IV A Suggested Methodology for Sequencing
- International Monetary Fund
- Published Date:
- April 2002
The general principles for sequencing capital account liberalization and coordinating liberalization with other policies need to be made operational in any given case. This requires an assessment or diagnosis that underpins the design of a broad strategy and the formulation of policy priorities and a plan for their implementation. The diagnosis may have to be updated from time to time in light of new developments; and the design and implementation of policies will need to be adjusted accordingly. The sequencing and speed of liberalization will generally be affected by these revisions.
Countries need to adopt a comprehensive approach to sequencing and coordinating capital account liberalization with other policies to obtain the full benefits from capital account liberalization while avoiding pitfalls. Box 7 presents the key steps in such an approach. A comprehensive approach is needed, given the links between the different segments of the economy and the scope that these links create for transmitting and amplifying disturbances. Thus, full account needs to be taken of the specific characteristics of the economy being liberalized and, in particular, of the risks and vulnerabilities in the financial system and in the financial structure of nonfinancial institutions. On this basis, reform priorities can be identified to address key risks at an early stage and to ensure that a critical mass and domestic ownership of reforms are in place at each stage of the liberalization process.
A good diagnosis of a country’s situation and outlook is crucial in designing an operational plan for sequencing capital account liberalization. The diagnosis should cover both macroeconomic and sectoral aspects. It needs to include the extent and effectiveness of capital controls, the condition and main vulnerabilities of the financial sector and of nonfinancial institutions, and the capacity of the financial infrastructure to deal with the effects of opening the capital account and adverse shocks.
An important facet of the diagnosis is an inventory of the existing capital controls and an assessment of their effectiveness. The analysis of the controls needs to be based on a thorough examination of laws, regulations, and administrative practices and should take into account the nature of the controls; the economic incentives and available modalities for circumventing the controls; the administrative and enforcement capacity of the authorities; and the authorities’ practices in applying and enforcing the controls.29 The assessment of the effectiveness of capital controls will require considerable judgment and will remain subject to a large margin of uncertainty, as it is often impossible to distinguish the effects of capital controls from the effects of other variables. Moreover, the effectiveness of controls typically depends significantly on the prevailing economic conditions that affect incentives for circumvention;30 and removing some controls opens up channels for the circumvention of the remaining controls.
Another component of the diagnosis is to assess the risks to financial stability and their relationship with international capital flows. Such an assessment covers three broad areas: macroeconomic conditions or policies, the development and stability of institutions and markets, and issues related to governance, including the observance of international standards. An assessment of the resilience of the financial sector to shocks is an integral part of developing a sequencing plan, and will influence the timing and coordination of steps in various areas of policy.31
Based on the overall diagnosis, a broad plan for sequencing and coordinating capital account liberalization with other policies can be developed. Figure 1 provides a stylized representation of such a broad plan. The pace, timing, and sequencing of liberalization or reform measures need to be adapted to country circumstances. Furthermore, in the event of unforeseen difficulties in implementing particular reforms that would require deviations from the sequencing plan, contingency plans need to be developed. In economies with a very weak financial infrastructure, it may take a significant amount of time to put in place basic policies and institutions. This may slow the pace of capital account liberalization. Once the process of developing an efficient and robust financial system is well under way in such economies, subsequent steps towards capital account liberalization may be accelerated. By contrast, in economies with an already well-established financial infrastructure, and hence a greater capacity to manage the risks associated with international capital flows, liberalization can proceed more quickly. Indeed, the experience of some countries (the United Kingdom, for example) shows that under the right macroeconomic and financial conditions, a rapid liberalization of all capital controls can be undertaken without undue risk.
