Swimming in a Sea of Finance: the Occasional Logic of Capital Controls


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Swimming in a Sea of Finance: the Occasional Logic of Capital Controls

  1. 1. Swimming in a Sea of Finance: TheOccasional Logic of Capital Controls Jonathon Flegg j.c.flegg@nus.edu.sg j.c.flegg@lse.ac.uk1|Page
  2. 2. ContentsIntroduction............................................................................................................................................ 3What is Capital Account Liberalisation? ........................................................................................... 5The Advent of International Capital Markets .................................................................................... 7Capital Account Liberalisation in Theory ........................................................................................ 10Capital Account Liberalisation and Risk ......................................................................................... 12Capital Account Liberalisation and Growth .................................................................................... 14Trade and Capital Liberalisation ...................................................................................................... 16Capital Account Liberalisation as a Policy Proscription ............................................................... 18Designing the Right Capital Control System .................................................................................. 23Concluding Remarks ......................................................................................................................... 26Bibliography ........................................................................................................................................ 282|Page
  3. 3. IntroductionFor decades the International Monetary Fund (IMF) had argued against governmentscreating barriers to capital flows in and out their countries. Then, on 10 th February2010, an initially insignificant-looking publication was released. The IMF staff positionnote suddenly reversed this long-standing policy by stating capital controls oninternational financial flows can now be “justified as part of the policy toolkit”available for sovereign states in their execution of economic policy (Ostry et al, 2010;Rodrik, 2010). The report also noted, “logic suggests that appropriately designedcontrols on capital inflows could usefully complement” other prudential andmacroeconomic policies. The quietness of the announcement betrayed its trueimportance. The IMF had argued that capital controls were counterproductivebecause they denied the private sector in developing economies access to much-needed investment finance. Only three months early they had chastised PresidentLula of Brazil for attempting to restrict the entry of short-term financial flows into hiscountry, and now all of a sudden the organisation was reversing this blanket policy.The IMF‟s decision has reignited a new round of debate on the logic behind capitalaccount liberalisation. While there is now almost unanimous agreement amongeconomists of the benefits behind liberalising international trade, the verdict onliberalising international finance is far from settled. While Dani Rodrik, JagdishBagwati, and Joseph Stiglitz all have been vocal critics of capital accountliberalisation, Stanley Fischer, Eswar Prasad and Lawrence Summers have all madestrong arguments in favour. That global financial integration facilitated the spread of3|Page
  4. 4. the 2008 Global Financial Crisis into the first truly worldwide financial collapse sincethe Great Depression has also contributed to a sense of urgency in the academicdebate.This paper takes a fresh look at the evidence for and against national governmentsdeciding to open up their financial systems and allowing the free movement of capitalacross their borders. Rather than as a temporary protection installed to protectagainst immanent crises, I take the view that capital account liberalisation should beconsidered as a mostly irreversible policy decision made within the context of thelong-term developmental trajectory of the real economy. Moreover it is mostoptimally employed at a larger stage of economic development, after other importantreforms, such as trade liberalisation and floating of the currency. Rather than adoctrinal approach I consider a range of characteristics that a country should havebefore the benefits of capital account liberalisation outweigh the potential costs.The paper will first consider what exactly is capital account liberalisation and ahistory of its recent popularity since the end of the Bretton Woods system. Thenstarting with a neoclassical approach I will review the theoretical literature on thepossible effects, benefits and costs involved in the decision to liberalise or preservefinancial autarky. I will conclude by assessing how the empirical literature can informthe theory, and introductory guidelines for policymakers confronted with the decisionto liberalise or not to liberalise, and if so, what policy design might be most effective.4|Page
