Risk management for countries

The prevailing orthodoxy used to be that interfering with capital flows was just plain bad. That's changed: as eminent an authority as the International Monetary Fund now writes that capital controls may be appropriate under some circumstances.

Brazil enacted a 2% tax on foreign purchases of stocks and fixed income investments in October of 2009. Last month, South Korea announced new restrictions on trading in currency derivatives and the uses to which loans from foreign banks can be put. June also saw Indonesia announce it is requiring investors to hold SBIs, debt issued by the central bank, for a minimum of one month.

What justifies capital controls? Think of it as countries practicing risk management. Reserves alone aren't always enough to insulate the value of a country's currency from capital flows, either in or out. When the exchange rate floats, capital inflows can provoke an appreciation that feeds asset bubbles and distorts trade flows. If, as was the case in late 2008 and early 2009, there's an abrupt reversal of investors' tolerance for risk and capital flees, a nasty devaluation follows, one that may have nothing to do with the underlying fundamentals of a country's economy. Investors taking advantage of carry trade opportunities (borrowing funds in a low interest rate country which are then invested in another country where interest rates are higher) complicate monetary policy.

As with most things, it's a question of "when" and "how much" with capital controls. A tool that might be used for prudent risk management on the part of one government could be seen by another as an instrument for controlling the exchange rate by another.

How countries can make the most of volatile capital flows while minimizing their risk is a policy issue that's here to stay.