Kevin P. Gallagher and Stephany Griffith-Jones
In the wake of the financial crisis, Western economists and policy-makers are to be applauded for recognizing that financial globalization has its limits and that capital controls may be necessary for emerging and developing nations to defend their economies from volatile capital flows. Most of the discussion to date has focused on controls on capital inflows, but could there be a role for controls on outflows as well?
Perhaps controls on outflows in the US would have bolstered the effect of quantitative easing. There may be situations where developing countries will need to resort to controls on outflows in order to prevent de-stabilizing outflows of capital from their countries as well.
Keynes thought so. He said that, “control of capital movements, both inward and outward, should be a permanent feature of the post-war system.” Indeed, Keynes and Harry Dexter White each argued that in order for capital controls to work coordination was needed at “both ends” of a capital flow, meaning at the source of the capital outflow and the receiving end or in terms of capital inflows.
The April World Economic Outlook (WEO) of the IMF shows that capital inflows to emerging markets have now surpassed their pre-crisis peak. According to the IMF, such a surge in inflows of short-term capital is largely due to factors related to the “two-speed” recovery—slow growth in the West and faster growth in the emerging markets.
A key driver in this context is the carry trade. With low interest rates in the United States investors are borrowing in the US and investing in emerging markets such as Brazil where rates are over 11 percent. Not only do investors reap profit from the “carry” or difference between the two interest rates, and from strengthening emerging market currencies, but also from a leverage factor.
This has proved dangerous, as Brazil and other nations have experienced significant currency appreciation, asset bubbles, and now inflation all partly fueled by large surges of very short-term and reversible capital. Ironically, under these conditions when Brazil raises interest rates to tame asset bubbles and inflation it attracts evermore investment due to the carry trade.
Thus the resort to capital controls. Brazil, South Korea, Indonesia, Taiwan and others have all recently used controls on inflows as an attempt to discourage such short-term inflows, and to grant countries like Brazil more autonomy over monetary policy.
The fragility here needs to be underscored. The slightest change in US interest rates (and such changes are likely at some point) could cause an unwinding of positions that could be utterly destabilizing. Indeed, in an analysis in Chapter 4 of the WEO the IMF shows that a 5 basis point increase in US rates could cause capital flight worth 0.5-1.25% of GDP out of the developing world. Capital flows to developing countries are at an all-time high at just over 2.3% of GDP, so the projected shortfall would be significant. As happened during US interest rate hikes and capital flight in the 1980s and 1990s, exchange rates across the developing world could plummet, thereby decreasing purchasing power and increasing debt service levels in local currencies of emerging markets’ foreign exchange exposure.
So during the quantitative easing period, what if the US had put a tax or margin requirement on the notional value of foreign exchange derivatives? It might have discouraged excessive short-term capital flows to emerging and developing countries, posing major problems for their macroeconomic management now and raising the risk of future crises.
Controls on short-term outflows might also have facilitated the liquidity created by the Fed to stay in the US and have a better chance of going toward productive investment in the US, which is precisely the aim of the FED policy. Such investment could help developing countries via trade, rather than causing speculative capital to flow to emerging markets and cause havoc to their financial systems and their economies. They could also be considered prudential measures as they would limit excessive leverage and risk-taking in foreign currencies.
Developing countries may eventually need controls on outflows as well. A drastic event like failing to raise the debt ceiling and a subsequent default in the US could send interest rates sky high, triggering the massive de-stabilizing capital outflows from the developing world predicted by the IMF in the WEO.
Having stand-by policies in place whereby industrialized and developing countries alike stand ready to impose counter-cyclical capital controls—controls on inflows when inflows are excessive, controls on outflows during periods of capital flight—may be an important part of a new macro-prudential toolkit to prevent and mitigate financial crises.
Financial instability anywhere can cause financial instability everywhere. Regulating capital flows for financial stability will take a global effort on “both ends” of capital markets, as Keynes and White forewarned long ago.