This document discusses capital account liberalization and the debate around it. It begins by providing context on the IMF's reversal of its long-standing policy in 2010 to now allow capital controls. It then defines what capital account liberalization is and provides a brief history of the advent of international capital markets since the end of Bretton Woods. The document goes on to summarize the theoretical literature on the potential effects of capital account liberalization from both a neoclassical perspective focused on efficiency as well as a risk perspective. It notes the empirical literature has found mixed results on the relationship between capital account liberalization and economic growth. The document concludes by assessing how theory and evidence can inform policymakers on whether and how to liberalize capital controls.
Swimming in a Sea of Finance: the Occasional Logic of Capital Controls
1. Swimming in a Sea of Finance: The
Occasional Logic of Capital Controls
Jonathon Flegg
j.c.flegg@nus.edu.sg
j.c.flegg@lse.ac.uk
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2. Contents
Introduction............................................................................................................................................ 3
What is Capital Account Liberalisation? ........................................................................................... 5
The Advent of International Capital Markets .................................................................................... 7
Capital Account Liberalisation in Theory ........................................................................................ 10
Capital Account Liberalisation and Risk ......................................................................................... 12
Capital Account Liberalisation and Growth .................................................................................... 14
Trade and Capital Liberalisation ...................................................................................................... 16
Capital Account Liberalisation as a Policy Proscription ............................................................... 18
Designing the Right Capital Control System .................................................................................. 23
Concluding Remarks ......................................................................................................................... 26
Bibliography ........................................................................................................................................ 28
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3. Introduction
For decades the International Monetary Fund (IMF) had argued against governments
creating barriers to capital flows in and out their countries. Then, on 10 th February
2010, an initially insignificant-looking publication was released. The IMF staff position
note suddenly reversed this long-standing policy by stating capital controls on
international financial flows can now be “justified as part of the policy toolkit”
available for sovereign states in their execution of economic policy (Ostry et al, 2010;
Rodrik, 2010). The report also noted, “logic suggests that appropriately designed
controls on capital inflows could usefully complement” other prudential and
macroeconomic policies. The quietness of the announcement betrayed its true
importance. The IMF had argued that capital controls were counterproductive
because they denied the private sector in developing economies access to much-
needed investment finance. Only three months early they had chastised President
Lula of Brazil for attempting to restrict the entry of short-term financial flows into his
country, and now all of a sudden the organisation was reversing this blanket policy.
The IMF‟s decision has reignited a new round of debate on the logic behind capital
account liberalisation. While there is now almost unanimous agreement among
economists of the benefits behind liberalising international trade, the verdict on
liberalising international finance is far from settled. While Dani Rodrik, Jagdish
Bagwati, and Joseph Stiglitz all have been vocal critics of capital account
liberalisation, Stanley Fischer, Eswar Prasad and Lawrence Summers have all made
strong arguments in favour. That global financial integration facilitated the spread of
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4. the 2008 Global Financial Crisis into the first truly worldwide financial collapse since
the Great Depression has also contributed to a sense of urgency in the academic
debate.
This paper takes a fresh look at the evidence for and against national governments
deciding to open up their financial systems and allowing the free movement of capital
across their borders. Rather than as a temporary protection installed to protect
against immanent crises, I take the view that capital account liberalisation should be
considered as a mostly irreversible policy decision made within the context of the
long-term developmental trajectory of the real economy. Moreover it is most
optimally employed at a larger stage of economic development, after other important
reforms, such as trade liberalisation and floating of the currency. Rather than a
doctrinal approach I consider a range of characteristics that a country should have
before the benefits of capital account liberalisation outweigh the potential costs.
The paper will first consider what exactly is capital account liberalisation and a
history of its recent popularity since the end of the Bretton Woods system. Then
starting with a neoclassical approach I will review the theoretical literature on the
possible effects, benefits and costs involved in the decision to liberalise or preserve
financial autarky. I will conclude by assessing how the empirical literature can inform
the theory, and introductory guidelines for policymakers confronted with the decision
to liberalise or not to liberalise, and if so, what policy design might be most effective.
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5. What is Capital Account Liberalisation?
