What Are Capital Controls?
The IMF recently published a report regarding the experiences that countries across the world have had with capital controls. The full document, entitled Country Experiences with the Use and Liberalization of Capital Controls, can be found on the IMF web page at http://www.imf.org/external/pubs/ft/op/op190/index.htm.
This FAQ summarizes key aspects of the IMF report. Please refer to the full document for further information.
I. What Are Capital Controls?
Capital controls restrict the free movement of capital. Countries use these controls to restrict volatile movements of capital entering (inflows) and exiting (outflows) their country. These increased volatile movements in capital can be attributed to the expanding global economy and a country's willingness to liberalize its financial system by allowing free convertibility of its currency. Analysts say currency convertibility has normally been allowed to finance current trade and direct investment transactions. Only recently has currency convertibility also been allowed in the capital account. By introducing this "capital account convertibility," countries expose themselves to autonomous inflows and outflows of funds (capital) by foreigners and locals, thus subjecting their currency to speculation and exchange rate volatility.
Restrictions can be placed on capital inflows and outflows. The IMF report states that most countries impose controls on inflows to respond to the macroeconomic implications of the increasing size and volatility of capital inflows. Outflow controls are used to limit the downward pressure on their currencies. Such controls are mainly applied to short-term capital transactions to counter speculative flows that threaten to undermine the stability of the exchange rate and deplete foreign exchange reserves.
A. Why Capital Controls?
The report states that many countries implement capital controls to help reconcile conflicting policy objectives when their exchange rate is fixed or heavily managed. The most common argument for the implementation of capital controls is to preserve the autonomy of monetary policy or of domestic objectives regarding direct monetary policy, as well as to reduce pressures on the exchange rate. A related argument is to protect monetary and financial stability during persistent capital flows. This is particularly important when there are concerns about the inflationary consequences of large capital inflows or when banks or the corporate sector inadequately assess their risk.
Inadequate assessment of risk typically occurs in the context of a heavily managed exchange rate that, by providing an implicit exchange rate guarantee, encourages a build-up of unhedged foreign currency positions. The report also states that capital controls have been used to support policies of financial repression to provide cheap financing for government budgets and priority sectors.
B. Types of Capital Controls
Capital controls encompass a wide range of diversified and often country-specific measures. These restrictions to capital movements usually take two broad forms: (a) "administrative" or direct controls and (b) "market-based" or indirect controls. Although these controls are usually applied separately during heavy capital flows, they are often applied in tandem.
Administrative or direct controls restrict capital transactions and associated payments and transfer of funds through outright prohibitions. These controls are designed to directly affect the volume of cross-border financial transactions.
They typically impose administrative obligations on a country's banking system to control the flows of capital.
Market-based or indirect controls make transactions more costly thereby discouraging capital movement and the associated transactions. These capital controls may take the form of dual or multiple exchange rate systems, explicit taxation of cross-border financial flows, indirect taxation of cross-border flows and other indirect regulatory controls.
II. Disadvantages
The report states that regardless of whether capital controls are effective, their use may come at a cost. First, restrictions on capital flows, particularly when they are comprehensive or wide-ranging, may interfere with desirable capital and current transactions along with less desirable ones.
Second, controls may entail non-trivial administration costs for effective implementation, particularly when the measures have to be broadened to close potential loopholes for circumvention.
Third, there is also the risk that shielding the domestic financial markets by capital controls may postpone necessary adjustments in policies or hamper private-sector adaptation to changing international circumstances.
Finally, controls may give rise to negative market perceptions, which may in turn make it costlier and more difficult for the country to access foreign funds.
III. Conclusions of Report
The effectiveness of the controls to achieve their intended objectives has been mixed. In most countries, the controls had some effect initially, but fell short of meeting each country's objectives. The report further breaks down its conclusions into short-term capital inflows and capital outflows.
A. Capital Inflows
The report suggests two tentative conclusions. First, to be effective, the coverage of controls needs to be comprehensive and the controls need to be implemented forcefully. Considerable administrative costs are incurred in continuously extending, amending, and monitoring compliance with the regulations. Second, although capital controls appeared to be effective in some countries, it is difficult to be certain of their role given the problems involved in disentangling the impact of the controls from that of the accompanying policies, which included the strengthening of prudential regulations, greater exchange rate flexibility and adjustment in monetary policy, as they are often imposed and modified for macroeconomic rather than microeconomic reasons, for example, at times of downward pressure on exchange rates.
