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Policy Instruments To Lean Against The Wind In Latin America1,2

Author(s):
G. Terrier, Rodrigo Valdes, Camilo Tovar Mora, Jorge Chan-Lau, Carlos Fernandez Valdovinos, Mercedes Garcia-Escribano, Carlos Medeiros, Man-Keung Tang, Mercedes Vera Martin, and W. Christopher Walker
Published Date:
July 2011
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IX. Reserve Requirements and Taxes on Capital Inflows

A. Introduction

Countries have used reserve requirements on capital inflows in response to a surge in capital inflows. Policy makers may require that a fraction of the private capital inflows from nonresidents—be deposited at the central bank for a period of time. At the end of the holding period, these deposits—which are known as reserve requirements (RRs)—are reimbursed along with any applicable remuneration. In general, RRs are usually unremunerated (URR).

RRs on capital inflows act as a price-based capital account restriction. In addition to limiting liquidity for foreign investors in the country, as RRs are either unremunerated or remunerated below market rates, RRs increase the cost of cross-border financing making domestic investment opportunities less attractive to foreign investors—in particular, for short-term investments. The cost of setting RRs on capital inflows can be expressed in terms of a tax-equivalent with analogous impact to an explicit tax on flows from non-residents, such as the Brazilian Imposto de Operações Financeiras (IOF) (which is also covered in this note).3 Further, the RR regulation could give investors the option of paying an up-front fee—equivalent or marginally higher than the foregone interest—for an early withdrawal of the deposit.

RRs on capital inflows can serve macroprudential purposes:

  • First, RRs could have a countercyclical impact during periods of easy and transitory global financing. If applied broadly across types of inflows and succeed in reducing total capital inflows, RRs could limit excessive and unsustainable foreign leverage, and in turn, limit the impact on flows absorption.
  • Second, RRs may help contain systemic and liquidity risk. By tilting foreign funding towards longer maturities, the funding structure of domestic corporates improves and becomes less vulnerable to sudden capital reversals.
  • Third, RRs can also help the central bank gain space for raising domestic interest rates without encouraging massive capital inflows into the country. The reason is that by increasing the cost of foreign capital, RRs sever the arbitrage link between domestic and international interest rates.
  • Last, they could also eliminate or reduce the quasi-fiscal costs associated with sterilized foreign-exchange intervention.

However, there are costs associated to the RRs.4 First, their effectiveness to limit capital inflows, if any, is transitory. Following the introduction of RRs on inflows, investors may try to find alternative capital account channels or instruments to bypass regulations, so RRs gradually loose power. Thus, an ongoing effort to tighten the policy and its administration—for example, raising the fraction that has to be deposited at the central bank or broadening the types of inflows subject to the RRs—may be needed to maintain their impact. Further, the alternative instruments used by investors may cause the buildup of vulnerabilities and foster future potential crisis. Moreover, their design and administration is complex. Another risk associated to RRs is that they be perceived as a regime change for a country, which could trigger a sudden and sharp decline in foreign financing and divert flows to other countries. For these reasons, the RRs on inflows should only be considered when other options for dealing with the inflows have already been deployed or are infeasible (IMF, 2011e).

Taking into account these caveats, countries that have deployed RR on inflows have tailored them to their circumstances. The RRs could apply to all flows or differentiate by type of flow (foreign borrowing, portfolio inflows and direct investment) and duration of the flow (short-term and medium-long term). RRs also differ in the holding period, the fraction of the flow that has to be deposited at the central bank, and the remuneration rate (if any). The currency denomination of the reserve requirement could also be a variable of choice for the investor or the authority. The Annex describes the forms that RRs on capital inflows have taken across countries in Latin America:5 URRs on foreign borrowing in Chile, URRs on foreign borrowing and portfolio inflows in Colombia, URRs on deposits in local currency from nonresident financial institutions in Peru;6 and the Brazilian IOF. It is important to note that RRs on capital inflows have usually been introduced in combination with other policies or measures to limit capital inflows.7

B. Theoretical Considerations

The economic effect of the reserve requirement on capital inflows can be derived in terms of the implied tax-equivalent cost. In the presence of RRs, a risk-neutral investor will face an additional cost when choosing to hold domestic assets. Or put it differently, RRs raise the cost of foreign borrowing. The tax-equivalent expression permits comparing the RR cost on foreign borrowing with a tax applied on foreign inflows, such as the IOF. The tax-equivalent of RRs is a function of the deposit rate at the central bank, the ratio of the maturity of the reserve requirement to the maturity of foreign borrowing and the foreign interest rate (see Box). When investors are allowed to choose the currency denomination, the reserve requirement cost is minimized if the investor chooses the currency that is expected to appreciate.

