Abstract

May 11, 2005

Statement by the Managing Director IMF Staff Response IEO Comments on Management/Staff Response

Summing Up of IMF Executive Board Discussion by the Acting Chair

Statement by the Managing Director on the Evaluation by the Independent Evaluation Office of the IMF’s Approach to Capital Account Liberalization: Executive Board Meeting

May 11, 2005

The Independent Evaluation Office’s study on the IMF’s approach to capital account liberalization should help in disseminating the lessons for Fund practice and enhancing the learning culture of the Fund. The staff has prepared a statement indicating its reactions to the report’s recommendations in the period ahead.

The Board discussion of the IEO report will provide an opportunity to draw out its implications for the Fund’s policies and procedures. The questions on capital account issues raised in this report will be addressed in the ongoing strategic priorities review, the results of which will help shape our agenda going forward.

Staff Response to the Evaluation by the Independent Evaluation Office of the IMF’s Approach to Capital Account Liberalization: Executive Board Meeting

May 11, 2005

1. The IEO report (SM/05/142) highlights the difficulties and complexities the Fund faces in providing advice on capital account issues. The two main recommendations put forward in the report are: the need for (i) greater clarity in the scope of the Fund’s policy advice on capital account issues to its membership, and (ii) greater attention to supply-side factors of international capital flows with a view to minimizing their volatility. This statement elaborates on some of the report’s analytical underpinnings. The report is timely in view of the ongoing work on the Fund’s strategic priorities.

2. The staff considers the sample underlying the report’s evaluation of our advice on capital account issues a fair representation of the diverse membership, although it believes that a finer distinction among these countries would have been useful. The staff appreciates the considerable work that was involved in evaluating 27 countries, and finds the description of the cases broadly accurate. However, in discussing the staff’s policy advice, the report could have made a useful distinction between three cases: countries with an actual or potential balance of payments or banking crisis; countries facing a major capital inflow; and those under “normal” conditions but with some remaining capital controls. This distinction would help to clarify and nuance the staff’s advice on capital account liberalization and imposition of temporary capital controls.

3. Relatedly, the report’s finding of some apparent inconsistencies in the Fund’s advice on capital account liberalization across countries needs to be more nuanced. The Fund is sometimes criticized as being a monolithic institution following a “one-size-fits-all” approach. In contrast, the IEO concludes that its evidence suggests no “one-size-fits-all” approach by the Fund staff. Indeed, the staff has used its own professional judgment in approaching capital account liberalization in individual countries, and there was active debate on the issue within the staff. In its assessment, however, the report seems critical of this discretion, and calls for greater consistency in country work and institutional approach. The apparent lack of consistency in the Fund’s advice to its members may have a number of causes, as acknowledged in the report, including the tailoring of policy advice to country-specific circumstances or the absence of an official position in the Fund on capital account issues. While we do not disagree with the report’s finding that the latter could have contributed to some variation in policy advice across the membership, the report could have gone further into explaining the different country circumstances that would warrant differentiated advice. Indeed, a detailed case study approach of the sampled countries would have perhaps made a more convincing analysis.

4. The staff largely concurs with the evaluation’s two key findings on the Fund’s policy advice to its member countries on capital account issues (Chapters III and IV). The IEO report finds that the Fund staff has been quite accommodating of the authorities’ policy choices when they involved a gradual approach to capital account liberalization or temporary use of capital controls. Moreover, in no case did the Fund require capital account liberalization as formal conditionality for use of its resources. In particular, the Fund has not pressured member countries—certainly not the emerging market countries sampled—to liberalize their capital accounts or to move faster than they wanted to go. In terms of advice on the temporary use of capital controls, the IEO concludes that the Fund staff seldom challenged the authorities’ decisions and even supported market-based controls in some cases as a second-best option. It notes that the staff pointed out the risks inherent in an open capital account as well as the need for a sound financial system, even in the early 1990s. However, the IEO considers that these risks were insufficiently highlighted and did not translate into operational advice until later in the 1990s. We would stress that the IEO sees recent improvements in this area. Indeed, substantial analytical work has been carried out by the Monetary and Financial Systems Department (MFD), the International Capital Markets Department (ICM), Research Department (RES), and area departments.

