On March 30, 2022, the International Monetary Fund published the Review of the Institutional View on the Liberalization and Management of Capital Flows. The review updates the IMF’s Institutional View (IV), adopted in November 2012, followed by guidance notes on capital flows added in April 2013 and December 2015. The IMF’s Institutional View is an important policy document because it provides an analytical framework for the Fund’s policy advice on liberalizing and managing capital flows.
Since its adoption, IMF staff members have applied the IV extensively throughout the Fund’s broad membership, providing policy advice on capital flow-related issues during Article IV consultations and lending programs with member countries. In addition, the Institutional View has been applied for technical assistance, capacity building, and multilateral surveillance.
A brief historical overview is necessary to comprehend the shifts in the IMF’s policies on liberalizing and regulating cross-border capital flows. Since its inception in 1944, the Fund has come a long way on the issue of capital controls. The IMF’s Articles of Agreement permitted countries to maintain capital controls, which most countries did during the Bretton Woods period that lasted from 1944 to 1971. Although the IMF’s Article VI (Section 3) recognizes the right of members to “exercise such controls as are necessary to regulate international capital movements”, the Fund became a strong votary of capital account liberalization (CAL) in the 1980s and 90s. In September 1997, the IMF management attempted to make the liberalization of capital movements one of the IMF’s goals and extend the Fund’s jurisdiction to this area. However, the Asian financial crisis (1997-98) unraveled the risks of capital account liberalization and overshadowed discussions, and the proposal was withdrawn in 1998.
After the Asian financial crisis, the IMF turned away from the big bang approach and adopted a more cautious approach that stressed the importance of an appropriate pace and sequencing of CAL. Another shift in the IMF’s position on capital controls came in the aftermath of the 2008 global financial crisis, when the Fund started supporting the use of capital controls, albeit temporarily and subject to certain conditions, to prevent and mitigate financial crises.
One welcomes the IMF’s willingness to review and update the IV, which it claims incorporates policy experiences and research findings and draws on its work on the Integrated Policy Framework (IPF), the findings of the Independent Evaluation Office (IEO)’s 2020 evaluation on IMF Advice on Capital Flows, and staff’s experience with the implementation of the IV.
So far, so good. However, a closer examination of the review document reveals that it does not propose any new thinking on managing and regulating capital flows and, therefore, cannot be considered a significant departure from the 2012 IV. Except for two notable changes proposed to the existing policies under the IV, little suggests that the IMF has drawn policy lessons from recent country experiences and empirical research and incorporated them into the updated framework.
The 2012 IV delineates the IMF’s approach to managing cross-border capital flows based on a broad consensus reached at the time among its members. No denying, the Institutional View is a welcome departure from the IMF’s previous rigid stance on capital controls. However, some national policymakers have expressed concern that the Fund’s recommendations on using capital controls are too general and restrictive, with inconsistent implementation across countries.
As the original IV endorses capital controls as a last resort, imposed selectively on capital inflows, and on a temporary basis within a broader approach of capital account liberalization, critics have highlighted its analytical shortcomings and increasing irrelevance in the current international economic environment that calls for the imposition of capital controls on a lasting basis, particularly in the case of emerging markets and developing economies (EMDEs) that are more prone to capital flows’ boom and bust cycles.
As the Institutional View was expected to be reviewed in the light of new experience, analysis, and empirical evidence, there is significant interest in academic and policy circles to find out to what extent the IMF has revised and updated its analytical approach to liberalizing and regulating capital flows.
Making Sense of Capital Controls Terminology
In academic literature and policy circles, the term ‘capital control’ is commonly used to refer to residency-based restrictions on capital flows, whereas macroprudential measures are described as measures aimed at limiting financial risks.
Capital controls are regulations that restrict or prohibit the movement of capital across national borders. The regulatory measures are designed to govern the capital account of a country’s balance of payments and, therefore, include restrictions on the movement of capital into or out of a country.
