Capital flow risks shaped by country policies, says IMF

IMF Survey online: Policymakers in advanced economies should pay more attention to the effects their policies have on the flow of capital to other countries, and their potential risks, according to a new study from the International Monetary Fund.

The new analysis is the latest research to develop a pragmatic, experience-based approach to help countries reap the benefits of capital flows while limiting their risks.

This work is part of a broader agenda to enhance the coverage, candour, and even-handedness of IMF policy advice to all member countries.

The crisis demonstrated that national policies, especially financial regulation and supervision, can affect global stability through capital flows. The IMF’s research examines the multilateral effects a country’s policies can have on capital flows. The aim is to draw greater attention to these effects, and help officials better understand them, to avoid potential adverse consequences.

The IMF analysis shows shortcomings in regulation and supervision in source countries of capital flows allowed banks and other financial institutions to take excessive cross-border risks, which led to the transmission of financial and economic risks across borders.

This resulted in too much capital flowing to countries in the boom years, and this was suddenly reversed when the crisis struck. More effective regulatory and supervisory policies in both source and recipient countries would have helped limit financial stress at both the national and global level.

Managing capital flows

Completing and fully implementing national and international regulatory and supervisory reforms now underway would benefit source and recipient countries of capital flows, and the global system as a whole.

Safer capital flows support stability in countries where they originate, as well as in the countries that receive them. These reforms would also foster better risk practices by the international financial markets and institutions that channel capital flows around the world.

The monetary policy of large advanced economy central banks also affects capital flows to other economies. However, just how capital flows transmit monetary policy across borders is complicated, with positive and negative effects that may offset each other in ways that shift over time.

It is not straightforward for major central banks to consider how their monetary policy affects other countries. Sound prudential frameworks in source countries, including regulations that cover more financial activities and institutions, as well as more comprehensive data monitoring, would help mitigate the risks associated with global liquidity creation and capital flows.

Capital flow management measures enacted by a recipient country could also in principle transmit multilaterally by increasing or decreasing capital flows to countries viewed by investors as similar. However, the preliminary empirical evidence on the magnitude and direction of the multilateral effects of the measures is mixed.

In some cases, the measures used by one country seem to be associated with a diversion of flows to other countries. In other cases, the measures used by one country seem to be accompanied by lower flows to both that country and to other countries. And in some cases, there does not seem to be a significant effect in either direction.

Limited use of capital flow management measures by a recipient country probably has few implications for the riskiness of capital flows and global stability. However, if many countries adopt these measures they could have escalating global costs.

Taking other countries into account

The IMF has developed elements to help policymakers understand how risks transmit across borders, and to help promote policy coordination to make the global financial system more stable.

nNational financial regulators and supervisors should know how the markets and institutions they regulate transmit risks across borders, and be prepared to take countervailing measures.

nRegulators and supervisors should have the capacity to identify and mitigate risks associated with capital flows, including through non regulated financial institutions.

nThe effects of capital flows on financial stability should be considered in macro-prudential policy frameworks.

nPolicymakers should agree to coordinate their macro-prudential policies.

nNational authorities should complete and fully implement the ongoing reforms of the international regulatory and supervisory architecture expeditiously.

nOpportunities for making profit solely by exploiting differences between the regulations of different countries can generate systemic risks and thus should be addressed by international coordination.

nThe sharing of information by national authorities on the objectives and implementation of their policies that affect capital flows can help further policy understanding and effectiveness.

As part of the IMF’s ongoing work on capital flows, further analysis of capital account liberalisation and capital outflows will be released in 2012.