The IMF and the capital account: Another step forward but still out of step

By Kevin P. Gallagher, Professor and Director of the Global Development Policy Centre at Boston University’s Pardee School of Global Studies, and Co-Chair of the ‘Think 20’ Task Force on International Finance to the G20 and José Antonio Ocampo, Professor at Columbia University and former UN Under-Secretary-General for Economic and Social Affairs and Finance to the G20

Last week, the International Monetary Fund (IMF) took another step forward in recognising that regulating international capital flows is important to maintain financial stability. However, the IMF’s new policy change is still not fully in step with the policies needed to manage the capital account volatility that emerging and developing countries face. 

Although the regulation of cross-border capital flows was enshrined in the IMF’s Articles of Agreement, the IMF conditioned its financing on deregulating finance during the 1980s and 1990s. In the late 1990s, the IMF went so far as to try and change the Articles of Agreement themselves to outlaw such regulation – i.e. to enshrine ‘capital account convertibility’ in the Agreement. Those efforts were put to a halt in the midst of the East Asian financial crises, which were largely a result of the premature deregulation of capital markets.  

After the North Atlantic Financial Crisis of 2008-2009, IMF economists found that emerging market and developing countries that had regulations in place were among the least hard hit by the crisis. Many of those countries began to push the IMF to officially change its view.

In 2012, the IMF changed, making a landmark break from its long-held view that nations should liberalise cross-border capital flows. After hotly contested debates, the IMF issued an ‘institutional view’ stating that liberalising capital flows was not always optimal for emerging market and developing countries. Moreover, the IMF said that temporary ‘capital flow management measures (CFMs)’ were justified on the inflow of capital when countries were experiencing ‘surges’ of capital inflows and on the outflow of capital in the midst of a crisis. In both cases though, only as a sort of ‘measure of last resort’, after exhausting all other possibilities.   

Last week, the IMF changed again. Ten years on, the IMF finished a review of its institutional view. The IMF’s Independent Evaluation Office and academic assessments had pointed to flaws in the original view and noted that it had been implemented unevenly. In a step forward, the IMF decided that regulations on inflow surges may not be sufficient and that under certain circumstances pre-emptive regulations on the inflow of capital may prevent surges from happening in the first place – and therefore be warranted. It also recognised that regulations may be needed to manage the currency mismatches that external debts can generate. 

This policy change is to be applauded. We co-chaired a Task Force in 2012 that engaged with the IMF on these matters. Drawing on the country experiences and the economic evidence, our Task Force stressed that nations needed the policy space to have more permanent regulations in place that allowed financial authorities to regulate both the inflow and outflow of capital.

However, the IMF’s steps forward are still out of step with current thinking and reality. In fact, the core premise of the IMF’s view is still that regulating capital flows should continue to be a sort of intervention of last resort, and particularly that it should not be used as a substitute for appropriate macroeconomic policies. Yet, advances in economic theory prove that regulations make global markets more efficient, not less, and that some regulations on capital flows should be part of the regular toolkit to manage financial stability risks. Domestic financial regulation in all countries has broadly recognised that reducing those risks is critical.

In 2012, Anton Korinek and Olivier Jeanne published an article in the IMF Economic Review showing how capital flows generate externalities because individual investors and borrowers do not take adequate account of the effects of their financial decisions on financial stability. Therefore, permanent regulations to internalise those externalities make markets work better.

A later, extensive review of the literature on capital account management published last year in the Journal of Economic Literature by Bilge Erten, Anton Korinek and José Antonio Ocampo reiterated that view. It also showed that the empirical literature indicated that capital account regulations not only smooth out boom-bust cycles in external financing, but also enhance monetary independence. Additionally, they smooth the business cycles that emerging and developing countries face due to capital account volatility.

The review of IMF policy on the regulation of outflows of capital remains unchanged. To the IMF, the regulation of outflows should only be carried out as a last resort in the midst of a crisis, rather than as a pre-emptive measure to prevent and mitigate capital flight. Furthermore, the review of the institutional view failed to build on the multilateral aspects of capital flow management. Advances in economic theory by the IMF itself show that it can be optimal to regulate capital flows at ‘both ends’—in source countries as well as in recipient ones. Indeed, this was the view held by the architects of the IMF and practiced in its early years. 

Relatedly, in 2012 the IMF acknowledged that advising countries to regulate capital flows may come into tension with contemporary investment and associated clauses in free trade agreements. Not only do these treaties mandate that all forms of capital flow freely across borders, but they also lack balance of payments exceptions and have more limited prudential exceptions. Furthermore, rather than having nation states and monetary authorities settling disputes over these provisions, these treaties provide access to ‘investor-state dispute settlement’ fora that allow private firms to directly file claims against governments for regulating capital flows.

At the time of writing, emerging market and developing countries face rising interest rates, oil and food price shocks and the possibility of a Russian default —any of which could trigger another sudden stop of external financing and capital flight. The growth of crypto-assets has added another dimension of financial instability. It is time, therefore, to expand further the regulation of global capital flows both nationally and internationally.