  5. 5. What is Capital Account Liberalisation?All of a country‟s economic dealings with the rest of the world are recorded in eithertheir current or capital accounts. While the current account is a measure of acountry‟s foreign income and expenditure1, the capital account covers changes in theownership of foreign and domestic assets. Assets can be real as well as financial,and include direct investment, and any kind of equities, debt securities, loans, bankaccounts and currency. Specifically it is equal to the net change in: Capital account = Change in foreign ownership of domestic assets – Change in domestic ownership of foreign assets.A capital account surplus is a net inflow of foreign capital, and occurs when a countryis financing a current account deficit, while a capital account deficit is associated witha current account surplus. By definition the current and capital accounts must be ofequal magnitude and opposite signs, because the capital account effectivelyrepresents the financing of the current account. The IMF has a slightly morenuanced definition of the capital account, dividing it into both a financial and morelimited capital account, but here we use the traditional broader definition andconsider capital account as meaning both capital and financial flows betweencountries.1 The current account includes an economy’s net exports, net factor income and net transfer payments.5|Page
  6. 6. Capital flows between countries consist of movements in: foreign direct investment,portfolio investment, other investment and changes in foreign reserves. Foreigndirect investment (FDI) is defined as the acquisition or construction of capital assets.Portfolio investment is simply purchases of debt and shares. The other category isdominated by capital in various bank accounts, while the reserve account is the netforeign assets held by the central bank.In a broad sense, capital account liberalisation is a policy decision by a governmentto ease restrictions on movement of capital in and out of its economy. Very fewscholars have attempted a precise definition of the term, although Fane (1998)defines capital controls as being, “measures which impose quantitative restrictions,or explicitly or implicitly tax broad categories of capital movements and which applyto all firms and households.” The IMF (1988) defines capital account convertibility asthe: Freedom from quantitative controls, taxes, and subsidies - that affect capital account transactions between residents and non-residents. Examples of such transactions include all credit transactions between residents and non-residents, including trade- and nontrade-related credits and deposit transactions, and transactions in securities and other negotiable financial claims.6|Page
  7. 7. Important to note here is that the definition does not include restrictions on theunderlying transactions themselves, although in practice limitations are often placedon them as well (Quirk et al, 1995: 1). The assumed result of liberalisation is usuallya greater level of financial integration between a given economy with global financialmarkets.The Advent of International Capital MarketsThe advent of widespread international capital markets is one of the definingfeatures of the current period of globalisation. During the last era of globalisation atthe turn of the 20th century, capital was totally free to move but the need to physicallytransfer gold still made it a difficult proposition. From WWII until the early-1970scapital account restrictions were the norm under the Bretton Woods internationalmonetary system. As the well-known „Impossible Trinity‟ of monetary policysuccinctly illustrates in Figure 1, while the Bretton Woods system of internationallypegged exchange rates has the virtues of stability in exchange rates and monetaryindependence for sovereign states, it prohibits the use of open international financialmarkets. If a currency system attempts to embody all three of these virtues, capitalmarket participants could engage in arbitrage by borrowing in a low-interestjurisdiction and lending in the high-interest jurisdiction. Without capital controls theseflows would happen in large enough volumes as to be extremely destabilising to theeconomy.7|Page
  8. 8. Figure 1: The Impossible Trinity of Monetary Policy Figure 2: The Post-Bretton Woods Reduction in Capital Controls (Kose and Pasad, 2004: 51)During the Bretton Woods period very little foreign investment existed, and themajority of international financial flows were official loans or concessional grants togovernments. However with the ending of the system of currency pegs many8|Page
  9. 9. governments, including in some developing countries, began to reconsider the needfor capital restrictions. As Figure 2 shows, by the 1980s a large number of advancedeconomies had completely removed capital restrictions. Firms in the United States,Europe and Japan were also discovering a plethora of new investment opportunitiesin what became known as „emerging markets‟. In developing economies with stablepolitical institutions and reasonable stocks of human capital and infrastructure, theopportunities for yield compared very favourably with alternative opportunities inadvanced economies. In between 1980 and 2005 the growth in international capitalflows have outstripped growth in world production, moving from around 5 to 18percent of world GDP. As can be seen in Figure 3, flows of international capital reallytook off in the early 1990s, particularly in portfolio and money market flows, whileforeign direct investment has increased at a more modest pace. In short the biggestincreases have been in institutional capital. Figure3: Gross International Capital Movements, 1980-2005 (Becker and Noone, 2008)9|Page
