A Rationale for Capital Controls?
During the Asian crisis the IMF urged countries to maintain unrestricted cross-border flows. These days, surprisingly, depending on circumstances it is endorsing capital controls. What at first view looks as a promise for relief can really be bad news. Why?
First of all because capital controls are bad.
Capital serves to finance economic activity and growth. Prices signal its relative scarcity and markets serve to channel it to where it is most needed. Hampering its flow invariably means creating distortions in the real economy, limiting economic agents’ access to a most important factor of production and weakening growth prospects.
Second, capital controls in emerging market economies are even worse.
In these economies the need for growth and thereby for capital is even greater. Investments here are sometimes riskier, but prices can be expected to reflect these risks. However, there is widespread agreement among economist that at times markets and prices do not function properly which then is taken as a reason for policy to interfere.
A study of recent IMF publications gives the following picture of the current situation:
– After the global financial crisis recovery shows a two-speed nature.
– In advanced economies it is slow and accompanied by loose monetary policy and low interest rates.
– In emerging markets growth prospects are stronger resulting in higher interest rates which attract capital inflows from low-interest-rate countries.
Seen as a whole, this scenario looks perfect: There is ample liquidity in one part of the world and growth in another one and capital is flowing to where it is needed bringing, as the IMF itself concedes, important investment and growth benefits to emerging economies. Where is the problem?
Actually, the IMF mentions three problems:
– The capital inflows are accompanied by an appreciation of the home currency which threatens to weaken international competitiveness and exports.
– Emerging economies may not be able to “digest” the capital inflows risking overheating and inflationary pressures.
– These days, capital inflows are predominantly portfolio investments, which in contrast to direct investments and cross-border bank lending are regarded as particularly volatile.
Under the impression of the Asian crisis of 1997, although acknowledging the beneficial nature of these portfolio flows in the current situation, the IMF argues that there is a danger that these flows reverse suddenly and in a synchronized manner and, exacerbated by herding behavior in financial markets, cause disastrous effects similar to the ones experienced before.
The question is whether this interpretation of what happened during the Asian crisis is right.
Lessons from the Asian crisis
IMF case studies in this context include three countries that suffered badly during the Asian crisis: Thailand, Indonesia and Korea.
Thailand was the first country hit by the crisis which started with pressures on the Thai baht in early 1997. Capital controls were to no avail and Thailand also became the first country to get an IMF standby credit. Within months, Indonesia and Korea, although in very different economic circumstances, were affected by “contagion” with their currencies, too, coming under heavy pressures. The IMF standby credits to these three countries where extremely large relative to their IMF quotas. In addition, in order to impress markets there were substantial financial commitments from other organizations such as ADB and IBRD. With a total of $117 billion the official amounts offered to these three countries reached unprecedented heights.
Can portfolio investments be named as culprits in the crisis? The chronology of events shows otherwise revealing a characteristic crisis pattern. In all cases the first hint of crisis and main dynamics came from currency markets. Foreign exchange traders tested one currency after another. Parallels in economic developments or other seeming weaknesses were sought, rumours and bandwagon effects made it ever harder for authorities to defend their position. Portfolio investments fleeing the currencies added to the picture but whether they were the driving force behind the crisis must be doubted.
One lesson from the course of events concerns the nature of financial markets involved. As a crisis unfolds – and often even at its very beginning – currency expectations and foreign exchange trading play a prominent role.
In contrast to a widely held view in macroeconomic circles, currency trades are not simply the other side of foreign trade, capital flows and portfolio investments. The foreign exchange market is a huge wholesale market where activities decide about the fate of economies large and small. Capital investors’ expectations and decisions may, in principle and under circumstances, influence market sentiments, but more often they serve as an explanation for banks justifying why they traded in a currency.
Let us have a look at volumes: In April 2010 the estimated daily fx turnover was 3,981 bn US dollar. By comparison: Market capitalization of world exchanges around that time was $57,107 billion, total issue of international debt securities amounted to $26,751 bn and foreign consolidated bank claims worldwide were $34,906 bn. World annual exports in 2010 were $14,950 bn. Claiming that portfolio investments drive a currency up or down is like saying the tail is wagging the dog.
Although there is at best anecdotal evidence, adding to the picture is the extraordinary performance of the top banks in emerging-market currencies trading in 1997.
Now, does it make you wonder if the efforts of Brazil’s government these days to halt the rise of the real by taxing capital flows does not stop it?
A handful of actors
One conclusion to be drawn from the Asian crisis is that in order to slow down crisis dynamics it is crucial to limit fx activity at the first signs of financial instability. Does this mean more currency intervention? Certainly not. Considering the comparably meagre amounts of official reserves there seems no chance to successfully stem the tide.
Given the lack of transparency of markets the best alternative were an agreement on voluntary self-restraint like the ones already existing in various realms of international finance. However, were it possible to agree on rules with hundreds and hundreds of financial and nonfinancial institutions worldwide? Actually, although this has been done before, in this case it is not necessary. In the foreign exchange interbank market trading is highly concentrated. In particular, in trading emerging-market currencies only the biggest institutions can afford the related risks. In April 1998, at the height of the Asian crisis, in the US market 15 dealers reported large trades of $250 million and more in Thai baht, only five in Korean won. In the UK, there were 16 dealers reporting large deals in Thai baht and 13 in Indonesian rupiah. And the trend toward greater overall market concentration continues.
Chance and challenge
Free and open financial markets are a precious good. This holds for currency markets, too. And as in any free and open market in order to benefit from the advantages rules must be agreed guaranteeing fair play and efficient outcomes. Bringing those active in trading emerging-market currencies to the negotiating table would be a big challenge. If it worked, in contrast to capital controls it would offer a chance to considerably reduce financial instability in future crises. It’s worth a try.
See for the IMF position, for example, here.
Those interested in more details are referred to this paper from 2002 on the Asian crisis.