5. The report does not do justice to the role played by external forces in promoting capital account liberalization. While it acknowledges the presence of exogenous factors, the country cases do not fully reflect their role. In particular, free trade agreements (FTAs) and multilateral trade liberalization through the World Trade Organization have covered significant components of the capital account related to financial services and investment chapters. In addition, recent bilateral investment treaties (BITs) frequently cover a broad range of instruments (including portfolio investments, inter-bank transactions, and sovereign debt) with no balance of payments safeguards; that is, signatories, to a point, cannot impose capital controls even during times of macroeconomic or financial stress. Moreover, a major source of pressure for liberalization is often a country’s own commercial sector, which may be looking for sources of competitive financing. All in all, the policy choices of emerging markets may have reflected these external factors at least as much as Fund policy advice.

6. The report proposes two main recommendations in light of the Fund’s experience with capital account issues. As discussed below, the Fund is already implementing some aspects and plans to address these issues further in its future work program and in the strategic priorities review.

7. Recommendation 1 is that more clarity is needed on the Fund’s approach to capital account issues. There are three aspects to this proposed recommendation, which are discussed in turn.

  • The report suggests that the place of capital account issues in Fund surveillance could be clarified, and there would be value if the Executive Board were to clarify formally the scope of Fund surveillance on capital account issues. The Board and the Fund staff have recognized that capital account developments and vulnerabilities constitute an increasingly important focus of the Fund’s work on promoting stability, and the process of clarifying the scope of Fund surveillance to include capital account issues is already underway. The Executive Board noted in the context of recent Biennial Surveillance Reviews (2002, 2004) that Fund surveillance needed to adapt to “a changing global environment, most notably to the rapid expansion of international capital flows.” This adaptation would imply a broadening of the coverage of surveillance “from a relatively narrow focus on fiscal, monetary and exchange rate policies, to a broader purview encompassing external vulnerability assessments, external debt sustainability analyses, financial sector vulnerabilities, and structural and institutional policies that have an impact on macroeconomic conditions” (SUR/02/81). The Board has also highlighted the risks of opening the capital accounts before floating the exchange rate, and especially the risks of sudden outflows (PIN No. 04/141). More recently, in the context of the discussion of the “Fund’s Medium-Term Strategy—Framework and Initial Reflections” (BUFF/0560), the Board has called for additional work on capital account issues.

  • Relatedly, the report proposes that the Executive Board could issue a statement clarifying the common elements of agreement on capital account liberalization. While this is an issue for the Executive Board to decide, the staff agrees that it would be useful to have some clear operational guidance that lays out the broad principles that Fund staff needs to follow in its policy advice across countries and that the outline of these principles in the IEO report is a useful starting point for such guidance. Indeed, staff (especially MFD) has already undertaken policy research and operational work on various aspects of capital account issues (including capital account liberalization and financial sector reform, country experiences with use and subsequent liberalization of capital controls, and sequencing), in the context of FSAPs and technical assistance. We would, however, caution that there is no single “right” approach. Our advice needs to take into account the different situations confronting our members. It also must recognize that for many members full capital account liberalization is an aspiration that will likely take substantial time to achieve.

  • Against this backdrop, the Fund’s future work on capital account issues should seek to buttress efforts to promote financial stability, while helping ensure that controls are not used to impede adjustment. An approach would be to build on the existing Fund expertise in this area, and to ensure that policy advice on capital account issues is fully incorporated into the mainstream of bilateral and multilateral surveillance, with analytic work being used to strengthen the basis for policy advice and technical assistance. This strategy would imply a measured approach to liberalization to facilitate countries’ integration into global economy while maintaining stability, rather than promoting liberalization, per se.

