Managing Capital Flows

The views expressed herein are those of the author and should not be attributed to the IMF, its Executive Board, or its management.

Bank Indonesia International Workshop and Seminar

Central Bank Policy Mix: Issues, Challenges and

Policies

Jakarta, 9-13 April 2018

Yoke Wang Tok

• The IMF’s Institutional View• Types of CFMs• Case studies• Effectiveness of Capital Flow Measures• Effectiveness of MPMs

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Outline

IMF and International Capital Flows

• No global framework (existing frameworks mainly regional, bilateral, limited considerations for macroeconomic stability or impact on global stability)

• The IMF Legal Framework:– Current/Capital account asymmetry: mandate on capital account more limited

– Original context: emphasis on international trade

– Second Amendment: recognition of the role of international capital movements in the international monetary system

– 1990 reform effort - eliminate the asymmetry between current/capital, introduce the obligation to liberalize capital account – interrupted by the Asian crisis

– The Global Financial Crisis

– The 2007 and 2012 surveillance decisions

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• Article VI, Section 3. Controls of capital transfers - Members may exercise such controls as are necessary to regulate international capital

movements, but no member may exercise these controls in a manner which will restrict payments for current transactions or which will unduly delay transfers of funds in settlement of commitments, except as provided in Article VII, Section 3(b) and in Article XIV, Section 2.

• Article IV. Obligations regarding exchange arrangements

- Section 1: The obligation to collaborate with the Fund and other members to assure orderly exchange arrangements and to promote a stable system of exchange rates. Also, specific obligations concerning the conduct of exchange rate and other economic and financial policies

• Article VIII, Section 2(a) and 3.- Avoidance of restrictions on current payments, discriminatory currency practices and multiple

currency practices

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IMF and International Capital Flows

• IMFC called for a “comprehensive,

balanced, and flexible approach”

• Similar calls by G20 and IEO

Need for a view

• Provide basis for consistent Fund

advice to member countries

To guide policy advice

• Pragmatic approach based on

country experience

Building on country

experience

Capital Flows I (Dec. 2010)

• Role of the Fund

Capital Flows II (Feb. 2011)

• Managing inflows

Capital Flows III (Nov. 2011)

• Multilateral effects of policies

Capital Flows IV (Apr. 2012)

• Liberalization and managing

outflows

Capital Flows V (Dec 2012)

• Bringing all previous work

together into an Institutional View

Capital Flows VI (Dec. 2016)

• Review of experience with the

Institutional View

Capital Flows VII (Jun. 2017)

• Increasing resilience to large and

volatile capital flows - The role of

macroprudential policies

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The Fund Developed an Institutional View on Capital Flows

Role of the Institutional View

• Guides general policy advice to members,

including in the Article IV consultations.

• Does not provide guidance on the scope of

members’ obligations under Article IV(1).

Guides Fund advice

• Has no automatic implications for the Fund’s

financing operations and members’ obligations.

• Has no implications for the Fund’s jurisdiction

under Article VIII.

No implications for Fund

members' rights and

obligations

• Facilitates collaboration with other institutions

involved in the design and promotion of

international frameworks.

Strengthens multilateral

collaboration

• Even where CFMs may be judged an appropriate

policy response under the Institutional View, they

may still violate a member’s obligations under

other agreements.

Countries’ obligations

under international

agreements unaltered

Development of the Institutional View 6

Poll: Is capital flows good or bad?

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The Fund’s Institutional View

• Capital flows can have substantial benefits, but..

• It also carries risk, even for countries who have long been open

• Capital flow Liberalisation : more beneficial and less risky if countries reached certain thresholds of financial and institutional development

• To reap the benefits of capital flows, liberalisationneeds to be well planned, timed and sequenced

• There is no presumption that full liberalization is an appropriate goal for all countries at all times

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The Fund’s Institutional View

• Rapid capital inflow surges can pose risks for macroeconomic and financial stability

• And create policy challenges

• Appropriate policy responses for both recipient and source countries

• Key role needs to be played by macroeconomic policies and sound financial supervision and regulation and strong institutions

• When macroeconomic policy space is limited, capital flow management measures (CFM) can be useful

• CFMs are no substitutes for right macroeconomic policies

Poll: Would you raise or lower rates?

