MANAGING RISKS ASSOCIATED WITH

VOLATILE CAPITAL INFLOWS

Atish R. Ghosh*

Research Department

International Monetary Fund

*The views expressed in this presentation are those of the presenter and do not necessarily represent those of the IMF, its

Executive Board, or its management. This presentation draws on IMF SPN/10/04, SDN/11/046, SDN/12/01 and SDN/12/10; it is

not meant to prejudge the outcome of the IMF’s ongoing work to articulate an institutional view on capital flows.

There is a tendency to regard foreign exchange

controls, or any interference with the free movement

of funds as, ipso facto, bad ... [but] there are times

when it is in the best economic interest of a country

to impose restrictions on movements of capital…[and]

there are periods when failure to impose

controls…have led to serious economic disruption.

The task before us is not to prohibit instruments of control but to develop those measures

of control, those policies of administering such control, as will be the most effective in

obtaining the objectives of world-wide sustained prosperity

Harry Dexter White

The advocacy of a control of capital movements must

not be taken to mean that the era of international

investment should be brought to an end. On the

contrary, the system contemplated should greatly

facilitate the restoration of international loans and

credits for legitimate purposes.

John Maynard Keynes

CAPITAL CONTROLS: A VERY OLD ISSUE

2

0.0

0.2

0.4

0.6

0.8

1.0

1960 - 1969 1970 - 1979 1980 - 1989 1990 - 1999 2000 - 2006

Capital Account Openness in Selected Advanced Economies

1960-2006

Canada France Germany UK US

0.0

0.2

0.4

0.6

0.8

1.0

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Canada France Germany United Kingdom United States

UK: Purchases of foreign securities by UK residents required foreign exchange bought at a premium

Canada: Interest payments on inward financial credits, and inter -bank loans and deposits subject to a withholding tax

Germany: Ban on non -resident purchases of German bonds introduced in 1972 (and lifted in 1974). Discriminatory reserve requirements employed

France: "Devise-titre” system: residents could only reinvest the proceeds of sales of previously held foreign securities; could not increase their foreign asset holdings

Capital Account Openness in Advanced Economies: Some Examples 1960 - 2006

USA: Interest Equalization Tax (IET) on purchases of foreign, fixed interest securities; tax was abandoned in 1974 soon after the adoption of floating exchange rates

Note: Capital account openness index (0=highly restrictive; 1=fully liberalized).

Source: Quinn and Toyoda (2008).

Note: Capital account openness index (0=highly restrictive; 1=fully liberalized).

Source: Quinn and Toyoda (2008), and OECD (1982).

THAT KEEPS CROPPING UP

3

-2

-1

0

1

2

3

4

5

6

7

8

-50

100

250

400

550

700

1980 1985 1990 1995 2000 2005 2010

Asia Europe Latin America & Carrib. Middle East & Africa Average net financial flows (in % GDP)--right axis

Surges seem to be increasing in frequency

and magnitude

Regions that experience the largest surges

are also those that generally experience the

largest drop in net flows, heightening the

challenge of managing volatility on the up-

and downsides

Net Financial Flows to EMEs (in USD bln.)

4

ALONGSIDE BOOM-BUST CYCLES IN

FLOWS

Debates on how to manage flows resurface time and again

Latin America prior to the 1980s debt crisis

Asia in the runup to the 1997-98 East Asian crisis

Emerging Europe in the runup to the 2008 crisis

CAPITAL FLOWS ARE BECOMING LARGER AND

MORE VOLATILE

5

Capital flow volatility has increased over time…

Global market volatility increases capital flow

volatility…

Source: EPFR.

*Rolling standard deviation of equity flows over the previous quarter.

Bond Funds to EMEs

(In bln. USD; weekly flows)

0

10

20

30

40

50

60

70

80

-3.5

-2.5

-1.5

-0.5

0.5

1.5

Jan-0

7

May-0

7

Sep-0

7

Jan-0

8

May-0

8

Sep-0

8

Jan-0

9

May-0

9

Sep-0

9

Jan-1

0

May-1

0

Sep-1

0

Jan-1

1

May-1

1

Sep-1

1

Jan-1

2

May-1

2

Sep-1

2

VIX index (right axis)

0

1

2

3

4

5

6

-12

-10

-8

-6

-4

-2

0

2

4

6

8

Jan-0

1

Aug

-01

Mar-0

2

Oct-0

2

May-0

3

Dec-0

3

Jul-0

4

Fe

b-0

5

Sep

-05

Apr-0

6

Nov-0

6

Jun-0

7

Jan-0

8

Aug

-08

Mar-0

9

Oct-0

9

May-1

0

Dec-1

0

Jul-1

1

Fe

b-1

2

Sep

-12

Volatility of equity

flows* (right-axis)

SHOULD WE CARE?

Capital flows are generally beneficial: financing for

productive investment; consumption-smoothing; risk

diversification, etc.