All of a country‟s economic dealings with the rest of the world are recorded in either
their current or capital accounts. While the current account is a measure of a
country‟s foreign income and expenditure1, the capital account covers changes in the
ownership of foreign and domestic assets. Assets can be real as well as financial,
and include direct investment, and any kind of equities, debt securities, loans, bank
accounts and currency. Specifically it is equal to the net change in:
Capital account = Change in foreign ownership of domestic assets –
Change in domestic ownership of foreign assets.
A capital account surplus is a net inflow of foreign capital, and occurs when a country
is financing a current account deficit, while a capital account deficit is associated with
a current account surplus. By definition the current and capital accounts must be of
equal magnitude and opposite signs, because the capital account effectively
represents the financing of the current account. The IMF has a slightly more
nuanced definition of the capital account, dividing it into both a financial and more
limited capital account, but here we use the traditional broader definition and
consider capital account as meaning both capital and financial flows between
countries.
1
The current account includes an economy’s net exports, net factor income and net transfer payments.
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6. Capital flows between countries consist of movements in: foreign direct investment,
portfolio investment, other investment and changes in foreign reserves. Foreign
direct investment (FDI) is defined as the acquisition or construction of capital assets.
Portfolio investment is simply purchases of debt and shares. The other category is
dominated by capital in various bank accounts, while the reserve account is the net
foreign assets held by the central bank.
In a broad sense, capital account liberalisation is a policy decision by a government
to ease restrictions on movement of capital in and out of its economy. Very few
scholars have attempted a precise definition of the term, although Fane (1998)
defines capital controls as being, “measures which impose quantitative restrictions,
or explicitly or implicitly tax broad categories of capital movements and which apply
to all firms and households.” The IMF (1988) defines capital account convertibility as
the:
Freedom from quantitative controls, taxes, and subsidies - that affect
capital account transactions between residents and non-residents.
Examples of such transactions include all credit transactions between
residents and non-residents, including trade- and nontrade-related credits
and deposit transactions, and transactions in securities and other
negotiable financial claims.
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7. Important to note here is that the definition does not include restrictions on the
underlying transactions themselves, although in practice limitations are often placed
on them as well (Quirk et al, 1995: 1). The assumed result of liberalisation is usually
a greater level of financial integration between a given economy with global financial
markets.
The Advent of International Capital Markets
The advent of widespread international capital markets is one of the defining
features of the current period of globalisation. During the last era of globalisation at
the turn of the 20th century, capital was totally free to move but the need to physically
transfer gold still made it a difficult proposition. From WWII until the early-1970s
capital account restrictions were the norm under the Bretton Woods international
monetary system. As the well-known „Impossible Trinity‟ of monetary policy
succinctly illustrates in Figure 1, while the Bretton Woods system of internationally
pegged exchange rates has the virtues of stability in exchange rates and monetary
independence for sovereign states, it prohibits the use of open international financial
markets. If a currency system attempts to embody all three of these virtues, capital
market participants could engage in arbitrage by borrowing in a low-interest
jurisdiction and lending in the high-interest jurisdiction. Without capital controls these
flows would happen in large enough volumes as to be extremely destabilising to the
economy.
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8. Figure 1: The Impossible Trinity of Monetary Policy
Figure 2: The Post-Bretton Woods Reduction in Capital Controls (Kose and Pasad, 2004: 51)
During the Bretton Woods period very little foreign investment existed, and the
majority of international financial flows were official loans or concessional grants to
governments. However with the ending of the system of currency pegs many
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9. governments, including in some developing countries, began to reconsider the need
for capital restrictions. As Figure 2 shows, by the 1980s a large number of advanced
economies had completely removed capital restrictions. Firms in the United States,
Europe and Japan were also discovering a plethora of new investment opportunities
in what became known as „emerging markets‟. In developing economies with stable
political institutions and reasonable stocks of human capital and infrastructure, the
opportunities for yield compared very favourably with alternative opportunities in
advanced economies. In between 1980 and 2005 the growth in international capital
flows have outstripped growth in world production, moving from around 5 to 18
percent of world GDP. As can be seen in Figure 3, flows of international capital really
took off in the early 1990s, particularly in portfolio and money market flows, while
foreign direct investment has increased at a more modest pace. In short the biggest
increases have been in institutional capital.
Figure3: Gross International Capital Movements, 1980-2005 (Becker and Noone, 2008)
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10. Financial innovation also paved the way for the development of global capital
markets. Information and transactions in overseas markets became virtually real
time, including in overseas equity markets. The converse is was also true: Financial
innovation was also undermined the sustainability of maintaining capital controls.
