Friday, 20 May 2011

The ‘trilemma’ of capital controls

What Are We To Do By Tan Sri Lin See-Yan

MY last column examined principles underlying the international monetary system (IMS) as we know it today. I also explained why the IMS isn't working. Today, I want to dwell on one of these principles, namely, the free international movement of goods, services & capital. We have since come a long way in freeing the movement of goods and services.

As a result, currencies of many emerging nations are today readily convertible for current transactions of the balance of payments (BOP). Unfortunately, failure at the Doha Round to further liberalise trade is a setback. Convertibility on capital transactions remains an issue.

First, some history: in the intermediate years after WWII, controls on capital movements were common. Unlike today's controls, directed at slowing down massive inflows of capital, these post-war controls mainly aimed at slowing down outflows. After the UK lifted exchange controls under Margaret Thatcher in 1979, more governments have come to allow freer movement of money into and out of their economies.

Developed countries led by the US blame China’s policy for tightly controlling its currency value, driving “capital into economies with freer exchanges.

While increasing free capital flows can help spur economic growth by enabling more productive investment, the growing volume of inflows into emerging nations has raised concerns. Today, capital controls refer to taxes or other administrative measures meant to regulate those flows.

Exchange control directly violates one of the precepts upon which the IMS is predicated: the world economy relies primarily upon decentralised decision making by billions of individuals and businesses responding to market forces. Government, to be sure, is responsible for influencing these market forces consistent with national objectives, but always without attempting to direct and interfere with individual transactions.

The Bretton Woods accord set up the IMS in 1945 based on this principle and changes made over the years have kept faith with it. Of course, as a matter of practical expediency, in the transition to free capital movements, countries in (what IMF calls) fundamental BOP disequilibrium, that is, with persistent payment imbalances, could temporarily impose exchange controls (previously called Article XIV nations) to enable them to better adjust under IMF supervision.

The French connection

Ironically, it was French socialists who brought global financial liberalisation home to the IMF. According to Harvard's Rawi Abdelal, when capital flight forced socialist French President Mitterand to abort his programme in 1983, it set in motion developments that ultimately enshrined free capital movements as a global objective. And this started first in the European Union in late 1980s, then on to the Organisation for Economic Co-operation and Development (OECD) and eventually, at the IMF under French socialist CEO M.Camdessus (Governor, Bank of France under Mitterand). It was again a French socialist, recently resigned CEO Dominique Strauss-Kahn (now in a New York prison) who distanced the IMF from its long-standing tenet on free capital movements. Speaking in Asia in January 2011, he said: “Capital controls can also play a role, particularly where the surge in capital flows is expected to be temporary or where exchange rate over-shoot is a real danger As long as it's temporary, it may be the only way.”

The trilemma'

Capital will go where it finds the best returns. In the past year, it has been Asia and also Latin America. Recipients of large capital inflows have begun to fret about their impact and on how to “manage” them. Indeed, emerging markets states seek some measure of protection against the new flows of cheap and easy money generated in the US, Europe & Japan. The massive inflows (estimated by the IMF at over US$1 trillion in '11, against a high of US$1.3 trillion in '07) have raised the chances of trade and currency conflicts. A long list of emerging nations from Indonesia, Thailand, South Korea, Taiwan, Philippines, India China to Turkey to Chile, Mexico and Brazil have already imposed capital controls, motivated simply to curb “hot money” that threatens to distort their economies, drive up demand and exert undue pressure on their currencies, and pose dangers of asset bubbles.

In China, besides monetary moves, exporters are allowed to hold more US$ offshore a negative capital control to keep foreign monies out, rather than a loosening of capital controls. Malaysia this week announced more liberal capital measures to promote large investments abroad. In South Korea, a levy was imposed on foreign currency debt held by banks while in Brazil, the tax on capital inflows was tripled to 6%. Indonesia set a minimum one-month holding period for investors of its bonds and India imposed a capital gains tax on all stock trades.

Nations face an economic choice: often 2 out of 3 (trilemma): fixed exchange rate, freedom to set monetary policy and free flow of capital. Having all 3 is impossible; only any 2 of the 3. The US has long had free capital flows and the right to set monetary policy. So, it is forced to live with currency fluctuations. The same orthodoxy is imposed by IMF on the world. The case of Japan in the late 1980s (Plaza'86 and Louvre'87) is classic. However, the IMF faces problems imposing it on China which prefers to give up free flow of capital; it likes very much for China to be like the US.

Smoke but do not inhale'

Notwithstanding the blaring narrative about peaking in global growth, sovereign debt risks in Europe, fiscal austerity, and “unusually uncertain” outlook for the US economy, many emerging nations continue to be saddled with massive capital inflows, if left unchecked could make some of them self-destruct. While these factors are worrisome, fortunately many of them have built-up enough “fat”. Consider their massive foreign reserves totalling more than US$7 trillion, exceeding 10% of global GDP. These reserves will be used as emerging nations move gradually to adjust to face the structurally impaired consumer demand in the west. This reminds me of FT's Martin Wolf who observed that emerging markets “smoke but do not inhale” global capital. While emerging nations welcome capital inflows (smoke it), it is concerned about speculation, quick exit and reversals, and large net inflows (inhaling is bad for health). This is reflected in their preference to intervene in the forex markets and to recycle the monies (through current BOP accounts and capital flows) into foreign exchange reserves.

