Capital flow management is coming back into vogue among economists, government officials in other countries and in international institutions. As international capital flows continue to grow to tens or even hundreds of trillions of dollars per year, washing around unpredictably between countries and financial institutions, officials are increasingly looking at ways to put some sort of control on them to minimize the inflation and external trade competitiveness problems they cause.
Mainstream economic management tools include fiscal policy, interest rates, macroprudential management and, in many countries, exchange rate management. However those policies can be overwhelmed by the destabilizing effects of large capital inflows leading to economic overheating, currency appreciation and/or loss of global competitiveness. For many countries including the U.S., capital flow management is the missing tool to fill out the suite.
In 2012 the International Monetary Fund (IMF) adopted a new official view which acknowledged that capital controls are a legitimate part of the policy toolkit. This is summarized in a document known as the IMF Institutional View. Today, capital controls, now referred to as capital flow management tools, are used by dozens of countries in Asia, Latin America, and Europe.
The IMF argued in several reports in recent years that capital flows have proven to be disruptive to many emerging market countries, typically because large inflows of foreign capital are often followed by a sudden outflow, which can plunge an economy into recession, destabilize its banking system, with severe political and social consequences. The IMF summarized its position in a briefing document prepared for a 2018 Group of 20 meeting: “Under the premise that capital flows provide substantial benefits, but also recognizing that inflow surges or disruptive outflows can give rise to macroeconomic and financial stability risks, the IV [Institutional View] recommends that….in certain circumstances CFMs [capital flow management tools] can be useful to support macroeconomic adjustment and safeguard financial stability.”[1]
This is an important evolution in thinking on international economic policy. To understand how this innovation can impact economic policymaking, three IMF economists, Atish Ghosh, Jonathan Ostry, and Mahvash Qureshi (henceforth GOQ) produced a book, Taming the Tide of Capital Flows, A Policy Guide, exploring policy options for managing a national economy in today’s world.
GOQ outline a conventional approach to typical macroeconomic objectives, but with strong awareness of the international dimension. They posit national economic objectives: output growth, inflation, the exchange rate, and financial stability. Fiscal policy is the prime policy tool for managing output growth. Much of this is not new. In many countries output growth is managed with a combination of fiscal and monetary policy. The GOQ analysis assumes fiscal policy will focus on output growth, and concentrates on the other tools.
The other three policy tools are interest rates set by the central bank (or government), foreign exchange intervention, and macroprudential regulations. Interest rates are the tool best suited to manage inflation. Foreign exchange intervention can be used to manage the exchange rate. This is important because a rise in interest rates often attracts capital, pushing up the exchange rate. To maintain international competitiveness while managing interest rates, the government authorities need to prevent excessive currency appreciation.
Macroprudential measures can be used to protect and enhance financial stability. Financial stability includes the stability of key individual banks and other financial institutions, as well as the stability and resilience of the financial system as a whole. Large-scale capital inflows can undermine financial stability at both the micro and the macro (systemic) level. Macroprudential measures typically include regulations on bank reserves or other institutions-specific financial requirements that prevent excessive credit growth, safeguarding the stability of the financial system.
Capital controls are recommended to be used to guard against excessive inflows that can be so powerful as to overwhelm the first three tools and subvert all the economic objectives. Excessive capital inflows can cause credit growth, generating inflation. They can drive up an exchange rate, depressing exports and increasing imports, resulting in a trade deficit and underemployment. They can also lead to financial instability and set the stage for a financial crisis, because inflows often involve debts in foreign currency and dangerous balance sheet mismatches at the level of the individual financial institution.
According to the GOQ analysis: “When some instruments are unavailable…or when the intensive use of the three instruments is excessively costly, then capital controls should be brought into play.”[2]
GOQ identify several forms of capital controls. Financial transaction taxes have been used by Brazil to restrain inflow surges. The tax rate has varied between a 2% and 6% levy on each financial transaction (purchase of a Brazilian security). The rates were raised at times of acceleration in inflows, and there is evidence the tax succeeded in reducing inflows and preventing undue appreciation of the Brazilian real. Other capital control measures have included direct limits on the volume of bank borrowing in foreign currencies. Korea and Thailand have removed withholding exemptions for nonresident investors on interest and dividends from their holdings.[3] GOQ concluded that these experiments with capital controls have had some degree of effectiveness.
Applicability to the US
The IMF’s Institutional View, like the arguments put forward by IMF economists Ghosh, Ostry, and Qureshi, are aimed primarily at emerging market economies (EMEs). Many EMEs have suffered economic dislocations, recessions, and financial crises resulting from large, sudden, intense outflows, which usually followed sustained periods of financial inflows.
However, these principles can also apply to the U.S. The U.S. has seen large inflows for many years, reaching an unusually high $596 billion in net inflows in 2021. The inflows contribute to appreciation of the dollar exchange rate. Without capital inflows, the 45 consecutive years of trade deficit (all but one of those years including also a deficit on current account) would have driven the dollar down to a more competitive level. In addition, the inflows into the U.S. contributed to lower interest rates in the years between the 2001 recession and the 2008 Global Financial Crisis. Economists including former Federal Reserve president Ben Bernanke have argued that those low interest rates contributed to the house price boom in the years to 2006, which in turn played a major role in the Global Financial Crisis and the failure of several large financial institutions (Weinberg, 2013).
In short, of the four major policy objectives the IMF economists identify, output growth, inflation, a competitive exchange rate, and financial stability, the large, persistent international capital inflows into the U.S. can be linked to all of them except inflation. Output growth has been hampered by the uncompetitive exchange rate, resulting in a loss of demand for American goods and services on the order of $500 billion to $800 billion annually (depending on whether one measures it by the current account or trade account deficit). The exchange rate has been persistently overvalued. The last CPA estimate for 2021 found the dollar was 16.7% overvalued. Financial stability has been undermined by the excessively low interest rates the Federal Reserve has been forced to implement for most of the past 20 years. The crisis in the Treasury bond market in March 2020 was a nightmarish example of the danger of financial crisis linked to large foreign inflows into Treasuries.
As we look to regain control over the U.S. economy, become internationally competitive and generate noninflationary growth in a form that creates high-paying jobs and strengthens our domestic industries, capital flow management tools will be a key part of the U.S. government’s arsenal.
Footnotes
[1] IMF, The IMF’s Institutional View on Capital Flows in Practice, 2018, pg. 5.
[2] GOQ, pg. 183.
[3] GOQ, pg. 261.
References
Ghosh, Atish R., Ostry, Jonathan D., Qureshi, Mahvash S., Taming the Tide of Capital Flows, A Policy Guide, 2017, MIT Press.
IMF, The Liberalization and Management of Capital Flows: An Institutional View, Nov. 14, 2012, IMF.
IMF Staff, The IMF’s Institutional View on Capital Flows in Practice, 2018, IMF.
Weinberg, John, The Great Recession and Its Aftermath, 2013, Federal Reserve Bank of Richmond.
