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This document discusses the growth of international capital flows over the past 50 years and debates around the risks and benefits of freely moving capital. It notes that the collapse of the Soviet Union in 1991 and subsequent liberalization policies in post-Soviet states led to increased foreign direct investment inflows to those countries as they sought to attract outside investors. The end of communist regimes in other parts of the world, like Latin America, also led countries there to abandon communism and liberalize their trade policies and open their borders to foreign capital. Overall, political changes and liberalization efforts have contributed significantly to the rapid growth of international capital flows globally since the 1990s.

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    International  Capital  Flows:  Remedy  or  Curse?     Keith  Mellott     Commonwealth  Honors  College   Isenberg  School  of  Management   May  4,  2015       Abstract     Capital   account   liberalization   has   increased   the   importance   and   prevalence   of   international   capital   flows.     There   is   much   debate   over   the   risks   and   benefits   of   freely  moving  capital,  especially  during  times  of  crisis  and  especially  for  developing   countries.     Capital   flow   “volatility”   is   often   blamed   for   worsening   the   effects   of   financial  crises  in  developing  countries.    In  an  attempt  to  control  the  behavior  of   capital   flows,   countries   have   implemented   different   types   of   capital   controls   to   varying  extents.    I  argue  that  capital  controls  have  a  relationship  with  capital  inflow   volume   both   during   crises   and   in   general.     Specifically,   I   determine   that   capital   account  restrictiveness  is  related  to  lower  volumes  of  capital  inflows  and  vice  versa.        
1.  Literature  Review   1.1   The  Growth  of  International  Capital  Flows   International  capital  flows  are  movements  of  money  across  country  borders  for  the   purpose   of   investment,   business   activities,   or   trade.     Gross   international   capital   flows  have  increased  drastically  over  the  past  half-­‐century  as  a  result  of  a  globalized   economy,   changes   in   the   international   political   landscape,   and   advances   in   technology.    As  gross  international  capital  flows  have  grown  in  volume,  they  have   also   grown   in   importance,   especially   for   developing   countries.     The   growth   in   international   capital   flows   became   markedly   more   rapid   in   the   mid   1990’s,   and   exploded  in  the  mid  2000’s,  as  indicated  in  Figure  1.    Although  the  majority  of  the   increases  in  capital  flows  are  attributable  to  advanced  countries,  Figure  1  indicates   that  developing  countries  are  starting  to  account  for  a  bigger  portion  of  the  gross   flows.                             The   dissipation   of   the   Soviet   Union,   which   occurred   in   1991,   is   one   of   the   most   important   political   events   of   the   last   50   years.     The   collapse   of   the   USSR   Figure  1:  Global  Gross  Capital  Inflows,  Advanced  and  Developing  Countries,  1980-­‐2010   This  figure  shows  annual  changes  in  global  gross  capital  inflows  and  separates  the  flows  that  are   attributable  to  developing  and  advanced  countries.   Source:  Calculations  by  Adams-­‐Kane  &  Yueqing  Jia  (2013),  based  on  data  from  the  IMF  International   Financial  Statistics  (IFS)  database;  annual  basis.  
  subsequently   created   15   states,   all   of   which   represented   new   opportunity   for   international   investors.     According   to   World   Bank   data,   these   newly   formed   countries   experienced   a   period   of   economic   depression   that   lasted   until   the   mid   1990’s,  with  GDP  declining  and  poverty  increasing.    Domestic  financial  liberalization   policies   allowed   these   countries   to   attract   outside   investors,   helping   to   satisfy   domestic  needs  for  financial  capital,  savvy  management,  and  advanced  technologies.     Levels   of   foreign   direct   investment   (FDI)   to   the   post-­‐Soviet   states   are   shown   in   Figure  2.    It  is  obvious  that,  in  the  5  years  following  the  collapse  of  the  USSR,  there   was  an  upward  trend  of  FDI  flows  to  these  countries.                             1         Communism  not  only  stymied  the  economic  relationship  between  capitalist   nations   and   the   Soviet   Union.     The   influence   of   communism   had   spread   to   other   parts  of  the  globe,  such  as  Latin  America.    Once  the  Soviet  regime  collapsed,  other   countries  also  abandoned  their  communist  regimes.    Countries  such  as  Argentina,                                                                                                                   1  Figure  2  depicts  the  mean  net  FDI  inflow  volume  as  a  %  of  GDP  for  the  15  post-­‐Soviet  states:   Armenia,  Azerbaijan,  Belarus,  Estonia,  Georgia,  Kazakhstan,  Kyrgyzstan,  Latvia,  Lithuania,  Moldova,   Russia,  Tajikistan,  Turkmenistan,  Ukraine  &  Uzbekistan.    There  are  no  country-­‐specific  weightings   for  FDI  as  a  %  of  GDP.   0   0.5   1   1.5   2   2.5   3   3.5   4   1992   1993   1994   1995   1996   FDI  Net  InHlows  (%  GDP)   Year   FDI  Net  Inglows  (%  of  GDP)   Figure  2:  Net  FDI  Inflows  to  Post-­‐Soviet  States  (%  of  GDP),  1992-­‐19961   This  figure  measures  the  average  annual  net  FDI  inflow  volume  to  post-­‐Soviet  States  from   1992  to  1996.       Source:  Author’s  calculations  based  on  World  Bank  data.  
  Uruguay,   Chile   and   Brazil   all   instituted   democracy,   no   longer   viewing   the   democratic,  developed  countries  of  the  world  as  political  and  ideological  enemies.     These   countries   also   liberalized   their   international   trade   policies,   opening   their   borders   to   foreign   investors   and   capital.     Foreign   direct   investment   inflows   to   former  communist  Latin  America  nations  rose  quickly  throughout  the  1990’s,  which   is  evident  in  Figure  3.                             2             China’s  emergence  as  a  global  economic  power  is  another  political  factor  that   has   contributed   to   the   vast   increases   in   global   gross   capital   flows.     During   the   1980’s,   China   became   a   member   of   the   International   Monetary   Fund,   the   World   Bank,   the   Asian   Development   Bank,   and   the   General   Agreement   on   Tariffs   and                                                                                                                   2  Figure  3  depicts  the  mean  net  FDI  inflow  volume  as  a  %  of  GDP  for  selected  Latin  American   countries  with  a  history  of  domestic  communist  regimes:  Argentina,  Bolivia,  Brazil,  Chile,  Colombia,   Ecuador,  Paraguay,  Peru,  Uruguay,  Venezuela,  El  Salvador  &  Guatemala.    There  are  no  country-­‐ specific  weightings  for  FDI  as  a  %  of  GDP.   Figure  3:  Net  FDI  Inflows  to  Selected  Latin  American  Countries  (%  GDP),  1990-­‐19982   This  figure  illustrates  the  annual  changes  in  Net  FDI  inflows  to  Latin  American  countries  with  a   history  of  domestic  communist  regimes  from  1990-­‐1998.   0   0.5   1   1.5   2   2.5   3   3.5   4   4.5   5   1990   1991   1992   1993   1994   1995   1996   1997   1998   FDI  Net  InHlows  (%  GDP)   Year   FDI  Net  Inglows  (%  GDP)   Source:  Author’s  calculations  based  on  World  Bank  Data.  
  Trade.     China   also   retooled   their   international   trade   policies,   becoming   more   receptive   to   foreign   sources   of   capital   and   even   allowing   foreign   banks   to   open   branches  within  the  country.    The  Chinese  government  implemented  policies  that   incentivized  foreign  investment,  a  stark  contrast  from  the  policies  that  were  in  place   prior   to   the   1980’s,   when   China   was   still   influenced   by   the   ideologies   of   Mao   Zedong’s  regime.    The  economic  changes  instituted  in  China  had  their  desired  effect.     According   to   data   from   the   World   Trade   Organization,   Chinese   trade   totaled   US   $27.7   billion   in   1979,   which   accounted   for   0.7%   of   worldwide   trade.     By   1985,   Chinese  trade  totaled  US  $70.8  billion,  which  accounted  for  2%  of  worldwide  trade.         Technological  advances  in  the  financial  industry  have  also  contributed  to  the   increase   in   global   gross   capital   flows.     New   computing   capabilities   have   enabled   financial  firms  to  cost-­‐effectively  create  index  funds  composed  of  assets  in  foreign   countries.     These   indices   have   reduced   the   necessary   amount   of   capital   to   invest   abroad,  making  it  feasible  for  individual  investors  to  include  foreign  assets  in  their   portfolios.    Developing  countries  have  experienced  the  largest  relative  increase  in   portfolio  inflows.      Mihaljek  (2008)  measured  changes  in  portfolio  flow  volume  to   emerging  market  economies  over  time.      2005,  global  portfolio  flows  to  emerging   market  economies  totaled  US  $127  billion.    By  2007,  this  number  had  increased  to   US  $432  billion.         1.2   Types  of  International  Capital  Flows   International  capital  flows  can  take  on  a  variety  of  forms,  one  of  which  is  foreign   direct  investment  (FDI).    FDI  is  defined  as  a  party  buying  controlling  ownership  in  a   business  enterprise  in  a  country  other  than  their  own.    The  IMF  defines  “controlling   ownership”  as  an  investment  that  equates  to  10%  or  more  of  voting  stock.    FDI  is   differentiated  from  other  types  of  capital  flows  because  it  generally  implies  that  the   investor  has  long-­‐term  confidence  in  both  the  investment  and  the  economic  outlook   of  the  country  where  the  capital  is  being  invested.    FDI  sometimes  brings  benefits  to   the  host  country  aside  from  the  capital  itself.    The  foreign  investor  often  provides   technology,   infrastructure,   and   managerial   skills   in   order   to   operate   the   business  
  venture   to   their   liking.     A   2002   report   from   the   Organization   for   Economic   Cooperation   and   Development   addressed   the   benefits   of   FDI.     “FDI   triggers   technology  spillovers,  assists  human  capital  formation,  contributes  to  international   trade   integration,   helps   create   a   more   competitive   business   environment   and   enhances   enterprise   development.     All   of   these   contribute   to   higher   economic   growth,  which  is  the  most  potent  tool  for  poverty  alleviation.”   As   with   the   other   types   of   capital   flows,   the   level   of   global   FDI   flows   has   grown  considerably  over  the  past  two  decades.    The  levels  of  net  global  FDI  inflows   from   1980   to   20012   are   depicted   in   Figure   4.     Global   net   FDI   inflow   volume   increased   rapidly   starting   in   the   early   1990’s   and   the   upward   trend   has   been   consistent   throughout   time.         The   figure   shows   decreases   in   global   FDI   inflow   volume  in  2000  and  2007,  which  are  attributable  to  global  crises  that  had  a  negative   impact  on  investor  confidence.                                       Figure  4:  Global  FDI  Net  Inflow  Volume  ($US  Millions),  1980-­‐2012   This  figure  shows  annual  changes  in  global  FDI  Net  inflow  Volume  between  1980-­‐2012.   -­‐$500,000.00   $0.00   $500,000.00   $1,000,000.00   $1,500,000.00   $2,000,000.00   $2,500,000.00   $3,000,000.00   Global  FDI  Net  InHlow  Volume  ($US  Millions)   Year   FDI  Net  Inglows   Source:  Author’s  calculations  based  on  World  Bank  data.    There  are  no  country-­‐specific  weightings  for   KAOPEN  values.  
  A  2009  United  Nations  Conference  on  Trade  and  Development  report  noted   that  FDI  inflow  volume  to  developing  countries  has  grown  at  a  faster  rate  than  FDI   inflow  volume  to  developed  countries.    Prior  to  the  1990’s,  global  outward  FDI  from   developing  economies  was  very  minimal.    Over  the  past  20  years  however,  global   outward  FDI  from  developing  economies  has  grown  significantly  in  both  nominal   terms  and  relative  to  the  global  outward  FDI  from  developed  countries.    The  most   important  determinant  of  a  country’s  outward  FDI  level  is  economic  growth,  which   dictates  the  demand  side  of  investment  and  the  demand  for  goods  and  services  from   foreign   countries.     As   developing   economies   continue   to   grow,   their   demand   for   investment  and  foreign  goods  and  services  will  increase  and  their  levels  of  outward   FDI  are  expected  to  do  the  same.   Foreign   portfolio   investment   (FPI),   a   financial   transaction   in   which   an   individual  or  institution  purchases  foreign  bonds  or  equity,  is  another  type  of  capital   flow.    Portfolio  flows  are  more  liquid  than  FDI  flows,  as  they  can  be  transferred  to   other  parties  more  easily.    Portfolio  flows  are  generally  regarded  as  more  volatile   than  FDI  flows  and  liquidity  is  one  of  the  primary  reasons  for  this.    Another  reason   for  this  volatility  is  herding  behavior  in  financial  markets,  which  is  the  tendency  of   asset  managers  to  follow  the  behavior  of  other  asset  managers,  causing  them  to  take   action  in  ways  that  they  independently  would  not.    Hwang  &  Salmon  (2004)  find   that  herding  towards  the  market  is  significant,  both  when  the  market  is  falling  and   rising.     Another   reason   for   portfolio   flow   volatility   is   asymmetric   information   between  financial  markets.    Portes  &  Rey  (2005)  find  that  inter-­‐country  differences   in  informational  wealth,  proxied  by  variables  such  as  telephone  traffic  and  amount   of   bank   branches,   had   significant   effects   on   the   behavior   of   cross-­‐border   equity   flows.    Informational  advantages  incentivize  the  international  movement  of  capital   as  information  bearers  seize  opportunities  to  profit.   Figure  5  shows  how  global  FDI  and  portfolio  flows  have  changed  in  volume   between   1995   and   2009.     The   figure   indicates   that,   after   peaking   around   1997,   portfolio   flows   declined   until   around   2002.     A   2002   UNDP   Report   attributes   this   decrease  to  the  Asian  financial  crisis,  which  made  asset  managers  wary  of  investing   in   foreign   equities   and   bonds.     Portfolio   flows   had   an   even   more   pronounced  
  reversal   in   response   to   the   2008   financial   crisis,   dropping   precipitously   before   rebounding   in   2009.     The   figure   indicates   that   FDI   flows   reversed   one   year   after   portfolio  flows.    This  reflects  the  difference  in  liquidity  between  the  two  types  of   flows.     When   the   crisis   began   in   2008,   asset   managers   could   immediately   sell   off   their  portfolio  investments,  whereas  investors  had  to  remain  committed  to  their  FDI   flows  in  the  short-­‐term.                                           Ananchotikul   &   Zhang   (2014)   discovered   that   portfolio   flows   to   emerging   markets  have  grown  in  volume  and  volatility  since  2003.    The  authors  found  that   portfolio  flows  to  emerging  markets  are  very  responsive  to  market  trends,  such  as   monetary  policies  in  advanced  economies  and  global  aversion  to  risk.    The  authors’   calculations  indicated  that  there  is  statistically  significant  correlation  between  the   behavior  of  portfolio  flows  to  emerging  markets  and  asset  prices  in  those  markets,   specifically   stock   market   indices,   10-­‐year   government   bond   yields   and   exchange   Figure  5:  Composition  of  Private  Capital  Flows,  1995-­‐2009  (US$  billions)   This  figure  measures  annual  changes  in  global  portfolio  investment  flows  and  FDI  flows   between  1995  and  2009.   Source:  Calculated  for  2002  UNDP  Report,  based  on  data  from  World  Bank,  Global  Finance  for   Development,  and  IMF,  Balance  of  Payment  Statistics  2009.  
  rates.    During  times  of  portfolio  outflows  from  emerging  markets,  there  also  were   drops   in   the   value   of   stock   market   indices   and   increases   in   10-­‐year   government   bond  yields.    Periods  of  portfolio  outflows  from  emerging  market  economies  also   were  concurrent  with  depreciation  in  those  markets.    The  authors  concluded  that   portfolio   flows   are   generally   more   volatile   than   other   types   of   capital   flows,   but   especially  so  during  times  of  financial  recession.    The  measured  effect  of  portfolio   flows  on  asset  prices  during  a  recession  was  5-­‐10  times  greater  than  the  magnitude   during  non-­‐recessionary  time  periods.   The  United  Nations  Development  Programme  published  a  report  in  2001  on   Millenial  Development  Goals,  acknowledging  the  risks  that  emerging  markets  face  as   a  result  of  portfolio  flow  volatility.    “The  consequences  of  such  volatility  for  growth   are   obvious,   especially   in   countries   highly   reliant   on   such   flows   for   investment.     When   investment   sources   are   unpredictable   and   volatile,   so   is   growth.     This   is   especially  the  case  for  the  smaller,  lower-­‐income  countries  where  many  FDI  projects   are  huge  in  relation  to  the  size  of  the  host  economy  and  because  these  countries   tend  to  be  much  less  diversified  and  depend  on  one  or  two  large  projects  or  sectors.”     Private  loans  are  another  type  of  capital  flow.    They  consist  of  every  type  of   bank   loan   as   well   as   loans   from   other   sectors,   such   as   trade   financing   loans,   mortgages   and   repurchase   agreements.     Private   loans   are   often   divided   into   two   categories:  short-­‐term  and  long-­‐term.    The  likelihood  of  short-­‐term  debt  to  expose   countries  to  risk  of  crisis  is  contested  in  economic  literature.    Stiglitz  (2000)  argues   that,  by  liberalizing  the  short-­‐term  capital  account,  a  country  opens  itself  to  the  risk   of   capital   flight,   which   occurs   when   assets   quickly   flow   out   of   a   country.     Capital   flight  decreases  the  level  of  domestic  wealth  and  is  almost  always  associated  with   depreciation   of   the   domestic   currency.     Diamond   &   Rajan   (2001)   assert   that   structural  flaws  are  to  blame  for  countries  being  exposed  to  such  risks.    “Short-­‐term   debt   mirrors   the   nature   of   the   investment   being   financed   and   the   institutional   environment   that   enables   investors   to   enforce   repayment.     It   is   no   surprise   that   illiquid  or  poor  quality  investment  when  a  bank  or  banking  system  is  close  to  its   debt  capacity  will  result  in  a  buildup  of  short-­‐term  debt.    The  higher  likelihood  of   crisis  stems,  not  from  the  short-­‐term  debt,  but  from  the  illiquidity  and  potentially  
  low   creditworthiness   of   the   investment   being   financed.”     Conventional   economic   wisdom  dictates  that  countries,  especially  those  with  developing  economies,  should   be   wary   of   short-­‐term   loan   flows   because   they   are   more   liquid   and   volatile   than   long-­‐term  loan  flows.     1.3   Benefits  of  Capital  Flows  &  Recessionary  Trends   One   feature   of   the   globalized   economy   is   an   integrated   international   financial   market.    An  interconnected  financial  system  facilitates  the  uninhibited  movement  of   capital  across  countries.    In  theory,  international  financial  integration  should  allow   for  capital  to  be  allocated  in  the  most  efficient  ways.    Fischer  (1997)  elaborated  on   these  benefits.    “Free  capital  movements  facilitate  a  more  efficient  global  allocation   of   savings,   and   help   channel   resources   into   their   most   productive   uses,   thus   increasing   economic   growth   and   welfare.”     Bailliu   (2000)   agrees   with   Fischer’s   assertion   that   freely   moving   capital   does   indeed   have   the   potential   to   maximize   economic   growth   and   welfare,   but   argues   that,   in   developing   countries,   freely   moving  capital  can  only  maximize  economic  benefits  if  the  domestic  banking  sector   has  achieved  a  minimum  level  of  development  and  sophistication.    Bailliu  (2000)   suggested   that   there   are   three   ways   capital   flows   can   foster   domestic   growth:   increasing  domestic  investment  rates,  facilitating  investments  from  foreign  agents   with   positive   spillover   effects   (such   as   technology   transfers),   and   increasing   domestic  financial  intermediation.   Fischer  (1997)  points  out  that  free  capital  movement  benefits  capital-­‐seeking   agents   because   institutions,   firms   and   individual   investors   have   access   to   ever-­‐ increasing  sources  of  capital.    The  author  notes  that  foreign  capital  markets  have   grown  substantially  in  terms  of  the  volume  of  funds  being  distributed  on  an  annual   basis.     Enhanced   capital   access   can   also   reduce   the   cost   of   capital.     International   sources   of   capital   are   oftentimes   cheaper   than   those   available   in   the   domestic   market.     Stulz   (2005)   discovered   that   the   largest   reductions   in   capital   cost   are   enjoyed   by   developing   countries   that   are   gaining   access   to   international   capital   markets   for   the   first   time.     He   determined   that   developed   countries   with   a  
  longstanding   presence   in   the   international   financial   market   can   also   reduce   their   capital  costs,  but  to  a  lesser  extent.     International  capital  account  liberalization  has  not  only  benefitted  recipients   of  capital,  but  also  distributors  of  capital.    The  interconnected  financial  system  has   created   new   opportunities   for   investors   to   diversify   their   portfolios   and   achieve   higher   returns.     Levey   and   Sarnat   (1970)   found   that   investment   portfolios   can   achieve   “material   improvements”   in   risk   reduction   by   diversifying   their   holdings,   specifically  by  purchasing  equities  in  developing  countries  to  complement  holdings   in  developed  countries.   As   Bailliu   (2000)   noted,   another   benefit   of   international   capital   flow   liberalization   is   the   transfer   of   technology,   infrastructure,   and   intellectual   capital   that  often  comes  with  FDI.    Acknowledging  that  multinational  corporations  account   for   a   large   portion   of   global   research   and   development   investment,   Borensztein,   Gregorio  &  Lee  (1998)  found  that  FDI  is  important  for  the  international  transfer  of   technology   and,   in   developing   countries,   leads   to   more   growth   than   domestic   investment   as   long   as   the   host   country’s   infrastructure   is   advanced   enough   to   absorb  the  technology  spillovers.   Despite   their   benefits,   freely   moving   international   capital   flows   have   not   always  created  positive  outcomes  for  emerging  market  economies.    One  of  the  most   important  drawbacks  of  capital  flows  is  the  pattern  of  reversals  in  periods  of  crises.     Capital  flight  occurs  when  a  large  volume  of  capital  flows  out  of  a  country.    Capital   flight  is  almost  always  a  symptom,  rather  than  a  cause,  of  a  financial  crisis.    Capital   flight  was  present  in  the  global  recession  of  2008.    Total  net  private  capital  flows   had  reached  a  historic  high  of  US  $1.2  trillion  in  2007,  only  to  fall  to  US  $649  billion   in  2008.    According  to  Suchanek  &  Vasishtha  (2009),  they  fell  even  further  in  2009,   to  US  $435  billion.    This  affirms  the  findings  of  Kaminsky,  Reinhart,  &  Vegh  (2005).   The  authors  calculated  that,  for  all  groups  of  countries,  capital  flows  are  pro-­‐cyclical,   with  higher  inflows  during  periods  of  growth  and  lower  inflows  during  periods  of   crisis.     Capital   flow   reversals   during   a   recession   can   worsen   a   crisis,   especially   in   emerging   market   economies.     Calvo   &   Reinhart   (1999)   discovered   that   during   a  
  crisis,   developing   countries   often   experience   decreased   access   to   sources   of   international  capital,  which  makes  recovery  more  difficult.    They  point  out  that  a   country  hoping  to  enact  expansionary  policies  to  recover  from  recession  will  find   this   increasingly   difficult   as   their   sources   of   international   capital   disappear.     Not   only  does  capital  decrease  in  availability,  but  it  also  increases  in  cost.       Bernanke   (2000)   discovered   that   reduced   access   and   increased   cost   of   capital   discourages   investment,   contributing   to   reduced   aggregate   demand   and   decreased  output  during  a  crisis.    During  recessions,  there  is  heightened  uncertainty   in  the  domestic  economy  and,  from  the  perspective  of  a  foreign  loaner,  risk.    Banks   become   reluctant   to   lend   as   liberally   as   they   did   during   the   pre-­‐crisis   period.     Bernanke   (2000)   discovered   that   banks’   unwillingness   to   lend   during   crises   has   gotten   more   severe   over   time.   Cyclical   decreases   in   bank   loans   contribute   to   decreases  in  private  loan  flows  during  a  recession.    Countries  cannot  expect  private   loan   flows   to   be   as   abundant   during   a   crisis   as   they   are   in   a   stabile   economic   environment.    Decreased  loan  flows  indicate  that  firms  are  not  undertaking  as  many   investment   projects   during   a   recession,   which   makes   it   difficult   to   recover   via   economic  growth  and  expansion.   Capital  flight  is  not  always  caused  by  a  financial  crisis  within  the  domestic   economy.     Capital   flow   reversals   can   also   be   triggered   by   exogenous   factors.     If   investment  opportunities  with  higher  returns  and  less  risk  are  available  in  foreign   entities,   investors   have   an   incentive   to   remove   their   money   from   the   domestic   economy   and   reallocate   it   to   the   more   attractive   investment.     When   this   occurs,   investors  demand  repayment  and  the  domestic  country  will  face  high  volumes  of   capital  outflows,  which  it  can  respond  to  in  two  ways.    First,  the  country  can  raise   the  domestic  interest  rate,  which  reduces  or  eliminates  the  opportunity  cost  that  the   investor  incurs  by  keeping  his  or  her  money  in  the  domestic  country.    This  will  be   effective   in   reducing   capital   outflows,   but   it   also   discourages   investment   because   interest   rate   hikes   increase   the   cost   of   borrowing.     Decreased   investment   contributes  to  a  growth  stall,  exasperating  the  effects  of  a  recession.    If  the  country   does  not  wish  to  raise  the  domestic  interest  rate,  it  can  opt  to  repay  the  investors.    