  • The report also suggests that the Fund could sharpen its advice on capital account issues, based on solid analysis of the particular situation and risks facing specific countries. The staff endorses this recommendation, which is in line with best practice and longstanding general guidance on Fund surveillance. In its policy advice to countries the staff will continue to draw on all existing analytical work as well as any future findings that may arise from staff studies that have been requested by the Board, or from other sources. Further, technical assistance provided by the Fund on operational issues provides hands-on advice to countries on how to proceed with capital account issues. We also note that MFD is reviewing, for the upcoming Biennial Review of Exchange Arrangement, Restrictions and Markets, the role of capital controls during financial stress and issues relating to financial liberalization and capital account regulations. However, the IEO’s suggestion that the Fund should provide some quantitative gauge of the benefits, costs, and risks of moving at different speeds is likely to prove difficult to put into practice, given the conflicting theoretical and empirical evidence on the subject and the political and economic complexities that capital account issues typically involve.

8. Recommendation 2 is that the Fund’s analysis and surveillance should give greater attention to the supply-side factors of international capital flows and what can be done to minimize the volatility of capital movements. Staff agrees with the crux of this recommendation, although given the large number of staff studies already completed (and more under way), we are not sure what other specific actions, if any, the IEO may have in mind. We agree with the report’s assessment that this is a difficult topic on which little professional consensus exists. That said, past work and current initiatives demonstrate that the staff recognizes that reducing volatility and cyclicality in the supply of capital are critical to achieving capital markets stability.

  • To strengthen Fund surveillance in this regard, several research initiatives have been under way. ICM has aimed to focus on global financial market linkages, financial and risk-related flows, and global asset allocation decisions of institutional investors. Recent Global Financial Stability Reports (GFSRs) have focused on the volatility of private capital flows to emerging markets (September 2003), and provided analysis of the institutional investor base in emerging markets (March 2004). The next GFSR will include studies of home bias and global diversification, and financial stability considerations of regulatory and accounting policies. Further, a considerable number of studies by IMF staff (appearing in both Fund documents and outside journals) have in recent years examined supply-side aspects, including: the potential impact of interest rates and risk appetite in advanced countries on emerging market spreads; herding behavior, contagion, and the possible role of institutional investors and hedge funds in this regard. The Fund has also delved into deepening domestic capital markets by examining ways in which local securities and derivative markets can be developed to tap on a more stable segment of the investor base.

  • The Fund is undertaking a number of initiatives at the country level. Through the Financial Sector Assessment Program (FSAP) initiative, the Fund is also contributing to identifying potential vulnerabilities and risks in the financial systems, particularly of systemically important countries, whose vulnerabilities may spill over to other countries owing to strong ties in the financial sector. Further, by way of the Reports on Observance of Standards and Codes (ROSC), Special Data Dissemination Standards (SDDS), General Data Dissemination System (GDDS), and technical assistance, the Fund is helping to improve information flow to investors, which in turn contributes to greater stability. In addition, the Fund has developed operational guidance to assist in maintaining the soundness of relatively large and complex banking organizations, with a view to creating stability in domestic and international financial sectors.

  • Several broader initiatives have also been undertaken by the Fund. The Capital Markets Consultative Group (CMCG), established in July 2000 by the IMF’s Managing Director, provides a forum for informal dialogue between participants in international capital markets and the IMF. More generally, the IMF is working on improving its understanding of recent trends in and future prospects of foreign direct investment (FDI) in emerging market countries (EMCs), the investment strategies of large multinational companies, and the determinants of FDI in EMCs. The Fund has also played a leading role in discussions about the possibility of a statutory sovereign debt restructuring mechanism (SDRM) for orderly debt workouts, and has encouraged the use of collective action clauses (CACs) to strengthen crisis resolution and reduce uncertainty associated with debt restructuring. As indicated in the report, the staff comments on the proposed New Basel Capital Accord (Basel II) have highlighted that using credit ratings to set capital charges could increase volatility and procyclicality.

  • With so many initiatives under way at the Fund, we are puzzled by the report’s finding that the Fund pays too little attention to supply-side risks. The past and current work, noted above, shows that the Fund staff has been at the forefront of the analysis and policy debate in this area. However, staff recognizes that it cannot rest here, and it will strive to enhance further its understanding of supply-side factors and their implications for our membership. However, it would have been more helpful if the IEO had proposed specific actions that could be taken on the supply-side to minimize volatility and cyclicality.

