Tuesday, April 05, 2011

IMF Considers Framework to Support Capital Controls

Sources: WSJ: IMF to Outline Framework For Temporary Capital Controls
Bloomberg: IMF Draft Guidelines Endorse Capital Controls as Last Resort for Inflows

In what could possibly be a significant shift in policy, the International Monetary Fund (IMF) recently hinted in a position paper that it might support the use of capital controls by countries to achieve economic stability. Since the IMF has long opposed restrictions on the free flow of funds across countries, an endorsement of capital controls would essentially represent a complete policy reversal for the IMF.

Capital controls are measures taken by countries to limit the flows of funds in and out of their countries. Examples of such controls include taxes on the profits of investments made by foreigners, or even explicit limits on the amount of foreign currency that is allowed to enter a country. Rapid currency inflows can, among other things, create rapid economic growth, which gives rise to inflationary pressures in the country receiving the inflows. In addition, large flows of currency can have a destabilizing effect on foreign exchange markets, resulting in rapid increases or decreases in the valuation of a home country’s currency, which carries with it a host of other problems. If a nation’s currency is too highly valued, it can negatively affect that nation’s exporting businesses by making their goods relatively more expensive to other countries. On the other hand, if a nation’s currency is too cheap, that can make it difficult for that nation to pay debts that are denominated in other currencies.

The IMF’s reconsideration of the usefulness of capital controls comes at a time when they are being widely used, especially by developing nations. Many developing countries have used capital controls to stem the large flows of currency into their countries from foreign investors attempting to take advantage of the economic growth in those countries. The trend of placing money in developing nations has been exacerbated by the fact that growth has been stagnant in developed nations, which makes those nations less attractive investment targets compared to developing nations. In 2010, the net flow of funds to developing countries was $753 billion, which represented an increase of 44% from the previous year.

While the approach taken in the position paper is a substantial step for the IMF towards condoning capital controls, the IMF is careful to qualify the use of capital controls only as a last resort. Instead, the IMF stressed that countries should first pursue macroeconomic policies (e.g., fiscal tightening and higher interest rates) that have the tendency of slowing economic growth and, therefore, reduce the attractiveness of those countries as a target for an over-abundance of foreign investment.

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