Figure 1.A Stylized Representation of Sequencing Box 7.Suggested Sequencing Methodology
Examine capital account regime and its effectiveness
Review pertinent laws and regulations
Assess scope for and evidence of circumvention in view of data on capital flows, state of market development, indicators of illicit activity, and information on the authorities’ administrative and enforcement capacity and practice
Analyze macroeconomic policies and conditions affecting financial sector stability
General effects of macroeconomic and sectoral policies and conditions on credit growth, credit quality, and financial soundness
Detailed analysis of the implications of fiscal, monetary, and exchange rate policy stances and the overall policy mix on private and public debt markets and debt dynamics (both in domestic and foreign currency, and for domestic and cross-border transactions), structure of finance (banks, debt securities, equity shares), financial safety nets and bank restructuring efforts, and capital flows
Based on the above, identify potential shocks and undertake stress testing
Evaluate state of development and risk exposures of institutions and markets
Assess in detail the state of development, risk profile, and sensitivity to shocks of various institutions and markets, including banks, nonbank financial institutions, nonfinancial corporations, money and foreign exchange markets, government securities markets, equity and private debt security markets, and payments and settlements systems
For banks, nonbank financial institutions, and non-financial corporations, use appropriate macro- and microprudential indicators, including liquidity, profitability, capital adequacy, leverage, measures of key risk exposures (especially those stemming from cross-border operations), and the results of stress tests
For markets, consider indicators of depth, liquidity, integrity, and efficiency, and examine the relationship between the functioning of these markets and the implementation of monetary policy and the functioning of payments and settlements systems
Assess the prudential and governance infrastructures, and the observance of relevant standards
Assess prudential infrastructure using applicable standards, including for banking, securities, insurance, and payments systems
Assess other policies and practices affecting the financial sector, including accounting, disclosure, insolvency regime, monetary and financial policy transparency, corporate governance, and financial safety nets (deposit insurance, lender-of-last-resort, and systemic restructuring of financial institutions)
Design a broad strategy for sequencing and coordinating reforms
Set policy priorities, applying the general principles for sequencing and drawing on the detailed assessment of conditions and vulnerabilities
Coordinate main steps in three areas: capital account liberalization, financial sector reform, and other policies (including statistics, corporate restructuring, insolvency, and accounting)
Reach tentative judgment on time needed to obtain a critical mass and domestic ownership of reforms at each point in time, and set pace of capital account liberalization accordingly
Organize measures according to priority along a time line
Prepare contingency plans or safeguards in the event of unexpected adverse shocks
Implement a detailed action plan
Identify and acquire expertise and technical assistance needed for the design and implementation of policies
Draw up detailed action plan for all policy areas, including a timetable for implementation
Review progress and revise action plan periodically
Consistent with the general principles for an orderly sequencing and coordination of capital account liberalization with other policies, countries wishing to proceed with capital account liberalization may be able to build on the methodology presented in this chapter. As experience is gained, methodologies and the associated tools and techniques should be developed further.
IMF surveillance and technical assistance in close collaboration with the World Bank can be useful vehicles for helping these countries to develop a plan for sequencing and coordinating liberalization with other policies. The bulk of the cost in developing a sequencing plan is in arriving at a well-founded assessment of the macroeconomic and financial sector vulnerabilities and reform priorities. Article IV consultations with IMF members can help in identifying the macroeconomic and structural policies that can support an orderly capital account liberalization; and a Financial Sector Assessment Program (FSAP) can deepen that analysis as it is relevant to the financial sector. However, the detailed analysis of sequencing is a task for technical assistance, and only at a country’s own request. Many member countries have for a long time received technical assistance on issues related to capital account liberalization, most notably on the development of foreign exchange markets, the design and drafting of foreign exchange regulations, the unification of exchange rate regimes, prudential regulation and supervision of the risks involved in cross-border financial transactions, and foreign debt and reserves management. Often, this technical advice was provided in support of capital account liberalization. IMF technical assistance on financial sector issues generally entails the sequencing and coordination of different areas of policy, which is embodied in detailed action plans similar to those proposed in this paper. Good practices in these and other areas are critical for an orderly sequencing of capital account liberalization.32
Drawing on in-depth technical analysis, supported by technical assistance as needed, a detailed plan for implementing capital account liberalization and other policies can be designed. A simplified example of such a plan, drawing on actual country experiences, is presented later in this chapter. Policy measures in this example are organized into three stages and cover in greater specificity capital account liberalization, financial sector measures, and other policies, including macroeconomic stabilization. An actual sequencing plan would, in addition, contain a specific timeline for individual policy measures, as embodied in legal and regulatory changes and official decisions, and seek to quantify macroeconomic objectives.
Applying the Methodology—An Example
The methodology for developing policy recommendations for sequencing and coordinating capital account liberalization with other policies can be illustrated through an example. Proceeding by example is desirable and necessary given the many country-specific factors that affect the appropriate sequencing of policies.33 The purpose is not to provide recommendations to a specific country but to illustrate how a plan for sequencing can be developed in practice, using the methodology outlined previously in the paper.