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CFM Terminology

• Capital flow management measures (CFMs) refer to measures that are designed to limit capital flows, comprising residency-based CFMs and other CFMs.

– Residency-based CFMs discriminate between residents and nonresidents, and are always CFMs by virtue of their own design.

– Other CFMs do not discriminate on the basis of residency, but are nonetheless designed to limit capital flows (e.g., currency-based MPMs and other measures typically applied to the non-financial sector).

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Key Elements of the Institutional View

• Controls can take the form of taxes, price or quantity controls

• The most recent trend has been to limit short-term capital flows because of their potential destabilizing effect.

• Controls are seen as a second-best solution to the destabilizing effects of volatile capital flows due to imperfectly regulated local financial system and/or to imperfect capital markets.

• But volatility of capital flows is not enough to justify capital controls or to justify a tax on the flow of capitals.

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Types of CFMs

Managing Capital Inflows

Key Elements of the Institutional View

Exchange rate overvalued

Economy overheatingReserves adequate

Intervene

+Sterilize

CFMs

Appreciate

Lower rates/

Intervene

Appreciate/

Lower rates

Appreciate/

Intervene +Sterilize

Lower rates

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Managing Capital Inflows -Considerations for Using CFMs

• CFMs can have a role in supporting macro policy adjustment and safeguarding financial system stability in certain circumstances during an inflow surge, or when the capital account is prematurely liberalized.

• CFM should not be implemented pre-emptively before an inflow surge.

Circumstances

• CFMs should seek to be targeted, transparent, temporary (being lifted once the surge abates) and non-discriminatory.

Implementation

Key Elements of the Institutional View 14

Managing Capital Outflows

Key Elements of the Institutional View

Exchange rate undervalued/

Balance sheet FX exposure high

Economy stagnatingReserves inadequate

Intervene

+Sterilize

(c)

Depreciate

Raise rates/

Intervene

Depreciate/

Raise rates

Depreciate/

Intervene +Sterilize

Raise rates

A country in (c) may be in crisis or imminent crisis.

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Managing Capital Outflows -Considerations for Using CFMs

• To be used only in crisis or imminent crisis situations, or when the capital account is prematurely liberalized.

• As part of broader policy package that addresses fundamental causes of the crisis.

• Outside of (imminent) crisis situations, there is normally scope to adjust macroeconomic and financial sector policies to address the outflow-related implications.

Circumstances

• CFMs on outflows should be transparent and temporary, being lifted once crisis conditions abate, and seek to be non-discriminatory.

• May need to be comprehensive.

Implementation

Key Elements of the Institutional View 16

Capital flow measures (PRICE controls)

Types of price controls to discourage short-term capital flows are:

•A tax on foreign exchange transactions: reduces the incentive to switch positions over short horizons and exch. rate volatility.

•A mandatory reserve requirement on short-term deposits from foreign residents or borrowing from foreign residents:

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Types of CFMs

Capital flow measures (mandatory reserve requirement)

•By the same token, from the point of view of a borrower, say a bank or a firm, the RR increases the cost of borrowing abroad.

•When they get a short-term loan abroad (less than a year), they should leave part of the total amount borrowed as a deposit at the central bank, say 30 percent, earning no interest.

•This is equivalent to imposing a tax on borrowing. It translates into paying higher interest rates, in particular, on short term loans.

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Types of CFMs

Capital flow measures (QUANTITY controls)

•A ceiling for new or existing borrowing from foreign residents.

•There could be administrative controls on cross-border capital movements.

•Regulations on the portfolio choice of institutional investors.

•Limit the amount of money firms can invest abroad

•Limits on the transferring of profits abroad.