  Since  many  foreign  investments  are  denominated  in  foreign  currency,  the  domestic   country  has  to  deplete  their  foreign  reserves  to  meet  their  repayment  obligations.       In  extreme  cases,  depleted  foreign  reserves  can  lead  a  country  to  insolvency.     According  to  World  Bank  data,  in  2008,  when  the  global  financial  crisis  was  starting   to  reach  its  apex,  Brazil  had  foreign  exchange  reserves  of  $205.5  billion,  which  was   12.9%  of  their  GDP.    According  to  The  Economist3,  these  foreign  reserves  gave  Brazil   the  ability  to  intervene  in  foreign  exchange  markets  and  stabilize  the  Brazilian  real.     They  also  were  able  to  provide  foreign  exchange  swaps  for  Brazilian  corporations   that   were   struggling   to   pay   back   US   dollar-­‐denominated   debt.     If   Brazil   hadn’t   possessed  substantial  pre-­‐crisis  amounts  of  foreign  reserves,  they  would  have  been   less   able   to   pay   back   their   short-­‐term   debts,   which   could   have   led   them   towards   insolvency.        Capital   flow   reversals   can   also   be   caused   by   the   exogenous   factor   of   quantitative  easing  (QE).    QE  is  the  process  of  a  central  bank  buying  securities  from   the  market  to  lower  global  interest  rates  and  increase  the  money  supply,  with  the   goals  of  promoting  more  lending  and  increasing  liquidity.    QE  is  most  effective  when   it   is   conducted   by   an   economy   of   large   scale,   such   as   that   of   the   US.     During   quantitative   easing,   countries   ideally   use   the   money   they   receive   from   selling   domestic  securities  in  ways  that  stimulate  growth  in  the  domestic  economy.    This   theoretically  increases  investor  confidence  in  the  domestic  economy,  promoting  a   resurgence  of  international  trade  and  investment.       In   response   to   the   2008   financial   crisis,   the   Federal   Reserve   instituted   aggressive  QE  policies,  eventually  purchasing  trillions  of  dollars  of  securities.    QE   creates  a  risk  of  capital  flow  reversals  when  the  policies  are  eventually  phased  out,   or   tapered.     In   May   2013,   Ben   Bernanke,   the   former   Chairman   of   the   Federal   Reserve,  provided  a  glimpse  of  the  chaos  that  can  ensue  when  quantitative  easing   policies  are  tapered.    According  an  article  published  by  Forbes4,  Bernanke  sparked                                                                                                                   3  The  article  Just  in  Case  was  authored  by  multiple  writers  for  The  Economist  and  was  electronically   published  on  October  12,  2013.   4  The  article  Bernanke’s  QE  Dance:  Fed  Could  Taper  in  Next  Two  Meetings,  Tightening  Would  Collapse   the  Market  was  electronically  published  on  May  22,  2013.    The  article  was  authored  by  Agustino   Fontevecchia.  
  wild  swings  in  the  market  when  he  hinted  at  the  possibility  of  tapering  QE  in  the   near  future.    The  Dow  Jones  Industrial  Average,  a  stock  market  index  composed  of   30  large  publically  owned  American  companies,  increased  and  decreased  by  over   100   points   at   various   points   throughout   Bernanke’s   speech.     It   is   inevitable   that   quantitative  easing  will  eventually  be  phased  out  and,  to  some  extent,  investors  will   probably   respond   by   withdrawing   their   capital   from   developing   countries.     The   degree  to  which  investors  respond  to  QE  tapering  by  withdrawing  their  capital  from   developing   countries   will   determine   how   severely   economic   growth   in   emerging   markets  will  be  hindered.       1.4   Capital  Controls:  History  &  Types     Most,   if   not   all,   of   countries   institute   at   least   some   capital   controls,   which   are   domestic   policies   that   regulate   flows   to   and   from   capital   markets.   Throughout   history,   capital   controls   have   been   used   for   varying   purposes   and   to   different   extents.     Eichengreen   (2008)   explains   that   capital   controls   initially   gained   popularity  in  mainstream  economics  during  the  time  period  between  World  War  I   and  World  War  II.    The  purpose  of  capital  controls  at  this  point  in  time  was  to  allow   countries  to  rebuild  their  economy  during  the  post-­‐World  War  I  period  without  the   fear  of  capital  flight.    Eichengreen  (2008)  mentions  that  during  the  three  decades   after  World  War  II,  capital  controls  became  less  prevalent  and  international  capital   flows   reached   record   highs.     Industrial   nations   led   the   way   in   liberalizing   international  capital  flow  policies,  while  encouraging  developing  countries  to  do  the   same.       Post-­‐World   War   II   financial   crises   started   to   highlight   the   risks   of   freely   moving   capital,   especially   in   developing   countries.     Economists   and   governments   have  tried  to  better  their  understanding  of  capital  flow  behavior  and  how  capital   controls   can   be   instituted   to   mitigate   the   risks   of   capital   volatility   during   crises.     (Chamon   &   Garcia,   2014)   examine   the   ways   that   Brazil   used   capital   controls   to   respond   to   the   2008   crisis.     Brazil   was   the   one   of   the   most   aggressive   emerging  
  markets  in  terms  of  their  reactionary  capital  control  policies.    Beginning  in  2009,  the   Brazilian   government   imposed   controls   such   as   portfolio   flow   taxes,   loan   flows   taxes,   currency   exchange   taxes,   and   increased   reserve   requirements   for   domestic   banks.    The  authors  discovered  that  capital  controls  increased  the  price  of  Brazilian   assets   and,   to   a   certain   extent,   isolated   the   Brazilian   financial   market   from   the   international  financial  market.    The  authors  also  concluded  that  the  capital  controls   as   a   whole   successfully   contained   the   appreciation   of   the   real   (the   domestic   Brazilian  currency).    The  Brazilian  government  began  relaxing  their  capital  controls   in  2011.    The  authors  infer  that  the  controls  allowed  Brazil  to  avoid  a  bubble  and   out-­‐of-­‐control  domestic  credit  levels.    The  downside  of  the  capital  controls  was  the   reduced  access  to  foreign  financing,  possibly  contributing  to  the  low  investment  and   growth  performance  during  the  post-­‐crisis  period.    Brazil  is  but  one  example  of  a   country   that   has   had   success   with   capital   control   policies   during   a   crisis.     These   success   stories   have   caused   many   economists   believe   that   capital   controls   are   a   legitimate  way  to  shield  countries  from  some  of  the  effects  of  recessions.     There   are   a   wide   variety   of   capital   controls   that   can   be   instituted   by   a   country.    Capital  controls  can  target  short-­‐term  investments,  long-­‐term  investments,   or  both.    Wary  of  the  risks  that  come  with  the  volatility  of  short-­‐term  capital  flows,   some   countries   impose   capital   controls   with   the   goal   of   attracting   investment   projects   that   necessitate   long-­‐term   commitment   from   investors.     In   Vietnam,   the   government  requires  as  a  precondition  that  foreign  investors  set  up  a  Vietnamese   capital  bank  account,  which  enables  the  tracking  of  flows  in  and  out  of  the  country.     Also,  the  Vietnamese  government  requires  that  foreign  investors  fulfill  all  financial   obligations  to  the  State  of  Vietnam  before  distributing  any  profits  (KPMG).    Ostry,   Ghosh,  Habermeier,  Chamon,  Qureshi  &  Reinhardt  (2010)  provide  another  example   of  capital  controls  that  target  short-­‐term  flows.    From  2006-­‐2008,  Thailand  imposed   an   unremunerated   reserve   requirement   on   any   foreign   currencies   sold   or   exchanged  against  the  domestic  baht.    The  requirement  was  30%  and  was  effective   in  reducing  the  volume  of  net  flows  as  well  as  altering  the  composition  of  inflows   (there  was  a  greater  percentage  of  foreign  direct  investment  inflows  and  a  lower   percentage  of  short-­‐term  flows).  
  Some  capital  controls  that  target  long-­‐term  capital  flows  are  due  to  domestic   aversion  to  foreign  ownership  of  domestic  assets.    In  Mexico,  for  example,  Article  27   of   the   constitution   limits   foreign   investment   in   domestic   real   estate   and   natural   resources.    Neely  (1999)  explains  that  this  is  a  protective  measure  Mexico  has  taken   to   prevent   foreign   companies   from   exploiting   Mexican   resources   for   short-­‐term   profits,  which  is  has  frequently  occurred  in  the  history  of  Mexico.    Another  reason  a   country   might   impose   capital   controls   specific   to   long-­‐term   flows   is   because   of   a   general  aversion  to  the  risks  of  taking  part  in  international  financial  markets.    South   Korea,   for   example,   restricted   long-­‐term   foreign   investment   inflows   before   they   radically  reformed  their  capital  account  starting  in  the  late  1990s.    Noland  (2007)   attributes  South  Korea’s  restrictions  on  FDI  inflows  to  the  country’s  unwillingness   to   have   the   foundation   of   their   economy   be   contingent   on   foreign   capital   and   uncontrollable   macroeconomic   factors.     South   Korea   is   exemplary   of   an   economy   that  rapidly  developed  without  relying  on  FDI  inflows.    The  country  instead  relied   on  technology  licensing  and  international  loans  to  spur  growth.     Capital   controls   can   also   be   categorized   by   whether   or   not   they   restrict   capital   account   transactions   via   price   mechanisms   or   quantity   controls.     Price   controls   usually   manifest   themselves   in   the   form   of   taxes.     A   popular   price   mechanism   is   the   “Tobin”   tax,   which   was   first   introduced   in   1972.     Tobin   taxes   impose  a  small  percentage  tax  on  all  foreign  exchange  transactions.    Frankel  (1996)   explains   that   the   purpose   of   the   Tobin   tax   was   to   reduce   the   incentive   to   switch   investment  positions  in  the  short-­‐term  in  the  foreign  exchange  market,  which  would   mitigate   market   volatility.     Another   price-­‐based   capital   control   is   the   mandatory   reserve   requirement,   which   requires   foreign   investors   to   deposit   a   percentage   of   their   investment   with   the   central   bank   (earning   no   interest).     Mandatory   reserve   requirements   are   meant   to   build   the   foreign   reserves   of   the   central   bank.     Chile   implemented   such   a   policy   from   1991   to   1998,   specifically   targeting   short-­‐term   inflows.     In   the   context   of   Chile,   their   mandatory   reserve   requirement   essentially   functioned  as  a  tax  on  short-­‐term  inflows.    Stiglitz  (2000)  praised  Chile’s  mandatory   reserve  requirement  because  it  reduced  the  volatility  of  short-­‐term  inflows  without   compromising  long-­‐term,  growth-­‐fostering  inflows  such  as  FDI.  
    Quantity-­‐based  capital  controls  can  take  the  form  of  policies  that  set  a  ceiling   for  borrowing  from  foreign  residents.    According  to  Athukoralge  (2001),  Malaysia   set   such   ceilings   in   response   to   the   1998   Asian   crisis,   limiting   foreign   currency   borrowings   by   residents   and   domestic   borrowing   by   non-­‐residents.     Malaysia   implemented  another  quantity-­‐based  control  by  setting  a  ceiling  on  banks/  external   liabilities  not  related  to  trade  or  investment.    Other  times,  countries  may  require   that   governmental   approval   be   granted   before   transactions   are   made   on   certain   types  of  assets.    The  case  of  South  Korea  prohibiting  nearly  all  long-­‐term  flows  is   one  example  of  this  type  of  quantity-­‐based  control.    
  2.  Data   2.1   Quantifying  Capital  Account  Restrictiveness   Due   to   the   variety   and   complexity   of   capital   controls,   quantifying   capital   account   openness   is   a   burdensome   task.     Different   countries   at   different   points   in   time   decide  to  impose  different  mixes  of  capital  controls.    Given  the  variety  of  available   capital  controls,  each  mix  tends  to  be  unique.    It  is  therefore  important  to  have  a   standard  measure  of  capital  control  restrictiveness.       Many   capital   account   openness   indices   have   been   constructed   using   the   IMF’s   Annual   Report   on   Exchange   Arrangements   and   Exchange   Restrictions   (AREAER).      The  AREAER  is  a  database  of  binary  variables  that  contains  information   about  the  types  of  capital  controls  are  employed  by  the  187  IMF  member  countries.       The  variables  in  the  AREAER  include  a  wide  variety  of  capital  controls,  such   as  restrictions  on  international  payments  and  transfers,  arrangements  for  payments   and   receipts,   regulations   on   residents’   and   nonresidents’   accounts,   exchange   rate   systems,  financial  sector  policies,  and  foreign  exchange  market  operations.    A  binary   variable   with   the   value   of   1   indicates   that   a   country   has   instituted   the   particular   capital  control  and  0  otherwise.     The  AREAR  is  effective  in  distinguishing  between  de  jure  and  de  facto  capital   controls.     De   jure   capital   controls   are   legally   instituted   policies.     De   facto   capital   controls   relate   to   how   robustly   the   controls   are   implemented,   and   how   effective   they  are  in  serving  their  purpose.    De  facto  capital  controls  are  harder  to  quantify   than  de  jure  capital  controls,  but  they  depict  reality  more  accurately,  which  makes   them  more  valuable  for  practical  perspective.   There  are  various  issues  that  arise  when  measuring  capital  account  openness   with  the  binary  variables  contained  in  the  AREAER.    Binary  measurements  indicate   whether   or   not   a   country   has   instituted   a   given   capital   control,   but   provide   no   information  on  the  degree  to  which  it  has  been  implemented.    Therefore,  there  is  no   way  to  measure  differences  in  intensity  of  a  given  capital  control  between  countries.     Another   issue   with   the   variables   in   the   AREAER   is   that   they   are   broadly   defined,   preventing   them   from   capturing   certain   details   and   distinguishing   features   of  
  capital   controls.     Some   of   the   problems   associated   with   a   lack   of   capital   control   specificity  were  addressed  in  1997,  when  the  IMF  revised  the  classification  of  the   variables   in   the   AREAER.     The   new   variable   categorizations   now   account   for   distinctions  between  restrictions  on  inflows  and  outflows  as  well  as  the  differences   between   different   types   of   capital   transactions.     However,   it   is   doubtful   that   any   categorization   of   the   variables   in   the   AREAR,   no   matter   how   specific,   could   ever   perfectly  encapsulate  the  complexity  and  variety  of  capital  controls.   Using   the   information   from   the   AREAER,   Chinn   and   Ito   (2008)   created   a   capital  account  openness  index  called  KAOPEN.    The  authors  reversed  the  values  of   the  binary  variables  in  the  AREAER  in  order  to  construct  KAOPEN  in  a  way  that  has   higher   index   values   corresponding   to   less   restrictive   current   account   policies.     Selected   binary   variables   in   the   AREAER   are   weighted   and   aggregated   into   individual   index   values   for   each   IMF   member   country.     The   aggregated   index   measurements   assume   values   between   0   to   1,   with   0   representing   complete   restriction   and   1   representing   complete   openness.     KAOPEN  values   are   measured   annually,  with  1970  being  the  earliest  year  that  data  is  available  for.     KAOPEN  is  the  most  appropriate  capital  account  openness  index  to  use  in  this   study   for   two   reasons.   KAOPEN   is   constructed   so   as   to   focus   on   de   jure   capital   controls,  making  it  effective  in  measuring  the  extent  of  regulatory  restrictions  on   capital   account   transactions.     Since   the   purpose   of   this   study   is   to   evaluate   the   effectiveness   of   a   country’s   legally   imposed   capital   controls   in   mitigating   the   negative   effects   of   a   financial   crisis,   KAOPEN’s   focus   on   de   jure   capital   controls   makes  it  a  logical  choice  of  index.       The   second   reason   KAOPEN   is   an   ideal   index   of   capital   account   restrictiveness  is  that  it  is  a  holistic,  robust  measure  of  capital  account  openness.   Countries  oftentimes  impose  capital  controls  in  a  variety  of  ways  to  increase  their   collective  effectiveness.    As  Edwards  (1999)  points  out,  the  private  sector  frequently   circumvents  capital  controls.    Countries  can  make  this  more  difficult  by  adopting  an   all-­‐inclusive   approach   to   their   capital   control   policies.     A   country   with   a   closed   capital   account   can   reinforce   these   policies   by   imposing   controls   on   the   current   account   or   by   changing   the   requirements   for   surrendering   export   proceeds.    