Capital controls can regulate a wide range of cross-border transactions carried out by non-residents and residents in a country. These transactions may include money transfers, direct investments, portfolio investments, bank loans, etc. For example, a tax applicable only on non-residents’ investments in domestic bonds or equities is a capital control. Similarly, caps on foreign equity investment in specific sectors (such as banking and defense) or limits on overseas investments by residents are classified as capital controls because these measures regulate the inflow and outflow of capital in a country.
Since the publication of the IV in 2012, the IMF has used the new term ‘capital flow management measures’ in place of ‘capital controls’. The IMF defines capital flow management (CFMs) as measures designed to limit capital flows, and macroprudential measures (MPMs) aimed to limit systemic financial risks. The IMF also classifies certain measures as CFMs and MPMs (CFM/MPMs) that aim to limit capital flows and reduce systemic financial risks.
Labeling a specific measure (CFM, MPM, or CFM/MPM) by the IMF is not only cumbersome and time-consuming, but also highly contentious due to significant overlaps. As a result, the IMF staff and the country authorities have repeatedly disagreed on differentiating between somewhat similar measures.
In the course of the IV implementation, it has been observed that the IMF staff’s increased attention to labeling issues has diverted attention away from a more substantive policy discussion with country authorities on the regulation of volatile capital flows. As noted in the IEO’s 2020 evaluation on IMF Advice on Capital Flows, “serious disagreements about the labeling of a measure have crowded out time for policy dialogue and have led to perceptions of a lack of even-handedness”.
Review Reaffirms the Core Principles of the IV
The 2022 review reaffirms the core principles underpinning the original Institutional View. “The core principles of the IV remain valid, namely the overall presumption that capital flows are desirable and can bring substantial benefits for countries. The IV should continue to aim to help countries reap those benefits while managing the risks to macroeconomic and financial stability of large and volatile capital flows. CFMs can be useful in certain circumstances, but should not substitute for warranted macroeconomic adjustments”, says the press statement issued by the IMF’s Executive Board on the updated policy framework.
One of the core principles of the IV that, “capital flows are desirable as they can bring substantial benefits for countries”, needs serious rethinking in the light of the IMF’s own recent work and database on special purpose entities (SPEs), which are typically established in jurisdictions that allow unrestricted movement of capital across national borders.
Conventional wisdom on capital flows suggests that foreign direct investment (FDI) is long-term, stable, and boosts the host country’s development by fostering productivity gains, technology transfers, and backward and forward linkages between foreign and domestic firms. However, that is certainly not the case for SPE-related FDI flows. Multinational enterprises and non-residents set up SPEs in host countries to obtain specific advantages such as reduced regulatory and tax burdens. As noted by the IMF, SPEs typically have little to no employment, physical presence, or production in the host economies. The IMF further notes that such entities transact almost exclusively with non-residents, and a large part of their financial balance sheet typically consists of cross-border claims and liabilities.
As per the IMF calculations, the share of SPE-related foreign direct investment is astronomically high in some economies, 45 times the size of the Luxembourg economy, 30 times in Mauritius, and 28 times in Bermuda. One can only wish that the IMF staff involved in the IV review had looked at the Fund’s own research and databases on SPEs to better assess the beneficial impacts of SPE-related FDI flows on host countries.
Furthermore, FDI comes in different forms and can have varying effects: the greenfield variant entails the establishment of new manufacturing facilities in host countries, while the merger and acquisition (M&A) variant reflects the transfer of ownership of existing companies. As documented by the IMF and World Bank, cross-border M&As play a prominent role in global FDI flows, particularly in advanced economies.
While FDI does not involve direct debt and interest repayments, it does involve significant foreign exchange outflows in the form of profits, dividends, royalty, and technical fees remittances. With services now accounting for more than half of global FDI inflows, foreign investment in non-tradeable services (e.g., telecommunications, energy, banking, insurance, and retailing) would entail significant forex outflows to purchase inputs and technology.
Another core principle of the IV, that “risks from capital flow volatility can be managed by macroeconomic and financial sector policies supported by strong institutions, and through temporary use of CFMs and CFM/MPMs under certain circumstances”, is contentious on three counts.