B. Capital Outflows
The reimposition of controls on capital outflows during episodes of financial crisis has provided only a temporary respite of varying duration to the authorities. The experiences of the countries studied suggests that: (a) to be effective, the controls must be comprehensive, strongly enforced and accompanied by necessary reforms and policy adjustments; (b) controls do not provide lasting protections in the face of sufficient incentives for circumvention (in particular, attractive return differentials in the offshore markets and strong market expectations of currency depreciation); (c) the ability to control offshore market activity may have been instrumental in containing outflows and stemming speculative pressures; and (d) effective measures risk discouraging legitimate transactions, including foreign direct investment and trade-related hedging transactions and may raise the cost of accessing international capital markets.
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Showing posts with label Lecture 4. Show all posts
Showing posts with label Lecture 4. Show all posts
International Rules for Capital Controls
Although economists generally agree that countries can derive substantial gains from international economic integration, the extent to which they should open themselves to international capital flows remains a controversial issue.
There is still, 20 years after the rise of emerging markets finance, a wide diversity of approaches to capital account policies. Some emerging market economies maintain a completely open capital account. Others, most notably Brazil, have experimented more actively with market-based prudential capital controls since the crisis. And still other countries, such as China, maintain tight restrictions on their capital account.
There has also been a shift in official views on this topic, which have become more sympathetic to capital controls (Ostry et al. 2011; IMF 2011). Unlike for trade in goods, however, there are no international rules to constrain, discipline, or indeed legitimise restrictions that countries put on their capital account.1 In our monograph Who Needs to Open the Capital Account? (Jeanne et al. 2012), we present the case for developing international rules for capital flows.
The case for prudential capital controls
The pros and cons of prudential capital controls to curb the boom-bust cycle in capital flows have been discussed before (Williamson 2005), but economists now understand better the theoretical case for such policies with a new literature on the welfare economics of prudential capital controls (Korinek 2011). This literature essentially transposes to international capital flows the closed-economy analysis of the macroprudential policies that aim to curb the boom-bust cycle in credit and asset prices. It finds that it is optimal to impose a countercyclical Pigouvian tax on debt inflows in a boom to reduce the risk and severity of a bust. Interestingly, the optimal tax would fall primarily on the flows (short-term or foreign currency debt) that are the least likely to be conducive to economic growth. The optimal tax has also been quantified in calibrated dynamic welfare optimising models. Models with endogenous and occasionally binding constraints are not tractable and must be simplified in some respects to be solvable, even numerically, but the results may be informative.
A nice example of this approach is Bianchi (2011), who finds, in a model calibrated to Argentina, that the optimal tax rate on one-year foreign currency debt increases with the country's indebtedness and fluctuates between 0% and a maximum of 22%. Obviously, capital controls are not a silver bullet.
Like any attempt to regulate the financial sector, they elicit attempts to circumvent or evade and can be used effectively only if they are used with moderation. But this observation applies to all taxes and regulations. Capital controls are not a panacea, but this does not prevent them from being a legitimate instrument in the macroprudential toolbox. Capital account policies and trade distortions The international community invests considerably more effort in maintaining a level playing field for international trade in goods than for international trade in assets. One could argue that this is justified by the fact that the gains from free trade seem much larger for the former than for the latter (Bhagwati 1998). And Chapter 3 of our book, which uses a “meta-regression” approach incorporating a large number of empirical specifications, confirms the finding in most of the literature: free capital mobility has little impact on economic development (although there is some evidence that foreign direct investment and stock market liberalisation may, at least temporarily, raise growth). The problem about using this finding to be agnostic or permissive about capital account restrictions is that those restrictions can be used to distort real exchange rates to the advantage of the countries that impose them. This contradicts the purpose of trade rules and over time may erode the support for free trade. China, because of its importance in the global economy, is the most significant example. It would be an exaggeration to describe the Chinese capital account as closed, if only because China receives large amounts of foreign direct investment (and even encourages it through tax incentives). But China severely restricts other forms of capital inflows, and controls its outflows too.
Most of the Chinese foreign assets are accumulated as international reserves, which the authorities have accumulated in large quantities. However, full control over capital flows implies full control over its macroeconomic doppelganger, the trade balance, and hence the real exchange rate.
Under some conditions, as shown in Jeanne (2011), full control over the capital account allows the authorities to undervalue the real exchange rate and affect trade flows in the same way as they would with import tariffs and export subsidies. The case for international rules Currently, the international regime is permissive about the use of capital controls: countries can use them or not as they wish. We view this status quo as problematic and see compelling reasons to establish an international regime for capital flows.
