Capital Flow Management Measures (CFMs)

Capital flow management measures (CFMs) are policies designed specifically to limit the size of capital flows into or out of a country, or to change their make-up. The term comes from the International Monetary Fund (IMF), which uses it in its Institutional View on the Liberalization and Management of Capital Flows, adopted in 2012 and revised in March 2022. Typical CFMs include taxes on foreign purchases of local bonds, minimum holding periods, limits on foreign borrowing and caps on banks' foreign-currency positions.

CFMs are a wider category than classic capital controls. The IMF divides them into residency-based measures, which treat residents and non-residents differently and match the traditional meaning of capital controls, and other measures that do not discriminate by residency but are still meant to curb flows, such as rules on foreign-currency borrowing. CFMs are also separate from macroprudential policy, which targets risk in the domestic financial system; a measure that does both jobs is labelled a CFM/MPM.

Think of a river that runs through a town. Most of the year the water is welcome: it powers mills and waters fields. Every few years, though, a storm upstream sends a flood that can wash away bridges, and in a drought the river can drain away almost overnight. A wall across the river would stop the damage and the benefits.

Many towns instead install sluice gates that can be partly closed when the water rises too fast and opened again once it calms. Capital flow management measures play that role for money. They do not ban foreign investment; they slow particular kinds of flows, usually short-term and borrowed money, when the volume threatens to overwhelm the local economy.

After the 2008 crisis, when low interest rates in advanced economies pushed large inflows into emerging markets, several countries reached for controls, and the Fund set out a common position in late 2012. The Institutional View accepts that open capital accounts bring benefits, but says there is no presumption that full liberalization suits every country at all times. CFMs can be useful during an inflow surge or a disruptive outflow, provided they do not replace needed changes to interest rates, the exchange rate or fiscal policy, and are transparent, targeted and temporary.

The March 2022 review kept those principles and added one change. It allows countries to use CFM/MPMs on debt inflows pre-emptively, even without a surge, when a build-up of foreign-currency external debt threatens financial stability. The reasoning is that such debt creates currency mismatch, which can turn a depreciation into a crisis.

• Taxes on inflows. A levy on foreign purchases of local securities raises the cost of short-term positions most.
• Unremunerated reserve requirements. Investors or banks must leave part of an inflow on deposit at the central bank, earning nothing, for a set period. Chile used this tool in the 1990s; it works like a reserve requirement aimed at foreign money.
• Limits on foreign borrowing and currency positions. Caps on banks' foreign-currency liabilities or derivatives books restrict how much they can borrow abroad.
• Outflow restrictions. Limits on residents moving money abroad or on non-residents withdrawing funds, normally reserved for crises.

Brazil is the best-known recent case. In October 2009 it reimposed a 2% financial transactions tax (the IOF) on foreign portfolio inflows into equities and fixed income, and in October 2010 raised the rate on fixed-income inflows to 4% and then 6%, aiming to slow the real's rise against a backdrop of carry trade flows. South Korea capped banks' foreign-exchange derivatives positions from October 2010, at 50% of equity for domestic banks and 250% for foreign bank branches, and in August 2011 added a levy of 2 to 20 basis points on banks' non-deposit foreign-currency liabilities.

A tax charged once on entry hurts short-term investors far more than long-term ones. An approximate annualized return after the tax is:

• $r$ is the annual return on the local asset, before the tax.
• $\tau$ is the one-off tax rate charged on entry.
• $T$ is the holding period in years.

With a 6% tax on a bond yielding 11% a year, an investor holding for one year earns about $11\% - 6\% = 5\%$. An investor holding for three months ($T = 0.25$) loses about $11\% - 24\% = -13\%$ a year. The approximation ignores compounding and currency moves, but it shows why such taxes mainly deter hot money.

The Institutional View accepts outflow CFMs in crisis conditions or when a crisis is imminent, alongside other policies, to stem capital flight and protect the balance of payments. Iceland imposed sweeping controls after its banks failed in October 2008, protecting the Icelandic króna, and lifted most of them in 2017. Cyprus restricted withdrawals and transfers during its 2013 banking crisis and removed the last restrictions in 2015.

Evidence on effectiveness is mixed. Studies often find that inflow measures lengthen the maturity of flows more than they reduce the total, and investors can route around them through derivatives or offshore entities. Measures in one country may push flows to its neighbours. Supporters reply that in a world of high capital mobility the measures buy room for monetary policy independence that the impossible trinity would otherwise deny. CFMs are also tied to the wider question of capital account liberalization, since a country that opens gradually may keep some measures in place for years.

• International Monetary Fund: The Institutional View on Liberalization and Management of Capital Flows
• International Monetary Fund: Executive Board concludes the review of the Institutional View (2022)