At a conceptual level, it is generally acknowledged that a free and open system for capital movements would contribute to the efficient allocation of world saving and enhance the welfare of participating countries. However, a strand of theoretical models also suggests that as a “second-best” solution, restrictions on capital movements may improve welfare in the presence of preexisting distortions. Accordingly, the preconditions for realizing the benefits of liberalization may not be present, and some countries may continue to restrict capital movements.3 Empirical literature, by contrast, while not conclusive, generally points to the ineffectiveness of controls in sustaining inconsistent macroeconomic policies.4
Over the last two decades, many countries have liberalized their capital accounts. As described in Section III, industrial countries adopted capital convertibility almost universally in the 1970s and 1980s, building on a process of international economic integration that was already well advanced in the area of trade in goods and services. The trend was facilitated by the Code of Liberalization of Capital Movements of the Organization for Economic Cooperation and Development (OECD), which was introduced in a limited way in 1961 and later extended in stages to encompass the full range of capital account transactions by 1989. The adoption in 1988 by the European Union (EU) of the Second Directive on Liberalization of Capital Movements was also instrumental.5 Many developing countries have lifted controls on capital movements, most relatively recently. A majority among them still retain such controls de jure,6 but de facto the controls are less prevalent. The group maintaining controls may be expected over time to seek the benefits of full integration into global markets through more open capital accounts, although the transition to a liberalized capital account raises important issues, as discussed below.7
Transition to an Open Capital Account
Moving to capital account convertibility requires careful consideration of the following: (1) whether a set of preconditions should be established before the capital account is liberalized and how liberalization measures should be sequenced; (2) whether, in view of the integration and development of international financial markets, restrictions on capital flows can be effectively enforced; and (3) whether difficulties might arise in the conduct of macroeconomic policies following liberalization, and what they might be. In addition, separate issues arise when considering whether under particular circumstances the temporary reimposition of controls, especially on capital inflows, can be appropriate.
Preconditions and Sequencing
As described in Sections III and IV, recent experience tends to support the view that the freeing of capital account transactions should be undertaken subsequent to, or at least broadly simultaneously with, certain other reforms. The most important among these are domestic financial market reforms and a strengthened capacity to adapt fiscal policy so as to keep resource pressures from arising when private demands mount. The centerpiece of financial sector reform would be to ensure that interest rates are internationally competitive, thus reducing pressures on the balance of payments and the exchange rate.8 Strengthening prudential regulations and requirements is also key to successful capital account liberalization; when there is generous government deposit insurance, or when there is a presumption that large banks will not be permitted to fail, there may be incentives for banks to take on excessive risk, and capital account liberalization could open up further high-risk opportunities for depository institutions.9
The type of exchange rate regime appears not to be a critical factor in successfully moving to capital account convertibility. Notwithstanding a trend toward more flexible exchange arrangements in developing countries,10 experience to date shows that countries have liberalized their capital accounts in the context of both flexible and fixed-rate regimes, including currency board arrangements. What would appear to be paramount is, if necessary, an initial adjustment of the exchange rate to a realistic level, followed by the pursuit of an appropriate policy mix that avoids abrupt adjustment in either interest rates or exchange rates. In particular, as noted above, fiscal policy should be sufficiently adaptable to sustain macroeconomic stability. Most, but not all, countries liberalizing the capital account did so in the context of a comprehensive stabilization package.