First, the lack of commonly agreed rules implies that capital controls are still marked by a certain stigma, so that the appropriate policies may be pursued with less than optimal vigour. But we also argue that an international regime for capital flows should go further, and take appropriate account of spill-over effects. This is particularly the case of policies that repress domestic demand and, through a combination of reserve accumulation and restrictions on inflows, maintain a current account surplus.
Those policies have the same economic effects as trade protectionism and undermine the global public good of free trade. But the point may apply also to prudential capital controls. As recently shown by Forbes et al (2012) in the case of Brazil, capital account restrictions are liable to divert capital flows from one recipient to another, and thereby give third countries a strong interest in the controls imposed by others.
The implications of this argument have not yet been absorbed by the profession, but it seems possible that they will turn out to be significant for the optimal international design of capital account policies. As for trade in goods, if there are controls, we would be strongly in favour of having transparent, price-based measures, such as a countercyclical tax on certain types of capital flows. The international community could agree on a ceiling on the tax rate to ensure that the harmful effects of controls (if any) would be limited. The new rules could be embodied in an international code of good practices developed under the auspices of the IMF. In a world where capital and trade flows have become so linked, the asymmetry of the status quo comprising permissiveness toward the former and strict regulation of the latter is increasingly untenable.
Source...click here
There is still, 20 years after the rise of emerging markets finance, a wide diversity of approaches to capital account policies. Some emerging market economies maintain a completely open capital account. Others, most notably Brazil, have experimented more actively with market-based prudential capital controls since the crisis. And still other countries, such as China, maintain tight restrictions on their capital account.
There has also been a shift in official views on this topic, which have become more sympathetic to capital controls (Ostry et al. 2011; IMF 2011). Unlike for trade in goods, however, there are no international rules to constrain, discipline, or indeed legitimise restrictions that countries put on their capital account.1 In our monograph Who Needs to Open the Capital Account? (Jeanne et al. 2012), we present the case for developing international rules for capital flows.
The case for prudential capital controls
The pros and cons of prudential capital controls to curb the boom-bust cycle in capital flows have been discussed before (Williamson 2005), but economists now understand better the theoretical case for such policies with a new literature on the welfare economics of prudential capital controls (Korinek 2011). This literature essentially transposes to international capital flows the closed-economy analysis of the macroprudential policies that aim to curb the boom-bust cycle in credit and asset prices. It finds that it is optimal to impose a countercyclical Pigouvian tax on debt inflows in a boom to reduce the risk and severity of a bust. Interestingly, the optimal tax would fall primarily on the flows (short-term or foreign currency debt) that are the least likely to be conducive to economic growth. The optimal tax has also been quantified in calibrated dynamic welfare optimising models. Models with endogenous and occasionally binding constraints are not tractable and must be simplified in some respects to be solvable, even numerically, but the results may be informative.
A nice example of this approach is Bianchi (2011), who finds, in a model calibrated to Argentina, that the optimal tax rate on one-year foreign currency debt increases with the country's indebtedness and fluctuates between 0% and a maximum of 22%. Obviously, capital controls are not a silver bullet.
Like any attempt to regulate the financial sector, they elicit attempts to circumvent or evade and can be used effectively only if they are used with moderation. But this observation applies to all taxes and regulations. Capital controls are not a panacea, but this does not prevent them from being a legitimate instrument in the macroprudential toolbox. Capital account policies and trade distortions The international community invests considerably more effort in maintaining a level playing field for international trade in goods than for international trade in assets. One could argue that this is justified by the fact that the gains from free trade seem much larger for the former than for the latter (Bhagwati 1998). And Chapter 3 of our book, which uses a “meta-regression” approach incorporating a large number of empirical specifications, confirms the finding in most of the literature: free capital mobility has little impact on economic development (although there is some evidence that foreign direct investment and stock market liberalisation may, at least temporarily, raise growth). The problem about using this finding to be agnostic or permissive about capital account restrictions is that those restrictions can be used to distort real exchange rates to the advantage of the countries that impose them. This contradicts the purpose of trade rules and over time may erode the support for free trade. China, because of its importance in the global economy, is the most significant example. It would be an exaggeration to describe the Chinese capital account as closed, if only because China receives large amounts of foreign direct investment (and even encourages it through tax incentives). But China severely restricts other forms of capital inflows, and controls its outflows too.
Most of the Chinese foreign assets are accumulated as international reserves, which the authorities have accumulated in large quantities. However, full control over capital flows implies full control over its macroeconomic doppelganger, the trade balance, and hence the real exchange rate.