The plethora of new financial instruments provide the market with novel new ways to
evade traditional capital barriers. The expansion of international trade has also
permitted the evasion of capital controls through the practice of under-invoicing and
over-invoicing (Mathieson and Rojas-Suárez, 1993; Pasad and Rajan, 2008).
Capital Account Liberalisation in Theory
Broadly there are two ways to theoretically approach the issue of capital account
liberalisation. The first is to view it as a means of achieving allocative efficiency and
the second is to focus on assessing the risk introduced with exposing a domestic
economy to the vicissitudes of international financial markets. In this section we will
first consider the former neoclassical literature before discussing the newer risk
literature in the following section.
The neoclassical approach begins with the Solow (1956) exogenous growth model. If
capital is free to move internationally it will naturally move from capital-rich, labour-
scarce advanced economies to where it can be more productively employed in the
capital-scarce, labour-rich economies of the developing world. The movement of
capital into developing economies reduces the cost of capital and delivers a boost to
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11. investment and provides permanently higher living standards (Fischer, 1998; Henry,
2007). Investors in developed economies should also enjoy a greater return on their
capital, as a wider range of investment opportunities becoming available to them.
While a simple neoclassical explanation provides a strong basis for advocating
capital account liberalisation, a number of other possible equilibrium effects make
the effects on economic growth more ambiguous. Firstly, while foreign capital flows
into a country can improve the level of investment, it can also lead to foreign
exchange rate appreciation, and hence lower exports, returns on investment, and
overall growth (Ostry et al, 2010). Conversely, if a central bank is struggling to
accumulate an adequate level of foreign reserves, capital account liberalisation
might be just the panacea that makes such a policy objective possible.
Financial liberalisation may also have indirect positive benefits that promote
economic development. Kose et al (2006) has called these potential “collateral
benefits” and, unlike the traditional neoclassical channel, should yield permanent
rather than temporary improvement in economic growth. For this reason they may
even be more important that the direct neoclassical effects on investment and growth
(Kose et al, 2006). Firstly, liberalisation is likely to develop the efficiency of domestic
financial markets through greater competition in the financial sector and the
introduction of new financial instruments and banking processes. Secondly,
liberalising might act as a commitment device that imposes discipline on the
domestic government‟s macroeconomic policies (Pasad and Rajan, 2008). This
commitment may also be a signal to international markets of the government‟s sound
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12. economic policies (Kose and Pasad, 2004). Finally, it may also improve public
governance and institutions, particularly corruption and prudential regulation. All
these indirect effects should lead to higher levels of investment and economic growth
in the economy.
Possible Effect of Capital Direct/Indirect Possible Out-products
Account Liberalisation
Lower cost of capital Direct Higher investment and economic
growth
Exchange rate Direct Lower exports and economic growth
appreciation
Foreign reserve Direct Higher net foreign assets
accumulation
Financial market Indirect Lower cost of capital and more diverse
development financial instruments available, higher
investment and economic growth
Institutional Indirect Higher investment and economic
development/public growth
governance
Sound macroeconomic Indirect Lower fiscal deficits, higher investment
discipline and economic growth
Figure 4: Possible Effects of Capital Account Liberalisation
Capital Account Liberalisation and Risk
While most of the proposed theoretical channels between capital account
liberalisation and the real economy are positive, a large body of newer research has
also been assembled pertaining to increased macroeconomic risk. Greater exposure
of an economy to the global financial system possibly entails idiosyncratic and
aggregate risk. Idiosyncratic risk is defined as the possibility of macroeconomic
crises that might impact only the liberalising the economy, while aggregate risk
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13. exposure is the susceptibility to crises that the particular national economy has no
functional control over.
Exposure to international risk may increase as an economy with liberalised capital
accounts is now more heavily linked to the fluctuations and imbalances in
international financial markets. Potential sources of crises become more numerous,
through greater contagion-transmitting interconnections. The severity of imbalances
and hence subsequent crashes may also become greater. Reinhart and Rogoff
(2008) have shown that in the post-Bretton Woods era financial crises are more
frequent due to widespread liberalisation of international capital movements. The
international closure of widespread capital account movements during the Bretton
Woods period effectively acted as insulation between financial crises spreading
between countries.