On issues of speed and sequencing of capital account liberalization in relation to other reforms, clear-cut lessons are difficult to draw. Liberalization in industrial countries tended to follow the gradual and phased approach to economic reform suggested by the literature, with capital account liberalization typically following relatively broad trade and domestic financial reforms. Moreover, experience in the late 1970s and early 1980s, especially in the Southern Cone countries, underlined the dangers of moving too rapidly in opening the capital account without supporting policies. More recently, a number of countries have successfully implemented complete reform packages over a relatively short time. It could be argued that an advantage of early removal of capital controls would be to limit the ability of vested interests adversely affected by the reforms to marshal political resistance to those reforms. Such an approach may also promote efficiency in the domestic financial sector by injecting competition for funds, improve global intermediation of resources from savers to investors, and allow enterprises and individuals to diversify activities and portfolios abroad. However, rapid liberalization may leave little time for the adoption of complementary policies, including development of well-functioning financial instruments and prudential arrangements. Several of the countries that have liberalized rapidly experienced problems in the financial sector; in most cases these difficulties reflected underlying weaknesses that were unrelated to the liberalization, although in some cases the reforms may have exacerbated the existing problems.11
In the context of a strong overall balance of payments position, the authorities may wish to minimize exchange rate or monetary pressures that could arise from foreign capital inflows by liberalizing capital outflows before inflows. There could also be a desire to limit short-term inflows that may be regarded as potentially more destabilizing but to liberalize long-term inflows, such as inward direct investment, that may be viewed as being more stable and productive.12 It may, however, be difficult to achieve such fine-tuning, except temporarily; liberalization of one component of the capital account may create pressures for deregulation of all capital transactions; moreover, there is some evidence that long-term capital flows are not necessarily more stable than flows through instruments with nominally short maturities.13
Effectiveness of Control Mechanisms
An important issue in the transition to an open capital account is whether the capital regulations can be enforced to the extent that they play a significant role. There is by now considerable evidence, particularly with regard to controls on capital outflows, that suggests only limited effectiveness.14 Notwithstanding the differentials created by capital controls between domestic and international interest rates, the evidence accumulated now points to the general inefficacy of such controls in maintaining an unsustainable exchange rate. In situations where exchange rate pressures result from capital flight induced by poor policies, there are considerable incentives to circumvent regulations through alternative mechanisms, thereby diminishing the effectiveness of controls.
It has been argued that measures to deter capital inflows have been more effective than those on outflows, because of the differing circumstances under which the two types of flows emerge as well as because of the choice of alternatives available in each case. Recent experience suggests that, although controls or taxes on inflows should not be viewed as a substitute for fundamental policy measures, especially in the area of fiscal policy, they might serve as temporary supplementary tools that could provide policymakers with some additional time to react. However, the experience relates as yet to a relatively small and recent set of countries with surges in inflows. Because quantitative restrictions on inflows are clearly less desirable than those that retain an element of market incentives, in some countries a price-based approach has been pursued to supplement more fundamental policy adjustments, for example, in Chile (see Box).15
Constraints on Macroeconomic Policies
An open capital account (de facto or de jure) places a particular premium on appropriate macro-economic policies. The risk of large capital reversals requires that monetary policy be managed so that interest rates and exchange rates are broadly consistent with underlying fundamentals and market conditions. Under fixed exchange rate arrangements, large movements in interest rates may be required to stem outflows in situations where markets question the sustainability of the exchange rate, possibly posing a conflict between domestic and external objectives of policy. Similarly, sharp and costly movements in exchange rates could result if monetary policy is out of line with market expectations where the exchange rate is managed flexibly. Considerable discipline is accordingly also required of fiscal policy so as not to overburden monetary policy.
Box. Capital Inflows and Reimposition of Controls
In recent years net capital inflows to developing countries have grown substantially, particularly to those countries that have liberalized their capital accounts. Several factors account for this trend, including strong economic performance in recipient countries, successful completion of macroeconomic adjustment and structural reforms in many countries following resolution of debt-service difficulties of the early 1980s, and slowdown in economic activity in industrial countries. The structure of these flows has evolved toward foreign direct investment and portfolio inflows. The latter may be viewed as being particularly susceptible to investor sentiment. The following tabulation shows the evolution of key categories of capital flows to developing countries:
(Annual averages in billions of U.S. dollars)1
For a discussion of recent experiences, see S. Schadler, M. Carkovic, Adam Bennett and Robert Kahn, Recent Experiences with Surges in Capital Inflows, IMF Occasional Paper 108 (Washington: International Monetary Fund, 1993); also D.J. Mathieson and L. Rojas-Suárez, Liberalization of the Capital Account: Experiences and Issues, IMF Occasional Paper 103 (Washington: International Monetary Fund, 1993).
(Annual averages in billions of U.S. dollars)1
| 1977–82 | 1983–89 | 1990–94 | |
|---|---|---|---|
| Total net capital inflows | 30.5 | 8.8 | 104.9 |
| Net foreign direct investment | 11.2 | 13.3 | 39.1 |
| Net portfolio investment | −10.5 | 6.5 | 43.6 |
| Other | 29.8 | −11.0 | 22.2 |
For a discussion of recent experiences, see S. Schadler, M. Carkovic, Adam Bennett and Robert Kahn, Recent Experiences with Surges in Capital Inflows, IMF Occasional Paper 108 (Washington: International Monetary Fund, 1993); also D.J. Mathieson and L. Rojas-Suárez, Liberalization of the Capital Account: Experiences and Issues, IMF Occasional Paper 103 (Washington: International Monetary Fund, 1993).