The example discussed here is based on the experiences of emerging market economies, which have significant access to private capital and, as recent crises have shown, may face unsustainable capital inflows and their rapid reversal. Moreover, in emerging market economies, basic elements of the financial infrastructure, such as interbank money and foreign exchange markets, payments systems, indirect instruments of monetary policy, and the like, tend to be fairly well developed. The recommendations for sequencing that emerge from the example will therefore differ from those that would be given to a low-income developing economy, where many of the basic markets and institutions are not adequately developed. Similarly, the recommendations in the example would also not be directly applicable to other emerging market economies with different mixes of macroeconomic and financial sector vulnerabilities.
In the country example, extensive capital controls are still in place; and prior liberalization has for the most part been sequenced prudently. Short-term flows remain more tightly controlled than long-term flows, and FDI, which tends to be more stable, has been liberalized more extensively than other categories of flows. However, banks’ derivatives transactions have already been liberalized. Although this may have benefits by allowing for improved hedging of foreign exchange and other market risks, it is questionable whether banks’ risk management capacity is sufficiently developed, and whether the prudential oversight of derivatives operations is adequate. A summary of the controls in place in the country example is provided in Table 2.34 A firm judgment on the effectiveness of the controls is difficult to reach. The still fairly extensive coverage of the controls, a generally well-developed administrative apparatus, and the restrictive implementation of the controls argue for their effectiveness. On the other hand, the effectiveness of the controls may have been somewhat eroded by the liberalization of trade, current payments, and some capital transactions. One source of uncertainty is that the existing capital controls have not been tested by an episode of serious macroeconomic or financial system stress.
|Type of Control||Description|
|Current account proceeds|
|Repatriation requirements1||Proceeds from goods exports and invisibles must be repatriated|
|Foreign direct investment|
|Inward||Substantial sectoral restrictions, including but not restricted to sectors considered to be of strategic importance|
|Outward||Limits on size and destinations|
|Liquidation by nonresidents||No restrictions|
|Capital and money market instruments|
|Purchase locally by nonresidents||Substantial restrictions on most types|
|Sale and issue locally by nonresidents||Permit required for all types|
|Purchase abroad by residents||Permit required for most types, and especially for short-term debt securities|
|Sale and issue abroad by residents||Substantial restrictions on all types, and especially for short-term debt securities|
|Commercial banks and other financial institutions|
|Borrowing by residents abroad||Substantial controls on short-term borrowing (including by banks), different reserve requirement on foreign currency deposits, prudential limits on banks’ open foreign exchange positions|
|Lending to nonresidents||Quantitative limits, prudential limits on banks’ open foreign exchange positions|
|Derivatives and related instruments|
|Forwards and futures||Restricted to banks|
|Other derivatives||Restricted to banks|
Technically, these measures are not capital controls as they involve transactions among residents, but they limit the scope for residents to undertake capital transactions.
Technically, these measures are not capital controls as they involve transactions among residents, but they limit the scope for residents to undertake capital transactions.
Vulnerabilities in the country example arise from the interaction among macroeconomic conditions, weaknesses in the banking system, and shortcomings in corporate governance (Table 3). These vulnerabilities argue for a carefully sequenced approach to capital account liberalization. In particular, the need to contain the foreign exchange debt of corporations within manageable limits favors maintaining some controls on foreign borrowing (and especially short-term borrowing). Moreover, the still somewhat fragile condition of the banking system, which is beginning to suffer the effects of an economic slowdown and an intensification of competition, may also call for adequate caution in liberalizing short-term portfolio and debt flows.