Risk Sources Insurable
Idiosyncratic (or country- Capital flight, Yes, through international
specific) risk speculative attacks, capital pooling
sudden stops,
domestic asset price or
banking crises
Aggregate (or international) International financial No
risk crises transmitted
through contagion
effects
Figure 5: Sources of Macroeconomic Risk from Capital Account Liberalisation
Idiosyncratic risk might also increase, although this is subject to much debate.
Possibly the greatest source of potential idiosyncratic risk is that of capital flight. If
the short-term state of the world changes in an economy with liberalised capital
accounts, foreign investors might withdraw capital relatively quickly causing a
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14. collapse in investment and asset prices. However the counterpoint to this argument
is that, as Pasad (2011) has argued, banking crises are more disruptive and occur
more frequently in closed economies. This is because the globalisation of capital
availability may actually facilitate insuring against such domestic crises through
international risk pooling. Risk that is idiosyncratic to a single economy can be
mitigated by accessing global finance in the event of a domestic macroeconomic
shock that affects the domestic ability to consume (Lucas, 1982; Pasad, 2011; Flood
et al, 2011). For small and open economies this is likely to be the case, although is
more difficult to substantiate for shocks to large economies such as the United
States or China. The bigger the economy the more likely it is that a domestic shock
is to take on the characteristics of an international shock, at least in terms of the
ability of the international financial system to insure against it are concerned.
In summary, while aggregate risk for countries can only increase as a consequence
of capital account liberalisation, the effect on idiosyncratic risk is ambiguous, given
that the extent to which international finance can facilitate risk pooling is unknown.
Empirically it does appear that overall capital account liberalisation does increase the
frequency and costliness of macroeconomic crises (Kose et al, 2003; Pasad and
Rajan, 2008; Flood et al, 2011). This fact can be regarded as the major drawback
associated with capital account liberalisation.
Capital Account Liberalisation and Growth
A large body of econometric evidence now exists that shows capital account
liberalisation is not associated with improved economic growth or levels of
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15. investment (Rodrik, 1998; Pasad et al, 2003; Henry, 2007). In a survey of 14 studies
on the topic, Kose et al (2003) found only three have shown a significantly positive
effect. The authors concluded:
…an objective reading of the vast research effort to date suggests that
there is no strong, robust, and uniform support for the theoretical argument
that financial globalization per se delivers a higher rate of economic
growth.
Pasad (2011) has since extended this survey to 25 papers, and still only three
empirical studies have shown a significantly positive effect. As Henry (2007) has
noted, this result is not necessarily inconsistent with the neoclassical approach, as
direct growth and investment improvements as a result of capital mobility should be
temporary rather than permanent. This can be explained because productivity
growth, rather than just accumulation of inputs, is the main determinant of long-term
growth (Hall and Jones, 1999). Long-term positive growth effects of capital account
liberalisation, where they exist, would be limited to the indirect improvements in
governance and financial institutions (Pasad and Rajan, 2008).
However an even deeper problem exists between the neoclassical theory and
economy growth. In 1990 Lucas published an important paper the highlighted the so-
called „Lucas Paradox‟: The neoclassical prediction – that in a world with liberalised
capital markets financial resources should flow from countries with high capital-
labour ratios to those with low capital-labour ratios – is not borne out in reality. In fact
often the reverse has been the case. As Pasad and Rajan (2008) have put it:
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16. … emerging market economies have, on net, been exporting capital to
richer industrial economies, mostly in the form of accumulation of foreign
exchange reserves, which are largely invested in industrial country
government bonds. These “uphill flows” of capital have had no discernible
adverse impact on the growth of developing economies, which suggests
that the paucity of resources for investment is not the key constraint to
growth in these economies.
A more nuanced view then is that there might be two different types of developing
economies, one which is characterised as net exports of capital to be invested
“uphill” in advanced economies, and others that are net importers who fail to reach
the growth potential suggested by the neoclassical model because they suffer from
more fundamental issues that discourage investment, such as a lack of private
property rights, adequate infrastructure or human capital or significant political risk.
In both groups of countries capital account liberalisation will fail to have a
discernable positive effect on economic growth.
