IMF warns against currency mismatch arising from external debts

THE International Monetary Fund (IMF) has warned against high exposure to external liabilities, saying they are riskiest when they generate currency mismatches especially when the external debts are in foreign currency and are not offset by foreign currency assets or hedges.

In its latest blog post titled, ‘Why the IMF is updating its view on capital flows,’ credited to Tobias Adrian, Gita Gopinath, Pierre-Olivier Gourinchas, Ceyla Pazarbasioglu, and Rhoda Weeks-Brown, the institution observed that in some circumstances, countries should have the option of preemptively curbing debt inflows to safeguard macroeconomic and financial stability.

It noted that capital flows can help countries to grow and to share risks. But economies with large external debts can be vulnerable to financial crises and deep recessions when capital flows out.

The dramatic capital outflows witnessed at the start of the global pandemic and recent turbulence in capital flows to some emerging markets following the war in Ukraine are stark reminders of how volatile capital flows can be and the impact this can have on economies, it stated.

“Since the beginning of the pandemic, many countries have spent to support the recovery, which has led to a build-up of their external debt. In some cases, the increase in debt in foreign currency was not offset by foreign currency assets or hedges.

“This creates new vulnerabilities in the event of a sudden loss of appetite for emerging market debt that could lead to severe financial distress in some markets,” it noted.

In a review of its Institutional View on capital flows released over the weekend, the IMF said that countries should have more flexibility to introduce measures that fall within the intersection of two categories of tools: capital flow management measures (CFMs) and macroprudential measures (MPMs).

“Today’s review said that these measures, known as CFM/MPMs, can help countries to reduce capital inflows and thus mitigate risks to financial stability not only when capital inflows surge, but at other times too,” it further stated.

The IMF first adopted the Institutional View in 2012 at a time when many emerging markets were contending with large and volatile capital flows.

Shaped by the financial crises of the 1990s and the global financial crisis of 2008-09, it sought a balanced and consistent approach to issues of capital account liberalisation and capital flow management.

In particular, the Institutional View recognised as a core principle that capital flows are desirable because they can bring substantial benefits to recipient countries, but they can also result in macroeconomic challenges and financial stability risks.

The Institutional View also noted the role of source countries in mitigating the multilateral risks associated with capital flows and the importance of international cooperation on capital flow policies.

The Institutional View incorporated CFMs and CFM/MPMs into the policy toolkit in a limited manner. It set out the circumstances in which they might be useful but stressed that they should not be a substitute for necessary macroeconomic adjustments.

According to the IMF, CFM/MPMs on inflows were considered useful only during surges of capital inflows, assuming that financial stability risks from inflows would arise mainly in that context.

At the time of its adoption, the IMF recognised that the Institutional View would evolve based on research and experience.

“Today’s review updates the Institutional View while maintaining the core principles that underpin it. It also preserves the existing advice on liberalisation, the use of CFMs and CFM/MPMs during inflow surges, and CFMs during periods of disruptive outflows.

“The main update is the addition of CFM/MPMs that can be applied preemptively, even when there is no surge in capital inflows, to the policy toolkit,” it stated, adding that this change builds on the Integrated Policy Framework (IPF), a research effort by the IMF to build a systematic framework to analyse policy options and tradeoffs in response to shocks, given country-specific characteristics.

The IPF and other research related to external crises delivered new insights on managing financial stability risks stemming from capital flows, the Briton Woods institution stated.

Another important update to the Institutional View is to give special treatment to some categories of CFMs. These measures would not be guided by the policy advice outlined in the Institutional View because they are governed by separate international frameworks for global policy coordination or are introduced for specific non-economic considerations.

The categories of CFMs given special treatment include certain macroprudential measures imposed in line with the basel framework, tax measures based on certain international cooperation standards against the avoidance or evasion of taxes, measures implemented in line with international standards to combat money laundering and financing of terrorism, and measures introduced for national or international security reasons, the IMF noted.

The IMF strives to learn and adapt continually to best serve its member countries. Like other IMF policies, the Institutional View would continue to be informed by advances in research as well as by developments in the global economy and experiences of its membership, it stated.