|Assessment of Conditions||Financial Sector Vulnerabilities|
|Macroeconomic Policies and Conditions Affecting Financial Sector Stability|
|Real economy||Growth slowing from previously high rate, led by manufacturing and real estate.||Could have some effect on capacity of households and corporations to repay loans. However, banks’ real estate exposure poses no systemic risk.|
|Fiscal policy||Additional tightening needed in view of limited progress thus far in reducing the high public debt/GDP ratio and lengthening maturities.||Failure to improve fiscal and monetary management could undermine external sustainability, erode the confidence of foreign investors, and lead to a reversal of capital inflows and a sharp exchange rate depreciation. The potential impact of these developments on financial stability needs to be monitored and evaluated. Macroeconomic policy mix that relies heavily on tight monetary policy (high interest rates) could also adversely affect bank profitability and capital adequacy.|
|Monetary policy||Inflation rate in single digits. Still somewhat higher than targeted, but expected to decline.|
|Exchange rate policy||Free floating, with no intervention by the central bank, even for smoothing.|
|External sustainability. including debt and reserves management||Large current account deficit. Significant interest rate premium on external debt. Reserves high relative to short-term debt.|
|Capital flows||Substantial private market access for both financial and nonfinancial entities. Flows play major role in financing current account deficit and in financial market liquidity.|
|Shocks||Significant exposure to terms of trade shocks (oil) and to adverse real and financial developments in trading partners.||Risk of contagion from crises in other countries, leading to exchange rate depreciation and financial sector instability.|
|Institutions and Markets—Development, Risk Profile, and Sensitivity to Shocks|
|Banks||Profitability falling and nonperforming loans rising, reflecting growing competition, disintermediation, and slowing growth. Large government share of banking system, but growing foreign bank ownership.||Ongoing threat to viability of some banks, to be addressed mainly by an orderly consolidation of weaker with stronger banks, and by progress in privatizing state-controlled banks. Macroprudential indicators and stress testing indicate a particular sensitivity to exchange rate changes.|
|Other financial institutions||Essentially sound, but concentration high.||No significant domestic vulnerabilities at present. However, improvements in risk management needed before being allowed to freely enter into full range of cross-border capital transactions.|
|Nonfinancial institutions||Considerable foreign exchange exposure. Leverage ratios somewhat high.||Serious vulnerability, documented by stress testing. May encounter difficulties in servicing foreign currency debt in the event of a large exchange rate depreciation. Requires some financial restructuring and improved risk management.|
|Monetary policy instruments||Use of indirect instruments generally well developed, but overly volatile call money rate owing to design of repo operations.||Helps to manage impact on money and credit of capital flows.|
|Interbank money and foreign exchange markets||Money market fairly well developed, although transactions are highly concentrated among the leading institutions. Lack of depth in foreign exchange market.||Possible liquidity problems, especially in foreign exchange market, resulting from and possibly aggravating financial system stress.|
|Treasury bill and bond markets||Generally well-functioning, but thin in longer maturities.||Development of full yield curve would help monetary policy to better manage the impact of capital flows.|
|Equity markets and private bond markets||Small, but developing depth and liquidity. Equities appropriately valued.||Needs further development to provide viable alternative to bank finance.|
|Payments and settlements systems||Sophisticated and efficient, reflecting high priority given to this area by the authorities.||Facilitates smooth cross-border transactions and reduces settlement risk.|
|Prudential and Governance Infrastructure1|
|Banks (Basel Core Principles)||Partial compliance, with weaknesses in consolidated supervision, enforcement powers, supervisory cooperation, and on-site supervision, especially of banks’ risk management.||Could hamper efforts to address weaknesses in banking system (see above). Banks’ management of risks associated with cross-border positions may not be adequately supervised.|
|Insurance (IAIS Core Principles)||Improvements needed in supervisory independence, on-site inspection, capital rules, and supervisory communication.||Relatively minor vulnerabilities, but improvements may be prudent before fully liberalizing cross-border transactions by these institutions.|
|Securities (IOSCO Core Principles)||Only minor weaknesses, e.g. in enforcement, insider trading rules.||Possible Instability in the event of a balance of payments crisis if foreign investors lose confidence in market integrity.|
|Payments systems (Core Principles)||Insignificant weaknesses.||Minor.|
|IMF standards (Fiscal Transparency, Monetary and Financial Policies, Statistics)||Only minor weaknesses.||Does not give rise to significant domestic or external vulnerabilities.|
|Corporate governance||Serious weaknesses in corporate governance, including in management accountability and shareholder rights.||May induce corporate managements to take on excessive risks, in particular excessive foreign currency debt.|
|Accounting (GAAP or IAS)||Generally sound accounting legislation, but some weaknesses in practice.||Only minor risks to financial system stability.|
|Insolvency||Notable weaknesses In both legislation and judicial system.||Weakens the “credit culture” and may contribute to a loss of confidence by foreign investors during periods of serious strain. Could delay corporate restructuring.|
|Arrangements for the resolution of systemic banking problems||Weaknesses in enforcement powers, some lack of clarity in responsibilities.||May deepen and prolong systemic banking problems in the event of a crisis. However, issues are being addressed, limiting vulnerabilities.|
|Financial safety nets||LOLR used to support institutions known to be insolvent. No issues in deposit insurance system.||Current LOLR policy creates moral hazard, raising the level of risk in the financial system.|
Where appropriate, relevant standards and codes for assessment are included in parentheses.