First, it advocates capital controls as a last resort to protect against excessive capital volatility. There could be many circumstances where capital controls should be the first choice to directly address the risks posed by destabilizing capital flows (inflows or outflows). Why should the IMF rule out such circumstances? Why set a hierarchy and preconditions for the use of capital controls?
Second, what is the rationale for recommending the use of CFMs and CFM/MPMs on a temporary basis? The review recommends that preemptive CFM/MPMs be “as temporary as possible”. Some situations may require the deployment of controls for sufficiently long periods. In Iceland, for instance, controls were initially introduced on a temporary basis, but they lasted for almost nine years. China and India — two recent ‘success stories’ — deploy capital controls on both a temporary and permanent basis to maintain financial stability. Both these economies have achieved impressive economic growth rates without full capital account liberalization. Another advantage of the continued deployment of capital controls is that the legal framework and bureaucracy are already in place to enforce new measures in the future.
Third, the Institutional View has narrowly construed all the potential costs and risks of capital flows within the bounds of capital flow volatility. It is widely accepted that unrestricted capital movements could induce asset market distortions, market concentration, and income inequality, adversely affecting the host economy and local populations. For example, large non-resident capital inflows into the housing markets could push up property prices, thereby reducing housing affordability for residents. As discussed later, neither the original IV nor the 2022 review highlight adverse distributional consequences of capital account liberalization.
Two Notable Improvements
While the 2022 review largely adheres to the core principles of the original IV, it makes two significant changes that are worth noting and welcoming.
First, it recommends the preemptive use of CFMs and MPMs on capital inflows under certain circumstances. Whereas the original IV stipulated that such measures should be used only when capital inflows surge and certain conditions are met, they should be phased out once the increase in capital inflows slows.
Indeed, it is a welcome step forward. Of particular concern is that the review policy paper focuses primarily on using preemptive CFM/MPMs on debt inflows. It discusses how such measures could be applied to foreign currency debt inflows to address systemic financial risks arising from currency mismatches.
While addressing systemic financial risks posed by debt inflows is timely and appropriate, the review omits a discussion on potential systemic risks posed by volatile components of non-debt capital inflows, such as portfolio investment. Portfolio investment flows tend to be more volatile than FDI and often create asset bubbles in the real estate and financial markets. Nor does the review offer advice on containing potential systemic risks arising from volatile components of non-debt capital inflows.
Nowadays, an increasing proportion of foreign capital is channeled through portfolio investments and investment funds into EMDEs. In many EMDEs, portfolio investors have overtaken banks as the largest source of money from external sources. Even though non-debt-creating inflows do not create any repayment burden, large swings in portfolio investments pose a significant risk to macroeconomic and financial stability in EMDEs, as their domestic financial systems are less resilient to shocks.
In the context of EMDEs, sharp reversals in capital inflows, so called “sudden stops”, have become more frequent and pronounced in recent decades. Sudden stop events are typically triggered by exogenous global shocks such as aggressive tightening of monetary policies in advanced economies. As was evident during the “taper tantrum” episode of 2013 and in the early stages of the COVID-19 pandemic, portfolio inflows into EMDEs reversed with unprecedented speed and magnitude, leading to sizeable domestic currency depreciation.
Furthermore, the weakening of domestic currencies could make the debt sustainability of EMDE’s external debt more complicated, as currency depreciation would automatically increase the stock of foreign currency liabilities in domestic currency. Even in the absence of foreign currency debt, exchange rate depreciation could be contractionary if government bond yields rise in response to the local currency depreciation. Therefore, the systemic vulnerabilities emanating from both debt and non-debt-creating capital inflows need to be analyzed and addressed coherently.
Second, the review provides special treatment (an exception) for certain categories of CFMs that would not be subject to the appropriateness assessments under the IV. These categories include measures put in place for national or international security reasons and measures taken in accordance with internationally-agreed prudential frameworks (e.g., the Basel Framework) and international standards (e.g., FATF).
