Regulation of international capital flows in developing countries: institutional and political challenges in their implementation
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By Juan Carlos Moreno-Brid and Lorenzo Nalin1
History has shown again and again that emerging market economies (EMEs) – even when they have solid macroeconomic fundamentals – may suffer acute balance of payments cum fiscal crises. The pattern of such recurrent crises in the developing world has both endogenous and exogenous roots. Indeed, some of such dramatic episodes have had their origin in fully-developed economies, like the international financial crisis of 2008-09. Or in other regions of the developing world, the most recent one is the covid-19 pandemic. Certainly, EMEs´ macroeconomic busts may be rooted too in internal phenomena, episodes of economic mismanagement or of domestic political tensions. Independently of their origin, all of them are accompanied by massive capital flight and a sharp collapse of fixed capital formation and domestic output, and even civil unrest and violence.
In EMEs´ recurrent boom-bust processes, short-term international capital flows have been and continue to be an important component, increasing systemic risk and sharping financial fragility in the recipient country.2 These flows certainly may serve as a source to finance development. But, as recognized in the economic development literature, they tend to play a destabilizing role, both in their entry in massive amounts which tends to appreciate the domestic currency as well as in their abrupt exit which brings about a loss of reserves that eventually detonates a full-blown balance of payments crisis.
By now, there is abundant theoretical support for capital flow management (CFM) to be considered as a legitimate tool in emerging market economies to improve their resilience against financial turmoil.3 In fact, even the IMF, stressing the pervasive destabilizing effects of short term capital flows, has come to recognize CFM as a legitimate and useful instrument of the macroeconomic policy tool kit.4 That it should be admitted as a standard, all-weather instrument of macroeconomic prudential regulation as opposed to a sort of last resort fire extinguisher to be used only in case of emergency is a point where consensus is swiftly being built.
Why is the application of CFM so scarce in the developing world? Is it due to, say, ignorance or lack of information by top officers in Central Banks and Ministries of Finance on the merits of such CFM? Hardly! In the vast majority of developing countries, these positions tend to be filled by sophisticated, well-trained professionals who regularly participate in high-level meetings and seminars organized by international financial organizations. Certainly, some years ago, the tendency in the popular literature on CMF was to stress negative experiences. The only one in Latin America that was systematically recognized as a success story was Chile in its use of “prudential” measures to contain foreign capital inflows for quite some time, until the financial liberalization program in the early 1980s. There is consensus that the removal of such measures led to massive capital inflows, real exchange rate appreciation and a credit boom that ultimately resulted in a crash.5 However, in the last say ten years this narrative has changed. In fact, numerous meetings in international financial organizations – inter alia, the IMF, the BIS – focusing on the challenges posed to macroeconomic stabilization by massive and volatile foreign capital flows have more and more concluded that CFM can and should be a tool of macroprudential concerns.
In our view there are two main reasons for the reluctance to impose CFM in emerging economies. The first one is the technical challenge that its implementation imposes on regulators, the functioning of the domestic circles of financial intermediation and on their international partners. The second one, equally important, is the historical cum institutional context as well as the status of the main domestic economic and political forces with vested interests in the dynamics and effects of short-term capital flows.
Certainly, the challenges brought about by a potential application of CFM have an important technical component. How, in a globalized, open and modern economy, can CFM measures be put in place with minimum disruptive effects? But the most significant challenges that CFM faces to become a standard instrument of economic stabilization are of a political cum institutional nature.
i) History matters.
Does the country have an episode in its not too distant past when controls on foreign capital flows were put in place? If so, in which macroeconomic context were they applied? Was it in the midst of a balance of payments cum financial crisis or as a precautionary tool in conditions of overall stability? How and for how long were they implemented and when were they lifted? What is the current perception of the local entrepreneurial and financial community of the benefits, costs, and overall short and long-term effects of the CFM measures implemented?
Depending on the extent to which the nation´s experience with regulations of capital flows is associated with traumatic balance of payments crises, the polity may be inclined to reject a new attempt to apply them except in extreme conditions. Fear of creating destabilizing pressures on the domestic financial markets may be used as an argument against even the mere theoretical possibility of their use. In such cases, any move towards CFM requires the buildup of a consensus that the fiscal, monetary and financial fundamentals of the economy are strong and that the government´s development agenda is fully committed to preserving stability and a sustainable trajectory of public debt. This is a major technical and political challenge.
ii) Political Economy matters.