Box 9.1.Tax-equivalent of RRs

In the simple case of a RR that is nonremunerated and that is reimbursed in the same currency it was deposited at the central bank, the tax-equivalent of the RR on capital inflows μk can be expressed as:1

where, i* is the cost of borrowing abroad for k months; and u is the fraction of the flow that has to be deposited at the central bank during a holding period of h months.

1 This simplified expression assumes there is no exchange rate risk and that the RR is the only tax (see De Gregorio, Edwards, and Valdés, 2000).

The simplified expression in Box 1 allows analyzing how different factors could change the economic importance of the RR. Table 1 shows the calculation of the tax-equivalent using different parameters to give an idea of the role of these factors for the cost of the RR.

  • The tax-equivalent of the RR is positively related to the foreign interest rate. Therefore, the tax-equivalent of the RR is lower in the case of low foreign borrowing costs.
  • RRs make short-term foreign borrowing more expensive. For a given holding period h, the cost of RR decreases with maturity. The implication is that RRs will lower the share of short-term inflows in total capital inflows altering the composition (term structure) of foreign liabilities.

There is an extensive literature on the economic impact of RRs on capital inflows. Magud, N., C. Reinhart, and K. Rogoff, 2005 review an array of empirical studies on this issue. Their literature review confirms the role of RRs in altering the composition of capital inflows tilting it towards longer maturities. Evidence on their usefulness on reducing the volume of net flows and exchange rate pressures is controversial.8 The impact on the total volume of capital inflows—as well as on alleviating appreciation on the currency—is not trivial as it depends on the elasticity of total capital flows with respect to short-term capital flows. These authors stress that the RR effectiveness could depend on different factors, such as the level of short-term capital flows at the moment that the measure is implemented and the specifics of the measure used.

Table 1.Tax-equivalent of Reserve Requirement
Libor

(percent)
Reserve

requirement

(percent)
Loan Maturity (months)
136912182436
1152.10.70.40.20.20.10.10.1
254.01.30.70.40.30.20.20.1
305.11.70.90.60.40.30.20.1
3156.42.11.10.70.50.40.30.2
2512.04.02.01.31.00.70.50.3
3015.45.12.61.71.30.90.60.4
Source: Author’s calculations considering different libor, reserve requirement rates and borrowing terms.
Source: Author’s calculations considering different libor, reserve requirement rates and borrowing terms.

C. Conclusions

During previous episodes of ample global financing, RRs on capital inflows have been part of the responses implemented by countries in the face of capital inflows to address macroeconomic and prudential concerns. The array of capital flows subject to the RR could range from nonresident deposits at the banking sector to all capital inflows. RRs are usually unremunerated, raise the cost of foreign financing and penalize short-term borrowing more heavily, thus, tilt the composition of foreign inflows towards longer maturities and help reduce vulnerability to sudden capital reversals. It could also be argued that RRs have a countercyclical role through the reduction in the volume of capital inflows, but the evidence is inconclusive as RR gradually loose power as foreign investors find ways to circumvent the requirement.

RRs may be needed on macroprudential grounds, but their use is subject to multilateral considerations. RRs affect the cross-border movements of capital. Specifically, RRs on inflows discriminate between the treatment of residents and non-residents in capital transactions and treat nonresident transactions less favorably. For these reasons, their use could be restricted by international arrangements or permitted only temporarily. The OECD, EU, GATs and (Bilateral Investment Treaties) BITS allow for the temporary implementation of restrictions to the movement of capital flows in case of “serious economic and financial disturbances” or “serious balance of payments”.

There are additional costs associated to the implementation of RRs. RRs may create an incentive for investors to rely on alternative and complex investment instruments that could foster the buildup of capital account and financial vulnerabilities. Also, their implementation could be perceived by investors as a regime change for a country leading to a decline of stable and long term capital flows. Therefore, preference should be given to other measures that impact capital inflows but do not discriminate on the basis of residency (IMF, 2011f).

Amidst the current surge in capital inflows, so far, only a few countries in Latin America have redeployed RRs on inflows. Peru has raised the RR rate on nonresidents bank deposits more than the RR rate applicable to residents’ deposits, while Brazil has reinstituted the IOF as part of its response to avoid excessive reliance on foreign financing.

