Capital controls

The 2008–09 global financial crisis has opened a new chapter in the debate over the proper policy responses to global capital flows. Until very recently, certain strands of the economics profession as well as industrialized countries’ national governments and international financial institutions have remained either hostile or silent towards regulat- ing capital movements. However, capital flows were at the heart of the crisis that occurred in 2008–09, and were the source of significant financial fragility thereafter. Capital flows from emerging markets and developing countries with current account surpluses fuelled the debt binge that led to the crisis in the industrialized world. When the crisis hit, there was a sudden stop in capital flows to emerging markets and developing countries. During the initial years of the recovery, capital flows surged into emerging markets as economic growth rates and interest rates were relatively low in the industrialized world.

A number of countries, including Iceland, Brazil, Taiwan, Indonesia, South Korea and others, have been experimenting with the re-regulation of capital flows during these turbulent times. Indeed, even the International Monetary Fund (IMF), long sceptical of regulating capital flows, has come to partially recognize the appropriateness of capital controls (as regulations on capital have traditionally been referred to) and has gone so far as to recommend that countries deploy them to mitigate the crisis and prevent further fragility (Grabel, 2011; Chwieroth, 2013).

Regulations on capital flows – or capital controls – are limits on the level or composi- tion of cross-border financial flows that enter or leave a country. They are often deployed to manage exchange-rate volatility, avoid maturity mismatches, limit speculative activity in an economy, and provide the policy-space for independent monetary policy. Measures often come in two varieties: price or quantity-based. Price-based measures alter the price of foreign capital, such as with a tax on inflows or outflows. Quantity-based measures require that a certain quantitative cap on certain types of capital flows be administered. A new generation of regulations was conceived in the wake of the crisis that occurred in the cross-border derivatives market and were used in South Korea, Brazil and else- where, which has become a key channel for global capital flows (see Ocampo et al., 2008; Gallagher, 2014).

In economic theory, a “new welfare economics” of capital controls has arisen. In this view, unstable capital flows to emerging markets can be viewed as negative externalities on recipient countries. Therefore, regulations on cross-border capital flows are tools to correct for market failures that can make markets work better and enhance economic growth, rather than worsen it (Korinek, 2011). According to this research, externali- ties are generated by capital flows because individual investors and borrowers do not know (or they ignore) what the effects of their financial decisions will be on the level of financial stability in a particular nation. A better analogy than protectionism would be the case of an individual firm not incorporating its contribution to urban air pollution. Whereas in the case of pollution the polluting firm can accentuate the environmental harm done by its activity, in the case of capital flows a foreign investor might tip a nation into financial difficulties and even a financial crisis. This is a classic market failure argument and calls for what is referred to as a Pigouvian tax that will correct for the market failure.

On the empirical front, the literature now demonstrates that capital account liberaliza- tion is not strongly associated with economic growth and stability. Jeanne et al. (2012) conduct a sweeping “meta-regression” of the entire literature and find little correlation between capital account liberalization and economic growth. They conclude that “the international community should not seek to promote totally free trade in assets – even over the long run – because free capital mobility seems to have little benefit in terms of long run growth and because there is a good case to be made for prudential and non- distortive capital controls” (Jeanne et al., 2012, p. 5). There is also considerable work demonstrating that capital account liberalization is associated with a higher probability of financial crises (Reinhardt and Rogoff, 2010).

There is also now strong evidence that capital controls can help manage exchange rate volatility and financial fragility. At the same time as these theoretical breakthroughs, a consensus is emerging on the efficacy of capital account regulations. The majority of studies suggest that the capital account regulations deployed in the period from the Asian financial crisis until the global financial crisis of 2008–09 met many of their stated goals. In the most comprehensive review of the literature, Magud et al. (2011) analyse studies on controls on capital inflows and outflows, as well as multi-country studies. The authors conclude that “in sum, capital controls on inflows seem to make monetary policy more independent, alter the composition of capital flows, and reduce real exchange rate pressures” (ibid., p. 11). There are fewer studies on controls about capital outflows, comprising mostly studies of Malaysia’s 1998 outflows restrictions. In Malaysia, Magud et al. (ibid.) found controls “reduce outflows and may make room for more independent monetary policy” (ibid., p. 11). In the wake of the global financial crisis, Ostry et al. (2010) further confirmed this literature when finding that those coun- tries that had deployed capital controls on inflows were among the world’s least hard-hit during that crisis.

See also:

Capital flight; Financial crisis; Financial instability; International Monetary Fund; Sudden stops.