Implications of a Surge in Capital Inflows
Available tools and Consequences for the Conduct of Monetary Policy
  • 1, International Monetary Fund

This paper seeks to extend discussion of monetary policy instruments to the situation of a country faced with major capital inflows when the process of domestic financial liberalization is incomplete. It briefly summarizes the recent usage of traditional monetary instruments, discusses the practical limits to classic sterilization measures as well as the pros and cons of using other supplementary measures including tax-based controls on capital inflows. It also examines the efficacy of such measures in Chile, Colombia, Indonesia, Korea, Spain, and Thailand. The conclusion is that, for a time and as a transitional measure, a country may find it opportune to supplement the traditional instruments with certain “belt and braces” measures including, in some instances, indirect (tax-based) capital controls.


This paper seeks to extend discussion of monetary policy instruments to the situation of a country faced with major capital inflows when the process of domestic financial liberalization is incomplete. It briefly summarizes the recent usage of traditional monetary instruments, discusses the practical limits to classic sterilization measures as well as the pros and cons of using other supplementary measures including tax-based controls on capital inflows. It also examines the efficacy of such measures in Chile, Colombia, Indonesia, Korea, Spain, and Thailand. The conclusion is that, for a time and as a transitional measure, a country may find it opportune to supplement the traditional instruments with certain “belt and braces” measures including, in some instances, indirect (tax-based) capital controls.

I. Introduction

As witnessed by many developing countries in recent years, one of the most welcome and yet most worrisome macroeconomic developments has been the surge in capital inflows. While potentially contributing to higher investment and economic growth through an easing of the external financing constraint, the typical adverse side effects of the capital inflows—often exacerbated by unexpected timing and magnitude—include an incipient tendency for the local currency to appreciate, inflationary pressure emanating from the build-up of the central bank’s foreign exchange reserves and associated expansion of the monetary base, heightened speculative activity on local asset markets, and possible disruption associated with sudden reversal of inflows. In addition, these inflows typically burden the monetary authorities with difficult choices over conflicting policy objectives and an equally challenging task of maintaining monetary control in a new, liberalized environment.

The monetary authorities in developing countries are not always well prepared to deal with the side effects of destabilizing capital inflows. All too often, the central banks in these financially semi-open economies are neither independent enough to initiate the most appropriate policy response, nor do they have adequate policy instruments to use in the pursuit of their goals. For example, a large surplus in the overall balance of payments—due primarily to capital account transactions—can induce a conflict between the need to maintain a stable exchange rate for reasons of promoting export competitiveness and the need to allow some exchange appreciation for reasons of promoting domestic price stability. In the event that the conflict is resolved in favor of preserving export competitiveness, the central bank may be poorly equipped to effect the sterilization of the capital flows that would be needed to preserve its inflation objective. However, even in situations where price stability prevails as the primary policy objective of monetary policy, a dilemma can be faced by the central bank since the traditional tools of direct monetary control can become ineffective in a liberalizing environment, and it cannot yet exercise or fully employ advanced instruments of indirect monetary control such as open-market operations, because various supporting institutional modalities are unfulfilled.2/

While the appropriate policy response to a surge in capital inflows has been extensively discussed and analyzed, the subject of operational implementation has received less attention.3/ Moreover, there has been relatively little focus on the implementation of monetary policy in the specific context of the “second best” world described in the preceding paragraph. In this latter regard, analysis has focused largely on the situation of a domestic financial sector liberalization in which capital inflows are not treated as a primary complicating factor. In such circumstances, a combination of direct controls and indirect instruments of monetary policy, a so-called belts and braces strategy is considered to be both feasible and desirable.4/ Although such a strategy would presume the intention to move progressively to a point where there could be exclusive reliance on (first best) indirect instruments of monetary policy, it explicitly recognizes that there may be a transitional period when the use of (some) direct controls can be effective.

The present paper seeks to extend discussion of monetary policy instruments to the situation of a country faced with major capital inflows when the process of domestic financial liberalization is incomplete. It abstracts from the question of the need to adjust policies other than monetary policy (for instance, fiscal, exchange rate, and trade policies),5/ and assumes that the authorities have decided to sterilize the capital inflows or seek ways to turn them aside.6/ This raises three important questions for the monetary authorities: Is sterilization a viable strategy? If so, what are the practical limits to its use? Can the scope for sterilization be expanded or its costs reduced through new or unconventional instruments? The paper seeks to answer these questions.

Broadly speaking, an affirmative response can be given to all questions: there is evidence that sterilization can be effective for a time, there are practical limits to its use, and new instruments can be designed to supplement conventional sterilization techniques. Analogous to the “belts and braces” prescription in the context of domestic financial sector liberalization and consistent with it, the thrust of this paper is that, for a time and as a transitional measure, a country may find it opportune to supplement traditional monetary instruments with less traditional measures, including in some instances direct controls on capital inflows. It argues that, particularly when such measures are imposed in the less distorting form of a tax rather than as an outright quantitative restriction, there is evidence that they do serve to some extent to mitigate capital inflows. That said, some of their value appears to lie in increasing the scope for sterilizing the effects of inflows on the rate of domestic monetary expansion and in offsetting some of the quasi-fiscal cost of other, large-scale sterilization operations. Thus, even in the absence of a significant quantitative impact on capital movements, use of such instruments may be warranted.

The next section of the paper presents an overview of the experience of six countries which have had to deal with large and sustained capital inflows (Chile, Columbia, Indonesia, Korea, Spain, and Thailand). Drawing on this experience, Section III discusses the practical limits to sterilization policy, noting in particular its effect in raising domestic interest rates and the high quasi-fiscal costs which sterilization typically entails. Section IV then discusses the use of supplementary sterilization techniques, including foreign currency swaps and the shifting of government deposits between the commercial banks and the central bank, as well as certain “belts and braces” measures including indirect capital controls such as the variable deposit requirement (VDR) and the interest equalization tax (IET), the scope for direct forward market intervention, and the introduction of wider fluctuation bands in the spot foreign exchange market. Section V presents empirical evidence on the effectiveness of both sterilization broadly defined and on particular controls on capital inflows. A final section offers concluding remarks.

II. An Overview of Country Experience

It is useful to summarize some of the major aspects of the recent surges in capital inflows to developing countries.7/ By examining the experiences of five countries, it is revealed that in most cases the timing of the surge in inflows coincided with an acceleration in the pace of financial liberalization and market opening that either allowed foreign ownership of domestic assets (Korea and Spain), or, if the capital account was already open, reduced taxes on some forms of investments by nonresidents (Thailand). In some cases, there also was a tightening of domestic monetary or credit policies before the onset of the episode, which led to a wide national interest rate differential in favor of domestic capital markets (Chile, Colombia and Thailand).8/ In such cases, the variation of the magnitude of the capital flows followed, albeit with a lag, fairly close to movements of the interest rate differential. (See individual country charts of the time-series plots in Appendix I.) It should also be mentioned that, in several cases, an expectation of exchange rate appreciation or at least a stable exchange rate on the horizon, especially in countries with a less-than-fully floating exchange rate system, served to reduce the forward discount.9/ This increased the covered interest differential for a given level of domestic and overseas interest rates, and contributed further to the increase in foreign capital inflows (Chile, Korea, Malaysia and Thailand).10/ In retrospect, therefore, it appears that all of these countries were faced with shocks whose effects were likely to be both large and durable.