As a side note, the review offers additional guidance on four concepts that could help in its implementation: macro-criticality, capital flow surges, imminent crises, and premature liberalization.
No Shift in Position on Outflow CFMs
Despite the fact that outflow CFMs are as prevalent as inflow CFMs, the review does not recommend using CFMs on outflows on a preemptive and lasting basis. “The IV’s proposition that outflow CFMs should be used only in crises or imminent crisis situations remains appropriate”, says the review.
The IMF’s rigid stance against outflow CFMs is highly problematic in light of recent country experiences and empirical research. One of the key shortcomings of the 2012 IV was its reluctance to endorse the use of outflow CFMs on a preemptive and lasting basis, much like how India and China have successfully used such measures to safeguard macroeconomic and financial stability. Despite having large forex reserves, both India and China still deploy numerous restrictions on capital outflows and fine-tune these in response to domestic and global financial conditions changes.
The IMF needs to recognize that the preemptive and continuous use of outflow CFMs is even more pressing for poor and developing countries that do not have large foreign exchange reserves or access to regional financing arrangements to manage abrupt capital reversals due to the tightening of global financial conditions. Unlike advanced economies, their vulnerability to external financial shocks is significantly higher owing to myriad reasons, including a weak local institutional investor base, limited acceptance of their currencies at the international level, and weaker regulatory frameworks and market infrastructures. Therefore, policymakers in EMDEs should be encouraged to pay more attention to capital outflows when inflows are excessive so that there is a proper balance between capital inflows and outflows.
Even in the absence of a crisis or imminent crisis situation, outflow CFMs could be helpful in dealing with multiple challenges posed by large capital outflows on exchange rates, domestic financing, and interest rates. Outflow CFMs could have numerous beneficial effects if implemented transparently and should become a permanent part of the policy toolkit.
No Assessment of International Trade and Investment Agreements
Another major disappointment with the 2022 review is the complete lack of assessment of obstacles posed by international trade and investment agreements in regulating cross-border capital flows and how to remove such obstacles.
A significant number of free trade agreements (FTAs) and bilateral investment treaties (BITs) limit countries’ ability to use capital controls on a preemptive and lasting basis. In addition, the OECD Codes of Liberalization of Capital Movements and the European Union (EU) Treaty provisions also oblige member countries to a high degree of capital account openness.
Such legally binding agreements could seriously impede the preemptive use of CFMs and MPMs on capital inflows recommended in the review of the Institutional View. Therefore, this matter requires the immediate attention of the IMF and national authorities to ensure the proper implementation of the new policy recommendation.
In the past decade, several national and international initiatives have been undertaken to reform international trade and investment agreements so that signatory states can retain policy space to pursue legitimate public policy goals.
Given its global membership and technical expertise in capital flows, the IMF is well-placed to push for concrete reforms in international trade and investment agreements that impede the use of capital controls on a preemptive and lasting basis. The IEO’s 2020 evaluation also recommended that the IMF launch a new initiative to promote the treatment of capital account issues in international trade and investment treaties, consistent with IMF policies.
No Roadmap for International Cooperation
Few can dispute that international policy cooperation is critical to managing volatile capital flows that can trigger global shocks due to unilateral action by countries.
This issue is of particular concern in the current context, as monetary policy normalization in the United States and other advanced economies would have adverse impacts on aggregate output, inflation, trade balance, and exchange rates in many EMDEs. There have been increasing calls in recent years to establish and improve a regulatory framework for global capital flows. Aside from imposing capital controls in the recipient countries, there is a logical reason to impose capital account restrictions in source countries to deal with destabilizing capital flows at both ends.
While the potential benefits of international cooperation are enormous, what is lacking is a multilateral initiative to collectively monitor, prevent, and mitigate risks to macroeconomic and financial stability.
While the 2012 Institutional View acknowledged the importance of international cooperation and noted the role of source countries in managing the multilateral risks posed by volatile capital flows, the 2022 review does not initiate further conversations on this important topic. Also absent are proposals as to what role the IMF could play in promoting international cooperation on capital flow policies.