(Annual averages in billions of U.S. dollars)1
| 1977–82 | 1983–89 | 1990–94 | |
|---|---|---|---|
| Total net capital inflows | 30.5 | 8.8 | 104.9 |
| Net foreign direct investment | 11.2 | 13.3 | 39.1 |
| Net portfolio investment | −10.5 | 6.5 | 43.6 |
| Other | 29.8 | −11.0 | 22.2 |
For a discussion of recent experiences, see S. Schadler, M. Carkovic, Adam Bennett and Robert Kahn, Recent Experiences with Surges in Capital Inflows, IMF Occasional Paper 108 (Washington: International Monetary Fund, 1993); also D.J. Mathieson and L. Rojas-Suárez, Liberalization of the Capital Account: Experiences and Issues, IMF Occasional Paper 103 (Washington: International Monetary Fund, 1993).
Faced with surges in capital inflows and in the context of other policy adjustments, several countries have chosen to reimpose capital controls in order to slow down inflows. A wide variety of measures have been adopted, including prudential controls on the banking system, market-based measures (special taxes and levies), and quantitative restrictions on inflows and outflows. For instance, in Indonesia, Malaysia, and the Philippines, a tightening of the prudential limits on banks’ offshore operations was effected, while Brazil, Chile, and Colombia imposed non-interest-bearing reserve requirements against foreign currency borrowing by firms. Malaysia also imposed some quantitative restrictions. Although the prolonged use of such measures would seem distortionary, the experience of these countries suggests that such measures may be justified on prudential grounds and on a temporary basis. On balance, however, capital controls seem to have been far less important in successfully dealing with capital inflows than the adjustment of underlying fundamental macroeconomic policies.
In recent years several developing countries that have liberalized their capital accounts, many from a position of capital outflows, have experienced sizable net capital inflows. While generally a welcome development, flows that are large relative to the size of the economy can complicate macroeconomic management as well as the task of ensuring that excessive risk taking does not undermine the health of the financial system. The nature of these macroeconomic and financial sector risks was detailed in a recent IMF publication.16 The risks stem from the difficulties in containing monetary and credit expansion in the context of large inflows, with potentially adverse implications for inflation, the real exchange rate, and the external current account. The threat of sudden reversal further underscores the need for careful adjustment to such inflows. Adjustment in fiscal policy is a key response that may dampen inflows through its effects on interest rates. In most countries, however, it is difficult to use fiscal policy as a short-run response, and it may also exacerbate the problem of unsustainable inflows if confidence in economic policy grows strongly.
IMF’s Approach to Capital Account Liberalization
The Executive Board had not until recently considered in a comprehensive way the specific issue of capital account liberalization with a view to developing guidelines for the membership as a whole. Rather, views on capital account issues have been expressed largely in the context of the IMF’s surveillance, use of IMF resources, and technical assistance activities.17 The general approach has recognized the freedom accorded to members under the Articles to maintain or impose capital controls in order to achieve balance of payments and exchange rate stability, providing that “members may exercise such controls as necessary to regulate international capital movements,” and even that the “Fund may request a member using its general resources to impose capital controls” (Article VI).18 Although it has recognized this freedom, the IMF has tended in the context of its multilateral surveillance discussions and bilateral policy advice to welcome members’ actions taken to liberalize capital account transactions and to urge such liberalization in cases where this was deemed to be a crucial element of broader structural reforms.
With the movement toward capital account liberalization in industrial countries and in a substantial number of developing countries, the IMF has taken a keen interest in the issues arising from the resulting progressive integration of the world’s capital markets. In its various multilateral surveillance discussions, the Executive Board has looked upon such integration favorably from the systemic perspective of promoting liberal international trade, sustainable economic growth, and overall economic efficiency. In the context of the IMF’s World Economic Outlook (WEO) exercise, in September 1994, the IMF’s Executive Board emphasized that global economic performance will be enhanced by the welcome trend toward currency convertibility and liberalization of capital movements. This view, however, has not been unqualified, with some concerns being expressed regarding the appropriateness of large capital inflows in situations where such inflows were not primarily the result of strong policy fundamentals and reform efforts in the recipient countries. In its various deliberations, the Board has also underscored the importance of appropriate prudential regulatory and supervisory frameworks in guarding against the propensity of financial intermediaries to take on additional risk in an environment of unrestricted capital flows.