Trade and Capital Liberalisation
Many authors have argued that financial liberalisation should be treated with more
caution that trade liberalisation (Stiglitz, 2002; Baghwati, 2004; Kose and Pasad, 2004;
Prasad and Rajan, 2008). The reason that the effects of capital liberalisation can be
considered different from trade liberalisation is because capital is different in kind to
trade. While trade is the exchange of economic products, capital has the duel
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17. characteristics of being both a production input and economic product. There is little
disagreement that in as much as capital is a tradable service, constituting the
product of an economic process, capital account liberalisation has positive indirect
effects. Corresponding with the “collateral benefits” argument of Kose et al (2006),
introduction of foreign financial providers has the effects of:
(a) reducing market power and rents accruing to domestic financial providers;
(b) increasing welfare through reductions in commercial interest rates and
expanded access to finance; and
(c) stimulating innovation within the financial services industry through
introducing a range of new technology („instruments‟ in the financial sector)
and efficient processes.
Notice how the introduction of competition from foreign financial services has
identical effects to those that are generally attributed to liberalisation of trade other
goods and services (Rodrik 1988; Pavcnik 2002). In that sense financial services are
no different to any other liberalised industry.
However in as much capital is a production input, its wholesale movement into and
out of an economy may be problematic. The risk of macroeconomic volatility
associated with capital control liberalisation is mainly due to the way it can rapidly
inflate and deflate the real economy because it is a prerequisite input into the
production process. Unlike labour inputs there is often a maturity mismatch between
short-term flows of capital and long-term changes in production in the real economy.
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18. Moreover the extent that particular capital inflows are bound to a particular
investment is proportional to its desirability to the overall economy. That is why so
called “hot money”, short-term flows of capital that simply follow interest rate
differentials, is generally regarded as the most dangerous form of capital inflow into
an economy.
Capital Account Liberalisation as a Policy Proscription
Experiences over the last two decades show that the decision of a government to
liberalise its capital account is fraught with difficulties, particularly in the years
immediately following a liberalisation episode. Moreover when a country decides to
open up to financial integration it is a difficult process to reverse. Even during the
Asian Financial Crisis, Malaysia‟s decision to temporarily impose selective exchange
and capital controls elicited incredible international controversy. This apparent
irreversibility might be partially explained by the implications for the political economy
when restricting existing foreign capital has an immediate and negative level effect of
asset prices. For example, in 2006 when the Thai central bank attempted to
implement a tax on short-term portfolio inflows on the stock market, the subsequent
15 percent collapse in stock prices prompted the government to quickly repeal it
(Pasad and Rajan, 2008: 18).
For capital inflows to be beneficial to an economy a number of assumptions need to
be made. Firstly, it assumes that investment in the domestic, presumably
developing, economy is credit-constrained. However as shown by the “Lucas
Paradox” the widespread adoption of open trade policies in many developing
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19. economies in recent years has contributed to a vast over-supply of capital in many
instances.
Secondly, in economies where capital does appear to be constrained, the cause of
underdevelopment might in fact be that domestic investment opportunities are of
limited profitability because of the poor quality of domestic institutions. While we
might accept the argument put by Kose et al (2006) that capital account liberalisation
has an indirect quality-enhancing effect on domestic institutions, it might also be the
case that more direct policy action is required to improve them. Simply liberalising
the capital account will not be enough to solve most countries difficulties with
achieving economic development.
Thirdly, as many recent experiences have attested to, such as the Argentinian
financial crisis in 1999-2002, there are strong reasons for treating capital account
liberalisation with suspicion in economies with fixed exchange rates. Croce and Khan
(2000) and Pasad and Rajan (2008) have both noted that in the presence of capital
mobility the fixed exchange rate mechanism makes domestic economies susceptible
to speculative attacks and sudden stops.
The presence of a large list of prerequisites for capital account liberalisation has led
many scholars to look favourably on a conditional argument for capital account
liberalisation. Pasad and Rajan (2008) describe their argument as “pragmatic”, while
the approach of Ostry et al (2010: 15) concludes: “There is no surefire one-size-fits-
all way to deal with the impact of potentially destabilizing short-term capital inflows.”
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20. Figure 6: IMF Staff Position on Imposing or Strengthening Capital Controls (IMF, 2010: Figure 1)
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21. The approach of this paper is broadly in line with such thinking. When making such a
decision with large implications for a country‟s economic policy it is prudent to weigh
up all the conclusions of economic theory in the light of the econometric evidence.
