IMF gives ground on capital controls

The International Monetary Fund has proposed its first ever guidelines for using controls on flows of speculative capital, legitimising a controversial tool that it once campaigned against.

The guidelines – which are not yet official Fund policy – say that countries can control capital inflows when their currency is not undervalued, when they already have enough foreign exchange reserves, and when they are unable to use monetary or fiscal policy instead.

The IMF said that around one-quarter to one-third of a group of countries that it studied are “currently likely” to meet its criteria for the use of controls.

The framework is the IMF’s attempt to recognise the short-term use of capital controls to manage inflows of “hot money” but distinguish them from long-term barriers against foreign capital.

The framework represents a big shift by an institution that spent the mid-1990s campaigning for free flows of capital, only to be embarassed by the Asian financial crisis of 1997-98, which showed the dangers of a sudden withdrawal of mobile foreign money.

“Our policy advice clearly cannot exclude a whole swath of economic policies – still less an area where the benefits of getting it right are significant, the economic and financial risks of getting it wrong large, and the potential global gains from internalising multilateral considerations substantial,” said IMF managing director Dominique Strauss-Kahn.

The IMF’s executive board said that capital controls are “squarely within the toolkit”. Most of its directors “broadly supported the substance of the proposed policy framework” suggesting that there was greater consensus than before between developed and developing countries on the use of controls.

A surge in capital flows in the wake of the financial crisis has led emerging countries from Brazil to Thailand to impose controls amidst international tension over “currency wars”.

Inflows push up asset prices and some developing countries fear a threat of inflation, financial market bubbles or a panic if all the capital suddenly flows out again at the same time.

Brazil levies a tax on foriegn capital flowing into domestic equities or bonds. Other other countries have used measures such as higher foreign currency reserve requirements for banks, minimum holding periods, or withholding taxes on foreign investment in order to discourage inflows.

The IMF’s framework says countries that are able to should first let their exchange rate appreciate or respond to capital inflows with looser monetary and tighter fiscal policy.

If that is not possible it urges countries to first use controls that do not discriminate between foreign and domestic investors. For example, it suggests limits on foreign currency borrowing by local banks or minimum holding periods.

According to its framework, measures that discriminate against foreign investment such as the taxes on foreign capital inflows imposed by Brazil, should be a last line of defence.

The IMF also says that the use of controls shouls be proportional to the economic risk, that they should be withdrawn when they are no longer needed, and that countries should bear in mind the costs of using them.