Where appropriate, relevant standards and codes for assessment are included in parentheses.
The overall diagnosis provides the basis for developing and implementing a plan for sequencing and coordinating capital account liberalization with other policies, notably macroeconomic and financial sector policies. Three main stages may be distinguished; and detailed recommendations for sequencing in the country example are provided in Table 4. These recommendations also address key development needs in the financial sector:
|Capital Account Liberalization||Financial Sector Reforms||Other Policies and Issues|
|Stage 1: Laying the Foundation for Liberalization|
|Capital inflows||Markets and systems||Mocroeconomic policies and conditions|
Key vulnerabilities stemming from macroeconomic conditions need to be addressed as a matter of priority:
Changes in this area may require considerable time, and preparations need to start at an early stage. The highest priorities are:
|Stage 2: Consolidating Reforms|
|Inflows and outflows||Prudential policies and risk management||Macroeconomic policies and conditions|
|Stage 3: Completing and Reassessing Liberalization and Reforms|
|Complete liberalization||Market and systems development||Macroeconomic conditions and policies|
In the first stage, the groundwork for an orderly liberalization needs to be laid. This includes achieving a high degree of macroeconomic stability and developing markets and institutions, fostering good risk management by banks and other financial and nonfinancial enterprises, and remedying the most important shortcomings in prudential regulation and supervision. Selected capital flows that pose a low stability risk can be liberalized during this stage, for example, inward FDI. Some liberalization of short-term foreign exchange borrowing and lending by banks may also be warranted as a means to facilitate the further development of the interbank foreign exchange market, but any such liberalization would need to be accompanied by strong prudential safeguards to prevent the development of an excessive foreign exchange exposure in the economy as a whole, or in any particular sector. Another question of particular interest in the example is how to deal with the premature prior liberalization of banks’ cross-border derivatives transactions. One option would be to reimpose some restrictions on these transactions. However, as the domestic market for financial derivatives has already been largely liberalized in the country example, it may be more appropriate to improve prudential regulation and supervision of these activities, with a particular emphasis on fostering better risk management by the banks.35
The second stage entails a consolidation and deepening of the progress made during the first stage. Preparatory work on time-consuming reform projects begun during the first stage should now be coming to fruition, financial markets and institutions should have reached a considerable level of sophistication and robustness, and financial sector stability should be supported by continuing sound macroeconomic policies and conditions. Again, the vulnerability assessment (Table 3) provides the guidance for setting reform priorities. Considerable further capital account liberalization can typically be undertaken during this stage, drawing on an appraisal of the risks associated with particular categories of flows (Table 1). In the country example, the recommendation is to liberalize all longer term and nondebt-creating capital flows at this stage, while keeping in place some controls on foreign borrowing and short-term capital flows. The latter recommendation is based mainly on an assessment that corporations, owing to inadequate risk management and poor corporate governance, might increase their short-term foreign currency debt to a level that could pose a threat to macroeconomic and financial sector stability.
During the third and final stage, all remaining capital controls can be lifted, as macroeconomic and financial sector conditions have improved to the point that the associated risks can be effectively managed. This stage also entails a fundamental reassessment of the process of liberalization and reform, with a view to identifying any remaining weaknesses or emerging vulnerabilities.36 In the country example, the full liberalization of capital flows during the third stage also presupposes the adoption of a legal framework suited to facilitating efficient and stable relations with a wide variety of foreign counterparties, including in the most advanced markets.
These factors include the type of the transactions covered, the enforcement mechanism, the penalties for noncompliance, the capacity of the authorities to adapt controls to changing circumstances, and whether permits are granted liberally or only rarely.
A system of controls that may be effective in defusing mild disturbances may be overwhelmed by a major crisis.
This aspect of the methodology draws on tools that staff are using in Financial Sector Assessment Program exercises.
In this sense, the suggested methodology is based on building blocks that already exist.
The facts for the example were adapted from actual country experiences.
The classification of the controls in Table 2 follows the IMF Annual Report on Exchange Arrangements and Exchange Restrictions. Not all types of controls are present in the example.
This recommendation requires an assessment that there is a capacity to successfully pursue this course, among both the supervisors and the banks.
This reassessment must be distinguished from the more routine adjustments to the timing and sequencing of capital account liberalization, which would need to be made regularly to reflect the progress, or lack of it, in particular areas.