The Effectiveness of Capital Controls and Prudential Policies in Managing Large Inflows
Author: Mr. Karl F Habermeier, Annamaria Kokenyne, and Chikako Baba

Contributor Notes

Authors’ E-mail Addresses:

khabermeier@imf.org; akokeny@imf.org;

cbaba@imf.org

Publication Date:
05 Aug 2011
eISBN:
9781463902896
Language:
English
Keywords:
SDN; control; capital control; capital; interest rate; inflow control; prudential measure; intensity of capital control; capital transactions; control policy in Croatia
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Staff Discussion Notes showcase the latest policy-related analysis and research being developed by individual IMF staff and are published to elicit comment and to further debate. These papers are generally brief and written in nontechnical language, and so are aimed at a broad audience interested in economic policy issues. This Web-only series replaced Staff Position Notes in January 2011.

Abstract

Staff Discussion Notes showcase the latest policy-related analysis and research being developed by individual IMF staff and are published to elicit comment and to further debate. These papers are generally brief and written in nontechnical language, and so are aimed at a broad audience interested in economic policy issues. This Web-only series replaced Staff Position Notes in January 2011.

I. Introduction

IMF staff have recently re-examined the conditions under which two sets of policies—capital controls and related prudential measures, referred to collectively as “capital flow measures,” or CFMs—might be used to address the risks posed by large capital inflows.1

In essence, this new work maintains that macroeconomic policies are appropriate tools to use in the face of capital inflows. These policies include: allowing the currency to appreciate when it is undervalued from a multilateral perspective; purchasing foreign exchange reserves if their level is not more than adequate from a precautionary perspective; and lowering policy rates (when overheating is not a concern) or tightening fiscal policy to allow space for monetary easing (consistent with inflation objectives). There is also an important role for structural policies to enhance the capacity of the economy to absorb inflows and cope with volatility, along with improved regulation and supervision of the financial sector.

Beyond this, it may be appropriate for countries to also use CFMs. These measures comprise (i) residency-based CFMs, often referred to as capital controls, which encompass a variety of measures affecting cross-border financial activity that discriminate on the basis of residency;2 and (ii) other CFMs that do not discriminate on the basis of residency but are nonetheless designed to influence inflows. If a measure is not designed to influence capital inflows, it would not fall under the CFM umbrella. In general, it is often difficult to determine ex ante whether a particular measure constitutes a CFM; and a range of criteria, including the overall policy context and the timing of the measure, need to be considered. Within CFMs, precedence would be given to those that do not discriminate on the basis of residency.3

While this framework provides a hierarchy of measures to address the risks from large capital inflows, two other important issues need to be considered in connection with the use of CFMs:

  • It is necessary to take account of their multilateral implications. For example, the use of a CFM might divert capital flows from one country to other countries, which may have a variety of effects, both positive and negative, on economic performance and welfare. These multilateral considerations are currently being studied in greater depth by IMF staff.

  • In addition, a judgment needs to be made on the effectiveness of CFMs. This is ultimately an empirical question, and one that has attracted a great deal of research over the years.

The present note seeks to provide further information on the second issue, effectiveness. The question of effectiveness has been a long-standing and at times controversial topic of debate, with no definitive resolution. The note begins by summarizing the existing empirical literature concerning the effectiveness of CFMs. It then presents some new econometric estimates by IMF staff covering the experience with CFMs in the past decade, drawing also on country experiences.

Overall, this note finds that, for reasons that are not yet fully understood, capital controls and related prudential measures achieve their stated objectives in some cases but not in others. Close attention thus needs to be given to the choice and design of such measures, as discussed for example in Ostry and others (2011).

