Capital Controls, ‘Currency Wars,’ and New Global Financial Architecture

Ilene Grabel

For those of us advocating change in the global financial architecture, the last few months have been fairly exhilarating.  Let’s recap…

Capital controls, as I’ve written previously, have become the ‘new normal’ in the developing world.  It’s hard to keep up with developments in countries that have introduced or tightened existing controls since I last wrote about them here (see below). IMF staff now write about capital controls with a taken-for-granted attitude (see even the institution’s October 2010 Global Financial Stability Report, which contains the by now customary bland language on the role and efficacy of capital controls, e.g. p. 28).

Staff members of tin-eared credit rating agencies do not flinch these days when another rapidly-growing developing country implements controls.  Neither do private investors: to the contrary, they continue to flood developing country financial markets even after new controls are announced.

Depressed interest rates in the USA and Japan have added fuel to the boom in developing country financial markets. Investors are borrowing at low cost in rich countries and using those borrowed funds to buy higher yielding assets (like government debt) in developing countries. (Finance geeks:  this is called the “carry trade.”)  The rapid pace of international capital inflows into developing country markets has caused currencies to appreciate sharply, threatening export performance. In this context, policymakers are implementing precautionary and (in many cases) finely calibrated capital controls in order to staunch speculative bubbles and dampen currency appreciation.  Wasn’t it just yesterday that policymakers in the developing world either would not or could not take these steps? We should wonder how different recent history across the developing world might have been had policymakers in the 1990s imposed capital controls to curb the speculative bubbles and currency pressures during that ‘emerging market boom,’ a boom that ended with the East Asian financial crisis.

And there’s more. Today national, bilateral and regional financial architectures in the developing world are evolving in ways that may ultimately reconfigure the global financial architecture. Indeed, and as I argue in a forthcoming paper, in the new era both the IMF and the US dollar may be displaced from their privileged positions. And on top of all that there is the matter of the emerging “currency wars,” a phrase we cannot seem to escape in the last few weeks. We’ll return to that war in a moment.

I should pause here to emphasize that not all is well in the global financial system.  Basel III is a disappointment; the G-20 and the EU continue Hooverite calls for austerity and debt sustainability (though social movements in Europe are challenging retrenchment with great force); the IMF continues to resurrect the pro-cyclical prescriptions it perfected in program countries over the last decades; IMF governance reforms that the G-20 was pushing last year have been shipwrecked on the shores of USA-Europe rivalry and conflict between larger and smaller European countries; and the prospect of serious financial reform in the USA…well, that seems to have gone about as far as Wall Street and the Tea Party will allow it. So there’s plenty of bad news alongside the hopeful indicators of fundamental change.

On the bright side, the last few weeks have witnessed a great deal of new capital market regulation. At the beginning of this month, South Korea added to the controls that were initially implemented in June 2010. Beginning on October 19, regulators will audit lenders working with foreign currency derivatives. The goal is to reduce the financial instability and currency appreciation caused by the capital inflows associated with these transactions.  Also this month, Brazil strengthened the capital controls it first put in place in October 2009.  The new Brazilian controls double (from 2 to 4%) the tax it charges foreign investors on investments in fixed-income bonds. The Brazilian controls tax foreign equity purchases at a lower rate (i.e., the same 2% rate that has been in place since 2009), and foreign direct investment is still not taxed at all. This is a particularly good example of fine tuning controls so that they affect the composition, rather than the level of foreign investment. (Indeed, the IMF’s recent Global Financial Stability Report makes note of this composition effect in Brazil.)  Thailand also has been making news:  earlier this month authorities introduced a 15% withholding tax on capital gains and interest payments on foreign holdings of government and state-owned company bonds. And rumors in the financial press suggest that additional measures are under consideration. Finally, Peru has been deploying a variety of inflow controls since early 2008. The country’s reserve requirement tax (which is a type of control on capital inflows) has been raised three times between June and August 2010.

This gets us back to the currency war that Brazil’s Finance Minister, Guido Mantega, warned about on September 27, 2010. He cited the intensifying competition among states to reduce the degree of currency appreciation (or to bring about an actual depreciation). This strategy is driven by concerns about trade performance as countries struggle to recover from the global financial crisis. Central banks across the developing world are engaging in a variety of interventions, such as buying dollars that come into the country to finance foreign investment (so as to reduce pressures on the domestic currency to appreciate), and also implementing capital controls on inflows. Will these strategies solve the problem they aim to address? No, and indeed, in the absence of viable, representative mechanisms of global economic management, we may descend into a period of nationalist, beggar-thy-neighbor policies.  But in the short turn at least the strategies will help protect developing countries from the negative trade effects of currency appreciation. More importantly, they solidify the growing international sentiment that unregulated capital flows and currency markets are no longer viable across the developing world.

The only real, enduring solution to the problems at hand (i.e., currency pressures, trade dislocation, speculative bubbles and other global imbalances) lies in the urgent but politically difficult challenge of constructing a new global financial architecture that promotes mutually beneficial coordination across countries on financial regulation, capital controls, and currency policies.  Until this emerges, we cannot expect national policymakers to refrain from mercantilist currency interventions. Let’s hope that the G-20 has the courage to take up these matters at its November meeting in Korea.  Truth be told, I am not very optimistic given the timidity of the G-20. But I am hopeful that developing country representatives have put the matter of recasting the global financial architecture back on the table, not least due to the global attention garnered by their unilateral actions on capital controls.