  • Beyond the present list of activities within the Fund to deal with the supply-side risks of capital flows, the staff emphasizes that additional inter-nationally coordinated efforts could help give these issues higher priority among policymakers in advanced economies. In this regard, the Financial Stability Forum (FSF), established in 1999 and, in whose work the Fund participates, works as a conduit for promoting international financial stability, improving the functioning of financial markets, and reducing systemic risks. Further, the Principles for Stable Capital Flows and Fair Debt Restructuring in Emerging Markets, a private-sector-led initiative with the support of a number of emerging market country issuers, are also aimed at improving the engagement between sovereign debtors and their creditors, with a view to promoting global financial stability.

Independent Evaluation Office Comments on Management/Staff Response to the Evaluation of the IMF’s Approach to Capital Account Liberalization: Executive Board Meeting

May 11, 2005

We would like to offer a few points of clarification, in response to the comments made by management and staff on the IEO report.1

The staff suggests that the report is critical of the discretion exercised in tailoring policy advice on capital account liberalization to country-specific circumstances (paragraph 3). This is not what the report says. The report tries to explain how the staff tailored its advice on capital account issues to country-specific circumstances but concludes that a full assessment is not possible because country documents generally do not provide sufficient analytical basis for understanding why a particular combination of policies was advised in a particular case. The IEO report does not take issue with discretion as such and we certainly agree that the IMF did not adopt a “one size fits all” approach in its approach to capital account liberalization (and other related issues) in individual countries. Rather, the message of the report is that this potentially admirable discretion needs to be guided by general principles and therefore would have benefited from a clearer official position in the IMF on capital account issues. Indeed, we read the staff response as agreeing that it would be useful to have some further operational guidance that lays out the broad principles that staff should follow in its policy advice across countries.

The staff notes that the IEO report does not do justice to the role played by external forces in promoting capital account liberalization (paragraph 5). We agree that the exogenous factors noted by the staff were an important influence on capital account liberalization in many countries. Indeed, the report does refer to these external forces; some of the detailed country cases in Appendix 1 and some boxes on country experiences are quite explicit in spelling out the external forces that influenced the decisions of these countries to open their capital accounts. The focus of the report, however, remains on the IMF’s approach. If the forces driving capital account liberalization were indeed beyond the IMF’s control, this does not alter the fact that the IMF had a potentially critical role to analyze the risks involved and to offer appropriate policy advice to minimize those risks. An assessment of the IMF’s approach to capital account liberalization does not depend on where the impetus came from.

Regarding Recommendation 1, the broad approach to the IMF’s future work on capital account issues set out in the third bullet of paragraph 7 of the staff response is consistent with what we had in mind. The staff also notes the practical difficulty of providing a quantitative gauge of the benefits, costs, and risks of liberalizing the capital account at different speeds. We concur that it is not an easy task, but assessing the trade-offs involved in different approaches is critical if the IMF’s advice on sequencing capital account liberalization is to be useful. Sequencing necessarily involves a piecemeal process in which some markets are liberalized while others remain closed. Then, sequencing is the right approach only if the risks avoided exceed the risks created by partial liberalization. While it is unlikely to be possible to quantify precisely the trade-offs involved, policy advice would be of limited usefulness unless some guidance on the nature and magnitude of the trade-offs were provided. Welfare economics—in which the consequence of opening a market when domestic distortions exist has been an important topic—may provide insight for thinking about how to make policy advice on sequencing more operational.

Finally, regarding Recommendation 2, the staff notes a number of initiatives that are already under way, to analyze supply-side factors influencing the volatility of international capital flows. We welcome these initiatives, some of which, but not all, were noted in the report. The point we make in the report is that the IMF’s analysis of supply-side factors has been largely descriptive and that the policy implications drawn are mainly targeted at recipients of capital flows. There are, of course, good reasons for this—including the evolving nature of the literature which has generated limited consensus on specific actions that could be taken on the supply side to minimize volatility and cyclicality. Therefore, our recommendation was not a call for the IMF to back any specific policy measure but rather to strive to enhance further its understanding of supply-side factors and their operational or policy implications, with the focus on how such factors influence inter-linkages between countries. But we agree that considerable progress has already been made in this direction, including through the various forthcoming activities noted by the staff in its response. Not all of these were known to us at the time the IEO report was prepared. For example, the planned thrust of the next GFSR is the type of activity we had in mind.

