The Pros and Cons of Capital Controls

September 2011

Andrew Flowers: Thank you for joining us for another EconSouth Now podcast. I'm Andrew Flowers of the Atlanta Fed's research department, and today we'll be discussing capital controls. Emerging-market economies face a unique set of challenges, among them the economic imbalances that large fluctuations in foreign investment can produce, making it difficult to conduct effective monetary policy. Some countries have begun implementing safeguards to stabilize their economies. We'll speak today with Dr. Kevin Gallagher, associate professor of international relations at Boston University. He is here to speak with me about capital controls and the evolving school of thought regarding them. Kevin, thanks for joining me today.

Kevin Gallagher: Thanks for having me.

Flowers: To start, could you define capital controls, and give a recent example?

photo of Dan Kevin GallagherGallagher: Capital controls are simply capital account regulations that help smooth the procyclicality of short-term debt inflows and outflows in and out of emerging markets. They often come in two forms—either price-based instruments or quantity-based instruments.

To give you a couple of examples, Brazil has a 6 percent tax on foreign currency when it's converted into equities or into short-term debt. They also have a 1 percent tax on betting against the real in derivatives markets. Those are examples of price-based controls, although I like to refer to them as capital account regulations. Quantity-based use more, sort of mandated-controls (if you will) as an instrument; one example is something called in-use limitation, where only firms with foreign currency reserves can borrow abroad. An example of something like that—South Korea currently has a measure where they are only allowing foreign currency conversion into foreign direct investment or if a company needs to purchase raw materials that they can't get domestically. That's an example of a quantity-based measure.

Flowers: Now, why would a country want to, or feel the need to, implement capital controls?

Gallagher: As I said, to try to smooth the procyclicality of short-term capital flows. Capital flows tend to be procyclical in emerging markets, meaning you often get too much during good times and they can cause asset bubbles and appreciation in the exchange rate or at least exchange rate volatility. You might also want to do it if you are concerned about the balance sheet of your banks—if there is lots of currency mismatches, or maturity mismatches, capital account regulations can be used to throw a wedge into those.

Another key reason why nations consider capital account regulations is to have a more independent monetary policy. In a world like we have today where we are in a fairly financially globalized world, meaning there are not very many restrictions, relative to the past anyway, in terms of the capital accounts across the world, things like the carry trade can make monetary policy sometimes work in the opposite way than it's been originally intended, at least from the textbooks. For example, right now we are obviously in an environment where we have relatively loose monetary policy in the United States with the Fed chair saying that we are going to have low interest rates locked in for the next couple of years, countries such as Brazil (that I mentioned before) that have some of these regulations, they have interest rates that are around 12 percent; so that's really ripe for carry trade activity where hedge funds and other investors can look at the low interest rates in the United States, high rates at a place like Brazil, and they can borrow dollars, convert them into real, and invest in Brazil. Not only do you make a profit based on the interest rate spread, you can also make a profit depending upon how you set up your hedge on the relative movements of the two currencies and if you have a leverage factor, you can also make a lot of money there, too. So there's a built-in major incentive there since we have a mismatch in monetary policy. Across the world right now there's a real incentive for short-term capital flows to really flow into some of these emerging markets. India has just raised their rate to 8.5 percent, so there's another place where folks could take advantage of those spreads.

So capital account regulations can help give a country the ability to have a more independent monetary policy. Obviously, if you are getting all these inflows you might be getting bubbles and so forth and concern about your real estate market or inflation, the natural thing to do would be to raise your interest rate to try to cool off the economy. However, if you raise the interest rate in this beneficial carry trade environment you could actually turn out getting more flows than you were in the very first place. That's why countries like Turkey, to reduce bubbles, they've actually lowered the interest rate.

Flowers: Before the recent financial crisis during the era of international capital liberalization, many economists, policymakers, and other academics argued capital controls were unwise, distortionary policies. Could you please elaborate on those arguments?

