The IMF’s Call for Complacence C. P. Chandrasekhar

A specter that haunts a number of so-called emerging markets, including India, is that of a sudden outflow of capital, either because of exit of foreign investors or because of the flight of resident capital. That fear has increased in recent times for two reasons. First, after capital inflows to these economies shrank during the crisis of 2008, they registered a sharp revival and then surged when large quantities of liquidity were infused into the world economy to save the banks and stall the downturn in the developed economies. This increased the stock of footloose capital in these economies, which could unpredictably exit and precipitate a crisis. Second, more recently, triggered by a range of factors varying from the over exposure of financial firms in emerging markets, expectations of increases in interest rates in the US and slowing growth in the world economy, especially in the emerging markets, a process of capital withdrawal that is destabilising the EMEs has begun.

According to figures collated by the IMF in the April 2016 edition of its World Economic Outlook, when the year ending the third quarter of 2015 is compared with calendar year 2010, net capital inflows to 45 emerging market economics (EMEs) declined by $1.123 trillion or the equivalent of 4.9 per cent of the GDP of this set of countries. To be more precise, net capital inflows into these countries moved from 3.7 per cent of their GDP in 2010 to a negative 1.2 per cent of GDP over the five years ending the third quarter of 2015. This swing the IMF establishes is equal in magnitude to that which occurred prior to the 1997 Southeast Asian financial crisis that was a precursor to a number of external crises across emerging markets in the years that followed. It is also similar to what happened during the debt crises of the 1980s, when international banks that had burned their fingers in developing countries and were saved by the restructuring packages instituted by their governments chose to withdraw from lending to these economies.

Thus, the evidence is strong that a huge swing from inflow to capital outflow of this kind is more than likely to trigger a spate of severe crises. Emergency measures are in order because the problem is unlikely to remain restricted to emerging markets but is already showing signs of spilling over into the rest of the global economy. With the world not having pulled itself out of the 2007-08 crisis that would turn a decade-long next year, another crisis could have catastrophic consequences.

Strangely, however, the IMF has chosen to play down this danger in the same chapter of its April Outlook as the one in which it provides evidence of a sharp reversal in capital flows. The “conclusion” it arrives at is that change “policy frameworks have played a role in mitigating the individual-country effects of global factors,” and therefore, reduced the likelihood that capital movements, including outflows, can precipitate crises. In the words of the IMF: “Policy frameworks have generally improved over time, reducing the vulnerabilities stemming from a potentially disorderly retrenchment of capital flows and the balance sheet effects that accompany exchange rate adjustments.” This, together with higher foreign exchange reserves (accumulated no doubt to counter the effects of sudden outflows) and greater reliance on borrowing in domestic currency (or lower exposure to foreign currency borrowing) has ostensibly reduced external vulnerability substantially.

The real risks in the current situation according to the Fund come from two other sources: the first is that there seems to be a strong positive relationship between gross capital inflows and growth differentials in the emerging markets. As that differential narrows foreign investor interest may be adversely affected and gross inflows may fall. The second is that in recent times the observed close relationship between gross inflows and gross outflows has given way, with gross out flows contributing to the decline in net inflows. But the Fund conveniently avoids explaining why this has happened and merely states that its “estimation results are less robust and harder to interpret for the determinants of capital outflows.”

The motivation behind this line of reasoning needs exploring. Clearly, the Fund has decided that the kind of policies adopted by emerging market governments, such as liberalisation of regulations governing capital inflows and outflows, moves to more liberalised exchange rate regimes and using open market intervention by the central bank to manage the exchange rate, which the IMF has favoured and even strongly advocated, are not responsible for the recent exodus of capital from the EMEs. The explanation, in its view, has to be found in the facts that narrowing of cross-country growth differentials and in an inability to incentivise domestic investment rather than investment abroad by resident firms and individuals that leads to capital outflow (which would also contribute to lower growth).