With regard to policy responses, these had to be taken before the non-temporary nature of the shock could be determined. The monetary authorities of all six countries initially resorted to some form of sterilized intervention, which was based primarily on open-market-type operations in domestic bond markets (e.g., government securities or central bank papers). Also, open-market sales were in some instances accompanied by increases in reserve requirements or tightened access to the central bank refinancing facility (Colombia and Korea).

Whether these instruments were completely or for long effective in sterilizing the sharp increase in foreign exchange reserves is debatable. Even when effective, the instruments could not be applied continuously as the outstanding stock of open-market bills rose sharply in most countries during the inflow episode.11/ Moreover, the size of the open-market sales for sterilization purposes was limited by the absorptive capacity of the domestic economy and especially by the stage of development of local securities markets. Where such markets were thin and illiquid, open-market operations could not be continuously relied on as the main instrument of monetary policy. Besides, the operations proved to be extremely costly for the central banks in terms of the loss in operating incomes, as well as frustrating as their use resulted in higher domestic interest rates which attracted additional capital inflows. Thus, most of the countries gradually stopped using open-market sales in their sterilization operations.12/

Subsequently, the authorities in these countries began to supplement their initial response with changes in underlying policies, such as fiscal adjustment (Thailand), an easing of restrictions on capital outflows (Chile, Colombia, and Spain), an acceleration of trade liberalization (Colombia and Korea), and a more flexible exchange rate policy that allowed for nominal appreciation (Chile, and Spain).13/ Some countries introduced more novel sterilization measures, such as swap operations in the foreign exchange market (Indonesia) or adjustment of government deposits (Thailand). Many sought to combine the (first-best) indirect instruments of monetary policy with some direct controls on capital inflows, although some controls were more in indirect forms. The variable deposit requirement (VDR) imposed on certain categories of foreign borrowings was the most common form of such controls (Chile, Colombia, and Spain), while other countries used an interest rate equalization tax (IET) to influence the relative rate of return on inward investment (Brazil).

III. The Practical Limits to Sterilization

The foregoing section strongly suggests that there are factors which limit the use of sterilization procedures, particularly when they are conducted through classic open-market operations.14/ It would be desirable, therefore, to seek techniques and instruments which could expand the scope of effective sterilization operations. In order to do so, it is helpful to consider the principal factors which do limit the effective range of open-market operations. These can then be taken into account in the design and selection of supplementary instruments and techniques.

There are four key limitations on the use of open-market sales for sterilization purposes. First, the ability to sterilize capital inflows is inversely related to the degree of international capital mobility. When capital is highly mobile internationally, sterilization becomes an essentially futile exercise because the sterilization efforts are quickly overwhelmed by continuing inflows.15/ In the limit when capital is perfectly mobile, sterilization is completely ineffective. The extent of capital mobility is, however, an empirical question and, based on the evidence provided below, most developing countries appear to have at least some scope for effective sterilization operations.16/ The authorities need to have a clear idea of the extent to which a particular sterilization operation will be “offset,” prior to commencing operations, in order to set realistic objectives for the exercise.

Second, sterilization policy fundamentally cannot work for long when shocks are durable because sterilization seeks to deal with effect rather than with underlying cause of the shocks. As shown in the country case studies, unless the underlying cause is treated, the capital flows will eventually exceed the sterilization capacity of the authorities. In these circumstances, sterilization can still be useful as a temporary measure to be employed until the primary cause of the inflows can be identified and more fundamental policy measures can be implemented.

Third, particularly for developing countries engaged in a process of financial sector reform, the scope for classical open-market operations can be severely restricted by the underdeveloped state of financial markets and by the fiscal costs which these operations entail:

  • The sterilization instruments (e.g., treasury bills, central bank paper) may be an imperfect substitute for the financial assets which (foreign) investors wish to hold (e.g., stocks, bonds). This implies that, if the degree of substitutability is low, sterilization efforts will push up interest rates on the sterilization instrument, while prices of the preferred asset (which is in limited supply) will continue to rise, altering the total return more in favor of domestic assets.17/ The result is that further capital inflows are encouraged as more domestic firms are induced to borrow abroad and as yield-seeking nonresident inflows accelerate in response to the perceived increase in total returns. In addition, the fiscal costs of sterilization operations are further exacerbated, particularly when the outstanding stock of government debt is mostly short-term or indexed to the short-term market rate of interest;

  • The authorities’ sterilization capacity is often limited by inadequate supply of the marketable instruments, particularly in those countries where prudent fiscal policies were pursued in the past. Also, in countries where the sterilization instruments have only short-term maturities, the open-market sales of longer-term instruments cannot be effectively used (Colombia);18/ and

  • The scale of open-market sales can be limited by the inadequate conditions of the local money/capital markets, i.e., by thin and segmented markets.19/ In particular, those developing countries which already had engaged in a series of open-market sales before the onset of the inflow episode may find it extremely difficult to place additional open-market securities at a reasonable cost, simply because the capacity of the local financial markets has been exhausted.

Finally, heavy fiscal costs may eventually curtail sterilization operations:

  • A large stock of outstanding bills, which results from extended heavy placement of bills, often places a heavy debt-service burden on the government or the central bank, leading to a deterioration in the fiscal or quasi-fiscal position (Chile and Colombia).20/ The negative implications of the fiscal cost also stem from the fact that the rate of return on the portfolio taken over by the authorities—to be invested in foreign assets that command prevailing world market interest rates—is normally lower than those on the portfolio sold to the public; and

  • These costs may also lead to operating losses at the central bank, which could force the central bank to compromise its independence in monetary policy, or when accumulated, may require the recapitalization of the central bank.

Finally, the heavy placement of open-market securities, by building up the central bank’s (or treasury’s) balance sheet, may expose the authorities to a larger credit risk and thus make them more vulnerable to the capital flow reversal. This possibility becomes more distinct when the capital inflows are composed primarily of short-term portfolio investment, because they are more reversible than foreign direct investment.21/

IV. Supplementary Measures

The discussion so far suggests that it may be necessary to use open-market operations in combination with other sterilization measures or some more direct controls on capital inflows, when there are persistently large capital inflows.22/ This section will first discuss various forms of supplementary sterilization measures as potentially useful means to achieve the sterilization goals under the condition of an open capital account. Then, the discussion of other less traditional measures will follow.