Annex 1. Country Experiences with Reserve Requirements on Capital Inflows

Chile

The Chilean authorities introduced RRs on capital inflows during 1991-98 in response to real appreciation pressures stemming from a surge in capital inflows. These took the form of URRs on all new foreign borrowing. During the initial phase, 20 percent of the credit had to be deposited in a non interest-bearing account at the central bank and at the end of the holding period (that ranged between 90 days and one year, depending on the term of the credit), the RR was reimbursed in the same currency in which the deposit was made.9 During the following years, changes on coverage, rates, holding periods, and currency denomination of deposits were introduced (Table A.1).

Table A.1.Changes in the Chilean URR Administration
Jun.199120 percent URR introduced on all new credit. Holding currency the same as the credit and holding period depending on the term of the credit, ranging from 3 to 12 months, according to Min (max (credit maturity, 3), 12).
May1992Holding period fixed at 1 year.
Aug.1992URR rate raised to 30 percent
Jan.1995Holding currency only US dollars
Jul.1995Extended to secondary American depository receipts (ADR)
Sep.1995Period to liquidate USD from secondary ADR tightened
Dec.1995Foreign borrowing to be used externally exempted
Dec.1996Foreign borrowing < US$200,000 (500,000 in a year) exempted
Mar.1997Foreign borrowing < US$100,000 (100,000 in a year) exempted
Jun.1998URR rate reduced to 10 percent
Sep.1998URR rate set at zero

The URRs affected the composition of capital inflows to Chile, but there is mixed evidence on their effectiveness in in addressing the appreciation of the real exchange rate.10 Their introduction had a persistent and significant effect on the maturity composition of capital inflows, tilting it towards longer maturities, although without affecting their overall volume of inflows (Figure A.1). They also modestly and temporarily allowed the central bank to raise interest rates without encouraging additional capital inflows. However, their impact on the real exchange rate was unclear; some authors suggest a slight appreciation effect, while others suggest the opposite.

Figure A.1:Chile experience with the URR

Source: Author’s calculation using data from De Gregorio, J., Edwards, S., and R. Valdés, 2000.

1 During some periods, investors were allowed to choose the currency denomination of the RR. Investors would minimize the URR cost by choosing the currency for which the interest rate was the lowest. In January 1995, investors were no longer able to choose the currency denomination of the RR.

Colombia

Colombia used URR in the 1990s and again in 2006-07. In September 1993, and in the context of the liberalization of foreign lending, Colombia introduced a URR of 47 percent on short-term (less than 18-month maturity) foreign loans different from trade financing to dampen short-term financial inflows. The deposit had to be kept during 12 months or redeemed with a discount that reflected the opportunity cost of those resources—notice the analogy with the IOF. The RR rate, its holding period, and the term of the foreign loan subject to the RR was actively managed during 1993–2000 (Table B.1). The URR was set to zero (but not eliminated) in April 2000.

Table B.1.Changes in the Colombian URR Administration
Maximum Term for
the Loan Subject toHolding
the DepositReserve RequirementsPeriod
Date(Months)(Percent)(Months)Currency
Sep.1993184712USD
Mar.19943693 for loans with maturities up to 1 year12USD
64 for loans with maturities up to 2 years18USD
50 for loans with maturities up to 3 years24USD
Aug.199460140 for loans maturing in less than 1 month1USD
USD
42.8 for loans maturing in 60 months60USD
Feb.199648856USD
USD
1048USD
Mar.1996365018USD
Mar.1997605018USD
1/
Mar.1997All3018USD & Pesos
Jan.1998All2512Pesos
Sep.1998All106Pesos
Apr.2000All00
May2007All406Pesos
May2008All506Pesos
Oct.2008All00
Source: Rincon, and Toro, 2010, and Ocampo and Tovar, 2003.

In addition to the RR, in January 1997, an explicit (Tobin) tax on all capital flows was introduced. It was shortlived as it was decreed unconstitutional in March 1007.

Source: Rincon, and Toro, 2010, and Ocampo and Tovar, 2003.

In addition to the RR, in January 1997, an explicit (Tobin) tax on all capital flows was introduced. It was shortlived as it was decreed unconstitutional in March 1007.