Policies in Article IV Consultations and in the Context of Use of IMF Resources
In the context of Article IV consultation, the IMF has been supportive of the liberalization of capital flows in industrial countries.19 The impetus for such liberalization was, however, largely provided by the frameworks of the OECD code and the EU directives.20 In these cases, the approach has generally been to welcome members’ initiatives within the OECD and EU codes and directives and has tended to focus on their systemic implications as well as those for policy fundamentals. Board views expressed at the time that capital account liberalization was undertaken suggested a high degree of consensus on its benefits, especially because the liberalization was often accompanied by other market-opening reforms.
The IMF has taken a case-by-case approach to capital account liberalization in its consultations with developing countries. While generally eschewing an activist policy of urging rapid liberalization, the institution has in some cases encouraged developing countries to open their economies to foreign capital inflows and to liberalize restrictions on capital account transactions. This approach is particularly demonstrated in countries in Central and Eastern Europe, where a significant liberalization of foreign direct investment has been one of the objectives of IMF-supported programs. Within this general setting, the treatment of capital account liberalization in consultations has been selective. The IMF’s views have featured prominently in some situations where capital flows have been substantial and called for adjustments in macroeconomic policies. In the recent cases reviewed for this paper involving large capital inflows, a suitable mix of fiscal, monetary, and exchange rate policies was considered an appropriate response, and the tightening of controls over capital movements as an alternative was generally discouraged.
Although the IMF has generally supported a gradual approach to capital account liberalization, it has encouraged an acceleration of this process in some cases. A case-by-case approach has also been followed for the reimposition of capital controls in developing countries in light of their diverse circumstances. The review of specific cases presented later in this paper suggests a general distaste for such controls as a way of addressing balance of payments difficulties. In contrast to the general preference for avoiding reintroduction of controls on capital flows for feasibility and credibility reasons, among others, prudential limits on foreign exchange risk exposure have been endorsed.
Technical Assistance to Member Countries
While the IMF’s treatment of the issue of capital account convertibility has been on a case-by-case basis in the context of its surveillance and use of IMF resources activities, an effort to facilitate capital liberalization has been applied more generally through the medium of technical assistance to develop foreign exchange markets.21 Traditionally, the IMF’s technical assistance in the area of foreign exchange systems focused on efforts to facilitate current account convertibility in its member countries; however, from the mid-1980s the focus shifted toward encouraging the adoption of full current and capital account convertibility.
Common themes in technical assistance supporting a move to capital convertibility have included the ineffectiveness of existing controls, improved transparency associated with a free exchange system, the benefits of recognizing an informal market through which a significant proportion of transactions was already taking place, and the need to develop a competitive and efficient exchange system.22 The IMF staff has also provided technical assistance in complementary areas, focused in particular on the desirability of maintaining interest and exchange rates at internationally competitive levels.23
Issues in Relation to Extending the IMF’s Role in Promoting Capital Account Convertibility
The IMF’s role with respect to capital controls was the subject of intense debate in the discussions preceding the Bretton Woods agreements. International responsibilities in this area remained thereafter relatively stable under the par value and related arrangements. However, with the advent of generalized floating in the early 1970s, considerable discussion emerged in the IMF and elsewhere regarding members’ obligations under the new international system. This culminated in the issuance of an Executive Board decision on exchange rate surveillance in 1977, which contained specific provisions for the IMF’s handling of capital controls.24
To date, the IMF’s approach has been modest with regard to promoting movement toward a more open system for international capital flows. Considering that all industrial countries and some developing countries have now moved to capital account convertibility and the related globalization of capital markets, a question can be raised as to whether the IMF should play a significantly more active role in this area than it has done so far. Three approaches are considered below: (1) continuation of current practices; (2) adaptation of existing surveillance procedures and technical assistance to more actively promote capital account liberalization; and (3) an extension of the IMF’s jurisdiction to capital account transactions.
Continuation of Current Practices
The IMF’s broad surveillance mandate under Article IV of the Articles of Agreement calls upon the IMF to take into account the “introduction or substantial modification for balance of payments purposes of restrictions on, or incentives for, capital flows” in determining observance by members of principles guiding their exchange rate policies. The 1977 Surveillance Decision further enjoins the IMF to take into account the pursuit, for balance of payments purposes, of monetary and other domestic financial policies that provide abnormal incentives for the inflow or outflow of capital, as well as the influence of long-term capital flows on the behavior of members’ exchange rates.