1. Supplementary sterilization measures

In a situation where the use of open-market operations has not been fully developed as the principal instrument of monetary control, a central bank necessarily employs other instruments to expand and contract the monetary base. Typically, achievement of a particular rate of monetary expansion will be programmed to rely on the growth of a number of different components of its balance sheet. In this case, rather than using open-market sales of market instruments to effect the sterilization, the authorities can achieve the same effect by cutting back on the programmed increases in some of these other components of its balance sheet.

The possibility of avoiding a high interest rate volatility provides another justification for the use of other sterilization instruments. An appropriate mix of indirect instruments, by allowing the interest cost of sterilization to be spread over several markets, enables the authorities to achieve the desired reserve effect without causing a sharp increase in domestic interest rates and the resultant capital inflows. The stable interest rates can also contribute to the overall development of financial markets. Therefore, even when the use of open market operations has been fully developed, the central bank often needs other supplementary instruments for efficient implementation of policy.

a. Discount policy and directed lending

As a supplementary means to contract the monetary base, the central bank could curtail programmed lending to commercial banks, either directly by restricting access, or indirectly by increasing the cost of central bank credit.

However, unlike advanced industrial countries, the discount windows of central banks in many developing countries which have not completed the transition to indirect methods of monetary control cannot be expected to play a prominent role as a flexible policy instrument. In many cases, most of the rediscounts and loans granted by the central banks are mere automatic rediscount of priority loans extended by commercial banks, often specialized banks, to enterprises in certain target sectors. In this case, the rediscount ratio—the ratio of the central bank’s rediscount to the face value of eligible securities (e.g., commercial bills issued by eligible enterprises)—can be adjusted, but it cannot be adjusted often, because the result would be contrary to the intent of the instrument, namely to supply credits to the commercial banks against their participation in priority loans. The limited scope for using the rediscount facilities as a policy instrument stems also from the implicit subsidies contained in the artificially-set low levels of rediscount rates. These, too, can be adjusted, but, unless these subsidy components are fully eliminated, the rediscount facilities cannot be relied on as a flexible instrument.23/ In some countries where interest rates are not fully liberalized, the central bank can be loathe to adjust the rediscount rates aggressively, because the interest rate elasticity of the demand for credit by the private sector is low. Thus, they are often reluctant to implement the sharp increase in the discount rate which would be required to generate an appreciable monetary effect.24/

There are other important advantages and disadvantages to the use of a restrictive discount policy as a supplementary means to sterilize the monetary impact of capital inflows:

  • As compared to the open market operations, the restrictive discount policy involves a smaller fiscal cost, mainly because the interest rate on refinance standing facilities in most developing countries is lower than the market interest rates.25/ Also, the reduction in the volume of rediscount may improve the fiscal or quasi-fiscal position of the central bank to the extent that the subsidized portion of the directed credit is reduced;26/

  • The use of this instrument may have smaller impact on market interest rates, because, unlike the open market operations, the use of the rediscount facilities can be reduced without going through local money/capital markets, at least in the short run. Interestingly, the weak link between the official discount rate and the short-term bank lending rates, which is often observed in some countries, can be viewed as an advantage because it means that the sterilization objective can be achieved without raising domestic interest rates and, thus, without inviting additional inflows; and

  • The scale of the sterilization operations through the use of this instrument is limited by the size of the planned increase in this particular item in the central bank’s balance sheet.

b. Reserve requirements

It is well known that an increase in the statutory reserve requirement on commercial banks’ deposits reduces the money multiplier and thereby limits the credit expansion caused by monetary injections deriving from capital inflows. Indeed, some countries have raised reserve requirements on bank deposits sharply in order to sterilize the monetary impact of the capital inflows (Colombia and Malaysia).27/

Basically, there are two types of reserve requirement: (i) remunerated reserve requirement; and (ii) unremunerated reserve requirement.

The remunerated reserve requirement can be adopted in a situation where the authorities’ primary concern is to avoid the disintermediation that would occur as a result of the high interest rate spread charged by commercial banks. In terms of its monetary impact, an increase in remunerated reserve requirement works in the same way as an open-market sale of sterilization bonds. The substantive difference is that the target of the reserve requirement policy is more directed at a subset of economic agents, i.e., the commercial banks which are subject to the reserve requirement, and their participation is involuntary. In terms of the cost of operations, both instruments have the same negative implications for the fiscal or quasi-fiscal position of the central bank.

The use of the unremunerated reserve requirement, on the other hand, can increase central bank profits by increasing noninterest-bearing liabilities. Thus, when combined with open-market operations, an increase in the unremunerated reserve requirement can help offset the quasi-fiscal cost of the sterilization operations. This instrument, however, should be employed cautiously, because banks may pass on the burden of the implicit tax to their customer in the form of high lending rates and further increase inflows in the form of offshore borrowing.28/

In practice, the use of reserve requirements has the following limitations. First, a change in the reserve requirement ratio is less binding when banks already hold reserve assets in excess of the statutory reserve requirement.29/ Second, the extent to which it can be relied on may be further limited by the presence of “weak” problem banks in the banking system, as is often the case with many developing countries. Beside the typical operational inefficiencies, the low profitability of commercial banks in these countries is often exacerbated by the central bank’s unwillingness to pay interest on required reserves.30/ Third, raising the reserve requirement ratios may not be a feasible option if the existing required reserve ratios are already at a fairly high level, possibly on account of the previous sterilization efforts (Colombia and Korea). In this case, increasing the reserve requirements would certainly lead to financial disintermediation.31/ Fourth, the central bank may have only limited capacity to monitor banks’ compliance and to control supply of eligible reserve assets. Thus, it may be difficult to enforce high and frequently changing reserve requirements. Fifth, even when the central banks have the necessary capacity, the reserve requirement is unlikely to be a convenient tool for short-term liquidity management, as frequent changes in the reserve requirement can disrupt banks’ efficient management of their portfolios.32/

Finally, it sends the wrong signal regarding the authorities’ reform intentions. Indeed, in most developing countries that are engaged in the process of financial sector reform, changes in reserve requirements have not played a prominent role as a monetary instrument, mainly because the use of the compulsory reserve requirements is regarded as somewhat inconsistent with their intention to move progressively towards a “liberal” system of monetary control (Argentina and Mexico). Moreover, the authorities have increasingly recognized that unremunerated reserve requirements (or remunerated, but at below market rates) are a tax on the banking system, causing financial disintermediation. They thereby eventually weaken monetary control as the share of deposits not controlled by the central bank will rise.33/

c. Government deposits

It is also well known that the “recycling” of government deposits between commercial banks and the central bank can give the central bank important leverage over bank reserves.34/ For example, the shifting of public sector deposits (or pension funds) from the banking system to the central bank absorbs liquidity in the banking system. Indeed, this action generates an effect which is similar to that of liquidity-draining open-market operations.35/ Several developing countries have used this instrument,36/ and where such deposits account for a significant portion of the banking system’s total deposit base, the instrument has proved to be an effective sterilization device to deal with capital inflows (Malaysia and Thailand).

