HLEG thematic workshop on measuring economic, social and environmental resili...
Are Capital Controls Effective in Preventing Financial CrisesA
1. Are Capital Controls Effective in
Preventing Financial Crises?
Ling Huang
School of Economics, the Peking University
and
Stanford Center for International Development
February 26, 2013
2. Fundamental questions: Capital controls
Feb 18th 2010 The Economist
The IMF
changes
its mind on
controls
on capital
inflows
3. Fundamental questions:
Capital controls
• On April 5th 2011 the IMF released two documents designed to
achieve just that … But several curious differences between them
suggest that the fund’s own thinking on managing capital flows is
far from settled.
• Jeanne, Subramanian and Williamson (2012) argue that capital
control should not be a last resort, rather “…properly designed they
might even be a regular instrument of economic policy.”
• Klein (2012)：“ With a few exceptions, there is little evidence of the
efficacy of capital controls on the growth of financial variables, the
real exchange rate, or GDP growth at an annual frequency. These
preliminary results raise doubts about assumptions behind recent
calls for a greater use of episodic controls on capital inflows”
• Brazil, Iceland, Ireland, Peru and Turkey introduced new controls on
capital inflows recently.
4. Key Points
• data sample : 118 emerging market and developing
countries; time frame： 1970-2009
• Most currency crash events occurred in tight capital
control settings;
• Loosening capital control is linked to reduced
likelihood of currency crises after controlling the
relevant macroeconomic and financial variables.
• Preliminary evidence of discipline effect of capital
account openness: in general, the tighter the
capital control, the weaker the macroeconomic
fundamentals.
5. Outline
• Key question：
Upon controlling the usual macroeconomic and financial
correlates of currency crises, how does a higher degree of
capital account openness marginally affect the likelihood of
currency crises?
6. Outline
• Structure :
– Literature review
– Identifying the currency crash events
– Univariate analysis: the behavior of the control variables
in the antecedent (T-3: T) and aftermath (T+1:T+3) of the
currency crash events – are they statistically different
from the control group observations (“tranquil periods”)
– Multivariate analysis: Probit estimation
– Further empirical work to explain the Probit regression
results.
7. Correlates of Currency Crises
• We select the following correlates of currency crises suggested by the
literature :
– (1) reserves adequacy variables: M2/international reserves, ratio
of short-term debt to international reserves
– (2) Policy indicators: domestic credit growth, domestic credit to
private sector, M2 growth rate, budget balance (% of GDP),
government consumption growth rate
– (3) Internal variables: inflation rate, real interest rate, investment
growth, consumption growth, real growth rate
– (4) External variables: overvaluation, current account, export
growth
– (5) External debt variables: total debt(% of GDP), short-term
debt(% if total debt), short-term debt/export ratio, short-term
debt (% of GDP), ratio of equity liabilities to debt liabilities
8. Index of de jure Financial Openness
The Chinn-Ito de jure index of financial openness kchin
variable min p25 p50 p75 max sd
-------------------------------------------------------------------------------------
kchin -1.808 -1.129 -0.086 1.497 2.541 1.552
The Chinn-Ito Rating Index is constructed out of the natural break of
the Chinn-Ito de jure index of capital control:
kchinr = 1, 2, 3, 4, 5
1 2 3 4 5
close open
9. Distribution of Countries under Different
Degree of Financial Openness
• 118 emerging and developing countries, Year 2007
Number of
countries under
each level of
kchinr
kchinr=1 kchinr=2 kchinr=3 kchinr=4 kchinr=5
Upper income
group
0 5 5 11 19
Middle income
group
3 15 7 6 7
Low income group 4 24 2 3 5
10. Indexes of de facto Financial Openness
(International Financial Integration)
• Data source: Lane and Milesi-Ferretti’s "External
Wealth of Nations" Dataset 1970-2007 and
calculation based on the IMF IFS dataset
• GFA: gross foreign assets
• GFL: gross foreign liabilities
• Indexes:
• IFI1=100*(GFA+GFL)/PPPGDP
• IFI2=100*(GFA+GFL)/GDP
• IFI3=100*(GFA+GFL)/TRADE
11. -1.00
-0.50
0.00
0.50
1.00
1.50
1970 1975 1980 1985 1990 1995 2000 2005 2010
1A. Chinn-Ito Index
0
100
200
300
400
1970 1975 1980 1985 1990 1995 2000 2005 2010
1B. IFI2=100*(GFA+GFL)/GDP
0
100
200
300
1970 1975 1980 1985 1990 1995 2000 2005 2010
1C. IFI1=100*(GFA+GFL)/PPPGDP
50
100
150
200
250
300
1970 1975 1980 1985 1990 1995 2000 2005 2010
1D. IFI3=100*(GFA+GFL)/TRADE
Average Trend of International Financial Integration
Upper income group Middle income group Low income group
12. Identifying “Currency Crash” Events
• Criterions for indentifying “currency crash” events
( a la Frankel and Rose 1996):
– Annual devaluation rate at least 25%
– Devaluation rate is at least 10% higher than in the previous
year.
– Events occurring within 3 years of an earlier event are
windowed out.
• 197 independent currency crash events are identified
– Reduced to 175 events if we count the group devaluations by
the 13 CFA countries in 1981 or 1994 as a single event.
