TWN Info Service on Finance and Development (Jan12/01)
25 January 2012
Third World Network

Capital controls an important macroeconomic policy tool
Published in SUNS #7289 dated 18 January 2012

Geneva, 17 Jan (Kanaga Raja) -- Contrary to claims in the popular press, by some in the economics profession as well as by some policymakers that capital controls are inherently protectionist measures, such controls can be justified ways to perform counter-cyclical balance to boom-and-bust cycles, to maintain monetary independence, and to support exchange rate and financial stability.

This is the main conclusion of a working paper by professor Kevin P. Gallagher of Boston University, released this month by the Political Economy Research Institute (PERI). The paper, titled "The Myth of Financial Protectionism: The New (and Old) Economics of Capital Controls", argues that capital controls are justified as an important part of the macroeconomic toolkit from a wide variety of theoretical perspectives within economics.

Controls can be seen as the means to these ends through the Keynesian and structuralist traditions, as well as through neo-classical based theories, it says.

Indeed, the paper adds, the newest wave of neo-classical research on the topic would brand controls not as protectionist policies, but as "correctionist" policies that make global capital markets work more efficiently.

According to the paper, unstable global capital flows to developing countries have been characteristic of the world economy in the wake of the global financial crisis.

"Such flows have triggered asset bubbles and exchange rate appreciation in a number of emerging and developing country markets, especially from 2009 until the Eurozone jitters in the fourth quarter of 2011. In response, some individual nations have deployed capital controls."

Resort to these measures has met a mixed response, says the paper. On the one hand, institutions such as the International Monetary Fund have supported the use of controls in limited circumstances. On the other hand, however, there has been a vociferous response by leading politicians, distinguished economists, and in the blogosphere claiming that the use of capital controls amounts to financial protectionism.

The paper notes that former UK Prime Minister Gordon Brown referred to the use of controls by emerging markets in 2010 as protectionist, as has former Nobel laureate Michael Spence.

However, the paper argues, such claims are unfounded.

"There is a longstanding strand of modern economic theory that dates back to [John Maynard] Keynes and [Raul] Prebisch, and continues to this day, that sees the use of capital controls as essential to financial stability, the ability to deploy an independent monetary policy, and to maintain exchange rate stability. These theories were supplanted in the 1980s and 1990s by theories of capital market liberalization."

However, the empirical record has shown that capital market liberalization was not associated with growth in developing countries. In a most recent development, mainstream economists have developed a "new welfare economics" of capital controls that sees controls as measures to correct for market failures due to imperfect information, contagion, uncertainty and beyond.

Taken as a whole then, rather than the "new protectionism," capital controls should be seen as the "new correctionism" that re-justifies a tool that has long been recognized to promote stability and growth in developing countries, the paper emphasises.

According to professor Gallagher, capital controls are regulations on capital flows that buffer from a number of risks that come with financial integration. Chief among those risks are currency risk, capital flight, financial fragility, contagion, and sovereignty.

Cross-border capital flows to emerging and developing countries tend to follow a similar pattern. Between 2002 and 2007, there were massive flows of capital into emerging markets and other developing economies.

After the collapse of Lehman Brothers, there was capital flight to the "safety" of the US market, which spread the North Atlantic financial crisis to emerging markets. As interest rates were lowered for expansionary purposes in the industrialized world between 2008 to 2011, capital flows again returned to emerging markets, where interest rates and growth were relatively higher.

Finally with Eurozone jitters in the final quarter of 2011, capital flight occurred to the "safety" of the US and beyond. The carry trade was one of the key mechanisms that triggered these flows. Increased liquidity induced investors to go short on the dollar and long on currencies in nations with higher interest rates and expectations of strengthening exchange rates.

With significant leverage factors, investors gained on both the interest rate differential and the exchange rate movements. Many nations deployed capital controls to regulate the negative effects of cross-border capital volatility.

The paper notes that economists usually differentiate between capital controls on capital inflows and controls on outflows. Moreover, measures are usually categorized as being "price-based" or "quantity-based" controls.

