When the COVID-19 shock hit international capital markets in March 2020, emerging market economies experienced the sharpest reversal of portfolio flows on record – more than $100 billion within a month (IMF 2020; for a broad analysis of the economic effects of COVID-19 see also Baldwin and Weder di Mauro 2020a, 2020b). This illustrated two important properties of capital flows to emerging markets: first, they are fickle; second, they disappear precisely when they are needed most by their recipients.
The episode thus serves as a reminder that managing capital flows represents a perennial challenge, not only for policymakers in developing and emerging economies, but also for international financial institutions and academics seeking to advise them. In light of this challenge, the IMF is currently working on integrating pro-active advice on managing international capital flows into a common framework with other macroeconomic and financial policies (see e.g. Gopinath 2019). We synthesise the lessons from academic research on the theory, empirics, and policy debate on capital controls in a forthcoming paper (Erten et al. 2020).
Capital controls: Theory
Like all economic actions, capital flows to emerging economies have benefits and costs. However, what is most relevant for public policy is that some of these costs may not be internalised by the individual actors, and hence represent externalities. The two most commonly observed reasons for public intervention in capital flows to emerging economies are that they may contribute to financial instability and that they may interfere with aggregate demand management.
Regarding financial instability, a significant body of literature has identified pecuniary externalities that arise when emerging economies experience financial crises with balance sheet effects (e.g. Jeanne and Korinek 2010, Korinek 2011, 2018, Bianchi 2011). The intuition is that economies in crises typically experience sharp exchange rate depreciations when capital flows out, and these depreciations reduce the value of domestic collateral and increase the relative value of repayments on foreign currency debt. Individual actors take the level of the exchange rate as given and do not internalise that they exacerbate the depreciations when they receive capital inflows that may reverse during crises. As a result, individually rational borrowers receive capital inflows that are excessive in level, excessively denominated in foreign currency, and excessively short-term. Capital controls can be used to internalise these externalities and restore efficiency.
Regarding aggregate demand, an important strand of literature has observed that there are aggregate demand externalities when borrowers in emerging economies are exposed to booms and busts in capital flows but cannot perfectly manage the level of aggregate demand (see e.g. Farhi and Werning 2012, 2014, 2016, Ocampo 2016, Schmitt-Grohé and Uribe 2016). Emerging economies with fixed exchange rates are an important example of this, since they are prevented from using domestic monetary policy to target domestic aggregate demand. When this is the case, capital inflows may lead to overheating and capital outflows may lead to demand shortages. Following the spirit of the Mundell-Fleming trilemma (Fleming 1962, Mundell 1963), capital controls can help to mitigate the trade-off, i.e. by enabling domestic interest rate policy to focus on its domestic objectives rather than being solely in the service of targeting external exchange rates.
Capital controls: Empirics
The recontruction of global private capital markets since the 1960s was accompanied by significant volatility, particularly in terms of flows towards emerging and developing countries. Figure 1 indicates that these countries have experienced three major cycles in external financing since 1990: from the early 1990s to the 1997-98 East Asian Financial Crisis; from 2003 to the Global Crisis; and from 2010 to the volatility of emerging markets in 2018-19 and the COVID-19 crisis.
Figure 1 Capital flows to emerging and developing countries (as % of GDP)
Source: Authors' calculations based on data from the Institute of International Finance.
To give a sense of how widespread capital controls are used to manage these cycles and the short-term volatility associated with them, Figure 2 plots the cross-country averages of capital account regulations across 51 emerging and developing economies from 1995 to 2015 (Schindler 2009, Ostry et al. 2012, Erten and Ocampo 2017). We observe that the most commonly used measures are foreign exchange (FX)-related regulations, followed by capital outflow controls, capital inflow controls, and financial sector regulations. Countries reduced FX-related and financial sector regulations in the run-up to the East Asian financial crisis, and began to tighten these regulations after the crisis. This was accompanied by relaxation of capital controls on outflows. Moreover, emerging and developing countries generally increased their regulations during and after the 2008-09 Global Crisis.
Figure 2 Capital account regulations, 1995 - 2015
Source: Erten and Ocampo (2017) based on data from the IMF's Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER) database.