The provisions of the surveillance decision relating to capital controls have been applied to questions of capital account liberalization in some countries. The overall approach has been to support and welcome removal of capital controls in cases where individual members have liberalized the capital account in a multicountry context, such as actual or prospective adherence to the OECD and EU codes, or on their own accord. Article VI, however, gives members the right to maintain capital controls. Reflecting the varied circumstances of its members, the IMF’s financial programs have generally not included explicit recommendations and performance criteria for capital account convertibility.
In the context of IMF-supported programs in transition economies, active promotion of capital account liberalization was pursued initially with regard to inward foreign direct investment. However, subsequently, and for other categories of capital, the policy recommendations have been more general. Liberalization efforts have been directed primarily toward persuading members to remove restrictions on current international transactions and to accept the obligations of Article VIII, where they have not already done so, without consideration of further actions in the capital account.25 Technical assistance reports have occasionally gone further and have included a discussion of the rationale and actual modalities for adopting full convertibility.
Adaptation of Existing Practices to Encourage Capital Account Liberalization
An alternative approach would be for the IMF to promote capital account liberalization more actively through its existing surveillance and technical assistance functions, still in the context of the existing Articles. The basis for these efforts would stem from the IMF’s mandate under the Articles to exercise surveillance over the exchange rate policies of members. The approach would be motivated by the desire to accelerate the pace of capital account liberalization, recognizing the uneven progress thus far among the IMF’s membership. There are two main vehicles through which the IMF could pursue this approach in persuading members to implement appropriate measures: ongoing surveillance activities and technical assistance. In adapting these policies, the IMF would need to ensure uniformity of treatment across its membership.
The Executive Board discussions of the biennial review of the IMF’s surveillance activities in early 1995 underscored the importance of capital market developments and the IMF’s efforts to strengthen surveillance and adapt to the changing world of increasingly integrated capital markets. One aspect of such adaptation could be for the IMF to pay greater attention to restrictions imposed by members on capital flows and to encourage their removal in conjunction with appropriate macroeconomic policy adjustments. In the first instance, this would involve strengthening the IMF’s information base on regimes governing capital account transactions in individual countries. Information on the effectiveness of the restrictions in limiting capital flows would also need to be sought. Beyond the identification of restrictions, such an approach would involve more explicit recommendations from the IMF staff regarding the scope for capital account liberalization.
The IMF staff would need to be mindful of a number of complementary considerations: the structure and strength of the balance of payments and external debt; the structure and health of the financial sector, including the effectiveness of prudential and regulatory mechanisms; the appropriateness of the exchange rate; the adequacy of international reserves; and the consistency of interest rate policy with the exchange rate regime. Possible response mechanisms in dealing with destabilizing capital flows would also need to be considered. Such an agenda would represent an expansion of the scope and depth of analysis for most Article IV consultation missions and would need to be supported by concerted technical assistance to a wider group of countries in recognition of the scope for financial sector development in many developing countries.
Further, important issues have arisen concerning the pace and sequencing of capital account liberalization. Considerable judgment would be required about the sustainability of the measures, their sequencing relative to other structural reforms, and the possibility of phased and sequential lifting of specific measures. Analogous to the IMF’s practice of encouraging members to accept the obligations of Article VIII, members would in such cases need to be satisfied that they would not be likely to require recourse to restrictive measures in the foreseeable future.
Under this approach, the IMF’s biennial review of members’ exchange and payments systems would continue to provide specific discussions of convertibility issues and developments, including an assessment of the systemic implications of the strategy of promoting widespread capital account liberalization. The IMF’s multilateral surveillance through the WEO exercises and reports on international capital markets would continue to provide the backdrop for members to consider in pursuing capital account liberalization. Strengthening the database on capital controls in the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions would also be undertaken.
