Juan O’Farrell, guest blogger
The increasing global economic uncertainty and the prospects of a flight-to-quality, with money flowing out of developing towards developed countries, raise the question of how prepared developing countries are to protect their economies from external shocks in the coming year. But volatility of financial flows also means that, most probably, following capital flight driven by the eurozone crisis emerging markets will again experience a surge in speculative financial inflows. The threat of continued ‘boom and bust’ cycles and lack of responses from international forums like the G20 and the IMF to address global monetary chaos makes the need for central banks to take action even more urgent.
There is a welcome shift in Latin America as countries continue their slow process of acceptance and de-stigmatisation of capital account regulations. In September this year Costa Rica joined the group of countries using these regulations, when it established that short-term foreign loans received by banks and other financial entities will be subject to a holding deposit of 15% of the value of the investment.
The evidence collected in a new report by Bretton Woods Project and Latindadd, Breaking the Mould, shows that regulations on capital inflows and outflows are helping Argentina, Brazil and Costa Rica to achieve not only financial stability, but also to promote development goals like poverty reduction and employment creation. These findings challenge the current IMF stance, which gives inadequate consideration to the impact volatile capital inflows have on economic activity and employment.
There are many ways that regulating financial flows can contribute to the achievement of social goals. In addition to the now widely acknowledged negative social impacts of the financial crises that followed financial liberalisation in the region during the 1990s, the report examines unregulated capital inflows artificially inflated the value of the Brazilian and Costa Rican currencies and undermined the export capacity of their local industries. This potential destruction of local industries has direct negative implications for employment creation and poverty reduction, and explains why regulating speculative financial flows is an intelligent policy.
Roberto Frenkel, a Buenos Aires based researcher, pointed earlier this year to the link between unregulated flows of money and what is known as Dutch Disease. The policies in Brazil, Costa Rica and Argentina to disincentivise speculative flows underline the concerns of many in the region, concerns that unfortunately the IMF is currently pretending to ignore. One more time, the Fund is falling short of understanding the social implications of the policies it advocates for.
Although not always mentioned by analysts, a comprehensive set of capital account regulations is one of the keys behind the economic growth and social progress of Argentina in the post-2001 crisis period. Since 2002, Argentina implemented several measures to deal with both inflows and outflows, such as requirements for exporters to sell foreign currencies internally, regulations to deal with currency mismatches, and non-remunerated reserve requirements on short term investments, among others. These measures supported the maintenance of a stable and competitive exchange rate and increased monetary policy space, which in turn stimulated economic activity and employment creation. Furthermore, less reliance on short-term investment also places the country in a strong position in the current context of global economic uncertainty.
In this sense, while in Argentina the capital account regulations implemented since the 2001 crisis are part of a comprehensive policy ‘toolkit’ which represents a U-turn from 1990s financial liberalisation, in Brazil and Costa Rica the regulations implemented come as isolated policies responding to a particular context.
The inflows that flooded Brazil and Costa Rica during the period 2009-2011 are not productive but speculative investment, mainly what is known as ‘carry-trade’ investment, where investors borrow in countries with low interest rates and lend into countries with high interest rates. Historically low interest rates in rich countries, and high interest rates in Brazil and Costa Rica because of inflation targeting policies, stimulated a surge in flows. The surge both induced exchange rate appreciation and increased their exposure to a sudden stop. This was clearly expressed in September this year when the eurozone crisis stimulated a strong outflow of capital from emerging markets, depreciating the Brazilian real by 14% against the dollar in only one month, forcing the central bank to intervene for the first time in two years in order to support the value of the currency
In order to make speculation on the Brazilian real less profitable and stop exchange rate appreciation, Brazil implemented a 2% tax on foreign purchases of stocks and bonds in 2009 and a 1% tax on financial derivates in July 2011. The same motivations are behind the regulations implemented by Costa Rica in September this year. Several studies showed that the regulations in Brazil have been effective in slowing inflows and reducing the pace of exchange rate appreciation.
Despite this positive impact, in the case of Brazil, and especially in the case of Costa Rica, it could be argued that the regulations implemented are too late and too little. Too late because they only implemented regulations once the value of their currencies was already heavily affected and the composition of flows shifted to larger proportions of short term capital. And too little because the measures are not comprehensive.
In Brazil, continued high interest rates, tax exemptions to foreign investors, and record profits in the financial sector make a 2% tax look too small. In fact, the evidence shows that the impact of the tax was stronger when the tax rate was increased to 6% in November 2010. In Costa Rica, following IMF advice, they decided to take action only after three years of strong exchange rate appreciation. Furthermore, the reserve requirement implemented covers only short-term loans, and leaves other flows unregulated, including trading activities on stocks and bonds. This suggests that there is still scope for short-term investments to affect the financial stability of the country. It is important to note that Costa Rica faces limits on imposing further regulations because of existing Bilateral Investment Treaties (BITs) and Free Trade Agreements (FTAs).
Latin American countries should continue their efforts to regulate financial flows in ways that benefit their citizens. The available evidence shows that using capital account regulations as a last resort policy, as advocated by the IMF, increases financial instability and puts jobs at risk. In order to increase the effectiveness and development impact of capital account management techniques, they have to be implemented early on as part of a comprehensive policy framework. Their effectiveness will increase with regional coordination; current discussions at Unasur (Union of South American Nations) on coordinated response to the crisis are a good sign.
Juan O’Farrell is research assistant of Finance and IMF at the Bretton Woods Project. See their new report, “Breaking the Mould: how Latin America is coping with volatile capital flows”