Taming the liquidity tide

Kevin P. Gallagher

In Germany this week Brazilian president Dilma Rousseff rebuked industrialised countries for creating a “liquidity tsunami” of speculative capital that is bubbling currencies, stock and bond markets across emerging markets and the developing world.  To stem the tide, her government extended a tax on speculative inflows of capital into Brazil.

A new task force report entitled Regulating Global Capital Flows for Long-Run Development, released this week, argues that regulating flows to tame the liquidity wave are justified more than ever in the wake of the global financial crisis.  Countries have more flexibility to deploy such measures given the new consensus in the peer-reviewed academic literature and at the IMF that capital account regulations have been effective tools to prevent and mitigate financial crises.  In this new environment Brazil, Indonesia, Taiwan, Peru, Thailand, South Korea, and many others have regulated flows.

However, the report also expresses serious concern that many countries lack the ability to regulate flows because many of the world’s economic integration clubs and trade and investment treaties have started to mandate capital account liberalisation.

The task force is a project of the Global Economic Governance Initiative at Boston University and similar endeavours at Columbia and Tufts universities.  Some of  its members are no strangers to these pages, such as Arvind Subramanian of the Peterson Institute for International Economics, and Dani Rodrik of Harvard University.  Others include former finance minister of Colombia, Jose Antonio Ocampo; former deputy governor of the Reserve Bank of India, Rakesh Mohan; as well as economists from the United Nations, the G-24, IMF missions, the Asian Development Bank Institute, the Chinese Academy of Social Sciences and academia in the United States.

The tsunami Ms Rousseff was referring to are the massive swings in capital inflows and outflows that followed the global financial crisis and the dawn of the euro crisis. Pair quantitative easing and low interest rates in the industrialised world, and relatively higher interest rates and faster growth in emerging markets, and you find some of the causes.  Until the eurozone jitters, capital flows returned to emerging markets after the crisis at an alarming rate. When the euro looked like it was on the verge of collapse the winds shifted and capital fled to the safety of the US and beyond.  With seemingly calmer waters in Europe, the tides have once again turned to emerging markets. This has caused significant asset and exchange rate volatility making for an uncertain climate for policy-making, investment and long-run growth alike.

In response, many countries deployed capital account regulations to curb the negative effects of cross-border capital volatility. Like earlier studies by the National Bureau of Economic Research and others confirming that capital controls can change the composition of inflows, make for more independent monetary policy, and ease exchange rate tensions, new studies by the IMF and others show how countries such as Brazil, Taiwan, and South Korea have been at least moderately successful.

The task force echoes a growing consensus that such acts are not protectionism, but correctionism. According to the new welfare economics of capital controls, unstable capital flows to emerging markets can be viewed as negative externalities on recipient countries. Therefore regulations on cross-border capital flows are tools to correct market failures that can make markets work better and enhance growth, not worsen it.  One of the conclusions of the task force is that countries and international bodies such as the IMF need to do a much better job of implimenting effective capital regulations, and monitor them.  Moreover, the group recommends that industrialised and emerging markets cooperate to regulate capital flows.

Article VI of the original IMF Articles of Agreement states that “Members may exercise such controls as are necessary to regulate international capital movements,” (though not movements related to current transactions).  Maurice Obstfeld and Alan Taylor point out that both Keynes and Harry Dexter White agreed on this, and further argued that the burden of regulating speculative capital should be at “both ends”: not only on the recipients of capital inflows, but also on the source countries of that capital.  The IMF shunned this mandate for much of the 1980′s and 1990′s, but has begun to recommend that countries deploy controls in both their Article IV consultations and in stand-by agreements.

Unfortunately, while this consensus was emerging, inconsistent and patchwork regime was constructed that restricts the ability of countries to regulate unstable capital flows.   The task force report notes that the membership of the OECD and European Union both limit the ability of countries to regulate capital flows.  Worse still are certain commitments in financial services under the GATS and in the thousands of trade and investment treaties.  Last week when Pacific Rim countries were negotiating a new trade deal with the United States called the Trans-Pacific Partnership Agreement, over 100 economists signed a letter to negotiators calling on them to grant flexibility to deploy capital account regulations to prevent and mitigate crises.  Many of the task force members signed the letter, as did otherwise steadfast free traders such Jagdish Bhagwati and others.

To try and put a new umbrella over the tsunami at the G-20 summit in Cannes, Germany and Brazil forged the “G20 Coherent Conclusions for the Management of Capital Flows Drawing on Country Experiences”.  The document was endorsed by the G20 finance ministers and central bank governors in October, then endorsed by the G20 leaders in Cannes.

The G20′s conclusions endorse regulating global capital flows. The G20 now calls on nations to develop their own country-specific approach to managing capital flows and, as Sarkozy said in his final Cannes speech, “the use of capital controls, and this is very important, is now accepted as a measure of stabilisation.”  You can’t tame a tsunami with an umbrella, but it is a start.

This article was originally published in the Financial Times.

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One Response to “Taming the liquidity tide”

  1. Cornel Ban says:

    An article waits to be written from this excellent argument. But the next question that comes to mind is: What explains the IMF’s epistemic shift on the issue? As such matters are usually political, it would be fascinating to find out how the IMF’s internal and external politics of ideas played a role relative to standard structuralist explanations (e.g the increasing leverage of emerging markets).

    Speaking of structural power, it’s intriguing to see Brazil going further this month by extending the tax on foreign borrowings and threatening further capital controls in an effort to protect the country’s manufacturers caught in the carpet bombing raids of the commodity boom. In early March the Rousseff government extended the existing 6 per cent financial transactions tax on overseas loans maturing in up to three years. Until this year, the levy was applied only to loans with maturities of under two years. This is more than the Germans expected.

    As for the Chinese, I see that their central bank suggests arresting the loosening of capital controls. This prudent move comes at the expense of those in the Party who want to see the renmibi compete with the dollar for reserve currency status. The fact that the call to caution was issued by the central bank rather than by the executive is wildly ironical given what we assume about the preferences of central banks elsewhere.