  Malaysia   adopted   this   strategy   in   response   to   the   Asian   Crisis   of   1998.     KAOPEN   incorporates  variables  from  a  variety  of  categories  in  the  AREAR,  accounting  for  a   wide  range  of  capital  controls.    Therefore,  KAOPEN  values  are  strong  measures  of   the  entirety  of  countries’  approaches  to  capital  account  restrictiveness.     Here,  I  first  examine  KAOPEN  values  from  1970  to  2012  across  the  entirety  of   the  IMF  member  countries  to  investigate  if  there  is  a  global  trend  towards  capital   openness   or   restrictiveness.     I   then   focus   on   the   regions   of   Latin   America   and   Southeast  Asia,  to  investigate  if  there  are  region-­‐specific  capital  account  openness   trends.    I  evaluate  KAOPEN  for  these  regions  across  the  entirety  of  the  time  series   (1970  to  2012)  as  well  as  specifically  for  time  periods  leading  up  to,  during,  and   after  a  crisis.    For  Latin  America,  my  analysis  focuses  on  the  five  years  preceding  and   following   the   2002   South   American   recession.     For   Southeast   Asia,   my   analysis   focuses  on  the  five  years  preceding  and  following  the  1998  Asian  financial  crisis.     2.2   KAOPEN  Values   Figure   6   presents   the   average   of   annual   KAOPEN   values   for   the   187   IMF   member  countries  as  a  group  from  1970  to  2012.    The  change  in  global  KAOPEN   values  over  time  indicates  that,  in  general,  capital  account  openness  has  increased   since  1970.    However,  Figure  6  shows  that  the  trend  toward  global  capital  account   openness  slowed  and  even  reversed  in  the  late  1970’s  and  early  1980’s.    The  mean   global   KAOPEN   value   did   not   begin   to   increase   again   until   the   late   1980’s.     The   reduction  in  KAOPEN  values  during  the  late  1970’s  and  early  1980’s  is  attributable   to  the  global  recession  that  occurred  during  the  same  time  period.    The  recession   negatively   impacted   both   developed   economies   and   emerging   market   economies.     The   trend   is   particularly   evident   in   the   Latin   American   debt   crisis   during   that   period.    In  the  1960’s  and  1970’s,  Latin  American  countries  built  up  vast  quantities   of   foreign   debt   by   borrowing   from   international   creditors   to   fund   economic   development   projects.     Investors   were   initially   eager   to   finance   projects   in   developing  Latin  America  because  GDP  in  the  region  was  rapidly  growing.    By  the   late  1970’s,  however,  Latin  American  countries  were  struggling  to  repay  their  debts,  
  partly  due  to  rising  oil  prices  and  increasing  interest  rates  in  the  United  States  and   Europe.    Investors  became  wary  of  Latin  America’s  ability  to  repay  their  debts.    They   withdrew   their   funds   from   the   region,   causing   a   large   outflow   of   capital   flight.     According   to   Pastor   (1989),   capital   flight   in   Latin   America   totaled   $151   billion   between  1973  and  1987.    This  equates  to  43%  of  their  total  external  debt  during   that   time   period.     The   rapid   outflow   of   capital   from   Latin   America   deprived   the   region  of  important  funding  that  was  expected  to  be  used  for  developing  projects   and  servicing  their  foreign  debt.    Latin  American  countries  came  to  identify  capital   flight  as  one  of  the  primary  causes  for  their  economic  woes.    As  a  result,  countries  in   the   region   became   more   restrictive   on   capital   account   transactions   and   even   the   IMF  made  stricter  capital  controls  a  precondition  for  Latin  American  countries  to   receive  debt-­‐relief  assistance  packages.                                         Figure  7  depicts  the  KAOPEN  value  for  Latin  American  countries  from  1970   to  1990.    The  figure  shows  a  strong  trend  towards  capital  account  restrictiveness   during   the   late   1970’s   and   early   1980’s   in   Latin   America.     The   figure   shows   that   0.3   0.35   0.4   0.45   0.5   0.55   0.6   1970   1972   1974   1976   1978   1980   1982   1984   1986   1988   1990   1992   1994   1996   1998   2000   2002   2004   2006   2008   2010   2012   KAOPEN   Year   Figure  6:  Mean  KAOPEN  Value  for  all  IMF  Member  Countries,  1970-­‐2012   The  figure  presents  the  mean  KAOPEN  value  for  all  IMF  member  countries  from  1970-­‐2012.   Source:  Author’s  calculations  based  on  World  Bank  data.    There  are  no  country-­‐specific   weightings  for  KAOPEN  values.  
  0   0.1   0.2   0.3   0.4   0.5   0.6   1970   1971   1972   1973   1974   1975   1976   1977   1978   1979   1980   1981   1982   1983   1984   1985   1986   1987   1988   1989   1990   KAOPEN   Year   Latin  American  countries  did  not  begin  liberalizing  their  capital  accounts  until  the   late  1980’s.         In   contrast,   this   trend   is   absent   for   developing   countries   during   the   same   period.    Figure  8  shows  the  KAOPEN  value  for  a  selected  group  of  countries  that  had   some  of  the  largest  economies  (in  terms  of  nominal  GDP)  in  the  world  in  1980.    The   figure   makes   it   evident   that   the   overall   trend   towards   capital   account   restrictiveness  was  not  present  in  developed  countries  with  prominent  economies.     Thus,  the  overall  trend  towards  stricter  capital  controls  in  the  late  1970’s  and  early   1980’s,   apparent   in   Figure   6,   did   not   apply   globally,   but   had   important   regional   distinctions.                     5                                                                                                                                       5  Figure  7  depicts  the  mean  KAOPEN  value  from  1970  to  1990  for  selected  Latin  American  countries:   Argentina,  Bolivia,  Chile,  Colombia,  Ecuador,  Guatemala,  Mexico,  Paraguay,  Peru,  Uruguay  &   Venezuela.    There  are  no  country-­‐specific  weightings  applied  to  KAOPEN  values.       Figure  7:  Mean  KAOPEN  Value  for  Latin  American  Countries,  1970-­‐19905   The  figure  presents  the  mean  KAOPEN  value  for  selected  Latin  American  countries  for  1970-­‐1990.   Source:  Author’s  calculations  based  on  World  Bank  data.    
                      6               Excluding  the  reversal  in  the  late  1970’s  and  early  1980’s,  there  is  clearly  an   overall  trend  towards  global  capital  account  openness.    This  has  made  international   capital   reallocation   and   international   trade   easier,   prominent   features   of   the   present-­‐day  integrated  global  economy.     Figures   9   graphs   the   KAOPEN  values   in   Latin   America   and   Southeast   Asia   from  1970  to  2012,  illustrated  the  regional  differences  in  capital  account  openness.     In  general,  Latin  American  countries  have  liberalized  their  capital  accounts  more  so   than   Southeast   Asian   countries.     The   next   section   of   this   paper   relates   KAOPEN   values  to  FDI  inflow  volume  on  a  regional  basis,  which  should  indicate  whether  or   not  the  dichotomy  of  the  approaches  taken  by  Southeast  Asian  countries  and  Latin                                                                                                                   6  Figure  8  depicts  the  mean  KAOPEN  value  from  1970  to  1990  for  a  selected  group  of  developed   countries  that  were  global  leaders  in  terms  of  GDP  in  1980:  Canada,  France,  Germany,  Italy,  Japan,   Spain,  the  United  Kingdom  &  the  United  States.    There  are  no  country-­‐specific  weightings  applied  to   KAOPEN  values.   0.4   0.45   0.5   0.55   0.6   0.65   0.7   0.75   0.8   0.85   1970   1971   1972   1973   1974   1975   1976   1977   1978   1979   1980   1981   1982   1983   1984   1985   1986   1987   1988   1989   1990   KAOPEN   Year   Figure  8:  Mean  KAOPEN  Values  for  Developed  Countries,  1970-­‐19906   The  figure  shows  the  mean  KAOPEN  values  for  a  selected  group  of  developed  countries   from  1970-­‐1990.   Source:  Author’s  calculations  based  on  World  Bank  data.    
  American   countries   towards   capital   account   restrictiveness   has   yielded   different   outcomes  for  the  countries  in  those  regions.                         7                 2.3   KAOPEN  &  FDI  Inflows;  Time-­‐Series  Data  Selection   I  examine  the  relationship  between  KAOPEN  values  and  net  FDI  inflow  volume  for   my   focus   countries   over   an   eleven-­‐year   period   centered   around   the   year   of   the   financial  crisis:  1998  for  Southeast  Asia  and  2002  for  Latin  America.    Figures  10  and   11  show  the  %  GDP  change  for  my  countries  of  focus  in  each  region  over  an  11-­‐year   period.    In  Latin  America,  the  crisis  was  deepest  in  2002  as  evidenced  by  the  GDP                                                                                                                   7  Figure  9  depicts  the  mean  KAOPEN  value  from  1970  to  1990  for  a  selected  group  of  Latin  American   and  Southeast  Asian  countries.    The  Latin  American  countries  included  are  Argentina,  Bolivia,  Chile,   Colombia,  Ecuador,  Guatemala,  Mexico,  Paraguay,  Peru,  Uruguay  &  Venezuela.    The  Southeast  Asian   countries  included  are  Cambodia,  Indonesia,  South  Korea,  Lao  PDR,  Malaysia,  Myanmar,  Philippines,   Singapore,  Thailand  &  Vietnam.    There  are  no  country-­‐specific  weightings  applied  to  KAOPEN  values.   Figure  9:  Mean  KAOPEN  Values  for  Latin  American  and  Southeast  Asian   Countries,  1970-­‐20127   This  figure  shows  the  mean  KAOPEN  value  for  Latin  American  and  Southeast  Asian  Countries   between  1970  and  2012.   0   0.1   0.2   0.3   0.4   0.5   0.6   0.7   0.8   1970   1972   1974   1976   1978   1980   1982   1984   1986   1988   1990   1992   1994   1996   1998   2000   2002   2004   2006   2008   2010   2012   KAOPEN   Year   LA  KAOPEN  values   SE  Asia  KAOPEN  Values   Source:  Author’s  calculations  based  on  World  Bank  data.  
  contraction  seen  in  figure  10.    In  Southeast  Asia,  the  crisis  was  deepest  in  1998  as   evidenced  by  the  GDP  contraction  seen  in  Figure  11.    Thus,  I  recognize  2002  as  the   start  of  the  financial  crisis  in  Latin  America  and  1998  as  the  start  of  the  financial   crisis  in  Southeast  Asia.                       8                         9                                                                                                                   8  Figure  10  shows  the  mean  annual  %  GDP  change  from  1997  to  2007  for  my  focus  countries  in  Latin   America:  Argentina,  Chile  &  Venezuela.  There  are  no  country-­‐specific  weightings  applied  to  GDP   change  values.   Figure  11:  Mean  Annual  %  GDP  Change  for  Southeast  Asian  Countries,  1993-­‐20039   This  figure  shows  the  annual  %  GDP  Change  for  my  focus  Southeast  Asian  Countries  from  1993-­‐2003.       -­‐8   -­‐6   -­‐4   -­‐2   0   2   4   6   8   10   12   1997   1998   1999   2000   2001   2002   2003   2004   2005   2006   2007   %  GDP  Change   Year   %  GDP   Figure  10:  Mean  Annual  %  GDP  Change  for  Latin  American  Countries,  1997-­‐20078   This  figure  shows  the  annual  %  GDP  Change  for  my  focus  Southeast  Asian  Countries  from  1991-­‐2001.       -­‐6   -­‐4   -­‐2   0   2   4   6   8   10   1993   1994   1995   1996   1997   1998   1999   2000   2001   2002   2003   %  GDP  Change   Year   %  GDP   Source:  Author’s  calculations  based  on  World  Bank  data.   Source:  Author’s  calculations  based  on  World  Bank  data.  
  The   KAOPEN   values   for   the   five   years   preceding   the   crisis   indicate   the   intensity  of  a  given  country’s  capital  controls  before  the  beginning  of  the  recession.     The  KAOPEN  values  in  the  years  after  the  start  of  the  crisis  reveal  if  a  given  country   responds  by  opening  or  closing  their  capital  account  and  to  what  extent.    The  FDI   inflow   levels   during   the   five   years   after   the   start   of   the   crisis   are   of   particular   interest,   because   they   show   how   effective   a   given   country’s   reactionary   capital   control  alterations  relate  to  actual  capital  flow  volume.    I  find  that  FDI  inflows  are   sensitive  to  capital  controls  imposed  in  response  to  a  crisis.   Figures  12  and  13  show  how  the  mean  KAOPEN  value  in  Latin  America  and   Southeast   Asia   changed   during   the   11-­‐year   periods   centered   around   the   year   in   which   their   respective   crises   began.     Figure   12   indicates   that   in   general,   Latin   American   countries   responded   to   the   2002   crisis   by   loosening   capital   controls.     Figure  13  shows  that  countries  in  Southeast  Asia  also  opened  their  capital  accounts,   but   less   drastically   than   Latin   American   countries.     In   2001,   one   year   before   the   start   of   2002   crisis,   the   average   KAOPEN   value   in   Latin   America   was   .655.     The   average  KAOPEN  value  in  Southeast  Asia  in  1997,  one  year  before  the  start  of  the   1998  crisis,  was  .371.    Before  the  start  of  the  crisis,  Southeast  Asian  countries  had   much  less  open  capital  accounts  than  countries  in  Latin  America.    This  is  consistent   with  the  broader  trend  of  Southeast  Asian  countries  being  more  averse  to  capital   account  liberalization  than  Latin  American  countries,  which  is  shown  in  Figure  9.                                                                                                                                                                                                                                                                                                                                                             9  Figure  11  shows  the  mean  annual  %  GDP  change  from  1992  to  2002  for  my  focus  countries  in   Southeast  Asia:  Vietnam,  Singapore,  Indonesia  &  Malaysia.    There  are  no  country-­‐specific  weightings   applied  to  GDP  change  values.  
                                    10   11       2.4   KAOPEN  &  FDI  Inflows;  Latin  America   The  Latin  American  crisis  of  2002  was  sparked  by  the  devaluation  of  the  Brazilian   real.    After  the  devaluation  of  the  real,  Argentine  export  competitive  was  damaged   because   the   Argentine   peso   was   pegged   to   the   US   dollar,   preventing   the   country   from  devaluing  in  order  to  restore  their  export  competitiveness.    What  started  out   as   a   currency   crisis   in   Argentina   turned   into   a   sovereign   debt   crisis   when   the   country’s   economy   started   contracting   because   decreased   tax   receipts   could   no   longer  finance  the  country’s  outstanding  interest  payments.    Despite  assistance  from   the  IMF,  the  market’s  confidence  in  Argentina  and  the  peso  continued  to  deteriorate.                                                                                                                     10  Figure  12  shows  the  mean  annual  KAOPEN  value  from  1997  to  2007  for  selected  countries  in  Latin   America:  Argentina,  Bolivia,  Chile,  Colombia,  Ecuador,  Guatemala,  Mexico,  Paraguay,  Peru,  Uruguay  &   Venezuela.    There  are  no  country-­‐specific  weightings  applied  to  KAOPEN  values.   11  Figure  13  shows  the  mean  annual  KAOPEN  value  from  1993  to  2003  for  selected  countries  in   Southeast  Asia:  Cambodia,  Indonesia,  South  Korea,  Lao  PDR,  Malaysia,  Myanmar,  Philippines,   Singapore,  Thailand  &  Vietnam.    There  are  no  country-­‐specific  weightings  applied  to  KAOPEN  values.     0   0.1   0.2   0.3   0.4   0.5   0.6   0.7   0.8   1997   1998   1999   2000   2001   2002   2003   2004   2005   2006   2007   KAOPEN   Year   0   0.1   0.2   0.3   0.4   0.5   0.6   0.7   0.8   1993   1994   1995   1996   1997   1998   1999   2000   2001   2002   2003   KAOPEN   Year   Figure  12:  Mean  Annual  KAOPEN  value  for   Latin  American  Countries,  1997-­‐200710   This  figure  shows  the  average  annual  KAOPEN   value  in  Latin  America  from  1997-­‐2007.   Figure  13:  Mean  Annual  KAOPEN  value  for   Southeast  Asian  Countries,  1993-­‐200311   This  figure  shows  the  average  annual  KAOPEN   value  in  Latin  America  from  1993-­‐2003.   Source:  Author’s  calculations  based  on  World  Bank  data.   Source:  Author’s  calculations  based  on  World  Bank  data.  
  Argentina  gradually  phased  out  the  peso’s  peg  to  the  dollar,  but  action  did  not  come   swiftly  enough.    The  crisis  reached  an  apex  near  the  end  of  2001,  when  confidence  in   the   peso   was   so   compromised   that   Argentina   experienced   a   bank   run.     Arellano   (2008)  notes  that  Argentina  eventually  decided  to  default  on  over  $100  billion  of   their   debt   in   December   of   2001.     This   should   have   worsened   the   situation   in   Argentina   because   a   default   would   theoretically   block   Argentina’s   access   to   international  capital  markets.    Towards  the  end  of  2002,  however,  World  Bank  data   shows  that  the  global  price  of  soy,  which  is  one  of  the  most  prominent  Argentine   exports,  soared  to  their  highest  level  since  mid-­‐2000.    Argentina  enjoyed  an  export-­‐ driven  recovery;  GDP  contracted  by  10.89%  in  2002  then  grew  by  8.84%  in  2003.       Argentina’s  economy  began  to  slow  down  in  1998  when  the  Brazilian  Real   was  devalued.    The  recession  was  by  no  means  mild;  World  Bank  data  indicates  that,   from   1998   to   2002,   the   Argentine   economy   shrank   by   over   25%.     Figure   14   indicates   that   Argentina   responded   to   the   crisis   by   increasing   capital   account   restrictiveness.     Net   FDI   inflow   volume   in   Argentina   follows   a   trend   similar   to   KAOPEN  values  in  Argentina.    Similar  year-­‐to-­‐year  relative  changes  in  KAOPEN  and   FDI   inflows   indicate   that   the   extent   of   Argentina’s   capital   controls   have   a   relationship   with   capital   flow   volume.     Although   Argentina’s   economy   began   to   recover  in  2003,  net  FDI  inflows  did  not  begin  to  increase  until  2004,  one  year  after   Argentina  began  to  reopen  their  capital  account.    This  indicates  that  FDI  inflows  are   more  responsive  to  capital  controls  than  macroeconomic  trends.                      
                                                                Figure  14:  FDI  Net  Inflows  &  KAOPEN  Values  in  Argentina,  1997-­‐2007   This  figure  shows  the  KAOPEN  values  and  FDI  net  inflow  volumes  for  Argentina  from  1997  to   2007.    FDI  Net  Inflows  are  measured  in  $US  Millions.   Figure  15:  FDI  Net  Inflows  &  KAOPEN  Values  in  Chile,  1997-­‐2007   This  figure  shows  annual  FDI  Net  Inflows  and  KAOPEN  Values  in  Chile  from  1997-­‐2007.     FDI  Net  Inflows  are  measured  in  $US  Millions.     0   0.2   0.4   0.6   0.8   1   1.2   $0.00   $2,000.00   $4,000.00   $6,000.00   $8,000.00   $10,000.00   $12,000.00   $14,000.00   1997   1998   1999   2000   2001   2002   2003   2004   2005   2006   2007   KAOPEN   FDI  Net  InHlows,  $US  MIllions   Year   FDI  Net  Inglows   KAOPEN   0   0.1   0.2   0.3   0.4   0.5   0.6   0.7   0.8   0.9   1   $0.00   $5,000.00   $10,000.00   $15,000.00   $20,000.00   $25,000.00   $30,000.00   1997   1998   1999   2000   2001   2002   2003   2004   2005   2006   2007   KAOPEN   FDI  Net  InHlows,  $US  Millions   Year   FDI  Net  Inglows   KAOPEN   Source:  Author’s  calculations  based  on  World  Bank  data.   Source:  Author’s  calculations  based  on  World  Bank  data.  
