Go with the flow

Hot money: The IMF for the first time has endorsed the idea of stopping hot money. It may sound like a good idea with so much of it sloshing around these days. But such capital controls impose large and opaque costs on the global economy and encourage fiscal indiscipline. Emerging market authorities should resist the temptation.

The longstanding policy position reversal by current IMF Managing Director Dominique Strauss-Kahn may be surprising but the timing is not. Controlling inward flows is a popular notion as easy money policies worldwide have led to a quintupling of global foreign exchange reserves since 1999 and a sea of unofficial hot funds seeking investment opportunities. When so much flows toward a single modest emerging market economy, the deluge can overwhelm local authorities trying to manage the situation. After studying inflows to Brazil, Korea, Turkey and others, the IMF found that controls can divert capital to equity, reduce domestic credit booms and make economies more resilient in crises. There are times, it's true, as with the Eastern European Swiss franc home lending mania of the mid-2000s, when irrationality takes over. But other regulatory approaches, such as limits on mortgage leverage, can better address the anomalies without preventing more appropriate movements of funds across borders. Capital controls are a dangerous soft step for local governments. Brazil, for example, has been attracting huge capital inflows with its high domestic interest rates, elevated in part by excessive government spending. Measures taken to keep the economy from overheating prevented its currency from appreciating and enabled further fiscal indiscipline.

In other cases, commodity booms may cause a payments imbalance and threaten the “Dutch disease” of an overvalued exchange rate, stunting development in other areas. As Chile and Norway have shown, however, a stabilization fund can solve that problem without the need for capital controls.

Blocking inward money flows ultimately hampers the optimal allocation of resources. There are generally better alternatives, including a country letting its own currency appreciate or buying up those of others. The IMF has at least put these measures atop its list of policy options, along with tightening fiscal policy. But by opening the door to controls, it may only serve to encourage the risky nostrum.