Today’s post is from Adrian Blundell-Wignall, Special Advisor to the OECD Secretary-General on Financial Markets. The view expressed here is his own and does not necessarily reflect that of any OECD government.
A couple of years ago the IMF produced some (cautious) comments and studies arguing that currency management and capital controls were OK in some circumstances. Many emerging market countries took this as an endorsement of their approach to policy which has not been limited to temporary crisis measures. The Figure below shows the national investment-saving correlations for the OECD countries over 1982-2010 and for a group of emerging countries (China, Brazil, India, South Africa, Mexico and South Korea) in the manner of Martin Feldstein and Charles Horioka.
In a 1980 paper, Feldstein and Horioka looked at two views of the relation between domestic saving and the degree of mobility of world capital. If capital is perfectly mobile, you would expect there to be little or no relation between the domestic investment in a country and the amount of savings generated in that country, since capital would flow freely to wherever the returns were highest. On the other hand, if the flow of long-term capital among countries is impeded by regulations or for other reasons, investors will be more likely to keep their money in their own country and increases in domestic saving will be reflected primarily in additional domestic investment. Feldstein and Horioka’s analysis supported the second view more than the first.
Three decades later, the OECD economies have more-or-less achieved an open economy without capital controls (led in large part by Europe). But the emerging markets have a high correlation of national savings to investment (0.7), indicating a prolonged lack of openness.
National Investment-Savings Correlations: OECD versus Emerging Economies
The growing gap between the correlations for the OECD (highly open) and the emerging economies (impeded) is pointing to a fundamental imbalance in the world economy. Does it matter? The IMF study mentioned above showed that countries with stronger capital controls had a lesser fall in GDP in the post-crisis period. While the original authors were cautious in interpreting their results, this was not so for the users of those findings. This is all the more worrying given that the OECD exactly reproduced the IMF study and found that the results were not robust to a simple stability test. In other words, the OECD tests show that these results certainly should not be used as a basis for claiming some form of general support for long-term use of capital controls.
The OECD also ran a simpler study using the IMF’s own measures of capital controls, with both the IMF’s original sample period and updating it. The OECD study found significant and contradictory results, which were much more consistent with an exchange rate targeting and “impossible trinity” interpretation of outcomes:
- In the good years prior to the crisis, capital controls are indeed good supporters of growth. This is likely because combined with exchange rate management there is a foreign trade benefit, companies are not constrained for finance, and containing inflows reduces the build-up of money and credit following from exchange market intervention (and associated asset bubbles).
- However, in the post-crisis period the exact opposite is found and the results are highly significant. Capital controls are negatively correlated with growth. The pressure on the exchange rate is down, not up, as foreign capital retreats, and international reserves are used up defending against a currency crisis (contracting money and credit). Companies are more constrained by cash flow and external finance considerations. Just at the time when foreign capital is needed, countries with the most controls suffer the greatest retreat of foreign funding. Investment and GDP growth suffer.
- The full sample period (data from both before and after the crisis) shows significant negative effects of capital controls. That is, the overall net benefit appears negative compared to less capital controls.
These results have an intuitive appeal, consistent with economic theory. While it is early days, and some caution is required, the findings suggest that in the long-run dealing with the global investment-savings imbalances could be of benefit not only to developed countries, but also to the developing world itself.
Capital Controls on Inflows, the Global Financial Crisis and Economic Growth: Evidence for Emerging Economies by Adrian Blundell-Wignall and Caroline Roulet of the OECD Directorate for Financial and Enterprise Affairs
This paper discusses the issues mentioned above in detail. It investigates whether countries that had controls on inflows in place prior to the crisis were less vulnerable during the global financial crisis. More generally, it examines economic growth effects of such controls over the entire economic cycle, finding that capital restrictions on inflows (particularly debt liabilities) may be useful in good times but may have adverse effects in a crisis.
Macro-prudential Policy, Bank Systemic Risk and Capital Controls by Adrian Blundell-Wignall and Caroline Roulet of the OECD Directorate for Financial and Enterprise Affairs
This paper looks at macro-prudential policies in the light of empirical evidence on the determinants of bank systemic risk, and the effectiveness of capital controls. It concludes that complexity and interdependence is such that care should be taken in implementing macro-prudential policies until much more is understood about these issues.
Today the OECD is hosting a high-level seminar on the role of international co-operation in capital flow management and liberalisation. We invited OECD Secretary-General Angel Gurría to describe the Organisation’s work in this field, notably the OECD Codes of Liberalisation of Capital Movements and of Current Invisible Operations.
International capital flows have increased dramatically in the past decades. Gross cross-border capital flows rose from about 5% of world GDP in the mid-1990s to historical highs of about 20% in 2007. This growth was around three times stronger than growth in world trade flows. The contraction caused by the crisis affected mainly international banking flows among advanced economies and subsequently spread to other countries and assets. Capital flows have rebounded since the spring of 2009, driven by portfolio investment from advanced to emerging-market economies and increasingly among emerging-market economies themselves.