      The  2002  crisis  did  not  affect  Chile  as  much  as  it  did  Argentina.    According  to   the  World  Bank,  Chile  only  had  GDP  contraction  in  1999,  while  Argentina’s  economy   shrank  for  four  consecutive  years.    Calvo  (2005)  attributes  Chile’s  relatively  strong   performance  during  the  recession  to  the  fact  that  Chile  did  not  have  as  severe  of  a   pre-­‐crisis   currency-­‐denomination   mismatch.     Figure   15   indicates   that   Chile   responded  to  the  crisis  by  opening  their  capital  account,  which  is  the  opposite  of   what  Argentina  did.    Chile  experienced  a  drop  in  FDI  inflows  from  1999  to  2002,  but   had  a  strong  resurgence  afterwards.    Again  the  relationship  between  capital  account   restrictiveness  and  net  FDI  inflows  appears  to  be  significant,  even  in  the  case  of  a   country  that  was  not  affected  by  the  crisis  to  the  same  degree  as  Argentina.    This   enforces   the   argument   that   net   FDI   inflows   are   more   sensitive   to   towards   short-­‐ term  variations  in  capital  controls  than  macroeconomic  trends.   Venezuela   also   experienced   adverse   effects   from   the   crisis   of   2002;   their   economy  shrank  by  9%  in  2002  and  by  8%  in  2003  according  to  the  World  Bank.     Adding  to  the  economic  problems  the  country  was  facing,  political  instability  led  to  a   strike  in  December  2002.    The  strike  caused  a  crisis  in  the  Venezuelan  oil  industry,   greatly  reducing  the  country’s  crude  oil  output  for  much  of  2003.    Venezuela  started   experiencing  capital  flight  as  confidence  in  their  economy  deteriorated.    In  order  to   curb  the  capital  flight  and  prevent  further  depletion  of  foreign  reserves,  Venezuela   increased  the  intensity  of  their  capital  controls  as  indicated  in  Figure  16.    FDI  inflow   volume  rose  during  2000  and  then  steeply  declined,  coinciding  with  the  time  that   Venezuela’s   KAOPEN   value   decreased.     Even   in   the   case   of   a   country   that   experienced  a  crisis  due  to  internal  rather  than  exogenous  factors,  there  appears  to   be  a  significant  relationship  between  capital  account  restrictiveness  and  capital  flow   volume.    It  is  difficult  to  ascertain  causality;  some  of  the  FDI  inflow  reductions  are   likely  due  to  a  general  lack  of  investor  confidence  in  the  region.    It  seems  probable,   however,  that  the  heightened  capital  account  restrictions  also  played  a  part  in  the   reduction  of  FDI  inflow  volume  during  and  after  the  crisis.        
                                          2.5   KAOPEN  &  FDI  Inflows;  Southeast  Asia   The  1998  Asian  financial  crisis  began  in  Thailand,  when  the  country  was  forced  to   float  the  Thai  baht  after  large-­‐scale  currency  speculation  attacks  and  a  shortage  of   foreign  reserves  led  to  the  failure  of  their  fixed  exchange  rate  system.    Thailand’s   outstanding   debt   payments,   which   they   had   already   struggled   to   honor,   became   even  more  difficult  to  pay  back  after  the  decision  to  float  the  baht  led  to  devaluation.     Similar   to   how   Brazil’s   devaluation   impacted   Argentina’s   export   competitiveness,   Thailand’s  devaluation  reduced  the  export  competitiveness  of  other  Southeast  Asian   countries.    Trade  links  were  the  channel  for  financial  contagion  and  caused  the  Thai   crisis  spread  to  most  other  countries  in  Southeast  Asia.   Figure  16:  FDI  Net  Inflows  &  KAOPEN  Values  in  Venezuela,  1997-­‐2007   This  figure  shows  annual  FDI  Net  Inflows  and  KAOPEN  Values  in  Venezuela  from  1997-­‐2007.     FDI  Net  Inflows  are  measured  in  $US  Millions.       0   0.2   0.4   0.6   0.8   1   1.2   $0.00   $1,000.00   $2,000.00   $3,000.00   $4,000.00   $5,000.00   $6,000.00   $7,000.00   1997   1998   1999   2000   2001   2002   2003   2004   2005   2006   2007   KAOPEN   FDI  Net  InHlows,  $US  Millions   Year   FDI  Net  Inglows   KAOPEN   Source:  Author’s  calculations  based  on  World  Bank  data.  
  Vietnam   has   historically   taken   a   conservative   approach   towards   capital   flows   by   implementing   a   wide   variety   of   capital   controls.   Vietnam   was   not   as   adversely   affected  by  the  1998  Asian  financial  crisis  as  other  countries  in  the  region.    Table  1   shows  the  average  annual  %  change  in  GDP  for  selected  Southeast  Asian  countries   between   1998   and   2002,   as   well   as   the   standard   deviation   for   the   yearly   fluctuations   in   %   GDP   change.     Vietnam   averaged   the   highest   annual   GDP   in   the   region   over   the   five-­‐year   period.     Vietnam’s   propensity   to   shield   itself   from   the   international   financial   system   reduced   the   country’s   interconnectedness   with   the   rest  of  the  market,  which  is  likely  one  explanatory  factor  for  their  relatively  strong   performance   during   the   crisis   of   1998.     Vietnam   also   had   the   smallest   standard   deviation  of  their  annual  %  GDP  changes,  indicating  that  Vietnam  has  less  year-­‐to-­‐ year  variability  in  their  economic  performance.    This  is  also  likely  attributable  to   severity  of  their  capital  control  policies.   Vietnam’s  FDI  inflow  volume  between  1992  and  2002  follows  closely  with   the  country’s  KAOPEN  values  over  the  same  time  period,  as  seen  in  Figure  17.    The   figure   indicates   that   Vietnam’s   capital   controls   were   gradually   loosened   between   1992  and  1996,  which  facilitated  higher  FDI  inflow  volume.    After  1996,  however,   Vietnam  stopped  liberalizing  their  capital  account  and  even  tightened  restrictions  a   bit  in  2001.    This  coincides  with  a  reduction  in  FDI  inflow  volume.    Although  there   appears  to  be  some  relationship  between  KAOPEN  and  FDI  inflows,  it  is  likely  the   small  variation  in  FDI  inflow  volume  during  the  crisis  period  is  due  to  a  general  lack   of  confidence  in  the  outlook  of  the  regional  economy.                     Country   Average  Annual   %  GDP  Change   Standard   Deviation   of   Annual  %  GDP  Changes   Vietnam   5.97%   0.76   Philippines   2.69%   1.92   Malaysia   2.71%   6.38   South  Korea   5.16%   6.49   Thailand   1.23%   6.67   Table  1:  Average  Annual  %  GDP  Change  &  Standard  Deviation   in  Selected  Southeast  Asian  Countries,  1998-­‐2002   Source:  Author’s  calculations  based  on  World  Bank  data.  
                                          Malaysia  and  Indonesia  had  similar  pre-­‐crisis  KAOPEN  values,  as  indicated  in   Figures   18   and   19.     Both   countries   reduced   their   capital   account   openness   in   response   to   the   crisis,   with   Malaysia   implementing   capital   controls   a   bit   more   severely   than   Indonesia.     Overall,   FDI   inflow   volume   decreased   in   both   countries   over   the   ten-­‐year   period,   as   depicted   by   the   trend   lines   in   the   figures.     Although   there  is  an  overall  downward  trend  in  FDI  inflow  volume,  there  are  drastic  year-­‐to-­‐ year  FDI  variations.    One  reason  for  this  could  be  that  Malaysia  and  Indonesia  had   liberalized   capital   accounts   prior   to   the   recession   (both   countries   have   the   maximum  KAOPEN  values  in  the  early  1990’s).    Year-­‐to-­‐year  variations  in  FDI  inflow   volumes  to  Malaysia  and  Indonesia’s  are  much  greater  than  those  of  Vietnam.    Less   variation   in   Vietnam   is   likely   due   to   the   country’s   capital   account   restrictiveness.     Liberalized  pre-­‐crisis  capital  accounts  in  Malaysia  and  Indonesia  and  the  resulting   Figure  17:  FDI  Net  Inflows  &  KAOPEN  Values  in  Vietnam,  1992-­‐2002   This  figure  shows  annual  FDI  Net  Inflows  and  KAOPEN  Values  in  Vietnam  from  1992-­‐2002.     FDI  Net  Inflows  are  measured  in  $US  Millions.       0   0.05   0.1   0.15   0.2   0.25   $0.00   $500.00   $1,000.00   $1,500.00   $2,000.00   $2,500.00   $3,000.00   1993   1994   1995   1996   1997   1998   1999   2000   2001   2002   2003   KAOPEN   FDI  Net  InHlows,  $US  Millions   Year   FDI  Net  Inglows   KAOPEN   Source:  Author’s  calculations  based  on  World  Bank  data.  
  interconnectedness  with  the  international  financial  system  could  have  made  their   economies  more  susceptible  to  market  trends.    The  economies’  responsiveness  to   market  dynamics  could  be  a  primary  cause  in  the  year-­‐to-­‐year  FDI  inflow  variations   seen  in  Figures  18  and  19.                                                         Figure  18:  FDI  Net  Inflows  &  KAOPEN  Values  in  Malaysia,  1992-­‐2002   This  figure  shows  annual  FDI  Net  Inflows  and  KAOPEN  Values  in  Malaysia  from  1993-­‐2003.     FDI  Net  Inflows  are  measured  in  $US  Millions.     Figure  19:  FDI  Net  Inflows  &  KAOPEN  Values  in  Indonesia,  1992-­‐2002   This  figure  shows  annual  FDI  Net  Inflows  and  KAOPEN  Values  in  Indonesia  from  1992-­‐2002.     FDI  Net  Inflows  are  measured  in  $US  Millions.       0   0.1   0.2   0.3   0.4   0.5   0.6   0.7   0.8   $0.00   $1,000.00   $2,000.00   $3,000.00   $4,000.00   $5,000.00   $6,000.00   1993   1994   1995   1996   1997   1998   1999   2000   2001   2002   2003   KAOPEN   FDI  Net  InHlows,  $US  Millions   FDI  Net  Inglows   KAOPEN   0   0.2   0.4   0.6   0.8   1   1.2   -­‐$6,000.00   -­‐$4,000.00   -­‐$2,000.00   $0.00   $2,000.00   $4,000.00   $6,000.00   $8,000.00   1993   1994   1995   1996   1997   1998   1999   2000   2001   2002   2003   KAOPEN   FDI  Net  InHlows,  $US  Millions   Year   FDI  Net  Inglows   KAOPEN   Source:  Author’s  calculations  based  on  World  Bank  data.  
        Singapore  is  a  unique  case  in  Southeast  Asia  due  to  its  interconnectivity  with   the  global  economy  as  well  as  the  sophistication  of  their  domestic  economy.    Figure   20   compares   annual   GDP   per   capita   from   1994   to   1997   in   my   Southeast   Asian   countries   of   focus.   Singapore’s   GDP   per   capita   in   every   year   dwarfs   those   of   its   regional  counterparts.    Strong  GDP  per  capita  in  Singapore  is  a  byproduct  of  their   industrialized   economy   and   a   stable   political   environment   that   actively   promotes   domestic  business.                                         Before  the  1998  Asian  financial  crisis,  Singapore  had  the  maximum  possible   KAOPEN  value,  as  seen  in  Figure  21.    Singapore  was  not  immune  to  contagion  effects   from  neighboring  countries;  according  to  the  World  Bank,  Singapore  experienced  a   $0.00   $5,000.00   $10,000.00   $15,000.00   $20,000.00   $25,000.00   1994   1995   1996   1997   GDP  per  Capita  (Constant  2005  $US)   Year   Singapore   Vietnam   Indonesia   Malaysia   Figure  20:  Annual  GDP  per  Capita  in  Southeast  Asian  Countries  of  Focus,  1994-­‐ 1997  (Constant  2005  $US)   This  figure  shows  how  annual  GDP  per  Capita  changed  between  1994-­‐1997  in  Singapore,   Vietnam,  Indonesia  &  Malaysia.   Source:  Author’s  calculations  based  on  World  Bank  data.   Source:  Author’s  calculations  based  on  World  Bank  data.  
  GDP  contraction  of  over  2%  in  1998.    Singapore  responded  quickly  and  decisively,   allowing   their   currency   to   depreciate   against   the   US   dollar,   which   reduced   the   potential  gains  of  would-­‐be  currency  speculators.     Singapore’s  strategy  of  slightly  increasing  capital  control  restrictiveness  can   be  observed  in  Figure  21.    FDI  inflows  to  Singapore  increased  at  a  steady  rate  prior   to  the  1998  crisis,  but  similar  to  the  other  countries  in  the  region,  decreased  after   1996.    Figure  21  shows  that  Singapore’s  FDI  inflow  volume  recovered  very  quickly   after  the  crisis,  reaching  an  all-­‐time  high  in  1999.    This  type  of  FDI  inflow  resurgence   did  not  occur  in  Malaysia,  Indonesia,  or  Vietnam.    It  is  likely  that  Singapore’s  post-­‐ crisis  FDI  inflow  increases  are  partly  due  to  the  timeliness  and  effectiveness  of  the   mild  capital  controls  they  imposed  after  1996.       Another  probable  cause  of  Singapore’s  post-­‐crisis  FDI  inflow  resurgence  is   the   sophistication   and   liberalization   of   their   pre-­‐crisis   economy.     Singapore   was   already   an   industrialized,   trade-­‐centric   nation   that   had   proved   itself   as   a   viable   investment  opportunity.    Past  performance  was  likely  the  primary  reason  that  the   market’s  confidence  in  Singapore,  and  FDI  inflow  volume,  was  restored  so  quickly   after  the  crisis.    The  case  of  Singapore  seems  to  indicate  that  a  country  with  an  open   capital  account  and  a  strong  presence  in  international  financial  markets  can  respond   to  crises  by  implementing  mild  capital  controls.    After  initially  experiencing  a  drop   in   capital   flows,   a   country   with   an   open   capital   account   will   likely   enjoy   a   swift   capital  inflow  recovery.                      
                                      2.6  Formalizing  the  Relationship  Between  KAOPEN  &  FDI  Inflows   In  order  to  ascertain  the  strength  of  the  relationship  between  KAOPEN  and  net  FDI   inflow  volume  for  my  focus  countries,  I  measure  the  correlation  between  the  two   variables.    The  correlation  is  measured  during  an  eleven-­‐year  period  centered  on   the  year  that  the  respective  crises  began.    It  inevitably  takes  some  time  for  changes   in  capital  account  restrictiveness  to  reflect  in  capital  flow  volume.    I  lagged  the  FDI   variable  by  one  year  to  account  for  this  time  delay.    If  KAOPEN  is  a  robust  measure   of   capital   account   openness   and   an   effective   determinant   of   flow   volume,   there   should   be   a   positive   correlation   between   the   index   value   and   FDI   inflow   volume.     The  correlations  are  displayed  in  Table  2.       Figure  21:  FDI  Net  Inflows  &  KAOPEN  Values  in  Singapore,  1992-­‐2002   This  figure  shows  annual  FDI  Net  Inflows  and  KAOPEN  Values  in  Venezuela  from  1997-­‐2007.     FDI  Net  Inflows  are  measured  in  $US  Millions.       0   0.2   0.4   0.6   0.8   1   1.2   $0.00   $2,000.00   $4,000.00   $6,000.00   $8,000.00   $10,000.00   $12,000.00   $14,000.00   $16,000.00   $18,000.00   1993   1994   1995   1996   1997   1998   1999   2000   2001   2002   2003   KAOPEN   FDI  InHlow  Volume  ($US  Millions)   Year   FDI  Net  Inglows   KAOPEN   Source:  Author’s  calculations  based  on  World  Bank  data.  
                                  The   correlation   values   indicate   a   strong   positive   relationship   between   KAOPEN  values  and  net  FDI  inflow  volume  in  each  of  my  focus  countries  except  for   Vietnam  and  Singapore.    Vietnam  and  Singapore  are  unique  cases  because  over  the   11-­‐year   crisis   period   centered   around   1998,   both   countries   made   smaller   alterations  in  their  capital  controls  than  the  five  countries.    It  is  difficult  to  derive   meaningful  correlation  values  for  Vietnam  and  Singapore  given  the  limited  number   of   years   in   the   sample   and   the   minimal   changes   made   to   each   country’s   capital   account  during  that  time  period.    The  correlation  values  are  encouraging  because   they   strengthen   the   argument   that   there   is   an   association   between   the   two   variables.    It  is  crucial,  however,  to  acknowledge  that  the  correlation  values  in  no   way  imply  causation.         Country   Correlation   Argentina   0.526   Chile   0.420   Venezuela   0.476   Vietnam   -­‐0.257   Malaysia   0.556   Indonesia   0.745   Singapore   0.069   Table  2:  Correlations  Between  KAOPEN  Values   &  FDI  Inflow  Volume  for  Focus  Countries,  11-­‐ Year  Period  Centered  on  Start  of  Crisis   Source:  Author’s  calculations   based  on  World  Bank  data.  
  3.  Conclusion   This  paper  evaluates  the  impact  of  capital  controls  on  capital  flow  volume  during  a   financial  crisis.    In  general,  I  find  that  capital  account  restrictiveness  has  a  negative   relationship  with  capital  flow  volume,  specifically  net  FDI  inflows.    This  relationship   was  present  for  both  Latin  American  and  East  Asian  countries.    This  relationship   held   whether   or   not   a   country   increased   or   decreased   their   capital   account   restrictiveness.     The   relationship   also   held   regardless   of   a   country’s   pre-­‐crisis   economic   vulnerability.     I   observed   that   countries   with   open   pre-­‐crisis   capital   accounts   can   effectively   respond   to   a   regional   crisis   by   imposing   mild   capital   controls,  and  then  eliminating  them  after  the  worst  phase  of  the  crisis  passes.     My   findings   suggest   that   capital   account   restrictiveness   is   a   more   robust   predictor  of  FDI  inflow  volume  than  macroeconomic  variables  such  as  GDP  growth.     Lessening   capital   controls   during   a   crisis   is   more   effective   at   increasing   capital   inflow   volume   than   domestic   macroeconomic   recovery.     I   find   that   changes   in   capital  account  restrictiveness  do  not  immediately  impact  net  FDI  inflow  volume.    It   generally   takes   about   one   year   to   observe   measureable   effects   of   imposing   or   eliminating  capital  controls  on  FDI  net  inflow  volume.              
  References     Adams-­‐Kane,  Jonathon,  and  Yueqing  Jia.  "Mapping  Global  Gross  Capital  Flows   Through  2030."  (n.d.):  n.  pag.  World  Bank,  May  2013.  Web.     Ananchotikul,  Nasha,  and  Ms  Longmei  Zhang.  Portfolio  Flows,  Global  Risk  Aversion   and  Asset  Prices  in  Emerging  Markets.  No.  14-­‐156.  International  Monetary  Fund,   2014.     "AREAER  Online."  IMF  ELibrary.  IMF,  n.d.  Web.     Arellano,  Cristina.  "Default  risk  and  income  fluctuations  in  emerging   economies."  The  American  Economic  Review  (2008):  690-­‐712.     Athukoralge,  Prema-­‐chandra.  Crisis  and  recovery  in  Malaysia:  the  role  of  capital   controls.  Edward  Elgar  Publishing,  2001.     Bailliu,  Jeannine  N.  Private  capital  flows,  financial  development,  and  economic  growth   in  developing  countries.  Ottawa:  Bank  of  Canada,  2000.     Bernanke,  Ben,  and  Mark  Gertler.  Monetary  policy  and  asset  price  volatility.  No.   w7559.  National  bureau  of  economic  research,  2000.     Borensztein,  Eduardo,  Jose  De  Gregorio,  and  Jong-­‐Wha  Lee.  "How  does  foreign  direct   investment  affect  economic  growth?."  Journal  of  international  Economics  45.1   (1998):  115-­‐135.     Chamon,  Marcos,  and  Marcio  Garcia.  "Capital  controls  in  Brazil:   effective?."International  Monetary  Fund,  manuscript  (2013).    
  Chinn,  Menzie  D.,  and  Hiro  Ito.  "A  new  measure  of  financial  openness."  Journal  of   comparative  policy  analysis  10.3  (2008):  309-­‐322.     "Data  |  The  World  Bank."  Data  |  The  World  Bank.  The  World  Bank,  n.d.  Web.     Diamond,  Douglas  W.,  and  Raghuram  G.  Rajan.  Liquidity  risk,  liquidity  creation  and   financial  fragility:  A  theory  of  banking.  No.  w7430.  National  bureau  of  economic   research,  1999.     Edwards,  Sebastian.  How  effective  are  capital  controls?.  No.  w7413.  National  bureau   of  economic  research,  1999.   Eichengreen,  Barry  J.  Globalizing  capital:  a  history  of  the  international  monetary   system.  Princeton  University  Press,  1998.     Fischer,  Stanley,  and  Fonds  monétaire  international.  "Capital  Account  Liberalization   and  the  Role  of  the  IMF."  (1997).   Fontevecchia,  Agustino.  "Bernanke's  QE  Dance:  Fed  Could  Taper  In  Next  Two   Meetings,  Tightening  Would  Collapse  The  Market."  Forbes.  Forbes  Magazine,  22  May   2013.  Web.     Frankel,  Jeffrey  A.  How  well  do  foreign  exchange  markets  function:  might  a  Tobin  tax   help?.  No.  w5422.  National  Bureau  of  Economic  Research,  1996.     "Global  FDI  in  Decline  Due  to  the  Financial  Crisis,  and  a  Further  Drop  Expected."   UNCTAD  Investment  Brief  (2009):  n.  pag.  UNCTAD,  2009.  Web.     Hwang,  Soosung,  and  Mark  Salmon.  "Market  stress  and  herding."  Journal  of   Empirical  Finance  11.4  (2004):  585-­‐616.     "Just  in  Case."  The  Economist.  The  Economist  Newspaper,  12  Oct.  2013.  Web.    