But sudden and excessive inflows can raise

• Macroeconomic concerns—exchange rate appreciation; general

overheating

• Financial-stability risks (banks, corporate, households)—

excessive, unhedged foreign currency borrowing; fragile

external liability structure; asset price bubbles

6

MACRO AND FINANCIAL-STABILITY CONCERNS OFTEN OVERLAP

7

Pre-crisis capital flows to EMEs and…

Domestic credit growth

Source: IMF’s VEE database.

Notes: All variables are averaged over 2005-07. Domestic credit growth is cumulative growth over last 3 years (in percent).

0

4

8

12

-10 0 10 20 30

Net private capital flows (in % of GDP)

Infla

tio

n (

in %

)

R2=0.09

-25

-15

-5

5

15

25

35

45

-10 0 10 20 30

Net private capital flows (in % of GDP)

Change in

dom

estic c

redit (

in %

)

R2=0.24

0

20

40

60

80

100

-10 0 10 20 30

Net private capital flows (in % of GDP)

FX

le

ndin

g in

tota

l le

ndin

g (

in %

)

R2=0.10

Inflation Foreign currency lending

8

ROADMAP

Three principles for policies

What is in the policy toolkit for macro concerns and financial-

stability risks associated with capital inflows?

How to choose between prudential measures and capital

controls for financial-stability risks

Spillovers and multilateral considerations

9

THREE PRINCIPLES FOR POLICIES

Neither capital controls nor other policies should be used to

avoid warranted external adjustment—nor should capital

controls substitute for available macroeconomic tools.

Both residency-based capital controls and non-residency

based prudential measures may be necessary to safeguard

financial stability depending upon circumstances.

Policies should take account of multilateral considerations.

10

Neither capital controls nor other policies should be used

to avoid warranted external adjustment—nor should

capital controls substitute for available macroeconomic

tools.

So, what is in the toolkit?

11

11

To address macroeconomic challenges

Allow external balance to move toward medium-term multilaterally

consistent equilibrium value

Floaters—allow nominal exchange rate to appreciate

Peggers—do not engage in sterilized intervention

Deploy macro policy tools as available

Accumulate reserves if not already more than adequate for country insurance

Lower interest rates if no inflationary/overheating concerns

Fiscal tightening if justified by cyclical position and debt sustainability

considerations

Capital controls (or prudential measures that act as capital

controls, e.g., currency-based measures)

WHAT’S IN THE POLICY TOOLKIT?

12

12

To address financial-stability risks

Macroeconomic policy may have some traction…

But prudential measures and capital controls that target specific risks

likely to play a more dominant role

FX-related prudential measures: Discriminate according to the currency,

not the residency, of the flow

Other prudential measures: Reduce systemic risk without discriminating

based on residency/currency

Capital controls: Discriminate between residents and non-residents (could

be economy-wide or sector specific; broad-based, or target specific types

of flows)

WHAT’S IN THE POLICY TOOLKIT?

13

13

HOW COMMON ARE THESE MEASURES?

14

14

SUMMARY OF POLICY ADVICE

15

Both residency-based capital controls and non-residency

based prudential measures may be necessary to

safeguard financial stability depending upon

circumstances.

So, how to choose between them?

16

Ceilings on banks’ foreign

derivative positions/Capital

controls on banks (esp. short-term

debt), e.g., taxes/reserve

requirements

Open FX limits/higher

capital requirements on

loans to unhedged

borrowers

Cyclical capital

requirements, LTV limits

Legal or

other

impediments

to capital

controls?

FX-related

prudential

Capital

controls

Fragile external liability

structure (maturity

mismatch/sudden-stop

risk)

Currency risk (due to open

FX position) or credit risk

(due to unhedged borrower)

Credit boom/asset price

bubble

FX-related

prudential1/

Other

prudential

Flows to domestic

banks

Concerns

about access

to finance/

distortions?

FX-related

prudential/

Capital

controls1/

1/ Once macro policy space exhausted, and taking due account of multilateral considerations.

16

CHOICE OF INSTRUMENTS: FLOWS INTERMEDIATED THROUGH THE FINANCIAL SECTOR

17

Direct flows or through

unregulated financial

sector

Fragile external liability

structure (debt,

especially short-term)

Currency risk (due to

lack of natural or

financial hedge)

Asset price bubble

Capital

controls1/

Capital controls to

discourage debt

instruments

Capital controls to

discourage FX borrowing

by unhedged entities

Broad-based capital

controls

Capital

controls1/ Capital controls1/

Borrower-

based FX-

measures

Legal or

other

impediments

to capital

controls?

1/ Once macro policy space exhausted, and taking due account of multilateral considerations.

17

CHOICE OF INSTRUMENTS: FLOWS NOT INTERMEDIATED THROUGH THE FINANCIAL SECTOR

18

Playing field for access to credit of large firms vs. SMEs

Prudential regulations may cause flows to be intermediated

through the unregulated financial sector (e.g., Croatia)

International obligations may prohibit or constrain the use of

capital controls (e.g., the EU treaty, the OECD code, or BITs)

All else equal (effectiveness, efficiency), prefer measures that

do not discriminate by residency or nationality

18

OTHER CONSIDERATIONS

19

• Broad principles

Effective: achieve intended aim; not easily circumvented

Efficient: minimize distortions and scope for non-transparent/arbitrary

enforcement

• But a number of questions…

Permanent or temporary inflow?

