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We thank Olivier Blanchard, Marcos Chamon, Raphael Espinoza, and David Lipton for helpful comments on earlier versions of this paper, and Jane Haizel for assistance.
Countries have an obligation under the IMF’s Articles of Agreement to avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of payments adjustment or to gain unfair competitive advantage. The “learning-by-doing” externalities discussed in this note are not meant to cover exchange rate policies that would violate this obligation.
In contrast to the optimal tariff argument for goods trade, here creditors suffer a capital loss (depending on the duration of assets) but gain in flow terms when interest rates rise. In what follows, we ignore the first effect.
If exportables are differentiated products, then all countries can export more. If the learning-by-doing stems from exportables production, then all countries can reap the benefits of a production subsidy. But since not all countries can run larger external surpluses, the controls-cum-undervaluation strategy (which, unilaterally, leads to excessive saving and current account surplus) becomes both unilaterally and multilaterally inefficient.
Specifically, regardless of whether costs are linear or convex, there will be a case for coordination among capital-receiving countries. If costs of controls are convex, global efficiency will also necessitate coordination between borrowers and lenders, so that the marginal cost of inflow controls in the recipient country equals the marginal cost of outflow controls in the source country. If costs are instead linear, then the global efficiency criterion does not, itself, determine the optimal split between inflow and outflow controls.
Coase’s (1960) theorem on the irrelevance of the assignment of externality-generating rights does not apply here because convex costs imply that technological efficiency requires splitting the burden of capital controls between source and recipient countries.
A voluminous literature documents the impact on source countries of financial crises in borrowing countries: see, e.g., Sachs and Huizinga (1987) on the Latin America debt crisis (which posed a systemic threat to U.S. banks); and Boughton (2012) for discussion of the Asia and Russian crises. If source countries have their own incentive to restrict outflows (perhaps because of negative repercussions of a crisis in the borrowing country), then global efficiency requires the equalization of the marginal cost of inflow controls in the recipient country to the marginal cost of outflow controls in the source country; when these costs are linear (i.e., not convex), the global efficiency criterion does not pin down the optimal split between inflow and outflow controls.
Moreover, learning-by-doing externalities seem more relevant for countries behind the technological frontier, not for those at the frontier. So the basis of an undervaluation strategy is likely to be fundamentally asymmetric.
Note that the argument, sometimes made, that quantitative easing produces a wall of liquidity that washes over emerging market countries, should really be recast in terms of the prices of different assets, with the actions by central banks engaged in QE providing incentives to invest in riskier assets, including riskier foreign assets.
Outflow restrictions by current account surplus (i.e., net source) countries keep the exchange rate more appreciated than otherwise, thus reducing the surplus; quantitative easing by current account deficit (i.e., net recipient) countries weakens the exchange rate, narrowing the deficit.
Limiting outflows from source countries may actually enhance the effectiveness of monetary policy on the domestic economy even as financial stability in recipient countries is buttressed.
In a world with both destabilizing and beneficial flows (say “hot money” and FDI) and imperfect targeting of flows by capital controls, measures imposed by one country may actually deflect “good flows” to other countries. Our assumption here is that deflection of good flows—the collateral damage from the measure—is smaller than deflection of bad flows. In such case, coordination would indeed seek to lower the extent of capital controls across countries. If the opposite were true, then the inefficiency in the Nash equilibrium would point in the opposite direction, and coordination would actually seek to raise the level of capital controls.