Financial globalisation, and the associated increase in the movement of capital across international borders, can be both a blessing and a challenge. As we argued in the 2011 OECD Economic Outlook, increasing international capital flows can support long-term income growth through a better international allocation of saving and investment, but they can also make macroeconomic management more difficult, because of the faster international transmission of shocks and the increased risks of overheating, credit and asset price boom-and bust cycles and abrupt reversals in capital inflows. Volatility indeed is one of the hallmarks of capital flows.
Several countries, including in the OECD area, have dealt with the adverse effects of such volatility by taking measures to limit capital inflows. Others are considering doing so. At the same time, some emerging economies with restrictive regimes are opening up. These contrasting situations are a good enough reason in themselves to bring together experts and officials from the public and private sectors to exchange experiences, analyses and opinions.
But there’s another reason for today’s seminar too. In June this year, the OECD invited non-members to join our Codes of Liberalisation of Capital Movements and of Current Invisible Operations. These codes are an important tool to promote orderly liberalisation, learn from each other’s experience, and ensure mutual accountability. While the two OECD Codes constitute legally binding rules, implementation involves “peer pressure” and dialogue exercised through policy reviews and country examinations.
Countries that adhere to the Codes are expected to fulfil three core principles. First, non-discrimination, meaning they grant the benefits of their liberalisation measures to all other adherents and do not discriminate against other adherents when applying any remaining restrictions.
Transparency is the second principle. Adherents must report up-to-date information on barriers to capital movements and trade in services that might affect the Codes’ obligations and the interests of other adherents.
“Standstill” is the third principle. This means that adherents should avoid taking new restrictive measures or introducing more restrictive measures except in accordance with the Codes’ provisions or established understandings regarding their application.
By adhering to the Codes, a country receives international support and recognition for its openness, and joins a community of countries that refrain from a “beggar-thy-neighbour” approach to capital flows. In other words, countries that adhere to the Codes will not try to improve their own situation by harming others.
An adherent also enjoys the liberalisation measures of other participants, regardless of its own degree of openness. It is protected against eventual unfair and discriminatory treatment of its investors established in other participating countries.
A more subjective, but equally important benefit is that the country reassures market participants that it does not intend to maintain controls broader or longer than necessary. This is crucial in today’s economy where expectations and attitudes play such a significant role in financial markets and investment decisions.
There is obviously an issue of sovereignty in any discussion of openness (whether to capital flows or trade). I’d argue that the Codes help reinforce national influence because as an adherent, a country fully participates in shaping jurisprudence and improving the rules of the framework.
Moreover, the Codes recognise the right of countries to regulate markets and operations. The liberty to conduct transactions is subject to national regulations, as long as they do not introduce discriminatory treatment, in like circumstances, between residents and non-residents. Countries have the right to set prudential measures to protect users of financial services, ensure orderly markets, and maintain the integrity, safety and soundness of the financial system.
It’s also worth emphasizing that while economies are increasingly interdependent and interconnected, they are not identical, and the Codes recognise this.
Countries can pursue liberalisation progressively over time, in line with their level of economic development. Emerging economies such as Chile, Korea and Mexico have adhered to the Codes. Some OECD countries used a special dispensation from their obligations under the Codes for countries in the process of development, while still enjoying the same rights as other adhering countries.
Last the Codes also provide countries with flexibility to cope with situations of short-term capital volatility including the introduction of controls on short-term capital operations and the re-imposition of controls on other operations by invoking the Codes’ “derogation” clause in situations of severe balance-of-payments difficulties or financial disturbance. This clause has been used 30 times since 1961, most recently in 2008 when Iceland introduced exchange controls and measures restricting capital movements in response to a severe banking and balance of payments crisis.
Hence the Codes are the only multilaterally-backed instruments promoting the freedom of cross-border capital movements and financial services while providing flexibility to cope with situations of economic and financial instability. They were also the first instruments created by the OECD when it was founded in 1961. For 50 years adhering countries have used the Codes to support reform, to co-operate to reap the full benefit of open markets and to avoid unnecessary harm from restrictive measures.
The OECD Council decided last June to open the Codes to adherence by all interested countries outside the OECD membership with equal rights as OECD countries. This is an important step in expanding international co-operation, maintaining deep liquid global capital markets, and making the most of international capital flows as a tool to finance growth and development. Time has also come to think about how the Codes should be improved to ensure we can continue to maximise the benefits from open capital markets while avoiding their downside effects.
Today’s seminar will, I hope, give us insight into how to adapt the Codes’ highly effective mixture of principle and pragmatism to the coming decades.