1

Paragraph references are to the staff response.

The Acting Chair’s Summing Up IEO Report on the Evaluation of the IMF’s Approach to Capital Account Liberalization: Executive Board Meeting

May 11, 2005

Executive Directors welcomed the report by the Independent Evaluation Office (IEO) on the IMF’s approach to capital account liberalization. They noted that financial integration can confer benefits to the global economy by promoting an efficient allocation of savings and a diversification of risks, with some Directors emphasizing the importance of orderly and well-sequenced liberalization. Directors stressed the increasing significance of capital account issues in Fund surveillance, and of fully understanding and addressing the difficulties and complexities faced by the Fund in providing advice in this area. They thus welcomed the opportunity that the report provides to explore how the Fund’s effectiveness in this area can be further advanced.

Directors appreciated the IEO’s efforts in evaluating the Fund’s experience since the early 1990s with a large sample of representative countries. They noted that the report offers a broadly accurate account of the evolution of Fund thinking and practice on the issues surrounding capital account liberalization and capital flow management, including the temporary use of capital controls. Such a history provides a crucial background for a discussion of these issues. Directors welcomed the IEO’s confirmation that the Fund did not apply an inappropriate “onesize-fits-all” approach to capital account liberalization in individual countries. Some Directors noted that, while it was important to apply discretion in individual cases, it would have been helpful for policy advice to have been guided by general principles. Directors concurred with the report’s finding that the Fund did not pressure members to liberalize their capital account sooner than desired by the authorities, and generally did not challenge the use of temporary capital controls. They considered that the Fund should continue to adopt a flexible approach to capital account liberalization that takes due account of countries’ specific circumstances and preferences. At the same time, Directors recognized that in the earlier period the risks of an open capital account had not always been sufficiently highlighted in the Fund’s operational policy advice, and that little policy advice had been offered in the context of multilateral surveillance. Directors were encouraged, however, that in recent years substantial strides have been made, based on the lessons of experience and supported by the Fund staff’s extensive analytical work on capital account issues and financial system stability. In this connection, some Directors suggested that the IEO report could have offered specific suggestions on how to ensure greater consistency and coordination between ongoing analyses on capital account liberalization issues at a conceptual level and their practical application in country operational work.

Directors expressed a variety of views on the importance of factors motivating capital account liberalization, such as free trade agreements and bilateral investment treaties. It was acknowledged that such agreements are negotiated voluntarily by country authorities when they are considered to be in the national interest. Some Directors felt that the role of such agreements in capital account liberalization should not be underestimated. At the same time, many Directors saw a key role for Fund involvement in policy advice on capital account issues as a means of promoting orderly and nondiscriminatory capital account liberalization.

Directors also commented on the two main recommendations of the IEO report.

Recommendation 1. There is a need for more clarity on the IMF’s approach to capital account issues.

Directors stressed that the Fund has long attached importance to capital account issues and vulnerabilities, and that the process of clarifying their role in surveillance is well under way. They noted that the Executive Board, in its various discussions including in the context of the Biennial Surveillance Reviews, has called for Fund surveillance to adjust to the changing global environment, notably the expansion in capital flows. The Fund has provided country-specific guidance to member countries on strengthening domestic policies and practices to manage risks related to capital account liberalization, including in the context of FSAPs and ROSCs. Furthermore, regional and global surveillance has increasingly focused on global financial market linkages, looking at demand- and supply-side factors, and the implied costs and benefits of capital account liberalization. Some Directors, however, saw merit in further clarifying the scope of Fund surveillance to recognize explicitly the central importance of capital account policies. Such clarification will also serve to improve the consistency of the Fund’s approach in this area across countries. Directors agreed that the Fund has an inherent responsibility to its members to analyze the benefits and risks involved in a world of open capital markets, and to provide practical, sound, and appropriate policy advice to its members on those issues. On the broader aspects of the Fund’s role in capital account liberalization, most Directors did not wish to explore further at present the possibility of giving the Fund jurisdiction over capital movements. However, a number of Directors felt that the Fund should be prepared to return to this issue at an appropriate time. Directors also noted that additional work on capital account issues is contemplated in the context of the Fund’s ongoing strategic review.

