At the outbreak of the Covid-19 crisis, some $70 billion left emerging economies in five weeks (see Figure 1). Despite these large outflows, there was no widespread use of capital controls. Emerging countries rather implemented countercyclical fiscal, macroprudential, or monetary policy measures and, in some cases, exchange rate interventions, which led to a selective return of capital.
Figure 1 Net capital flows to emerging countries excluding China (in billion US dollars)
Source: EPFR and authors’ calculations
Yet, capital controls have been increasingly in the policy toolkit of many countries since the Global Crisis. As emphasised by Fernández et al. (2015, 2016), the number of measures increased since 2008, both on outflows and inflows (see Figure 2).
Figure 2 Capital controls on outflows and inflows (average number per year and per country)
Note: countries of destination for inflows and country of origin for outflows controls on direct investment, debt, money market or financial credits
Source: Fernández et al. (2016), updated.
Macroprudential measures have increasingly entered the policy toolkit as well (Cerutti et al. 2017). These are mostly targeting borrowers, but measures targeting financial institutions are on the rise throughout the period (see Figure 3). These measures may also impact capital flows. In emerging and advanced economies, Beirne and Friedrich (2017) find that macroprudential measures are effective in managing cross-border bank flows, especially in a context of higher regulatory quality and a higher credit-to-deposit ratio. Buch and Goldberg (2017) find a spillover effect of macroprudential measures across borders through bank lending, which might be positive or negative. The intensity of spillovers depends on the particular macroprudential instruments applied, the bank’s balance sheet conditions, and its international business model. Spillovers frequently occur for countries interlinked through international banking.
Figure 3 Macroprudential measures on borrowers and financial institutions (share in percent of countries implementing at least one measure)
Source: 2018 update of Cerutti et al. (2017).
How can we explain the limited use of capital controls in that period? And the more extensive use of macroprudential measures?
Capital controls may not be the most effective tools to manage outflows
The limited use of capital controls as a countercyclical instrument is not a new feature of this crisis. Capital controls tend to be persistent, following structural characteristics of the countries rather than short-term fluctuations in output (Eichengreen and Rose 2014).
Their effectiveness has been questioned, as they may be circumvented. To address this issue, Bricongne et al. (2021) implement a gravity equation, using a novel database of bilateral financial flows and assets developed by the European Commission from 2000 to 2015. Gravity equations relate bilateral financial flows to structural relationships between countries, such as distance or common language, which are captured here by an extensive set of fixed effects. Foreign direct investment (FDI), equity portfolio flows, debt portfolio flows, and other investments are distinguished.
Restrictions on outflows are effective only for FDI, but not on equity or debt portfolio flows and on other investments, which constitute generally the largest share of capital flows.
In contrast, restrictions on inflows are mostly effective for foreign direct investment, debt portfolio flows, and other investments, but less so for equity portfolio flows.
This means that capital controls may be used effectively as a macroprudential tool to prevent overheating due to foreign capital inflows, but less so in case of a sudden stop, when capital flows brutally reverse from flowing into the country to leaving the country. This supports recent work done by the IMF (Basu et al. 2020, Adrian et al. 2020) in the prospect of revising their institutional view on the liberalisation and management of capital flows. In particular, the pre-emptive effectiveness of capital controls on inflows seems to be comforted.
Macroprudential measures can increase outflows and reduce inflows
Bricongne et al. (2021) also test the impact of macroprudential measures on these different types of flows. Macroprudential measures bearing on the financial sector tend to increase outflows (except for FDI), as constraining domestic financial investment may lead to search for other investment opportunities abroad.
On the other hand, they tend to reduce inflows for FDI and other investments, as financial investment opportunities are reduced domestically. Macroprudential measures on borrowers have a very limited impact on capital flows, both for outflows and inflows.
Relaxing macroprudential measures in times of stress may hence be efficient in order to reduce outflows and increase inflows. If capital controls measures have convex costs, with the toll they take on the economy growing faster than their intensity, macroprudential measures may be useful complements to limit the intensity of capital controls.
Cooperation between origin and destination countries increases the efficiency of both types of measures
Cooperation between the origin and destination countries, both for capital controls and macroprudential measures, is more effective than measures at one end only of the capital flow. Indeed, when accounting for their stand-alone impact, the combination of measures in the origin and destination countries has a supplementary and significant impact on capital flows. This idea was already promoted by Keynes and demonstrated for cross-border bank flows by Ghosh et al. (2014). It is confirmed in this paper on a larger set of types of capital flows and for macroprudential measures as well.
Indeed, regarding capital controls, this cooperation effect appears for other investments, portfolio equity, and FDI. Macroprudential measures on borrowers in origin combined with measures on financial sector in destination tend to have a positive impact on capital positions/flows, but for other investments: investors in the origin country, especially financial institutions, tend to divert their investment to other countries, except to the banking system (making the bulk of other investments), which is also constrained. Other investments appear to be curbed down by a combination of macro-prudential measures on financial sector in origin and on borrowers in destination.
As a policy conclusion, measures to control capital flows have very specific conditions for effectiveness. Capital controls should be used proactively, when capital inflows lead to macroeconomic imbalances, while they have limited impact when capital leaves the country. Macroprudential measures are useful complements to capital controls and can reduce their costs. Finally, cooperation between source and destination countries can reduce intervention costs by having more than additive effects.
Authors’ note: The opinions and arguments expressed here are those of the authors and do not necessarily reflect the views of the Banque de France or the Eurosystem.
References
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