24 January 2013

Bundesbank/Dombret: Limits for capital stock

If measures are deployed to control the flow of capital in very limited exceptional cases, they should be of a limited duration, transparent, targeted and, as far as possible, non-discriminatory.

Mervyn King, Governor of the Bank of England, recently said that he feared that we would be seeing more exchange rate interventions by countries looking to keep their exchange rates at an artificially low level so as to reap global trade benefits. 

Mervyn King’s comments thus reflect widespread concerns that measures designed to manage capital flows, such as capital controls or additional capital requirements, might be coming back into vogue in some countries. A clear set of rules will be needed if unnecessary conflicts and measures that might damage the global economy are to be avoided.

Under the right conditions, liberalised capital flows have a positive impact on economic growth, which is why measures aimed at restricting them can come at a cost to an economy. Thus, a country would need to have compelling, country-specific grounds to justify a temporary exception from the free movement of capital regime. That is why Germany, as part of its work in the G20 and the International Monetary Fund, has helped to develop approaches to dealing with measures designed to manage capital flows. The IMF recently published its institutional view on this topic, which the Bundesbank broadly shares.

This view states that the degree of liberalisation of capital flows should take account of a country’s specific circumstances if risks are to be contained and the positive effects of liberalised capital flows are to bear fruit. The risks involved in unregulated international capital flows can particularly arise if the general framework in the recipient countries, and specifically the structure of each country’s financial sector, are not yet sufficiently developed. Otherwise, there is a danger that a growing supply of cheap capital, for instance, might lead to a build-up of unsound financing structures, making the financial sector vulnerable and adversely affecting the real economy.

Various measures can be taken to deal with substantial capital flows and the associated stability risks. These include lowering public borrowing, raising the minimum reserve, increasing the value of the domestic currency or making the exchange rate more flexible, or the carefully judged build-up of foreign exchange reserves. If these measures prove to be difficult to implement or insufficiently effective, even though the political will is there, consideration can also be given to the option of directly restricting capital flows. However, one should be aware of the potential economic costs involved in an intervention and that other countries might respond with counter-measures.

To summarise, if measures are deployed to control the flow of capital in very limited exceptional cases, they should be of a limited duration, transparent, targeted and, as far as possible, non-discriminatory. Measures designed to manage capital flows should not be used as a means of avoiding or postponing essential adjustments to a country’s domestic economic policy. Such an approach with a clear set of rules helps to promote international financial stability and safeguards the benefits of global capital flows. It also counters the emergence of a currency war as feared by Governor King.

Full article

© Deutsche Bundesbank