Even though CFM can strengthen a country´s prospects of stabilization and economic growth as a whole, its impact at the micro level may be highly variable. For certain economic groups whose financial operations are very much integrated in the global capital markets, CFM may be a severe disruption to their activities. What is being diagnosed by the monetary authorities as risky and unstable capital flows dynamics – and thus with a social need for their regulation – is contrarily seen by such groups as fair opportunities for portfolio adjustment. Restrictions on foreign capital flows may reduce expected profits and alter the business climate for the financial sector and certain foreign direct investors. This would inevitably create tensions among the business community and political actors.
Will the economic interests of certain private groups be strong enough to block or circumvent CFM? An historical example is, say, the last-minute intervention by New York bankers in the final draft of the IMF´s Articles of Agreement; an intervention that aimed at watering down proposals regarding CFMs put forward by Keynes and White. Recall too that, as stressed by Keynes, CFM would not be effective unless applied “at both ends”; from their source of origin to the country of destination. Intervening only on one “side” of is bound to be ineffective as “players” will find ways to circumvent any such controls. An illustrative example is the development of the FOREX market in England. Despite imposing controls on capital outflows, the 1950s and 1960s saw the birth and boom of the Eurodollar market in London partly as a result of a “loophole” in the regulations that permitted transactions on the forward exchange market (Schenk, 1998).
iii) The Productive Structure and Financial Architecture matter.
Both aspects should be considered when evaluating the convenience of introducing some form of CFM. Countries with sound domestic banking sectors may not find it particularly difficult to absorb the impact of the reduction of foreign capital inflows as a source of finance of their current account deficit. Others, in particular those lacking strong development banks, may find it impossible without facing acute shortages of financial resources, especially in hard currency.
It is crucial to identify how CFM might harm fixed capital formation, to identify which investment projects will most likely be affected by its introduction. If, say, foreign capital is mainly devoted to financing speculative asset purchases, CFMs may be more easily legitimized. In this regard, and incidentally not independent of the previous point on the significance of political economy considerations, it is fundamental to assess whether their implementation may lead credit rating agencies to downgrade the country´s sovereign debt. The adverse impact of such a measure on the country´s business climate and policy space may dwarf its potential benefits.
iv) The country´s institutional and legal context with the international community matters.
The institutional sphere is a key element to consider in the discussion on CMF. Whether the country has signed international agreements is crucial, as many such agreements discourage or even prohibit any policy intervention to restrict foreign capital outflows or inflows. They may prohibit what their partners see as, say, unfair exchange rate interventions to provide commercial advantage. Mexico, which recently signed the USMCA agreement with U.S. and Canada (replacing the original NAFTA signed in the mid-1990s) is an example. Despite having a sophisticated financial system – including a deep forex market and the second most traded currency in the developing world – it has been lately suspected of currency manipulation by the US. In fact, the U.S. Treasury recently placed it on its foreign exchange monitoring country list. This implies that the Mexican central bank is to be monitored to assess if it is manipulating its exchange rate to promote price competitiveness. If, say, found guilty of currency manipulation, application of pecuniary sanctions may proceed. In brief, given the USMCA, implementing CFM in Mexico would be rather difficult, not to say impossible.
As a final reflection to close this contribution, we welcome the enormous attention that has been paid in recent years by the academic community and international financial organizations to the examination of the technical aspects, and pros and cons, of implementing CFM. The vast literature developing in this direction has created, in our view, a consensus in favor of not only de-demonizing CFM but also of considering it as a legitimate tool of macroeconomic stabilization cum macro prudential policies; in other words as a tool to be used in “normal” times and not only in the face of balance of payments and financial crises. This is an important achievement. However we point here to the need to devote significant research efforts to identifying the non-technical factors that today condition – and sometimes impede – the implementation of CFM in the developing world. We have sketched four of them here, but certainly more in-depth analysis is required.
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1 Universidad Nacional Autónoma de México, January 4, 2022
2 See Minsky (2008)
3 See, inter alia Ostry (2012), Ostry et al (2012), Zeev (2017)
4 See IMF (2020)
5 A most entertaining and illuminating description of this episode can be found in Diaz Alejandro´s 1985 article: Goodbye financial repression, hello financial crash”.
From: pp.9-12 of WEA Commentaries 11(4), December 2021