Capital convertibility has been embraced by virtually all industrial countries in the 1970s and 1980s, and in the aftermath of the debt crisis by a rapidly growing number of developing countries. Recent experience in which convertibility has been adopted in the context of comprehensive stabilization programs, and with support from market-determined exchange rates, has contrasted sharply with the adverse experience with convertibility in the southern cone of Latin America in the late 1970s.
In earlier years, the main objectives of capital controls had been either to retain savings, or to insulate the domestic economy from external shocks. However, this paper contends that, based on its brief survey of the recent literature, optimality arguments for the long-term retention of controls to affect savings have been widely rejected. What has remained are questions of sequencing, whereby controls are either modulated (in either direction) as an adjunct to monetary policy instruments, or are phased out gradually as certain macroeconomic preconditions are met.
The paper reviews recent experiences in several developing countries (Costa Rica, El Salvador, Guyana, Indonesia, Jamaica, Trinidad and Tobago, and Venezuela) and suggests that controls can be dropped with little consideration of sequencing. Reforms of foreign exchange and domestic money and credit markets to provide sufficient flexibility in interest and exchange rates, can be, and have been, implemented quickly as part of essentially simultaneous “multi-pronged” packages. Success with such packages in this group of countries has been sufficiently pronounced that private capital flight has reversed rapidly. The paper finds that sterilization policies have prevented the inflows from re-igniting inflation, in part because the associated loosening of the external constraint has permitted increased import absorption, where it is supported by a sufficiently open trade system.