II. What Does the Literature Tell Us?

As discussed further below, the extant literature deals mainly with capital controls (CFMs that discriminate based on residency). Accordingly, the focus in this review of the literature is on the effectiveness of capital controls in countries that have already liberalized many types of international capital flows. This is the situation in which many emerging market economies find themselves today. By contrast, countries with well-established controls and strong foreign exchange enforcement capacity seem to have less difficulty controlling capital inflows, but at the cost of greater distortions. China and India are the prime examples: they have lifted controls on capital inflows only to a limited extent, and they continue to use various administrative controls, including approval procedures and quantitative limits. The comprehensive systems in China and India allow for close monitoring of flows and a calibrated tightening of controls when needed.4

There is relatively little empirical research on the effectiveness of CFMs other than capital controls in managing the risks from inflows in countries with a broadly open capital account. The pace at which countries have adopted or modified prudential measures in response to capital inflows, either instead of capital controls or together with them, seems to have picked up in the last few years. What work there is in this area is based on country cases or event studies.

The effectiveness of capital controls is measured by the achievement of specified objectives. These typically include the following: (i) reducing the total volume of inflows to prevent currency appreciation; (ii) altering the composition of inflows to minimize the impact of sudden stops or reversals on financial stability and exchange rate volatility; and (iii) providing additional room for monetary policy. In terms of data, studies seek to measure the effect of controls on the volume or composition (maturity, type) of the inflows, the exchange rate (changes, volatility), and the differential between domestic and foreign interest rates (market and/or policy rates).

Measuring effectiveness is often difficult because CFMs are almost always part of a broader package of policies, all of which can affect capital inflows. Indeed, there seem to be no cases in which only CFMs were used to deal with increased inflows. Disentangling the effects of different policies and quantifying the contribution of CFMs to the outcome poses difficult statistical problems. Accordingly, the results of such investigations are not clear-cut.

Circumvention further confounds attempts to measure effectiveness. Studies of the effect of CFMs on the composition of flows are particularly susceptible to this problem. Circumvention often means that targeted flows find other channels—the flow covered by a particular measure decreases but other types of flows increase. For example, in Brazil, balance of payments data indicate that the implementation of a tax on portfolio inflows was followed by lower portfolio flows but increased foreign direct investment (FDI) flows. It seems that some flows were disguised as FDI to avoid the tax.

Earlier reviews of the literature on effectiveness concluded that the evidence is mixed.5 Based on the experience of a number of emerging market economies through 1999, it appeared that the principal motivation for the use of controls was to maintain a differential between domestic and foreign interest rates and to reduce pressures on the exchange rate. Controls were found to be effective initially, but countries in general could not achieve both objectives simultaneously—the interest rate differential could be maintained but the exchange rate had to be adjusted. Controls lengthened the maturity of foreign exchange inflows but were less successful in reducing the overall volume.

The conclusions of the more recent literature on effectiveness are consistent with the previous findings. Many of these papers reexamine earlier episodes that had been studied previously, but some also look at more recent experiences in one or more countries.

The key results overall are that controls on capital inflows have a stronger effect on the composition of flows and on domestic–foreign interest rate differentials than on the overall volume of inflows. However, some more recent cross-country studies suggest that countries that are less open to financial flows experienced smaller inflow surges. Appendix I provides further details.

  • Most econometric studies find no effect of controls on the overall volume of inflows. In single equation models (such as OLS, IV), some do not find a significant reduction in volume,6 while others do.7 For Brazil and Malaysia, vector auto-regressions (VARs) find a significant but short-lived reduction.8

  • Controls can increase the maturity of inflows. Significant evidence is found for Brazil, Chile, Colombia, Croatia, Malaysia, and Thailand regardless of the econometric methods.9 These studies find that short-term inflows significantly dropped after the imposition of controls, while observing no statistically significant change in long-term inflows. There is also indirect evidence that controls on equity inflows were binding in Chile, Korea, and Argentina but not in Indonesia.10

  • Inflow controls had no clear effect on currency appreciation in most cases. Most studies find that an unremunerated reserve requirement (URR) on inflows in particular11 had no impact—or only a small impact—on the exchange rate.12 Only one study, using a GARCH model, found that a tightening of controls (a URR) led to a depreciation in the nominal exchange rate band.13

  • With regard to monetary policy autonomy, inflow controls can contribute to the differential between domestic and foreign interest rates. Using a VAR framework, one study finds that Chile’s central bank was able to target a higher domestic interest rate for 6 to 12 months.14 In China and India, which maintain more extensive controls, interest rate spreads remain significant and persistent over time.15 This conclusion is consistent with the view that controls are more effective in countries that more heavily control capital flows.

