xavlav capital flows

Capital flows can bring substantial benefits for countries but also carry risks. They help smooth consumption and finance investment, diversify risks, and contribute to a more efficient allocation of resources. They can also foster economic growth by transferring technology and managerial skills, stimulating financial sector development, and generating incentives for better governance and stronger macroeconomic policies. At the same time, large and volatile flows can pose macroeconomic and financial stability risks, which can be magnified by gaps in a country’s financial and institutional infrastructure. To mitigate such risks while retaining policy autonomy, many IMF member countries, particularly emerging market and developing economies with less-developed financial markets, maintain some form of restrictions on capital flows. Capital flow management measures (CFMs) can be part of a broader policy toolkit to help countries reap the benefits of capital flows while managing the associated risks. Although the appropriate combination of policies to handle capital flows depends on country circumstances and includes macroeconomic and financial policies—such as exchange rate flexibility, foreign exchange intervention, and monetary, fiscal, and macroprudential policies—CFMs may play a useful role in managing the risks associated with large and volatile cross-border capital flows in a way that protects macroeconomic and financial stability and does not produce significant negative outward spillovers. Indeed, the IMF’s “Institutional View” on Liberalization and Management of Capital Flows envisages several circumstances in which CFMs may be appropriate, even though they would rarely be the sole warranted policy response.2 Implementation of CFMs is facing the rising challenge of crypto assets. Such implementation typically requires that financial intermediaries verify the nature of transactions and the identities of transacting parties; however, crypto assets can be held and traded on a peer-to-peer (P2P) basis without any intermediaries. Even when these assets are traded and held through intermediaries such as exchanges and wallets, those intermediaries may not be regulated or obligated to comply with CFMs. Moreover, no common and consistent taxonomy of crypto assets currently exists, which leads to inconsistencies in regulations and gaps in regulatory coverage. Many crypto service providers operate across borders, making supervision and enforcement by national authorities more difficult. Importantly, most crypto assets are traded pseudonymously and held without identification of the residency of the asset holder. Crypto assets have grown considerably in market value; they are now a significant instrument for payments and speculative investments in some countries. Globally, the scale of crypto assets remains relatively small—at $2–$3 trillion, or about 1 percent of total market value of financial assets (Figure 1, panel 1); however, in some countries, large segments of the population now have exposures to crypto assets (Chainalysis 2021), and trading of US dollar–linked stablecoins vis-à-vis some emerging market and developing economy currencies has soared since 2020 (Aramonte, Huang, and Schrimpf 2022). Alongside this rapid growth in scale, the market structure has been changing. Stablecoins have gained market share, and the decentralized finance (“DeFi”) market has grown into a multibillion-dollar industry (Figure 1, panels 2 and 3). Although retail investors have driven much of the crypto adoption, institutional investors and corporations contributed to the 2020–21 rally, particularly in the advanced economies in North America and Europe (J.P. Morgan 2022). At the same time, the crypto-assets ecosystem has broadened and increased in complexity (Box 1). 2 International Monetary Fund—Fintech Notes A host of macroeconomic, institutional, and demographic factors has driven the adoption of crypto assets (Appendixes 1 and 2). The ease with which payments are made using cryptos, perceived anonymity of transactions, novelty and lure of crypto asset (particularly among the young), and desire to hedge against macrofinancial risks in economies with weaker fundamentals have incentivized populations to trade or invest in crypto assets. Geographically, the top 20 countries with the highest “intensity of crypto adoption” are composed of emerging market and developing economies from Asia, Latin America, and sub-Saharan Africa (Figure 1, panel 4).3 The United States is the only advanced economy in the group (Chainalysis 2021). Econometric analysis using a panel regression model confirms the relative importance of macroeconomic and demographic factors in driving crypto-asset adoption (Appendix 2; see also Feyen, Kawashima, and Mittal 2022). Empirical results show that volatile macroeconomic conditions (such as currency depreciation and high inflation) and a younger population age structure tend to boost crypto-asset adoption. Continued growth and adoption of crypto assets could also induce new macrofinancial risks such as “cryptoization.” Crypto assets may be regarded by some as a new asset class with distinct return and risk characteristics, creating additional incentives for investors to allocate capital across borders. If the growth of crypto assets is sustained, they could increase the transmission of financial shocks across the world and amplify global financial cycles (IMF 2020a). Crypto assets, especially stablecoins, may replace local currency as a medium of exchange, a store of value, or even a unit of account, particularly in countries plagued with high inflation and exchange rate volatility; this phenomenon is referred to as “cryptoization” (IMF 2021). These macrofinancial risks may make it necessary to adapt the design of CFMs in the digital age. This paper aims to analyze how crypto assets could impact CFMs from a structural and longer-term perspective and to identify possible policy responses and strategies. The analysis takes as given country authorities’ preferences about the degree to which they manage their exchange regime and capital account; it neither advocates for nor discourages the use of CFMs. Rather, it leaves to future research questions on the desirability and suitability of CFMs as a tool for managing macrofinancial risks in the digital age. The analysis aims to explore possible regulatory and technological solutions that can preserve countries’ ability to implement CFMs while facilitating a predictable regulatory environment conducive to productive financial innovations. Although this paper sheds light on some of the challenges that regulators may face in applying sanctions and CFMs from a structural and longer-term perspective, it does not analyze how crypto assets may have been used to evade country-specific sanctions or CFMs.4 In the face of rising challenges from digitalization, central banks are exploring the pros and cons of issuing their own digital currencies. To maintain the attractiveness of central bank money as the official unit of account and the ultimate settlement asset in the digital age, central banks should continue to run effective monetary policy and strengthen monetary policy frameworks (IMF 2020a). At the same time, central banks are carefully considering the benefits of issuing central bank digital currencies (CBDCs). CBDCs could be designed to facilitate the implementation of CFMs while making cross-border payments more efficient; however, close collaboration between the issuing central bank and foreign central banks and other relevant authorities is crucial to realizing the potential efficiency gains of CBDCs while guarding against risks to the international monetary system. Those design choices and policy considerations will be discussed in a forthcoming companion paper tentatively titled “Capital Flow Management Measures in the Digital Age (II): Design Choices of CBDC.”