One of the main attractions of this instrument is that, to the extent that the central bank does not pay a market rate of interest on the government deposits, there are smaller fiscal or quasi-fiscal costs associated with the classic sterilization operations. Another important advantage is that it enables the authorities to spread the interest cost of sterilization over two markets—both the T-bill market and the interbank market (for the government deposit auctions)—and thereby limits the potentially adverse effect of sterilization on short-term interest rates and the resultant additional capital inflows.37/ Another important advantage is that, unless the government deposits at the central bank are remunerated at a rate that is higher than the rate of interest paid on government deposits by the commercial banks, there are no fiscal or quasi-fiscal costs associated with the classic sterilization operations.

Despite these advantages, the use of this instrument requires some caution. Like the use of reserve requirement policy, frequent and unpredictable changes in the allocation of the government deposits between the central bank and commercial banks may introduce greater uncertainty in the banks’ management of the reserve position, and thereby make it difficult for the banks to obtain an efficient portfolio.

In addition, the use of this technique may be limited by the availability of the government deposits already held in commercial banks. In some countries, the government deposits must always be held in the central bank by law. And in others, some of the deposits are not government deposits in nature.38/

d. Foreign exchange swap facility

Foreign exchange swaps can be used by central banks as a standard instrument of monetary policy similar to an open-market operation in domestic markets.39/ The mechanism through which a contractionary swap operation decreases the monetary base is as follows: a central bank sells foreign exchange against domestic currency and simultaneously agrees to buy the same amount at a certain date in the future at the forward exchange rate; if the counterparty is a bank, the bank’s reserves are debited by the domestic currency equivalent of the foreign exchange transaction, and the bank’s foreign assets increase. Thus, reserve money decreases. If banks then make foreign currency loans to residents, the principal effect is a reduction in the monetary base. However, banks may well choose to invest the funds abroad or to make foreign currency loans to nonresidents, in which case a capital outflow is generated. Moreover, the swap facility can be designed to provide an incentive for domestic banks to “export” funds abroad. This can be achieved by setting the price of the swap in such a way that the difference between the forward exchange and spot exchange rates (swap margin) is bigger than the prevailing interest rate differential between domestic and foreign markets.40/

Another important advantage is that, unlike some indirect instruments that have an automatic lending feature (e.g., rediscount facility), swap operations can be controlled flexibly and implemented solely at the initiative of the authorities. If the foreign exchange swap market is well developed, swaps can be conducted at the prevailing market rate, analogously to the way in which an open-market sale of securities would be conducted. However, depending on the prevailing differential between the domestic and foreign interest rates and the expectation of future exchange rate changes, the authorities can flexibly change (i) the swap margin (or forward premium),41/ and (ii) the length of the swap contract period. At the market rate, the swap margin would include a return (forward discount) for the covering of the exchange rate risk. However, the authorities may choose to set the swap margin more favorably to increase the size of foreign-reserve drainage from the banking system, by offering the swap facility to the commercial banks at par, i.e., free of charge, or even with a forward rate at a premium over the spot rate.42/ In doing so, however, the authorities should be aware of the potential problem that the provision of the swap facility by the central bank must not constitute a “multiple currency practice,” which would be illegal under the jurisdiction of the Fund (in light of the obligations under Article VIII, Section 3). In addition, the length of the swap contract can be varied to reflect the authorities’ expectations regarding the duration of the capital inflows and the perceived need to offset the inflows. In the normal case, the maturity of the swap contract would be relatively short, but it can usually be renewed at the maturity. The short-term maturity and frequent “roll-over” feature would enable the central bank to adjust flexibly the optimal time horizon for the swap contract and thus for the capital outflows.43/44/

In addition, the swap operation has other important advantages. First, its use does not require the existence of a sufficient amount of short-term government securities in the central bank’s portfolio, which is often missing in countries that do not usually run budget deficits,45/ or which may already have been exhausted by open-market sales. Second, in order to prevent the foreign exchange holdings of the banking system from rising again at the maturity of the swap contract, the principal and net returns on foreign portfolio investments can be encouraged to be reinvested in foreign markets.46/ Third, in countries with a liquid secondary market for the sterilization instrument (e.g., treasury bills), the swap may be more effective than an open-market sale in reducing the liquidity in the system because it does not involve the supply of domestic securities.47/ Often, the effect of an open-market operation is to replace base money with another form of highly liquid domestic currency-denominated financial instrument.48/

Notwithstanding these practical advantages, the use of the swap facility has been relatively little used as a means of sterilizing the impact of the large capital inflows.49/ This suggests that currency swaps also have certain drawbacks. First, like open-market operations, the swap facility may have a negative effect on the profits of the central bank, especially if the central bank guarantees a favorable swap margin to the banks. In some cases, however, the short-term costs of providing a favorable swap margin may well be offset by the long-term valuation gains on the central bank’s holdings of foreign assets.50/ Second, there is a risk that the foreign exchange sold to the banks through the central bank’s swap operation could be covertly sold back against the local currency, thereby nullifying the intent of the swap. This type of “opposite transaction” will likely be a popular money game when there exists an active swap market in the private sector and the swap margins offered by the central bank are more favorable than the prevailing margins in the market. However, this problem can be partially addressed by a strengthening of monitoring and supervision on banking activities to ensure compliance; and by introducing restrictions on the use of the swap proceeds.51/

2. Other measures

Discussions so far have identified some major forms of supplementary sterilization measures which can be employed in an open, liberal environment. Many authorities of the developing countries, however, have recognized that their ability to sterilize foreign monetary flows on an extended basis depends on the characteristics of their financial markets, the magnitude of the capital inflows, and the degree of capital mobility. Some developing countries, after exhausting the menu of supplementary sterilization measures in the face of the persistently large inflows, have responded by allowing the nominal exchange rate to appreciate through, for example, a “wider band policy,” while other countries have resorted to official intervention in the forward exchange market to influence the exchange rate or its expectation. In a more threatening situation where the authorities found it impossible to sterilize the inflows, they eventually decided to impose a mild form of indirect capital controls: a variable deposit requirement (VDR) on foreign borrowings or an interest equalization tax (IET) on certain capital transactions. Behind such decision was the authorities’ belief that most of the side-effects of the sterilized intervention policies could be reduced by imposing capital controls: under conditions of imperfect capital mobility, the authorities’ initial attempt to sterilize the effects of inflows would not be thwarted by additional capital inflows attracted by the wider interest differential that the sterilization operations would inevitably generate. Also, they turned to this type of capital control because they were perceived to be less distortionary and more transparent than other quantitative controls. The discussions in this section will focus on these four measures.

a. Wider exchange rate band

An exchange rate band system is usually adopted by a country which is committed to defend its currency value within a predefined bound. The idea is to allow a degree of flexibility (and monetary autonomy) and, at the same time, to reduce the possibility of destabilizing speculation by providing an anchor to the public’s expectation of exchange rate movements. Such a band system generally served policy purposes fairly well in the face of external shocks (Chile, Israel).52/ More recently, however, authorities in several developing countries have recognized that, in the face of large and persistent capital inflows, the band system lacked the required flexibility, and have widened the exchange rate band (Chile, Colombia, and Korea).

