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Capital controls: An evaluation
Carmen Reinhart and Nicolas Magud
University of Maryland, College Park, Department of Economics
Online at http://mpra.ub.uni-muenchen.de/14097/
MPRA Paper No. 14097, posted 16. March 2009 14:28 UTC
Capital controls: An evaluation
University of Oregon
Carmen M. Reinhart
University of Maryland and NBER
A revised version was published in: Sebastian Edwards (ed.), Capital Controls and
Capital Flows in Emerging Economies: Policies, Practices, and Consequences (Chicago:
Chicago University Press for the NBER, 2007), 645-674.
The literature on capital controls has (at least) four very serious apples-to-oranges problems: (i) There is not unified theoretical framework to analyze the macroeconomic consequences of controls; (ii) there is significant heterogeneity across countries and time in the control measures implemented; (iii) there are multiple definitions of what constitutes a “success” and (iv) the empirical studies lack a common methodology – furthermore these are significantly “overweighted” by a couple of country cases (Chile and Malaysia). In this paper, we attempt to address some of these shortcomings by: being very explicit about what measures are construed as capital controls. Also, given that success is measured so differently across studies, we sought to “standardize” the results of over 30 empirical studies we summarize in this paper. The standardization was done by constructing two indices of capital controls: Capital Controls Effectiveness Index (CCE Index), and Weighted Capital Control Effectiveness Index (WCCE Index). The difference between them lies only in that the WCCE controls for the differentiated degree of methodological rigor applied to draw conclusions in each of the considered papers.
Inasmuch as possible, we bring to bear the experiences of less well known episodes than those of Chile and Malaysia.
This paper was prepared for the NBER’s International Capital Flows Conference, Santa Barbara, California, December 16-18, 2004. The authors want to thank conference participants and Vincent R. Reinhart and Miguel A. Savastano for useful comments and suggestions. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research
I. INTRODUCTIONThe literature on capital controls has (at least) four very serious issues that make it difficult, if not impossible, to compare across theoretical and empirical studies. We dub these the apples-to-oranges problems and they include: (i) There is no unified theoretical framework (say, as in the currency crisis literature) to analyze the macroeconomic consequences of controls; (ii) there is significant heterogeneity across countries and time in the capital control measures implemented; (iii) there are multiple definitions of what constitutes a “success” (capital controls are a single policy instrument—but there are many policy objectives); and (iv) the empirical studies lack a common methodology and are furthermore significantly “overweighted” by the two poster children--Chile and Malaysia.
Our goal in this paper is to find a common ground among the non-comparabilities in the existing literature. Of course, there is usually a level of generality that is sufficiently encompassing. After all, an apples-to-oranges problem can be solved by calling everything fruit. Our goal is, as far as possible, to measures of capital controls on a uniform basis.
Once done, it should be easier to understand the cross-country and time-series experience.
We attempt to address some of these apples-to-oranges shortcomings by being very explicit about what measures are construed as capital controls. We not only document the more drastic differences across countries/episodes and between controls on inflows and outflows, but the more subtle differences in types of inflow or outflow controls. Also, given that success is measured so differently across studies, we standardize (wherever possible) the results of over 30 empirical studies summarized in this paper. Inasmuch as possible, we bring to bear the experiences of episodes less well known than those of Chile and Malaysia.
The standardization was done by constructing two indices of capital controls:
Indices of Capital Controls Effectiveness (CCE), and Weighted Capital Control Effectiveness (WCCE ). The difference between them lies only in that the WCCE controls for the differentiated degree of methodological rigor applied to draw conclusions in each of the considered papers.
With these indexes, our results can be summarized briefly. Capital controls on inflows seem to make monetary policy more independent, alter the composition of capital flows, and reduce real exchange rate pressures (although the evidence there is more controversial). Capital controls on inflows seem not to reduce the volume of net flows (and hence, the current account balance). As to controls on outflows, there is Malaysia and there is everybody else. In Malaysia, controls reduced outflows, and may have given room for more independent monetary policy (the other poster child does not fare as well, in that our results are not as conclusive as for the Chilean controls on inflows). Absent the Malaysian experience, there is little systematic evidence of “success” in imposing controls, however, defined.
The paper proceeds as follows. The next section summarizes some of the key reasons why capital controls—particularly capital controls on inflows—are either considered or implemented. Controls, as we note help deal with what we dub as the “four fears”. Section III focuses on the distinctions among types of capital controls—highlighting that not all capital control measures are created equal and therefore can be simply lumped together in a rough capital controls index. Section IV, examines the existing empirical evidence by standardizing and sorting studies along a variety of criteria. Namely, we focus on the following sorting strategy. First, we analyze separately cases where the study was multi country or focused on a single case study; second, we distinguish the cases where the controls were primarily designed to deal with inflows or outflows; third, we provide an ad hoc (but uniform) criteria to rank the approach or econometric rigor applied in the study to test hypotheses about the effects of the controls; and last, we evaluate the outcomes reported in the studies according to the definition of what constitutes a success. The last section discusses some of the policy implications of our findings.
Anyone examining the literature on capital controls, which spans many decades and all the regions around the globe, would be well advised to retain a sense of irony.
Repeatedly, policy makers have sought refuge in tax laws, supervisory restraint, and regulation of financial transactions to cope with external forces that they deem to be unacceptable. Often they rationalized their actions on loftier grounds, sometimes so effectively as to make it difficult to clearly identify episodes of controls on capital.
But in all these episodes, four fears lurk beneath the surface.
