How to Slow Down Hot Money
Until recently, respectable opinion frowned on all barriers to money flowing across borders. Today, the old thinking has been overturned. Sometimes, it’s agreed, capital controls are necessary.
The old consensus was wrong and won’t be missed. The new view, however, lacks clarity and, when it comes to application, effective oversight. Capital controls may sometimes be necessary -- but they are always dangerous and open to abuse. These policies need to be better considered and more carefully supervised.
Since 2008, interest rates in the U.S. have fallen almost to zero, and international investors have looked elsewhere for a good return. But the resulting financial flows can be much more than economists previously believed.
Some developing economies have seen enormous capital infusions and a corresponding appreciation of their currencies -- which makes their exports less competitive and threatens to cause bubbles in domestic asset prices. Brazil, for instance, responded with a control that once would have been strongly opposed: a tax on foreign investors’ holding of Brazilian assets. Lately, the pressure of inflows has abated, and the controls have been eased.
Even the International Monetary Fund, once a trenchant critic of such barriers, now agrees that they can make sense. A new study by Olivier Jeanne, Arvind Subramanian and John Williamson of the Peterson Institute for International Economics goes further, arguing that use of capital controls needn’t be confined to incipient asset bubbles. A country with a persistent current-account deficit -- such as India -- might also find them useful for avoiding a chronic overvaluation of the currency.
That argument highlights a danger, however. An instrument that can be used to stop a currency from appreciating too much can also be used to keep it undervalued. China has used capital controls -- severe restrictions on the domestic assets foreigners can buy -- for exactly this purpose. What China does is equivalent to subsidizing exports and putting tariffs on imports, policies that would be forbidden under the promises it has made as a member of the World Trade Organization.
Governments have developed an elaborate and mostly successful regime to regulate the unfair use of ordinary trade restrictions. The Peterson Institute’s economists argue that capital controls should be brought under a similar regime, and we agree.
The current non-system, as they say, is too restrictive in some ways and too permissive in others. Too restrictive because any policy that departs from openness in international trade and finance still invites stigma, which discourages governments from acting promptly and forcefully when it makes sense to do so. Too permissive because it allows a case like China to continue indefinitely, where the purpose is not to prevent a currency distortion but to create and perpetuate one, at great cost to others.
New international rules on capital controls could correct those mistakes by addressing two factors: the form of the restrictions and their rationale.
Just as global trade rules insist on tariffs not import quotas, a rule-guided system for capital controls should prefer market-based restrictions, such as taxes, over administrative barriers, such as prohibitions or discriminatory regulation similar to what Argentina has . Market-based measures make it easier for other governments to see what is going on and to judge the effects. In a spirit of cooperation, this is something any government can reasonably ask of another. To curb excesses, the rules on instruments should also specify a maximum rate of tax on capital flows. The academic literature suggests that a moderate rate of, say, 15 percent, is optimal.
In addition, again in parallel with the regime for goods and services, governments resorting to capital controls should have to say why -- and convince a representative international body with oversight powers. The WTO could take that role, or perhaps the IMF. Merely demanding an explanation would be progress; and ultimately, countervailing sanctions could be made available to governments expressing a grievance.
Nobody would claim that the international effort to police trade in goods and services works perfectly. On the other hand, it’s a minor miracle that the global slowdown of the past few years has provoked no great upsurge of protectionist sentiment or policy. The WTO and its predecessors deserve some credit: They have entrenched norms of good behavior that, so far at least, have stuck.
Now that we better understand the close connections between currency valuations, flows of capital and flows of goods, we need a similar global effort to codify and oversee the limited use of capital controls. Do it before bad habits become too hard to break.
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