When capital flows out, the International Monetary Fund (IMF) has warned that economies with large external debts may be vulnerable to financial crises and deep recessions.
This was stated by the IMF in a Review of the Institutional View on Capital Flow Liberalization and Management released on Wednesday. While the overall assumption that capital flows can bring significant benefits to countries and that capital flow management measures (CFMs) can help, it should not be used as a substitute for warranted macroeconomic adjustment, according to the report.
“Capital flows can help countries grow and share risks,” it said. When capital flows out, however, economies with large external debts are vulnerable to financial crises and deep recessions.
External liabilities are most dangerous when they cause currency mismatches, or when external debt is denominated in a foreign currency that isn’t offset by foreign assets or hedges.
“The IMF said today that countries should have more flexibility to introduce measures that fall into the intersection of two categories of tools: capital flow management measures (CFMs) and macro-prudential measures,” according to a review of its Institutional View on capital flows released today (MPMs).
“These measures, known as CFM/MPMs, can help countries reduce capital inflows and thus mitigate risks to financial stability not only when capital inflows are high, but also at other times,” according to today’s review.
It also stated that traditional policy instruments may not be effective in addressing the balance sheet effects of FX mismatches during a capital flow reversal.
“First, while a currency depreciation resulting from a capital flow reversal may increase net exports, it may also tighten external borrowing constraints by lowering the FX value of local-currency assets, collateral, and income in relation to FX debt and liabilities.
“In such circumstances, monetary policy faces a difficult trade-off: raising the interest rate could lead to excessively tight domestic monetary conditions, with pro-cyclical effects on credit and economic activity; while lowering it could lead to further depreciation, further tightening external borrowing constraints.”
Second, due to insufficient FX reserves or other sources of FX funding, the government’s or central bank’s ability to provide FX liquidity to the private sector to meet rollover needs on FX debt may be limited,” it added.
It also stated that, in the absence of a surge in inflows, FX debt inflows could be used to prevent the accumulation of already-high FX mismatches and the associated systemic financial risks.
“If the negative balance sheet effects of currency depreciation can be mitigated in advance through CFM/MPMs that reduce FX mismatches, the exchange rate can be allowed to adjust more flexibly after external shocks, lowering the cost of capital flow reversals and facilitating the necessary external adjustment.”
As rationales for the pre-emptive use of inflow CFM/MPMs, such arguments have been developed in the IPF workstream and the IEO report.
Financial vulnerabilities in the private sector can arise as a result of the accumulation of external debt in local currency, but a broader set of policy tools is typically available to address them. “Rollover risks and the likelihood of fire-sales of domestic assets during capital flow reversals are increased by maturity mismatches and excessive leverage in local-currency debt positions.” “Adequate MPMs would typically address these risks effectively in those cases,” it continued.