– The magnitude of the devaluations rates for these events:
median 59%; 25th percentile 37%; 75th 110%
19. Nonparametric Tests:
(T-3:T) vs. Control Group
Variables
Kruskal-
Wallis
Kolmogorov-
Smirnov
t-test
M2/intl reserves 0 0 0.054
Short debt/intl reserves 0 0 0.009
Domestic credit growth 0 0 0.828
DC to private sector growth 0 0 0
DC to private sector/M2 0 0 0.002
Bank loans(% GDP) 0.392 0.312 0.82
M2 growth 0 0 0
Budget balance(% GDP) 0.001 0.011 0.005
Government debt(% GDP) 0.132 0.048 0.028
Inflation 0 0 0
Investment(% GDP) 0 0 0
Investment growth 0 0 0
20. Variables
Kruskal-
Wallis
Kolmogorov-
Smirnov
t-test
Consumption growth 0 0 0
GDP growth 0 0 0
Current account(%GDP) 0 0 0
Export growth 0 0 0
openness 0 0 0
de facto International Financial
Integration1
0 0 0
de facto International Financial
Integration2
0 0 0
Total debt(%GDP) 0 0 0
Short-term debt(%GDP) 0 0 0
Short-term debt/export & income 0 0 0
Short-term debt(% export) 0 0 0
Debt/equity ratio 0 0 0.079
21. Probit Estimates
• The model:
– K -- Chinn-Ito index
– X -- control variables
– In order to avoid the endogeneity problem and to
smooth out the short-run fluctuations of the variables,
we use averages of the T-3, T-2, T-1 values for all the
regressors.
β)XKΘ(1)sProb(crisi iitit +== α
23. kchinl ifidl sdrl dc3gl drerl ygl cayl
-0.018 -0.021 0.008 0.003 -0.015 -0.024 -0.015
kchinl ifidl imresl dcpv3gl drerl sdx1l ygl cayl
-0.018 -0.026 0.008 -0.003 -0.016 0.016 -0.023 -0.013
Marginal effect on the likelihood if the regressor goes up by
one standard deviation
24. • Given that all other regressors are evaluated at the mean,
the likelihood that a country encounters a crisis will drop to
0.032 from 0.089 if it moves from the lowest degree of
capital account openness to highest degree of openness.
– Marginal effects after dprobit
– y = Pr(ev) (predict, p)
– = .03225865
– Marginal effects after dprobit
– y = Pr(ev) (predict, p)
– = .0894081
25. • Finding: currency crash events are more likely to occur
under a setting of tighter capital controls.
• Why?
26. • “Core” and “Peripheral” research themes in the
literature
“The Costs and Effects of Capital Controls – A Review of Recent
Literature and Implications for China” (working paper, Huang 2012)
– Core: Does financial openness promote higher
economic growth?
– Peripherals:
1. Are capital controls effective in preventing large
volumes of capital inflows or outflows?
2. Will capital controls bring about monetary autonomy
for the countries who aims to stabilize their exchange
rates?
3. Do capital controls bring about distortion and
corruption to the economy?
27. • “Core” and “Peripheral” research themes in the
literature
– Core: Does financial openness promote higher
economic growth?
– Peripherals:
4. Will capital account liberalization promote the
development of domestic financial system?
5. Does financial openness possess “discipline effects”–
to discipline and motivate the governments to pursue
macro-prudential and sustainable policies?
6. Are capital controls effective in preventing financial
crises? Or do capital controls help the economies to
fare better in the aftermath of the financial crises?
28. Why capital control is linked to higher
odds of currency crises?
• Theoretical arguments against capital controls:
– From microeconomic perspective: capital control can
cause distortion and facilitate corruption with the cost of
reduced efficiency and resource mis-allocation,
resulting in lower productivity and growth potential.
• Rajan and Zingales (1998)
• Johnson and Mitton (2002), Desai et. al. (2002), Forbes (2003)
– From macroeconomic perspective, financial openness
may possess a “discipline effect”. Therefore, policy
makers may be subject to adverse selection or moral
hazard problems when deciding capital account policies.
• Obstfeld (1998)，Tytell and Wei (2005)
29. Why capital control is linked to higher
odds of currency crises?
• Empirical exploration about the relationship
between economic performance and capital
controls:
kchinr vs. economic fundamentals
31. variables 1 2 3 4 5
Investment growth 4.999 5.622 6.057 6.966 7.838
Consumption growth 3.251 4.005 4.463 4.105 5.745
GDP growth 4.000 4.400 4.755 4.253 5.668
Export growth 4.800 5.955 6.695 6.700 8.303
openness 46.176 56.063 68.769 68.036 96.161
De facto k open1 68.200 94.600 96.400 105.400 194.500
De facto k open2 34.000 41.100 48.500 49.900 107.400
Debt/equity ratio 5.460 4.314 2.812 2.183 2.730
32. Why capital control is linked to higher
odds of currency crises?
• Capital control practices are not effective in limiting
capital inflows or outflows.
– Edwards(1999，2001)，Simone and Sorsa (1999)，
Valdés and De Gregorio (2000)，Cowan and De Gregorio
(2005) conclude that the “encaje” policy didn’t
effectively reduce the total volume of capital inflows, but
only had limited effect in lengthening the maturity of
capital inflows.
– Garcia and Barcinski (1998)，Garcia and Valpassos
(2000)，Goldfajn and Minella (2005)，Carvalho and
Garcia (2006) come to similar conclusions regarding
Brazil’s capital control practices.
33. Conclusions and Policy Implications
• In general, capital control does not reduce the probability
of financial crises. On the contrary, the tighter the control,
the more likely the inertia to postpone reforms, hence
leading to destablizing elements, and resulting in a higher
likelihood of financial crises.
• Under the ongoing trend of global financial integration,
capital control measures are becoming increasingly
ineffective while incurring increasingly higher costs and
distortions.
• A wiser approach to strenghen financial safety is to push on
necessary reforms and institutional development, to
pursue sustainable macroeconomic policies and to improve
the macroeconomic fundamentals.