This is disingenuous to say the least, though the argument is so weak that it can beguile at most a few. Consider for example the issue of rising gross outflows. According to the IMF: “In recent years, more sizable gross outflows contributed to the slowdown in net inflows, rather than mitigating it. This is because, in contrast to previous episodes, which featured a tight positive comovement between gross capital inflows and gross capital outflow, such comovement has been much looser this time, including some negative comovement between gross inflows and gross outflows in some countries and during some quarters.”

One obvious reason this is the exit of foreign investors. The magnitude of that exodus is large because these countries had, as a result of capital account liberalisation and the crisis-response-induced surge in capital flows to their economies, accumulated large stocks of footoloose foreign capital within their borders. Another is the flight abroad of resident capital, facilitated by removal of capital controls. Thus the reason gross capital outflows have been rising is deregulation which dilutes or removes capital controls.¹

Given that and given the fact that the increase in gross outflows explains to a much greater degree the recent decline in net inflows the argument should be that policy initiatives that liberalise the capital account have increased external vulnerability and worked against stability. So, to cite improved policy as a factor that mitigates the risk of crisis associated with declining net capital inflows is to misread the evidence. In fact the empirical exercises reported by the WEO indicate that EMEs “that are financially more open appear more exposed to the common trend in capital inflows to emerging markets.”² However, according to the IMF, while this “does suggest that capital control regulations can have a real impact,” it does not imply that such controls “can be as effective (and certainly not as desirable) as other policy tools.” So it is not the empirical evidence and and it own exercises based on them but the IMF’s predilections that explain its position on the best policy.

Another peculiar conclusion (this time supported by its evidence) is that countries with flexible exchange rates are less prone to volatility in capital flows. Peculiar because experience has shown that when exchange rates are flexible, periods of capital inflow surges see currency appreciation that not only hurts exports and encourages imports, but triggers speculative capital inflows seeking to benefit from that appreciation, which further strengthens the currency. On the other hand, the negative trend in the balance of payments that appreciation puts downward pressure on the currency and can precipitate a collapse.

Thus, a surge in capital inflows creates difficulties not only when outflows occur as has been the case in recent quarters. Even when a country is the “beneficiary” of a surge, sharp currency appreciations can cause difficulties and attempts to prevent them can undermine the central bank’s ability to effectively pursue its monetary policy agenda. But that problem is far less severe than the effects of capital exit that can result in currency, financial and real economy crises.

However, according to the IMF, “countries that have flexible exchange rate regimes would tend to see immediate currency depreciations in response to a broader downward trend in the supply of capital to emerging market economies. By making domestic assets cheaper, a weaker currency would tend to attract capital into a country.” In this way, exchange rate flexibility is seen as reducing the sensitivity of capital inflows to global factors. That, however, is an interpretation of the positive relationship between capital inflows and flexible exchange rates that the IMF’s econometrics delivers that just does not match the evidence from the EMEs. It also ignores the fact that the currency risk implicit in a depreciation would discourage capital inflows.

Having thus dismissed (based on faulty arguments and questionable evidence) the principal policy-related explanations for the reversal in capital flows into emerging markets, the Fund opportunistically latches on to the narrowing growth differentials between emerging and developed economies to “explain” the tendency. This essentially means that the policy response to the capital reversal should not be capital controls or exchange rate management measures, but policies that address growth. And here the IMF once again makes a case for its conventional, much-discredited tools. In its view, the policies necessary to address narrowing growth differentials “include prudent fiscal policies (as the slowdown can raise the cost to an economy of servicing its debt), proactive macroprudential policies (to limit currency mismatches), exchange rate flexibility (which can work as a shock absorber), and foreign reserve management (which can insulate the domestic economy from shocks, though not indefinitely).” To repeat these recommendations that on many occasions have only worsened crises is to encourage complacency. But that should not be surprising coming from an institution which had declared, just months before the collapse of the Thai Baht triggered the Southeast Asian crisis, that Thailand was a model economy, pursuing good policies that were delivering exceptional performance. Ideology-driven complacence proved disastrous then. It can do so in the current conjuncture as well.