  10. 10. Financial innovation also paved the way for the development of global capitalmarkets. Information and transactions in overseas markets became virtually realtime, including in overseas equity markets. The converse is was also true: Financialinnovation was also undermined the sustainability of maintaining capital controls.The plethora of new financial instruments provide the market with novel new ways toevade traditional capital barriers. The expansion of international trade has alsopermitted the evasion of capital controls through the practice of under-invoicing andover-invoicing (Mathieson and Rojas-Suárez, 1993; Pasad and Rajan, 2008).Capital Account Liberalisation in TheoryBroadly there are two ways to theoretically approach the issue of capital accountliberalisation. The first is to view it as a means of achieving allocative efficiency andthe second is to focus on assessing the risk introduced with exposing a domesticeconomy to the vicissitudes of international financial markets. In this section we willfirst consider the former neoclassical literature before discussing the newer riskliterature in the following section.The neoclassical approach begins with the Solow (1956) exogenous growth model. Ifcapital is free to move internationally it will naturally move from capital-rich, labour-scarce advanced economies to where it can be more productively employed in thecapital-scarce, labour-rich economies of the developing world. The movement ofcapital into developing economies reduces the cost of capital and delivers a boost to10 | P a g e
  11. 11. investment and provides permanently higher living standards (Fischer, 1998; Henry,2007). Investors in developed economies should also enjoy a greater return on theircapital, as a wider range of investment opportunities becoming available to them.While a simple neoclassical explanation provides a strong basis for advocatingcapital account liberalisation, a number of other possible equilibrium effects makethe effects on economic growth more ambiguous. Firstly, while foreign capital flowsinto a country can improve the level of investment, it can also lead to foreignexchange rate appreciation, and hence lower exports, returns on investment, andoverall growth (Ostry et al, 2010). Conversely, if a central bank is struggling toaccumulate an adequate level of foreign reserves, capital account liberalisationmight be just the panacea that makes such a policy objective possible.Financial liberalisation may also have indirect positive benefits that promoteeconomic development. Kose et al (2006) has called these potential “collateralbenefits” and, unlike the traditional neoclassical channel, should yield permanentrather than temporary improvement in economic growth. For this reason they mayeven be more important that the direct neoclassical effects on investment and growth(Kose et al, 2006). Firstly, liberalisation is likely to develop the efficiency of domesticfinancial markets through greater competition in the financial sector and theintroduction of new financial instruments and banking processes. Secondly,liberalising might act as a commitment device that imposes discipline on thedomestic government‟s macroeconomic policies (Pasad and Rajan, 2008). Thiscommitment may also be a signal to international markets of the government‟s sound11 | P a g e
  12. 12. economic policies (Kose and Pasad, 2004). Finally, it may also improve publicgovernance and institutions, particularly corruption and prudential regulation. Allthese indirect effects should lead to higher levels of investment and economic growthin the economy.Possible Effect of Capital Direct/Indirect Possible Out-productsAccount LiberalisationLower cost of capital Direct Higher investment and economic growthExchange rate Direct Lower exports and economic growthappreciationForeign reserve Direct Higher net foreign assetsaccumulationFinancial market Indirect Lower cost of capital and more diversedevelopment financial instruments available, higher investment and economic growthInstitutional Indirect Higher investment and economicdevelopment/public growthgovernanceSound macroeconomic Indirect Lower fiscal deficits, higher investmentdiscipline and economic growth Figure 4: Possible Effects of Capital Account LiberalisationCapital Account Liberalisation and RiskWhile most of the proposed theoretical channels between capital accountliberalisation and the real economy are positive, a large body of newer research hasalso been assembled pertaining to increased macroeconomic risk. Greater exposureof an economy to the global financial system possibly entails idiosyncratic andaggregate risk. Idiosyncratic risk is defined as the possibility of macroeconomiccrises that might impact only the liberalising the economy, while aggregate risk12 | P a g e
  13. 13. exposure is the susceptibility to crises that the particular national economy has nofunctional control over.Exposure to international risk may increase as an economy with liberalised capitalaccounts is now more heavily linked to the fluctuations and imbalances ininternational financial markets. Potential sources of crises become more numerous,through greater contagion-transmitting interconnections. The severity of imbalancesand hence subsequent crashes may also become greater. Reinhart and Rogoff(2008) have shown that in the post-Bretton Woods era financial crises are morefrequent due to widespread liberalisation of international capital movements. Theinternational closure of widespread capital account movements during the BrettonWoods period effectively acted as insulation between financial crises spreadingbetween countries.Risk Sources InsurableIdiosyncratic (or country- Capital flight, Yes, through internationalspecific) risk speculative attacks, capital pooling sudden stops, domestic asset price or banking crisesAggregate (or international) International financial Norisk crises transmitted through contagion effects Figure 5: Sources of Macroeconomic Risk from Capital Account LiberalisationIdiosyncratic risk might also increase, although this is subject to much debate.Possibly the greatest source of potential idiosyncratic risk is that of capital flight. Ifthe short-term state of the world changes in an economy with liberalised capitalaccounts, foreign investors might withdraw capital relatively quickly causing a13 | P a g e
