MANAGING capital inflowS : WHAT TOOLS TO USE?. Jonathan D. Ostry* Research Department, IMF United Nations Conference on Capital Flows Rio De Janeiro August 23, 2011. - PowerPoint PPT Presentation
Policy advice on capital controls
Jonathan D. Ostry*Research Department, IMF
United Nations Conference on Capital FlowsRio De Janeiro
August 23, 2011*The views expressed in this presentation are those of the presenter and do not necessarily represent those of the IMF or IMF policy. This presentation draws on joint work with Atish Ghosh, Karl Habermeier, Luc Laeven, Marcos Chamon, Mahvash Qureshi, and Annamaria Kokenyne.MANAGING capital inflowS: WHAT TOOLS TO USE?
0There is a tendency to regard foreign exchange controls, or any interference with the free movement of funds as, ipso facto, bad ... [but] there are times when it is in the best economic interest of a country to impose restrictions on movements of capital[and] there are periods when failure to impose controlshave led to serious economic disruption.
The task before us is not to prohibit instruments of control but to develop those measures of control, those policies of administering such control, as will be the most effective in obtaining the objectives of world-wide sustained prosperityHARRY DEXTER WHITEThe advocacy of a control of capital movements must not be taken to mean that the era of international investment should be brought to an end. On the contrary, the system contemplated should greatly facilitate the restoration of international loans and credits for legitimate purposes.
JOHN MAYNARD KEYNES
Capital Controls: Not Just An EME Phenomenon2
20.00.20.40.60.81.01960-19691970-19791980-19891990-19992000-2006Capital Account Restrictiveness in Selected Advanced Economies 1960-2006 CanadaFranceGermanyUKUS0.00.20.40.60.81.01960196519701975198019851990199520002005CanadaFranceGermanyUnited Kingdom United StatesUK: Purchases of foreign securities by UK residents required foreign exchange bought at a premiumCanada: Interest payments on inward financial credits, and inter-bank loans and deposits subject to a withholding taxGermany: Ban on non-resident purchases of German bonds introduced in 1972 (and lifted in 1974). Discriminatory reserve requirements employedFrance: "Devise-titre system: residents couldonly reinvest the proceeds of sales of previously held foreign securities;could not increase their foreign asset holdingsCapital Account Restrictiveness in Advanced Economies: Some Examples 1960-2006USA: Interest Equalization Tax (IET) on purchases of foreign, fixed interest securities; tax was abandoned in 1974 soon after the adoption of floating exchange ratesNote: Capital account restrictiveness index (0=highly restrictive; 1=fully liberalized).Source: Quinn and Toyoda (2008). Note: Capital account restrictiveness index (0=highly restrictive; 1=fully liberalized).Source: Quinn and Toyoda (2008), and OECD (1982). 2Context
333#Capital Inflows: Recovery or Historic Surge?4Net Quarterly Capital Flows into EMEs, 2006Q1-11Q1 (billions of US dollars)
Net Annual Capital Flows into EMEs, 2001-2016 (billions of US dollars)
45Strong Fundamentals in EMEsSource: IMFs WEO database.Note: Average year-on-year growth (in percent).Annual Real GDP Growth (in percent)Public Debt to GDP (in percent)Source: IMFs WEO database.Note: Average gross general government debt to GDP ratio (in percent).
6The Search for YieldReturns on Assets (in percent)Source: J.P. Morgan.Note: Returns as of June 29, 2007 to May 31, 2011 (in percent).Interest Rate Differential (in basis points)
Source: Bloomberg.Note: 10-year government bond yield minus 3-month US T-bill rate in basis points.7Improved Sovereign Credit RatingsSovereign Rating Upgrades & DowngradesEMBI Global Average Credit Rating
Source: Chang (2011).Note: EM fixed income indices are now investment grade. (> BBB-).Source: Chang (2011).Note: the total number of upgrades and downgrades includes both S&P and Moodys actions. Last developed market sovereign rating upgrade occurred in 2007.
Is it Push or Pull Factors?