The adoption of a “wider-band” policy has a number of merits. First, by allowing more room for the nominal exchange rate to appreciate in the face of the capital inflows, it can serve the policy objective of limiting inflation through a reduction of import prices and by reducing the need to sterilize all inflows. Second, the increased flexibility in exchange rate policy, by raising the perceived risk of short-term exchange rate fluctuations, may discourage the speculative component of capital flows. Third, if the underlying cause of the inflows is an undervalued exchange rate, the rapid appreciation made possible by the wider band can also contribute to the reduction of incentives for the endogenous inflows. Fourth, from a policy point of view, the wide band system allows for more flexible central bank intervention in the foreign exchange market. In the event of a reversal in inflows which necessitates a quick offsetting policy response, for example, it can be a relatively simple matter to change the exchange rate within the band, without having to formally adjust the parity.53/

On the other hand, there are costs associated with the “wider-band” approach. For example, the fact that the exchange rate can be used more flexibly as a policy instrument can itself be disruptive to the economy. In most cases, such exchange rate changes are anticipated, provoking large outflows or inflows of capital.54/ Also, the widened band may lead the public to perceive the possibility of devaluation (associated with competitiveness-oriented intervention) rather than appreciation (aimed at an anti-inflationary objective). More importantly, it would be difficult to send out clear and credible signals to private agents about prospects for inflation, especially when the “nominal anchor” approach has been adopted in their exchange rate policy.

Overall, as a policy response to deal with destabilizing effects of capital inflows, allowing some nominal, hopefully temporary appreciation (or modification in the exchange rate band system) can be a superior option than to wait for the intense demand pressure to push up prices and generate the real appreciation.55/

b. Forward exchange market intervention

That the authorities’ intervention in forward exchange can be an important instrument of monetary policy is an old idea.56/ A variant of such intervention is the swap operation, which was discussed in the previous section. The discussion in this section will, instead, focus on “outright” forward market transactions conducted by the central bank.

An outright forward facility is an arrangement by which the central bank directly guarantees a certain level of forward exchange rate to local residents. The main idea is to allow “hedging” behavior on the part of private wealth-holders who would like to invest the funds abroad, so that capital outflows will balance inflows as local residents adjust their portfolio holdings. The first-best solution would be to develop a forward market.57/ However, it takes time and efforts to develop a well-functioning forward market.58/ Therefore, the central bank’s outright forward facility can be an alternative means to be employed in the short run until the forward market can be further developed.

Unlike spot market intervention, official intervention in the forward exchange market has no immediate effect on the level of foreign reserves so that the level of domestic money supply can remain unchanged. Thus, the outright forward facility can be an appealing device for the central bank to exert its influence on the exchange rate without disturbing the domestic money market.

It is also noteworthy that forward market intervention and sterilized spot market intervention (i.e., the combination of spot exchange market intervention and open market sales of domestic bonds) do represent different policy instruments. In an idealistic world with perfectly efficient financial markets where the interest rate parity condition always holds, both operations may yield the same effects on macroeconomic variables, because a private wealth-holder would be indifferent about becoming a counterparty of the central bank’s sterilized spot market intervention or that of the forward market intervention, and thus would not alter his portfolio choice.59/ However, in a less than perfect world with various forms of transaction costs, which drive a wedge between the interest differential and the forward discount prevailing in the market, the two types of exchange market intervention may elicit significantly different responses from private agents.60/

Notwithstanding these advantages, the outright forward facility can be a highly risky operation, because it can subject the central bank to huge capital losses. Also, it has fiscal costs, for exactly the same reason why the currency swap operation that provides a favorable swap margin lowers central bank profits. Hence, authorities should refrain from engaging in aggressive forward market activities which offer excessively favorable forward premium as compared to the existing interest differentials.61/

More importantly, authorities should exercise extreme caution so that the use of this facility may not constitute an exchange restriction subject to the IMF jurisdiction. For example, the direct form of forward exchange rate guarantee offered by the central bank, besides being distortionary in economic effect, would constitute a multiple currency practice subject to the Fund jurisdiction under Article VIII, and hence needs to be approved by the Board.62/

In the long run, a more desirable solution would be to develop and enhance the efficiency of the forward market. It can be achieved by encouraging private sector’s demand for forward transactions. For example, the underlying documentation requirement on certain forward transactions (real demand principle) can be relaxed (Korea, 1994). Also, the ceilings on forward transactions can be expanded progressively in line with the volume of international transactions.

c. Easing of restrictions on outflows

In some cases, countries have sought to counterbalance capital inflows by relaxing controls on private capital outflows (Chile, Colombia), or by further liberalizing the trade system to raise imports (Colombia, Korea). The first category includes measures such as easing surrender requirements on foreign exchange earnings, permitting domestic institutional investors to make portfolio investments abroad, and allowing international organizations to issue local-currency denominated bonds in the local capital market. Acceleration of trade reform, particularly tariff reform and reduction, and liberalization of tightly restricted trade credit (e.g., deferred payments for imports) are examples of measures that are included in the latter category.63/

Of course, easing restrictions on outflows will be effective only if the measures have been effective in the past and are actually a binding restraint on outflows.64/ Assuming that they are binding, these measures have other advantages in addition to encouraging the capital outflows. For example:

  • they can enhance the overall efficiency of investment by allowing the international diversification of institutional portfolios. As well, domestic investors can benefit from the opportunities to build the technical skills in portfolio investments;

  • exporters, when allowed to retain their exports and other foreign exchange proceeds abroad, can manage their foreign assets more efficiently in their payment and settlement process;

  • they may facilitate reform in the domestic financial sector as more foreign borrowers are allowed to issue financial instruments in domestic financial markets, increasing competition in the local markets;

  • simplifying the process for profits and income remittance may send a positive signal about future ability to move capital out of the country, and thus contributes to the lowering of the risk-premium on the country’s financial assets;

However, against these benefits is the potentially problematic response of capital inflows to the signal sent off by the liberalization of the exchange controls: simplifying the process for repatriating profits and capital can restore confidence in the new exchange system and thus might attract additional inflows from abroad.65/ Also, there is a threat that a large and prolonged current account deficit would weaken the country’s external position, particularly for those countries which had accumulated large external debts in the past.

d. Variable deposit requirement

Formally, VDR is a tax on foreign borrowing in the form of a nonremunerated reserve requirement, which is denominated and paid in foreign currency; it is usually viewed as a form of capital control.66/ However, it can also be viewed as a sterilization instrument, since it directly sterilizes a fraction of capital inflows, and thus can offset the high cost of other sterilization measures. Moreover, unlike open-market operations, the use of VDR does not have a direct impact on domestic interest rates and hence does not directly risk perpetuating the inflows. As a form of capital control, the VDR is superior to a direct prohibition (e.g., embargo) or other quantitative and administrative measures, because it is a yield-affecting or cost-affecting control, and thus tends to be market-oriented.

