IEO calls for IMF to rethink house view on capital controls

The International Monetary Fund should revisit its “institutional view” (IV) on the use of capital controls to tackle several shortcomings, a new report by the fund’s Independent Evaluation Office finds.

The IEO says the IV, adopted in 2012, was a “major step forward” in providing better advice to member countries on how to deploy capital controls. But the IV also would benefit from a “refresh” in several areas, the organisation says.

The 2012 reform was a watershed moment for the fund, which had previously been a strict champion of open capital markets. The IV conceded that in some cases, capital controls were necessary, even if they remained broadly undesirable for their distortive effect on capital movements worldwide.

The IEO says the 2012 framework was generally followed during the Covid-19 crisis in markets. Emerging and developing countries adopted a package of measures including aggressive fiscal and monetary support, letting exchange rates “bear the brunt of adjustment” and only then using “limited recourse” to foreign exchange intervention and capital controls.

But the IEO notes the IMF has sometimes clashed with local authorities on when capital controls and interventions are appropriate. A background paper by former Bank of Israel governor Karnit Flug and IEO consultant Christopher Towe highlights how in the case of Israel, the IMF and central bank disagreed on the appropriate level of the exchange rate.

The Israeli authorities felt the IMF was relying too heavily on cross-country models of the exchange rate and ignoring several pertinent local factors. “The credibility of [IMF] staff advice about current account and exchange rate sustainability appeared at times to have been undermined by its heavy dependence on cross-country models,” Flug and Towe write.

Another moment when the fund and local authorities clashed was in Iceland’s 2016 decision to reimpose capital controls. The fund had previously backed Iceland’s capital controls during the 2008 crisis – to the surprise of the local authorities – but the lack of an impending crisis in 2016 led the fund to argue the reimposition of controls was unnecessary.

The IEO report argues the fund should show more flexibility in the area of using capital controls pre-emptively, as the Icelandic authorities were trying to do. IMF opposition to pre-emptive action has faced “considerable pushback from country authorities”, the IEO says. It adds that recent research suggests capital controls may be a “valuable part of the financial stability framework”.

It notes also there is an issue with defining key terms – when is capital “surging”? What exactly is a “crisis”? The report calls on the fund to make these thresholds clearer as a means of reducing the likelihood of clashing with the views of local authorities.

Additionally, the IEO takes aim at the IMF’s historical support for using flexible exchange rates to cushion shocks. “Country experience and recent research suggest that exchange rate flexibility may bring less stabilisation benefits through the trade account than previously believed and that exchange rate movements can sometimes be a shock amplifier in the face of volatile flows.”

Responding to the IEO’s findings, IMF chief Kristalina Georgieva described the report as “timely and useful”. She stressed the “major advance” of the 2012 IV and said she was pleased the IEO found staff advice to countries was broadly in line with it.

Georgieva said she acknowledged the theoretical advances that had taken place in recent years and said the IV was always meant to evolve. “I generally support the broader messages of the IEO evaluation, with some qualifications,” she said.

The main qualification Georgieva raised was to defer to an upcoming review of the IV, a process that is expected to take place in 2021. She also noted any improvements to the fund’s capacity had to take place in the context of its severely constrained budget. The IMF’s executive board has opposed budget increases in real terms for the past several years.