Extension of the IMF’s Jurisdiction to Capital Account Transactions
A fundamental argument for extending IMF jurisdiction to deal with capital transactions is that the original Articles of Agreement (including Article VI, Section 3) were framed in a different era and are no longer in harmony with the new international system of globalized markets and massive capital flows.26 Not only has the importance of capital account issues increased, but recent experience has indicated the difficulty of making exchange controls effective. There would be credibility gains regarding the authorities’ commitment to a liberal system for trade and financing arising from their acceptance of capital convertibility. For these reasons, the provisions of Article VI, Section 3—allowing members to exercise such controls as necessary (with specified exceptions) to regulate international capital movements—as well as related provisions in other Articles could be reconsidered to the extent necessary.27
The need for the IMF to reconsider its approach to capital account restrictions also arises from the role of capital liberalization in broader aspects of financial market development. There would be clear systemic benefits from capital account liberalization on a broadly multilateral basis. One result that has become clear is that the development of more sophisticated financial instruments (e.g., foreign exchange forwards or futures) is dependent upon freedom from direct controls or incentives on a very broad basis. Capital convertibility has thus become even more bound up with other aspects of the IMF’s role in promoting the development of financial institutions and infrastructure.
The scope of Article VI, Section 3 has affected the IMF’s consideration of capital controls: the Executive Board has not had a broad-ranging discussion of this issue since the 1970s and has also focused less on data and experiences in this area than on restrictions on the current account of the balance of payments. One benefit of extending jurisdiction would be to harmonize better across the entire IMF membership the treatment of exchange controls for capital with the consideration accorded to restrictions on current account transactions, including the transitional arrangements under the Articles for such restrictions.28
Evidence that controls on short-term capital inflows can be effective in providing temporary breathing space for the strengthening of macroeconomic policies suggests that some special provision may well be desirable for such flows. However, the increasing fungibility of short- and long-term capital, particularly in times of balance of payments crises, can be seen as making such a distinction difficult to apply. Just as leads and lags on trade financing offer an escape valve, so too do movements of longer-term capital, owing to the delay or acceleration of investment decisions and the role of secondary markets in which residents participate. Accordingly, the approach of the OECD and EU codes, as amended in the late 1980s to comprehend short-term capital symmetrically, would seem a desirable one for the IMF to follow both on its own merits and for reasons of international consistency. Bringing direct investment under the ambit of an enhanced IMF code, particularly the exchange aspects, would also have the benefit of introducing considerable symmetry with the OECD and EU codes.29
Under an approach that extended the IMF’s jurisdiction to capital account transactions, a two- to three-year learning period may be both desirable and necessary to allow the IMF to build up its information and policy approaches in this area and assess resource implications before considering whether to pursue a formal jurisdictional extension. During this interim period, the IMF would distribute questionnaires to members seeking full information, along the lines of the OECD codes. In this way, the option of extension of IMF jurisdiction would be left open while at the same time allowing the IMF to gain valuable experience and knowledge on capital account issues.
Relations with Other Organizations
Any approach to fostering capital account liberalization would be facilitated by appropriate coordination with other multilateral institutions. Considerable expertise in this area now exists at the OECD and the EU, and their codes and directives as regards liberalization of capital movements could initially serve as a useful guide. The IMF would need to develop similar mechanisms, albeit for a much wider range of countries, which could be facilitated by intensifying an ongoing dialogue with these institutions on capital account matters. Apart from building an information base, such a dialogue would also be necessary to ensure that actions members take in response to destabilizing capital movements do not discriminate against other IMF members.30 If the IMF’s jurisdiction were to be extended to the capital account, the implications of any jurisdictional overlap between the IMF and other entities would also need to be clarified. Relations with the OECD will be an important consideration, particularly in view of the May 23-24, 1995 agreement by OECD members on the immediate start of negotiations aimed at reaching a multilateral agreement on investment by 1997. The agreement would aim at providing a multilateral framework, open also to non-OECD member countries, for liberalizing investment regimes and investment protection. In addition, in light of the advance made, under the General Agreement on Trade in Services, in liberalizing certain capital movements, it would be important to collaborate with the World Trade Organization (WTO).
Financing Considerations
A more active role on the part of the IMF in seeking capital account liberalization would raise the issue of providing financing to members faced with balance of payments pressures emanating from the capital account. One concern may be that the IMF could become increasingly involved in financing fluctuations of capital flows because, by accepting the obligations of an expanded Article VIII, members may expect that they would be supported by access to IMF financing in the event that they experience pressures resulting from capital account imbalances. Specifically, consideration would have to be given to the revision of Article VI, Section I, which specifies that IMF resources could not be used to “meet a large or sustained outflow of capital.”
