by Arvind Subramanian, Peterson Institute for International Economics
Op-ed in the Business Standard, New Delhi
September 30, 2009
© Business Standard
The IMF will strike a triumphalist tone at its forthcoming annual meetings in Istanbul. Some of this will be warranted because the IMF's record in responding to the global financial crisis was commendable, even if its record leading up to it was less stellar (see "The IMF Crisis Balance Sheet" for more details).
Beyond Istanbul, two key changes will signal that the leopard has truly changed its spots. The first will be the selection of a competent non-European, non-American, preferably Asian, as the next Managing Director (MD). Favoring an Asian candidate over others would recognize the growing economic weight of the region; more importantly, it would allow the IMF to salvage its legitimacy in the region where it is most eroded. A future Asian MD (potential candidates: Zhou Xiaochuan of China and Montek Ahluwalia of India) may be the best bet for transforming what is now essentially a Euro-Atlantic Monetary Fund to a truly International Monetary Fund. In symbolism and substance, this change will be more meaningful than the increased voting power of 3–4 percent that will accrue to Asian countries as a result of the G-20 agreement at Pittsburgh.
The second key change must be ideological and intellectual, relating to foreign capital flows.
Some of the countries worst hit by the crisis, especially in Eastern Europe, were those that succumbed to what might be called the foreign finance fetish. Thus Hungary, Latvia, and other East European countries sucked in vast amounts of foreign capital that were clearly imprudent, and not just retrospectively. And they did so on the IMF's watch. If the global crisis owes in part to a belief system that unduly elevated the status of finance, the IMF must reflect on its contribution to deifying, implicitly or explicitly, foreign finance.
Leading up to the Asian financial crisis in the 1990s, the IMF was complicit in the strong push to get emerging market countries to open up to foreign capital. After the crisis, the IMF shifted ground. It backed off an aggressive advocacy of capital account opening. But it never went on to argue that countries should be cautious toward foreign capital. Rather its line was that foreign capital remained fundamentally beneficial and that reaping the benefits required a series of complementary reforms such as macroeconomic stability, good governance and a well-regulated financial system.
This view precluded the IMF from providing guidance to emerging markets on the serious and pressing practical question: if these complementary reforms could not be undertaken, what should countries do? Should they regulate the inflows, and if so: how? Setting itself to answer these questions would have legitimized the view that foreign capital could be potentially harmful, a view with which the IMF did not want to be associated.
So, how can the IMF make amends? It must lead the charge in evolving a new, sensible approach to capital flows based on the experience of this crisis, and indeed previous ones. The Fund must make a key distinction on capital flows. On the one hand, it should be supportive of countries in their pursuit of more open capital flows as a medium-term objective (echoing Reserve Bank of India [RBI] Governor Subbarao's recent description of capital account liberalization as a "process not an event"). On the other, it must recognize that surges in capital inflows can pose serious macroeconomic challenges that may require a different response.
It is now clear that the policy arsenal against future crises, especially the buildup of asset bubbles, must include "macroprudential" measures, which in a domestic context cover measures to countercyclically restrict credit growth and leverage. For emerging markets, one important source of asset price bubbles is surging capital flows. Macroprudential measures must, therefore, encompass the countercyclical management of capital flows. Note that such measures are analytically different from the so-called Tobin tax, which would be applied to all flows regardless of the state of the macroeconomic cycle.
We know little about questions such as: under what circumstances is it desirable to limit capital inflows? If desirable, what are the best ways of achieving it? Should there be price-based or quantity-based measures to limit such flows? What kinds of flows are best addressed—debt or portfolio? Over what duration are limits most effective? When should they be withdrawn? These are tough questions. But we know little about them in part because the IMF has been intellectually missing in action.
The new macroprudential approach to capital flows can draw upon an interesting parallel in trade. When countries liberalize trade, they retain the use of a safety valve in the event that liberalization leads to surges in imports. This safety valve takes the form of safeguards, which are narrowly specified and time-bound restrictions on imports. Having a safety valve can actually help further trade liberalization by assuring domestic producers of some relief when competitive pressures are greatest. Macroprudential management can serve as a similar safety valve against the buildup of potential bubbles.
At Istanbul, emerging market officials, especially India, should give the IMF the concrete task of reviewing its approach to capital flows. For example, it could require the IMF to prepare a best-practices manual for countries on whether, when, and how best to deal with flows that have the potential of creating asset bubbles and financial crises.
Such a manual would allow the IMF to make a genuine intellectual contribution to the still nascent area of appropriate macroprudential measures and demonstrate its usefulness to emerging market countries. India, sooner rather than later, will face yet again the predicament of surges in capital flows, and the RBI will need to be intellectually and operationally prepared for effectively dealing with them to avoid repeating the costly and damaging controversies over exchange rate management in 2007 and 2008.
There would be a large collateral benefit for the IMF too. An IMF that is seen to be honestly and disinterestedly engaging on the issue of capital flows would address its legitimacy problems because in the eyes of many developing countries the IMF's support for free capital flows reflected the belief system of the rich countries and the interests of their financial sector.
Creating the intellectual climate for sustainable foreign finance rather than perpetuating the foreign finance fetish is the next intellectual challenge for the IMF. And it is long overdue.
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