  • Another strand of the literature focuses on the microeconomic impact of inflow controls. Forbes (2007) argues inflow controls in Chile imposed a financial constraint on small firms. Gallego and Hernandez (2003) find that controls were associated with lower leverage and greater reliance on retained earnings.

An important recent meta-study by Magud, Reinhart, and Rogoff (2011) seeks to standardize the results of a significant part of the earlier literature and generally confirms these broad findings:

Capital controls on inflows seem to make monetary policy more independent, alter the composition of capital flows, and reduce real exchange rate pressures (although the evidence there is more controversial). Capital controls on inflows seem not to reduce the volume of net flows (and hence the current account balance).

Nonetheless, the divergent findings in the literature are striking, and it is important to understand them more fully.

First, and perhaps most importantly, there is no generally accepted framework for analyzing the effectiveness of capital controls. It is well known that attempts to measure effectiveness suffer from simultaneity bias: capital controls are usually tightened when capital inflows surge, creating an endogeneity problem. Many different econometric approaches have been used to address this problem, including the use instrumental variables and VAR with a variable ordering assumption. The results are also sensitive to the details of model specification, notably the choice of control variables. Of course, not all studies even go this far: many on the experience of individual countries do not use a rigorous econometric methodology but instead draw conclusions from observed changes in macroeconomic variables and the volume of capital flows—for example, Jankov (2009), Mohan and Kapur (2009), Reinhart and Smith (1998), and Thaicharoen and Ananchotikul (2008).

Second, effectiveness is more difficult to measure when low-frequency data are used. Capital controls lose their effectiveness over time, as markets find ways to circumvent them. Thus, studies that track changes in capital flows using high-frequency data (and with a close focus on the announcement or the effective date of the introduction of controls) are more likely to find some effectiveness. Some studies using daily or weekly financial variables find significant changes in stock market or forward premia when capital controls are introduced or lifted—for example, Levy-Yeyati, Schmukler, and Van Horen (2009), and Hutchison and others (2009).

Third, there are good reasons why effectiveness may differ across countries or over time. Notably, the practical experience of IMF staff strongly suggests that effectiveness depends on the design or implementation of the controls. Different countries may implement or enforce the same capital controls differently, reflecting differences in administrative capacity. The level of legal compliance may also vary. These and other details of a control’s design and the environment in which it is implemented are not captured by the data used in the available studies, and cross-sectional or panel data analysis will find it difficult to identify these factors in a consistent manner. For example, Campion and Neumann (2004) use panel data on seven Latin American countries and find a significant impact on the volume of flows, while a study by Binici, Hutchison, and Schindler (2009) that covers 74 countries does not find controls to be effective.

Fourth, the intensity of capital controls is measured in the literature in many different ways. Some studies use a binary variable indicating the existence of a specific measure, and some use combination of a few binary variables (see Clements and Kamil, 2009; Coelho and Gallagher, 2010). Other studies count the number of regulation changes, as in Cardoso and Goldfajn (1998). Yet others calculate tax equivalent intensity, as in De Gregorio, Edwards, and Valdes (2000). Some studies further distinguish between controls on inflows and outflows (for example, Binici, Hutchison, and Schindler, 2009). Most of the indices are based on de jure controls, that is, the presence of controls in domestic laws and regulations. These measures do not take into account whether and how they are implemented in practice.

Fifth, the measurement of capital flows varies. Studies with narrowly defined capital flows (that is, flows subject to the analyzed controls) are more likely to find effectiveness, in particular with respect to the compositional effect of the controls (see De Gregorio, Edwards, and Valdes, 2000).

