The Global Financial Crisis has triggered a remarkable self-examination by the International Monetary Fund of its received wisdom. A couple of weeks ago the Fund softened its in-principle advocacy of pure floating exchange rates, acknowledging that most emerging countries are more comfortable with a managed float. Then their Chief Economist committed central bank heresy by advocating raising inflation targets from 2 per cent to 4 percent, to make more room to ease monetary policy during a crisis.
Now another core belief is being abandoned: that international capital flows should be unconstrained by any restrictions. This is a big shift in thinking. Just over ten years ago, the Fund attempted to have free flows of international capital given the same status as free trade flows, with a very strong presumption that all countries should allow unrestricted flows. The timing was particularly poignant: this was immediately after the 1997-8 Asian crisis, which was in large part caused by excessive and volatile foreign capital flows.
All that has now changed. The Fund recognizes that foreign capital flows, while usually beneficial (particularly 'greenfields' foreign direct investment) can also be excessive and volatile. The measures taken by various countries have been reexamined and found to be acceptable, in some ways beneficial. Even Malaysia, the butt of much derision for its capital controls during the Asian crisis, has been reassessed and given a pass mark.
This re-think seems particularly timely. With the prospect of continuing low interest rates in the crisis countries, and rising rates in the emerging countries, capital inflows to emerging countries are likely to increase, and put unwelcome upward pressure on exchange rates, reducing international competitiveness.
Emerging countries have explored various responses, including the unremunerated reserve requirements associated with Chile in the early 1990s, Thailand's similar measures in 2006 and, more recently, Brazil's 2 percent tax on portfolio inflows.
These policies have been treated rather disparagingly by Fund commentary in the past. The Fund's new attitude and public comments are important because it is the arbiter of good behaviour in this area. Its past criticisms have reinforced the financial market's natural aversion to any form of taxation or restriction on its actions.
Thus this shift is both noteworthy and praiseworthy. We can hope that it will lead to more analysis of the operational details of capital constraints so that the Fund supports best-practice procedures. It is still true that capital flows are largely beneficial for emerging countries. The Fund is in a better position to advise emerging countries on how to reap maximum benefits with fewest problems, now that doctrine has been discarded.
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