Overlooking Social and Distributional Effects
As rightly emphasized in the IEO’s evaluation (2020), the IV has not paid adequate attention to the broader implications of capital account liberalization, particularly its social and distributional effects. Given the strong interactions between the financial sector and inequality, it is difficult to fathom why the IV and its review skip over the effects of capital account liberalization policies on inequality.
Put aside academic research and empirical evidence gathered by others, recent research at the IMF suggested that “capital account liberalization reforms on average have led to limited output gains but contributed to significant increases in inequality”.
These issues become even more pressing in the current environment, as several advanced economies (including Australia, Canada, New Zealand, and Singapore) have recently imposed restrictions on capital inflows into housing markets (in the form of additional stamp duties and property transfer taxes on non-resident entities) in order to cool foreign demand and ensure housing affordability for residents.
Healthcare and education are other sectors where unrestricted inflows of foreign capital could hamper access to affordable services. By failing to acknowledge and address the adverse distributional consequences of capital account liberalization, the review falls short of providing a comprehensive and balanced approach.
What about Pace and Sequencing of CAL?
The review reiterates the IV guidance that capital account liberalization must be “well planned, timed, and sequenced to ensure that its benefits outweigh the costs and to reduce the risks of potentially costly backtracking that may undermine the credibility of the liberalization plan”. Indeed, since the early 2000s, the IMF has advocated a carefully paced and sequenced approach to CAL. Simply put, sequencing capital account liberalization means liberalizing non-debt flows before debt flows, long-term (e.g., FDI) before short-term (e.g., portfolio investment), and inflows before outflows.
The sequencing of capital account liberalization appears appealing in theory. However, it could be highly problematic in practice, as countries often liberalize capital accounts haphazardly under intense pressure from powerful lobbies and vested interests.
In the political economy context, the pace and sequencing of capital account liberalization are influenced by several factors that may result in an uneven approach. To illustrate, take the case of Korea, which accelerated the opening of the capital account in the early 1990s to join the OECD. In Korea, the strong political clout of corporate conglomerates, known as chaebols, contributed to a biased approach whereby short-term capital flows were liberalized before long-term and restrictions on domestic firms’ borrowing in foreign currency were eased before restrictions on foreign investments in domestic assets were lifted.
In addition, Korea further liberalized its capital account to implement the OECD Codes of Liberalization of Capital Movements. These reforms encouraged short-term foreign currency borrowing over long-term FX borrowing. As a result, short-term FX borrowing by domestic financial institutions increased dramatically as they financed corporate investments with long-term loans. This policy bias contributed not only to maturity mismatches but also to currency mismatches. It heightened the vulnerability of the corporate and banking sectors, culminating in a series of bankruptcies in 1997.
In the case of India, the S S Tarapore Committee (1997), appointed by the Reserve Bank of India, recommended full convertibility of the rupee on the capital account within a short span of three years. The Committee put forward a roadmap for achieving full capital account convertibility by 2000, subject to fulfilment of macro targets on fiscal deficit, inflation, debt-service ratio, and non-performing loans in the banking sector.
The Committee’s recommendations received strong support from powerful corporates, who wanted unrestricted access to cheap external credit. Some even called for the capital account restrictions to be lifted quickly, even if all the preconditions were not met. At the time, not many questioned the need and urgency of full capital account liberalization when the real sector and trade regime were not yet fully liberalized. The move was deferred by the outbreak of the Asian financial crisis as India escaped the Asian financial contagion due to limited capital account liberalization. Had it not been for the Asian financial crisis, India might have introduced full capital account liberalization.
In conclusion, the IMF’s updated framework for liberalizing and regulating capital flows fails to take into account some of the most important advances in research, policy, and practice over the last ten years. The IMF appears to be lagging behind current thinking and practice on capital account liberalization. The Fund has squandered an opportunity to rethink some of the core principles underpinning the IV and recognize that the unrestricted movement of capital across borders poses far more risks than potential benefits.