A capital-controlled future?

• Position: A SYMPOSIUM OF VIEWS

What are the chances that, in the next five to ten years, large parts of the world economy move to some form of capital controls in the management of exchange rates? What are the implications of this more mercantilist approach? Could, for example, U.S., Canadian, and Mexican policymakers feel the need to tighten up their collective trade pact in light of this potential fundamental change in global exchange rate management?

Fourteen global experts rate the probability.

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MANSOOR DAILAMI

Manager, Emerging Global Trends Team, World Bank Group

The fundamental question is how global financial governance will adapt to the greater influence of emerging market economies.

It is a testimony of how times have changed that we are discussing the issue of capital controls in managing exchange rate regimes over the next five to ten years. Prior to the 2008-2009 crisis, the international agenda supported continued liberalization of the capital accounts of major emerging economies in pace with their local capital market development and capacity to institute the necessary operating framework for managing floating exchange rate regimes. But recent years have seen a resurgence of support for capital controls in academic and official circles, with the International Monetary Fund now endorsing their use as part of countries' policy tools for managing large-scale capital flows. Capital controls have also been used in practice. Brazil, for example, imposed formal mechanisms to curb large capital inflows in 2009. Perhaps more unexpected was the Swiss National Bank's commitment to maintaining an exchange rate floor of 1.20 Swiss francs per euro as of September 2011, a notable move given that it put a currency of considerable international status under control.

A key challenge facing the international economic policy community---certainly one that is greater during turbulent times--is to deliver well-coordinated policies in response to current conditions while keeping sight of long-term developments and underlying structural shifts. Over the long term, the interest of the world economy, including developing countries, is best served by policies that encourage open and prudentially regulated markets. The current incarnation of capital controls thus should be viewed as transitory responses rather than a fixture of the global financial landscape. But the landscape is undergoing a transformative change. The progress of a growing number of emerging market economies in improving their domestic institutions and finances over the past two decades has allowed them better access to international financial markets, and these countries have a growing stake in the safety and stability of the global financial system. At the same time, advanced economies are increasingly dependent on capital from emerging market economies for public sector financing given their anemic growth prospects and rising health care and pension costs. Once the instability associated with the current macroeconomic policy imbalances is properly addressed, the broad incentive is for more liberalized international capital. This is the crux of the issue. Capital flows are a symptom, not a cause, of financial instability. It is the combination of zero interest rate policy in countries with mature financial centers and heightened risk aversion due to the euro area sovereign debt crisis that is behind the yield-seeking and safe haven motivations we see driving speculative capital to the United States, core Europe, and major emerging economies.

When gross global capital flows peaked at $22 trillion in 2007, almost 87 percent of that amount was movement of capital among advanced countries. That share will decline in the future, tilting increasingly toward emerging economies.... For those countries, the best way forward is to renegotiate the terms of global financial governance to better reflect the long-term development agenda and with a mind toward reducing the negative risks involved with protectionism and currency wars. I would put the overall chances of widespread use of capital controls at three out of ten.

The views expressed here are those of the author. They do not necessarily represent the views of the World Bank and its affiliated organizations.

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MIROSLAV SINGER

Governor, Czech National Bank

Most developed economies are experiencing economic slowdown or outright recession. Growth is slowing even in many emerging economies. The source of this situation is deleveraging in previously overextended financial sectors in the majority of developed economies. We can therefore conclude that the recovery in the years ahead will be shallow. It will take time to rectify many of the imbalances. Since the most common monetary policy tool--interest rate--has almost exhausted its potential in most developed economies, other macroeconomic policy tools are being and will be tried. Capital controls have been used by some emerging economies. Exchange rate interventions have been employed by developed economies. And some economies have used trade restrictions in the area of commodity trading--for example, China with regard to scarce metals. So there is a clear increase in the probability of such tools being used. Even the likelihood of tools more directly related to control of international trade has increased.

Let me offer some more general comments. The world is becoming more fundamentally uncertain. As a result. alignment and coordination of macroeconomic policy tools and policies can only take us so far. There is no guarantee that rules and harmonization will produce the fight outcome, that the new rules will be significantly better than previous ones, or that the "right" set of rules exists at all. Therefore, it is surprising to me that we are so obsessed at least in Europe---with limiting the space for diversification of rules. Diversification is a tried and tested strategy for dealing with fundamental uncertainties. The push for harmonization at the expense of space for diversification is leading individual sovereigns to take a different approach, namely, that of insulation and buffering. This is no bad thing. We should take a lesson from the maritime world, where ships are constructed with watertight compartments to contain flooding if the hull is breached. The rules of shipbuilding are fundamentally more clear and effective than the current rules of global macroeconomic management.

The marginal benefits of focusing more on space for diversification of approaches and on rules for the proper use of macroeconomic tools other than pure fiscal and interest rate policies are perhaps currently greater than the benefits of further policy alignment. The latter benefits may be positive, but they are diminishing significantly.

I do not think the U.S.-Canada-Mexico bloc will follow Europe as far down the road of harmonization. I doubt that it needs to do so very urgently, as its component parts are doing relatively well following a rather different set of policies stemming from different strategic priorities.

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BERNARD CONNOLLY

CEO, Connolly Insight, LP

The probability of widespread capital controls in the world in the next five years is very high--eight or nine out of ten. The underlying problem in the world is one of dynamic inefficiency, which, as scholars Maurice Obstfeld and Kenneth Rogoff put it in 1996, "wreaks havoc with our intuition about the laws of economics." The result is intertemporal disequilibrium, in which interest rates are too high and too low at the same time: too high to produce a mature-economy recovery without a new credit bubble; too low to avoid aggravating imbalances. In other words, the world as a whole cannot get off the conveyor belt towards an ultimate depression and financial collapse without some very improbable (however desirable) reemergence of Thatcher-Reagan-Douglas policies (and such policies would probably need to be accompanied by the temporary nationalization and complete restructuring of the whole financial system).

In such circumstances, with the first best unavailable, policymakers will seek the second best--and probably come up with something close to the worst. Countries will no doubt attempt to keep on increasing the size of credit bubbles, such as that represented by monetary union in Europe. They will need capital flows and maintained or increased risk appetite to do that, so forms of financial repression other than capital controls will come, and indeed have already started coming, first But in the next big "risk-off' crisis, flows of capital seeking safe havens are likely to overwhelm foreign exchange intervention, central bank swap lines, and attempts at "coordination." Capital controls...