Economic Letter 2001-25; August 31,
2001
Capital Controls and Emerging Markets
The financial crises in the 1990s resurrected the debate on whether emerging
markets should stay open to foreign capital or impose capital controls.
The stakes are high. Emerging markets that have been open to foreign capital
have seen it contribute to sharply improved living standards; at the same
time, the volatility of capital flows has made these markets vulnerable
to economic boom and bust cycles. Under these circumstances, one may dispute
whether the benefits of liberalizing capital controls outweigh the costs.
To shed light on this question, this Economic Letter discusses
the benefits and costs of liberalizing capital controls, cites some empirical
evidence, and briefly reviews the recent experiences Chile and Malaysia
have had with capital controls.
Why lift capital controls?
Capital controls are regulations or taxes that make cross-border financial
transactions or investments costly or difficult, typically by restricting
the access of a country's residents to foreign currency. Toward the end
of the 1980s, many countries lifted such restrictions. Their reasons for
liberalizing capital flows were partly pragmatic, as technological innovations,
such as new financial instruments, made it easier to circumvent capital
controls, and as, in a number of cases, economic instability provided
large incentives for doing so. Their reasons also reflected a general
shift in thinking among policymakers toward favoring greater reliance
on market forces and less government intervention.
At least two benefits of a more open capital account have been cited.
First, more openness can stimulate growth by reducing distortions and
enhancing access to foreign financing. The wealthiest countries have
open capital accounts, suggesting a relationship between openness and
higher levels of prosperity. And it is apparent that foreign financing
is very important for those emerging markets fortunate enough to attract
it, accounting for a large share of their economic activity. According
to Lopez-Mejia (1999), in 1996 (before the Asian crisis) capital flows
were equivalent to about 4.5% of GDP in Asia and Latin America, or 20%
and 30% of exports, respectively. The importance of these flows was probably
even larger for the top 12 emerging market recipients, who received 75%
of total capital flows.
Second, an open capital account may improve economic performance over
the business cycle by encouraging more prudent domestic macroeconomic
and financial policies, as well as improved short-term access to financing.
Policymakers in countries with open capital accounts must adopt prudent
policies because investors are free to put their money elsewhere, whereas
policymakers in countries with capital controls can pursue less prudent
policies because investors cannot easily move their funds, at least in
the short run. This may explain why, between the 1980s and the 1990s,
a number of countries that opened their capital accounts simultaneously
reduced budget deficits and dramatically reduced money growth and inflation.
There is also evidence that over the business cycle, economies with more
open capital accounts have more access to credit, implying that consumption
or investment can be boosted more easily during a recession.
Costs of lifting capital controls
The potential long-run benefits of lifting capital controls must be weighed
against two short-run costs. First, greater openness increases a country's
vulnerability to global shocks or to sudden changes in investor sentiment.
Moreno and Trehan (2000) find evidence indicating that shocks to global
interest rates, inflation, and capital flows can explain a large proportion
of the global incidence of currency crises. Capital flows are subject
to pronounced cycles that may induce boom and bust cycles in production
and investment among recipient countries and trigger financial or currency
crises when financing is withdrawn. One source of vulnerability is mismatching
of maturities or currencies, which makes recipient countries illiquid.
As is well known, this illiquidity makes a system vulnerable to panics.
For example, foreign financing may be in U.S. dollars, while the local
borrowers' earnings are in local currency. A sudden withdrawal of funds
could lead to a collapse in the currency, bankrupting local borrowers
of foreign currency by raising their debt burdens in their own currency.
The impact of cycles in capital flows may be more extreme in countries
with weak financial systems, where government guarantees may encourage
excessive risk-taking with foreign funds.
Second, greater openness also restricts policymakers' options. A country
cannot simultaneously maintain an open capital account, peg the exchange
rate, and adopt an independent monetary policy (that is, a money or interest
rate target). This constraint, sometimes known as the "impossible trinity,"
complicates efforts to implement stabilization policy. For example, if,
as a result of attractive returns, capital is flowing into a country and
the central bank keeps the domestic interest rate high, the currency will
tend to appreciate, which may hurt exporters and dampen economic activity.