  14. 14. collapse in investment and asset prices. However the counterpoint to this argumentis that, as Pasad (2011) has argued, banking crises are more disruptive and occurmore frequently in closed economies. This is because the globalisation of capitalavailability may actually facilitate insuring against such domestic crises throughinternational risk pooling. Risk that is idiosyncratic to a single economy can bemitigated by accessing global finance in the event of a domestic macroeconomicshock that affects the domestic ability to consume (Lucas, 1982; Pasad, 2011; Floodet al, 2011). For small and open economies this is likely to be the case, although ismore difficult to substantiate for shocks to large economies such as the UnitedStates or China. The bigger the economy the more likely it is that a domestic shockis to take on the characteristics of an international shock, at least in terms of theability of the international financial system to insure against it are concerned.In summary, while aggregate risk for countries can only increase as a consequenceof capital account liberalisation, the effect on idiosyncratic risk is ambiguous, giventhat the extent to which international finance can facilitate risk pooling is unknown.Empirically it does appear that overall capital account liberalisation does increase thefrequency and costliness of macroeconomic crises (Kose et al, 2003; Pasad andRajan, 2008; Flood et al, 2011). This fact can be regarded as the major drawbackassociated with capital account liberalisation.Capital Account Liberalisation and GrowthA large body of econometric evidence now exists that shows capital accountliberalisation is not associated with improved economic growth or levels of14 | P a g e
  15. 15. investment (Rodrik, 1998; Pasad et al, 2003; Henry, 2007). In a survey of 14 studieson the topic, Kose et al (2003) found only three have shown a significantly positiveeffect. The authors concluded: …an objective reading of the vast research effort to date suggests that there is no strong, robust, and uniform support for the theoretical argument that financial globalization per se delivers a higher rate of economic growth.Pasad (2011) has since extended this survey to 25 papers, and still only threeempirical studies have shown a significantly positive effect. As Henry (2007) hasnoted, this result is not necessarily inconsistent with the neoclassical approach, asdirect growth and investment improvements as a result of capital mobility should betemporary rather than permanent. This can be explained because productivitygrowth, rather than just accumulation of inputs, is the main determinant of long-termgrowth (Hall and Jones, 1999). Long-term positive growth effects of capital accountliberalisation, where they exist, would be limited to the indirect improvements ingovernance and financial institutions (Pasad and Rajan, 2008).However an even deeper problem exists between the neoclassical theory andeconomy growth. In 1990 Lucas published an important paper the highlighted the so-called „Lucas Paradox‟: The neoclassical prediction – that in a world with liberalisedcapital markets financial resources should flow from countries with high capital-labour ratios to those with low capital-labour ratios – is not borne out in reality. In factoften the reverse has been the case. As Pasad and Rajan (2008) have put it:15 | P a g e
  16. 16. … emerging market economies have, on net, been exporting capital to richer industrial economies, mostly in the form of accumulation of foreign exchange reserves, which are largely invested in industrial country government bonds. These “uphill flows” of capital have had no discernible adverse impact on the growth of developing economies, which suggests that the paucity of resources for investment is not the key constraint to growth in these economies.A more nuanced view then is that there might be two different types of developingeconomies, one which is characterised as net exports of capital to be invested“uphill” in advanced economies, and others that are net importers who fail to reachthe growth potential suggested by the neoclassical model because they suffer frommore fundamental issues that discourage investment, such as a lack of privateproperty rights, adequate infrastructure or human capital or significant political risk.In both groups of countries capital account liberalisation will fail to have adiscernable positive effect on economic growth.Trade and Capital LiberalisationMany authors have argued that financial liberalisation should be treated with morecaution that trade liberalisation (Stiglitz, 2002; Baghwati, 2004; Kose and Pasad, 2004;Prasad and Rajan, 2008). The reason that the effects of capital liberalisation can beconsidered different from trade liberalisation is because capital is different in kind totrade. While trade is the exchange of economic products, capital has the duel16 | P a g e