In 2007, amidst a rapid currency appreciation and a surge in non-FDI capital inflows, the Colombian central bank reactivated URRs (Figure B.1). A URR of 40 percent with a holding period of 6 months was imposed on foreign borrowing and portfolio inflows of all maturities.11,12 As before, early withdrawals of funds were allowed but with sizable penalties, ranging from 9.4 percent of the RR (for immediate withdrawals) to 1.6 percent (if held for 5 months). URRs were loosened in December 2007, tightened back in May 2008 and again loosened in September 2008.13 The URR rate was set down to zero in October 2008.

Figure B.1:Colombia’s Experience with the URR

Source: Left-hand panel: author’s calculation using data from Rincon, H. and J. Toro, 2010. Right-hand panel: Author’s calculation using data from Ocampo and Tovar, 2003.

Colombia’s experience with URRs was successful in altering the composition of capital inflows, but did not have a significant impact on reducing the volume of inflows or modifying the level of the exchange. Most studies on the 1990s URRs experience conclude that they were effective in reducing short-term flows with mixed results on the impact on total capital flows. For example, Ocampo and Tovar (2003) argue that restrictions diminished not only short-term but also long-term capital flows. Studies on the most recent 2007 experience also find a significant effect on short-term capital inflows. Clements and Kamil (2009) find significant reductions in foreign borrowing and non-resident portfolio inflows, and no impact on total net private capital movements. Clements and Kamil (2009) and Rincon and Toro (2010) find an increased the volatility of the exchange rate but no evidence of diminished appreciation pressures.14

Peru

The central bank of Peru has actively used RRs on bank deposits from non-resident financial institutions during 2008 and again since early-2010. Amidst the surge in capital inflows during 2008, the central bank increased the minimum and marginal reserve requirements on deposits, but even more so the marginal rate applying to deposits from the following foreign institutions: financial institutions, hedge funds, pension funds, brokers, mutual funds and investment banks.15 However, these measures proved to be temporary as they were eliminated in late 2008 following Lehmann’s collapse. In early 2010, renewed inflows led the central bank to impose again marginal reserve requirement on deposits from non-resident financial institution at levels similar to those of mid-2008 (see a summary of measures adopted in Figure C.1). Peru’s use of RRs was effective in altering the composition of bank’s liabilities: the amount of non-resident deposits declined sharply in response to changes to the reserve requirements during 2008 (Figure C.2).

Figure C.1:Peru Management of Reserve Requirements on Capital Inflows

Source: Author’s calculations on the basis of BCRP data.

1 Includes deposits and bank CDs.

2 Applies to non-resident financial insitutions.

3 Neither the minimum RR on bank deposits or the marginal RR on non-resident deposits are remunerated.

Figure C.2:Peru Experience with Reserve Requirements on Nonresidents Bank Deposits

Source: Author’s calculation with data from Quispe, Z., D. Leon, and A. Contreras, 2009.

Brazil

In late-2009, Brazil reinstituted the Imposto de Operações Financeiras (IOF)--a tax on the entry on capital flows—in response to heavy capital inflows and currency appreciation pressures. Amidst these pressures, in October 2009, Brazil re-introduced the IOF, which had been reduced to zero in October 2008. The tax rate was set at 2 percent on local bonds and equity inflows (leaving direct investment and external borrowing by Brazilian banks and firms not directly affected by the tax) compared to 1½ percent rate only on fixed income in the previous year. On the day following the reintroduction of the IOF, the Brazilian real, which had appreciated by 35 percent against the U.S. dollar since the beginning of this year, depreciated by about 2 percent (to R$1.75 to the dollar) but quickly afterwards resumed its appreciation trend. In October 2010, the IOF tax on foreign investment in local bonds was raised to 4 percent from 2 percent while tax rate for the purchase of Brazilian stocks by foreigners was left at 2 percent. A few weeks later, the tax rate on fixed-income was raised again to 6 percent from 4 percent.

The re-introduction of the IOF may have changed the composition of capital inflows, while its impact on the total volume of capital inflows was debatable (Walker, 2010). Equity flows did diminish after the IOF was re-introduced in October 2009, while inflows into domestic bonds remained quite robust. Walker (2010) shows that the IOF had some impact, although small, in inserting a wedge between domestic and foreign fixed-income markets.16

In addition, the IOF combined with macroprudential measures may have stimulated foreign borrowing motivating the extension of the IOF tax to short-term foreign borrowing. The IOF led to a widening spread between onshore and offshore funding rates. Meanwhile, the introduction of a new reserve requirement limiting the short dollar position of banks in the spot market (see companion note “Limiting net foreign exchange positions” in this volume) created an incentive to issue debt abroad and bring the dollars into the country (reducing short dollar positions). Consequently, external short-term debt in Brazil doubled between December 2010 and February 2011. In order to help curve down short-term external borrowing, in March 2011, the IOF tax on short-term foreign borrowing by residents was increased to 6 percent on loans of up to 360 days, from a previous rate of 5.38 percent on loans of up to 90 days and zero rate when the operation exceeded 3 months.17 Thus, the tax continues to be zero for foreign borrowing exceeding 360 days, while overseas corporate 1-year bonds will be subject to the IOF.

