Boston, MA – Leaders of the International Monetary Fund (IMF) will convene in Washington this month for their annual spring meetings. The last meetings were sidetracked because of the eurozone’s woes. Since those waters have (temporarily) calmed, the IMF needs to address the “tsunami” of speculative finance that is wreaking havoc in emerging market and developing countries.
The IMF’s own work has shown that cross-border financial flows have been flooding stock and bond markets in developing countries and raising the value of many currencies as well. Indeed, in the current climate, speculating on the poor seems like a no-brainer for many global investors.
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Low interest rates and slow growth in the rich countries and higher interest rates and faster growth in the developing world create ample incentive for investors to pull money from rich countries and send their investments to emerging and developing country markets.
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In the immediate wake of the global financial crisis until late in September 2011, cross-border capital flows had reached their pre-crisis crests in many places, especially Latin America and East Asia. Then, when the eurozone started to spiral into a whirlpool toward the end of 2011, the sea winds changed course and capital flew out of developing countries back to the “safety” of the United States market.
Brazilian President Dilma Rousseff has referred to these unstable capital flows as a “liquidity tsunami“. The initial waves in part triggered an over 40 per cent appreciation of the Brazilian real and started asset bubbles in the country.
Exporters and their workers alike began losing competitiveness and jobs and demanded change. Late in 2011, there was capital flight when the storms gathered over Europe, but the tsunami is gathering pace and bubbling in Brazil once again.
Brazil has reacted aggressively by putting in place regulations on speculative capital entering the country. On numerous occasions, it has levied taxes on stock and bond trading, and derivatives as well. Brazil has not been alone in taking such action. Argentina, Costa Rica, Indonesia, South Korea, Peru, Taiwan and many others have as well.
The communique of the recent BRIC summit stated:
Excessive liquidity from the aggressive policy actions taken by central banks to stabilise their domestic economies have been spilling over into emerging market economies, fostering excessive volatility in capital flows and commodity prices.
Work by a new global task force that I co-chair with Jose Antonio Ocampo and Stephany Griffith Jones from Columbia University confirms that these concerns and reactions are justified and necessary. However, the task force is concerned that developing countries are struggling to effectively weather the storms because of lack of co-operation by the industrialised countries and a lack of full leeway for regulation and co-operation due to misplaced dikes in the form of trade and investment treaties.
Nations such as Brazil and South Korea are justified in their determination to regulate cross-border flows of finance into and out of their economies. Global financial markets are what economists call “pro-cyclical”.
There is too much capital when the economy is doing well and too little during a downturn. Regulating capital flows during waves of hot money inflows helps lower the crests, regulation during outflows limits the troughs.
Thus, regulations serve as “counter-cyclical” measures to smooth these cycles. New research also shows that such measures can correct for inherent market failures in the world economy and thus increase world welfare.
The IMF Articles of Agreement grant nations the leeway to regulate cross-border capital flows and also enable North-South co-operation on such regulations. Economists Maurice Obstfeld and Alan Taylor point out that both John Maynard Keynes and Harry Dexter White – the chief crafters of the Articles – agreed that the burden of regulating speculative capital should be at “both ends“: not only on the recipients of capital inflows, but also on the source countries of that capital.
From 1944 when the Articles were adopted to 1970, there was some degree of this type of collaboration. Indeed, France convinced the United States to maintain its capital control on outflows in the 1970s so France wouldn’t suffer the currency appreciation of heavy inflows of capital from the US. During the same period, France convinced Germany to tighten capital controls on outflows in order for France not to suffer the consequences of excessive inflows of speculative capital.
Regulating capital flows
Despite numerous reports documenting the severe volatility of capital flows in the world economy by the IMF and other bodies, and communiques by the BRICS and individual countries, the industrialised world has failed to co-operate. This lack of co-operation is ironic given that low interest rates in the developed world are in place to try and spur growth and employment within industrialised nations.
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It is thus not in the interest of rich countries for the finance to spill over into the developing world. Thus the countries that need the investment to revive growth and employment do not receive it, the countries where too much investment can flood their economies receive too much.
Some nations that probably should be deploying regulations on capital flows are not because such measures could be found to violate recent trade and investment treaties. On the receiving end of all the capital flows are nations that may have signed on to the financial services commitments under the General Agreement on Trade and Services (GATS) at the WTO that limits the ability of nations to regulate cross border trade in financial services.
And/or a nation may be party to a “free trade agreement” or bilateral investment treaty with the United States that requires that nations allow the transfer of all forms of capital – including stocks, bonds and derivatives – into and out of all parties to the agreement “freely and without delay”.
As a matter of policy, Brazil does not have trade or investment treaties with the US and has made only limited commitments under the GATS, whereas neighbours like Chile and Colombia that have also been stormed by speculative capital do have treaties and have less measures to mitigate capital flows.
Many of the nations that are source of speculative capital flows could be co-operating with emerging market nations to steer investment into their slow growing and job needing economies.
Unfortunately, most industrialised countries are not permitted to regulate capital flows under the codes and treaties of membership to the Organisation for Economic Co-operation and Development (OECD) and the European Union.
If industrialised nations can get on the same wavelength at the IMF meetings, there may be an alignment of interests to coordinate on capital flows. Industrialised nations are aiming to recover from the crisis and hope that credit and capital stays in their nations.
Meanwhile, the developing world has been urging rich countries to close the flood gates of speculative capital flows. There is therefore some alignment of interests that could form the means for industrialised nations to adjust their tax codes and deploy other types of regulation to keep capital in their countries, as developing countries strengthen their regulations to tame the liquidity tsunami.
As IMF leaders gather in Washington in mid-April, they should reiterate that individual nations have the right to deploy regulations to mitigate the harmful effects of speculative capital flows. Moreover, the industrialised nations should be encouraged to share some of the responsibility of such regulation because it is in the interest of developed nations to keep channel investment at home, not overseas. Moreover, the IMF should address the extent to which numerous trade and investment treaties violate the IMF Articles of Agreement.
Kevin P Gallagher is associate professor at Boston University where he co-chairs the Pardee Task Force on Regulating Global Capital Flows. You can follow him on Facebook at BUKevinGallagher.