8Large literature on determinants of capital flows to EMEs identifies:Push factorsInterest rate in advanced economies, commodity prices, investor risk appetite, regional contagionPull factorsMacroeconomic performance, trade and financial openness, institutional quality, external vulnerability Ghosh et al. (2011) examine inflow surges to EMEs over 1980-2009Surges are highly synchronized across regions; butConsiderable heterogeneity in the amount of inflow in a surgeBoth push and pull factors matterbut in different waysFor surge occurrence, push factors matter (notably, the real US interest rate; international market uncertainty)For surge magnitude, domestic conditions are important (e.g. macroeconomic performance, trade & financial openness, exchange rate flexibility)
9Inflation and Credit Growth: Selected Cases
10Are New Bubbles Emerging in EMs?Note: Non-weighted averages of the real house price index. 2007Q3 is set to equal 100. Source: OECD, Global Property Data, Haver Analytics and national sources. Note: Non-weighted averages of the annual growth of real private credit. (in percent). The group of other emerging economies lies below the 75th percentile of the distribution of the 2010Q1-2010Q4 average of the annual growth of real domestic credit to the private sector.Source: IMF IFS. Real Credit to the Private Sector
Real House Prices11Policy Responses to Capital Inflows
Capital Controls, Macroeconomic and Prudential Risks12
#When are Capital Controls Appropriate?13IMF staff (Ostry et al., Feb. 2010) argued that capital controls appropriate for inclusion in the policy toolkit to address:Macroeconomic risks, whenCurrency overvaluedFurther reserve accumulation undesirableInflation/overheating concernsLimited scope for fiscal tighteningFinancial-stability risks, whenPrudential framework still leaves high risk of financial fragility
1313Key Questions to be Addressed14How macroeconomic and prudential rationales for capital controls fit together?What are the main elements of the policy toolkit (once macro-policy space is exhausted)?What combination of prudential measures and controls should be deployed to address inflow-induced risks?How should capital controls be designed?Ostry et al. (2011) examine:
1414How do Macro and Prudential Concerns Fit Together?15Prudential policies: Strengthen/introduce prudential measuresMacroeconomic concernsFinancial-stability risksMacro policies: exchange rate appreciation, reserves accumulation, fiscal and monetary policy mixImpose/intensify capital controls (or measures that act like them) subject to multilateral considerations and macro testsPrimary responsesMacro policy options exhausted? Residual risks?Capital inflow surge
1515How do Macro and Prudential Concerns Fit Together?16Both macroeconomic and prudential considerations suggest that capital controls are appropriateNo real conflictbut possible design issuesMacro considerations say yes, but prudential ones say noNo conflict of principle, but again possible conflict of design Controls as transitional measure given macro policy implementation lags?Macro considerations say no, prudential ones say yesGenuine conflictMultilaterally-consistent approach implies the bar is much higher for the use of capital controlsespecially broad-based controlsExhaust the available macro policy space and allow exchange rate appreciation before tightening capital controls on inflows for prudential risks
1616The Policy Toolkit17
#Whats in the Toolbox?18FX-related prudential measuresDiscriminate according to the currency, not the residency, of the flowApplied to regulated financial institutions, primarily banksExamples: limits on banks open FX position (as a proportion of their capital), and limits on FX lending by domestic banks (or higher capital requirements)Other prudential measures Reduce systemic risk without discriminating based on residency/currency Examples: LTV ratios, limits on credit growth and sectoral lending, dynamic loan-loss provisions, and counter-cyclical capital requirementsCapital controlsDiscriminate between residents and non-residents in cross-border capital movements (OECD Code of Liberalization of Capital Movements, 2009)Economy-wide or sector specific (usually the financial sector) or industry specificCover all flows, or target specific types (debt, equity, FDI; short vs. long-term)Examples: taxes, URRs, licensing requirements, and outright limits or bans
18How Common are the Measures?19
1920Recent Examples of Measures
Issues in Classifying Instruments21De jure prudential tools may operate like capital controlsA regulation differentiating based on the currency of denomination may operate like a capital control to the degree that most FX liabilities are to nonresidentsA measure that requires banks to pay a tax on their non-core liabilities could well in practice operate just like a capital control if most of the funding that banks receive comes from abroadA regulation discouraging FX lending to unhedged borrowers may act as a capital control (reduce inflow) or prudential measure (change currency composition of foreign liabilities). Difficult to tell at implementation stageDe jure capital controls may have primarily prudential intent (e.g. differential reserve requirements by residence of liability)Fine line between FX-related and other prudential measures (e.g. differential LTV ratio by currency of denomination)
