More IMF public support for capital controls

Following up on maladjusted's weekend update, Nicolas Eyzaguirre, the IMF's top guy for the western hemisphere, said yesterday that the Fund supports the use of controls on capital inflows to prevent unwanted currency appreciation and potential overheating. Now, this isn't breaking news, but it's certainly nice to see someone high up reiterate this position, especially after the Global Financial Stability report released a couple weeks ago seemed to backtrack a bit.

In any case, Mr. Eyzaguirre had this to say:

In some cases, exchange rate flexibility, good fiscal discipline, and a prudent set of macro prudential policies, may not be enough to avoid an over-expansion or a potential bubble. Thus, we do not bar or disapprove the potential contribution of carefully designed taxes on capital inflows that may have a role in complementing the policy toolkit—although we should always bear in mind that these kinds of more orthodox responses do have their limitations.

And he should know too, having worked at Chile's Central Bank during the 1990s when the country implemented its own well known capital controls.

The IMF's new position on capital controls is by no means groundbreaking. It actually follows the consensus in the academic literature quite closely and can essentially be summed up with this nice flow chart (click to enlarge):

If you face a surge of capital inflows (as many developing countries are facing today due to low interest rates in the north) you should first consider if your currency has room to appreciate. If this isn't the case, then you should consider if reserve accumulation is desirable and if inflation is a problem, then you should attempt sterilization. But sterilization can prove too expensive, in which case capital controls become a useful policy option. Of course, if inflation isn't a problem you can just lower interest rates to discourage the inflows from coming at all.

This is all very right, but there are certainly a lot of caveats in the IMF's position--enough to make one wonder how often the Fund will actually recommend the use of capital controls during its consultations with its member countries. For instance, the Fund insists on overstating the problem of the evasion of controls by sophisticated financial actors and has also warned that controls cause distortions.

Now, of course any regulation is only as good as its regulators. But nevertheless, no matter the extent of sophistication of your financial sector, evading controls always entails a cost, which is exactly what controls are supposed to do. In fact, most empirical studies have found controls effective to the extent that they manage to "segment" the domestic financial market from the international market--meaning there's a wedge between domestic and international interest rates or between the price of stocks traded in both markets. And very frequently, this is the case even in countries where critics have claimed that controls were evaded.