If the central bank chooses to stabilize the exchange rate instead, it
must print money in order to buy up the foreign currency that is flowing
in (allowing domestic interest rates to fall), which may lead to excessive
domestic money creation, an unsustainable boom in economic activity, and
inflation (and a crash if the capital inflow suddenly reverses). With
capital controls, a central bank can set both the interest rate and the
exchange rate simultaneously, at the cost of limiting capital inflows
that could finance productive activity.
The constraints facing policymakers in countries with open capital accounts
became painfully apparent during the East Asian financial crises of the
late 1990s. According to the Institute for International Finance, the
inflow of private capital to the region peaked at $118 billion in 1996
and then fell to an outflow of nearly $38 billion in 1998. The withdrawal
of capital caused currencies to collapse and led to steep reductions in
investment and growth. Some countries initially raised interest rates
in order to stabilize the currency and reassure investors. However, in
the uncertain environment, interest rates in some cases had to be raised
very high, further weakening economic activity and the financial sector.
In an open economy, aggressively lowering interest rates to stimulate
economic activity also had disadvantages, as the prospect of further depreciation
could keep investors away. Also, many firms had borrowed in foreign currencies
without hedging their currency exposure, and the resulting depreciations
could (and eventually did) cause widespread bankruptcies. Countries with
capital controls in place, like China or Vietnam, were largely insulated
from these pressures.
Do the benefits of liberalizing outweigh the
costs?
There are few systematic studies on the growth effects of liberalizing
capital controls, and the available evidence suggests that the impact
is not the same for all countries. Edwards (2001) studied the experience
of advanced and developing countries in the 1980s (but not the 1990s,
due to the time span of the capital controls index he uses) and found
that, on average, countries with lower capital controls have faster real
GDP or total factor productivity growth than countries with more stringent
controls. (These results appear to be robust to outlying observations,
but are sensitive to measurement error.) However, only countries, including
some emerging markets, whose income exceeds a certain threshold benefit
from lower capital controls (among these countries are Israel, Venezuela,
Hong Kong, Singapore, and Mexico). Poorer countries with less stringent
capital controls grow more slowly.
Evidence suggesting that capital controls are associated with less prudent
macroeconomic policies is mixed. Grilli and Milesi-Ferretti (1995) found
that such controls are associated with higher inflation, while Rodrik
(1998) found no evidence of such a relationship. Glick and Hutchison (2001)
report evidence that capital controls are associated with a higher, rather
than lower, likelihood of currency crises. Their results suggest that
economic policies are indeed less prudent in economies with capital controls
and contribute more to crises than does the greater vulnerability to shocks
that result from openness.
Case studies
Two case studies illuminate the benefits and costs of liberalizing capital
controls: Chile's controls on capital inflows in the 1990s, and Malaysia's
controls on capital outflows in September 1998.
In an effort to limit surging capital inflows, in June 1991 Chilean
policymakers imposed an unremunerated reserve requirement (URR), first
on foreign borrowing (except trade credit) and later on short-term portfolio
inflows (foreign currency deposits in commercial banks and potentially
speculative foreign direct investment). The reserve requirement rose from
20%, to 30%, but then fell to 0% when capital flows to Chile (and other
emerging markets) dried up in 1998. A minimum stay requirement for direct
and portfolio investment from abroad also was imposed (eliminated in May
2000), as were minimum regulatory requirements for corporate borrowing
abroad. Banks also were required to report capital transactions. The controls
do not appear to have been very effective. According to Ariyoshi, et al.
(2000), capital inflows rose, despite the controls, from 7.3% of GDP in
1990-1995 to 11.3% in 1996-1997, before falling in 1998; investors found
ways to circumvent the controls, leading policymakers to expand the program.
It is also unclear whether the controls succeeded in shifting the composition
of foreign capital towards longer maturities. Finally, the program did
not seem to give Chile increased monetary autonomy. The real exchange
rate continued to appreciate, at an average rate of 4% a year from 1991
to mid-1997. While the differential between domestic and foreign real
interest rates rose (from 3.1% in 1985-91 to 5.2% in 1992-97), this may
have been due to continued sterilized intervention in foreign currency
markets, not the capital controls.