  17. 17. characteristics of being both a production input and economic product. There is littledisagreement that in as much as capital is a tradable service, constituting theproduct of an economic process, capital account liberalisation has positive indirecteffects. Corresponding with the “collateral benefits” argument of Kose et al (2006),introduction of foreign financial providers has the effects of: (a) reducing market power and rents accruing to domestic financial providers; (b) increasing welfare through reductions in commercial interest rates and expanded access to finance; and (c) stimulating innovation within the financial services industry through introducing a range of new technology („instruments‟ in the financial sector) and efficient processes.Notice how the introduction of competition from foreign financial services hasidentical effects to those that are generally attributed to liberalisation of trade othergoods and services (Rodrik 1988; Pavcnik 2002). In that sense financial services areno different to any other liberalised industry.However in as much capital is a production input, its wholesale movement into andout of an economy may be problematic. The risk of macroeconomic volatilityassociated with capital control liberalisation is mainly due to the way it can rapidlyinflate and deflate the real economy because it is a prerequisite input into theproduction process. Unlike labour inputs there is often a maturity mismatch betweenshort-term flows of capital and long-term changes in production in the real economy.17 | P a g e
  18. 18. Moreover the extent that particular capital inflows are bound to a particularinvestment is proportional to its desirability to the overall economy. That is why socalled “hot money”, short-term flows of capital that simply follow interest ratedifferentials, is generally regarded as the most dangerous form of capital inflow intoan economy.Capital Account Liberalisation as a Policy ProscriptionExperiences over the last two decades show that the decision of a government toliberalise its capital account is fraught with difficulties, particularly in the yearsimmediately following a liberalisation episode. Moreover when a country decides toopen up to financial integration it is a difficult process to reverse. Even during theAsian Financial Crisis, Malaysia‟s decision to temporarily impose selective exchangeand capital controls elicited incredible international controversy. This apparentirreversibility might be partially explained by the implications for the political economywhen restricting existing foreign capital has an immediate and negative level effect ofasset prices. For example, in 2006 when the Thai central bank attempted toimplement a tax on short-term portfolio inflows on the stock market, the subsequent15 percent collapse in stock prices prompted the government to quickly repeal it(Pasad and Rajan, 2008: 18).For capital inflows to be beneficial to an economy a number of assumptions need tobe made. Firstly, it assumes that investment in the domestic, presumablydeveloping, economy is credit-constrained. However as shown by the “LucasParadox” the widespread adoption of open trade policies in many developing18 | P a g e
  19. 19. economies in recent years has contributed to a vast over-supply of capital in manyinstances.Secondly, in economies where capital does appear to be constrained, the cause ofunderdevelopment might in fact be that domestic investment opportunities are oflimited profitability because of the poor quality of domestic institutions. While wemight accept the argument put by Kose et al (2006) that capital account liberalisationhas an indirect quality-enhancing effect on domestic institutions, it might also be thecase that more direct policy action is required to improve them. Simply liberalisingthe capital account will not be enough to solve most countries difficulties withachieving economic development.Thirdly, as many recent experiences have attested to, such as the Argentinianfinancial crisis in 1999-2002, there are strong reasons for treating capital accountliberalisation with suspicion in economies with fixed exchange rates. Croce and Khan(2000) and Pasad and Rajan (2008) have both noted that in the presence of capitalmobility the fixed exchange rate mechanism makes domestic economies susceptibleto speculative attacks and sudden stops.The presence of a large list of prerequisites for capital account liberalisation has ledmany scholars to look favourably on a conditional argument for capital accountliberalisation. Pasad and Rajan (2008) describe their argument as “pragmatic”, whilethe approach of Ostry et al (2010: 15) concludes: “There is no surefire one-size-fits-all way to deal with the impact of potentially destabilizing short-term capital inflows.”19 | P a g e
  20. 20. Figure 6: IMF Staff Position on Imposing or Strengthening Capital Controls (IMF, 2010: Figure 1)20 | P a g e