Under some conditions, as shown in Jeanne (2011), full control over the capital account allows the authorities to undervalue the real exchange rate and affect trade flows in the same way as they would with import tariffs and export subsidies. The case for international rules Currently, the international regime is permissive about the use of capital controls: countries can use them or not as they wish. We view this status quo as problematic and see compelling reasons to establish an international regime for capital flows.
First, the lack of commonly agreed rules implies that capital controls are still marked by a certain stigma, so that the appropriate policies may be pursued with less than optimal vigour. But we also argue that an international regime for capital flows should go further, and take appropriate account of spill-over effects. This is particularly the case of policies that repress domestic demand and, through a combination of reserve accumulation and restrictions on inflows, maintain a current account surplus.
Those policies have the same economic effects as trade protectionism and undermine the global public good of free trade. But the point may apply also to prudential capital controls. As recently shown by Forbes et al (2012) in the case of Brazil, capital account restrictions are liable to divert capital flows from one recipient to another, and thereby give third countries a strong interest in the controls imposed by others.
The implications of this argument have not yet been absorbed by the profession, but it seems possible that they will turn out to be significant for the optimal international design of capital account policies. As for trade in goods, if there are controls, we would be strongly in favour of having transparent, price-based measures, such as a countercyclical tax on certain types of capital flows. The international community could agree on a ceiling on the tax rate to ensure that the harmful effects of controls (if any) would be limited. The new rules could be embodied in an international code of good practices developed under the auspices of the IMF. In a world where capital and trade flows have become so linked, the asymmetry of the status quo comprising permissiveness toward the former and strict regulation of the latter is increasingly untenable.
Source...click here
For and against Capital controls
Full freedom of movement for capital and payments has so far only been approached between individual pairings of states which have free trade agreements and relative freedom from capital controls, such as Canada and the U.S., or the complete freedom within regions such as the European Union, with its "Four Freedoms" and the Eurozone. During the first age of globalization that was brought to an end by World War I, there were very few restrictions on the movement of capital, but all major economies except for Great Britain and the Netherlands heavily restricted payments for goods by the use of current account controls such as tariffs and duties.[8]
[edit]Arguments in favour of free capital movement
Pro free market economists claim the following advantages for free movement of capital:
- It enhances the general economic welfare by allowing savings to be channelled to their most productive use.[28]
- By encouraging foreign direct investment it helps developing economies to benefit from foreign expertise.[28]
- Allows states to raise funds from external markets to help them mitigate a temporary recession.[28]
- Enables both savers and borrowers to secure the best available market rate.[12]
- When controls include taxes, funds raised are sometimes siphoned off by corrupt government officials for their personal use.[12]
- Hawala-type traders across Asia have always been able to evade currency movement controls
- Computer and satellite communication technologies have made Electronic funds transfer a convenience for increasing numbers of bank customers.
[edit]Arguments in favour of capital controls
Pro capital control economists have made the following points.
- Capital controls may represent an optimal Macroprudential policy that reduces the risk of financial crises and prevents the associated externalities.[3] [50] [62] [63]
- Global economic growth was on average considerably higher in the Bretton Woods periods where capital controls were widely in use. Using Regression analysis, economists such as Dani Rodrik have found no positive correlation between growth and free capital movement.[28]
- Capital controls limiting a nation's residents from owning foreign assets can ensure that domestic credit is available more cheaply than would otherwise be the case. This sort of capital control is still in effect in both India and China. In India the controls encourage residents to provide cheap funds directly to the government, while in China it means that Chinese businesses have an inexpensive source of loans.[23]
- Economic crises have been considerably more frequent since the Bretton Woods capital controls were relaxed. Even economic historians who class capital controls as repressive have concluded capital controls, more than the period's high growth, were responsible for the infrequency of crisis.[23] Studies have found that large uncontrolled capital inflows have frequently damaged a nation's economic development by causing its currency to appreciate, by contributing to inflation, and by causing unsustainable economic booms which often precede financial crises - caused when the inflows sharply reverse and both domestic and foreign capital flee the country. The risk of crisis is especially high in developing economies where the inbound flows become loans denominated in foreign currency, so that the repayments become considerably more expensive as the developing country's currency depreciates. This is known as original Sin (economics).[8][64][65]
What are capital controls?
Capital controls are residency-based measures such as transaction taxes and other limits or outright prohibitions, which a nation's government can use to regulate flows from capital markets into and out of the country's capital account.
These measures may be economy-wide, sector-specific (usually the financial sector), or industry specific (for example, “strategic” industries). They may apply to all flows, or may differentiate by type or duration of the flow (debt, equity, direct investment; short-term vs. medium- and long-term).
