In Turbulent Times the IMF Can Safeguard Financial Stability By Fully Embracing Capital Controls

The latest release of the International Monetary Fund’s World Economic Outlook paints a grim picture, revising downward global growth projections and warning of elevated economic and social risks, especially for emerging and developing markets.

The persistence of the Covid-19 pandemic and the impact on commodity prices of Russia’s war in Ukraine continue to add to inflationary pressures as food prices reach record levels. In response, central banks in advanced economies are raising interest rates, which will have significant implications for the rest of the world. As the yields and asset prices change, countries will be left vulnerable to capital flight. But even before this monetary policy shift, 60 percent of low-income countries were already unable to—or at high risk of being unable to—make debt payments. Now, this number is poised to grow among all developing countries.

After a long period of low interest rates in advanced economies, investors directed more money toward developing and emerging markets where they could earn higher returns. As interest rates and returns in advanced economies rise and uncertainty over the economy mounts, investors are no longer willing to tolerate the higher risks of investing in developing and emerging markets. This puts additional pressure on those countries’ exchange rates, increasing external debt and possibly triggering financial and economic crises.

How, then, can developing countries lessen their financial risks stemming from decisions made by other nations and over which they have no control?

One option the WEO suggests is to introduce capital controls (a way to limit and regulate funds entering or exiting a country, which the IMF calls “capital flow management measures”) in line with its own recently updated Institutional View on capital flows. We question, however, whether this new guidance allows countries the flexibility they need to lessen risks, because it fails to address systemic issues.

The IMF has the mandate to ensure the stability of the global financial and monetary system. In addition to providing emergency liquidity, two other pillars of the Fund’s mission are surveillance and policy advice aimed at safeguarding financial stability.

To shore up that stability and help emerging countries insulate themselves from capital flow volatility, then, the IMF should encourage them to put capital controls in place as a precautionary measure. When implemented before a shock hits, capital controls can help manage the ebb and flow of funds while discouraging short-term speculators looking for returns from interest-rate arbitrage. Yet the IMF’s Institutional View, even after its recent update, continues to actively discourage any measures on managing capital outflows. That is a mistake, since emerging countries are more prone to experience large and rapid capital outflows, and sudden stops have been more frequent or disruptive.

However, simply acknowledging the possible risks to financial stability from cross-border capital flows is a testament to the IMF’s notable evolution on the issue since the 1990s. It was only in the aftermath of the 2008 Global Financial Crisis that views on the merits of managing cross-border financial flows started to shift within the IMF. This culminated with the 2012 adoption of an Institutional View that recognized how global flows of capital pose potential risks to financial stability and that, in certain cases, capital controls are an appropriate response. But these measures were still only recommended as a temporary, last-resort crisis measure.

In addition, recent research by our team at the Boston University Global Development Policy Center on the implementation of the Institutional View reveals that, in practice, the advice given to countries was inconsistent and uneven. In some countries with high volatility in portfolio flows, measures to manage capital flow were not discussed, despite possible threats to financial stability. Since then, a growing body of economic literature has recognized the merits of precautionary capital controls, an interpretation supported by the IMF’s own Independent Evaluation Office.

The March approval of the IMF’s updated capital flow management guidance was seen by academics, civil society organizations and policymakers as an opportunity to embrace the use of precautionary capital controls. It was the IMF’s chance to reclaim its place as the preeminent international institution governing financial stability and to push back against a growing trend of trade and investment treaties restricting the rights of countries to make use of capital controls in policy.

Nevertheless, the latest review takes only small steps forward. It recognizes the benefits of precautionary capital controls for debt inflows, and stresses that unbalanced flows might expose countries to exchange risks. But it falls short of updating advice for capital outflows.

And now, the IMF’s latest World Economic Outlook warns emerging and developing countries that the interest rate hikes for advanced economies might trigger capital outflows and exchange-rate depreciation and jeopardize financial stability.

This March, before any interest rate hikes, the Institute of International Finance reported that investors already withdrew close to $9 billion from emerging markets (excluding China). Latin America recorded over $10 billion in inflows in the same month, with investors drawn to commodity-exporting countries. Shifts in commodity prices, or other developments, could suddenly reverse investment flows with little notice.

This is precisely the situation that could be avoided with a review recommendation to regulate outflows as well as inflows. Policy advice that only addresses the latter puts emerging markets at risk of exchange-rate depreciation, rising external debt levels and lower investment.

The IMF’s charter clearly states that its members have the right to control capital flows when needed. It also mandates the IMF to safeguard its resources and ensure they are not used to sustain capital flight. Some scholars have recently argued that given the example of Argentina’s latest agreement—where $44 billion disbursed by the IMF mostly left the country—the IMF should not only support capital controls but mandate them in its loan agreements. We are of the same opinion, and urge the Fund to instruct its country staff to follow these guidelines.

This approach should also be spelled out in an Institutional View. Rather, the updated version is a missed opportunity for the IMF to match its advice with global realities, ensure even implementation and enable countries to take steps to mitigate risks and prevent a crisis – not just respond once the damage has been done.

The IMF must do more. It can start by setting clear guidelines for staff and using broader criteria to define crises in all upcoming guidance publications.

The opinions expressed by the author(s) do not necessarily reflect the opinions, viewpoints or policy positions of the Initiative for Policy Dialogue.