In 1998, as capital flowed out of East Asia, uncertainty
about the stability of the Malaysian currency (the ringgit) and the economic
outlook generated speculation against the ringgit. As noted earlier, the
openness of the capital account limited Malaysia's (and other East Asian
economies') options to boost growth. The government eventually decided
to stimulate the economy by easing monetary policy aggressively. To prevent
the capital outflows such a measure might trigger, on September 1, 1998,
capital controls were imposed, focusing on two broad areas. First, to
prevent speculation against the ringgit, access to local currency by non-residents
was restricted, and rules requiring all ringgit to be repatriated effectively
closed the offshore market in ringgit. Second, the repatriation of portfolio
capital held by non-residents was blocked for 12 months (this was subsequently
replaced by an exit tax on short-term investments), and capital outflows
by residents were restricted. Restrictions focused on short-term maturities
and did not apply to international trade or long-term foreign investment
transactions. The exchange rate was then pegged, interest rates were lowered,
and commercial banks were encouraged to lend.
While Malaysia's capital controls successfully curbed capital flows,
there is no agreement on whether they were needed to restore growth. The
Malaysian economy recovered soon after controls were imposed, but strong
demand for the region's exports brought about comparable recoveries in
other East Asian economies that did not impose controls. For example,
Malaysia's growth switched from -7.4% in 1998 to 5.8% in 1999. In Korea,
which imposed no controls, the comparable figures are -6.7% and 10.9%.
Some argue that Malaysia was more vulnerable than the other Asian economies
in 1998, so that its performance would have been poorer without capital
controls, but there is disagreement on this point.
Conclusions
Two broad conclusions emerge from the research and experiences surveyed
here. First, recent research suggests that poorer countries face a tradeoff,
as capital controls appear to be associated with faster growth (the reverse
is true for wealthier countries), but less macroeconomic stability and
a greater incidence of crises.
Second, studies of the experiences of Chile and Malaysia highlight some
of the difficulties in the design and application of capital controls.
Chilean policymakers attempted to minimize the costs of capital controls
by designing restrictions that were not too onerous or distortionary.
As a result, however, the effectiveness of these controls was apparently
limited. Changes in conditions may also make controls unnecessary. For
example, the pattern of recovery in East Asia after recent crises suggests
that Malaysia might have done as well without imposing capital controls.
Ramon Moreno
Research Advisor
References
Ariyoshi, A., K.Habermeier, B. Laurens, I. Otker-Robe, J. Canales-Kriljenko,
and A. Kirilenko. 2000. Capital Controls: Country Experiences with
Their Use and Liberalization. IMF Occasional Paper No. 190 (May).
Edwards, S. 2001. "Capital Mobility and Economic Performance: Are Emerging
Markets Different?" NBER Working Paper No. W8076.
Glick, R., and M. Hutchison. 2001. "Capital Controls and Exchange Rate
Stability in Developing Countries." FRBSF Economic Letter No. 2001-21
(July 20). http://www.sf.frb.org/publications/economics/letter/2001/el2001-21.html
Grilli, Vittorio, and Gian Maria Milesi-Ferretti. 1995. "Economic Effects
and Structural Determinants of Capital Controls." Staff Papers, International
Monetary Fund. 42(September):517-51.
Lopez-Mejia, Alejandro. 1999. "Large Capital Flows: A Survey of Causes,
Consequences and Policy Responses." IMF Working Paper WP/99/7.
Moreno, Ramon, and Bharat Trehan. 2000. "Common Shocks and Currency Crises."
FRBSF Working Paper No. 2000-05. http://www.sf.frb.org/econrsrch/workingp/2000/wp00-05.pdf.
Rodrik, Dani. 1998. "Who Needs Capital Account Convertibility?" In Peter
B. Kenen (ed.) Should the IMF Pursue Current Account Convertibility?
Essays in International Finance, No. 207 (May). International Finance
Section, Department of Economics, Princeton University.
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