Illustration by S. Kambayashi

LEFTOVER piles of slushy snow from the heaviest snowfall in over a century make it hard to take sharp turns on the roads of Washington, DC, these days. But the past couple of weeks have seen plenty of ideological swerves at the IMF's downtown headquarters.

Earlier this month the fund's chief economist, Olivier Blanchard, questioned the focus of modern macroeconomic policy on keeping inflation low, arguing that central banks should aim at an inflation rate of 4%, rather than the conventional goal of 2%. Now a paper* by a group of IMF economists suggests that the fund has substantially rethought its position on the use of restrictions by emerging markets on capital inflows. It concludes that controls are sometimes “justified as part of the policy toolkit” for an economy seeking to deal with surging inflows.

This is surprising. The fund has historically opposed capital controls, even trying in 1997 to amend its articles of agreement to allow it explicitly to promote capital- account liberalisation. Its economists have argued both that capital controls are costly because they induce distortions to resource allocation and that they are not effective because they are easily evaded. But there is a contradiction between these arguments: if controls have no effect, how can they be distortionary?

The new paper provides some welcome clarity on the effectiveness of inflow controls. Its authors find that GDP fell less sharply during the financial crisis in countries that already had such policies in place. Prior research has shown that the maturity structure of a country's external liabilities gets longer as a result of capital controls. The composition of inflows also seems to matter. Countries with a larger overall stock of debt had bigger credit booms and suffered bigger growth collapses during the crisis. So too did countries with more foreign direct investment (FDI) in the financial sector. Unlike other types of FDI, these flows contribute to debt growth because they include lending from parent banks to local subsidiaries. “The use of capital controls,” the fund's economists write, “was associated with avoiding some of the worst growth outcomes.”

The economists are also candid about situations in which capital controls may be needed. In the past the fund has urged countries facing surging capital inflows to allow their exchange rates to appreciate or to accumulate reserves. But exchange rates can overshoot, with consequences for the competitiveness of a country's exports. And if reserves are adequate, then further accumulation is not optimal.

If allowing exchange rates to adjust is not a viable option, the fund has typically advocated cutting interest rates to make the country less attractive to foreign funds. One reason for the resurgence in capital flows to emerging markets—which the Institute of International Finance, a financial-industry association, thinks will rise to $721.6 billion in 2010 from $435.2 billion last year—is the difference between their interest rates and the very low rates of the rich world. But some countries would risk overheating if they cut any further.

The fund's reconsideration of capital controls suggests that it is trying to adapt its advice to global economic realities. That is welcome. But the paper has little to say about what an effective and non-distortionary system would look like. Now that the IMF views controls on inflows more kindly, perhaps it could help countries to design them more cleverly.





