A view on Capital Flows: IMF changes its mind

YESTERDAY the International Monetary Fund (IMF) adopted its reviewed institutional view of Capital Flow management and policy. An FT editorial more or less praises this “U-turn” by the IMF. The FT says:

“On Monday, after a thorough three-year review, the fund has accepted institutionally that direct controls can play a useful role in calming volatile, international capital flows [...]

As the IMF rightly argues, the first line of defence against financial instability should always be more conventional macroeconomic tools. When an emerging market is facing a precipitate inflow of hot money, cutting the interest rate and tightening fiscal policy can be more effective than direct controls.”

Initially this view seems very easy to agree with. However, I suspect that a problem for many emerging markets will be the fact that domestic conditions and economic policy does not play a major role in the decision making of global investors. American and European banks buy South African assets because they look for EM exposure, not necessarily because the yield is high. It is very difficult to find statistical evidence that higher policy rates in SA have increased non-resident purchases of SA bonds. On the other hand, the one consistently significant explanatory variable of all non-resident purchases of SA assets is the VIX (the current situation seems to be an anomaly) . That is, capital flows to SA when global risk is low (or risk appetite is high). In such a scenario, a lower policy rate will not do much to reduce this flow of capital.

My favorite current academic research on the topic of global capital flows is being done by Hyun Song Shin at Princeton University. He has presented his observations at multiple conferences, including the 2011 High-Level Conference by the Brazilian Authorities and the IMF on Managing Capital Flows in Emerging Markets. In the audience at this conference sat Dr. Olivier Blanchard, Economic Counsellor and Director of the Research Department of the IMF. In a blog post Dr. Blanchard summarized what he took away from this conference, here is a selection of his notes:

None of the tools—be they reserve accumulation, prudential measures, or capital controls—are water-tight. So we should move away from strict policy orderings toward a more fluid approach of using “many or most of the tools most of the time” instead of “this now, that later”.

This lesson seems to have made an impression on Dr. Blanchard, as it nicely summarizes the general feel of the new institutional IMF view published now (more than a year later). Unfortunately Dr. Blanchard does not mention what lessons he took from Prof. Shin’s presentation. Shin’s research has pointed out that many of these capital flows are in fact caused by cross-border banking: A US or Europe based bank lending directly to emerging market clients, or through a local affiliate. Shin’s model predicts that these flows will be determined by US monetary policy and the VIX (price of risk). The model does not allocate any role to domestic policy in the recipient country other assuming capital flows are completely liberalized.

Such a view does not correspond well to the notion that domestic interest rates can be influential in affecting EM capital flows. In that case, if capital flows are deemed to be too costly (risky), regulation may be the only option. Regulation can effectively reduce or stabilize capital flows into a country, but they carry a substantial cost in terms of lost efficiency, competitiveness, and diversification of idiosyncratic country risks. I personally tend to support the idea of liberal capital flows with monetary policy focused on the domestic economy: that is – raise rates when the economy is overheating, even if the overheating is caused by capital inflows.


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