The IMF Has Finally Dumped a Damaging Orthodoxy

(Bloomberg Opinion) -- The International Monetary Fund long had an unyielding view of how global finance should work: Capital must flow freely across borders, no matter the consequences. It just took an important step away from that orthodoxy — and not a moment too soon for some developing nations.

Having barely weathered the Covid crisis, in part with the help of emergency lending and debt-service relief from their wealthier counterparts, the world's low- and middle-income countries face another challenge: The cost of servicing their external debt — which amounted to about $9 trillion in 2020 — is set to increase sharply as central banks such as the U.S. Federal Reserve raise interest rates to combat inflation. In 2022 alone, public and private borrowers will have to pay almost $1 trillion, according to the World Bank.

The danger is that global speculative investors, spooked by the daunting debt payments, will further undermine developing nations' finances by pulling out en masse. Such reversals can be swift and punishing, as private credit vanishes and exchange-rate swings boost foreign-currency debt burdens. During the last central-bank tightening cycle in 2013, more than $20 billion in capital fled emerging markets in just 45 days. During the Covid crisis, the outflows reached $100 billion.

The threat illustrates a quandary for emerging markets: Foreign capital is critical for development, but extremely hard to manage. In good times, inflows of hot money expand credit and fuel inflation. And as long as capital flows freely, there's not much developing-nation central banks can do to cool things down: Higher interest rates only attract even more foreign money, further overheating the economy until some event triggers an exodus. It's a dynamic that has played out time and again, from Mexico in 1994 to Asia in the late 1990s.

Officials in developing nations aren't helpless to control fickle and temperamental capital flows. On the contrary, they've developed tools to slow inflows when credit expansion starts to look like a bubble, and to mitigate outflows when the bubble bursts. Some, such as Malaysia, limit foreign ownership or foreign sales of property to constrain excessive real-estate investment. Others, such as Indonesia, require banks to maintain a higher percentage of foreign investment in the form of liquid reserves. In all cases, the broader aim is to encourage the kind of longer-term investment that contributes to sustainable growth.

Unfortunately, the IMF has long been reluctant to approve capital flow measures — and in those rare cases where it does, it typically encourages their swift retraction. This position has created tension with even developed-nation members such as Australia, Canada, Korea and New Zealand. For emerging economies, it can be devastating, as they're more likely to depend on IMF support and their foreign investors are more sensitive to the fund's recommendations.

In a 2020 report, the IMF recognized that its position was “at odds with country experience and recent research.” Consider the case of India, which in 2013 faced a sudden capital reversal triggered by the Fed's plans to remove monetary accommodation in the U.S. The Reserve Bank of India moved quickly to restrict outflows, attract inflows, support the market for currency swaps and limit outward foreign direct investment. The IMF later concluded that the measures “helped to restore confidence,” but it never endorsed them at the time — a failure that interfered with their efficacy.

Now, the IMF has officially revised its institutional view to be more accepting of capital controls that are also macroprudential measures — that is, those put in place to pre-empt crises or to mitigate systemic risk — and those that are meant to ensure “national or international security.” This is a crucial step toward rebalancing power, toward giving emerging economies more autonomy in managing their capital accounts and monetary policy. That said, the IMF can and should do more — for example, by also allowing for targeted capital controls aimed at specific domestic goals, such as inflow controls to curb housing price bubbles.

Capital controls alone can't address the deeper issues of international finance, such as why investment doesn't flow the way it should to higher-growth countries, or how emerging economies can achieve the safety and stability that command such a large premium during crises. But the measures can at least mitigate the volatility that so often does so much damage — which is why the IMF's policy shift is welcome, and well overdue.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Natalie Leonard is a research associate at the Yale Program on Financial Stability.