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Types of CFMs

Measures to Limit Inflows

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• Brazil (2009) - Introduction of a 2% tax on portfolio equity and debt inflows

• Indonesia (2001) – Imposition of (1) a 6-mth holding period on central bank bonds and (2) a limit on short-term foreign borrowing by banks to 30% of capital

• Peru (2010) - Increase of fee on non-resident purchases of central bank paper to 400 bps (from 10 bps)

• Thailand (2010) - restoration of a 15% withholding tax on non-residents’ interest earnings and capital gains on new purchases of state bonds

• Korea (2011) - restoration of a 14% withholding tax on interest income on non-resident purchases of treasury and monetary stabilization bonds

Measures to Limit Outflows

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Thailand (1997) - Imposition of limits on forward transactions and introduction of export surrender requirements

Malaysia (1998) - Imposition of 12-mth waiting period for nonresidents to convert proceeds from the sale of Malaysian securities

Argentina (2001) - Establishment of Corralito, which limited ban withdrawals and imposed restrictions on transfers and loans in foreign currency

Iceland (2008) - Stop convertibility of domestic currency accounts for capital transactions

Ukraine (2008) - Introduction of a 5-day waiting period for nonresidents to convert local currency proceeds from investment transaction to foreign currency

Case Studies

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Indonesia

• Authorities have implemented CFMs since 2010 when capital inflows surged, complicating liquidity management and leading to excessive fluctuations in bond yield and exchange rate.

• A minimum holding period of 1 month was introduced on central bank bills (SBIs) for both domestic and foreign investors

• Limit on the daily balance of banks’ short-term external debt to 30% of capital

• The reserve requirement on deposit accounts in foreign exchange was raised to 5% from 1%. In June 2011, the reserve requirement was raised to 8 percent

• Eased LTV for residential mortgages (measure for counter slowdown).

South Korea (2008-11)

• The banking system has been heavily reliant on wholesale funding—including from abroad—and prone to the pro-cyclical building up of leverage that creates persistent vulnerabilities to changes in global funding conditions

• Build-up of external liabilities was driven in part by speculative demand for currency forward contracts by the corporate sector on expectations of KRW appreciation

• Following the GFC, Korea experienced a “sudden stop” in capital flows (short-term external bank flows, outflows from local equity and bond markets);

• On shore banks and foreign bank branches were unable to roll-over maturing short-term external debt;

• Bank of Korean reacted promptly to provide FX liquidity by drawing on reserves and through the Fed swap lines;

• Korean authorities also took longer term measures to reduce the vulnerability to capital flows. -24-

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South Korea

FX caps and levy in Korea

• In June 2010, Korean authorities announced a package of measures to reduce excessive short-term external borrowing:

– Require banks to raise their long-term FX borrowing from 80 to 90% (later raised to 100%) of their long-term FX lending (Nov 2009)

– A leverage cap on banks FX derivatives positions (June 2010)

– A levy on non-core FX bank liabilities (April 2011)

South Korea (2008-11)

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• Restoration of a 14% withholding tax on interest income on nonresident purchases of treasury and monetary stabilization bonds, leading to equal treatment for both foreign and domestic investors

South Korea (2008-11)

Effectiveness of Measures

Korea

• FX derivative positions and related short-term external borrowing have fallen as FX hedges become more expensive, but:– FX hedges move offshore

– External inflows shift to other sectors

• The measures in Korea appear to have lengthened the maturity of capital inflows, thus helping to reduce maturity mismatches in the banking sector.

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Effectiveness of Measures :South Korea

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•Another example of extensive use of capital controls is Brazil (especially, after 2009).

•Instead of an unremunerated reserve requirement, Brazil taxes financial transactions, mostly to portfolio flows, including both equity and fixed income (Chamon and Garcia, 2016).

•In 2011 an URR was also imposed to banks’ gross FX liabilities, to limit the bypassing of such taxes on flows with offshore operations.

•A tax on firms’ foreign borrowing of less than 1 year maturity, extended to maturities below 3 and later 5 years.

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Brazil

31Source: Chikako Baba, Annamaria Kokenyne; “ Effectiveness of capital controls in emerging markets in the 2000s”, IMF WP/11/281

Effectiveness of Macroprudential Policies to stem inflows and credit growth

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• Mixed results• In some cases, a tightening of macroprudential measures in

Croatia (2003-2007), Korea 2008), India (2007) and Peru (2007-2008) contributed to reduction of credit growth.