Directors expressed a variety of views on the merit of an Executive Board statement clarifying the elements of agreement on capital account issues. A number of Directors supported such a statement, which could build on the “integrated” approach that has gradually evolved in the Fund’s operational work, as outlined in the IEO report. However, many Directors underlined the challenge that would be faced in developing such a statement in view of the inherent difficulty in developing common guidelines that adequately take into account country-specific circumstances. Further, these Directors noted that, at present, firm theoretical and empirical conclusions are lacking, and accordingly, such a statement might need to be crafted in rather general terms, thereby not providing significant additional guidance. Directors noted that they would have an opportunity to come back to this issue in the context of the Fund’s ongoing strategic review. More generally, Directors stressed that staff will need to continue to exercise their informed professional judgment and discretion.

Directors saw scope for sharpening the Fund’s advice on capital account issues. They emphasized that Fund staff should continue to draw upon all available research in its policy advice to members, and that further research and study are needed to fully understand how best to obtain the benefits and manage the risks of capital account liberalization, including sequencing issues. Directors urged the staff to base its policy advice on solid analysis of individual country situations. To this end, a number of Directors recommended that staff reports should include a clearer and more systematic and analytical rationale for Fund advice. Directors also encouraged the staff to further strengthen its technical expertise on capital account issues. With regard to the IEO’s suggestion that the Fund staff should aim to provide more quantitative assessments of the benefits, costs, and risks of liberalizing the capital account at different speeds, a few Directors saw merit in the proposal, while others considered it to be very difficult to implement because of the technical challenges and economic complexities involved.

Recommendation 2. The IMF’s analysis and surveillance should give greater attention to the supply-side factors of international capital flows and to what can be done to minimize the volatility of capital movements.

Directors welcomed the various initiatives under way in the Fund to strengthen research, analysis, and surveillance of the supply side of capital flows, and agreed with the IEO’s view that considerable progress has already been made in this area. A number of recent analytical staff studies have examined supply-side features of capital flows, and Directors noted that the recent Global Financial Stability Reports have examined the determinants and volatility of capital flows to emerging market countries including their institutional investor base. Directors further pointed to the Capital Markets Consultative Group, which serves as an informal forum for dialogue between participants in international capital markets and Fund management, as well as to the visibility given to supply-side issues by staff at the Financial Stability Forum and the Basel Committee of Bank Supervisors. A number of Directors accordingly felt that the Fund is already paying due regard to supply-side factors that influence the volatility of capital flows.

Directors encouraged the staff to continue to build on the work already being undertaken at the Fund in order to further its understanding of supply-side factors and their operational and policy implications, including how such factors influence interlinkages and imbalances among countries in the context of the Fund’s multilateral and bilateral surveillance. In particular, they suggested that more attention be devoted to the spillover effects from regional developments and from policies in systemically important advanced and developing countries. Directors cautioned that any expanded work on supply-side issues should not entail Fund involvement in the regulation of the sources of capital, noting that the Fund should instead coordinate with the FSF and other fora that have the necessary expertise and mandate in the setting of standards. Some Directors would have welcomed suggestions by the IEO for additional specific actions that the Fund could take to address risks related to the volatility of capital flows.

In concluding, Directors agreed that the Fund’s future work on capital account issues should seek to buttress efforts to promote financial stability, while helping ensure that controls are not used as a substitute for adjustment. The aim would be to build on the existing Fund expertise in this area, and to ensure that policy advice on capital account issues is fully incorporated into the mainstream of bilateral and multilateral surveillance, with analytical work being used to strengthen the basis for policy advice and technical assistance. This strategy would imply orderly and nondiscriminatory liberalization aimed at facilitating countries’ integration into the global economy while maintaining stability. As a follow-up to the findings of the IEO report, Directors looked forward to capital account issues being addressed in the context of the Fund’s ongoing strategic review.