Capital controls back in vogue - Overheating economies encouraged to restrict cross-border financial flows
Published:Thursday | April 21, 2011 | 12:00 AM
Lavern Clarke, Business Editor
The stage appears set for confrontation between some emerging powers and the Big Seven who run the world over what the former sees as efforts to impose a "code of conduct" on their management of capital flows.
The talk in Washington all of last week centred around 'capital controls', signalling a shift in International Monetary Fund (IMF) policy that previously backed a laissez-faire system for cross-border movement of capital.
The IMF now sees virtue in limits.
"Yesterday capital controls was not in the toolbox; today it is in the toolbox," said IMF Managing Director Dominique Strauss-Kahn, immediately ahead of the Group of 24 meeting.
But amid the IMF-speak - where language is deliberately couched in generalities so as not to offend political egos and to avoid the appearance of sovereign interference - it emerged that not everyone feels the need to obfuscate.
Brazil's position enunciated two days later at the International Monetary and Financial Committee (IMFC) meeting was clear and unambiguous: that the frame of the policy lacked even-handedness, and that emerging markets are being dictated to on how to clean up the inflationary mess they believe advanced economies have created through quantitative easing - that is, monetary stimulus whereby central banks buy up government bonds and other financial assets to increase money supply.
"We oppose any guidelines, frameworks or codes of conduct that attempt to constrain, directly or indirectly, policy responses of countries facing surges in volatile capital inflows," said Guido Mantega, the finance minister of Brazil, at the 23rd annual meeting of the IMFC.
"Governments must have flexibility and discretion to adopt policies that they consider appropriate, including macroeconomic, prudential measures and capital controls."
Restrictions on capital are unlikely to be favoured by financial markets.
But the World Bank Group suggests that the adoption of a sound capital flow management policy that allows itself and the IMF to give countries "even-handed policy advice", could mitigate blowback.
Potential market stigma
The policy framework "will reduce the potential market stigma that comes with the use of capital controls as markets come to better understand the positive contribution that well-designed and temporary CFMs" can have on financial stability and growth, the World Bank said in its statement at the April 16 IMFC meeting.
The issue is broadly about the rapid flow of capital into emerging markets and some developing economies, and more narrowly about the dangers of using short-term stimulus flows to fund programmes, given the expected and eventual reversal of such capital flows.
Depending on who you ask, the United States Federal Reserve's second round of quantitative easing to buy up some US$600 billion of Treasurys up to June this year - the so-called QE2 - has served to inflate commodity prices, some of it driven by speculation, and has bled into overseas financial markets and spiked asset prices.
Economic experts like Professor Joseph Stiglitz of Columbia University suggest that most of the stimulus funds did not remain in the issuing markets - for which they were intended to boost the stock of credit - but flowed to liquid financial markets overseas to fund private asset purchases.
"QE2 money did not stay in the US where it is needed, but is going to markets wherecompanies perceive demand exists," Stiglitz told a group of journalists on an IMF Fellowship in Washington.
Such funds, he warns, flow out as easily as they flow in, and tend to enrich individual portfolio owners and not necessarily the economy in which the investments occur.
That's why, said Stiglitz, China is open to foreign direct investments, which tends to be long-term capital, but has kept its capital markets closed to short-term portfolio investments that offer no real economic returns to the country in which the funds are invested.
Mantega said Colombia and his country, which have floating exchange rates, were already seeing signs of currency overvaluation and declining export competitiveness, which he blamed on the spillover effects of "ultra-expansionary" monetary policy in reserve currency countries.
Brazil represents itself, Colombia, Dominican Republic, Ecuador, Guyana, Haiti, Panama, Suriname, and Trinidad and Tobago on the IMFC.
China, which speaks only for itself at the IMFC, was less combative in tone, but said the fund would need to be vigilant in its monitoring of capital flows to and from currency-issuing countries.
"The majority of emerging market economies and developing counties have continued to grow strongly, but great volatility of cross-border massive capital flow brings heightened risks in terms of inflation and asset bubbles," said Yi Gang, deputy governor of the People's Bank of China.
"They will need to closely watch the potential changes in the monetary policy stance of developed countries in order to manage the risks of the reversal of cross-border capital movement."
Wrapping his argument in Keynesian economic philosophy as well as the IMF's own by-laws, Mantega reminded the IMFC that capital controls has long been a policy tool available to member countries - even if not embraced by the fund.
Article VI of the IMF Articles of Agreement, he said, allows countries to exercise controls as necessary to regulate international capital movements.
And: "Fortunately, the attempt to suppress or amend this article in the late 1990s was not successful," said Mantega.
Liberty to control
"The fund was conceived with the explicit aim of allowing member countries 'full liberty of action to control such movements' as Keynes explained at the time. From the beginnings of this institution, each country was given the choice to enforce controls or leave all transactions free. And, as Keynes also observed, if a country were to decide in favour of controls, it was left 'to discover its own technique'."
The Brazilian official said his country would do what was necessary and adequate - not what was prescribed - to address challenges from large and volatile capital flows.
Those comments came at the end of a week of warnings from the IMF that rising commodity prices, a marked upswing in public spending, and accelerated credit expansion linked to high capital inflows, could lead to overheating in emerging markets - that is, where aggregate demand outstrips or grows faster than productive capacity, leading to higher inflation and potentially aggressive central bank interventions by raising interest rates to drain liquidity from the system and ease price pressures.
Mantega agreed that there was room at the national level for government intervention on capital flows - welcoming IMF's conversion to that gospel last year - but disagrees with the way the fund is writing the new policy, saying it is "lacking in even-handedness" and ignores push factors - that is, global or external causes - in this case, the policies in major advanced economies that have "produced large and often disruptive" cross-border capital flows.
"We are concerned with recent calls by some advanced countries to establish codes of conduct or policy frameworks for the management of capital flows," said Mantega.
"Ironically, some of the countries that are responsible for the deepest crisis since the Great Depression and have yet to solve their own problems are eager to prescribe codes of conduct to the rest of the world, including countries that are overburdened by the spillover effects of the policies adopted by them."
The IMF said the majority of the QE2 funds financed private asset purchases - investments that are easily reversible and potentially harmful to the receiving country if outflows are not properly managed - but seems not to agree that QE2 has leaked substantially into emerging markets in a way that is disruptive.
Despite acknowledging in the 2011 Global Financial Stability Report that "US investors showed a preference for emerging market assets with stronger growth, higher yield and more liquid markets through the third quarter of 2010", the fund said its surveillance shows that while foreign asset purchases by US residents did surge, they remained below pre-crisis purchase levels.
The report also acknowledges increased financial flows from the US to private portfolios at the same time that output gaps are closing and inflation rates are on the rise, but said surveillance suggests limited effect on net inflows in emerging markets.
The IMF has detected rising asset prices in some countries but while noting this as a concern, refused to characterise the current condition as a bubble.
Instead, director of the Western Hemisphere Department, Nicolás Eyzaguirre, reverted to IMF-speak, saying that there were early signs of "possible excesses", and that some asset prices were looking "a bit bubbly".