This instrument requires that a certain percentage of foreign liabilities incurred by domestic residents be placed with the central bank in interest-free, non-assignable deposits for a certain fixed period of time. The percentage is set by the authorities, but is changeable. Typically, the ratio is to be applied to new flows, and may be adjusted frequently in response to a rapidly changing environment and the needs of monetary policy.67/ The deposit holding period (the minimum time period for the required deposit held by the central bank) is also flexible. As such, one of the key advantages of the VDR is that it can be applied flexibly and intermittently to counter unanticipated fluctuations in capital inflows.

Another major advantage is that the VDR scheme has a built-in feature that penalizes foreign borrowings of shorter-term maturity more severely, and thereby influences what is normally considered to be the principal form of destabilizing speculative capital movements.68/ The reason is that, once the deposit holding period is fixed, the effective cost of borrowed funds rises as the borrowing period is shortened. (See Table 1 in Appendix IV which illustrates how the effective cost of funds are raised by smaller amounts as the borrowing period gets extended). This means that the VDR can be modified so that its disincentives are targeted more precisely at “hot-money” inflows seeking short-term gains: the authorities can either place a higher reserve requirement ratio on shorter-term loans than on longer-term loans, or lengthen the deposit holding period to lift the effective interest cost.

A third advantage of the VDR is that the nonremunerated feature of the VDR deposits can help offset, at least partially, the central bank’s operating losses from other sterilization operations. This could be a critical point of consideration when the initial sterilization policy generates losses and thus jeopardizes the sustainability of the anti-inflationary effort.69/

Finally and most importantly, the imposition of the VDR on foreign borrowings can serve the role of an automatic sterilization device, as it can temporarily lock up a significant portion of the capital inflow, thereby obviating to a degree the need for other costly sterilization measures.

Despite these advantages, the VDR does have all the potential difficulties and limitations germane to any other form of capital controls. Thus, the effectiveness of the control may be eroded as the targeted borrowers may seek to circumvent the control imposition through various “loopholes.”70/ As well, it raises the cost of capital and may result in a misallocation of resources. For example:

  • an across-the-board imposition of VDR may prevent some borrowers from refinancing their loans at more favorable terms: the borrowers under this scheme would be denied an option to take advantage of changing interest rate levels in international financial markets, because all funds borrowed abroad would be for a fixed term and the deposits would be held for a specified minimum length of time;

  • the VDR scheme may exert uneven impact on availability of low-cost funds between those firms engaged in international trade and those that are not, the former possessing the ability to finance their imports by utilizing foreign suppliers’ credits, a standard practice in international commerce;71/

  • there is a criticism that the VDR scheme allows only very limited discrimination between “speculative” financial inflows and those which result from “genuine” direct investment decisions taken before the control was activated. In other words, though it has an automatic feature that penalizes borrowings of shorter-term maturity more severely, the VDR may exert a possible adverse impact on corporate financing and investment activity through increased uncertainty of financing investment projects.

It is germane to note, however, that set against these potential difficulties is the market-oriented nature of the VDR, which reduces its distorting impact and raises its transparency as compared to other types of capital controls that take the form of a direct quantitative restriction.

Whether the VDR can be effective in discouraging capital inflows and, if yes, for how long, are controversial subjects. However, as will be discussed in the next section of this paper, the empirical studies focusing on the use of these instruments reveal that, in some countries, the controls turned out to be partially effective in discouraging capital inflows.72/ In other countries, however, their effects appear to be short-lived (Spain). Overall, the experience suggests that countries which are poorly equipped with monetary control instruments may be able to gain time by employing this instrument as a supplementary monetary control measure (i.e., breathing space), until the authorities can determine whether the inflows are likely to be transitory or not, at which point they can resort to more fundamental policy adjustments.

e. Interest equalization tax

Unlike the VDR, the interest equalization tax (IET) is capable of impacting on either capital inflows or outflows. For example, when imposed on outward-bound capital transactions, the IET takes the form of a tax levied on the acquisition of foreign securities by domestic residents. In such a situation, the IET can be designed to equalize the yield of foreign issues with that of domestic issues and thus diminish the attractiveness of foreign debt issues. Of course, it can also be imposed, for capital inflow control purposes, on the acquisition by nonresidents of equity and debt instruments of domestic issuers. This can be called a “Capital Import Tax.” From the viewpoint of foreign investors who are subject to the IET, the imposition of the tax implies a lower effective rate of return on the assets they hold. For residents who can borrow at lower levels of interest rates in foreign capital markets, the existence of an IET would effectively increase the cost of capital raised overseas and bring it more in alignment with costs prevailing in domestic markets. In this case it is similar to a VDR, except that the tax (deposit) is not returned to the borrower after a period of time.

Theoretical literature focuses on the role of the IET in enhancing monetary policy effectiveness, the main thrust of which being that the IET can be used as a monetary policy instrument in a setting where a shock to the uncovered interest rate parity (UIP) condition needs to be neutralized.73/ If a shock (ε) drives the national interest rate differential and expected change in the exchange rate in such a way that the following deviation from the UIP condition is observed by the monetary authorities


where Et [St+1] denotes the expectation at time (t) of the spot exchange rate St that would prevail at time (t+1), then the UIP condition can be restored by imposing an interest-equalization tax (t*) on a nonresident’s acquisition of domestic assets, thereby lowering the effective rate of return on domestic assets held by nonresidents. In other words, the interest differential is now reduced to R-R*-t* in the left-hand side of the UIP condition. Thus, the main advantage of the IET is that it enables the policymaker to influence the exchange rate by means other than an adjustment of the domestic interest rate or direct intervention in the exchange market. To a certain extent, this releases the policymaker from the constraint imposed by the UIP condition.74/

There could arise many economic issues relating to the actual design and operation of the IET. First, the IET can be designed to influence international capital flows exclusively by exempting those financial transactions that do not involve currency conversion. However, the tax on currency conversion may not always fall on cross-border capital flows. In some cases, transactions between residents could be affected. Second, another issue arising in the design of the IET is whether it is desirable to tax short-term transactions more heavily. However, as in the VDR scheme, short-term transactions would automatically be more heavily taxed in terms of an effective tax rate, if a uniform ad valorem rate is applied for all financial assets regardless of their maturities. Third, another important issue is whether public debt should be exempt. If the main policy objective is to discourage foreign borrowings by the private sector, the public debt could be exempt from the IET. However, the exemption would not be desirable in situations where other forms of preferential treatment of government debt are already hampering the overall efficiency of the financial markets.

