Capital flows to emerging economies


Rising interest rates in the United States have revived lingering concerns about the external debt of emerging economies. As rates rise and the US dollar appreciates, the debt burden becomes heavier and riskier. In this environment, destabilizing capital outflows are more likely. Some fear a repeat of the ‘tantrum’ of 2013 – a reactionary panic by investors after the US Federal Reserve hinted it might scale back its asset purchases. It could be much worse for some chronically overworked borrowers.

Some struggling economies should never have borrowed in the first place: Argentina and Sri Lanka come to mind. But many others are well-managed economies, which can benefit from global capital flows, provided these flows are stable, without massive inflows in good times or sudden outflows when sentiment changes.

The International Monetary Fund, however, has consistently and strongly discouraged any policy action that would restrict inflows or outflows. Capital controls – now known as “capital flow management” (CFM) – attract strong opprobrium. Just like “real men don’t eat quiche,” the Fund’s message is that serious countries don’t limit their capital inflows.

“Pilot error” has long been the Fund’s standard diagnosis for emerging market crises.

The 1997 Asian crisis demonstrated the dangers of large global capital flows into embryonic financial markets. Today, a quarter of a century later, the International Monetary Fund is still hesitant to see measures likely to smooth these flows.

In 2012, fifteen years after the Asian crisis and five years after the global financial crisis of 2008 clearly demonstrated the weaknesses of global financial markets, the Fund reviewed its doctrine. The Institutional View (IV) of the IMF admitted that policy could impose certain constraints on flows. But this option was surrounded by caveats and caveats: managing capital flows sat at the very bottom of the policy toolbox, to be used only as a last resort. Foreign exchange (FX) intervention was frowned upon, to be used only temporarily to smooth daily volatility.

Gita Gopinath, now the IMF’s first deputy managing director, defends the IMF’s argument about macroeconomic policies in emerging economies (IMF/Flickr)

More recently, the Fund revisited this issue in a guidance document presented as a step forward from the 2012 IV. Capital flow management still comes with caveats, but macro-prudential policy could be used to protect financial stability. The problem is that many of the issues – such as volatility in portfolio flows and direct foreign currency borrowing by non-financial firms – fall outside of macroprudential policy, which is largely concerned with the stability of the banking sector. The main selling point of the new policies is that they are “preventive” – and could therefore be imposed before the crisis hits. But that only underscores how pathetically inadequate the 2012 IV was: what was the use of policies that could only be applied at the onset of the crisis?

Fortunately, other international financial institutions are promoting more active policies to address these vulnerabilities. The Bank for International Settlements addressed these issues in its presentation at the G20 finance meeting in Bali this month.

Intervention FX, as well as specifically designed [macro-prudential] and GFCs, will be particularly useful in coping with the consequences of changing external financial conditions.

It is not often that these international institutions disagree so explicitly.

Olivier Blanchard, now freed from the bureaucratic constraints of his former position as chief economist of the IMF, finds that the latest version of the Fund’s manifesto is lacking. With admirable politenesshe debates his successor at the Fund, which defends a weak defense based largely on the argument that if emerging economies got their macroeconomic policies in place, they wouldn’t need capital flow management.

The defense of this position by Gita Gopinath, now the first deputy managing director of the IMF, recalls certain initial reactions to the problems of the Boeing 737 Max. After two crashes, some Boeing supporters argued that a good pilot could have gotten the plane back on track when the computers kicked in. Thus, the cause of the accidents was “pilot error”. Similarly, the IMF blames imperfect domestic policy-making for any problems arising from capital flows. “Pilot error” has long been the Fund’s standard diagnosis for emerging market crises. In a narrow sense, both of these verdicts may be true, but just as airplanes should be safe enough to be flown by pilots who are not perfect, the global financial system should not require policy perfection to be safe, because the policies will certainly not be perfect.

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