A year ago the IMF recognised that it had been wrong in its doctrinal advocacy of free international capital flows and acknowledged the legitimacy of capital controls, although in very restricted circumstances.
After mulling this for a year, the Fund has now produced two documents which set out their research and their operational framework.
Some form of capital controls (taxes on inflows or prudential measures on the financial sector) are now part of the approved policy tool-kit, although restrictions on capital flows are very specifically down at the very bottom of the tool-box, to be used only when everything else (exchange rate, monetary policy, fiscal policy) has been fully used to deal with excessive capital inflows.
This shift is very timely. For the past decade or so, capital inflows into the emerging countries of East Asia have been strong but not overwhelming, and the reversals during the Global Financial Crisis did only limited damage.
Large inflows were handled by a mixture of reserve accumulation and exchange rate appreciation. But reserves are now more-than-adequate in most of these countries (much more in some cases: equal to the GDP of Hong Kong and Singapore, half of GDP in China, Thailand and Malaysia) and exchange rates have appreciated enough to whittle away export competitiveness.
The IMF analysis sees the flows in terms of temporary surges of capital, but the problem may be more structural. These emerging countries will go on growing much faster than the mature countries. They need higher interest rates to maintain equilibrium.
The on-going interest differential will encourage greater capital flows as financial sectors become more closely linked internationally. The huge financial portfolios in North America and Europe only need to shift their allocation towards these emerging markets by a tiny percentage to create disruptively large inflows.
The IMF has not yet put forward a convincing policy answer to this.
But, having wasted more than a decade in denial about the nature of the problem, the Fund has now made a good start on understanding it.
Photo courtesy of the IMF.
