access to currency swap lines with advanced economy central banks.
Nevertheless, much additional work remains to be done to improve policy coordination in the financial sector. Further progress on reforms in financial regulation and supervision would contribute to the robustness of the infrastructure for intermediating capital flows. In particular, cross-border cooperation on resolution plans and on the treatment of global systemically important financial institutions needs to advance. And many countries still need to address weaknesses in supervision. For many ASEAN countries there is a need to strengthen the regulatory and supervisory framework, particularly for nonbank financial institutions.
The IMF has made a concerted effort in recent years to clarify its policies on capital flows. This has been put into operation and is at the center of the IMF’s interaction with your governments during the Article IV surveillance process.
The IMF could also play a useful role in promoting a more consistent approach toward the treatment of capital flow management measures under international agreements. These agreements—for instance, the OECD Codes of Liberalization of Capital Movement, and the Treaty of the Functioning of the European Union, which establish members’ obligations for openness—are useful in many ways. However, a number of them do not contain sufficient safeguards and exceptions that provide governments with the policy space needed to accommodate balance of payments pressures. Consequently, there is a need for a more consistent multilateral approach that will better support the stability of the international monetary system.
There is also room for international organizations to share experiences, measure and monitor global liquidity, and discuss policy coordination and structural reforms. The IMF is already working with the G20 to support discussions on these issues among advanced and emerging market economies.
Macroprudential Policy
Before concluding, I would like to go back to prudential policies. Effective macro- and micro-prudential policy frameworks at the national level can complement and reinforce macroeconomic policies designed to address capital flows. These policies are aimed at systemic financial stability and can play an important role in shaping the incentives of markets and institutions.
Recent IMF research shows that Asian countries have been quite active in using macroprudential tools related to the housing market, where capital inflows have had a major impact—for example, Hong Kong SAR, Korea, and Singapore. These policy measures have included limits on loan-to-value ratios, debt-to-income ratios, and taxes on housing transactions. Such measures have helped reduce credit growth, slow housing price inflation, and dampen bank leverage. We estimate that one quarter after implementation, the “typical” housing-related measure reduced house price inflation by close to two percentage points.
On the other hand, there appears to be little evidence that foreign currency-related macroprudential policy and capital flow management measures have had a systemic and measurable effect on lending, leverage, or portfolio inflows in Asia. However, these policies may have had an impact on the distribution of risks in the financial system and enhanced resilience in the face of systemic pressures. For example, foreign exchange-related measures can contain currency and liquidity mismatches without necessarily having a strong impact on credit growth or asset prices.
While macroprudential measures have been helpful when capital was flowing in and credit and asset prices were booming, experience still needs to be gained on how these policies could be recalibrated in the event of a downturn in the financial cycle. Certain measures might be eased, including reserve requirements to release additional liquidity and possibly some housing-related instruments where conditions are very tight.
Conclusion
In conclusion, the benefits of improved national prudential frameworks are clear, so it is urgent to complete and implement the remaining agenda for national regulatory and supervisory reforms.
These reforms would also reduce the risks inherent in capital flows and thus reduce systemic risks in the international financial system. The experience of the global crisis, as well as recent economic and market developments, adds extra urgency to the imperative to continue the reform effort. It is through interactions like today’s panel that we can most effectively advance the cooperation agenda.
I look forward to our discussion and congratulate SEACEN for its efforts to strengthen regional and global economic stability. Thank you very much.
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