Contents
Executive Summary
I. Introduction
II. How Do Macro and Financial-Stability Considerations Fit Together?
III. The Policy Toolkit
IV. Managing Capital Inflows: Matching Risks and Tools
V. Some Evidence on Effectiveness of Instruments in Managing Inflows
VI. Designing Capital Control Instruments
VII. Conclusions
References
Boxes:
1. Prudential Policies—Micro versus Macro
2. Korea—Macroprudential Rules in Relation to Capital Inflows
3. Macroprudential Policies, Credit Growth, and Asset Prices: Some Recent Experiences
4. Dealing with Capital Inflows and Excessive FX Lending: The Case of Croatia
5. International Arrangements Restricting the Scope for Capital Controls
6. Effectiveness of Capital Controls: Brazil and Colombia
7. Taxes vs. URRs
Figures
1. Using Capital Controls for Macroeconomic and Financial-Stability Risks
2. Frequency Distribution of Pre-Crisis Policy Measures
3a. Choice of Instruments to Mitigate Risks Associated with Flows through the Banking System
3b. Choice of Instruments to Mitigate Risks Associated with Flows through the Unregulated Financial Sector
4. Domestic Credit and Net Capital Flows to GDP
5. Debt Liabilities and Policy Measures
6. Domestic Private Credit and Policy Measures
7. Crisis Resilience and Policy Measures
8. Capital Controls: Design Considerations
A1. Correlation Between Policy Measures
A2. Pre-Crisis Country Coverage of Policy Measures, 2007
Tables
A1. Policy Measures and Debt Liabilities
A2. Policy Measures and Foreign-Currency Lending
A3. Policy Measures and Domestic Credit Booms
A4. Policy Measures and Crisis Resilience
Appendix
1. Empirical Analysis
A. Measuring Capital Controls and Prudential Policies
B. Estimation Results
EXECUTIVE SUMMARY
Emerging market economies are facing increasing challenges in managing the current wave of capital inflows. In an earlier note (Ostry et al., 2010), we laid out a set of circumstances under which capital controls could usefully form part of the policy response to inflow surges. For countries whose currencies were on the strong side, where reserves were adequate, where overheating concerns precluded easier monetary policy, and where the fiscal balance was consistent with macroeconomic and public debt considerations, capital controls were a useful part of the policy toolkit to address inflow surges. Beyond macroeconomic considerations, capital controls could also help to address financial-stability concerns when prudential tools were insufficient or could not be made effective in a timely manner. We also stressed that the use of capital controls needs to take account of multilateral considerations, as well as their costs and the mixed evidence on their effectiveness in restraining aggregate flows.
This note elaborates on how the macro and financial-stability rationales for capital controls fit together; how prudential and capital control measures should be deployed against various risks that inflow surges may bring; and specifically, how capital controls should be designed to best meet the goals of efficiency and effectiveness. Four broad conclusions emerge.
First, capital controls may be useful in addressing both macroeconomic and financial-stability concerns in the face of inflow surges, but before imposing capital controls, countries need first to exhaust their macroeconomic-cum-exchange-rate policy options. The macro policy response needs to have primacy both because of its importance in helping to abate the inflow surge, and because it ensures that countries act in a multilaterally-consistent manner and do not impose controls merely to avoid necessary external and macro-policy adjustment.
Second, while prudential regulations and capital controls can help reduce the buildup of vulnerabilities on domestic balance sheets, they both inevitably create distortions—reducing some “good” financial flows alongside “bad” ones—and may be circumvented. Thus, there is no unambiguous welfare ranking of policy instruments (though non-discriminatory prudential measures are always appropriate), and a pragmatic approach taking account of the economy’s most pertinent risks and distortions needs to be adopted.
Third, measures need to be targeted to the risks at hand. When inflows are intermediated through the regulated financial system, prudential regulation will be the main instrument. When inflows bypass regulated markets and institutions, capital controls may be the best option if the perimeter of regulation cannot be widened sufficiently quickly or effectively.
Fourth, the design of capital controls needs to be tailored to country circumstances. Where inflows raise macro concerns, controls will need to be broad, usually price-based, and temporary (though institutional arrangements to implement controls could be maintained). To address financial-stability concerns, controls could be targeted on the riskiest flows, might include administrative measures, and could be used even against more persistent inflows.