Preventing capital inflows from reaching the real economy has been their best insurance against the impact of rising currencies on competiveness, inflation and stroking domestic demand.

Conventional wisdom has it that a nation's reserves are adequate if they are (i) equivalent to 3 months' imports, and (ii) equal to or exceed short-term debt. Most emerging nations easily pass these rules of thumb. China's reserves (at US$3.15 trillion) far exceeded its short-term debt. The reserves to debt ratio of Russia, India and Brazil also points to large excesses. Saudi Arabia and Algeria have reserves that cover more than 2-years imports; Brazil, a year and India, 9-months. Their robust financial health augurs well for the future.

After successfully weathering one of the worst financial crises in history, growth in 2011 and 2012 will slacken saving less and spending more. This policy switch comes at a time when emerging nations recognise that future growth rests in their own hands, and not on the fortunes (or lack of it) of the much indebted west. Although forced to “smoke” massive inflows (including collateral smoke), they should heed Prof Stigliz's (Nobel laureate in economics 2001) advice: “Now that the IMF has blessed such interventions (exchange control) should be a key part of any system to ensure financial stability; resorting to them only as a last resort is a recipe for continued instability it is best if countries use a portfolio of them as management tools.”

Controls stir debate

In Hong Kong, at its 1997 annual meetings, the IMF tried to push deep into capital market liberalisation. The timing was bad as the East Asia crisis was just brewing. The crisis exploded soon enough in a region of high savings with little need for more capital inflows. The crisis showed that free and unfettered markets are “neither efficient nor stable” (Stigliz). Studies have shown that capital controls have helped small nations (e.g. Iceland) to manage. The far reaching surge of cheap and loose money from the US, Europe and Japan into emerging markets loomed so large that even finance ministers and central bank governors who are ideologically adverse to intervention, now believe they have no choice but do so. Hence, the change of stance at the IMF.

At its April meetings, IMF's “guidelines” on managing capital inflows was rebuffed by most emerging nations as an attempt to restrain them, rather than help. As a result, they were delayed for further study. The IMF's recent reversal of its long standing opposition to limits on free capital flows was based on the compelling need by emerging markets to curb surging inflows, which they recognise can fuel asset bubbles and inflation (e.g. China, India and Brazil), and hurt exporters by driving currency value higher.

IMF wanted nations to use exchange controls as a last resort, after they had used other tools including interest rates, currency values and fiscal adjustments. But emerging nations objected vehemently viewing the proposals as hamstringing their policies. Brazil's finance minister called capital controls, “self-defence” measures. Ironically, some major advanced countries, most responsible for the global crisis and have yet to resolve their own problems, are most eager to prescribe “codes of conduct to the rest of the world, including countries that have become over-burdened by the spill-over effects of policies adopted by them.”

Who's to blame?

The controversy is centred on “blame.” Emerging nations blame the US “as a fountain of excess cheap capital because it is holding short-term interest rates near zero and pumping money into the economy by buying government bonds.” Developed countries led by the US blame China's policy for tightly controlling its currency value, driving “capital into economies with freer exchanges.” IMF has a tough-sell to establish a shared understanding around the use of capital controls. It tries to create a “comfort zone” which nobody wants because there is nothing comforting about being judged negatively at the Fund's annual review if they did not follow the rules.

Nations need all the tools at their disposal to prevent financial crises and mitigate massive capital flows. Controls may not always be the first-best response, but they are easy to understand and implement, and have a strong “announcement” impact.

There are of course many pitfalls to controls. Most important is the danger from a self-feeding system of continuing tightening of controls. There is Prof. Cohen's Iron Law of Economic Controls: “to be effective, controls must reproduce at a rate faster than that at which means are found for avoiding them.” Moreover, a partial system of controls would readily breakdown as funds flowed through uncontrolled channels spurred by fear of still further controls.

In the end, a complete system of controls is required. Any policy of attempting to “muddle through” via adopting certain controls only reduces and distorts the volume of international trade and investment. Controls can breed revival of a brand of mercantilism which cannot be for the global good.

Any shake-up of conventional wisdom and comfortable modes of behaviour is bound to pose a challenge.
J.M.Keynes once said “what used to be heresy (restrictions on capital flows) is now endorsed as orthodoxy.” That happened in 1945 at the dawn of the Bretton Woods era. More than 65 years later, it is ironical that we need a similar shift in mindset to effectively meet the challenge.

Former banker, Dr Lin is a Harvard educated economist and a British Chartered Scientist who now spends time writing, teaching and promoting the public interest. Feedback is most welcome; email:

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