Gallagher: Sure. As you said, it's really changed now, there's really a sea change in thinking about these controls. But traditionally, I guess, there have been three concerns about capital controls. Certainly in the 1990s, theoretical economists were writing a lot about the optimality of having an open capital account, and freeing capital in the same way that a country might free its current account or its trade. And there was such momentum around that idea that there was actually almost a move to change the International Monetary Fund, or the IMF's, articles of agreement to cover the capital account. Currently, the IMF mandates that there be a free flow of goods and services through the current account and the investments and profits made through that. But countries are now wide open, and have been ever since Bretton Woods was forged, to have restrictions on capital flows and the capital accounts. Indeed, both Harry Dexter White (on the U.S. side) and John Maynard Keynes (on the side of the United Kingdom) both agreed that restrictions on capital flows should be a fundamental part of an international monetary system. But in the 1990s that started to be questioned with the rise of new classical economics, new classical macroeconomics. There was theoretical research done that showed that it could be optimal for developing countries to have open capital accounts. For one, in most cases these countries have traditionally had lower savings, and so with an open capital account it would allow funds to flow from the countries that are relatively well off to the countries that needed that savings so that they could accumulate for development. Many countries tried that, and the empirical record from the mainstream economic journals show that there isn't a correlation between an open capital account and economic growth. This became manifest in the financial crises of the 1990s, late 1990s, starting with Asia, rippling across Latin America and Russia, and so forth. So, the seeds of the change in thinking around open capital accounts started in the 1990s when we began to empirically test some of these theories.

The second concern about capital controls is that they might be what's called "beggar-thy-neighbor." If capital controls are used as an instrument to try to keep the exchange rate relatively low, then that could have spillover effects on some of your neighbors.

And the third concern that folks have expressed in the past was that they just don't work, that they haven't been effective. And that's really changed recently with the bulk of the econometric evidence. If you look at new work by Carmen Reinhart and Nicolas Magud for the National Bureau of Economic Research, they have a very rigorous review of the literature that shows that indeed, those nations that deploy capital controls seem to be able to change the composition of flows toward more long-term debt, reduce exchange rate volatility, and have a more independent monetary policy, and this has been echoed by even more recent econometric work at the International Monetary Fund, where they found that those nations that use capital controls were actually among the least hard-hit during the crisis, and the IMF is now actively recommending that certain nations use controls in this environment now where we have this multispeed recovery and this interest rate gap that is causing massive inflows into the developing world.

Flowers: You mentioned the sea change of thought at the IMF; they recently released two reports this spring sanctioning the use of capital controls under certain circumstances. Could you please elaborate on those circumstances?

Gallagher: At the spring International Monetary Fund meetings in April of 2011, the board approved a set of guidelines to help nations think about when to use capital controls, and the set of guidelines outlines a handful of conditions. They think that a nation should use controls only if their currency is not valued after they have accumulated a sufficient amount of foreign exchange reserves, after they have exhausted fiscal policy and macroprudential policies to try to meet the same goal, and then if they have tried all those mechanisms and those aren't working, then to use capital controls as a last resort.

Flowers: The IMF's attempt to gain the authority of deciding when capital control usage is appropriate was rebuffed by developing countries. Why did they resist these IMF guidelines?

Gallagher: For two reasons: First, the guidelines came out of the G20 when the president of France charged the IMF with developing a set of guidelines, and in his speech, when he asked the IMF to set up guidelines, he said that guidelines should be set for the use of capital controls in the context of the need for countries to fully open up their capital accounts, or to have capital market liberalization, and then when nations should use capital controls as a safeguard mechanism. So, first, developing countries are very concerned, especially given the empirical evidence now that there be any official push to make it globally mandated that nations open up their capital accounts, especially in this environment. The emerging markets seem to have fared better after the crisis than the developed countries that have had such open markets. So, almost categorically, anything that was seen as a road toward a global mandate for capital account liberalization, they took with great caution.

And then, secondly, they just found it fairly ironic that all of this new International Monetary Fund econometric work, and work by econometricians in the North, confirmed that what many of these emerging markets had been doing for the past 10 years is working. And then they see it ironic as those same countries turn around and tell the emerging markets when they should and when they shouldn't be using the things because, obviously, they're figuring something out, they've created a set of regulations that help them buffer the worst of the crisis and have a much speedier recovery. And they see it ironic for the nations that are not recovering and that are continuing to have gridlock about financial regulatory reform be the ones to tell them how to regulate their financial markets.

Flowers: In your own research, you suggest that the IMF should instead focus its efforts on (1) helping developing countries enforce capital controls and, (2) promoting global coordination regarding controls. Can you elaborate on that?

Gallagher: Sure. One of the great services that the IMF has done is that it has unearthed through this econometric work that in many cases these controls are meeting their desired goals. But the IMF is in the business of giving a lot of advice to emerging markets and developing countries and having a very deep influence in the workings of central banks and monetary authorities across the world. So they are uniquely poised to sort of go behind the econometrics and say, "OK, well if India's controls played a big role in buffering the effects of the crisis, and if Brazil's controls are working now, exactly how are these administered and designed," helping nations learn from the other countries that are using such controls in a positive manner and that are working. And also help nations and do some more research on its own end about how these things are circumvented. As I mentioned, one of the arguments against controls, traditionally, has been, "Well, they don't work very well, and they don't work for very long," and that's true if you're not dynamic and continually fine-tuning them. Regulators and members of the market community alike have a lot to teach the world about how the controls can be circumvented and how regulators need to continually monitor the markets and try to administer and develop the administrative capacity to put together controls.

