Over the past year, the international financial community has revisited the complex issues raised by international capital flows and policies affecting them. Collective attention is appropriate because the flows, and actual or possible tightening of controls on them, create externalities for many countries. While not all of the attention to this topic over the past year has been calm and dispassionate, and the debate is not entirely over, progress to date has been encouraging.
A central question in the debate is whether capital flows are good or bad. The answer is both. More generally, but without any content as a guide to policy, the answer depends (a) on the country, (b) on its circumstances, and (c) on the capital flows—their size, composition, and motivation.
The emerging consensus approach on capital flows is that a country facing an unwanted increase in capital inflows should not first act to limit those inflows, but should, rather, examine other dimensions of its macroeconomic and financial situation, as well as the country's policies that might usefully be adjusted. If policymakers subsequently do resort to tools designed to manage inflows, preference should be given (1) to measures that involve national treatment (do not discriminate by residency such as prudential measures) over those that target specific flows from abroad and (2) to measures of whatever type that are transparent, targeted, and temporary in order to limit distortions that may affect the country's own economy and financial system as well as those of other countries. I read the evidence on recent policy actions by recipients of unwanted capital inflows that has been assembled in several papers by the International Monetary Fund (IMF) staff as consistent with this consensus—be slow to act to restrict capital flows and calibrate any actions. However, over the past week, the topic appears to have become more contentious.
What is the problem? Why did the suggested framework to guide IMF staff in their interactions with member countries on these issues, which was broadly endorsed by a majority of IMF executive directors on March 21, come in for sharp criticism in the recent meetings of the G-20 finance ministers and central bank governors and in the International Monetary and Financial Committee (IMFC)? I see two reasons.
First, although most policymakers in fact have followed the consensus approach in their recent policy actions, a number of them do not want to be bound to do so in the future. They see the potential for criticism of any future deviations from the consensus as an infringement on their sovereignty. They want to preserve maximum room for maneuver even though their actions to block capital inflows potentially not only may adversely affect their own economies but also may adversely affect other economies as flows are redirected elsewhere and create further distortions in the international financial system.
The second reason is that it is argued that insufficient attention has been paid to push factors. In evaluating the strength of this argument, it is important to distinguish between net capital flows and gross capital flows. Net capital flows (including changes in official reserves) are the counterpart of current account surpluses or deficits—global imbalances. Global imbalances are an important issue, but they are not central to concerns about capital flows from the perspective of the impacts of those flows on individual economies or the system as a whole. The primary focus should not be on imbalances, or net capital flows. Gross flows can be large and expanding at the same time that net flows are small and unchanged.
One strand in the debate about capital flows that has fueled some of the recent controversy is criticism of effects of the Federal Reserve's current policy of quantitative easing on the rest of the world. These effects are poorly understood. The macroeconomic models of the Federal Reserve and the IMF tell us that the net effect of US monetary easing (conventional or quantitative) on the US current account balance is essentially zero—no change in the net flow. The (negative) effects through the stimulation of domestic demand offset the (positive) exchange rate and other effects boosting demand from the rest of the world. It follows that the corresponding net effect on the rest of the world necessarily also is approximately zero—the combined current account surplus with the United States and the counterpart combined net capital inflow (private plus official) to the United States are unchanged. This is an empirical result. It need not hold for every country, though in all countries one would expect offsetting effects from monetary easing with the resulting net effect smaller in absolute value than either of the individual effects.
On the other hand, the net effects of US monetary easing on current accounts, and corresponding net capital flows, for each individual country may deviate more substantially from zero. Moreover, the effects on actual or potential gross flows need not be zero in the aggregate or for individual countries. From a prudential standpoint, it is the gross flows that matter, including the composition of the gross flows—though this is another area where it is difficult unambiguously to sort out good from bad.
In addition, how an individual country responds to gross flows matters, including for ultimate signs of its net flows. A country may allow its exchange rate to appreciate. This would tend to limit gross inflows but also would reduce the country's current account balance and affect its net capital flow. Countries may also respond not only to the financial spillovers from the US monetary easing but also to the real spillovers from stronger US aggregate demand. Before the US monetary easing a number of countries faced dilemmas involving, for example, an overheated economy and a growing current account deficit. The US policy action did not create the dilemma; it only exacerbated and highlighted the dilemma.
These spillovers and their differential impacts, depending on individual country circumstances, provide the case for surveillance over countries' policies. In this example, the surveillance should cover both US policies and policies of other countries, but the surveillance needs not only to examine the policies in source and destination countries but also to be grounded in a full appreciation of all the effects of those policies, not just focus on one component—gross financial flows. More generally, the potential for spillovers from rising gross capital flows to and from emerging market countries and spillovers from policies of countries in response to those flows provides the rational for collective attention and some weak constraint on sovereignty.