  Kaminsky,  Graciela  L.,  Carmen  M.  Reinhart,  and  Carlos  A.  Végh.  "When  it  rains,  it   pours:  procyclical  capital  flows  and  macroeconomic  policies."  NBER   Macroeconomics  Annual  2004,  Volume  19.  MIT  Press,  2005.  11-­‐82.     Levy,  Haim,  and  Marshall  Sarnat.  "International  diversification  of  investment   portfolios."  The  American  Economic  Review  (1970):  668-­‐675.     Mihaljek,  Dubravko.  "The  financial  stability  implications  of  increased  capital  flows   for  emerging  market  economies."  BIS  papers  44  (2008):  11-­‐44.     Neely,  Christopher  J.  "An  introduction  to  capital  controls."  Federal  Reserve  Bank  of   St.  Louis  Review  81.November/December  1999  (1999).     Noland,  Marcus.  "South  Korea's  experience  with  international  capital  flows."Capital   Controls  and  Capital  Flows  in  Emerging  Economies:  Policies,  Practices  and   Consequences.  University  of  Chicago  Press,  2007.  481-­‐528.     Organisation  for  Economic  Co-­‐operation  and  Development.  Foreign  direct   investment  for  development:  Maximising  benefits,  minimising  costs.  OECD  Publishing,   2002.     Ostry,  Jonathan  D.,  et  al.  "Capital  inflows:  The  role  of  controls."  Revista  de  Economia   Institucional  12.23  (2010):  135-­‐164.     Portes,  Richard,  and  Helene  Rey.  "The  determinants  of  cross-­‐border  equity   flows."  Journal  of  international  Economics  65.2  (2005):  269-­‐296.     Reinhart,  Carmen,  and  Guillermo  Calvo.  "Capital  flow  reversals,  the  exchange  rate   debate,  and  dollarization."  (1999):  13-­‐15.    
  Resilience,  Towards  Human.  "Sustaining  MDG  Progress  in  an  Age  of  Economic   Uncertainty."  (2011).     Stiglitz,  Joseph  E.  "Capital  market  liberalization,  economic  growth,  and   instability."  World  development  28.6  (2000):  1075-­‐1086.     Stulz,  René  M.  "Globalization,  corporate  finance,  and  the  cost  of  capital.  "Journal  of   applied  corporate  finance  12.3  (1999):  8-­‐25.     Suchanek,  Lena,  and  Garima  Vasishtha.  "The  evolution  of  capital  flows  to  emerging-­‐ market  economies."  Bank  of  Canada  Review  2009.Winter  (2010):  19-­‐31.     "Trade  Profiles."  Trade  Profiles-­‐  China.  World  Trade  Organization,  n.d.  Web.     "Vietnam  -­‐  Foreign  Exchange  Control  Rules  for  Foreign  Direct  Investments  ."  KPMG,   n.d.  Web.        

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Final Draft

  • 1.
        International  Capital  Flows:  Remedy  or  Curse?     Keith  Mellott     Commonwealth  Honors  College   Isenberg  School  of  Management   May  4,  2015       Abstract     Capital   account   liberalization   has   increased   the   importance   and   prevalence   of   international   capital   flows.     There   is   much   debate   over   the   risks   and   benefits   of   freely  moving  capital,  especially  during  times  of  crisis  and  especially  for  developing   countries.     Capital   flow   “volatility”   is   often   blamed   for   worsening   the   effects   of   financial  crises  in  developing  countries.    In  an  attempt  to  control  the  behavior  of   capital   flows,   countries   have   implemented   different   types   of   capital   controls   to   varying  extents.    I  argue  that  capital  controls  have  a  relationship  with  capital  inflow   volume   both   during   crises   and   in   general.     Specifically,   I   determine   that   capital   account  restrictiveness  is  related  to  lower  volumes  of  capital  inflows  and  vice  versa.        
  • 2.
    1.  Literature  Review   1.1   The  Growth  of  International  Capital  Flows   International  capital  flows  are  movements  of  money  across  country  borders  for  the   purpose   of   investment,   business   activities,   or   trade.     Gross   international   capital   flows  have  increased  drastically  over  the  past  half-­‐century  as  a  result  of  a  globalized   economy,   changes   in   the   international   political   landscape,   and   advances   in   technology.    As  gross  international  capital  flows  have  grown  in  volume,  they  have   also   grown   in   importance,   especially   for   developing   countries.     The   growth   in   international   capital   flows   became   markedly   more   rapid   in   the   mid   1990’s,   and   exploded  in  the  mid  2000’s,  as  indicated  in  Figure  1.    Although  the  majority  of  the   increases  in  capital  flows  are  attributable  to  advanced  countries,  Figure  1  indicates   that  developing  countries  are  starting  to  account  for  a  bigger  portion  of  the  gross   flows.                             The   dissipation   of   the   Soviet   Union,   which   occurred   in   1991,   is   one   of   the   most   important   political   events   of   the   last   50   years.     The   collapse   of   the   USSR   Figure  1:  Global  Gross  Capital  Inflows,  Advanced  and  Developing  Countries,  1980-­‐2010   This  figure  shows  annual  changes  in  global  gross  capital  inflows  and  separates  the  flows  that  are   attributable  to  developing  and  advanced  countries.   Source:  Calculations  by  Adams-­‐Kane  &  Yueqing  Jia  (2013),  based  on  data  from  the  IMF  International   Financial  Statistics  (IFS)  database;  annual  basis.  
  • 3.
      subsequently   created   15   states,   all   of   which   represented   new   opportunity   for   international   investors.     According   to   World   Bank   data,   these   newly   formed   countries   experienced   a   period   of   economic   depression   that   lasted   until   the   mid   1990’s,  with  GDP  declining  and  poverty  increasing.    Domestic  financial  liberalization   policies   allowed   these   countries   to   attract   outside   investors,   helping   to   satisfy   domestic  needs  for  financial  capital,  savvy  management,  and  advanced  technologies.     Levels   of   foreign   direct   investment   (FDI)   to   the   post-­‐Soviet   states   are   shown   in   Figure  2.    It  is  obvious  that,  in  the  5  years  following  the  collapse  of  the  USSR,  there   was  an  upward  trend  of  FDI  flows  to  these  countries.                             1         Communism  not  only  stymied  the  economic  relationship  between  capitalist   nations   and   the   Soviet   Union.     The   influence   of   communism   had   spread   to   other   parts  of  the  globe,  such  as  Latin  America.    Once  the  Soviet  regime  collapsed,  other   countries  also  abandoned  their  communist  regimes.    Countries  such  as  Argentina,                                                                                                                   1  Figure  2  depicts  the  mean  net  FDI  inflow  volume  as  a  %  of  GDP  for  the  15  post-­‐Soviet  states:   Armenia,  Azerbaijan,  Belarus,  Estonia,  Georgia,  Kazakhstan,  Kyrgyzstan,  Latvia,  Lithuania,  Moldova,   Russia,  Tajikistan,  Turkmenistan,  Ukraine  &  Uzbekistan.    There  are  no  country-­‐specific  weightings   for  FDI  as  a  %  of  GDP.   0   0.5   1   1.5   2   2.5   3   3.5   4   1992   1993   1994   1995   1996   FDI  Net  InHlows  (%  GDP)   Year   FDI  Net  Inglows  (%  of  GDP)   Figure  2:  Net  FDI  Inflows  to  Post-­‐Soviet  States  (%  of  GDP),  1992-­‐19961   This  figure  measures  the  average  annual  net  FDI  inflow  volume  to  post-­‐Soviet  States  from   1992  to  1996.       Source:  Author’s  calculations  based  on  World  Bank  data.  
  • 4.
      Uruguay,   Chile   and   Brazil   all   instituted   democracy,   no   longer   viewing   the   democratic,  developed  countries  of  the  world  as  political  and  ideological  enemies.     These   countries   also   liberalized   their   international   trade   policies,   opening   their   borders   to   foreign   investors   and   capital.     Foreign   direct   investment   inflows   to   former  communist  Latin  America  nations  rose  quickly  throughout  the  1990’s,  which   is  evident  in  Figure  3.                             2             China’s  emergence  as  a  global  economic  power  is  another  political  factor  that   has   contributed   to   the   vast   increases   in   global   gross   capital   flows.     During   the   1980’s,   China   became   a   member   of   the   International   Monetary   Fund,   the   World   Bank,   the   Asian   Development   Bank,   and   the   General   Agreement   on   Tariffs   and                                                                                                                   2  Figure  3  depicts  the  mean  net  FDI  inflow  volume  as  a  %  of  GDP  for  selected  Latin  American   countries  with  a  history  of  domestic  communist  regimes:  Argentina,  Bolivia,  Brazil,  Chile,  Colombia,   Ecuador,  Paraguay,  Peru,  Uruguay,  Venezuela,  El  Salvador  &  Guatemala.    There  are  no  country-­‐ specific  weightings  for  FDI  as  a  %  of  GDP.   Figure  3:  Net  FDI  Inflows  to  Selected  Latin  American  Countries  (%  GDP),  1990-­‐19982   This  figure  illustrates  the  annual  changes  in  Net  FDI  inflows  to  Latin  American  countries  with  a   history  of  domestic  communist  regimes  from  1990-­‐1998.   0   0.5   1   1.5   2   2.5   3   3.5   4   4.5   5   1990   1991   1992   1993   1994   1995   1996   1997   1998   FDI  Net  InHlows  (%  GDP)   Year   FDI  Net  Inglows  (%  GDP)   Source:  Author’s  calculations  based  on  World  Bank  Data.  
  • 5.
      Trade.     China   also   retooled   their   international   trade   policies,   becoming   more   receptive   to   foreign   sources   of   capital   and   even   allowing   foreign   banks   to   open   branches  within  the  country.    The  Chinese  government  implemented  policies  that   incentivized  foreign  investment,  a  stark  contrast  from  the  policies  that  were  in  place   prior   to   the   1980’s,   when   China   was   still   influenced   by   the   ideologies   of   Mao   Zedong’s  regime.    The  economic  changes  instituted  in  China  had  their  desired  effect.     According   to   data   from   the   World   Trade   Organization,   Chinese   trade   totaled   US   $27.7   billion   in   1979,   which   accounted   for   0.7%   of   worldwide   trade.     By   1985,   Chinese  trade  totaled  US  $70.8  billion,  which  accounted  for  2%  of  worldwide  trade.         Technological  advances  in  the  financial  industry  have  also  contributed  to  the   increase   in   global   gross   capital   flows.     New   computing   capabilities   have   enabled   financial  firms  to  cost-­‐effectively  create  index  funds  composed  of  assets  in  foreign   countries.     These   indices   have   reduced   the   necessary   amount   of   capital   to   invest   abroad,  making  it  feasible  for  individual  investors  to  include  foreign  assets  in  their   portfolios.    Developing  countries  have  experienced  the  largest  relative  increase  in   portfolio  inflows.      Mihaljek  (2008)  measured  changes  in  portfolio  flow  volume  to   emerging  market  economies  over  time.      2005,  global  portfolio  flows  to  emerging   market  economies  totaled  US  $127  billion.    By  2007,  this  number  had  increased  to   US  $432  billion.         1.2   Types  of  International  Capital  Flows   International  capital  flows  can  take  on  a  variety  of  forms,  one  of  which  is  foreign   direct  investment  (FDI).    FDI  is  defined  as  a  party  buying  controlling  ownership  in  a   business  enterprise  in  a  country  other  than  their  own.    The  IMF  defines  “controlling   ownership”  as  an  investment  that  equates  to  10%  or  more  of  voting  stock.    FDI  is   differentiated  from  other  types  of  capital  flows  because  it  generally  implies  that  the   investor  has  long-­‐term  confidence  in  both  the  investment  and  the  economic  outlook   of  the  country  where  the  capital  is  being  invested.    FDI  sometimes  brings  benefits  to   the  host  country  aside  from  the  capital  itself.    The  foreign  investor  often  provides   technology,   infrastructure,   and   managerial   skills   in   order   to   operate   the   business  
  • 6.
      venture   to   their   liking.     A   2002   report   from   the   Organization   for   Economic   Cooperation   and   Development   addressed   the   benefits   of   FDI.     “FDI   triggers   technology  spillovers,  assists  human  capital  formation,  contributes  to  international   trade   integration,   helps   create   a   more   competitive   business   environment   and   enhances   enterprise   development.     All   of   these   contribute   to   higher   economic   growth,  which  is  the  most  potent  tool  for  poverty  alleviation.”   As   with   the   other   types   of   capital   flows,   the   level   of   global   FDI   flows   has   grown  considerably  over  the  past  two  decades.    The  levels  of  net  global  FDI  inflows   from   1980   to   20012   are   depicted   in   Figure   4.     Global   net   FDI   inflow   volume   increased   rapidly   starting   in   the   early   1990’s   and   the   upward   trend   has   been   consistent   throughout   time.         The   figure   shows   decreases   in   global   FDI   inflow   volume  in  2000  and  2007,  which  are  attributable  to  global  crises  that  had  a  negative   impact  on  investor  confidence.                                       Figure  4:  Global  FDI  Net  Inflow  Volume  ($US  Millions),  1980-­‐2012   This  figure  shows  annual  changes  in  global  FDI  Net  inflow  Volume  between  1980-­‐2012.   -­‐$500,000.00   $0.00   $500,000.00   $1,000,000.00   $1,500,000.00   $2,000,000.00   $2,500,000.00   $3,000,000.00   Global  FDI  Net  InHlow  Volume  ($US  Millions)   Year   FDI  Net  Inglows   Source:  Author’s  calculations  based  on  World  Bank  data.    There  are  no  country-­‐specific  weightings  for   KAOPEN  values.  
  • 7.
      A  2009  United  Nations  Conference  on  Trade  and  Development  report  noted   that  FDI  inflow  volume  to  developing  countries  has  grown  at  a  faster  rate  than  FDI   inflow  volume  to  developed  countries.    Prior  to  the  1990’s,  global  outward  FDI  from   developing  economies  was  very  minimal.    Over  the  past  20  years  however,  global   outward  FDI  from  developing  economies  has  grown  significantly  in  both  nominal   terms  and  relative  to  the  global  outward  FDI  from  developed  countries.    The  most   important  determinant  of  a  country’s  outward  FDI  level  is  economic  growth,  which   dictates  the  demand  side  of  investment  and  the  demand  for  goods  and  services  from   foreign   countries.     As   developing   economies   continue   to   grow,   their   demand   for   investment  and  foreign  goods  and  services  will  increase  and  their  levels  of  outward   FDI  are  expected  to  do  the  same.   Foreign   portfolio   investment   (FPI),   a   financial   transaction   in   which   an   individual  or  institution  purchases  foreign  bonds  or  equity,  is  another  type  of  capital   flow.    Portfolio  flows  are  more  liquid  than  FDI  flows,  as  they  can  be  transferred  to   other  parties  more  easily.    Portfolio  flows  are  generally  regarded  as  more  volatile   than  FDI  flows  and  liquidity  is  one  of  the  primary  reasons  for  this.    Another  reason   for  this  volatility  is  herding  behavior  in  financial  markets,  which  is  the  tendency  of   asset  managers  to  follow  the  behavior  of  other  asset  managers,  causing  them  to  take   action  in  ways  that  they  independently  would  not.    Hwang  &  Salmon  (2004)  find   that  herding  towards  the  market  is  significant,  both  when  the  market  is  falling  and   rising.     Another   reason   for   portfolio   flow   volatility   is   asymmetric   information   between  financial  markets.    Portes  &  Rey  (2005)  find  that  inter-­‐country  differences   in  informational  wealth,  proxied  by  variables  such  as  telephone  traffic  and  amount   of   bank   branches,   had   significant   effects   on   the   behavior   of   cross-­‐border   equity   flows.    Informational  advantages  incentivize  the  international  movement  of  capital   as  information  bearers  seize  opportunities  to  profit.   Figure  5  shows  how  global  FDI  and  portfolio  flows  have  changed  in  volume   between   1995   and   2009.     The   figure   indicates   that,   after   peaking   around   1997,   portfolio   flows   declined   until   around   2002.     A   2002   UNDP   Report   attributes   this   decrease  to  the  Asian  financial  crisis,  which  made  asset  managers  wary  of  investing   in   foreign   equities   and   bonds.     Portfolio   flows   had   an   even   more   pronounced  
  • 8.
      reversal   in   response   to   the   2008   financial   crisis,   dropping   precipitously   before   rebounding   in   2009.     The   figure   indicates   that   FDI   flows   reversed   one   year   after   portfolio  flows.    This  reflects  the  difference  in  liquidity  between  the  two  types  of   flows.     When   the   crisis   began   in   2008,   asset   managers   could   immediately   sell   off   their  portfolio  investments,  whereas  investors  had  to  remain  committed  to  their  FDI   flows  in  the  short-­‐term.                                           Ananchotikul   &   Zhang   (2014)   discovered   that   portfolio   flows   to   emerging   markets  have  grown  in  volume  and  volatility  since  2003.    The  authors  found  that   portfolio  flows  to  emerging  markets  are  very  responsive  to  market  trends,  such  as   monetary  policies  in  advanced  economies  and  global  aversion  to  risk.    The  authors’   calculations  indicated  that  there  is  statistically  significant  correlation  between  the   behavior  of  portfolio  flows  to  emerging  markets  and  asset  prices  in  those  markets,   specifically   stock   market   indices,   10-­‐year   government   bond   yields   and   exchange   Figure  5:  Composition  of  Private  Capital  Flows,  1995-­‐2009  (US$  billions)   This  figure  measures  annual  changes  in  global  portfolio  investment  flows  and  FDI  flows   between  1995  and  2009.   Source:  Calculated  for  2002  UNDP  Report,  based  on  data  from  World  Bank,  Global  Finance  for   Development,  and  IMF,  Balance  of  Payment  Statistics  2009.  
