This guest post was submitted by Arvind Subramanian, a senior fellow at the Peterson Institute for International Economics. Arvind is a leading proponent of the view that we need to rethink capital controls – he sees them as central to meaningful macroprudential regulation going forward. (He also has an op ed in today’s Financial Times, on climate change, economic development, and the basis for an international agreement.)
The Bretton Woods Committee is organizing a panel (today, Wednesday) on the role of the G-20 in coordinating global growth with speakers from the IMF, US Treasury, and the G-24 group of developing countries. “Global imbalances” (the US current account deficit, the Chinese current account surplus, etc) will be discussed extensively. But I will also raise the question of whether there is a new imbalance in the world economy that threatens emerging markets, and what they should do about it.
Extraordinarily loose monetary policy and the resulting close-to-zero interest rates in many industrial countries are pushing capital out to emerging markets—Brazil, China, and India—whose growth prospects are buoyant and relatively unaffected by the crisis. Brazil’s currency has appreciated by 30 percent this year, India’s stock market soared by 70 percent, and China is once again furiously accumulating foreign exchange reserves, $62 billion in September.
Now, foreign capital can be good for emerging markets because it brings down the cost of capital for domestic firms, provides finance, facilitates greater investment, and boosts growth. But, as my co-authors and I have shown in two papers, the evidence in favor of foreign capital is awfully hard to find.
In part, this is because foreign capital causes the exchange rate to appreciate which hurts exports, especially in manufacturing, and growth in the long run. Another reason is that domestic financial systems and their regulation are not strong enough to prevent and cope with financial crises that result when foreign capital bolts for the exits. Time and again we have learnt (or rather failed to learn) that large foreign capital flows to emerging markets are not sustainable (Latin America 1982; Asia 1997-98; and Eastern Europe 2008). Think of this: if sophisticated regulatory systems such as those in the US and Europe cannot avoid financial crises, how much more vulnerable are emerging markets?
So, how should emerging market countries respond? Is it time for them to impose serious restrictions on capital flows? In answering these questions, two points must be kept in mind: this policy challenge is going to be around for some time, at least as long as the Fed keeps interest rates low; and second, because the cause of the increased flows is common to all countries, namely Fed policy, it will be a policy challenge not just for individual countries but for emerging markets as a group.
Chile in the early 1990s and Malaysia in the wake of the Asian financial crisis in the late 1990s are the two poster boys for serious capital account restrictions. The evidence on their effects—in limiting flows and preventing currency overvaluation—is contested because restrictions can be circumvented. But Carmen Reinhart and Nicholas Magud suggest that their effects cannot be dismissed.
Going forward, there is the technical question of how best to design restrictions on flows: Should they be price-based or quantity-based? What kinds of flows are best addressed, debt or portfolio? When should they be withdrawn? The IMF should deploy its considerable technical expertise to help answer these questions.
But there is also the political issue of removing the stigma from countries that want to impose serious capital controls. Brazil recently botched its attempt at such controls because the policy action was half-hearted, anxious about the reaction of markets. One possibility could be coordinated restrictions on capital flows action by a set of emerging markets that could be blessed by the G-20. No doubt this would be risky, perhaps even counter-productive, but in these unusual times no policy option should be off limits, at least for discussion.
By Arvind Subramanian