Abstract
How should emerging market countries handle surges in capital inflows that may pose both prudential and macroeconomic policy challenges? We review the arguments on the appropriate management of inflow surges and discuss the conditions under which controls on capital inflows may be appropriate. We argue that if the economy is operating near potential, if reserves are adequate, if the exchange rate is not undervalued, and if the flows are likely to be transitory, then controls on capital inflows—together with macroeconomic policy adjustment and prudential measures—may usefully form part of the policy toolkit.
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Notes
See Dell’Ariccia and others (2008); on costs and distortions, including resource misallocation, that controls give rise to, see Edwards and Ostry (1992), and Forbes (2007).
Although the discussion here is confined to controls on inflows, relaxing controls on outflows may also have an impact on aggregate net inflows, and hence on the exchange rate and other macroeconomic variables.
The IMF's Articles of Agreement recognize that members generally may exercise such controls as are necessary to regulate international capital movements (Article VI, Section 3). However, the general right of members to regulate international capital movements is qualified by members’ obligations subject to IMF surveillance under Article IV.
For example, in the cases of Chile and Colombia, controls appear to have had some success in tilting the composition of inflows toward less vulnerable liability structures; see De Gregorio and others (2000); and Cardenas and Barrera (1997).
See Ghosh and others (2008) for a discussion of appropriate policy responses to capital inflows and positive balance of payments pressures.
Estimating an equilibrium real exchange rate is particularly challenging if there is a perception of structural shifts in the role of EMEs in the global financial landscape.
Keeping credit conditions constant—so that sterilized intervention of capital inflows essentially replaces domestic credit with foreign credit—may require a greater-than-corresponding decrease in the volume of domestic credit since foreign credit will typically be offered at a lower interest rate (even adjusting for exchange rate expectations).
Other forms of sterilization include raising reserve requirements, which does not incur a fiscal cost (especially if reserves are not remunerated), though their excessive use can lead to undesirable financial disintermediation.
To the extent that the capital inflow represents a stock shift in portfolio preferences toward domestic assets, however, issuance of sterilization bonds may satisfy that demand, reducing further inflow pressures.
Cardarelli, Elekdag, and Kose (2007) provide evidence that real appreciation and demand growth was more contained in countries that responded to capital inflows by pursuing a tighter fiscal policy. However, there is often a political temptation to avoid making necessary fiscal adjustments and to rely instead on capital controls.
The literature does not provide unambiguous evidence on the relative effectiveness/distortedness of price-based vs. administrative controls. Countries tend to use the types of controls they are most familiar with from past practice—the obvious advantage being easier implementation for both the authorities and the banking sector.
Gallego, Hernández, and Schmidt-Hebbel (1999) present evidence that the effectiveness of Chile's unremunerated reserve requirements was eroded over time (for a given rate and interest rate differential).
The extent to which flows bypass banks is likely to be endogenous to their regulation; excessively tight limits on banks could lead to disintermediation and proliferation of nonregulated financial institutions (Wakeman-Linn, 2007).
Such a policy will be less effective if foreign investors circumvent the restrictions, for example, by writing currency swap contracts.
However, if the alternative to capital controls is stricter banking regulations, this could also affect small and medium enterprises (which typically are more dependent on bank financing and have limited scope for borrowing directly abroad).
To the extent that capital inflows to EMEs are driven by the policy environment in advanced economies, they too need to take account of the multilateral implications of their policies.
Of course, if capital controls against especially risky flows proliferate without undermining beneficial flows, such “ratchet effects” may not in the end be problematic.
See Ghosh, Ostry, and Tsangarides (2010) for a discussion of how reducing the precautionary demand for reserves would contribute to systemic stability by helping narrow global imbalances and avoid a sudden tipping point in the demand for major reserve assets.
One rule of thumb is that flows that push the real exchange rate toward equilibrium are more likely to be persistent than flows that contribute to overshooting. For an analysis of the cyclical behavior of different types of capital flows, see Becker and others (2007), which argues that banking flows are much more prone to reversal than other types of inflows (portfolio and FDI).
See Cardarelli, Elekdag, and Kose (2007), who find that, among countries facing inflow surges, those with controls experienced smaller inflows—2 percent of GDP in episodes with “high” capital controls compared with 4 percent of GDP in instances where the country had no or low controls. In a panel of EMEs, Kim, Qureshi, and Zalduendo (2010) likewise find that controls are associated with smaller surges.
See Gallego, Hernández, and Schmidt-Hebbel (1999) and De Gregorio and others (2000) for Chile; and Clements and Kamil (2009) for Colombia. Using a GARCH model, however, Edwards and Rigobon (2009) find that a tightening of controls led to depreciation of the nominal exchange rate within its band in Chile.
De Gregorio and others (2000) find that capital controls allowed Chile's central bank to target a higher domestic interest rate over a period of 6-12 months; Ma and McCauley (2008) and Hutchison and others (2009) find that interest differentials are significant and persistent in China and India, which maintain more extensive capital controls. However, Ghosh, Ostry, and Tsangarides (2010) find significantly lower monetary autonomy in countries with fixed exchange rates compared with more flexible regimes, even in countries with relatively closed capital accounts.
Ariyoshi and others (2000) examine the experience with capital controls of five countries (Brazil, Chile, Colombia, Malaysia, and Thailand) in the 1990s to limit short-term inflows. De Gregorio and others (2000), Cardoso and Goldfajn (1998), Cardenas and Barrera (1997), and Goh (2005) find that controls can lengthen the maturity of inflows. Of course, a finding of an effect on the composition of inflows belies the lack of a finding on aggregate volumes, unless one believes that substitution between different types of capital inflows is perfect.
Note that FDI includes loans between a parent and subsidiary, as long as the parent has a controlling interest, where controlling interest is usually taken to be an ownership stake of at least 10 percent.
In a sample of about 200 crisis episodes over 1970–2007, Gupta and others (2007) report a similar result, namely, that drops in output during crisis episodes are significantly lower if capital controls existed before the crisis.
In a comment on Ostry and others (2010), Cline (2010) finds no relationship between capital account openness and the output decline during the crisis, and questions whether such a relationship exists (or whether it is driven by the experience of the Baltic countries in the EME sample, which he considers unrepresentative). Cline, however, uses a composite index of capital account restrictiveness, which does not distinguish between controls on inflows and controls on outflows, whereas Ostry and others (2010) analysis, based on Schindler's (2009) index, distinguishes explicitly between inflow and outflow controls. Another important difference is that Cline's analysis is based on a sample of just 24 EME countries, whereas Ostry and others (2010) cover 41 EMEs, including the Baltic countries, whose experience in the recent financial crisis we believe offers important insights. Excluding the Baltic countries from the sample weakens the statistical significance of the association between overall controls on inflows and the growth decline, but the association between the growth decline and capital controls on debt liabilities remains statistically significant.
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Additional information
This note draws on Ostry and others (2010 and 2011).
*Jonathan D. Ostry is the Deputy Director of the Research Department at the International Monetary Fund. His areas of responsibility span both research (issues related to the capital account, fiscal and monetary policies, exchange rate regimes and the stability of the international monetary system), and surveillance (including the IMF-FSB Early Warning Exercise and multilateral exchange rate assessments). Atish R, Ghosh is Assistant Director in the Research Department of the International Monetary Fund. Prior to joining the IMF he was an assistant professor in the Department of Economics and Woodrow Wilson School of Public and International Affairs of Princeton University. Chamon is a senior economist and Mahvash S. Qureshi is an economist in the Research Department of the International Monetary Fund. The authors have published widely on international macroeconomic issues.