  • 9.
      rates.    During  times  of  portfolio  outflows  from  emerging  markets,  there  also  were   drops   in   the   value   of   stock   market   indices   and   increases   in   10-­‐year   government   bond  yields.    Periods  of  portfolio  outflows  from  emerging  market  economies  also   were  concurrent  with  depreciation  in  those  markets.    The  authors  concluded  that   portfolio   flows   are   generally   more   volatile   than   other   types   of   capital   flows,   but   especially  so  during  times  of  financial  recession.    The  measured  effect  of  portfolio   flows  on  asset  prices  during  a  recession  was  5-­‐10  times  greater  than  the  magnitude   during  non-­‐recessionary  time  periods.   The  United  Nations  Development  Programme  published  a  report  in  2001  on   Millenial  Development  Goals,  acknowledging  the  risks  that  emerging  markets  face  as   a  result  of  portfolio  flow  volatility.    “The  consequences  of  such  volatility  for  growth   are   obvious,   especially   in   countries   highly   reliant   on   such   flows   for   investment.     When   investment   sources   are   unpredictable   and   volatile,   so   is   growth.     This   is   especially  the  case  for  the  smaller,  lower-­‐income  countries  where  many  FDI  projects   are  huge  in  relation  to  the  size  of  the  host  economy  and  because  these  countries   tend  to  be  much  less  diversified  and  depend  on  one  or  two  large  projects  or  sectors.”     Private  loans  are  another  type  of  capital  flow.    They  consist  of  every  type  of   bank   loan   as   well   as   loans   from   other   sectors,   such   as   trade   financing   loans,   mortgages   and   repurchase   agreements.     Private   loans   are   often   divided   into   two   categories:  short-­‐term  and  long-­‐term.    The  likelihood  of  short-­‐term  debt  to  expose   countries  to  risk  of  crisis  is  contested  in  economic  literature.    Stiglitz  (2000)  argues   that,  by  liberalizing  the  short-­‐term  capital  account,  a  country  opens  itself  to  the  risk   of   capital   flight,   which   occurs   when   assets   quickly   flow   out   of   a   country.     Capital   flight  decreases  the  level  of  domestic  wealth  and  is  almost  always  associated  with   depreciation   of   the   domestic   currency.     Diamond   &   Rajan   (2001)   assert   that   structural  flaws  are  to  blame  for  countries  being  exposed  to  such  risks.    “Short-­‐term   debt   mirrors   the   nature   of   the   investment   being   financed   and   the   institutional   environment   that   enables   investors   to   enforce   repayment.     It   is   no   surprise   that   illiquid  or  poor  quality  investment  when  a  bank  or  banking  system  is  close  to  its   debt  capacity  will  result  in  a  buildup  of  short-­‐term  debt.    The  higher  likelihood  of   crisis  stems,  not  from  the  short-­‐term  debt,  but  from  the  illiquidity  and  potentially  
  • 10.
      low   creditworthiness   of   the   investment   being   financed.”     Conventional   economic   wisdom  dictates  that  countries,  especially  those  with  developing  economies,  should   be   wary   of   short-­‐term   loan   flows   because   they   are   more   liquid   and   volatile   than   long-­‐term  loan  flows.     1.3   Benefits  of  Capital  Flows  &  Recessionary  Trends   One   feature   of   the   globalized   economy   is   an   integrated   international   financial   market.    An  interconnected  financial  system  facilitates  the  uninhibited  movement  of   capital  across  countries.    In  theory,  international  financial  integration  should  allow   for  capital  to  be  allocated  in  the  most  efficient  ways.    Fischer  (1997)  elaborated  on   these  benefits.    “Free  capital  movements  facilitate  a  more  efficient  global  allocation   of   savings,   and   help   channel   resources   into   their   most   productive   uses,   thus   increasing   economic   growth   and   welfare.”     Bailliu   (2000)   agrees   with   Fischer’s   assertion   that   freely   moving   capital   does   indeed   have   the   potential   to   maximize   economic   growth   and   welfare,   but   argues   that,   in   developing   countries,   freely   moving  capital  can  only  maximize  economic  benefits  if  the  domestic  banking  sector   has  achieved  a  minimum  level  of  development  and  sophistication.    Bailliu  (2000)   suggested   that   there   are   three   ways   capital   flows   can   foster   domestic   growth:   increasing  domestic  investment  rates,  facilitating  investments  from  foreign  agents   with   positive   spillover   effects   (such   as   technology   transfers),   and   increasing   domestic  financial  intermediation.   Fischer  (1997)  points  out  that  free  capital  movement  benefits  capital-­‐seeking   agents   because   institutions,   firms   and   individual   investors   have   access   to   ever-­‐ increasing  sources  of  capital.    The  author  notes  that  foreign  capital  markets  have   grown  substantially  in  terms  of  the  volume  of  funds  being  distributed  on  an  annual   basis.     Enhanced   capital   access   can   also   reduce   the   cost   of   capital.     International   sources   of   capital   are   oftentimes   cheaper   than   those   available   in   the   domestic   market.     Stulz   (2005)   discovered   that   the   largest   reductions   in   capital   cost   are   enjoyed   by   developing   countries   that   are   gaining   access   to   international   capital   markets   for   the   first   time.     He   determined   that   developed   countries   with   a  
  • 11.
      longstanding   presence   in   the   international   financial   market   can   also   reduce   their   capital  costs,  but  to  a  lesser  extent.     International  capital  account  liberalization  has  not  only  benefitted  recipients   of  capital,  but  also  distributors  of  capital.    The  interconnected  financial  system  has   created   new   opportunities   for   investors   to   diversify   their   portfolios   and   achieve   higher   returns.     Levey   and   Sarnat   (1970)   found   that   investment   portfolios   can   achieve   “material   improvements”   in   risk   reduction   by   diversifying   their   holdings,   specifically  by  purchasing  equities  in  developing  countries  to  complement  holdings   in  developed  countries.   As   Bailliu   (2000)   noted,   another   benefit   of   international   capital   flow   liberalization   is   the   transfer   of   technology,   infrastructure,   and   intellectual   capital   that  often  comes  with  FDI.    Acknowledging  that  multinational  corporations  account   for   a   large   portion   of   global   research   and   development   investment,   Borensztein,   Gregorio  &  Lee  (1998)  found  that  FDI  is  important  for  the  international  transfer  of   technology   and,   in   developing   countries,   leads   to   more   growth   than   domestic   investment   as   long   as   the   host   country’s   infrastructure   is   advanced   enough   to   absorb  the  technology  spillovers.   Despite   their   benefits,   freely   moving   international   capital   flows   have   not   always  created  positive  outcomes  for  emerging  market  economies.    One  of  the  most   important  drawbacks  of  capital  flows  is  the  pattern  of  reversals  in  periods  of  crises.     Capital  flight  occurs  when  a  large  volume  of  capital  flows  out  of  a  country.    Capital   flight  is  almost  always  a  symptom,  rather  than  a  cause,  of  a  financial  crisis.    Capital   flight  was  present  in  the  global  recession  of  2008.    Total  net  private  capital  flows   had  reached  a  historic  high  of  US  $1.2  trillion  in  2007,  only  to  fall  to  US  $649  billion   in  2008.    According  to  Suchanek  &  Vasishtha  (2009),  they  fell  even  further  in  2009,   to  US  $435  billion.    This  affirms  the  findings  of  Kaminsky,  Reinhart,  &  Vegh  (2005).   The  authors  calculated  that,  for  all  groups  of  countries,  capital  flows  are  pro-­‐cyclical,   with  higher  inflows  during  periods  of  growth  and  lower  inflows  during  periods  of   crisis.     Capital   flow   reversals   during   a   recession   can   worsen   a   crisis,   especially   in   emerging   market   economies.     Calvo   &   Reinhart   (1999)   discovered   that   during   a  
  • 12.
      crisis,   developing   countries   often   experience   decreased   access   to   sources   of   international  capital,  which  makes  recovery  more  difficult.    They  point  out  that  a   country  hoping  to  enact  expansionary  policies  to  recover  from  recession  will  find   this   increasingly   difficult   as   their   sources   of   international   capital   disappear.     Not   only  does  capital  decrease  in  availability,  but  it  also  increases  in  cost.       Bernanke   (2000)   discovered   that   reduced   access   and   increased   cost   of   capital   discourages   investment,   contributing   to   reduced   aggregate   demand   and   decreased  output  during  a  crisis.    During  recessions,  there  is  heightened  uncertainty   in  the  domestic  economy  and,  from  the  perspective  of  a  foreign  loaner,  risk.    Banks   become   reluctant   to   lend   as   liberally   as   they   did   during   the   pre-­‐crisis   period.     Bernanke   (2000)   discovered   that   banks’   unwillingness   to   lend   during   crises   has   gotten   more   severe   over   time.   Cyclical   decreases   in   bank   loans   contribute   to   decreases  in  private  loan  flows  during  a  recession.    Countries  cannot  expect  private   loan   flows   to   be   as   abundant   during   a   crisis   as   they   are   in   a   stabile   economic   environment.    Decreased  loan  flows  indicate  that  firms  are  not  undertaking  as  many   investment   projects   during   a   recession,   which   makes   it   difficult   to   recover   via   economic  growth  and  expansion.   Capital  flight  is  not  always  caused  by  a  financial  crisis  within  the  domestic   economy.     Capital   flow   reversals   can   also   be   triggered   by   exogenous   factors.     If   investment  opportunities  with  higher  returns  and  less  risk  are  available  in  foreign   entities,   investors   have   an   incentive   to   remove   their   money   from   the   domestic   economy   and   reallocate   it   to   the   more   attractive   investment.     When   this   occurs,   investors  demand  repayment  and  the  domestic  country  will  face  high  volumes  of   capital  outflows,  which  it  can  respond  to  in  two  ways.    First,  the  country  can  raise   the  domestic  interest  rate,  which  reduces  or  eliminates  the  opportunity  cost  that  the   investor  incurs  by  keeping  his  or  her  money  in  the  domestic  country.    This  will  be   effective   in   reducing   capital   outflows,   but   it   also   discourages   investment   because   interest   rate   hikes   increase   the   cost   of   borrowing.     Decreased   investment   contributes  to  a  growth  stall,  exasperating  the  effects  of  a  recession.    If  the  country   does  not  wish  to  raise  the  domestic  interest  rate,  it  can  opt  to  repay  the  investors.    
  • 13.
      Since  many  foreign  investments  are  denominated  in  foreign  currency,  the  domestic   country  has  to  deplete  their  foreign  reserves  to  meet  their  repayment  obligations.       In  extreme  cases,  depleted  foreign  reserves  can  lead  a  country  to  insolvency.     According  to  World  Bank  data,  in  2008,  when  the  global  financial  crisis  was  starting   to  reach  its  apex,  Brazil  had  foreign  exchange  reserves  of  $205.5  billion,  which  was   12.9%  of  their  GDP.    According  to  The  Economist3,  these  foreign  reserves  gave  Brazil   the  ability  to  intervene  in  foreign  exchange  markets  and  stabilize  the  Brazilian  real.     They  also  were  able  to  provide  foreign  exchange  swaps  for  Brazilian  corporations   that   were   struggling   to   pay   back   US   dollar-­‐denominated   debt.     If   Brazil   hadn’t   possessed  substantial  pre-­‐crisis  amounts  of  foreign  reserves,  they  would  have  been   less   able   to   pay   back   their   short-­‐term   debts,   which   could   have   led   them   towards   insolvency.        Capital   flow   reversals   can   also   be   caused   by   the   exogenous   factor   of   quantitative  easing  (QE).    QE  is  the  process  of  a  central  bank  buying  securities  from   the  market  to  lower  global  interest  rates  and  increase  the  money  supply,  with  the   goals  of  promoting  more  lending  and  increasing  liquidity.    QE  is  most  effective  when   it   is   conducted   by   an   economy   of   large   scale,   such   as   that   of   the   US.     During   quantitative   easing,   countries   ideally   use   the   money   they   receive   from   selling   domestic  securities  in  ways  that  stimulate  growth  in  the  domestic  economy.    This   theoretically  increases  investor  confidence  in  the  domestic  economy,  promoting  a   resurgence  of  international  trade  and  investment.       In   response   to   the   2008   financial   crisis,   the   Federal   Reserve   instituted   aggressive  QE  policies,  eventually  purchasing  trillions  of  dollars  of  securities.    QE   creates  a  risk  of  capital  flow  reversals  when  the  policies  are  eventually  phased  out,   or   tapered.     In   May   2013,   Ben   Bernanke,   the   former   Chairman   of   the   Federal   Reserve,  provided  a  glimpse  of  the  chaos  that  can  ensue  when  quantitative  easing   policies  are  tapered.    According  an  article  published  by  Forbes4,  Bernanke  sparked                                                                                                                   3  The  article  Just  in  Case  was  authored  by  multiple  writers  for  The  Economist  and  was  electronically   published  on  October  12,  2013.   4  The  article  Bernanke’s  QE  Dance:  Fed  Could  Taper  in  Next  Two  Meetings,  Tightening  Would  Collapse   the  Market  was  electronically  published  on  May  22,  2013.    The  article  was  authored  by  Agustino   Fontevecchia.  
  • 14.
      wild  swings  in  the  market  when  he  hinted  at  the  possibility  of  tapering  QE  in  the   near  future.    The  Dow  Jones  Industrial  Average,  a  stock  market  index  composed  of   30  large  publically  owned  American  companies,  increased  and  decreased  by  over   100   points   at   various   points   throughout   Bernanke’s   speech.     It   is   inevitable   that   quantitative  easing  will  eventually  be  phased  out  and,  to  some  extent,  investors  will   probably   respond   by   withdrawing   their   capital   from   developing   countries.     The   degree  to  which  investors  respond  to  QE  tapering  by  withdrawing  their  capital  from   developing   countries   will   determine   how   severely   economic   growth   in   emerging   markets  will  be  hindered.       1.4   Capital  Controls:  History  &  Types     Most,   if   not   all,   of   countries   institute   at   least   some   capital   controls,   which   are   domestic   policies   that   regulate   flows   to   and   from   capital   markets.   Throughout   history,   capital   controls   have   been   used   for   varying   purposes   and   to   different   extents.     Eichengreen   (2008)   explains   that   capital   controls   initially   gained   popularity  in  mainstream  economics  during  the  time  period  between  World  War  I   and  World  War  II.    The  purpose  of  capital  controls  at  this  point  in  time  was  to  allow   countries  to  rebuild  their  economy  during  the  post-­‐World  War  I  period  without  the   fear  of  capital  flight.    Eichengreen  (2008)  mentions  that  during  the  three  decades   after  World  War  II,  capital  controls  became  less  prevalent  and  international  capital   flows   reached   record   highs.     Industrial   nations   led   the   way   in   liberalizing   international  capital  flow  policies,  while  encouraging  developing  countries  to  do  the   same.       Post-­‐World   War   II   financial   crises   started   to   highlight   the   risks   of   freely   moving   capital,   especially   in   developing   countries.     Economists   and   governments   have  tried  to  better  their  understanding  of  capital  flow  behavior  and  how  capital   controls   can   be   instituted   to   mitigate   the   risks   of   capital   volatility   during   crises.     (Chamon   &   Garcia,   2014)   examine   the   ways   that   Brazil   used   capital   controls   to   respond   to   the   2008   crisis.     Brazil   was   the   one   of   the   most   aggressive   emerging  
  • 15.
      markets  in  terms  of  their  reactionary  capital  control  policies.    Beginning  in  2009,  the   Brazilian   government   imposed   controls   such   as   portfolio   flow   taxes,   loan   flows   taxes,   currency   exchange   taxes,   and   increased   reserve   requirements   for   domestic   banks.    The  authors  discovered  that  capital  controls  increased  the  price  of  Brazilian   assets   and,   to   a   certain   extent,   isolated   the   Brazilian   financial   market   from   the   international  financial  market.    The  authors  also  concluded  that  the  capital  controls   as   a   whole   successfully   contained   the   appreciation   of   the   real   (the   domestic   Brazilian  currency).    The  Brazilian  government  began  relaxing  their  capital  controls   in  2011.    The  authors  infer  that  the  controls  allowed  Brazil  to  avoid  a  bubble  and   out-­‐of-­‐control  domestic  credit  levels.    The  downside  of  the  capital  controls  was  the   reduced  access  to  foreign  financing,  possibly  contributing  to  the  low  investment  and   growth  performance  during  the  post-­‐crisis  period.    Brazil  is  but  one  example  of  a   country   that   has   had   success   with   capital   control   policies   during   a   crisis.     These   success   stories   have   caused   many   economists   believe   that   capital   controls   are   a   legitimate  way  to  shield  countries  from  some  of  the  effects  of  recessions.     There   are   a   wide   variety   of   capital   controls   that   can   be   instituted   by   a   country.    Capital  controls  can  target  short-­‐term  investments,  long-­‐term  investments,   or  both.    Wary  of  the  risks  that  come  with  the  volatility  of  short-­‐term  capital  flows,   some   countries   impose   capital   controls   with   the   goal   of   attracting   investment   projects   that   necessitate   long-­‐term   commitment   from   investors.     In   Vietnam,   the   government  requires  as  a  precondition  that  foreign  investors  set  up  a  Vietnamese   capital  bank  account,  which  enables  the  tracking  of  flows  in  and  out  of  the  country.     Also,  the  Vietnamese  government  requires  that  foreign  investors  fulfill  all  financial   obligations  to  the  State  of  Vietnam  before  distributing  any  profits  (KPMG).    Ostry,   Ghosh,  Habermeier,  Chamon,  Qureshi  &  Reinhardt  (2010)  provide  another  example   of  capital  controls  that  target  short-­‐term  flows.    From  2006-­‐2008,  Thailand  imposed   an   unremunerated   reserve   requirement   on   any   foreign   currencies   sold   or   exchanged  against  the  domestic  baht.    The  requirement  was  30%  and  was  effective   in  reducing  the  volume  of  net  flows  as  well  as  altering  the  composition  of  inflows   (there  was  a  greater  percentage  of  foreign  direct  investment  inflows  and  a  lower   percentage  of  short-­‐term  flows).  
  • 16.
      Some  capital  controls  that  target  long-­‐term  capital  flows  are  due  to  domestic   aversion  to  foreign  ownership  of  domestic  assets.    In  Mexico,  for  example,  Article  27   of   the   constitution   limits   foreign   investment   in   domestic   real   estate   and   natural   resources.    Neely  (1999)  explains  that  this  is  a  protective  measure  Mexico  has  taken   to   prevent   foreign   companies   from   exploiting   Mexican   resources   for   short-­‐term   profits,  which  is  has  frequently  occurred  in  the  history  of  Mexico.    Another  reason  a   country   might   impose   capital   controls   specific   to   long-­‐term   flows   is   because   of   a   general  aversion  to  the  risks  of  taking  part  in  international  financial  markets.    South   Korea,   for   example,   restricted   long-­‐term   foreign   investment   inflows   before   they   radically  reformed  their  capital  account  starting  in  the  late  1990s.    Noland  (2007)   attributes  South  Korea’s  restrictions  on  FDI  inflows  to  the  country’s  unwillingness   to   have   the   foundation   of   their   economy   be   contingent   on   foreign   capital   and   uncontrollable   macroeconomic   factors.     South   Korea   is   exemplary   of   an   economy   that  rapidly  developed  without  relying  on  FDI  inflows.    The  country  instead  relied   on  technology  licensing  and  international  loans  to  spur  growth.     Capital   controls   can   also   be   categorized   by   whether   or   not   they   restrict   capital   account   transactions   via   price   mechanisms   or   quantity   controls.     Price   controls   usually   manifest   themselves   in   the   form   of   taxes.     A   popular   price   mechanism   is   the   “Tobin”   tax,   which   was   first   introduced   in   1972.     Tobin   taxes   impose  a  small  percentage  tax  on  all  foreign  exchange  transactions.    Frankel  (1996)   explains   that   the   purpose   of   the   Tobin   tax   was   to   reduce   the   incentive   to   switch   investment  positions  in  the  short-­‐term  in  the  foreign  exchange  market,  which  would   mitigate   market   volatility.     Another   price-­‐based   capital   control   is   the   mandatory   reserve   requirement,   which   requires   foreign   investors   to   deposit   a   percentage   of   their   investment   with   the   central   bank   (earning   no   interest).     Mandatory   reserve   requirements   are   meant   to   build   the   foreign   reserves   of   the   central   bank.     Chile   implemented   such   a   policy   from   1991   to   1998,   specifically   targeting   short-­‐term   inflows.     In   the   context   of   Chile,   their   mandatory   reserve   requirement   essentially   functioned  as  a  tax  on  short-­‐term  inflows.    Stiglitz  (2000)  praised  Chile’s  mandatory   reserve  requirement  because  it  reduced  the  volatility  of  short-­‐term  inflows  without   compromising  long-­‐term,  growth-­‐fostering  inflows  such  as  FDI.  
  • 17.
        Quantity-­‐based  capital  controls  can  take  the  form  of  policies  that  set  a  ceiling   for  borrowing  from  foreign  residents.    According  to  Athukoralge  (2001),  Malaysia   set   such   ceilings   in   response   to   the   1998   Asian   crisis,   limiting   foreign   currency   borrowings   by   residents   and   domestic   borrowing   by   non-­‐residents.     Malaysia   implemented  another  quantity-­‐based  control  by  setting  a  ceiling  on  banks/  external   liabilities  not  related  to  trade  or  investment.    Other  times,  countries  may  require   that   governmental   approval   be   granted   before   transactions   are   made   on   certain   types  of  assets.    The  case  of  South  Korea  prohibiting  nearly  all  long-­‐term  flows  is   one  example  of  this  type  of  quantity-­‐based  control.    
  • 18.