  21. 21. The approach of this paper is broadly in line with such thinking. When making such adecision with large implications for a country‟s economic policy it is prudent to weighup all the conclusions of economic theory in the light of the econometric evidence.Moreover policymakers must be clear about the potential costs and benefits whendeciding on such a course of action. My approach differs most from the IMF positiondisplayed in Figure 6 in that Ostry et al (2010) are trying to determine the short-termmacroeconomic and prudential conditions necessary to implement temporary capitalcontrols in response to a crisis (similar to the situation faced by Malaysia during theAsian Economic Crisis). My conditions in Figure 7 are an attempt to assess whatstructural attributes are favourable for an economy to maintain longer-term capitalcontrol arrangements. Also rather than a series of necessary conditions, myapproach is a list of characteristics that together make capital controls more useful orless harmful to an economy‟s development.Given that many of the characteristics are time-dependent, this raises the obviousissue of policy sequencing. Is there a time-optimal stage in an economy‟sdevelopmental trajectory where capital account liberalisation becomes optimal, or atleast advisable? Many of the characteristics listed are correlated with stages ofeconomic development, and therefore this policy formulation does have asequencing component, much like the old sequencing literature in developmenteconomics. Generally speaking, integration with global financial markets should onlybe entertained after trade protectionism has been abandoned and the currency is nolonger a pegged regime (Obstfeld and Rogoff, 1995; Pasad and Rajan, 2008). Asequenced approach also exposes one of the major shortcomings of theeffectiveness of liberalising capital, as most of the characteristics that would make21 | P a g e
  22. 22. liberalisation most beneficial to a country are also the characteristics of an economyless in need of external capital at the higher-levels of economic development.So what characteristics should we look for to determine whether capital accountliberalisation is a good policy idea for a given country? Here I will discuss just someof the characteristics raised in Figure 7. Firstly, as stated above, a floating currencyis necessary to ensure the chances of adverse macroeconomic events such asspeculative attacks will not also increase. Secondly, trade openness is necessary asthere is a robust empirical relationship between trade openness dampening thefrequency and costliness of crises associated with financial liberalisation (Prasadand Rajan, 2008). Strong monetary management is also very important to successfulcapital account liberalisation. If an economy already has poor management of itscurrency chances are it is not going to be able to successfully absorb the resultantinstability that comes along with exposure to international financial markets.Two characteristics that favour liberalisation that are shared by many developingeconomies are a lack of financial competition and a low level of reserves.Liberalisation of the capital account might provide significant benefits for developingeconomies seeking to make gains in these areas. Countries with high public debtgenerally suffer more intensely and for a longer period after macroeconomic crises,although a resultant appreciation might make the chances of a public debt crisismore remote. Finally, a country should consider what type of capital inflow mix theyare likely to receive before liberalising. Speculators might be attracted to certaineconomies for the purposes of currency speculation or the possibility of earning22 | P a g e
  23. 23. higher interest rates, however these kinds of capital flows may do more harm thangood in the long-run. Characteristics in Favour of Characteristics Against Liberalisation LiberalisationThe domestic currency is a float or The domestic currency if pegged.managed float.Trade protectionism has been dropped. Trade protectionism is an active government policy.Monetary policy has a history of sound Monetary policy has a history of poormanagement and the currency is management and the currency isgenerally stable. unstable.Domestic investment is higher than Domestic savings are higher thandomestic savings. domestic investment.A lack of competition within the financial Adequate competition within financialservices sector. services sector.Foreign reserves are low by international Foreign reserves are already quite high.standards.External public debt is low. Government is already carrying a large stock of external debt.There are adequate opportunities for FDI Investment opportunities are moreinvestment. speculative, including currency speculation or high interest rate earnings. Figure 7: Characteristics That Influence the Potential Costs and Benefits of Capital Account LiberalisationDesigning the Right Capital Control SystemAll types of capital controls cannot be considered equal. For instance, mostgovernments prefer foreign direct investment over portfolio capital as it lesssusceptible to capital flight. Here we consider some of the design features ofworkable capital control policies. Generally we can judge the design of variouscapital control systems by how well they manage to achieve any of the following fourpossible criterion: (a) extend the maturity of capital investments; (b) encourage a particular type of capital flow; (c) prevent procyclical withdrawal of capital; and23 | P a g e
