Worries about capital flows and the potential side effects of poorly designed capital controls (trade wars, market inefficiencies and distortions) are all the rage these days.
But some economists are sceptical (here’s one) as to whether capital controls even work, or if the market — in the form of investors using fancy bank-contrived derivatives — will simply find a way around them. Perhaps they’re inconvenient but ineffective?
Injecting his analysis into the issue is economist Eduardo Levy-Yeyati, who studied the experiences of Chile in the late 1990s and Argentina in the earlier part of the last decade.
His conclusions:
Are capital controls effective?
Yes, as they impose a toll on traffic in and out of domestic markets.
How effective?
This will depend on the cost of the toll (and the volume of traffic). For example, a 2% tax will not obtain much more than a 3% cut in the value of local assets (including the local currency); a 10% tax will obtain a proportionally (but probably not linearly) stronger effect. A 2% tax opened to future adjustments (as recently seen in Brazil) should have an effect somewhere in between, as it affects the expectations and should keep the position of short-term speculative investors relatively light.
Given that they are effective, are they efficient?
Probably yes, if the objective is to mitigate the impact of the capital flows that emulate (and usually amplify) global or domestic economic cycles. But, at this point, controls need to be considered as part of a macro-prudential toolkit to prevent asset inflation and overvaluation that is costly to revert in the down cycle. This toolkit should also include sterilised intervention, debt policy (as in sovereign debt de-dollarization), incentives for foreign asset accumulation (as in the relaxation of foreign assets investment limits on pension funds), and micro prudential regulation on financial intermediaries.
The convenience of the capital controls can only be analysed within the optimal macro-prudential mix (the combination of instruments, intensity, and contingent rules) – a complex subject that is already at the centre of the macroeconomic policy debate in the developing world.
A quick reminder that this study is based on only two examples. That said, more such inquiry into the question is obviously welcome given its importance. (Here is another study broadly in favour, also from VoxEU.)
It’s also important to remember that capital flows come in different shapes, each of which has a different impact on their target country. Buying a company differs from investing in a bond fund. Or at least that’s the assumption.
Because unfortunately, economists are still limited in how much they know about these varying effects. It’s not entirely their fault. Here’s a passage from This Time is Different, the history of financial crises by Carmen Reinhart and Ken Rogoff (our emphasis):
The aforementioned academic literature does not actually paint sharp distinctions between different types of capital flows—for instance, debt, equity, and foreign direct investment (FDI)—or between long-term versus short-term debt. Practical policy makers, of course, are justifiably quite concerned with the exact form that cross-border flows take, with FDI generally thought to have properties preferable to those of debt (FDI tends to be less volatile and to spin off indirect benefits such as technology transfer). We generally share the view that FDI and equity investment are somewhat less problematic than debt, but one wants to avoid overstating the case. In practice, the three types of capital inflows are often interlinked (e.g., foreign firms will often bring cash into a country in advance of actually making plant acquisitions). Moreover derivative contracts can blur the three categories. Even the most diligent statistical authority may find it difficult to accurately separate different types of foreign capital inflows (not to mention the fact that, when in doubt, some countries prefer to label a particular investment FDI to make their vulnerabilities seem lower).
Here’s another:
There is evidence to suggest that capital flows to emerging markets are markedly procyclical (that is, they are higher when the economy is booming and lower when the economy is in recession). Procyclical capital inflows may, in turn, reinforce the tendency in these countries for macroeconomic policies to be procyclical as well. The fact that capital inflows collapse in a recession is perhaps the principal reason that emerging markets, in contrast to rich countries, are often forced to tighten both fiscal policy and monetary policy in a recession, exacerbating the downturn. Arguably, having limited but stable access to capital markets may be welfare improving relative to the boom-bust pattern we so often observe. So the deeply entrenched idea that the growth trajectory of an emerging market economy will be hampered by limited access to debt markets is no longer as compelling as was once thought.
A rethinking has been in order for a while, and it seems that’s exactly what we’re getting. All the same, the language here is hedged — and another interpretation is simply that there remains an awful lot we simply don’t know about the consequences of capital flows, capital controls, or, more generally, about the appropriate pace and nature of financial liberalisation in developing economies.
As we’ve said before, despite their protectionist associations, capital controls aren’t the worst thing in the world when imposed with the right motivations, and not overdone. Certainly they are more favourable than a proper trade war.
Concerns that emerging markets will absorb too much capital too quickly, potentially leading to financial instability later, are perfectly legitimate. But they shouldn’t be taken too far, and should be balanced with the understanding that it’s perfectly natural for greater and greater amounts of capital to be flowing from the developed world to emerging Tilt markets.
It was far less natural when such large amounts of capital were flowing in the opposite direction in the decade before the crisis. The question now is to what extent this recent increase is part of a deeper, secular trend versus a passing investor fad.
It’s not so easy to know to answer in real time, it seems. More on this later.
Related link:
A G20 “victory” – FT Alphaville