Monday, April 27, 2015

The remarkable persistence of the idea of open capital account

It is remarkable that the idea of open capital account as a macroeconomic policy goal, a central pillar of the Washington Consensus and the policy recipe of any multilateral agency, still finds support among influential policy makers in countries like India when the orthodoxy has turned the full circle elsewhere. 
I have blogged extensively on this several occasions. This oped briefly makes the case against rapid capital account liberalization, arguing that markets over-react when countries respond to signs of trouble by reintroducing capital controls and other capital flows management measures, thereby making the original decision on liberalization all the more critical.  

There is nothing profound about this. The contagion from cross-border flows operates through multiple channels. Surging inflows cause exchange rate appreciation, which in turn lowers export competitiveness and generates current account imbalances, apart from unleashing inflationary pressures and adversely affecting local manufacturing and other tradeables. Simultaneously, in the financial markets, it engenders resource mis-allocation manifested in asset bubbles and reckless corporate leveraging. When the tide turns, the risks of over-leveraged corporate balance sheets and aggressive bank lending become evident, with devastating consequences. Sudden stop follows and capital rushes out. Interestingly, and this is important, the trigger for a reversal of capital flows, can happen due to exogenous events which have little to do with the host country. This is a reflection of the deep global financial linkages and necessitated by liquidity and portfolio rebalancing among global financial market participants. Unfortunately, by this time, the country's current account imbalances would have approached unsustainable levels, thereby amplifying the country risk perceptions and hastening the capital flight. De-leveraging and banking crisis invariably follow, accompanied by recession and prolonged slowdown. A decade or so is lost. And it is no different this time.    

In fact, in a landmark confession (the Economist said that "it was as if the Vatican had given its blessing to birth control!"), after rigorous examination of the evidence, the IMF, no less, argued that 'capital controls are part of the toolkit' and admitted to this,
Capital flows can have substantial benefits for countries. At the same time, they also carry risks, even for countries that have long been open and drawn benefits from them... They are volatile and can be large relative to the size of a country's financial markets or economy. This can lead to booms and busts in credit or asset prices, and makes countries more vulnerable to contagion from global instability... Global financial market volatility... has significant spillovers to emerging market economies... Countries with extensive and long-standing measures to limit capital flows are likely to benefit from further liberalization in an orderly manner. There is, however, no presumption that full liberalization is an appropriate goal for all countries at all times... For countries that have to manage the risks associated with inflow surges or disruptive outflows, a key role needs to be played by macroeconomic policies, as well as by sound financial supervision and regulation, and strong institutions. In certain circumstances, capital flow management measures can be useful. They should not, however, substitute for warranted macroeconomic adjustment. 
The IMF's latest country report on India, which examined the impact of global financial market volatility on India, has more to say,
A surge in global financial market volatility is transmitted very strongly to key macroeconomic and financial variables of emerging markets, and the extent of its pass-through increases with the depth of external balance-sheet linkages between advanced countries and emerging markets... We argue that strong fundamentals and sound policy frameworks per se are not enough to isolate countries from an increase in global financial market volatility. This is particularly the case where there is a sudden adjustment of expectations triggered by monetary policy normalization uncertainty in advanced economies... no country (neither advanced markets nor emerging markets) appears immune from the impact of a surge in global financial market volatility. 
In a speech in 2013 at the central banker's retreat at Jackson Hole, Helene Rey (pdf from here) of the London Business School went so far as to claim that "independent monetary policies are possible if and only if thee capital account is managed directly or indirectly". In fact, she describes monetary policy autonomy and free capital flows as an "irreconcilable duo". 

There has been an explosion of research and publications on this issue in recent years. Barry Eichengreen and Poonam Gupta used evidence from the Fed's 2013 tapering talk to show that capital flows volatility spares none,
Better fundamentals (the budget deficit, the public debt, the level of reserves, the rate of economic growth) did not provide insulation. A more important determinant of the differential impact was the size of the country’s financial market: countries with larger markets experienced more pressure on the exchange rate, foreign reserves and equity prices.
In this context, supporters of full convertibility point to the impossibility of effective enforcement of capital controls. This straw man is disingenuous since nobody disputes that capital controls are imperfect. In fact, several studies on the impact of capital controls in recent years while pointing to a mixed picture, also acknowledge the undoubted short-term benefits of capital flows management measures in limiting capital inflow surges. The best evidence that it has some intended effect comes from no less a person than Mohamed El-Erian, former CEO of world's largest bond trader PIMCO, as quoted in the Economist, who has this to say about capital controls,
They do exactly what they are intended to do : put sand in the market. We think twice, or three times.
From all these five things stand out. 
  1. Capital flows carry considerable risks.
  2. Even countries with credible institutional mechanisms are not immune to these risks.
  3. In fact, the vulnerability to global financial market volatility increases with increased economic integration with the world economy.
  4. There is nothing to suggest that full capital account liberalization should be the ultimate objective.
  5. Capital controls can be useful in certain circumstances.
This lends credence to the use of various capital flows management measures like capital controls and macro-prudential instruments. In fact, given their relatively greater effectiveness in comparison to capital controls, macro-prudential measures have become an increasingly common capital flows management instrument in the armory of central banks. They include counter-cyclically increasing capital reserve buffers on systemically important financial institutions, counter-cyclical leverage caps on trading positions and financial intermediaries, systemic liquidity surcharges, and regulatory restraints on asset markets (like loan-to-value and debt-to-income ratios in property markets) and external commercial borrowing (say, on short-term unhedged debts) to attenuate credit bubbles.  

Perceptions matter as much as reality, atleast in the short and medium term, in the financial markets. Credibility comes from consistency in public pronouncements. India's history of external account management is filled with some or other form of capital controls, the most egregious being the restrictions on gold imports, to mitigate the impact of worsening current account balance. The global consensus too is in that direction - all the major emerging economies have embraced capital controls in some form or other in recent years, albeit with varying levels of success. In the circumstances, it surely does little to enhance your credibility if we advocate the need for capital account convertibility.

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