Gone with the Flow
Gone with the Flow
The IMF is pressing ahead with the campaign to amend its articles. But the need to secure 85 percent support from its diverse membership means that its language has become more cautious. The Fund's buzzword is now 'orderly' liberalisation, as it emphasises to nervous emerging market governments that they will not be forced to run before they can walk. Nevertheless, there remains disagreement within the Fund as well as outside, about the appropriate timing of capital market liberalisation in a country's economic development and what role - if any - remains for capital controls.
In cases where capital flows are already largely unrestricted, countries can be the victims of their own success. The process of structural reform and macroeconomic stabilisation that began in Mexico 12 years ago encouraged huge net capital flows into the country during the early 1990s. Likewise, the extraordinary pace of economic development in Asia attracted capital flows into that region. In both cases, these capital inflows fuelled aggregate demand, inflated equity and real estate prices, expanded bank balance sheets and financed big current account deficits. Combined with political instability, rising international interest rates and an exchange rate peg that contributed to deteriorating competitiveness, this made and explosive cocktail. Meanwhile in Asia financial intermediaries channelled capital inflows into risky investments with no foreign exchange cover, promoting asset bubbles.
This story highlights one research priority and two policy conclusions. The research priority is to further investigate what it is that determines when a current account deficit becomes unsustainable. Senior officials at the IMF seem to use a rule of thumb in which their attitude progresses from one of mild nervousness to extreme anxiety as a country's current account deficit widens from four to eight percent of GDP. But in this context, for example, can economic research tell us whether New Zealand should be as worried now as - with hindsight - it seems Thailand should have been 18 months ago?
Several factors might plausibly determine when a deficit becomes unsustainable. Openness to trade should be important, as a country with large export earnings should be able to absorb bigger external debt service payments than one in which export earnings are relatively small. Openness also means that a country - and the markets - can also be more sanguine about the need to compress imports, because a smaller proportion of them will be 'essentials'.
It is also clear that the current account deficit that a country can sustain will depend in part on its holdings of foreign exchange reserves. If investors are becoming more sensitive to current account deficits, then one policy conclusion is that countries may need to hold more reserves than they do now. Greater emphasis on the capital rather than the current account, only reinforces this conclusion. Indeed, the level of international reserves should perhaps be judged against the variability of capital flows rather than months of imports, as integration into world capital markets will increase flows in and out. As Paul Krugman has warned, policymakers may need far more reserves than they have so far contemplated.
The second policy conclusion is that countries should be wary of fixed but adjustable exchange rate regimes. In both Mexico and Asia, real exchange rate appreciation, growing short-term external debt and widening current account deficits undermined market confidence and prompted speculative attacks. Weak domestic financial systems meant that the tightening in domestic interest rates needed to defend the peg soon became implausible because of its impact on financial intermediaries and corporates. Countries seem to be better off with floating rates or currency boards. But what of a developing country that has not liberalised capital flows? Should it do so? Or have the Asian and Mexican crises shown that it is too risky? The basic case for capital liberalisation needs re-stating. It is that:
When private capital can flow freely across national borders, it can be channelled towards its most effective uses on a global scale.
This effect can be particularly valuable for developing countries, where domestic resources are in short supply.
The prize in theory is increased investment, faster economic growth and improved standards of living.
Free flow is the more advantageous if the influx of foreign capital stimulates the broadening and deepening of domestic capital markets.
But substantial inflows and outflows of capital can cause enormous problems for economic policymakers, and some commentators believe they outweigh any plausible benefit from free capital flows. The outcome of this cost-benefit analysis depends in part on the way in which capital liberalisation is sequenced: in other words, whether it should precede or follow trade liberalisation and whether it should precede or follow liberalisation of the domestic financial system. A case might be argued for government intervention when capital flows into a country with unsustainable policies, but at a rate that exceeds the economy's capacity to absorb them.
Capital controls are not the only response to undesirably large inflows. Recent experience suggests, for example, that countries should be quicker and more aggressive in tightening fiscal policy. And returning to the danger of fixed exchange rate regimes, they should also be more prepared to allow the nominal exchange rate to appreciate. This having been said, even the IMF now accepts (although some of its officials do so with more enthusiasm than others) that capital controls can play a valid role. The Fund sees its role as policing - rather than outlawing - them.
Assessing the effectiveness of existing capital control regimes must be an important research priority. While noting the failure of capital controls in Indonesia and Thailand, observers frequently point to the Chilean system as an exemplar of success, in which there is - in effect - a tax on short-term external borrowing justified on prudential grounds. But it is important to remember that before introducing the system, Chile had already adopted a relatively flexible exchange rate regime and addressed serious weaknesses in its banking system following an earlier crisis.