1. Fear of appreciation Being the darling of investors in global financial centers has the decided, albeit often temporary, advantage of having ample access to funds at favorable cost. With the capital inflow comes upward pressure on the exchange value of the currency, rendering domestic manufacturers less competitive in global markets, and especially so relative to their close competitors who are not so favored as an investment vehicle. A desire to stem such an appreciation (which Calvo and Reinhart, 2002, refer to as “fear of floating”) is typically manifest in the accumulation of foreign exchange reserves. Over time, though, sterilizing such reserve accumulation (the topic of Reinhart and Reinhart, 1998) becomes more difficult, and more direct intervention more appealing.
2. Fear of “hot money” For policy makers in developing countries, becoming the object of foreign investors’ attention is particularly troubling if such affection is viewed as fleeting. The sudden injection of funds into a small market can cause an initial dislocation that is mirrored by the strains associated with their sudden withdrawal. Such a distrust of “hot money” was behind James Tobin’s initial proposal to throw sand in the wheels of international finance, an idea that has been well received in at least some quarters. Simply put, a high-enough tax (if effectively enforced) would dissuade the initial inflow and pre-empt the pain associated with the inevitable outflow.
3. Fear of large inflows Policy makers in emerging market economies do not universally distrust the providers of foreign capital. Not all money is hot but even then, sometimes the sheer volume of flows matters. A large volume of capital inflows, particularly when it is sometimes indiscriminate in the search for higher yields (in the manner documented by Calvo, Leiderman and Reinhart, 1994), causes dislocations in the financial system. Foreing funds can fuel asset price bubbles and encourage excess risk taking by cash-rich domestic intermediaries. Again recourse to tax may seem to yield a large benefit.
4. Fear of loss of monetary autonomy The interests of global investors and domestic policy makers need not always—or even often—align. But a trinity is always at work that it is not possible to have a fixed (or highly managed) exchange rate, monetary policy autonomy, and open capital markets (as discussed in Frankel, 2001). If there is some attraction to retaining some element of monetary policy flexibility, something has to give up. However, in the presence of the aforementioned fear of floating, giving up capital mobility may seem more attractive than surrendering monetary policy autonomy.
Whatever the reason inducing action, some form of capital control might seem as controlling exchange rate pressures, stemming large inflows, and regaining an element of monetary autonomy. Less fortunate are those policy makers who impose controls to reduce capital flight, because investors seeking safety—most importantly including domestic residents as well as foreigners—are seldom dissuaded by regulatory restraint.
III. CAPITAL CONTROLS? WHAT DO WE MEAN BY CAPITAL CONTROLS?In most of the empirical literature there are no distinctions between controls on outflows and inflows—these exercises suffer from the same problems as the de jure IMF classification of exchange rate arrangements. Even when a distinction is made between inflows and outflows (as we do here), controls can and do range from the explicit to the subtle and the market friendly to the coercive.
Furthermore, when considering the impacts and effectiveness of capital controls one cannot lump together the experiences of countries that have not substantially liberalized (i.e., India and China) with countries that actually went down the path of financial and capital account liberalization and decide at some point to reintroduce controls, as the latter There is, of course, the important issue of temporary versus permanent policies which is a distinction not addressed here owing to the fact that most empirical studies do not focus on this issue. For a model and a discussion of the temporary versus permanent issue see Reinhart and Smith (2002).
have developed institutions and practices that are integrated in varying degrees to international capital markets.
Tables 1-2, which squarely focus on measures targeted to affect inflows in countries which had already gone the route of capital account liberalization 2 indeed highlight the heterogeneity in both subtlety and “market-friendliness” of capital control measures that have been tried in Asia, Europe, and Latin America during booms (these involve controls on capital inflows) as well as crashes (and attempts to curb capital outflows). These measures not only differ in subtlety and other features but also in intensity. 3 Hence, these cases involve the reintroduction of controls.
For a measure that “quantifies” the intensity of these measures see Montiel and Reinhart (1999).
Table1. Restrictions on Inflows and “Prudential Requirements:” Asia Country and date (in parentheses) denoting the first year of the surge in inflows Indonesia (1990) March, 1991: Central Bank adopts measures to discourage offshore borrowing.
Bank Indonesia begins to scale down its swap operations by reducing individual banks' limits from 25 to 20 percent of capital. The three-month swap premium was raised by 5 percentage points.
October, 1991: All state-related offshore commercial borrowing was made subject to prior approval by the Government and annual ceilings were set for new commitments over the next five years.
November, 1991: Further measures are taken to discourage offshore borrowing. The limits on banks' net open market foreign exchange positions were tightened by placing a separate limit on off-balance sheet positions.
Bank Indonesia also announced that future swap operations (except for "investment swaps" with maturities of more than two years) would be undertaken only at the initiative of Bank Indonesia.
Malaysia (1989) June 1, 1992: Limits on non-trade-related swap transactions were imposed on commercial banks.
January 17, 1994-August 1994: Banks were subject to a ceiling on their non-trade- or noninvestment-related external liabilities.
January 24, 1994-August 1994: Residents were prohibited from selling short-term monetary instruments to nonresidents.
February 2, 1994-August 1994: Commercial banks were required to place with Bank Negara the ringgit funds of foreign banking institutions (Vostro accounts) held in non-interest bearing accounts. However, in the January-May period these accounts were considered part of the eligible liabilities base for the calculation of required reserves, resulting in a negative effective interest rate in Vostro balances.
February 23, 1994-August 1994: Commercial banks are not allowed to undertake non-trade related swap and outright forward transactions on the bid side with foreign customers.
Philippines (1992) July, 1994: Bangko Central begins to discourage forward cover arrangements with non-resident financial institutions.