Moreover policymakers must be clear about the potential costs and benefits when
deciding on such a course of action. My approach differs most from the IMF position
displayed in Figure 6 in that Ostry et al (2010) are trying to determine the short-term
macroeconomic and prudential conditions necessary to implement temporary capital
controls in response to a crisis (similar to the situation faced by Malaysia during the
Asian Economic Crisis). My conditions in Figure 7 are an attempt to assess what
structural attributes are favourable for an economy to maintain longer-term capital
control arrangements. Also rather than a series of necessary conditions, my
approach is a list of characteristics that together make capital controls more useful or
less harmful to an economy‟s development.
Given that many of the characteristics are time-dependent, this raises the obvious
issue of policy sequencing. Is there a time-optimal stage in an economy‟s
developmental trajectory where capital account liberalisation becomes optimal, or at
least advisable? Many of the characteristics listed are correlated with stages of
economic development, and therefore this policy formulation does have a
sequencing component, much like the old sequencing literature in development
economics. Generally speaking, integration with global financial markets should only
be entertained after trade protectionism has been abandoned and the currency is no
longer a pegged regime (Obstfeld and Rogoff, 1995; Pasad and Rajan, 2008). A
sequenced approach also exposes one of the major shortcomings of the
effectiveness of liberalising capital, as most of the characteristics that would make
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22. liberalisation most beneficial to a country are also the characteristics of an economy
less in need of external capital at the higher-levels of economic development.
So what characteristics should we look for to determine whether capital account
liberalisation is a good policy idea for a given country? Here I will discuss just some
of the characteristics raised in Figure 7. Firstly, as stated above, a floating currency
is necessary to ensure the chances of adverse macroeconomic events such as
speculative attacks will not also increase. Secondly, trade openness is necessary as
there is a robust empirical relationship between trade openness dampening the
frequency and costliness of crises associated with financial liberalisation (Prasad
and Rajan, 2008). Strong monetary management is also very important to successful
capital account liberalisation. If an economy already has poor management of its
currency chances are it is not going to be able to successfully absorb the resultant
instability that comes along with exposure to international financial markets.
Two characteristics that favour liberalisation that are shared by many developing
economies are a lack of financial competition and a low level of reserves.
Liberalisation of the capital account might provide significant benefits for developing
economies seeking to make gains in these areas. Countries with high public debt
generally suffer more intensely and for a longer period after macroeconomic crises,
although a resultant appreciation might make the chances of a public debt crisis
more remote. Finally, a country should consider what type of capital inflow mix they
are likely to receive before liberalising. Speculators might be attracted to certain
economies for the purposes of currency speculation or the possibility of earning
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23. higher interest rates, however these kinds of capital flows may do more harm than
good in the long-run.
Characteristics in Favour of Characteristics Against Liberalisation
Liberalisation
The domestic currency is a float or The domestic currency if pegged.
managed float.
Trade protectionism has been dropped. Trade protectionism is an active
government policy.
Monetary policy has a history of sound Monetary policy has a history of poor
management and the currency is management and the currency is
generally stable. unstable.
Domestic investment is higher than Domestic savings are higher than
domestic savings. domestic investment.
A lack of competition within the financial Adequate competition within financial
services sector. services sector.
Foreign reserves are low by international Foreign reserves are already quite high.
standards.
External public debt is low. Government is already carrying a large
stock of external debt.
There are adequate opportunities for FDI Investment opportunities are more
investment. speculative, including currency
speculation or high interest rate earnings.
Figure 7: Characteristics That Influence the Potential Costs and Benefits of Capital Account Liberalisation
Designing the Right Capital Control System
All types of capital controls cannot be considered equal. For instance, most
governments prefer foreign direct investment over portfolio capital as it less
susceptible to capital flight. Here we consider some of the design features of
workable capital control policies. Generally we can judge the design of various
capital control systems by how well they manage to achieve any of the following four
possible criterion:
(a) extend the maturity of capital investments;
(b) encourage a particular type of capital flow;
(c) prevent procyclical withdrawal of capital; and
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24. (d) possibly direct flows to specific capital-constrained sectors of the economy.
