Liberalization of capital flows can benefit both source and recipient countries by improving resource allocation, reducing financing costs, increasing competition and accelerating the development of domestic financial systems. The empirical evidence, however, is mixed on the benefits, and it suggests that countries benefit most when they meet certain thresholds related to institutional and financial development. The principal cost of capital flow liberalization stems from the economic instability brought on by volatile capital flows. In extreme cases, sudden stops or reversals in capital inflows can trigger financial crises followed by prolonged periods of weak growth.

Liberalization of capital flows can benefit both source and recipient countries by improving resource allocation, reducing financing costs, increasing competition and accelerating the development of domestic financial systems. The empirical evidence, however, is mixed on the benefits, and it suggests that countries benefit most when they meet certain thresholds related to institutional and financial development. The principal cost of capital flow liberalization stems from the economic instability brought on by volatile capital flows. In extreme cases, sudden stops or reversals in capital inflows can trigger financial crises followed by prolonged periods of weak growth.

The Guidance Note for the Liberalization and Management of Capital Flows (IMF 2013a) provides operational guidance to staff on the use of the Fund’s institutional view on the liberalization and management of capital flows (Box 1). It discusses appropriate policies with respect to the liberalization of capital flows and the management of disruptive capital inflows and outflows. With respect to capital outflows, the institutional view considers that capital flow management measures (CFMs) may be appropriate in crisis-type circumstances or, in the context of capital flow liberalization, if countries find that they have liberalized prematurely and are unable to handle the resulting capital flows. In non-crisis-type circumstances, the guidance considers outflows as being appropriately handled by macroeconomic, financial, and structural policies. It is intended to mirror the policy advice with respect to capital inflows. The guidance is, however, relatively brief and would benefit from some elaboration to lay out the possible configurations of policies in the context of the institutional view. This note seeks to provide such an elaboration, which is particularly relevant as capital outflows are becoming a more relevant policy challenge.

This is the fourth in a series of Board papers developing a comprehensive Fund view on capital flows and the policies that affect them. A first paper in December 2010 dealt with the Fund’s overall role in this area, both historically and prospectively. The second paper in March 2011 developed a framework for policy advice on managing capital inflows broadly endorsed by the Board, which constitutes a first round articulation of the Fund’s institutional views on managing capital inflows. The third paper in November 2011 examined the multilateral aspects of policies affecting capital flows, and focused mainly on source country policies. This paper covers liberalizing capital flows and the management of outflows.

This note provides operational guidance to staff for how to use the Fund’s institutional view on the liberalization and management of capital flows. The institutional view is a consistent basis for providing policy advice on capital flows and policies related to them and assessments when required for surveillance. In the absence of an institutional view, country teams risk providing inconsistent advice to countries in similar circumstances (IEO, 2005). The view does not have mandatory implications for Fund-supported programs or technical assistance. It does not alter members’ rights and obligations under the Fund’s Articles of Agreement or under any other international agreements. The institutional view and guidance will evolve over time to reflect new experience, emerging views of authorities and staff, and research. Staff teams are encouraged to reflect useful lessons from authorities’ experiences with capital flow liberalization and management in Fund reports so that these experiences can continue to influence the Fund’s approach to these issues.

This paper assesses the implications of Chinese capital account liberalization for capital flows. Stylized facts from capital account liberalization in advanced and large emerging market economies illustrate that capital account liberalization has historically generated large gross capital in- and outflows, but the direction of net flows has depended on many factors. An econometric portfolio allocation model finds that capital controls significantly dampen cross-border portfolio asset holdings. The model also suggests that capital account liberalization in China may trigger net portfolio outflows as large domestic savings seek to diversify abroad.

Capital flows have increased significantly in recent years and are a key aspect of the global monetary system. They offer potential benefits to countries, but their size and volatility can also pose policy challenges. The Fund needs to be in a position to provide clear and consistent advice with respect to capital flows and policies related to them. In 2011, the International Monetary and Financial Committee (IMFC) called for ?further work on a comprehensive, flexible, and balanced approach for the management of capital flows.? This paper proposes an institutional view to underpin this approach, drawing on earlier Fund policy papers, analytical work, and Board discussions on capital flows.