Global Prospective: IMF urges developing nations to consider capital controls

It looks like the IMF is finally abandoning the neoclassical orthodoxy aka Washington Consensus. When Malaysia imposed strict capital controls following the Asian crisis in 1997-8, the IMF and the US Treasury led by none other than Larry Summers (Deputy Treasury Secretary then) severely criticized the action. How much one's beliefs change in 10 years?

This news is important from Nepal's point of view because Nepal might seek IMF's aid if its Balance of Payment worsens. Hopefully that won't happen. However, there is silver lining to IMF's intervention if there is one. NepaliEconomy.com believes that only IMF can impose politically unpalatable, and in current circumstance politically impossible, economic reforms in Nepal.

IMF urges developing nations to consider capital controls
WSJ, 19-Feb-2010
By BOB DAVIS

International Monetary Fund economists, reversing the fund's past opposition to capital controls, urged developing nations to consider using taxes and regulation to moderate vast inflows of capital so they don't produce asset bubbles and other financial calamities. It said emerging markets with controls in place had fared better than others in the global downturn.

The recommendation is the IMF's firmest embrace of capital controls and a reversal of advice it gave developing nations just three years ago. The IMF has long championed the free flow of capital, as a corollary to the free flow of trade, to help developing countries prosper. But the global financial crisis has prompted the fund to rethink long-held beliefs. It recently suggested the world might be better off with a higher level of inflation than central bankers now are targeting.

"We have tried to look at the evidence and tried to learn something from the current crisis," said Jonathan Ostry, the IMF's deputy director of research, who wrote "Capital Inflows: The Role of Controls" with five other IMF economists.

The IMF examined capital restrictions tried by Brazil, Chile, Malaysia and other countries, such as explicit taxes on capital inflows, requirements that a portion of foreign capital be held interest-free at the central bank, and various regulations to reduce foreign lending. The fund recommends that countries first look at whether traditional policies, such as allowing currencies to appreciate, will work to moderate capital inflows. Countries whose currencies are appropriately valued and that are wary of lowering interest rates to ward off inflows should look at "unconventional" measures, Mr. Ostry said.

Money is flooding into emerging markets, producing fears that asset bubbles are forming in China, South Korea, Taiwan, Singapore and elsewhere, particularly in real-estate markets. This year, about $722 billion in private capital is expected to flow to developing nations, a 66% increase over 2009 but far below the $1.28 trillion that flowed to emerging markets in 2007 before the financial crisis, according to the Institute of International Finance, a banking trade association.

Private investment generally helps growth, the IMF says, but a too-rapid increase can lead to a boom and then a bust. About six months ago, IMF economists started examining the ability of capital controls to limit financial damage. Countries that had controls in place before the global recession, they found, were much less likely to have suffered a sharp economic downturn. "The less risky financial structure meant you were less likely to undergo a credit boom-credit bust cycle," said Mr. Ostry.

The IMF says capital restrictions have tended to make it harder for investors to pull money from a country quickly, thus reducing financial fragility. It isn't clear whether the measures also reduce total capital entering the country, it said.

Before the crisis, a very different IMF gave very different advice. In a July 2007 speech in Bangkok, the IMF's managing director at the time, Rodrigo de Rato, advised nations that capital controls "rapidly become ineffective" and are easily circumvented.

The IMF now says that finding a way around restrictions increases costs for investors and acts as "sand in the wheels" of international capital. Columbia University economist Jagdish Bhagwati, who criticized IMF opposition to capital controls during the Asia crisis in the late 1990s, applauded the change. "Better late than never," he said. "This is so clearly an area where letting markets rip isn't a good idea."

Deploying restrictions to maintain undervalued currencies, the authors warned, would be undesirable:In that circumstance, money would flow to other countries, pushing up their currencies and making their exports less competitive internationally. The authors didn't mention any country in particular, but it is clear they were warning China. The IMF has labeled the yuan as undervalued, joining the U.S. and Europe in pressing China to let its currency rise.