In considering the use of the IET, the implication of the taxes for the Fund’s approval jurisdiction on multiple currency practices under Article VIII needs to be addressed. Formally, the Executive Board of the Fund has not yet endorsed the staff’s view that multiple currency practices applying exclusively to capital transactions are subject to Article VIII, Section 3.75/ Thus, even if the taxes are deemed to give rise to multiple currency practices, they would not be subject to the Fund’s approval jurisdiction. However, member countries are expected to provide the Fund with full information on the taxes and any other measures even if they are applied solely to capital transactions, so as to enable the staff to identify whether or not they constitute multiple currency practices and to assess their economic consequences. In addition, care needs be taken to assume that foreign exchange restrictions do not arise in the context of certain payments for services, such as interest payments or authorization, or this could constitute a violation under Article VIII.

In practice, the United States and Brazil are among the few countries that actually imposed an interest equalization tax (IET) on the transfer of financial assets between residents and nonresidents. A slightly different approach as used by Thailand: they intermittently used a 10 percent withholding tax on interest payments to nonresidents. Another slightly different form of discriminatory tax treatment is the “Thin Capitalization Provision” adopted by Australia in 1987. The provision penalized offshore borrowings by prohibiting the tax deductibility of the interest payment when the value of foreign loans exceeded a certain stipulated percentage of capital.76/

In the United States in the 1960s, the IET was used as a policy instrument to stem the outflow of U.S. dollars: when the higher returns on foreign stocks and bonds had attracted unprecedented amounts (over $1 billion) of domestic savings during the period July-December 1963, the government imposed the IET on the acquisition by a U.S person of bonds or stock issued in the U.S. by a foreign issuer.77/ The application of the IET was limited to the area of long-term investment.78/ No tax was initially imposed on commercial bank loans. However, as bank loans soon became a substitute channel for securities purchases, the authorities decided to tax them also later in 1964. The estimated effect of these tax rates on the interest cost was to raise a foreigner’s cost of raising capital in the U.S. by approximately 1 percent a year, the prevailing interest gap between Europe and U.S. that time. Although the tax was intended to be only a temporary measure, it has been repeatedly extended until its expiration in 1974. This partly reflected the authorities’ belief in the IET’s success in reducing residents’ foreign investment as well as the continued balance-of-payments deficit experienced by the United States. However the increased circumvention and the erosion of the effectiveness of the control also necessitated the continual amendment of the tax provisions.

In Brazil, on the other hand, the principal concern in 1993 was the excessive capital inflow driven by a surge in portfolio investment in domestic mutual funds and stocks. The response was to impose a small tax on foreign sector operations which was intended mainly to discourage intense placements of bonds on international markets issued by Brazilian enterprises and financial institutions.79/ In the measures adopted in November 1993 nonresident investment in the newly created Foreign Capital Fixed-Income Fund (FRF-CE) was subject to a financial transaction tax (IOF) of 5 percent, payable at the time the capital enters the country. Also, the proceeds of foreign borrowings through the placement of bonds, notes, and commercial paper, when converted into domestic currency, were made subject to a financial transaction tax (IOF) of 3 percent. In addition, a uniform 15 percent withholding tax on profits, dividends and bonuses was established for all foreign capital (December 1993). The effects were immediately visible: bond issues, which had risen from US$3.7 billion in 1992 to US$6.7 billion in 1993, declined from US$2.1 billion in the fourth quarter of 1993 to US$1 billion in the first quarter of 1994.

In summary, the IET can be proposed as a measure to deal with destabilizing capital movements. The U.S. experience shows, however, that it is best regarded as a temporary measure because its effectiveness is likely to erode as additional means are found to circumvent it. Like all forms of capital control, moreover, there is an associated administrative burden and, when effective, it can raise the cost of capital and distort resource allocation. For these reasons, the IET should be carefully designed, preferably with some special features that can minimize such side-effects.80/

V. Empirical Evidence

Numerous studies have examined and empirically tested the determinants and the effectiveness of capital controls (Edwards and Khan (1985), Haque and Montiel (1990), Faruque (1991), and Johnston and Ryan (1994)). The first three papers, however, measure and evaluate the effectiveness indirectly—i.e., by looking at national interest rate differentials and by examining whether there are unexploited arbitrage opportunities in the differentials. The general conclusion of these studies is that capital controls were relatively ineffective in protecting countries against short-term capital movements.81/

By contrast, Johnston and Ryan (1994) examined directly the impact of controls on the capital accounts of countries’ balance of payments. As an explanatory variable, they focus on the structural “shift” in the capital control regime, and find significant evidence that, at least for a subsample of industrial countries, the control regime changes (i.e., from restricted to liberalized regime) have some impact in deteriorating the countries’ net capital accounts. For developing countries, however, the study does not find any statistics to be significant for any of the different measures of net private capital flows. This estimation result implies that capital controls adopted by developing countries do not seem to have had a significant influence on the structure of capital flows. Concerning the effects of partial liberalizations in developing countries, they also find that the partial liberalizations of outflows were not associated with a significant weakening of net capital flows, while the liberalizations of inflows were associated with a significant improvement in net capital flows. This could be interpreted to mean that controls imposed on outward-bound capital flows do not effectively prevent the capital outflows from developing countries, while those imposed on inward-bound flows are effective in reducing the flows.82/

The present paper, while being close in spirit to Johnston and Ryan (1994), differs in the main focus as well as methodology: this paper focuses on the effectiveness of various types of sterilization measures (e.g., swap facility) and indirect capital controls (VDR, IET), in the context of an individual country’s experience. The paper finds that all of the estimated coefficients on the dummy variables identifying the temporary imposition of the restrictive measures had the expected signs, and their effects on capital flows were statistically significant for three of the four sample countries. The paper also finds that for all of the four countries the changes in monetary policies were significantly offset by the capital movements, implying some degree of capital mobility, but that the offset coefficients were not large enough to prevent the authorities from using discretionary monetary policy in the face of capital inflows.83/

The empirical estimation model in this paper utilizes Kouri and Porter’s (1974) model based on the “monetary approach” to the balance of payments, which treats net capital flows (NC) basically as the mechanism by which a domestic excess demand for money is removed, i.e.,


where d(Md) and d(NDA) denote the changes in money demand and net domestic assets, and Y, R, CAB denote the domestic income, interest rate, and the current account surplus, respectively. If we consider a more realistic version of the model which: (i) allows the relative return on domestic and foreign assets (adjusted for exchange rate changes) to enter the money demand function as an argument; and (ii) includes “other factors” that influence the capital flows, such as a dummy variable to represent the imposition of capital controls for a few periods, the capital flow equation can be written as:


where the change in covered interest differential is denoted by D(R-R*e), and “other factors” are reflected in the Dummy variable. The anticipated signs of the coefficients are α1, α4 > 0; and α2, α3 < 0. The expected sign on α5 can be either negative and positive, depending on the nature of the dummy variable.85/

As frequently observed in many empirical studies on capital flows, there is a critical issue of how to measure net private capital flows, particularly for developing countries with the wide-spread problem of inaccurate, less reliable data. The data used here were taken from the International Financial Statistics (IFS), and net private capital flows were defined to include net errors and omissions on the assumption that they capture various types of unrecorded private capital movements, including those which may be associated with the circumvention of capital control measures.86/ Indeed, estimation results revealed that the addition of errors and omissions to the dependent variable significantly increased the explanatory power of the estimation model.