The first design consideration is whether governments apply capital controls to
inflows or outflows. As a general principle it is possible for governments to control
inflows much more than outflows, particularly because when capital wants to leave it
typically is in a hurry (Reinhart and Smith, 2002). While Malaysia was generally
considered to have successfully managed to stem the outflow of capital during the
Asian Financial Crisis because it had tight control over the banking system, a
number of Latin American economies that have implemented similar outflow controls
have not been so successful (Pasad and Rajan, 2008). On most accounts outflow
restrictions fail on most of the four criteria for good capital control design, and if
administered well may qualify on criterion (c). As a result control of inflows is usually
regarded as superior to attempting to control outflows.
Secondly is the specific choice of capital control. Moore (2010) lists three different
basic types:
(a) exchange or quantitative limits;
(b) taxes on financial transactions; and
(c) dual exchange rate systems.
In terms of administrative complexity, the list follows an ascending order.
Quantitative limits are either restrictions on any foreign ownership or a ceiling on the
proportion of foreign ownership of assets in a particular class. While they are quite
effective in directing foreign capital away from specific sectors (criterion (d)), they are
not generally successful at preventing capital flight (criterion (c)) or ensuring capital
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25. investment is long-lived (criterion (a)). In this sense quantitative limits are generally
about maximising the benefits of foreign capital for investment rather than minimising
the potential costs of economic crises.
Taxes on foreign transactions can take a number of forms, such as:
… interest equalisation taxes, attempts to eliminate the difference in yields
between domestic and foreign investments and restrict either inflows or
outflows. A mandatory reserve requirement is one example of a price-
based capital control. This type of capital control requires foreign
investors to deposit a percentage of their capital investment with the
central bank for a minimum period (Moore, 2010: 7).
A successful example of mandatory reserve requirements was introduced by Chile in
1991. Short-term debt inflows where required to be accompanied by a 20 percent
reserve requirement (Pasad and Rajan, 2008). These measures have been arguably
the most successful in disincentivising short-term capital flows (criteria (a) and (c))
without limiting productive foreign investment.2 To the extent that certain types of
capital, such as FDI, are more likely to be attracted to longer-term investment
opportunities, taxes on foreign transactions also can satisfy criterion (b).
The final form of capital control is dual exchange rates, where commercial
transactions enjoy a stabilised exchange rate, while financial transactions face a fully
floating rate. Financial transactions hence face the disadvantage of having to
2
Brazil, Chile, Colombia, the Czech Republic and Malaysia have all attempted such measures with some
success.
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26. assume exchange rate risk. The system fails on all the criteria, except perhaps on
criterion (b), as it may only encourage short-term currency speculation, the exact
type of capital inflows that are entirely unproductive to the real economy. The only
possible virtue of dual exchange rates is that they discourage most forms of foreign
capital transactions, but in this case it is likely to be administratively simpler to just
implement quantitative restrictions.
In essence the most appropriate form of capital controls, when necessary, are either
quantitative restrictions or simple taxes on short-term foreign transactions. They are
the least distortionary to the economy, simplest to administer, and achieve the
greater number of policy goals. Taxes should be applied to incoming capital where
possible and are most effective in protecting domestic economies against potential
macroeconomic crises.
A final comment is necessary about capital control design. Like most regulatory
systems, simplicity has its virtues. All capital controls are generally administratively
burdensome and require constant vigilance in monitoring developments within the
economy. To work at all they require competent prudential regulators otherwise
private markets will easily find ways to evade the system.
Concluding Remarks
The heightened academic and political debate on the validity of capital controls has
led many to find satisfaction in a pragmatic, non-proscriptive approach. So too has
this paper. Liberalising capital has the benefit of allowing financially-constrained
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27. economies to reach their developmental potential and may even induce other
institutional and technological changes in the same way as trade liberalisation is
thought to do. However it also entails significant costs by exposing fragile domestic
financial systems to the „open waters‟ of trillions of dollars swimming around in
international financial markets. Governments that fail to anticipate the risks involved
with such a move could likely be the victims of financial crises that are so
devastating they negate any of the international financial system‟s possible growth
benefits. If a government decides to move forward with capital account liberalisation
they need to carefully consider a number of prerequisites before doing so, and the
design of the system must learn from other country‟s experiences or run the
additional risk of being redundant in the face of innovative capital markets. Ultimately
a Catch-22 exists with the decision to liberalise: The characteristics that would make
liberalisation most beneficial to a country are also the characteristics of an economy
less in need of external capital at the higher-levels of economic development.
Perhaps this why the post-Bretton Woods era is replete with so many examples of
failure and so few sterling examples of success.
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