Capital controls no longer taboo as emerging markets battle flight

When Haruhiko Kuroda, governor of the Bank of Japan, suggested last week that China should use capital controls to support its currency, it was as if he had broken a taboo.

Asked if she approved, Christine Lagarde, managing director of the International Monetary Fund, sitting with Mr Kuroda on a panel at the World Economic Forum in Davos, dodged the question — although she did agree that it would be unwise for Beijing to burn through its foreign exchange reserves to support the renminbi.

Her circumspection was not surprising. Policymakers talk of capital controls at their peril: merely to mention them can send jittery investors rushing for the exit. Investors in China, where the Shanghai index is down by 47 per cent from last June’s peak, have been extremely jittery this year.

Nevertheless, more and more policymakers are suggesting the use of unorthodox methods. Days before Mr Kuroda spoke at Davos, Agustín Carstens, the widely-respected governor of Mexico’s central bank, told the Financial Times it might soon be time for emerging market central bankers “to become unconventional”.

The reason lies in the recent, unprecedented outflows of capital from emerging markets (EMs). The Institute of International Finance, an industry group, estimates that total net capital outflows from EMs amounted to $735bn last year, the first year of net outflows since 1988.

“These countries are bleeding,” says Kevin Gallagher, a professor at Boston University and author of Ruling Capital: Emerging Markets and the Reregulation of Cross-Border Finance. “They can’t just let their [foreign exchange] reserves go on propping up their currencies when markets have already made their own decisions.”

Mr Gallagher is one of a group of academics and others who, since the global financial crisis of 2008-09, have called on EM policymakers to use capital controls when circumstances demand. Between 2010 and 2012, the IMF published guidelines for their use, a move that surprised many at the time, although Mr Gallagher says it did not mark any abrupt change in IMF thinking.

“The IMF and many of us in academia got on the same page in 2008-09, saying it was important to regulate capital flows in conjunction with better macro policies,” he says. “Some countries didn’t want to listen, and now it’s all coming home to roost.”

Mr Gallagher says capital controls work best when they are designed to contain potentially destabilising inflows, accompanied by clear communication and by fiscal reforms to address the structural issues that can help fuel financial instability.

Using them in an attempt to stem outflows – as China, Azerbaijan, Nigeria and Saudi Arabia, among others, have done this month – is often much less successful, he says.

“If the money is already in the country, capital controls scare markets a lot more,” Mr Gallagher says. “People will always find a way to circumvent them and get their money out.”

Despite such reservations, the IMF has endorsed the idea of using capital controls as a component of the crisis-fighting tool kit in places like Greece, where they were dramatically introduced last year amid an escalating crisis.

The fund still argues that open economies fare better than closed ones and that in most cases capital should be allowed to flow freely across borders.

Yet the IMF’s recent change in attitude and practice is facing its biggest test so far in what is playing out in China and other emerging economies.

Ms Lagarde has said she wants to start a global conversation on how to encourage long-term flows into productive assets versus more volatile investments in stocks and bonds.

In a speech this month she warned that it had become more difficult “to prevent liquidity shocks from doing serious harm to an economy”.

China poses an awkward case, however.

The fund’s shareholders at the end of November voted to include China’s renminbi in the elite basket of currencies used to value its own de-facto currency, the special drawing rights, in part on the basis that the RMB was becoming increasingly “freely useable”.

People at the fund insist that any capital controls introduced by China in response to the current surge in outflows would be temporary. They believe the leadership in Beijing is still intent on a gradual, longer term opening up.

To an extent, the fund predicted what is now unfolding.

In a 2013 paper IMF staff warned that moving to an open capital account would lead to “substantial” flows in and out of China and that “the likely direction of net flows would be outflows”.

“Our estimated orders of magnitude would imply significant repercussions for both Chinese and global financial markets,” the IMF economists wrote.

In a statement, the Institute of International Finance said China should not try to prevent people swapping renminbi for dollars.

“We do not expect harsh capital control measures,” it said. “[The] authorities don’t want to jeopardize progress towards RMB internationalisation and capital account liberalisation. Gap plugging efforts can be futile.”

FT