CAPITAL CONTROLS

1
CAPITAL CONTROLS

• Several developing economies have relied on
  capital controls during the 1990s to deal with
  capital flows
• Capital controls can take the following forms
• -- Controls to limit short-term capital inflows
• -- Controls of capital outflows during periods
  of financial crises
• -- Long-standing and extensive controls

2

• What are the arguments for the use of capital
  controls?
• -- Second-best policy tool (compensating for
  financial market imperfections)
• -- Controls help reconcile conflicting policy
  objectives when exchange rate is fixed
  (Impossible trinity)

3

• Impossible trinityfixed exchange rates, free
  capital mobility and autonomous monetary policy
  cannot exist at the same time
• Capital controls help preserve monetary policy
  autonomy and
• -- direct policy on domestic objectives
• -- reduce pressure on exchange rate

4

• Also, capital controls can help protect monetary
  and financial stability when
• -- there are inflationary pressures from capital
  inflows
• -- there is inadequate assessment of risks by
  banks and corporations in an environment of fixed
  exchange rates

5
HOW EFFECTIVE CAN CAPITAL CONTROLS BE?

• Usually, effectiveness is assessed based on the
  effects of capital controls on
• -- capital flows
• -- achieving policy objectives (exchange rate
  stability, monetary policy autonomy, preserving
  financial stability)
• Evaluation of controls is based on the gap
  between domestic and foreign interest rates

6

• If controls are effective, domestic rates will
  differ from foreign rates
• However, there are incentives to go around the
  existing controls
• If controls are effective, capital flows become
  less sensitive to interest rates
• Monetary authorities can then use interest rates
  for domestic policy objectives

7

• Capital flows are distinguished in long-term
  (FDI) and short-term (portfolio flows)
• In general, short-term flows have an horizon of
  less than one year and include
• -- flows for investment in domestic stock
  markets
• -- flows for investment in domestic bond markets

8

• It is sometimes difficult to distinguish between
  the two types of flows
• Short-term flows can become long-term by being
  rolled over repeatedly
• Long-term financial instruments can be sold at
  short notice in secondary markets
• This distinction depends on the depth and
  liquidity of domestic financial markets

9

• Imposing capital controls involves costs
• First, capital controls may interfere,
  particularly wide-ranging ones, with desirable
  capital transactions
• Second, controls may involve significant
  administrative costs, especially if there are
  loopholes in the system
• Third, protecting the domestic system may
  postpone necessary reforms
• Finally, controls may damage a countrys
  reputation

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TYPES OF CAPITAL CONTROLS

• In general, capital controls have taken two
  forms
• -- administrative or direct controls
• -- market-based or indirect controls
• Administrative controls involve either outright
  prohibition or approval for cross-border flows
• Market-based controls attempt to discourage
  certain types of flows by making them costlier

11

• Market-based controls can take several forms such
  as
• -- Dual or multiple exchange rate systems
• -- Explicit or implicit taxation of cross-border
  financial flows (Tobin tax)
• -- Other predominantly price-based measures

12

• In a two-tier or multiple-tier exchange rate
  system, different exchange rates apply to
  different types of transactions
• This policy is typically implemented when
  authorities regard high interest rates that are
  needed to prevent speculative activity as very
  costly
• Usually, activities involving foreign trade,
  foreign direct investment, and equity investments
  are exempted

13

• Two-tier exchange rates make it very costly for
  speculators to establish short positions on the
  domestic currency
• Explicit taxation of cross-border flows involves
  taxes on external financial transactions
• It can also involve taxation of income of
  residents from holding foreign assets

14

• Alternatively, it can involve taxation of income
  of non-residents from holding domestic assets
• Indirect taxation of capital flows involves
  non-interest-bearing mandatory reserve/deposit
  requirements (Unremunerated Reserve Requirements)

15

• Under a URR, banks will be required to deposit an
  amount of domestic or foreign currency in the
  central bank at no interest
• The amount is equivalent to a proportion of the
  inflows or net position in foreign currency
• Other controls have attempted to discriminate
  between types of transactions or investors
  through both price- and quantity-based measures

16

• These may include
• -- Provisions for net external positions of
  banks
• -- Credit rating requirements to borrow abroad
• -- Reporting requirements for specific
  transactions (derivative transactions,
  non-trade-related transactions with non-residents)

17
CAPITAL CONTROLS TO LIMIT SHORT TERM FLOWS

• Short-term capital controls were implemented by a
  number of countries in the 1990s
• -- Brazil (1993-1997)
• -- Chile (1991-1998)
• -- Colombia (1993-1998)
• -- Malaysia (1994)
• -- Thailand (1995-1997)

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• The purpose of these controls was to minimize
  destabilizing effects of increased capital
  inflows
• Short-term inflows reflected high domestic
  interest differentials combined with fixed
  nominal exchange rates
• The first line of defense against these inflows
  was sterilization policy

19

• Sterilization can be costly for the central bank
  if there are differences between the cost of
  issuing securities and the return on foreign
  assets
• Also, sterilization may attract further inflows
  if it keeps interest rates high
• The goal of capital controls was to reduce the
  above negative effects

20

• Short-term controls were accompanied by
• -- liberalization of outflow controls (Chile,
  Colombia)
• -- increased flexibility of the exchange rate
  (Chile, Colombia)
• -- further strengthening of the prudential
  framework of the financial system (Chile,
  Colombia, Malaysia)

21

• In some cases, fiscal policy also remained tight
• In these countries, the goal was to change the
  composition of inflows towards
• -- less volatile flows (longer maturities)
• -- and decrease the overall volume of short-term
  flows

22
HOW WERE CONTROLS DESIGNED?

• Design of short-term controls varied among
  countries
• All countries used market-based controls
• -- direct or indirect taxation of inflows
• -- limits on asymmetric open positions
• -- reporting requirements
• Controls seem to have had an initial impact, but
  not to have achieved their objectives

23

• Countries were able to maintain large interest
  rate differentials
• But, some had to adjust their exchange rates
  gradually under market pressure (Brazil, Chile,
  Colombia)
• Real exchange rates appreciated significantly
• Controls did not seem to reduce the overall level
  of inflows, but seemed to partly reduce
  short-term inflows

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• Why were objectives not met?
• -- Well-developed and sophisticated financial
  markets found ways around controls (Brazil)
• -- In Chile, market participants found loopholes

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CONCLUSIONS

• First, for controls to be effective, they must be
  comprehensive and forcefully implemented
• Second, even where controls have been effective,
  it is difficult to separate them from the effects
  of other policies (exchange rates, regulations,
  monetary policy)
• Third, controls on inflows are not suited as
  instruments of prudential policy