Equation (2b) was estimated for four sample countries: three developing countries (Indonesia, Korea, and Thailand) and one industrial country (Spain).87/88/ Also, in most countries, it was rather difficult to construct the data on covered interest differentials because the forward exchange rate data did not exist. In this case, realized spot rates were used as a proxy for expected changes in exchange rates.

Finally, to test the effectiveness of a specific capital controls in each country’s context, a dummy variable technique was used.89/ To this end, the exact timing of the introduction and lifting of various types of control measures and supplementary sterilization instruments was carefully examined.

The estimated parameters are reported in Table 1.

Table 1.

Estimation Results of Private Capital Flow Equations

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The dummy variable for the 4th quarter of 1990 represents the central bank’s provision of currency swap facility under forward cover at a premium aimed at encouraging inflows.


The dummy variable represents the reduction of swap facilities for foreign banks and the temporary reversal of interest rate deregulation during the 4th quarter of 1989-1st quarter of 1990.


The dummy variable for 2nd quarter of 1988-1st quarter 1990 represents the suspension of 10 percent withholding tax on interest payments on long-term foreign loans aimed at encouraging inflows.


The dummy variable represents the imposition of reserve requirements on nonresidents’ Spanish bank accounts in the first quarter of 1987, and also a 30 percent nonremunerated reserve requirement on new foreign loans in the first quarter of 1989.

The major findings from this empirical study for four sample countries (Indonesia, Korea, Thailand, and Spain) are as follows:

  • As shown by the R-square statistics, the explanatory power of the estimation equation is in line with what other studies of capital flows have obtained, suggesting that the model specification along the monetary and portfolio approach was fairly successful.

  • The offset coefficient that measures the extent to which domestic monetary measures are offset by capital flows (α2) was statistically significant in all cases. This implies that, for these countries, the degree of capital mobility is less than perfect. In three countries, the magnitude of the offset coefficients was found to be small (below 0.5), magnitude of the offset coefficients was found to be small (below 0.5), implying that the authorities in these countries have substantial scope for sterilizing capital movements.90/

  • The estimated coefficients on the dummy variable representing various types of sterilization measures and capital controls (α5) have the expected signs in all cases, and a statistically significant for three countries at the 95 percent significance level.91/ These were Indonesia for the use of foreign exchange swaps during the fourth quarter of 1990; Spain for the use of VDR during the first quarter of 1987 and again the first quarter of 1989; Korea for the reduction of the central bank’s swaps facilities for foreign bank branches and the temporary reversal of interest rate deregulation during the fourth quarter of 1989 and the first quarter of 1990.

  • The measured effects of interest rate differentials (adjusted for exchange rate movements) on the capital flows were found to be large, but statistically insignificant for three of the sample countries at the 95 percent significance level.92/

  • The estimated coefficient on the proxy variable representing speculative forces (α6), which is measured by the announced level of net international reserves at the last month of the preceding quarter, turned out to be significant in Spain. This seem to indicate that fears of a depreciation of the local currency, which is assumed to depend on the depletion of the official international reserves, has some influence on capital flows in an adjustable peg exchange rate system.

Overall, the results of the empirical studies suggest that there still remains some scope for an independent monetary policy during the process of capital account liberalization and that in conducting such policies, the use of the supplementary sterilization measures and certain forms of indirect capital controls can be effective in limiting the capital inflows, at least for a few periods.

VI. Conclusions

The recent experiences of many developing countries reveal that the monetary authorities often lack suitable instruments that can sterilize, fully or for long, persistently large capital inflows. In the context of a liberalizing environment, their traditional tools of monetary control typically lose effectiveness; at the same time, they cannot fully rely on more advanced instruments of market-based monetary control because various elements of the supporting institutional infrastructure have yet fully to be developed. If indirect instruments of monetary control are used exclusively, it appears that their scope of application often is too limited to contain the effects of capital inflows of the order of magnitude which many countries have faced recently.

The evidence considered in this paper shows that the mobility of capital to these countries, while rising, is not yet so high as to preclude attempts to sterilize the inflows. The use of open-market operations in domestic securities is clearly the most efficient sterilization response. However, there are a number of practical limits to the use of this instrument, including thin and segmented local financial markets with limited capacity to absorb open-market sales, a low degree of substitutability between sterilization bonds (treasury papers or central bank bills) and other financial assets which puts upward pressure on local interest rates, and substantial fiscal costs.

In these circumstances, the scope for sterilizing capital inflows can be extended through the use of supplementary techniques, in particular central bank discount policy, reserve requirements, the switching of government deposits, and foreign currency swaps. While some of these measures are widely used, others (notably foreign currency swaps and switching government deposits between commercial banks and the central bank) have been hardly used at all. Although not without their drawbacks, supplementary sterilization measures have potentially beneficial side effects, including a positive effect on central bank profits and an absence of a direct effect on domestic interest rates.

Beyond the use of sterilization techniques, it may be possible to resort to measures which seek to turn aside or forestall additional capital inflows. The specific measures considered in this paper include the introduction of wider exchange rate fluctuation bands, direct intervention in forward exchange markets, the variable deposit requirement (VDR) and the interest equalization tax (IET).

Both the VDR and the IET can be viewed as a form of capital control. As such, their use is not without the limitations germane to any other form of control including administration costs, susceptibility to circumvention and potentially distorting effects on resource allocation. They are best seen as a temporary “belts and braces” measure which may be used to smooth the transition to the “first best” world of full financial market liberalization and development, and capital account convertibility.

That said, their market-oriented nature does make them less distortionary and more transparent than other capital controls in the form of a direct quantitative restriction. Moreover, the empirical results presented in this paper, while based on a small sample and therefore hardly conclusive, suggest that these measures can have at least some temporary effect in reducing inflows. Nor does their use incur the heavy fiscal costs or upward pressure on local interest rates that would be associated with exclusive use of open-market operations.

In summary, developing countries that are engaged in the process of domestic financial sector reform and capital account liberalization may need additional instruments in their policy arsenal to deal effectively with destabilizing capital movements when they arise. Classic open-market operations may need to be accompanied by other supplementary sterilization measures or other measures to turn the flows aside. While the long-term objective must be to achieve a fully market-based system of policy management, there is a case for making capital controls a part of second best policy-making during the transition. This is likely to be the case particularly in a small open economy where adverse spill-overs from unsynchronized macroeconomic policies pursed by bigger economies are often felt to be uncontrollable.