Listing examples of controls on inflows and outflows, the paper finds that sometimes the distinction can be murky. Examples of quantity-based controls are restrictions on currency mismatches, and minimum stay requirements and end-use limitations.

Many of these have been used by nations such as China and India. Examples of price-based controls include taxes on inflows (Brazil) or on outflows (Malaysia). Un-remunerated reserve requirements are both. On one hand they are price-based restrictions on inflows, but they also include a minimum stay requirement which can act like a quantity-based restriction on outflows.

The paper underscores that controls are most often targeting foreign-currency and local currency debt, equity, and currency trading of a short-term nature.

Foreign direct investment is often considered less volatile and less worrisome from a macroeconomic stability standpoint. Inflow restrictions on currency debt can reduce the overall level of such borrowing and steer investment toward longer-term productive investments and thus reduce risk.

Taxes on such investment cut the price differential between short- and long-term debt and thus discourage investment in shorter-term obligations. Outflows restrictions and measures are usually deployed to "stop the bleeding" and keep capital from leaving the host nation too rapidly.

A variety of these techniques have been used during the global financial crisis but have been branded as protectionist measures, the paper notes.

It points out that two major economists of the early 20th century were among the first to discuss the need for capital controls in modern economic theory. Raul Prebisch and John Maynard Keynes each articulated the need for regulating cross-border capital as a macroeconomic management tool in order to allow for national policy autonomy to generate productive economic activity.

Each of these economists spawned "post-structuralist" and "post-Keynesian" approaches to economic policy. Leaders in these fields, as well as policymakers have further developed and justified these early contributions by Prebisch and Keynes.

New archival work by economists Esteban Perez and Matias Vernengo (2012) has unearthed how Prebisch in particular had, "a preoccupation with the management of the balance of payments and the need for capital controls as a macroeconomic management tool, considerably before Keynes and White's plans led to the Bretton Woods agreement."

Professor Gallagher adds: "Of course the name that most would say is the intellectual antecedent of the contemporary use of capital controls is Keynes. Keynes saw the regulation of speculative capital as essential to maintain national autonomy for productive growth and employment."

In a statement that foreshadows much of the concerns of today that relate the carry trade to excessive capital flows in the wake of the financial crisis (with an unregulated carry trade raising the interest rate to cool off asset bubbles will actually attract more speculative capital, not less), Keynes said: "In my view the whole management of the domestic economy depends on being free to have the appropriate rate of interest without reference to the rates prevailing elsewhere in the world. Capital controls is a corollary to this."

According to the Gallagher paper, Paul Davidson points out that Keynes also says controls as a means to manage capital flow booms and busts: If there is a sudden shift in the private-sector's bull-bear disposition, what can be called the bandwagon effect, then price stability requires regulations constraining capital flows into and/or out of the market to prevent the bears from liquidating their position too quickly (or the bulls from rushing in) and overcoming any single agent (private or public) who has taken on the responsible task of market maker to promote "orderliness."

During the Bretton Woods negotiations that established a fixed but adjustable pegged exchange rate system, the International Monetary Fund (IMF), and the World Bank, Britain's chief negotiator, Keynes, and his US counterpart Harry Dexter White both agreed that a distinction should be made between "speculative" capital and "productive" capital, and that speculative "hot money" capital was to be scrutinized.

Indeed, says the paper, at those meetings, Keynes argued that, "control of capital movements, both inward and outward, should be a permanent feature of the post-war system." Capital controls (on capital account transactions) were made fully permissible under the Articles of the International Monetary Fund and remain so, despite efforts to the contrary, to this day. As Keynes said, "What used to be a heresy is now endorsed as orthodoxy."

Both Post-Keynesian and Structuralist economists have continued to emphasize that uncontrolled capital flows unleash serious financial risks and macroeconomic constraints, which render economies vulnerable to financial crises, exchange rate instabilities, slower output growth and greater unemployment.

While the paper says that a full survey of this literature is beyond its scope, it underlines that a handful of the core and more contemporary examples are necessary to note in order to show that these schools have long seen controls as a cornerstone of macroeconomic policy.