      2.  Data   2.1   Quantifying  Capital  Account  Restrictiveness   Due   to   the   variety   and   complexity   of   capital   controls,   quantifying   capital   account   openness   is   a   burdensome   task.     Different   countries   at   different   points   in   time   decide  to  impose  different  mixes  of  capital  controls.    Given  the  variety  of  available   capital  controls,  each  mix  tends  to  be  unique.    It  is  therefore  important  to  have  a   standard  measure  of  capital  control  restrictiveness.       Many   capital   account   openness   indices   have   been   constructed   using   the   IMF’s   Annual   Report   on   Exchange   Arrangements   and   Exchange   Restrictions   (AREAER).      The  AREAER  is  a  database  of  binary  variables  that  contains  information   about  the  types  of  capital  controls  are  employed  by  the  187  IMF  member  countries.       The  variables  in  the  AREAER  include  a  wide  variety  of  capital  controls,  such   as  restrictions  on  international  payments  and  transfers,  arrangements  for  payments   and   receipts,   regulations   on   residents’   and   nonresidents’   accounts,   exchange   rate   systems,  financial  sector  policies,  and  foreign  exchange  market  operations.    A  binary   variable   with   the   value   of   1   indicates   that   a   country   has   instituted   the   particular   capital  control  and  0  otherwise.     The  AREAR  is  effective  in  distinguishing  between  de  jure  and  de  facto  capital   controls.     De   jure   capital   controls   are   legally   instituted   policies.     De   facto   capital   controls   relate   to   how   robustly   the   controls   are   implemented,   and   how   effective   they  are  in  serving  their  purpose.    De  facto  capital  controls  are  harder  to  quantify   than  de  jure  capital  controls,  but  they  depict  reality  more  accurately,  which  makes   them  more  valuable  for  practical  perspective.   There  are  various  issues  that  arise  when  measuring  capital  account  openness   with  the  binary  variables  contained  in  the  AREAER.    Binary  measurements  indicate   whether   or   not   a   country   has   instituted   a   given   capital   control,   but   provide   no   information  on  the  degree  to  which  it  has  been  implemented.    Therefore,  there  is  no   way  to  measure  differences  in  intensity  of  a  given  capital  control  between  countries.     Another   issue   with   the   variables   in   the   AREAER   is   that   they   are   broadly   defined,   preventing   them   from   capturing   certain   details   and   distinguishing   features   of  
  • 19.
      capital   controls.     Some   of   the   problems   associated   with   a   lack   of   capital   control   specificity  were  addressed  in  1997,  when  the  IMF  revised  the  classification  of  the   variables   in   the   AREAER.     The   new   variable   categorizations   now   account   for   distinctions  between  restrictions  on  inflows  and  outflows  as  well  as  the  differences   between   different   types   of   capital   transactions.     However,   it   is   doubtful   that   any   categorization   of   the   variables   in   the   AREAR,   no   matter   how   specific,   could   ever   perfectly  encapsulate  the  complexity  and  variety  of  capital  controls.   Using   the   information   from   the   AREAER,   Chinn   and   Ito   (2008)   created   a   capital  account  openness  index  called  KAOPEN.    The  authors  reversed  the  values  of   the  binary  variables  in  the  AREAER  in  order  to  construct  KAOPEN  in  a  way  that  has   higher   index   values   corresponding   to   less   restrictive   current   account   policies.     Selected   binary   variables   in   the   AREAER   are   weighted   and   aggregated   into   individual   index   values   for   each   IMF   member   country.     The   aggregated   index   measurements   assume   values   between   0   to   1,   with   0   representing   complete   restriction   and   1   representing   complete   openness.     KAOPEN  values   are   measured   annually,  with  1970  being  the  earliest  year  that  data  is  available  for.     KAOPEN  is  the  most  appropriate  capital  account  openness  index  to  use  in  this   study   for   two   reasons.   KAOPEN   is   constructed   so   as   to   focus   on   de   jure   capital   controls,  making  it  effective  in  measuring  the  extent  of  regulatory  restrictions  on   capital   account   transactions.     Since   the   purpose   of   this   study   is   to   evaluate   the   effectiveness   of   a   country’s   legally   imposed   capital   controls   in   mitigating   the   negative   effects   of   a   financial   crisis,   KAOPEN’s   focus   on   de   jure   capital   controls   makes  it  a  logical  choice  of  index.       The   second   reason   KAOPEN   is   an   ideal   index   of   capital   account   restrictiveness  is  that  it  is  a  holistic,  robust  measure  of  capital  account  openness.   Countries  oftentimes  impose  capital  controls  in  a  variety  of  ways  to  increase  their   collective  effectiveness.    As  Edwards  (1999)  points  out,  the  private  sector  frequently   circumvents  capital  controls.    Countries  can  make  this  more  difficult  by  adopting  an   all-­‐inclusive   approach   to   their   capital   control   policies.     A   country   with   a   closed   capital   account   can   reinforce   these   policies   by   imposing   controls   on   the   current   account   or   by   changing   the   requirements   for   surrendering   export   proceeds.    
  • 20.
      Malaysia   adopted   this   strategy   in   response   to   the   Asian   Crisis   of   1998.     KAOPEN   incorporates  variables  from  a  variety  of  categories  in  the  AREAR,  accounting  for  a   wide  range  of  capital  controls.    Therefore,  KAOPEN  values  are  strong  measures  of   the  entirety  of  countries’  approaches  to  capital  account  restrictiveness.     Here,  I  first  examine  KAOPEN  values  from  1970  to  2012  across  the  entirety  of   the  IMF  member  countries  to  investigate  if  there  is  a  global  trend  towards  capital   openness   or   restrictiveness.     I   then   focus   on   the   regions   of   Latin   America   and   Southeast  Asia,  to  investigate  if  there  are  region-­‐specific  capital  account  openness   trends.    I  evaluate  KAOPEN  for  these  regions  across  the  entirety  of  the  time  series   (1970  to  2012)  as  well  as  specifically  for  time  periods  leading  up  to,  during,  and   after  a  crisis.    For  Latin  America,  my  analysis  focuses  on  the  five  years  preceding  and   following   the   2002   South   American   recession.     For   Southeast   Asia,   my   analysis   focuses  on  the  five  years  preceding  and  following  the  1998  Asian  financial  crisis.     2.2   KAOPEN  Values   Figure   6   presents   the   average   of   annual   KAOPEN   values   for   the   187   IMF   member  countries  as  a  group  from  1970  to  2012.    The  change  in  global  KAOPEN   values  over  time  indicates  that,  in  general,  capital  account  openness  has  increased   since  1970.    However,  Figure  6  shows  that  the  trend  toward  global  capital  account   openness  slowed  and  even  reversed  in  the  late  1970’s  and  early  1980’s.    The  mean   global   KAOPEN   value   did   not   begin   to   increase   again   until   the   late   1980’s.     The   reduction  in  KAOPEN  values  during  the  late  1970’s  and  early  1980’s  is  attributable   to  the  global  recession  that  occurred  during  the  same  time  period.    The  recession   negatively   impacted   both   developed   economies   and   emerging   market   economies.     The   trend   is   particularly   evident   in   the   Latin   American   debt   crisis   during   that   period.    In  the  1960’s  and  1970’s,  Latin  American  countries  built  up  vast  quantities   of   foreign   debt   by   borrowing   from   international   creditors   to   fund   economic   development   projects.     Investors   were   initially   eager   to   finance   projects   in   developing  Latin  America  because  GDP  in  the  region  was  rapidly  growing.    By  the   late  1970’s,  however,  Latin  American  countries  were  struggling  to  repay  their  debts,  
  • 21.
      partly  due  to  rising  oil  prices  and  increasing  interest  rates  in  the  United  States  and   Europe.    Investors  became  wary  of  Latin  America’s  ability  to  repay  their  debts.    They   withdrew   their   funds   from   the   region,   causing   a   large   outflow   of   capital   flight.     According   to   Pastor   (1989),   capital   flight   in   Latin   America   totaled   $151   billion   between  1973  and  1987.    This  equates  to  43%  of  their  total  external  debt  during   that   time   period.     The   rapid   outflow   of   capital   from   Latin   America   deprived   the   region  of  important  funding  that  was  expected  to  be  used  for  developing  projects   and  servicing  their  foreign  debt.    Latin  American  countries  came  to  identify  capital   flight  as  one  of  the  primary  causes  for  their  economic  woes.    As  a  result,  countries  in   the   region   became   more   restrictive   on   capital   account   transactions   and   even   the   IMF  made  stricter  capital  controls  a  precondition  for  Latin  American  countries  to   receive  debt-­‐relief  assistance  packages.                                         Figure  7  depicts  the  KAOPEN  value  for  Latin  American  countries  from  1970   to  1990.    The  figure  shows  a  strong  trend  towards  capital  account  restrictiveness   during   the   late   1970’s   and   early   1980’s   in   Latin   America.     The   figure   shows   that   0.3   0.35   0.4   0.45   0.5   0.55   0.6   1970   1972   1974   1976   1978   1980   1982   1984   1986   1988   1990   1992   1994   1996   1998   2000   2002   2004   2006   2008   2010   2012   KAOPEN   Year   Figure  6:  Mean  KAOPEN  Value  for  all  IMF  Member  Countries,  1970-­‐2012   The  figure  presents  the  mean  KAOPEN  value  for  all  IMF  member  countries  from  1970-­‐2012.   Source:  Author’s  calculations  based  on  World  Bank  data.    There  are  no  country-­‐specific   weightings  for  KAOPEN  values.  
  • 22.
      0   0.1   0.2   0.3   0.4   0.5   0.6   1970   1971   1972   1973   1974   1975   1976   1977   1978   1979   1980   1981   1982   1983   1984   1985   1986   1987   1988   1989   1990   KAOPEN   Year   Latin  American  countries  did  not  begin  liberalizing  their  capital  accounts  until  the   late  1980’s.         In   contrast,   this   trend   is   absent   for   developing   countries   during   the   same   period.    Figure  8  shows  the  KAOPEN  value  for  a  selected  group  of  countries  that  had   some  of  the  largest  economies  (in  terms  of  nominal  GDP)  in  the  world  in  1980.    The   figure   makes   it   evident   that   the   overall   trend   towards   capital   account   restrictiveness  was  not  present  in  developed  countries  with  prominent  economies.     Thus,  the  overall  trend  towards  stricter  capital  controls  in  the  late  1970’s  and  early   1980’s,   apparent   in   Figure   6,   did   not   apply   globally,   but   had   important   regional   distinctions.                     5                                                                                                                                       5  Figure  7  depicts  the  mean  KAOPEN  value  from  1970  to  1990  for  selected  Latin  American  countries:   Argentina,  Bolivia,  Chile,  Colombia,  Ecuador,  Guatemala,  Mexico,  Paraguay,  Peru,  Uruguay  &   Venezuela.    There  are  no  country-­‐specific  weightings  applied  to  KAOPEN  values.       Figure  7:  Mean  KAOPEN  Value  for  Latin  American  Countries,  1970-­‐19905   The  figure  presents  the  mean  KAOPEN  value  for  selected  Latin  American  countries  for  1970-­‐1990.   Source:  Author’s  calculations  based  on  World  Bank  data.    
  • 23.
                          6               Excluding  the  reversal  in  the  late  1970’s  and  early  1980’s,  there  is  clearly  an   overall  trend  towards  global  capital  account  openness.    This  has  made  international   capital   reallocation   and   international   trade   easier,   prominent   features   of   the   present-­‐day  integrated  global  economy.     Figures   9   graphs   the   KAOPEN  values   in   Latin   America   and   Southeast   Asia   from  1970  to  2012,  illustrated  the  regional  differences  in  capital  account  openness.     In  general,  Latin  American  countries  have  liberalized  their  capital  accounts  more  so   than   Southeast   Asian   countries.     The   next   section   of   this   paper   relates   KAOPEN   values  to  FDI  inflow  volume  on  a  regional  basis,  which  should  indicate  whether  or   not  the  dichotomy  of  the  approaches  taken  by  Southeast  Asian  countries  and  Latin                                                                                                                   6  Figure  8  depicts  the  mean  KAOPEN  value  from  1970  to  1990  for  a  selected  group  of  developed   countries  that  were  global  leaders  in  terms  of  GDP  in  1980:  Canada,  France,  Germany,  Italy,  Japan,   Spain,  the  United  Kingdom  &  the  United  States.    There  are  no  country-­‐specific  weightings  applied  to   KAOPEN  values.   0.4   0.45   0.5   0.55   0.6   0.65   0.7   0.75   0.8   0.85   1970   1971   1972   1973   1974   1975   1976   1977   1978   1979   1980   1981   1982   1983   1984   1985   1986   1987   1988   1989   1990   KAOPEN   Year   Figure  8:  Mean  KAOPEN  Values  for  Developed  Countries,  1970-­‐19906   The  figure  shows  the  mean  KAOPEN  values  for  a  selected  group  of  developed  countries   from  1970-­‐1990.   Source:  Author’s  calculations  based  on  World  Bank  data.    
  • 24.
      American   countries   towards   capital   account   restrictiveness   has   yielded   different   outcomes  for  the  countries  in  those  regions.                         7                 2.3   KAOPEN  &  FDI  Inflows;  Time-­‐Series  Data  Selection   I  examine  the  relationship  between  KAOPEN  values  and  net  FDI  inflow  volume  for   my   focus   countries   over   an   eleven-­‐year   period   centered   around   the   year   of   the   financial  crisis:  1998  for  Southeast  Asia  and  2002  for  Latin  America.    Figures  10  and   11  show  the  %  GDP  change  for  my  countries  of  focus  in  each  region  over  an  11-­‐year   period.    In  Latin  America,  the  crisis  was  deepest  in  2002  as  evidenced  by  the  GDP                                                                                                                   7  Figure  9  depicts  the  mean  KAOPEN  value  from  1970  to  1990  for  a  selected  group  of  Latin  American   and  Southeast  Asian  countries.    The  Latin  American  countries  included  are  Argentina,  Bolivia,  Chile,   Colombia,  Ecuador,  Guatemala,  Mexico,  Paraguay,  Peru,  Uruguay  &  Venezuela.    The  Southeast  Asian   countries  included  are  Cambodia,  Indonesia,  South  Korea,  Lao  PDR,  Malaysia,  Myanmar,  Philippines,   Singapore,  Thailand  &  Vietnam.    There  are  no  country-­‐specific  weightings  applied  to  KAOPEN  values.   Figure  9:  Mean  KAOPEN  Values  for  Latin  American  and  Southeast  Asian   Countries,  1970-­‐20127   This  figure  shows  the  mean  KAOPEN  value  for  Latin  American  and  Southeast  Asian  Countries   between  1970  and  2012.   0   0.1   0.2   0.3   0.4   0.5   0.6   0.7   0.8   1970   1972   1974   1976   1978   1980   1982   1984   1986   1988   1990   1992   1994   1996   1998   2000   2002   2004   2006   2008   2010   2012   KAOPEN   Year   LA  KAOPEN  values   SE  Asia  KAOPEN  Values   Source:  Author’s  calculations  based  on  World  Bank  data.  
  • 25.
      contraction  seen  in  figure  10.    In  Southeast  Asia,  the  crisis  was  deepest  in  1998  as   evidenced  by  the  GDP  contraction  seen  in  Figure  11.    Thus,  I  recognize  2002  as  the   start  of  the  financial  crisis  in  Latin  America  and  1998  as  the  start  of  the  financial   crisis  in  Southeast  Asia.                       8                         9                                                                                                                   8  Figure  10  shows  the  mean  annual  %  GDP  change  from  1997  to  2007  for  my  focus  countries  in  Latin   America:  Argentina,  Chile  &  Venezuela.  There  are  no  country-­‐specific  weightings  applied  to  GDP   change  values.   Figure  11:  Mean  Annual  %  GDP  Change  for  Southeast  Asian  Countries,  1993-­‐20039   This  figure  shows  the  annual  %  GDP  Change  for  my  focus  Southeast  Asian  Countries  from  1993-­‐2003.       -­‐8   -­‐6   -­‐4   -­‐2   0   2   4   6   8   10   12   1997   1998   1999   2000   2001   2002   2003   2004   2005   2006   2007   %  GDP  Change   Year   %  GDP   Figure  10:  Mean  Annual  %  GDP  Change  for  Latin  American  Countries,  1997-­‐20078   This  figure  shows  the  annual  %  GDP  Change  for  my  focus  Southeast  Asian  Countries  from  1991-­‐2001.       -­‐6   -­‐4   -­‐2   0   2   4   6   8   10   1993   1994   1995   1996   1997   1998   1999   2000   2001   2002   2003   %  GDP  Change   Year   %  GDP   Source:  Author’s  calculations  based  on  World  Bank  data.   Source:  Author’s  calculations  based  on  World  Bank  data.  
  • 26.
      The   KAOPEN   values   for   the   five   years   preceding   the   crisis   indicate   the   intensity  of  a  given  country’s  capital  controls  before  the  beginning  of  the  recession.     The  KAOPEN  values  in  the  years  after  the  start  of  the  crisis  reveal  if  a  given  country   responds  by  opening  or  closing  their  capital  account  and  to  what  extent.    The  FDI   inflow   levels   during   the   five   years   after   the   start   of   the   crisis   are   of   particular   interest,   because   they   show   how   effective   a   given   country’s   reactionary   capital   control  alterations  relate  to  actual  capital  flow  volume.    I  find  that  FDI  inflows  are   sensitive  to  capital  controls  imposed  in  response  to  a  crisis.   Figures  12  and  13  show  how  the  mean  KAOPEN  value  in  Latin  America  and   Southeast   Asia   changed   during   the   11-­‐year   periods   centered   around   the   year   in   which   their   respective   crises   began.     Figure   12   indicates   that   in   general,   Latin   American   countries   responded   to   the   2002   crisis   by   loosening   capital   controls.     Figure  13  shows  that  countries  in  Southeast  Asia  also  opened  their  capital  accounts,   but   less   drastically   than   Latin   American   countries.     In   2001,   one   year   before   the   start   of   2002   crisis,   the   average   KAOPEN   value   in   Latin   America   was   .655.     The   average  KAOPEN  value  in  Southeast  Asia  in  1997,  one  year  before  the  start  of  the   1998  crisis,  was  .371.    Before  the  start  of  the  crisis,  Southeast  Asian  countries  had   much  less  open  capital  accounts  than  countries  in  Latin  America.    This  is  consistent   with  the  broader  trend  of  Southeast  Asian  countries  being  more  averse  to  capital   account  liberalization  than  Latin  American  countries,  which  is  shown  in  Figure  9.                                                                                                                                                                                                                                                                                                                                                             9  Figure  11  shows  the  mean  annual  %  GDP  change  from  1992  to  2002  for  my  focus  countries  in   Southeast  Asia:  Vietnam,  Singapore,  Indonesia  &  Malaysia.    There  are  no  country-­‐specific  weightings   applied  to  GDP  change  values.  
  • 27.
                                        10   11       2.4   KAOPEN  &  FDI  Inflows;  Latin  America   The  Latin  American  crisis  of  2002  was  sparked  by  the  devaluation  of  the  Brazilian   real.    After  the  devaluation  of  the  real,  Argentine  export  competitive  was  damaged   because   the   Argentine   peso   was   pegged   to   the   US   dollar,   preventing   the   country   from  devaluing  in  order  to  restore  their  export  competitiveness.    What  started  out   as   a   currency   crisis   in   Argentina   turned   into   a   sovereign   debt   crisis   when   the   country’s   economy   started   contracting   because   decreased   tax   receipts   could   no   longer  finance  the  country’s  outstanding  interest  payments.    Despite  assistance  from   the  IMF,  the  market’s  confidence  in  Argentina  and  the  peso  continued  to  deteriorate.                                                                                                                     10  Figure  12  shows  the  mean  annual  KAOPEN  value  from  1997  to  2007  for  selected  countries  in  Latin   America:  Argentina,  Bolivia,  Chile,  Colombia,  Ecuador,  Guatemala,  Mexico,  Paraguay,  Peru,  Uruguay  &   Venezuela.    There  are  no  country-­‐specific  weightings  applied  to  KAOPEN  values.   11  Figure  13  shows  the  mean  annual  KAOPEN  value  from  1993  to  2003  for  selected  countries  in   Southeast  Asia:  Cambodia,  Indonesia,  South  Korea,  Lao  PDR,  Malaysia,  Myanmar,  Philippines,   Singapore,  Thailand  &  Vietnam.    There  are  no  country-­‐specific  weightings  applied  to  KAOPEN  values.     0   0.1   0.2   0.3   0.4   0.5   0.6   0.7   0.8   1997   1998   1999   2000   2001   2002   2003   2004   2005   2006   2007   KAOPEN   Year   0   0.1   0.2   0.3   0.4   0.5   0.6   0.7   0.8   1993   1994   1995   1996   1997   1998   1999   2000   2001   2002   2003   KAOPEN   Year   Figure  12:  Mean  Annual  KAOPEN  value  for   Latin  American  Countries,  1997-­‐200710   This  figure  shows  the  average  annual  KAOPEN   value  in  Latin  America  from  1997-­‐2007.   Figure  13:  Mean  Annual  KAOPEN  value  for   Southeast  Asian  Countries,  1993-­‐200311   This  figure  shows  the  average  annual  KAOPEN   value  in  Latin  America  from  1993-­‐2003.   Source:  Author’s  calculations  based  on  World  Bank  data.   Source:  Author’s  calculations  based  on  World  Bank  data.  
  • 28.
      Argentina  gradually  phased  out  the  peso’s  peg  to  the  dollar,  but  action  did  not  come   swiftly  enough.    The  crisis  reached  an  apex  near  the  end  of  2001,  when  confidence  in   the   peso   was   so   compromised   that   Argentina   experienced   a   bank   run.     Arellano   (2008)  notes  that  Argentina  eventually  decided  to  default  on  over  $100  billion  of   their   debt   in   December   of   2001.     This   should   have   worsened   the   situation   in   Argentina   because   a   default   would   theoretically   block   Argentina’s   access   to   international  capital  markets.    Towards  the  end  of  2002,  however,  World  Bank  data   shows  that  the  global  price  of  soy,  which  is  one  of  the  most  prominent  Argentine   exports,  soared  to  their  highest  level  since  mid-­‐2000.    Argentina  enjoyed  an  export-­‐ driven  recovery;  GDP  contracted  by  10.89%  in  2002  then  grew  by  8.84%  in  2003.       Argentina’s  economy  began  to  slow  down  in  1998  when  the  Brazilian  Real   was  devalued.    The  recession  was  by  no  means  mild;  World  Bank  data  indicates  that,   from   1998   to   2002,   the   Argentine   economy   shrank   by   over   25%.     Figure   14   indicates   that   Argentina   responded   to   the   crisis   by   increasing   capital   account   restrictiveness.     Net   FDI   inflow   volume   in   Argentina   follows   a   trend   similar   to   KAOPEN  values  in  Argentina.    Similar  year-­‐to-­‐year  relative  changes  in  KAOPEN  and   FDI   inflows   indicate   that   the   extent   of   Argentina’s   capital   controls   have   a   relationship   with   capital   flow   volume.     Although   Argentina’s   economy   began   to   recover  in  2003,  net  FDI  inflows  did  not  begin  to  increase  until  2004,  one  year  after   Argentina  began  to  reopen  their  capital  account.    This  indicates  that  FDI  inflows  are   more  responsive  to  capital  controls  than  macroeconomic  trends.                      