Issues also arise regarding the size of the financing that would be needed, the speed with which it would need to be provided, and its relationship with other forms of private and official financing. In this context, the increase in annual access limits for the use of IMF resources by its members and the possibility of greater access under exceptional circumstances provide the IMF with greater scope for addressing members’ financial needs. The Halifax summit communique urged the IMF to establish an emergency financing mechanism to provide faster access to IMF arrangements with strong conditionality and larger up-front disbursements in crisis situations.31 Another issue is whether financing would be needed in support of members’ liberalization of the capital account, analogous to the balance of payments need associated with structural reforms under the extended Fund facility (EFF) and the enhanced structural adjustment facility (ESAF). Preferably, appropriate policy adjustments would be advocated to address any adverse effects on the balance of payments, but cases could be envisioned where an appropriate combination of adjustment and financing might be desirable.
For an early review of these issues, see A.K. Cairncross, Control of Long-Term International Capital Movements (Washington: Brookings Institution, 1973).
For a survey of the literature, see Michael Dooley, A Survey of Academic Literature on Controls over International Capital Transactions (Washington: International Monetary Fund, forthcoming).
The codes and directives have since undergone revision. Organization for Economic Cooperation and Development, Code of Liberalization of Capital Movements (Paris, 1993); and European Union, The Agreement on the European Economic Area, chap. 4 (Luxembourg, 1992).
For a survey of capital controls in developing countries, see Section VI. Developing countries with an open capital account include a number of oil exporting developing countries with relatively strong balance of payments positions, most Latin American and Caribbean economies, Hong Kong, Lebanon, Malaysia, Singapore, Thailand, a few countries in Africa (The Gambia, Kenya, and Mauritius), the Baltic countries (Estonia, Latvia, and Lithuania), and the Kyrgyz Republic.
Specific multilateral or regional provisions for capital account liberalization have been much less prominent in developing countries. In the East Caribbean, a regional agreement to permit free intraregional flows meant effective multilateral capital convertibility because of an open system maintained by one member (Anguilla). The relationship of the franc zone countries to France has resulted in a similar situation, although the effect of new uniform foreign exchange regulations for the member countries of the Central Bank of West African States (BCEAO) and the Bank of Central African States (BEAC) has yet to be clarified. The use of another country’s currency has implied capital account convertibility in other instances (Kiribati, Liberia, Marshall Islands, Panama, and San Marino).
Liberalizing countries have for the most part raised negative real interest rates to such levels prior to or simultaneously with opening the capital account, and in the few other cases the adjustment occurred soon after. Virtually all had systems of monetary policy management that did not depend on credit rationing.
However, a number of the liberalizing countries, at the time of opening the capital account, had considerable weaknesses in the banking system, reflected in large-scale nonperforming assets and in an absence of effective prudential risk-management systems.
For a recent discussion of developments in this area, see International Monetary Fund, Issues and Developments, pp. 17–20.
For a detailed discussion, see Section IV.
Available evidence suggests, paradoxically, that considerably more IMF members maintain restrictions on inward foreign direct investment than on banking and portfolio flows (see Section VI).
See C. Claessens, M.P. Dooley, and A. Warner, “Portfolio Capital Flows: Hot or Cold?” World Bank Economic Review, Vol. 9 (January 1995), pp. 153–74.
See Section IV, and Dooley, Survey of Academic Literature.
The evidence to date is inconclusive in this area. In Chile, which is often quoted as an example of successful supplementary use of controls over short-term inflows, gross capital inflows have remained very strong. The apparent shift in the composition of inflows could be somewhat illusory because of the possible fungibility of different types of flows. There is also the fundamental question of whether the controls on capital inflows are the optimal response. Where fundamental policies are weak, the first-best solution is to correct them; if policies are appropriate, other options, such as sterilization, may be preferable. One lesson from experiences with surges in capital inflows has been the need for better prudential risk management and market information and processing to lessen the likelihood of market failure. For further discussion of measures taken to control capital inflows in Chile, Colombia, and Malaysia, see Section VII.
International Monetary Fund, International Capital Markets, 1995.