So the fund is uniquely poised because they have the audience, which are the people who are going to be putting in place these regulations. And I think there is a danger now that the stigma is being lifted with respect to capital controls that the Indonesias or the Palaus of the world will say, "Hey, these are good, and they just announced through a press release from their central bank that they've got a withholding tax on certain bonds," and there is much more to it than that; you just don't flick a switch, it takes a lot of administrative capacity, and the IMF could really help nations build that and learn from each other. So, that's on developing and enforcing controls at the national level.

And, I also think that the IMF could promote coordination regarding controls in at least two or three ways. First, they could argue that there should be no further restrictions on controls, that, under the articles of agreement of the IMF (like I mentioned before), nations are fully able to be able to deploy capital account regulations, and they should articulate that that is a nation's freedom and they should do what they can to preserve that given now that their own research shows that it is an important policy space to have—for an emerging market to manage its financial system.

The second thing that the IMF could do, and I would argue that they've been doing this very boldly and are in the lead here, and that is reducing the stigma of capital account regulations, or capital controls. Just by publishing the reports that they are doing and by recommending to the Colombians, to the Indians, to the Brazilians that they might want to consider more capital controls, more of that dispassionate and reasoned recognition of this as a regulation that should be an important part of a macroprudential tool kit takes the stigma away from it, and if we cooperated on getting the stigma away from this and started seeing these as just another part of the tool kit that should be part of a country's arsenal to manage its capital account and financial system would go a long way.

And then the third thing on global cooperation is that there is a real problem with the fact that many of the trade and investment treaties from the United States and increasingly from the European Union make it difficult, or at least actionable, to deploy controls, and countries can get sued by private investors if they use controls. We need more attention put on that, and the IMF could play a role with helping come up with a framework to have more consistency across the patchwork of over 2,000 trade treaties that are out there in the world, so the countries have the freedom to prevent and mitigate financial crises.

Flowers: Kevin, for my last question I want to express a concern some economists and policymakers have regarding the potential for increased reliance on capital controls by developing countries that it would lead to increased trade protectionism and counterproductive, as you said, beggar-thy-neighbor policies. Do you feel that these are valid concerns?

Gallagher: To a certain extent, yes. First of all, I should say that capital controls are no substitute for a whole package of macroeconomic and financial policies to prevent and mitigate financial crises. They should be seen, as I've said, as part of a broad tool kit. We learned the hard way that countries need as big of an arsenal as they can to prevent and mitigate a crisis, and now the evidence shows that these kinds of measures should be part of that tool kit, but in no way are they a substitute or a salvation.

In regards to being distortionary and beggar-thy-neighbor, [it] really depends on how you think about economic theory and how you look at the evidence. Some will argue that capital controls, or capital account regulations, are distortionary because it's the government acting in an environment where markets would act better. But there's a lot of new welfare economics that shows that while financial markets are procyclical, there's lots of information externalities, and coordination externalities, and therefore, capital controls aren't distortionary; in fact, they are actually correctionism where they are correcting in a Pigovian way market imperfections the same way a tax on pollution or air pollution in Atlanta might be internalizing externalities. Capital controls can be internalizing some of the externalities that we have, especially information externalities that are rife in capital markets.

With respect to the beggar-thy-neighbor concerns, sure, if a country is using capital controls as part of a program to keep its exchange rate excessively undervalued, that can have spillover effects on some of its neighbors. But thus far, there isn't a real body of empirical research that shows that there is a significant amount of spillovers when it comes to controls. As a matter of fact, more often than not, capital controls are being used to manage spillovers from industrialized countries. The quantitative easing from the United States and the carry trade interest rate gap that I mentioned before are generating massive spillovers from industrialized countries to emerging markets, and capital controls are in one way a corrective mechanism to make those markets that are so imperfect across the world right now with respect to this more efficient.

Flowers: Kevin, thanks a lot for joining us today.

Gallagher: Thank you very much for having me.

Flowers: Again, we've been speaking today with Kevin Gallagher of Boston University's international relations department. This concludes our EconSouth Now podcast on capital controls. To read the article about this topic, please see the third-quarter 2011 edition of EconSouth magazine. On our website,, you can read the full article about this topic or subscribe to EconSouth in print.

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