− Macroeconomic concerns: Controls for temporary, not permanent inflows

− Financial stability: Controls could be imposed for persistent flows

Broad-based or targeted controls?

− Macroeconomic concerns: Broad based possibly with limited exemptions

− Financial stability: Targeted but taking account of circumvention possibilities

Price or quantity-based controls?

− Macroeconomic concerns : Price-based are easier to adjust, and simpler to administer

− Financial stability: Quantitative measures more appropriate when authorities face

information asymmetries/uncertainty about private sector’s response

Other considerations: Administrative and institutional capacity

19

DESIGNING CAPITAL CONTROLS AND PRUDENTIAL

MEASURES

20

Policies should take account of multilateral

considerations.

So, what are these spillovers and how do they modify

policy advice?

21

21

Capital-receiving countries

If controls are ineffective, no spillovers

If controls are effective, then possible deflection to other recipient

countries (and back to source countries)

Weak and contradictory evidence: need to base on logic

Benign? Pecuniary externality? Depends on whether capital is

welcome and controls are costly.

Capital-sending countries

Controversy over effect of QE, but generally strong evidence of push

factors

Pecuniary externality? Convex costs

POTENTIAL SPILLOVERS OF POLICIES

22

22

Policy measures to limit capital flows should not be deployed to

Avoid necessary external adjustment

Exploit market power and manipulate terms of trade

Capital controls and prudential measures (that act as capital

controls) imposed for genuine domestic externalities are a

legitimate part of the toolkit, but may require coordination

among:

Recipient countries: to impose lower controls when there are

generalized surges of capital

Source-recipient countries: such that source countries take into account

the impact of their policies. May benefit them through terms of trade

gain and by reducing crisis likelihood in borrowing countries

ISD shines spotlight on spillovers, including those that are not

explicitly manifested through the BOP

MULTILATERAL CONSIDERATIONS

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Policies should not try to avoid warranted, orderly external adjustment

Macro challenges—macro policies (as available) and capital controls

(prudential measures); broad-based; temporary (not longer than duration of

surge); likely price-based

Financial-stability—prudential policies and capital controls; targeted; not

necessarily temporary; not necessarily price-based.

Prudential measures main instrument when flows are intermediated through

the banking sector

Capital controls main instrument when flows by-pass the banking sector

Multilateral effects of policy measures that limit capital flows are complex

May require recipient countries to take account of policy responses of other

recipient countries

And source countries to take account of impact of their policies (especially

monetary, regulatory) on recipient countries

Return to Keynes’-White’s idea that capital flow management would be more

effective if movements “could be controlled at both ends”?

KEY TAKEAWAYS

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Ghosh, Atish R., 1991, “Strategic Aspects of Public Finance in a World of High Capital Mobility,” Journal of International

Economics, Vol. 30, pp. 229–47.

Ghosh, Atish R., and Jun Kim, 2008, “Export Subsidies, Undervalued Exchange Rates, and Consumption Taxes—Some

Equivalence Results of Relevance to Bretton Woods II,” Mimeo (Washington DC: International Monetary Fund).

Ghosh, Atish R., J. Kim, M. S. Qureshi, and J. Zalduendo, 2012, “Surges,” IMF Working Paper WP/12/22 (Washington

DC: International Monetary Fund).

International Monetary Fund, 2010, The Fund's Role Regarding Cross-border Capital Flows (Washington, DC:

International Monetary Fund)

_______, 2011, Recent Experiences in Managing Capital Inflows—Cross-Cutting Themes and Possible Guidelines

(Washington, DC: International Monetary Fund).

_______, 2011, The Multilateral Aspects of Policies Affecting Capital Flows (Washington, DC: International Monetary

Fund).

_______, 2012, Liberalizing Capital Flows and Managing Outflows (Washington, DC: International Monetary Fund).

Ostry, J.D., A.R. Ghosh, K. Habermeier, M. Chamon, M.S. Qureshi, and D.B.S. Reinhardt, 2010, “Capital Inflows: The

Role of Controls,” IMF Staff Position Note 10/04 (Washington, DC: International Monetary Fund).

Ostry, J. D., A.R. Ghosh, K. Habermeier, M. Chamon, M.S. Qureshi, L. Laeven, and A. Kokenyne, 2011, “Managing

Capital Inflows: What Tools to Use?” IMF Staff Discussion Note 11/06 (Washington, DC: International Monetary

Fund).

Ostry, J.D., A.R. Ghosh and M. Chamon, 2012a, “Two Targets, Two Instruments: Monetary and Exchange Rate Policies

in Emerging Market Economies,” IMF Staff Discussion Note 12/01 (Washington, DC: International Monetary Fund)

Ostry, J.D., A.R. Ghosh and A. Korinek, 2012b, “Multilateral Aspects of Managing the Capital Account,” IMF Staff

Discussion Note, 12/10, (Washington, DC: International Monetary Fund)

24

REFERENCES