The IMF’s decision on surveillance over exchange rate policies adopted in 1977 includes, among developments that might indicate the need for discussion with a member: “(iii)(b) the introduction or substantial modification for balance of payments purposes of restrictions on, or incentives for, the inflow or outflow of capital;…,” International Monetary Fund, Selected Decisions, p. 11. The surveillance decision was amended at the time of the 1995 biennial review of surveillance to take greater account of the importance of private capital flows. The Articles do not, however, give the Fund jurisdiction over exchange controls related to most capital account transactions. Moreover, surveillance has related to the appropriateness of changes—introduction or substantial modification for balance of payments purposes—in a member’s capital controls, but it has not lent itself to broad appraisals of the outstanding position of a member’s system of controls.
Certain transactions that are normally regarded as capital transactions, such as payments of moderate amounts for amortization and normal short-term banking and credit facilities, are deemed by the Fund under Article XXX(d) as being current.
Article IV, Section 3(b) of the IMF’s Articles of Agreement enjoins the IMF to exercise firm surveillance over the exchange rate policies of members. The procedures for the implementation of surveillance under Article IV, adopted at the time of the Second Amendment to the Articles, require that in principle members consult with the IMF annually. For further discussion of IMF policy treatment, see Sections III and IV.
For further discussion, see Section IV.
Specific arguments have also reflected the circumstances of the individual countries—for example, decontrol would remove incentives for capital flight and provide incentives for capital re-flows; liberalization is likely to encourage competition in the financial sector and facilitate investment and growth by a more efficient allocation of resources; and convertibility would facilitate integration into the world economy.
Assistance has been provided in such areas as linkages with monetary management, prudential mechanisms, monetary policy, general development of instruments and markets, reserves management, reporting systems, legal reform, and the development of interbank market operations in foreign exchange.
See footnote 17 on p. 5.
Article VIII of the IMF’s Articles of Agreement spells out members’ obligations regarding, inter alia, avoidance of restrictions on payments for current transactions, discriminatory currency practices, and convertibility of foreign-held balances.
The framing of the original Articles took place in the context of a debate of the role of speculative versus productive capital movements. In the international environment of the Bretton Woods arrangements, difficulties arising from such distinctions were seen to be less crucial simply because of the limited volume of capital transactions. However, with the integration of the global economy and the enormous growth in capital transactions, these difficulties have moved to center stage.
There is no evidence in the legislative history of the IMF that the concept of “necessary” in Article VI, Section 3 was intended to limit the authorities’ discretion in any way, and this argument has never been invoked in the practice of the IMF. Indeed, when this provision was explained to the U.S. Congress prior to ratification, it was stated that, under this provision, member countries have the right to control capital exports when such control is regarded by them as desirable. The primacy of the right under Article VI, Section 3 was confirmed in 1956, when the Committee on Interpretation of the Executive Board concluded that the use of discriminatory currency arrangements for control of capital movements did not require IMF approval under Article VIII, Section 3. It is also worthy of note that, at the time of the Second Amendment, no modification was made to Article VI, notwith-standing the changes that had taken place in the international exchange rate arrangements.
Increasingly in recent years, Article VIII obligations have been adopted in tandem with capital convertibility, raising an issue of whether obligations under the original Article VIII should be merged under an expanded Article VIII that would include capital account transactions. Such an approach would remove ambiguous administrative separations between the current and capital transactions that have on occasion impeded elimination of controls on current account transactions. (Even within the IMF, numerous legal questions have arisen in connection with Article XXX.) Ex-tending the IMF’s jurisdictional interest to capital transactions could therefore ease completion of the unfinished business represented by the 76 countries that remain under the transitional arrangements of the IMF’s Article XIV. It would also allow for a flexible treatment of the question of reimposing capital controls, because there are already arrangements under Article VIII approval policies to provide for members’ rights to effect such reintroductions in the case of current account transactions, subject to certain criteria that have been applied in a pragmatic fashion.
Another issue of transactions coverage results from the fact that Article VIII refers to payments and transfers for, and not receipts accruing from, current international transactions. Repatriation and surrender requirements are in many ways similar to capital controls and are important in determining the efficiency of foreign exchange markets.
For instance, the EU directive calls for consultation among its members and a collective response to disruptive capital movements relating to third countries.
Communique of the Group of Seven, Halifax Summit of the Group of Seven, June 15–17, 1995.
Note: This section was prepared by Vicente Galbis and Kal Wajid. It deals with the experiences of the 23 countries defined by the IMF as industrial countries: Australia, Austria, Belgium, Canada, Denmark, France, Finland, Germany, Greece, Iceland, Ireland, Italy, Japan, Luxembourg, the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, United Kingdom, and United States.