The international community needs to understand better which capital control regimes work and which will still be effective if transferred elsewhere. Capital controls - especially in the form of prudential limits on short-term external borrowing by corporates or the banking system - do seem appropriate in some cases. But they will not be successful as sticking-plasters to cover up a weak and badly regulated domestic financial system, in which borrowers and lenders alike are encouraged to take excessive risks by implicit government guarantees that they will be repaid if things go wrong. Liberalisation of capital flows and domestic financial systems can go hand-in-hand, so long as the regulatory system keeps pace.
As the work described in this edition of Insights demonstrates, there are various dimensions to the capital flows debate. In Africa, the priority is not to guard against excessive capital inflows but to create a stable, investment-friendly environment to encourage the return of flight capital. In more integrated emerging markets, there is the need to strengthen domestic financial systems - and perhaps to police them internationally.
And then there is the question of what to do when things go wrong. The priorities here are to improve domestic bankruptcy procedures to cope with private sector debt and to provide a more orderly framework for workouts of sovereign debt. The latter point again spotlights the role of the IMF. As well as policing capital controls in normal times, should it sanction payment standstills in times of crisis? The debate promises to be long and contentious.
Robert Chote
Economics Editor
The Financial Times
Southwark Bridge
London SE1 9HL
UK
Gone with the Flow - To learn more about this author, visit id 21's Website.
Like this article? Share it with your friends
When the then British Chancellor Kenneth Clarke proposed in 1996 that the International Monetary Fund should amend its articles of agreement to encourage the liberalisation of capital flows, it seemed an uncontroversial idea that would merely rubber-stamp existing practice. But in the wake of the financial crises that have swept Asia in the last 12 months, the wisdom of letting capital flow in and out of a country unimpeded no longer seems self-evident.
The IMF is pressing ahead with the campaign to amend its articles. But the need to secure 85 percent support from its diverse membership means that its language has become more cautious. The Fund's buzzword is now 'orderly' liberalisation, as it emphasises to nervous emerging market governments that they will not be forced to run before they can walk. Nevertheless, there remains disagreement within the Fund as well as outside, about the appropriate timing of capital market liberalisation in a country's economic development and what role - if any - remains for capital controls.
In cases where capital flows are already largely unrestricted, countries can be the victims of their own success. The process of structural reform and macroeconomic stabilisation that began in Mexico 12 years ago encouraged huge net capital flows into the country during the early 1990s. Likewise, the extraordinary pace of economic development in Asia attracted capital flows into that region. In both cases, these capital inflows fuelled aggregate demand, inflated equity and real estate prices, expanded bank balance sheets and financed big current account deficits. Combined with political instability, rising international interest rates and an exchange rate peg that contributed to deteriorating competitiveness, this made and explosive cocktail. Meanwhile in Asia financial intermediaries channelled capital inflows into risky investments with no foreign exchange cover, promoting asset bubbles.
This story highlights one research priority and two policy conclusions. The research priority is to further investigate what it is that determines when a current account deficit becomes unsustainable. Senior officials at the IMF seem to use a rule of thumb in which their attitude progresses from one of mild nervousness to extreme anxiety as a country's current account deficit widens from four to eight percent of GDP. But in this context, for example, can economic research tell us whether New Zealand should be as worried now as - with hindsight - it seems Thailand should have been 18 months ago?
Several factors might plausibly determine when a deficit becomes unsustainable. Openness to trade should be important, as a country with large export earnings should be able to absorb bigger external debt service payments than one in which export earnings are relatively small. Openness also means that a country - and the markets - can also be more sanguine about the need to compress imports, because a smaller proportion of them will be 'essentials'.
It is also clear that the current account deficit that a country can sustain will depend in part on its holdings of foreign exchange reserves. If investors are becoming more sensitive to current account deficits, then one policy conclusion is that countries may need to hold more reserves than they do now. Greater emphasis on the capital rather than the current account, only reinforces this conclusion. Indeed, the level of international reserves should perhaps be judged against the variability of capital flows rather than months of imports, as integration into world capital markets will increase flows in and out. As Paul Krugman has warned, policymakers may need far more reserves than they have so far contemplated.
The second policy conclusion is that countries should be wary of fixed but adjustable exchange rate regimes. In both Mexico and Asia, real exchange rate appreciation, growing short-term external debt and widening current account deficits undermined market confidence and prompted speculative attacks. Weak domestic financial systems meant that the tightening in domestic interest rates needed to defend the peg soon became implausible because of its impact on financial intermediaries and corporates. Countries seem to be better off with floating rates or currency boards. But what of a developing country that has not liberalised capital flows? Should it do so? Or have the Asian and Mexican crises shown that it is too risky? The basic case for capital liberalisation needs re-stating. It is that:
When private capital can flow freely across national borders, it can be channelled towards its most effective uses on a global scale.
