The IMF’s nod earlier this month to some capital controls – limits on the free flow of money in and out of a country – could spell trouble for global trade and investment. Shielding their economies against “hot money” from abroad has become fashionable among Asian and Latin American governments worried about credit bubbles and currency appreciation, as investors fleeing low interest rates in Europe and the United States seek higher returns in emerging markets. Sympathetic to emerging markets’ concerns about volatility, the IMF has this year broken with its longstanding rejection of capital controls to suggest there are situations when controls could be permitted. This would be a mistake. The costs of capital controls outweigh their presumed benefits.
Free flow of finance is a force of great good, inspiring financial development and entrepreneurship the world over. Studies show that financial openness boosts growth by about 1 percent annually for industrial countries, and 0.5 percent annually for emerging market countries. Stock market liberalization leads to a 15 percent appreciation in firms’ equity values and raises the annual compensation of manufacturing workers by 25 percent.
It is these benefits that inspired advanced economies to lift controls on financial flows in the 1970s and 1980s, and emerging markets to follow suit about a decade later. The IMF’s cautious nod to controls is less well founded, based on the latest crisis and a handful of Baltic nations.
There are further reasons why capital controls are a bad idea. First, they obstruct trade. An open trade regime generally requires an open financial regime because exporters and importers need access to international financial markets to transact. By the end of the 20th century, three-quarters of the countries that had liberalized trade had also liberalized financial flows. The growth in intra-regional trade was a key reason for Europeans to dismantle capital controls in the 1980s.
Second, capital controls on “hot” portfolio flows have a chilling effect on the more stable foreign direct investment that emerging markets covet for generating well-paying jobs and accessing new technologies. A recent Harvard study finds that foreign affiliates of US parent companies have 5.2 percent lower profit rates in countries with capital controls. Income is drawn away from these affiliates because of the negative spillovers from capital controls to trade and financing. As a result, the parent is less likely to set up the affiliate in the first place.
Third, research finds no clear relationship between capital controls and success at avoiding crises. During the economic duress in the 1970s and 1980s, Latin America was unable to contain capital outflows despite pervasive controls. In the more complex financial markets, investors are quite able to circumvent capital controls. In the meantime, some African countries have enjoyed only minimal inflows despite the absence of restrictions on capital.
Fourth, at the global level, one country’s controls are another country’s headache. Blocked from one market, money will find its way to the next. Worse, prevalent use of controls in nations with current account surpluses and undervalued exchange rates, such as China, will exacerbate global imbalances, generating worldwide pressures for trade protectionism.
Emerging markets claim that US Federal Reserve’s quantitative easing policies have caused a destabilizing gush of liquidity that justifies capital controls. But such controls are ultimately self-defeating, whatever their cause. The first-best policies for weathering volatility are good governance and well-supervised financial markets, and, in the short-run, fiscal and monetary tightening, something also the IMF stresses. Emerging markets have so far shunned tightening so as to offset the lackluster growth now experienced in the advanced economies. But capital controls do not substitute for disciplined macroeconomic policies, and they can discourage countries from making institutional reforms key to stability. It is no accident that the benefits of free financial flows have been greatest in advanced countries, which have the most open capital accounts and best institutions. Emerging markets need more rather than less financial integration, and to do their homework on money management.
The problem is that the horse is out of the barn: a number of emerging nations such as Brazil, Thailand, and South Korea have already imposed restrictions on capital flows.
What, then, can be expected going forward? Chances of a binding framework on when capital controls could and could not be used are next to nil – emerging nations in particular do not want to bind themselves and loose elbowroom. And even if adopted, rules would be ineffective unless married with an enforcement body akin to the WTO’s dispute settlement mechanism, whereby aggrieved parties could challenge the discriminatory actions of other nations. For its part, the G20 group of leading economies should avoid crafting its own rules that end up not being followed.
There will unlikely be much concrete action to limit capital controls. Instead, IMF’s softening on controls only risks encouraging them. That would trigger more economic volatility than it is meant to stem.