  • 29.
                                                                    Figure  14:  FDI  Net  Inflows  &  KAOPEN  Values  in  Argentina,  1997-­‐2007   This  figure  shows  the  KAOPEN  values  and  FDI  net  inflow  volumes  for  Argentina  from  1997  to   2007.    FDI  Net  Inflows  are  measured  in  $US  Millions.   Figure  15:  FDI  Net  Inflows  &  KAOPEN  Values  in  Chile,  1997-­‐2007   This  figure  shows  annual  FDI  Net  Inflows  and  KAOPEN  Values  in  Chile  from  1997-­‐2007.     FDI  Net  Inflows  are  measured  in  $US  Millions.     0   0.2   0.4   0.6   0.8   1   1.2   $0.00   $2,000.00   $4,000.00   $6,000.00   $8,000.00   $10,000.00   $12,000.00   $14,000.00   1997   1998   1999   2000   2001   2002   2003   2004   2005   2006   2007   KAOPEN   FDI  Net  InHlows,  $US  MIllions   Year   FDI  Net  Inglows   KAOPEN   0   0.1   0.2   0.3   0.4   0.5   0.6   0.7   0.8   0.9   1   $0.00   $5,000.00   $10,000.00   $15,000.00   $20,000.00   $25,000.00   $30,000.00   1997   1998   1999   2000   2001   2002   2003   2004   2005   2006   2007   KAOPEN   FDI  Net  InHlows,  $US  Millions   Year   FDI  Net  Inglows   KAOPEN   Source:  Author’s  calculations  based  on  World  Bank  data.   Source:  Author’s  calculations  based  on  World  Bank  data.  
  • 30.
          The  2002  crisis  did  not  affect  Chile  as  much  as  it  did  Argentina.    According  to   the  World  Bank,  Chile  only  had  GDP  contraction  in  1999,  while  Argentina’s  economy   shrank  for  four  consecutive  years.    Calvo  (2005)  attributes  Chile’s  relatively  strong   performance  during  the  recession  to  the  fact  that  Chile  did  not  have  as  severe  of  a   pre-­‐crisis   currency-­‐denomination   mismatch.     Figure   15   indicates   that   Chile   responded  to  the  crisis  by  opening  their  capital  account,  which  is  the  opposite  of   what  Argentina  did.    Chile  experienced  a  drop  in  FDI  inflows  from  1999  to  2002,  but   had  a  strong  resurgence  afterwards.    Again  the  relationship  between  capital  account   restrictiveness  and  net  FDI  inflows  appears  to  be  significant,  even  in  the  case  of  a   country  that  was  not  affected  by  the  crisis  to  the  same  degree  as  Argentina.    This   enforces   the   argument   that   net   FDI   inflows   are   more   sensitive   to   towards   short-­‐ term  variations  in  capital  controls  than  macroeconomic  trends.   Venezuela   also   experienced   adverse   effects   from   the   crisis   of   2002;   their   economy  shrank  by  9%  in  2002  and  by  8%  in  2003  according  to  the  World  Bank.     Adding  to  the  economic  problems  the  country  was  facing,  political  instability  led  to  a   strike  in  December  2002.    The  strike  caused  a  crisis  in  the  Venezuelan  oil  industry,   greatly  reducing  the  country’s  crude  oil  output  for  much  of  2003.    Venezuela  started   experiencing  capital  flight  as  confidence  in  their  economy  deteriorated.    In  order  to   curb  the  capital  flight  and  prevent  further  depletion  of  foreign  reserves,  Venezuela   increased  the  intensity  of  their  capital  controls  as  indicated  in  Figure  16.    FDI  inflow   volume  rose  during  2000  and  then  steeply  declined,  coinciding  with  the  time  that   Venezuela’s   KAOPEN   value   decreased.     Even   in   the   case   of   a   country   that   experienced  a  crisis  due  to  internal  rather  than  exogenous  factors,  there  appears  to   be  a  significant  relationship  between  capital  account  restrictiveness  and  capital  flow   volume.    It  is  difficult  to  ascertain  causality;  some  of  the  FDI  inflow  reductions  are   likely  due  to  a  general  lack  of  investor  confidence  in  the  region.    It  seems  probable,   however,  that  the  heightened  capital  account  restrictions  also  played  a  part  in  the   reduction  of  FDI  inflow  volume  during  and  after  the  crisis.        
  • 31.
                                              2.5   KAOPEN  &  FDI  Inflows;  Southeast  Asia   The  1998  Asian  financial  crisis  began  in  Thailand,  when  the  country  was  forced  to   float  the  Thai  baht  after  large-­‐scale  currency  speculation  attacks  and  a  shortage  of   foreign  reserves  led  to  the  failure  of  their  fixed  exchange  rate  system.    Thailand’s   outstanding   debt   payments,   which   they   had   already   struggled   to   honor,   became   even  more  difficult  to  pay  back  after  the  decision  to  float  the  baht  led  to  devaluation.     Similar   to   how   Brazil’s   devaluation   impacted   Argentina’s   export   competitiveness,   Thailand’s  devaluation  reduced  the  export  competitiveness  of  other  Southeast  Asian   countries.    Trade  links  were  the  channel  for  financial  contagion  and  caused  the  Thai   crisis  spread  to  most  other  countries  in  Southeast  Asia.   Figure  16:  FDI  Net  Inflows  &  KAOPEN  Values  in  Venezuela,  1997-­‐2007   This  figure  shows  annual  FDI  Net  Inflows  and  KAOPEN  Values  in  Venezuela  from  1997-­‐2007.     FDI  Net  Inflows  are  measured  in  $US  Millions.       0   0.2   0.4   0.6   0.8   1   1.2   $0.00   $1,000.00   $2,000.00   $3,000.00   $4,000.00   $5,000.00   $6,000.00   $7,000.00   1997   1998   1999   2000   2001   2002   2003   2004   2005   2006   2007   KAOPEN   FDI  Net  InHlows,  $US  Millions   Year   FDI  Net  Inglows   KAOPEN   Source:  Author’s  calculations  based  on  World  Bank  data.  
  • 32.
      Vietnam   has   historically   taken   a   conservative   approach   towards   capital   flows   by   implementing   a   wide   variety   of   capital   controls.   Vietnam   was   not   as   adversely   affected  by  the  1998  Asian  financial  crisis  as  other  countries  in  the  region.    Table  1   shows  the  average  annual  %  change  in  GDP  for  selected  Southeast  Asian  countries   between   1998   and   2002,   as   well   as   the   standard   deviation   for   the   yearly   fluctuations   in   %   GDP   change.     Vietnam   averaged   the   highest   annual   GDP   in   the   region   over   the   five-­‐year   period.     Vietnam’s   propensity   to   shield   itself   from   the   international   financial   system   reduced   the   country’s   interconnectedness   with   the   rest  of  the  market,  which  is  likely  one  explanatory  factor  for  their  relatively  strong   performance   during   the   crisis   of   1998.     Vietnam   also   had   the   smallest   standard   deviation  of  their  annual  %  GDP  changes,  indicating  that  Vietnam  has  less  year-­‐to-­‐ year  variability  in  their  economic  performance.    This  is  also  likely  attributable  to   severity  of  their  capital  control  policies.   Vietnam’s  FDI  inflow  volume  between  1992  and  2002  follows  closely  with   the  country’s  KAOPEN  values  over  the  same  time  period,  as  seen  in  Figure  17.    The   figure   indicates   that   Vietnam’s   capital   controls   were   gradually   loosened   between   1992  and  1996,  which  facilitated  higher  FDI  inflow  volume.    After  1996,  however,   Vietnam  stopped  liberalizing  their  capital  account  and  even  tightened  restrictions  a   bit  in  2001.    This  coincides  with  a  reduction  in  FDI  inflow  volume.    Although  there   appears  to  be  some  relationship  between  KAOPEN  and  FDI  inflows,  it  is  likely  the   small  variation  in  FDI  inflow  volume  during  the  crisis  period  is  due  to  a  general  lack   of  confidence  in  the  outlook  of  the  regional  economy.                     Country   Average  Annual   %  GDP  Change   Standard   Deviation   of   Annual  %  GDP  Changes   Vietnam   5.97%   0.76   Philippines   2.69%   1.92   Malaysia   2.71%   6.38   South  Korea   5.16%   6.49   Thailand   1.23%   6.67   Table  1:  Average  Annual  %  GDP  Change  &  Standard  Deviation   in  Selected  Southeast  Asian  Countries,  1998-­‐2002   Source:  Author’s  calculations  based  on  World  Bank  data.  
  • 33.
                                              Malaysia  and  Indonesia  had  similar  pre-­‐crisis  KAOPEN  values,  as  indicated  in   Figures   18   and   19.     Both   countries   reduced   their   capital   account   openness   in   response   to   the   crisis,   with   Malaysia   implementing   capital   controls   a   bit   more   severely   than   Indonesia.     Overall,   FDI   inflow   volume   decreased   in   both   countries   over   the   ten-­‐year   period,   as   depicted   by   the   trend   lines   in   the   figures.     Although   there  is  an  overall  downward  trend  in  FDI  inflow  volume,  there  are  drastic  year-­‐to-­‐ year  FDI  variations.    One  reason  for  this  could  be  that  Malaysia  and  Indonesia  had   liberalized   capital   accounts   prior   to   the   recession   (both   countries   have   the   maximum  KAOPEN  values  in  the  early  1990’s).    Year-­‐to-­‐year  variations  in  FDI  inflow   volumes  to  Malaysia  and  Indonesia’s  are  much  greater  than  those  of  Vietnam.    Less   variation   in   Vietnam   is   likely   due   to   the   country’s   capital   account   restrictiveness.     Liberalized  pre-­‐crisis  capital  accounts  in  Malaysia  and  Indonesia  and  the  resulting   Figure  17:  FDI  Net  Inflows  &  KAOPEN  Values  in  Vietnam,  1992-­‐2002   This  figure  shows  annual  FDI  Net  Inflows  and  KAOPEN  Values  in  Vietnam  from  1992-­‐2002.     FDI  Net  Inflows  are  measured  in  $US  Millions.       0   0.05   0.1   0.15   0.2   0.25   $0.00   $500.00   $1,000.00   $1,500.00   $2,000.00   $2,500.00   $3,000.00   1993   1994   1995   1996   1997   1998   1999   2000   2001   2002   2003   KAOPEN   FDI  Net  InHlows,  $US  Millions   Year   FDI  Net  Inglows   KAOPEN   Source:  Author’s  calculations  based  on  World  Bank  data.  
  • 34.
      interconnectedness  with  the  international  financial  system  could  have  made  their   economies  more  susceptible  to  market  trends.    The  economies’  responsiveness  to   market  dynamics  could  be  a  primary  cause  in  the  year-­‐to-­‐year  FDI  inflow  variations   seen  in  Figures  18  and  19.                                                         Figure  18:  FDI  Net  Inflows  &  KAOPEN  Values  in  Malaysia,  1992-­‐2002   This  figure  shows  annual  FDI  Net  Inflows  and  KAOPEN  Values  in  Malaysia  from  1993-­‐2003.     FDI  Net  Inflows  are  measured  in  $US  Millions.     Figure  19:  FDI  Net  Inflows  &  KAOPEN  Values  in  Indonesia,  1992-­‐2002   This  figure  shows  annual  FDI  Net  Inflows  and  KAOPEN  Values  in  Indonesia  from  1992-­‐2002.     FDI  Net  Inflows  are  measured  in  $US  Millions.       0   0.1   0.2   0.3   0.4   0.5   0.6   0.7   0.8   $0.00   $1,000.00   $2,000.00   $3,000.00   $4,000.00   $5,000.00   $6,000.00   1993   1994   1995   1996   1997   1998   1999   2000   2001   2002   2003   KAOPEN   FDI  Net  InHlows,  $US  Millions   FDI  Net  Inglows   KAOPEN   0   0.2   0.4   0.6   0.8   1   1.2   -­‐$6,000.00   -­‐$4,000.00   -­‐$2,000.00   $0.00   $2,000.00   $4,000.00   $6,000.00   $8,000.00   1993   1994   1995   1996   1997   1998   1999   2000   2001   2002   2003   KAOPEN   FDI  Net  InHlows,  $US  Millions   Year   FDI  Net  Inglows   KAOPEN   Source:  Author’s  calculations  based  on  World  Bank  data.  
  • 35.
            Singapore  is  a  unique  case  in  Southeast  Asia  due  to  its  interconnectivity  with   the  global  economy  as  well  as  the  sophistication  of  their  domestic  economy.    Figure   20   compares   annual   GDP   per   capita   from   1994   to   1997   in   my   Southeast   Asian   countries   of   focus.   Singapore’s   GDP   per   capita   in   every   year   dwarfs   those   of   its   regional  counterparts.    Strong  GDP  per  capita  in  Singapore  is  a  byproduct  of  their   industrialized   economy   and   a   stable   political   environment   that   actively   promotes   domestic  business.                                         Before  the  1998  Asian  financial  crisis,  Singapore  had  the  maximum  possible   KAOPEN  value,  as  seen  in  Figure  21.    Singapore  was  not  immune  to  contagion  effects   from  neighboring  countries;  according  to  the  World  Bank,  Singapore  experienced  a   $0.00   $5,000.00   $10,000.00   $15,000.00   $20,000.00   $25,000.00   1994   1995   1996   1997   GDP  per  Capita  (Constant  2005  $US)   Year   Singapore   Vietnam   Indonesia   Malaysia   Figure  20:  Annual  GDP  per  Capita  in  Southeast  Asian  Countries  of  Focus,  1994-­‐ 1997  (Constant  2005  $US)   This  figure  shows  how  annual  GDP  per  Capita  changed  between  1994-­‐1997  in  Singapore,   Vietnam,  Indonesia  &  Malaysia.   Source:  Author’s  calculations  based  on  World  Bank  data.   Source:  Author’s  calculations  based  on  World  Bank  data.  
  • 36.
      GDP  contraction  of  over  2%  in  1998.    Singapore  responded  quickly  and  decisively,   allowing   their   currency   to   depreciate   against   the   US   dollar,   which   reduced   the   potential  gains  of  would-­‐be  currency  speculators.     Singapore’s  strategy  of  slightly  increasing  capital  control  restrictiveness  can   be  observed  in  Figure  21.    FDI  inflows  to  Singapore  increased  at  a  steady  rate  prior   to  the  1998  crisis,  but  similar  to  the  other  countries  in  the  region,  decreased  after   1996.    Figure  21  shows  that  Singapore’s  FDI  inflow  volume  recovered  very  quickly   after  the  crisis,  reaching  an  all-­‐time  high  in  1999.    This  type  of  FDI  inflow  resurgence   did  not  occur  in  Malaysia,  Indonesia,  or  Vietnam.    It  is  likely  that  Singapore’s  post-­‐ crisis  FDI  inflow  increases  are  partly  due  to  the  timeliness  and  effectiveness  of  the   mild  capital  controls  they  imposed  after  1996.       Another  probable  cause  of  Singapore’s  post-­‐crisis  FDI  inflow  resurgence  is   the   sophistication   and   liberalization   of   their   pre-­‐crisis   economy.     Singapore   was   already   an   industrialized,   trade-­‐centric   nation   that   had   proved   itself   as   a   viable   investment  opportunity.    Past  performance  was  likely  the  primary  reason  that  the   market’s  confidence  in  Singapore,  and  FDI  inflow  volume,  was  restored  so  quickly   after  the  crisis.    The  case  of  Singapore  seems  to  indicate  that  a  country  with  an  open   capital  account  and  a  strong  presence  in  international  financial  markets  can  respond   to  crises  by  implementing  mild  capital  controls.    After  initially  experiencing  a  drop   in   capital   flows,   a   country   with   an   open   capital   account   will   likely   enjoy   a   swift   capital  inflow  recovery.                      
  • 37.
                                          2.6  Formalizing  the  Relationship  Between  KAOPEN  &  FDI  Inflows   In  order  to  ascertain  the  strength  of  the  relationship  between  KAOPEN  and  net  FDI   inflow  volume  for  my  focus  countries,  I  measure  the  correlation  between  the  two   variables.    The  correlation  is  measured  during  an  eleven-­‐year  period  centered  on   the  year  that  the  respective  crises  began.    It  inevitably  takes  some  time  for  changes   in  capital  account  restrictiveness  to  reflect  in  capital  flow  volume.    I  lagged  the  FDI   variable  by  one  year  to  account  for  this  time  delay.    If  KAOPEN  is  a  robust  measure   of   capital   account   openness   and   an   effective   determinant   of   flow   volume,   there   should   be   a   positive   correlation   between   the   index   value   and   FDI   inflow   volume.     The  correlations  are  displayed  in  Table  2.       Figure  21:  FDI  Net  Inflows  &  KAOPEN  Values  in  Singapore,  1992-­‐2002   This  figure  shows  annual  FDI  Net  Inflows  and  KAOPEN  Values  in  Venezuela  from  1997-­‐2007.     FDI  Net  Inflows  are  measured  in  $US  Millions.       0   0.2   0.4   0.6   0.8   1   1.2   $0.00   $2,000.00   $4,000.00   $6,000.00   $8,000.00   $10,000.00   $12,000.00   $14,000.00   $16,000.00   $18,000.00   1993   1994   1995   1996   1997   1998   1999   2000   2001   2002   2003   KAOPEN   FDI  InHlow  Volume  ($US  Millions)   Year   FDI  Net  Inglows   KAOPEN   Source:  Author’s  calculations  based  on  World  Bank  data.  
  • 38.
                                      The   correlation   values   indicate   a   strong   positive   relationship   between   KAOPEN  values  and  net  FDI  inflow  volume  in  each  of  my  focus  countries  except  for   Vietnam  and  Singapore.    Vietnam  and  Singapore  are  unique  cases  because  over  the   11-­‐year   crisis   period   centered   around   1998,   both   countries   made   smaller   alterations  in  their  capital  controls  than  the  five  countries.    It  is  difficult  to  derive   meaningful  correlation  values  for  Vietnam  and  Singapore  given  the  limited  number   of   years   in   the   sample   and   the   minimal   changes   made   to   each   country’s   capital   account  during  that  time  period.    The  correlation  values  are  encouraging  because   they   strengthen   the   argument   that   there   is   an   association   between   the   two   variables.    It  is  crucial,  however,  to  acknowledge  that  the  correlation  values  in  no   way  imply  causation.         Country   Correlation   Argentina   0.526   Chile   0.420   Venezuela   0.476   Vietnam   -­‐0.257   Malaysia   0.556   Indonesia   0.745   Singapore   0.069   Table  2:  Correlations  Between  KAOPEN  Values   &  FDI  Inflow  Volume  for  Focus  Countries,  11-­‐ Year  Period  Centered  on  Start  of  Crisis   Source:  Author’s  calculations   based  on  World  Bank  data.  
  • 39.
      3.  Conclusion   This  paper  evaluates  the  impact  of  capital  controls  on  capital  flow  volume  during  a   financial  crisis.    In  general,  I  find  that  capital  account  restrictiveness  has  a  negative   relationship  with  capital  flow  volume,  specifically  net  FDI  inflows.    This  relationship   was  present  for  both  Latin  American  and  East  Asian  countries.    This  relationship   held   whether   or   not   a   country   increased   or   decreased   their   capital   account   restrictiveness.     The   relationship   also   held   regardless   of   a   country’s   pre-­‐crisis   economic   vulnerability.     I   observed   that   countries   with   open   pre-­‐crisis   capital   accounts   can   effectively   respond   to   a   regional   crisis   by   imposing   mild   capital   controls,  and  then  eliminating  them  after  the  worst  phase  of  the  crisis  passes.     My   findings   suggest   that   capital   account   restrictiveness   is   a   more   robust   predictor  of  FDI  inflow  volume  than  macroeconomic  variables  such  as  GDP  growth.     Lessening   capital   controls   during   a   crisis   is   more   effective   at   increasing   capital   inflow   volume   than   domestic   macroeconomic   recovery.     I   find   that   changes   in   capital  account  restrictiveness  do  not  immediately  impact  net  FDI  inflow  volume.    It   generally   takes   about   one   year   to   observe   measureable   effects   of   imposing   or   eliminating  capital  controls  on  FDI  net  inflow  volume.              
  • 40.
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