By Tobias Adrian, Gita Gopinath, Pierre-Olivier Gourinchas, Ceyla Pazarbasioglu, and Rhoda Weeks-Brown
Capital flows can help countries to grow and to share risks. But economies with large external debts can be vulnerable to financial crises and deep recessions when capital flows out. External liabilities are riskiest when they generate currency mismatches -when external debt is in foreign currency and is not offset by foreign currency assets or hedges.
The dramatic capital outflows witnessed at the start of the global pandemic and recent turbulence in capital flows to some emerging markets following the war in Ukraine are stark reminders of how volatile capital flows can be – and the impact this can have on economies.
Since the beginning of the pandemic many countries have spent to support the recovery, which has led to a build-up of their external debt. In some cases, the increase in debt in foreign currency was not offset by foreign currency assets or hedges. This creates new vulnerabilities in the event of a sudden loss of appetite for emerging market debt that could lead to severe financial distress in some markets.
In a review of its institutional view on capital flows released today, the IMF said that countries should have more flexibility to introduce measures that fall within the intersection of two categories of tools: capital flow management measures (CFMs) and macroprudential measures (MPMs).
Today’s review said that these measures, known as CFM/MPMs, can help countries to reduce capital inflows and thus mitigate risks to financial stability – not only when capital inflows surge, but at other times too.
A major milestone
The IMF first adopted the institutional view in 2012 at a time when many emerging markets were contending with large and volatile capital flows.
Shaped by the financial crises of the 1990s and the global financial crisis of 2008-09, it sought a balanced and consistent approach to issues of capital account liberalization and capital flow management.
In particular, the institutional view recognized as a core principle that capital flows are desirable because they can bring substantial benefits to recipient countries, but they can also result in macroeconomic challenges and financial stability risks.
The institutional view also noted the role of source countries in mitigating the multilateral risks associated with capital flows and the importance of international cooperation on capital flow policies.
Capital flow management
The institutional view incorporated CFMs and CFM/MPMs into the policy toolkit in a limited manner. It set out the circumstances in which they might be useful but stressed that they should not be a substitute for necessary macroeconomic adjustments.
CFMs to restrict inflows might be appropriate for a limited period, the institutional view said, when a surge in capital inflows constrains the policy space to address currency overvaluation and economic overheating. It said CFMs to restrict outflows might be useful when disruptive outflows risk causing a crisis.
In turn, CFM/MPMs on inflows were considered useful only during surges of capital inflows, assuming that financial stability risks from inflows would arise mainly in that context.
At the time of its adoption, the IMF recognized that the institutional view would evolve based on research and experience.
Today’s review updates the institutional view while maintaining the core principles that underpin it. It also preserves the existing advice on liberalization, the use of CFMs and CFM/MPMs during inflow surges, and CFMs during periods of disruptive outflows.
Pre-emptive measures
The main update is the addition of CFM/MPMs that can be applied pre-emptively, even when there is no surge in capital inflows, to the policy toolkit.
This change builds on the Integrated Policy Framework (IPF), a research effort by the IMF to build a systematic framework to analyze policy options and tradeoffs in response to shocks, given country-specific characteristics.
The IPF and other research related to external crises delivered new insights on managing financial stability risks stemming from capital flows. They highlighted that risks to financial stability can arise from a gradual buildup of external debt denominated in foreign currency, even without an inflow surge. In narrow and exceptional cases, they also highlighted risks arising from external debt denominated in local currency.
Further, these risks may be challenging to address given the evolving nature of global financial intermediation beyond the banking system. MPMs alone may not always be able to contain risks such as those stemming from foreign currency borrowing of non-financial corporates and shadow banks.
Pre-emptive CFM/MPMs to restrict inflows can mitigate risks from external debt. Yet they should not be used in a manner that leads to excessive distortions. Nor should they substitute for necessary macroeconomic and structural policies or be used to keep currencies excessively weak.
Other updates to the institutional view
Another important update to the institutional view is to give special treatment to some categories of CFMs. These measures would not be guided by the policy advice outlined in the institutional view because they are governed by separate international frameworks for global policy coordination or are introduced for specific non-economic considerations.
The categories of CFMs given special treatment include certain macroprudential measures imposed in line with the Basel framework, tax measures based on certain international cooperation standards against the avoidance or evasion of taxes, measures implemented in line with international standards to combat money laundering and financing of terrorism, and measures introduced for national or international security reasons.
In addition, the review explains how to use the IPF to inform key judgments required under the institutional view, such as relating the nature of shocks and relevant market imperfections to the necessary macroeconomic adjustments.
It also provides practical guidance for policy advice related to CFMs, including how to identify capital inflow surges, how to decide whether it is premature to liberalize capital flows, and which CFMs are significant enough to highlight in surveillance.
A living framework
The IMF strives to learn and adapt continually to best serve its member countries. Like other IMF policies, the institutional view will continue to be informed by advances in research as well as by developments in the global economy and experiences of its membership. The review has expanded the policy toolkit for policymakers, particularly in emerging and developing countries, while maintaining the core principles of the original Institutional View.
Our goal is that countries can make use of this updated toolkit to preserve macroeconomic and financial stability while at the same time reaping the benefits that capital flows can provide.
