The Brazilian action in imposing a tax on certain kinds of foreign inflows to moderate the rise in its currency is of great importance, symbolic and substantive. The symbolic value lies in signalling an end to an era in which emerging markets were enamoured with foreign finance and expressing a willingness to take action to moderate inflows of foreign finance. Substantively, it is important in increasing the arsenal of weapons that countries can deploy to moderate overheating of their economies. It is a good illustration of the types of measures that policymakers can use to arrest incipient asset price overheating.
The International Monetary Fund’s (IMF’s) response to the Brazilian measure was lukewarm, or even mildly negative. A senior official responded: “These kinds of taxes provide some room for manoeuvre, but it is not very much, so governments should not be tempted to postpone other more fundamental adjustments. Second, it is very complex to implement those kinds of taxes, because they have to be applied to every possible financial instrument,” he said, adding that such taxes have proven to be “porous” over time in a number of countries.
This response is disappointing not because it is wrong, but because it reflects business-as-usual in terms of the IMF’s intellectual approach to financial globalisation. This approach has been to implicitly disapprove of such measures by asking countries to do a lot of complementary action (improving corporate governance, strengthening financial regulations, etc) so that foreign flows, considered sacrosanct by the IMF, could be preserved. For emerging market countries, the problem has been that it is not always easy to implement these actions in the short run, so that the practical and pressing issue of what to do with excessive inflows has remained with little guidance from the IMF on appropriate responses.
Taxes on foreign inflows have problems but that is not an argument against such measures. No sensible person believes that taxes generally should not be imposed because they can be, and are, evaded. Rather, it should lead to a search for the best ways of designing these measures (Should they be price-based or quantity-based? What kinds of flows are best addressed — debt or portfolio? Over what duration are limits most effective? When should they be withdrawn?) so that the benefits are maximised and risks minimised.
Brazil itself had a tax of 1.5 per cent on capital inflows (though only into the bond market) until the crisis. But the country that was most famous in the 1990s for trying to keep a competitive exchange rate by discouraging capital inflows was Chile, which imposed a requirement that those bringing in fixed-interest money should deposit 30 per cent of the inflow with the central bank for a year. There has been a dispute in Chile about how effective this measure was. Everyone agrees that it was effective in lengthening the maturity of the debt (the deposit with the central bank was constant irrespective of the length of the liability bought, so there was a much higher implicit tax rate on short-term than longer-term inflows).
But there has been a big dispute among economists in Chile and around the world as to whether it also diminished the total inflow and thus gave Chile scope to maintain higher interest rates than the rest of the world. We are on the side of those who believe that the measure was reasonably effective: it would be out of keeping with the habits of the financial sector to maintain a drumbeat of opposition, as they did, to a measure which was as ineffective as the critics maintain. But the important thing is now to study seriously the experiments like the Chilean one and draw conclusions, which do not start with strong priors about foreign finance.
In the case of the IMF, instead of continuing to throw cold water on such measures, it should really view this as an intellectual opportunity. It could continue to be supportive of countries in their pursuit of more open capital flows as a long-term, structural, objective. However, it must recognise that surges in capital inflows can pose serious macroeconomic challenges that may require a different cyclical response. For emerging markets, the policy arsenal against future crises must cover measures to counter-cyclically restrict credit growth and leverage notably surging capital flows.
The larger reason that the IMF should take the Brazilian measure seriously relates to ideology and narrative. If the global crisis stems, in part, from a belief system that unduly elevated the status of finance, the IMF contributed to sanctifying, implicitly or explicitly, foreign finance. This imposed a big and under-recognised cost for emerging market countries: if they took actions to restrict capital flows, they risked being seen as market-unfriendly and imprudent in their economic policy. By recognising that in some instances sensible curbs on inflows might be a reasonable and pragmatic policy response, the Fund can eliminate the market-unfriendly stigma that actions of the Brazilian type might otherwise risk incurring.
Indeed, the fear of this stigma is evident in the recent Brazilian action: the magnitudes are small, and Brazil is at pains to emphasise its temporary nature — both of which make markets take the action less seriously and hence undermine its aims. If this stigma had been absent, the tax on inflows could have been better designed and imposed with greater confidence to ensure its effectiveness.
The world needs a less doctrinaire approach to foreign capital flows. Helping Brazil in its decision last week rather than being negative would signal the IMF is playing a constructive role in facilitating this shift.
The authors are senior fellows at the Peterson Institute for International Economics.
