Peter Chowla, guest blogger
The storm brewing in Europe makes it all the more important that all countries prepare themselves for dangerous economic shocks. For developing countries, as we learned in 2008, shocks are transmitted through multiple channels, a key one of which is capital flows.
The exit of some countries from the euro, or even its break-up, is now a high probability. There are two big implications: capital flight within the EU and the risk aversion by global investors. Imagine the accelerated flight from Greek banks towards German ones if Greece no longer participates in the euro project. The most recent example would be the Icelandic banking collapse of 2008, at which the Icelandic authorities resorted to strong foreign exchange and capital outflow controls, controls that were even endorsed by the IMF. However, as the report explains, within the EU there are deeply entrenched policy hurdles, not least of which is the Lisbon Treaty, which would prevent the Greek authorities from trying to stem a run on their banks in the same way the Icelandic authorities did.
As for developing countries, there are already high risks that capital flow surges experienced in the last two years will reverse. Already in September a sell-off occurred in Brazil and other countries. A deeper reversal due to a global economic downturn could be disastrous for countries that are relying on short-term capital inflows to finance deficits. The best placed countries will be those that act early to mitigate the surges of inflows, alter their composition and deter short-term speculation. Those that have not done so yet should be thinking clearly about the risks they face and put in place pragmatic, preventative regulations that can help prevent financial speculators wreaking havoc.
Last month the G20 accepted that capital controls and capital account regulations should not be seen as last resort options. As Kevin Gallagher points out, the IMF should do more to accept the G20’s conclusions that “capital flow management measures may constitute part of a broader approach to protect economies from shocks.”
A new report we have released today, Time for a new consensus, explains the drawbacks, especially for development, of policies to deregulate the movement of money across borders, and makes suggestions for a new pragmatic approach to regulation of financial flows to ensure stability and development.
The global economic developments show once again the need to rethink the entire system from the bottom up, as ad hoc responses to bonanzas and sudden stops will be more costly and less effective than preventative regulations. Many thinkers address this issue through the lens of “global imbalances”. Last Monday, the Bank of England published two new financial stability papers about global imbalances and reform of the international monetary system. They present some clear thinking about the problems of the system and the reasons why reform is needed. However, the Bank of England’s big idea is worrisome: “countries with current account deficits would be allowed to tax current [account] inflows from countries with whom they run bilateral current account deficits. In this framework, the burden of adjustment would be on all countries with current account surpluses, regardless of whether their respective imbalances were justifiable with respect to fundamental determinants.” The approach boils down to the UK following the US Senate in trying to slap import tariffs on Chinese goods.
The Bank of England explicitly rejects the idea of tackling imbalances from the capital account side rather than the trade side, saying “capital flows might be harder to measure and control in practice.” However, our new report shows that, in fact, measures to control capital flows have been quite effective and could be even more so with global cooperation and better enforcement. It is the political hurdles that prevent this happening, including entrenched powerful interests in the rich countries that are the source of most capital flows: the US, the UK and Europe. Policy makers need better data, more enforcement, more regional coordination, and a rewriting of the rules contained in investment and free-trade agreements.
Developing and developed countries would benefit and stability would be enhanced by a more hard-headed approach to macroeconomic policy and cross-border financial flows. It is time for a new consensus, one in favour of pragmatic policies that will seek to channel financial flows for the benefit of people, especially those in developing countries. Given the occurrences of the last few years, it is clear that while the hurdles may be high, achieving finance that works for development is not beyond our reach. Civil society organisations and social movements are vital pressure points to achieve political change, but their action should be complemented by new thinking among responsible financial actors and policy makers.
Peter Chowla is Programme Manager of Finance and IMF at the Bretton Woods Project. See his new report, “Time for a new consensus: Regulating financial flows for stability and development.“