One of the more novel applications is in the Minsky tradition. To capture the financial fragility inherent in a regime of free capital flows, Weller (2001) and Arestis and Glickman (2002) extend Hyman Minsky's financial instability hypothesis to an open and financially liberalized economy.

In a financially liberalized open economy without capital controls, an economic boom will significantly "import the drive towards financial innovation" by attracting capital inflows from foreign investors looking for new investment opportunities and enabling households, firms, the government and banks to seek foreign sources of finance.

The initial economic euphoria, reflected in rising asset prices, investments and profits, acts to validate and encourage these foreign borrowings. Capital inflows produce an appreciation of the domestic currency, and thus encourage the taking of short-term positions in foreign currency. The euphoria also causes economic units to become more reckless in the risks they undertake, and resort to greater speculative financing.

However, says the Gallagher paper, over time, the initial economic boom and resulting increase in demand also acts to increase costs in the domestic capital goods industries. These rising costs, combined with the surge in speculative financing act to generate present-value reversals, and a decline in asset prices. With an erosion of their profit margin, over time, some speculatively financed units are likely to begin to default, and the chances of more units following suit increases.

Furthermore, the increase in foreign borrowings, particularly short-term liabilities, results in a rising debt-to-reserves ratio. Without capital controls, and given the rapid reversal tendency of short-term capital flows, both these developments will generate a panic among foreign investors, resulting in a rapid flight towards liquidity and a heavy selling of the domestic currency. Capital flight acts to reduce the values of assets, and through possible spillover effects in other sectors, it tends to aggravate the risk of a sharp depreciation in the domestic currency, making a country vulnerable to a financial crisis.

Given the volatile and pro-cyclical nature of free capital flows and their destabilizing effects, Post-Keynesian and Structuralist economists (e. g., Davidson, Eatwell and Taylor, Ocampo, Helleiner, Saad-Filho, Palma and Grabel) have argued for a permanent system of capital account regulation, which not only regulates capital outflows during financial crises, but also controls capital inflows during economic booms.

The paper says: "This could involve regulating the international exposure of domestic banks, regulating the availability of foreign exchange to domestic banks and private sector residents, and reducing real deposit rates. By helping to avoid over-borrowing, such a system provides a means of exercising monetary and domestic credit restraint during economic booms, and thereby guards against unsustainable exchange rate appreciations, and thus against the very occurrence of crises. In the event that a crisis nevertheless occurs, regulating capital outflows can help to avoid a sharp currency depreciation, and unmanageable increases in debt-service costs."

With respect to the threat of capital flight, Grabel (2006) emphasizes that policies restricting capital account convertibility help to reduce this risk by discouraging foreign investors from buying short-term assets that are most vulnerable to capital flight and by restricting their ability to liquidate such investments and send the proceeds out of the country.

Furthermore, says the paper, by reducing a country's vulnerability to sharp exchange rate fluctuations, capital flight and financial fragility, capital controls can guard against the risk of contagion due to financial and macroeconomic instability in another economy.

According to the paper, Frenkel (2002) argues that the destabilizing effects of unregulated capital inflows (e. g., unsustainable expansions in credit and liquidity, exchange rate appreciations and appreciation of financial and real assets) will be exacerbated in developing countries when financial markets are small, and not sufficiently diversified. He cites the Latin American experience, where liberalization was introduced in an environment in which the degree of monetization and financial depth was low, banking systems were weak, the menu of financial assets was poor and credit for the private sector was scarce.

The Post-Keynesian and Structuralist literature also draws attention to the fact that free capital flows severely reduce the degrees of freedom for macroeconomic management and policy autonomy since sustaining private foreign capital inflows require a strong exchange rate and high interest rates. A high interest rate acts to discourage domestic investment, while an appreciating exchange rate reduces the competitiveness of a country's exports. Thus, the ability to stimulate domestic investment (in accordance with national priorities of output and employment) is curtailed, and it becomes difficult for a country to use the exchange rate as a strategic device for gaining entry into the world market for manufactured goods.