2122Alternative ClassificationCapital Flow Management Measures (CFMs)measures designed to influence capital flows Residency-basedcommonly referred to as capital controlsOthermeasures that do not discriminate on the basis of residency, but are nonetheless designed to influence capital inflows (including a subset of prudential measures that discriminate on the basis of currency) Non-CFMsstructural and prudential policies not designed to influence capital flows. Include measures that do not discriminate by residency and typically, but not always, do not differentiate by currency
Matching Risks and Tools23
#24Ceilings on banks foreign derivative positions/Capital controls on banks (esp. short-term debt), e.g., taxes/reserve requirementsOpen FX limits/higher capital requirements on loans to unhedged borrowersCyclical capital requirements, LTV limitsLegal or other impediments to capital controls?FX-related prudentialCapital controlsFragile external liability structure (maturity mismatch/sudden-stop risk)Currency risk (due to open FX position) or credit risk (due to unhedged borrower)Credit boom/asset price bubbleFX-related prudential1/Other prudentialFlows to domestic banksConcerns about access to finance/ distortions?FX-related prudential/ Capital controls1/1/ Once macro policy space exhausted, and taking due account of multilateral considerations.Choice of Instruments: Flows Intermediated through the Financial Sector
24Direct flows or through unregulated financial sectorFragile external liability structure (debt, especially short-term)Currency risk (due to lack of natural or financial hedge)Asset price bubbleCapital controls1/Capital controls to discourage debt instrumentsCapital controls to discourage FX borrowing by unhedged entitiesBroad-based capital controlsCapital controls1/Capital controls1/Borrower-based FX-measuresLegal or other impediments to capital controls?251/ Once macro policy space exhausted, and taking due account of multilateral considerationsChoice of Instruments: Flows Not Intermediated through the Financial Sector
Exceptions to Flow Chart26 Playing field for access to credit of large firms vs. SMEs Prudential regulations may cause flows to be intermediated through the unregulated financial sector (e.g. Croatia) Extend the perimeter of regulation? Not easy in short run Regulatory arbitrage more likely in countries with weak supervision, sophisticated financial institutions, and deep capital markets International obligations may prohibit or constrain the use of capital controls (e.g., the EU treaty, the GATS, the OECD code, or various bilateral investment treaties)
26Policy Measures and Financial Stability Risks: Some Suggestive Evidence27
Empirical Evidence: External Liability StructureDebt in proportion to total external liabilitiesCross section (2007; measures in 2003-05, 38 countries)Economy-wide, and financial sector capital controls significantly associated with lower debt (controlling for external vulnerability) FX regulations significantly associated with lower debt (though FX regulations lose significance when included together with economy-wide capital controls)Moving from 25th to 75th percentile of economy-wide capital controls or FX-regulation lowers debt share by almost 10 pptPanel data (1995-2008)Economy-wide, and financial sector capital controls significantly associated with lower debt External vulnerability index, region and time effects, and per capita income included as additional regressors28
Capital controls and FX-related prudential measures associated with smaller proportionof debt in external liabilities 29External Liability Structure: Cross-Sectional Evidence*Source: Authors estimates.*Sample: 38 EMEs over 2003-07. Debt liabilities is the residual (including constant) obtained after regressing the share of debt liabilities in total external liabilities in 2007 (in percent) on a (lagged) composite external vulnerability index. Debt Liabilities
Empirical Evidence: FX LendingForeign currency loans in total domestic creditCross section (2007; measures in 2003-05, 28 countries)Economy-wide, and financial sector capital controls significantly associated with lower proportion of FX credit (controls: initial private credit ratio; exchange rate regime)FX regulations significantly associated with lower FX creditBoth economy-wide capital controls and FX regulations significant when included togetherMoving from 25th to 75th percentile of economy-wide capital controls and FX regulations lowers proportion of FX credit by 20-25 pptPanel data (1995-2008)Results similar to those abovePrivate credit (lagged, in % of GDP); exchange rate regime; per capita income; institutional quality index; region and time dummies included as additional regressors 30
Capital controls and FX-related prudential measures associated with lower foreign currency denominated lending by domestic banks31FX Lending: Cross-Sectional Evidence*Source: Authors estimates.*Sample: 28 EMEs over 2003-07. Forex credit is the residual (including constant) obtained after regressing forex credit to GDP in 2007 on private credit to GDP in 2005 and a binary variable (=1) if fixed exchange rate regime in place.
Empirical Evidence: Credit BoomsChange in private sector credit to GDP ratioCross section (change in credit ratio 2003-07; measures in 2000-02, 28 countries)Prudential regulations significantly associated with smaller credit booms (controls: real per capita income in 2005; political stability index; financial market development; exchange rate regime; and credit bureaus)Prudential regulations signific...