Abstract
The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.
This paper reviews the experience with capital controls in industrial and developing countries, considers the policy issues raised when the effectiveness of capital controls diminishes, examines the medium-term benefits and costs of an open capital account, and analyzes the policy measures that could help sustain capital account convertibility. Since World War II, many countries have maintained restrictions on capital account transactions in an attempt to limit capital flows that could lead to sharp changes in foreign exchange reserves; to ensure that domestic savings are used to finance domestic investment; to maintain revenues from taxes on financial activities and wealth; and to prevent capital flows that would disrupt a stabilization and structural reform program. Empirical studies suggest, however, that capital controls have often been ineffective in both industrial and developing countries when incentives for moving funds abroad have been substantial. In addition, the effectiveness of capital controls appears to have eroded more rapidly in the 1980s than in earlier periods. As the effectiveness of capital controls has eroded, new constraints have been placed on the formulation of monetary and fiscal policies. Moreover, capital flight during the 1970s and 1980s created large holdings of external assets by the residents of many developing countries. The initial phase of recent stabilization and structural reform programs has often been characterized by partial repatriation of these external assets. Sterilization of these inflows has often proven difficult, and tightening capital controls to limit these inflows has at times interfered with normal trade financing.
Experience suggests that countries can attain the benefits of capital account convertibility and reduce the financial risks created by an open capital account if they adopt macroeconomic and financial policies that minimize the differences between domestic and external financial market conditions; avoid imposing taxes that create strong incentives to move funds abroad; strengthen the safety and soundness of their domestic financial system; take measures to increase price and wage flexibility; allow residents to hold internationally diversified portfolios; and employ modern hedging and risk-management practices.