Moreover, as pointed out by Davidson (2000), besides a loss of export-market share, an appreciating exchange rate also threatens domestic firms with a loss of home-market share since imports become cheaper. By making it more difficult for domestic entrepreneurs to gauge the potential profitability of large investment projects involving significant irreversible sunk costs, exchange rate volatility can have serious adverse effects on domestic investment.

Nayyar (2002) also argues that when short-term inflows such as portfolio investment become a major means of financing trade and current account deficits, the resulting appreciation of the real effective exchange rate acts to further widen these deficits. A vicious circle emerges, with these larger deficits requiring even greater portfolio investment inflows. Persistent large deficits may, over time, reduce investor confidence, and thus generate adverse expectations, ultimately resulting in a reversal of inflows and speculative attacks on the domestic currency.

The paper says that besides constraining policies in normal times, free capital mobility also severely constrains policy autonomy during a financial crisis, therefore exacerbating problems of falling output, reduced domestic investment and unemployment. As Grabel (2006) argues, a crisis forces a government to resort to contractionary monetary and/or fiscal policies (through higher interest rates and reduced social spending) so as to reverse a capital flight. This curtails the ability to use expansionary policies (such as government deficits or low interest rates) to stimulate aggregate demand and domestic investment.

Epstein and Schor (1992) develop a macroeconomic model which captures how capital controls allow for macroeconomic management and policy autonomy by controlling the links between the domestic real interest rate, capital flows and real exchange rate. By providing a safeguard against capital flight, a system of effective capital controls allows a government to pursue an expansionary monetary policy by lowering the domestic real interest rate without significantly affecting the real exchange rate or foreign exchange reserves. By stimulating domestic investment, an expansionary monetary policy can therefore be used to raise domestic output and employment.

Similarly, says the paper, even if an expansionary fiscal policy raises the domestic real interest rate, by restricting capital inflows, capital controls will cause the real exchange rate to appreciate less than it would in the case of unrestricted inflows. Less exchange rate appreciation in turn would mean that export competitiveness is less adversely affected. Finally, by regulating capital outflows, capital controls also insulate an economy from adverse effects on domestic investment and/or export competitiveness due to changes in foreign real interest rates or foreign policies.

The paper adds: "Backed by new developments in economic theory and interest groups that sought to deepen global capital markets, capital account liberalization became vogue in the 1980s and 1990s. While capital market liberalization seemed to be correlated with economic growth in the industrialized world during this period, the same cannot be said in developing country contexts. Towards the end of this liberalization in the early 1990s, however, currency crises erupted and many developing nations became afflicted with financial crises. In lieu of this, the merits of capital account liberalization in developing countries came under great scrutiny in the early 2000s and even more so in the wake of the financial crisis."

In terms of empirical evidence, it has been shown that capital market liberalization in developing countries is not associated with economic growth. Indeed, the most recent research has shown that capital market liberalization is only associated with growth in nations that have reached a certain institutional threshold - a threshold that most developing nations are yet to achieve. This is partly due to the fact that the binding constraint for some developing country growth trajectories is not the need for external investment, but the lack of investment demand. This constraint can be accentuated through foreign capital flows because such flows appreciate the real exchange rate, thus reducing the competitiveness of goods and reducing private sector willingness to invest.

The paper goes on to address the new welfare economics of capital controls, saying that the demise of capital market liberalization has only been accentuated by the global financial crisis. As global capital flows became recognized as having adverse effects in the wake of the crisis, UN agencies and governments with Post-Keynesian and Post-Structuralist tendencies have regained their legitimacy.

"What is equally remarkable is a new strand of economic theory has arisen in response to the inadequacies of capital market liberalization and the recognition of the inherent instability of capital flows to developing countries. ‘New' Keynesians working in a general equilibrium context have begun to see capital controls as measures to correct for market failures in the world economy - thus arguing that controls are market correcting rather than distortionary or protectionist. This has been referred to as the ‘new welfare economics of capital controls'."

Citing the Mundell-Fleming model, the paper says that one main conclusion of Robert Mundell (1963) is that perfect capital mobility, a fixed exchange rate regime, and independent monetary policy cannot all coexist; countries can maintain at most two of the three. This so-called "trilemma," continues to be reinforced by empirical studies and thereby remains a central assumption of studies on capital flows.

