By Jonathan D. Ostry

One of the main arguments against capital controls is that, though they may be in an individual country’s interest, they could be multilaterally destructive in the same way that tariffs on goods can be destructive.

A particular concern is that a country might impose controls to avoid necessary macroeconomic and external adjustment, in turn shifting the burden of adjustment onto other countries.

A proliferation of capital controls across countries, moreover, may not only undercut warranted adjustments of exchange rates and imbalances across the globe, it may lead in the logical extreme to a situation of financial autarky or isolation in the same way that trade wars can shrink the volume of world trade, seriously damaging global welfare.

So should multilateral considerations trump national interests?

Possible rationales for controls

To begin, it is worth reviewing some of the reasons why countries may wish to impose controls.

The first is the exploitation of market power (akin to the “optimal tariff” argument in trade). By restricting inflows (or outflows, respectively), debtors (or creditors) can manipulate the (intertemporal)terms of trade (the interest rate) in their favor.

Of course, what is good for the imposing country is bad for everyone else on the other side of the transaction—the terms of trade is inherently a zero-sum concept, so the exercise of market power has no multilateral justification. And although deliberate terms of trade manipulation may sound farfetched, it is worth bearing in mind that not only do some of the biggest players maintain capital controls (including creditors on outflows), many other measures, such as expansionary monetary policy, may have a material impact on the world interest rate.

The second rationale for capital controls relates to financial stability. Foreign borrowing may amplify risks of a financial crisis, and such risks may not be taken into account in private borrowing-lending decisions (an externality). Capital controls allow the authorities to price in the social risk inherent in private foreign borrowing, so that the externality can be "internalized" in private decisions.

But controls can also create problems for other countries by deflecting capital flows elsewhere (by how much is a matter of some debate; but logically the deflection must occur, all that is in question is the amount). Some countries might welcome the additional flows, so for them, this is a bonus. But others may be in the same boat as the country that chooses to restrict inflows, that is, they may be worried about financial-stability risks at home, and the additional inflows they now face will only compound that worry.

Does this mean that multilateral considerations should proscribe action by the first country?

Not necessarily.  If country A’s interest is served by restricting inflows, and a (similar) country B faces more inflows as a result, the right answer is for each country, acting in a decentralized fashion, to impose controls appropriate to its own concerns. This would be unilaterally optimal and multilaterally efficient.

So when would a multilateral solution be necessary?

As argued in a paper by Ostry, Ghosh,  and Korinek, the crux is whether the capital controls themselves carry a welfare cost. You can think of the cost in many ways (bureaucracy, compliance), but perhaps the most salient cost is the one due to “imperfect targeting”—the likelihood that when countries seek to keep “hot money” out, they unwittingly also keep out “good flows” (such as foreign direct investment for start- up projects).

Once controls have an identified cost, coordination—which simply means each country taking into account the impact on other countries when choosing its own intervention—will generally be necessary to achieve global efficiency.

When an inflow surge affects multiple recipient countries at once, there will be a tendency for each country to impose inflow controls that are too high under laissez-faire and coordination across recipient countries would seek to de-escalate an inflow control war (as countries on their own fail to take account of “mutual deflection” of flows and the escalating response of others).

The efficient outcome is not one where countries do not impose any controls—just lower controls than they would have chosen unilaterally.

Coordination becomes thornier when the costs associated with controls are not only rising but, plausibly, rising at an increasing rate (a 10 percent tax is more than twice as distortionary as a 5 percent tax).

This is because a solution now needs to involve the lender exercising some restraint on outflows, and the lender’s interests to do so are not obvious.

This brings us to the third and last rationale for capital controls—an externality in the production of exportables—sometimes referred to as a learning-by-doing externality (the more you produce, the more productive you become).

Here the correct response from a national standpoint is a subsidy to producers—a solution that has nothing whatever to do with capital controls.

But suppose for some reason this first-best response is not feasible (for example because there is no budget to finance the subsidy and some alternative policies, like a tax on producers of nontraded goods or an import tariff, are also not feasible—for example because the nontraded goods sector is “informal” and thus not easily taxed, and international obligations rule out an import tariff).

Then a policy of currency undervaluation, supported by capital controls (which limit inflows that would otherwise undo the undervaluation), may look an attractive option for the country.

What does this look like from a multilateral perspective? Theoretically, it’s no different from the financial-stability case considered earlier and so by this logic the country should be allowed to go ahead with controls and any spillovers to other countries should be viewed as an inherent part of how the market system functions.

But here the case is far less clear cut. A high bar is necessary to ensure that countries do not disguise old-fashioned mercantilism as building up infant industries or “learning-by-doing”.

Moreover, currency undervaluation inherently has larger multilateral implications—in terms of the trade balance or the current account—than the optimal response (a production subsidy), and may frustrate other countries’ attempts to benefit from learning-by-doing in their own tradables sector.

For these reasons, in most cases, policies of undervaluation supported by capital controls should raise red flags. As such, there would likely be scrutiny attached to situations in which countries adopt or sustain policies that are likely to have a substantial effect on capital inflows when their currencies are undervalued, and particularly when the intent of the controls is to support undervaluation.


Our analysis underscores that capital flows, which bring enormous benefits to borrowers and lenders alike, may nevertheless require some multilateral principles for their safe management.

The notion that international cooperation can mitigate the severity of boom-bust cycles in capital flows is one that goes back to the IMF’s founding fathers.

Global financial integration has progressed a long way in six decades, but multilateral oversight of both source and recipient countries to assist in the management of capital flow volatility remains a worthy objective, and one likely to be essential to safeguard the stability of the international monetary system—a core purpose of the IMF and its members.