• In others, e.g. Columbia (2007), it did not• Macroprudential measures appear to have lengthened

composition of capital inflows in Croatia, Peru, Romania and Uruguay

• However, macroprudential measures have contributed to financial sector resilience - measures in Croatia, Korea and Peru have lengthened the maturity of capital inflows and reduced maturity mismatches in the banking sector

Effectiveness of Macropru Policiesto stem inflows and reduce credit growth

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Country Measure Aim of Measures Effectiveness

Columbia Dynamic provisioning, marginal reserve requirement and limits on banks’ gross derivative positions in conjunction with URR (all 2007)

Reduce credit growth No strong effect on credit growth overall but some effects in specific sectors

Croatia Speed limit (2003,2007), liquidity ratio (2006-08), marginal reserve requirement (2004-2007(

Reduce credit growth and unhedged foreign borrowing

Speed limit and reserve ratio reduced credit growth but MRR had no strong impact. Prudential measures reduced FX lending and lengthened maturity of capital inflows, but had no effect on asset prices

Effectiveness of Macropru Policiesto stem inflows and reduce credit growth

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Country Measure Aim of Measures

Effectiveness

Peru Tighter loan classification and provisioning requirement (2007-08), MRR on FX deposits (2008)

Reduce credit growth

Reduced credit growth and lengthened maturity of capital inflows

Romania Speed limit on credit growth (2005-07); raised reserve requirements on FX deposits (2002-06); tighten prudential rules on real estate lending

Reduce credit growth and unhedged foreign borrowing

Reduced bank-intermediated foreign flows, but strong credit growth and FX lending to residents continued as increase in financial FDI funded lending

Uruguay Prudential measures on loan classification and provisioning (2003-08)

Address financial fragilities after the banking crisis and dedollarise economy

Insig effect on credit expansion that started in 2006 and reflected a gradual recovery from the drastic contraction during the banking crisis, but reduced credit risk and FX lending to residents and shifted the composition of inflows away from foreign borrowing to FDI inflows.

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Summary

• Capital controls cannot substitute for sound macro policy and good financial regulation.

• Countries should first exhaust their macro policy options before implementing capital controls (or prudential measures that act as controls)

• Prudential regulations and capital controls can help to reduce the buildup of vulnerabilities on balance sheets and the emergence of credit booms, but they both inevitably create distortions

• When inflows/outflows are largely intermediated through the regulated financial system, prudential tools can be the main instrument

• When inflows/outflows bypass regulated markets and institutions (e.g., because domestic entities borrow directly abroad), prudential regulations will have little traction and capital controls may be the only option

• CFMs on inflows tend to be more targeted but CFMs on outflows need to be more comprehensive

References

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References

Bruno, V. Hyun Song Shin, 2015. “Assessing Macroprudential Policies: Case of Korea.” http://www.nber.org/papers/w19084.pdf

Cardarelli, Roberto, Selim Elekdag, and M. Ayhan Kose, 2009. “Capital Inflows: Macroeconomic Implications and Policy Responses.” IMF wp/09/40.

Chinn, Menzie D. and Hiro Ito, 2006. "What Matters for Financial Development? Capital Controls, Institutions, and Interactions," Journal of Development Economics, Volume 81, Issue 1, Pages 163-192 (October).

Cowan, K. and J. De Gregorio, 2007. “International borrowing, capital controls and the exchange rate: lessons from Chile.” In Edwards, S., Capital Controls and Capital Flows in Emerging Economies: Policies, Practices and Consequences, U. of Chicago Press.

Diaz-Alejandro, Carlos, 1985. “Good-bye Financial Repression, Hello Financial Crash,” Journal of Development Economics 19, 1-24.

De Gregorio, Edwards, and Valdes, 2000. “Controls on Capital inflows: Do they work? Journal of Development Economy 63(1): 59-83.

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References

Korinek, 2011. “Systemic risk taking, amplification effects, externalities and regulatory responses” ECB WP 1345.

Korinek, 2014. “Regulating Capital Flows to Emerging Markets: An Externality View .” John Hopkins University mimeo.

Krugman, P., 1979. “A model of balance-of-payments crises,” Journal of Money, Credit and Banking, August.

Magud, Nicolas E., C. Reinhart, and K. S. Rogoff, 2011. “Capital Controls: Myth and Reality – A Portfolio Balance Approach.” NBER Working Paper 16805, Cambridge, MA, National Bureau of Economic Research.

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THE END

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