Types of capital control include exchange controls that prevent or limit the buying and selling of a national currency at the market rate, caps on the allowed volume for the international sale or purchase of various financial assets, transaction taxes such as the proposed Tobin tax, minimum stay requirements, requirements for mandatory approval, or even limits on the amount of money a private citizen is allowed to remove from the country.
There have been several shifts of opinion on whether capital controls are beneficial and in what circumstances they should be used. Capital controls were an integral part of the Bretton Woods system which emerged after World War II and lasted until the early 1970s. This period was the first time capital controls had been endorsed by mainstream economics. In the 1970s free market economists became increasingly successful in persuading their colleagues that capital controls were in the main harmful. The US, other western governments, and the international financial institutions (the International Monetary Fund (IMF) and World Bank) began to take an increasingly critical view of capital controls and persuaded many countries to abandon them to reap the benefits of financial globalization.[1] The Latin American debt crisis of the early 1980s, the East Asian Financial Crisis of the late 1990s, the Russian Ruble crisis of 1998-99, and the Global Financial Crisis of 2008, however, highlighted the risks associated with the volatility of capital flows, and led many countries—even those with relatively open capital accounts—to make use of capital controls alongside macroeconomic and prudential policies as means to dampen the effects of volatile flows on their economies. In the aftermath of the Global Financial Crisis, as capital inflows surged to emerging market economies, a group of economists at the IMF outlined the elements of a policy toolkit to manage the macroeconomic and financial-stability risks associated with capital flow volatility, and the role of capital controls within that toolkit.[2] The study, as well as a successor study focusing on financial-stability concerns stemming from capital flow volatility,[3] while not representing an IMF official view, were nevertheless influential in generating debate among policy makers and the international community, and ultimately in bringing about a shift in the institutional position of the IMF.[4][5][6] With the increased use of capital controls in recent years, the IMF has moved to destigmatize the use of capital controls alongside macroeconomic and prudential policies to deal with capital flow volatility. More widespread use of the capital controls instrument, however, raises a host of multilateral coordination issues, as enunciated for example by the G-20, echoing the concerns voiced by Keynes and White more than six decades ago.[7
The links refer to this article
These measures may be economy-wide, sector-specific (usually the financial sector), or industry specific (for example, “strategic” industries). They may apply to all flows, or may differentiate by type or duration of the flow (debt, equity, direct investment; short-term vs. medium- and long-term).
Types of capital control include exchange controls that prevent or limit the buying and selling of a national currency at the market rate, caps on the allowed volume for the international sale or purchase of various financial assets, transaction taxes such as the proposed Tobin tax, minimum stay requirements, requirements for mandatory approval, or even limits on the amount of money a private citizen is allowed to remove from the country.
There have been several shifts of opinion on whether capital controls are beneficial and in what circumstances they should be used. Capital controls were an integral part of the Bretton Woods system which emerged after World War II and lasted until the early 1970s. This period was the first time capital controls had been endorsed by mainstream economics. In the 1970s free market economists became increasingly successful in persuading their colleagues that capital controls were in the main harmful. The US, other western governments, and the international financial institutions (the International Monetary Fund (IMF) and World Bank) began to take an increasingly critical view of capital controls and persuaded many countries to abandon them to reap the benefits of financial globalization.[1] The Latin American debt crisis of the early 1980s, the East Asian Financial Crisis of the late 1990s, the Russian Ruble crisis of 1998-99, and the Global Financial Crisis of 2008, however, highlighted the risks associated with the volatility of capital flows, and led many countries—even those with relatively open capital accounts—to make use of capital controls alongside macroeconomic and prudential policies as means to dampen the effects of volatile flows on their economies. In the aftermath of the Global Financial Crisis, as capital inflows surged to emerging market economies, a group of economists at the IMF outlined the elements of a policy toolkit to manage the macroeconomic and financial-stability risks associated with capital flow volatility, and the role of capital controls within that toolkit.[2] The study, as well as a successor study focusing on financial-stability concerns stemming from capital flow volatility,[3] while not representing an IMF official view, were nevertheless influential in generating debate among policy makers and the international community, and ultimately in bringing about a shift in the institutional position of the IMF.[4][5][6] With the increased use of capital controls in recent years, the IMF has moved to destigmatize the use of capital controls alongside macroeconomic and prudential policies to deal with capital flow volatility. More widespread use of the capital controls instrument, however, raises a host of multilateral coordination issues, as enunciated for example by the G-20, echoing the concerns voiced by Keynes and White more than six decades ago.[7
The links refer to this article
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