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1Prepared by Mercedes Garcia-Escribano. Comments by C. Tovar and M.K. Tang are acknowledged.
2The instruments described in this chapter could be referred to as “residency-based capital flow management measures” according to the nomenclature in IMF, 2011e.
3Given the similarity between RRs on capital inflows and inflow taxes, administrative considerations determine the choice. In particular, while the central bank may have the authority to impose URRs, it does not have authority to levy taxes (Ostry et al., 2011).
5Other countries that deployed RRs on capital inflows include Thailand during 2006–08, Russia during 2004–06, and Malaysia in 1994.
6Reserve requirements on bank deposits that discriminate in terms of residency are covered in this chapter, while those that differentiate in terms of the currency of denomination are described in Chapter VI on reserve requirements on bank liabilities. This classification is consistent with that presented in IMF, 2011k and Ostry et al., 2011.
7For example, in 1994 Malaysia (i) required that commercial banks placed with the central bank the ringgit funds of foreign banks in non-interest bearing accounts, and also (ii) prohibited residents from selling short-term monetary instruments to nonresidents, and (iii) introduced asymmetric open position limits.
8Note that despite the similarities between RRs on capital inflows and taxes, their impact on the exchange rate could be different. RRs that are deposited in foreign exchange immediately reduce the exchange rate pressure by the amount of the deposit. On the contrary, paying the inflow tax requires conversion of the foreign exchange into local currency, resulting in exchange rate pressures (Ostry et al, 2011).
9In order to avoid liquidity problems arising from this requirement, foreign creditors were given the option to pay an up-front fee marginally higher than the implied opportunity cost of the URR, and hence, the URR acted as a tax analogous to the Brazilian IOF.
10De Gregorio, Edwards, and Valdes, 2000 report the following effects of the Chilean 30 percent URR: domestic interest rate increases between 130 and 150 basis points; short-term flows decrease by about US$750 million, long-term inflows increase around US$1,300 million, and overall inflow practically unaffected; and a small real exchange depreciation of about 2.5 percent.
11Between December 2004 and June 2006, the authorities reintroduced controls on portfolio inflows of nonresidents which required one year as a minimum investment period. On July 2007, they put in place thresholds on bank’s currency derivate positions. In May 2008, a minimum stay of 2 years was imposed on FDI, and was revoked in September 2008.
12Colombian institutional funds, including pension funds, were exempted. In June 2007, equities issued abroad were exempted, so the issuances through ADRs were exempted.
13In December 2007, the penalties for early withdrawal of funds were reduced and the initial public offerings of equities were exempted from the URR. The URR on portfolio inflows was raised from 40 to 50 percent in May 2008, and in June, the penalty for early withdrawal of deposits was raised. In September 2008, URR was loosened as purchases of equities were exempted.
14Clements and Kamil (2009) explain that the increased exchange rate volatility could be due to the fact that the URR placed the pension funds in a privileged position, as they were excluded from the restrictions, and hence, increased the importance of domestic pension funds in exchange rate market trading.
15In addition to the RR management, the central bank rose the RR on short-term foreign liabilities and introduced a fee to the transfer of Bank certificates.
16If the IOF is binding and if there was full arbitrage before the IOF was imposed, then, its introduction would result in a difference between the implied interest rate in Brazilian reais available offshore through the nondeliverable-forwards (NDF) market, and the interest rate in reais available onshore in Brazil (e.g., the implied interest rate in reais should be lower offshore, where the IOF cannot be collected). Walker (2010) finds that following the introduction of the IOF the offshore NDFs strengthened relative to onshore currency forwards, and the NDF-implied basis spread widened, although by only a fraction of the 2 percent that would occur on instruments with a one-year maturity if the IOF were fully binding.
17The IOF tax on short-term foreign borrowing used to be 5 percent since 2007 and was increased to 5.38 percent in January 2008.

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