A large body of empirical work has focused on the effects of capital controls on financial fragility. One of the consistent findings is that capital controls have a robust impact on the composition of capital flows by reducing relatively short-term flows. Their effectiveness in terms of reducing the total volume of capital flows has been subject to mixed results in the case of emerging economies, with agreement that there is no effect in the case of developed countries. The more restrictive the controls are, the more likely it is that they would reduce capital flows. There is also broad agreement that capital controls allowed for a more independent monetary policy in emerging economies, but results relating to their effects on exchange rates are mixed. However, when exchange rate pressures and foreign exchange reserve movements are seen as two elements of ‘foreign exchange pressures’ affecting emerging economies, capital controls are found to be effective (Erten and Ocampo 2017).
Studies using high frequency data also show that a tightening in capital controls reduces financial fragility indicators such as bank leverage, bank credit, and exposure to portfolio liabilities; and their increased intensity in the post-crisis period has led to a decline in net capital inflows, particularly net portfolio flows. In cases where domestic prudential regulations were used as complements to capital flow restrictions, there is also evidence that this has led to a decline in private credit growth and housing prices’ appreciation, improving overall financial stability.
Another strand of empirical literature focuses on how a wide range of macroeconomic outcomes is affected by capital controls. The cross-country evidence shows no evidence of a positive association between economic growth and financial openness. However, several studies document that the countries that increased the restrictiveness of capital inflow controls prior to the Global Crisis exhibited more resilience during the crisis, and the countries that used capital controls prior to the post-crisis period experienced less overheating after the crisis. These findings suggest that the counter-cyclical use of capital controls helps to reduce boom-bust cycles in real output growth.
Capital controls: Policy debate
The intellectual fathers of the Bretton Woods Agreement, John Maynard Keynes and Harry Dexter White, shared the view that free capital movements had been a major source of financial instability in the 1920s and the 1930s, and that countries should be allowed to control international capital movements in order to pursue their domestic policy objectives, particularly full employment. The Bretton Woods Agreement obliged countries to eliminate international payment regulations affecting current account transactions but allowed members to exercise “controls as are necessary to regulate international capital movements”.
However, the reconstruction of global private finance eventually led to the liberalisation of capital flows by developed countries, starting with the US in 1974. This process was essentially completed by the early 1990s and was accompanied by the adoption of stronger OECD principles on capital account liberalisation in the late 1980s. As indicated in the previous section, capital account liberalisation was slower and less widespread in the emerging and developing world. There was, however, a growing literature supportive of broad financial liberalisation because of its perceived advantages, and a strong push by some developed countries –particularly the US—for emerging economies to liberalise capital account movement.
The attempt to introduce capital account convertibility into the IMF Articles of Agreement in the 1997 Hong Kong meetings failed, no doubt under the difficulties generated by the East Asian crisis already under way. After this and the global financial crises, the liberalisation of capital flows in emerging economies slowed, and a growing literature started to underscore the risks associated with capital account volatility. The IMF staff played a central role in this new line of research (Prasad et al. 2009, Ostry et al. 2012, and Ghosh et al. 2017). Together with the broader skepticism generated by the two crises, this led to the ‘Institutional View’ on capital account liberalization and management adopted by the IMF (IMF 2012). In this framework, The G-20 also adopted a set of “coherent conclusions for the management of capital flows” during its 2011 Summit (G-20, 2011). The Financial Stability Board, by contrast, which was given the responsibility to strengthen financial regulation and supervision to reduce systemic risk in financial markets, left out policies to reduce the risks of cross-border capital flows.
The IMF recognised that “there is no presumption that full liberalization is an appropriate goal for all countries at all times” and that they should use “capital flow management measures”, alongside other macroeconomic policies – counter-cyclical monetary and fiscal policies, active foreign exchange reserve management, and macroprudential domestic financial regulations – to manage the effects of capital flow volatility.
The IMF Institutional View also recognised that the freedom that countries have to regulate capital flows may be at odds with other international commitments: those at OECD but, particularly, those embedded in regional and bilateral trade and investment treaties –notably those involving the US that require that all forms of capital to flow “freely and without delay”. The revision, in 2019, of the OECD Code of Liberalisation of Capital Movements agreed with the need to keep the space for macroprudential policies to manage financial stability concerns, particularly to manage capital inflow surges (OECD 2019), but a number of trade agreements continue to undermine the ability of many economies to employ capital controls (e.g. Gallagher 2014). The Institutional View also indicated that source countries should pay attention to the potentially negative spillover effects of their macroeconomic policies.
We therefore view it of utmost importance that developing and emerging economies have access to capital controls as part of the toolkit of policy measures at their disposal to lean against the externalities generated by international capital flows, both to maintain financial stability and to allow full policy space for aggregate demand management.
References
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