  24. 24. (d) possibly direct flows to specific capital-constrained sectors of the economy.The first design consideration is whether governments apply capital controls toinflows or outflows. As a general principle it is possible for governments to controlinflows much more than outflows, particularly because when capital wants to leave ittypically is in a hurry (Reinhart and Smith, 2002). While Malaysia was generallyconsidered to have successfully managed to stem the outflow of capital during theAsian Financial Crisis because it had tight control over the banking system, anumber of Latin American economies that have implemented similar outflow controlshave not been so successful (Pasad and Rajan, 2008). On most accounts outflowrestrictions fail on most of the four criteria for good capital control design, and ifadministered well may qualify on criterion (c). As a result control of inflows is usuallyregarded as superior to attempting to control outflows.Secondly is the specific choice of capital control. Moore (2010) lists three differentbasic types: (a) exchange or quantitative limits; (b) taxes on financial transactions; and (c) dual exchange rate systems.In terms of administrative complexity, the list follows an ascending order.Quantitative limits are either restrictions on any foreign ownership or a ceiling on theproportion of foreign ownership of assets in a particular class. While they are quiteeffective in directing foreign capital away from specific sectors (criterion (d)), they arenot generally successful at preventing capital flight (criterion (c)) or ensuring capital24 | P a g e
  25. 25. investment is long-lived (criterion (a)). In this sense quantitative limits are generallyabout maximising the benefits of foreign capital for investment rather than minimisingthe potential costs of economic crises.Taxes on foreign transactions can take a number of forms, such as: … interest equalisation taxes, attempts to eliminate the difference in yields between domestic and foreign investments and restrict either inflows or outflows. A mandatory reserve requirement is one example of a price- based capital control. This type of capital control requires foreign investors to deposit a percentage of their capital investment with the central bank for a minimum period (Moore, 2010: 7).A successful example of mandatory reserve requirements was introduced by Chile in1991. Short-term debt inflows where required to be accompanied by a 20 percentreserve requirement (Pasad and Rajan, 2008). These measures have been arguablythe most successful in disincentivising short-term capital flows (criteria (a) and (c))without limiting productive foreign investment.2 To the extent that certain types ofcapital, such as FDI, are more likely to be attracted to longer-term investmentopportunities, taxes on foreign transactions also can satisfy criterion (b).The final form of capital control is dual exchange rates, where commercialtransactions enjoy a stabilised exchange rate, while financial transactions face a fullyfloating rate. Financial transactions hence face the disadvantage of having to2 Brazil, Chile, Colombia, the Czech Republic and Malaysia have all attempted such measures with somesuccess.25 | P a g e
  26. 26. assume exchange rate risk. The system fails on all the criteria, except perhaps oncriterion (b), as it may only encourage short-term currency speculation, the exacttype of capital inflows that are entirely unproductive to the real economy. The onlypossible virtue of dual exchange rates is that they discourage most forms of foreigncapital transactions, but in this case it is likely to be administratively simpler to justimplement quantitative restrictions.In essence the most appropriate form of capital controls, when necessary, are eitherquantitative restrictions or simple taxes on short-term foreign transactions. They arethe least distortionary to the economy, simplest to administer, and achieve thegreater number of policy goals. Taxes should be applied to incoming capital wherepossible and are most effective in protecting domestic economies against potentialmacroeconomic crises.A final comment is necessary about capital control design. Like most regulatorysystems, simplicity has its virtues. All capital controls are generally administrativelyburdensome and require constant vigilance in monitoring developments within theeconomy. To work at all they require competent prudential regulators otherwiseprivate markets will easily find ways to evade the system.Concluding RemarksThe heightened academic and political debate on the validity of capital controls hasled many to find satisfaction in a pragmatic, non-proscriptive approach. So too hasthis paper. Liberalising capital has the benefit of allowing financially-constrained26 | P a g e
  27. 27. economies to reach their developmental potential and may even induce otherinstitutional and technological changes in the same way as trade liberalisation isthought to do. However it also entails significant costs by exposing fragile domesticfinancial systems to the „open waters‟ of trillions of dollars swimming around ininternational financial markets. Governments that fail to anticipate the risks involvedwith such a move could likely be the victims of financial crises that are sodevastating they negate any of the international financial system‟s possible growthbenefits. If a government decides to move forward with capital account liberalisationthey need to carefully consider a number of prerequisites before doing so, and thedesign of the system must learn from other country‟s experiences or run theadditional risk of being redundant in the face of innovative capital markets. Ultimatelya Catch-22 exists with the decision to liberalise: The characteristics that would makeliberalisation most beneficial to a country are also the characteristics of an economyless in need of external capital at the higher-levels of economic development.Perhaps this why the post-Bretton Woods era is replete with so many examples offailure and so few sterling examples of success.27 | P a g e
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