For many emerging market economies (EMEs), foreign capital inflows are a critical step in the path to economic development. But for some rapidly growing EMEs, an incoming flood of foreign capital is creating a new set of challenges, writes economic analyst Andrew Flowers in "Capital Controls Gain Currency in Today's Global Economy."
The article, featured in the third-quarter issue of EconSouth, explores the risks associated with large foreign capital inflows and the measures EMEs are taking to manage those risks.
Capital controls, which include taxes on foreign capital and investment quotas, are one such measure. Conventional wisdom, especially among economists and policymakers in developed economies, has long held that capital controls were inefficient and created distortions in the domestic economy. Indeed, Flowers notes that "until recently, the International Monetary Fund (IMF), seen as the global authority on matters of foreign capital management, had maintained a policy that capital controls were ineffective (at best), if not harmful (at worst)."
Today, however, manufacturers and exporters in many EMEs with strong currencies are calling for capital controls. And in a departure from the past, these interventions are, in some instances, receiving the IMF's nod of approval.
In Brazil, for example, rapid economic growth in recent years has been accompanied by a deluge of foreign capital inflows. "This ostensible blessing…could also be considered Brazil's curse," writes Flowers. "The country's large growth rates, along with its high domestic interest rates, have caused these huge investment flows, which in turn have complicated the central bank's efforts to control inflation." In response to those challenges, Brazil instituted a foreign financial transaction tax.
The ongoing debate over the merits of capital controls has no doubt been complicated by currency interventions that advanced countries have taken. Switzerland and Japan both intervened in currency markets in recent weeks to dampen the excessive appreciation of their currencies, which was hurting exporters. At least one thing is certain, concludes Flowers: "The debate over capital controls, which only recently appeared to have been settled, is far from over."