The global financial crisis and the role that capital mobility played in the crisis and its aftermath has attracted a burgeoning level of theoretical attention not seen on this issue since the days of Mundell and Fleming. Indeed, recent studies of capital controls directly model the welfare implications of controls by focusing on the externalities of capital flows. These studies focus on the macro-prudential role of capital controls. A Pigouvian tax on capital inflows is one such macro-prudential policy that corrects for the externalities associated with highly integrated capital markets.

Theoretical analysis with emphasis on externalities and welfare effects can be described as the "new welfare economics" of capital controls, as stated in Jeanne, Subramanian and Williamson (2012). The main motivation of this literature stems from the recent global financial crisis and the capital flow behaviour in emerging markets. In the recent decade, emerging markets have been subject to substantial capital inflows and a buildup of international reserves. Such high levels of external borrowing raise the probability of sudden stops and capital flight. As observed during the 2008-2009 financial crisis, de-leveraging and fire sales of assets can result. Such are externalities associated with financial contagion, yet on the international level.

According to the paper, the externalities arise because borrowers do not internalize the impact of their behaviour on aggregate instability, e. g. systemic risk and the likelihood of fire sales. The purpose of the prudential capital control is then to induce private agents (borrowers) to internalize the externalities. The optimal capital control is effectively a Pigouvian tax on capital inflows, which will enhance welfare and restore efficiency of the decentralized market equilibrium. This type of control may then improve financial stability and prevent sudden stops or capital flight. Indeed, emerging market economies such as Brazil have implemented controls in the form of taxes on foreign debt; hence, their welfare implications are highly relevant to current public policy.

The paper notes that rising capital market liberalization and the recent global financial crisis has motivated many studies to examine the adverse consequences of highly integrated markets. Joseph E. Stiglitz has been a significant skeptic of capital market liberalization and has presented arguments for intervention in capital flows based on empirical and theoretical findings. The main arguments against full capital market capitalization arise from the following outcomes of open markets: increased risk diversification, more pro-cyclical capital flows, increased risk of contagion, increased risk of capital flight, increased financial instability.

The paper also highlights that another newly designed theory examines controls on capital flows in a portfolio allocation approach. Motivated by the lack of a unified theoretical framework to analyse capital controls, Magud, Reinhart, and Rogoff (2011) present a model to examine the effects of controls on short-term capital flows.

Before presenting their model, Magud, Reinart, and Rogoff (2011) outline four "fears" caused by open capital markets, describe the measures and empirical results of existing studies, and provide results from their standardization technique. The four fears pertain to financial instability and thus explain the use of capital controls. All four are: fear of appreciation or of a floating exchange rate, fear of "hot money" flows, fear of large inflows, and fear of loss of monetary independence.

In its overall conclusions, the paper notes that one objection to the use of controls that has remained outside of theoretical discussions is the efficacy of controls.

While stressing that a full review of this literature is beyond the scope of the paper, it says that it is important to note that a mountain of high-level research has recently shown that capital controls have been effective in the 21st century.

In a February 2010 Staff Position Note, the IMF staff reviewed all the evidence on capital controls on inflows, pre- and post-crisis and concluded: "capital controls - in addition to both prudential and macroeconomic policy - is justified as part of the policy toolkit to manage inflows. Such controls, moreover, can retain potency even if investors devise strategies to bypass them, provided such strategies are more costly than the expected return from the transaction: the cost of circumvention strategies acts as ‘sand in the wheels'".

To come to this conclusion, this recent and landmark IMF study reviews the experiences of post-Asian crisis capital controls. The IMF also conducted its own cross-country analysis in this study, which also has profound findings, says professor Gallagher.

The econometric analysis conducted by the IMF examined how countries that used capital controls fared versus countries that did not use them in the run-up to the current crisis. They found that countries with controls fared better: "the use of capital controls was associated with avoiding some of the worst growth outcomes associated with financial fragility". This work has been echoed by National Bureau of Economic Research studies.

These landmark developments in theory and practice can be built upon. Further research and policy is needed within and outside of economics, the paper concludes. +