This effect can be particularly valuable for developing countries, where domestic resources are in short supply.
The prize in theory is increased investment, faster economic growth and improved standards of living.
Free flow is the more advantageous if the influx of foreign capital stimulates the broadening and deepening of domestic capital markets.
But substantial inflows and outflows of capital can cause enormous problems for economic policymakers, and some commentators believe they outweigh any plausible benefit from free capital flows. The outcome of this cost-benefit analysis depends in part on the way in which capital liberalisation is sequenced: in other words, whether it should precede or follow trade liberalisation and whether it should precede or follow liberalisation of the domestic financial system. A case might be argued for government intervention when capital flows into a country with unsustainable policies, but at a rate that exceeds the economy's capacity to absorb them.
Capital controls are not the only response to undesirably large inflows. Recent experience suggests, for example, that countries should be quicker and more aggressive in tightening fiscal policy. And returning to the danger of fixed exchange rate regimes, they should also be more prepared to allow the nominal exchange rate to appreciate. This having been said, even the IMF now accepts (although some of its officials do so with more enthusiasm than others) that capital controls can play a valid role. The Fund sees its role as policing - rather than outlawing - them.
Assessing the effectiveness of existing capital control regimes must be an important research priority. While noting the failure of capital controls in Indonesia and Thailand, observers frequently point to the Chilean system as an exemplar of success, in which there is - in effect - a tax on short-term external borrowing justified on prudential grounds. But it is important to remember that before introducing the system, Chile had already adopted a relatively flexible exchange rate regime and addressed serious weaknesses in its banking system following an earlier crisis.
The international community needs to understand better which capital control regimes work and which will still be effective if transferred elsewhere. Capital controls - especially in the form of prudential limits on short-term external borrowing by corporates or the banking system - do seem appropriate in some cases. But they will not be successful as sticking-plasters to cover up a weak and badly regulated domestic financial system, in which borrowers and lenders alike are encouraged to take excessive risks by implicit government guarantees that they will be repaid if things go wrong. Liberalisation of capital flows and domestic financial systems can go hand-in-hand, so long as the regulatory system keeps pace.
As the work described in this edition of Insights demonstrates, there are various dimensions to the capital flows debate. In Africa, the priority is not to guard against excessive capital inflows but to create a stable, investment-friendly environment to encourage the return of flight capital. In more integrated emerging markets, there is the need to strengthen domestic financial systems - and perhaps to police them internationally.
And then there is the question of what to do when things go wrong. The priorities here are to improve domestic bankruptcy procedures to cope with private sector debt and to provide a more orderly framework for workouts of sovereign debt. The latter point again spotlights the role of the IMF. As well as policing capital controls in normal times, should it sanction payment standstills in times of crisis? The debate promises to be long and contentious.
Robert Chote
Economics Editor
The Financial Times
Southwark Bridge
London SE1 9HL
UK
Gone with the Flow - To learn more about this author, visit id 21's Website.
Like this article? Share it with your friends
 | |
 |
No article feedback found. |
| |
Leave Your Feedback |
 | |
| |||
|
To learn more about the Evan Elite Author Program please contact us. |
 | |
|  |
Subscribe to id's articles
 | |
|
|  |
 | |
|
| |
 | |||||||
|
 | ||
 |
||
 |
||
 |
||
|
| ||
 |
| Have you written articles that would be of value to entrepreneurs? Become an expert on our site by publishing them! Expose yourself to a wide audience, drive more traffic to your website and get more sales! Click Here for details. |
|
|
 |
| Modeling the Masters: Learn the true secrets behind Walt Disney's business success factors & grow your company! Video produced by Phanta Media |
|
|
 |
"Learn straight from Evan how you can Make a Full Time Income (And More) from a Website"
Click Here To Learn More |
|
|
|
|
Get advice & tips from famous business owners, new articles by entrepreneur experts, my latest website updates, & special sneak peaks at what's to come!
|
|
|
 The Entrepreneurial Sweet Spot Solving Problems Testing and Measuring Networking To Get Results Conversations of Leadership |
|
 | ||
 |
Top 50 Social Media Blogs
Top 50 Social Media Blogs | |
 |
The Top 10 ProBlogger Posts
Best Posts for Bloggers | |
| ||
 | ||||
| ||||
|
| ||||
| ||||
|
|
|
|
|
|||||||||
|
Email us your ideas on how to make our website more valuable! Thank you Sharon from Toronto Salsa Lessons / Classes for your suggestions to make the newsletter look like the website and profile younger entrepreneurs like Jennifer Lopez and Sean Combs!
|
|
|
| ||||||||||||
| ||||||||||||
|
|
||||||||||||