In sum, studies ideally should adequately correct for simultaneity bias; use high-frequency data; capture important institutional features of countries such as administrative capacity and legal compliance; cover a broad range of countries; and measure the intensity of controls based on how actively they are enforced. None of the extant studies meets all of these requirements, and indeed data limitations will, for the foreseeable future, preclude combining all of these features in a single study.

III. Capital Controls in the 2000s—Some New Econometric Evidence

One important question is whether the findings of the literature change once country experiences and data since 2000 are more systematically taken into account. In the last decade, there have been several major surges in capital flows to emerging markets, including in central and eastern Europe, Asia, and Latin America.

The discussion here is based on Baba and Kokenyne (forthcoming–a), who provide a quantitative assessment of the effect of inflow control tightening and outflow liberalization in selected emerging market economies (EMEs) in the 2000s. The following episodes are examined: the foreign exchange tax in Brazil (2008), the URR in Colombia (2007–08) and in Thailand (2006–08), and extensive outflow liberalization in Korea (2005–08).

The analysis uses indices that track the intensity of temporary price-based capital controls and other types of capital controls, drawing on information on reported policy changes (Figure 1). The use of separate indices for temporary price-based controls and for other—more permanent—controls helps to measure the effect of these policies separately in achieving the policy objectives.

Figure 1.
Figure 1.

Indices of Capital Controls

Citation: Staff Discussion Notes 2011, 014; 10.5089/9781463902896.006.A001

Source: IMF AREAER database and authors’ calculation.Note: For indices of inflow controls and outflow controls, higher values indicate that transactions are subject to more restrictions. For the tax and URR indices, higher values indicate that the regulation applies to more types of inflows.

Estimation of the determinants of capital flows (Table 1) is by generalized method of moments (GMM), while the effectiveness in achieving various macroeconomic objectives is assessed using VAR. Both sets of regressions control for various country-specific and global correlates of capital flows.16 As in much of the previous literature, the study gauges the success of controls in achieving four objectives: (i) stemming capital flows; (ii) lengthening the maturity of capital flows; (iii) allowing greater room for maneuver for raising domestic interest rates; and (iv) easing currency appreciation pressures.

Table 1.

Impact of Capital Controls on the Volume of Capital Flows

article image
Source: IMF staff estimates.Note: GMM 2SLS estimates with lagged variables as instruments. Values in parentheses are White’s heteroskedasticity consistent standard errors. ** and * indicate the estimate is significant at the 5 percent and 10 percent level, respectively. Capital flows are expressed as a percent of GDP. The regressions include interest rates and business cycles in the respective country and in the United States, forward premium, ICRG, VIX, and current account balance. EMBI sovereign spread is additionally included for Brazil and Colombia. Period: January 2000–August 2008 for Brazil and Korea; January 2004–August 2008 for Colombia; and 2000: Q1–2008: Q2 for Thailand.

The estimates show that the effectiveness of capital controls varies across countries:

  • The volume of net capital inflows was reduced by the URR in Colombia. Colombia’s URR affected short-term flows and thus helped lengthen the maturity structure of inflows. Thailand’s URR also affected the volume of net capital flows; however, the effect materialized through increasing outflows. The foreign exchange tax in Brazil and outflow liberalization in Korea do not appear to have had a significant impact on the volume or composition of inflows.

  • The price-based capital controls in Brazil and Colombia provided greater room for monetary policy to increase interest rates.

  • Controls or outflow liberalization did not ease appreciation pressure in any of the countries.

  • Thailand’s general inflow controls, which were tightened just before the introduction of the URR, and the liberalization of outflows helped maintain monetary policy autonomy.

In addition, the macroeconomic impact of the inflow controls depends on their coverage, the level of capital market development, other supporting policies, and whether the capital inflow surge is short-lived or longer-lived:

  • When measures target a narrow component of capital flows, even if successful on the targeted flows, they may not have a significant macroeconomic impact such as lowering the total volume of flows or easing currency appreciation pressures. For example, in Colombia, the measures successfully moderated short-term flows but could not stem the appreciation of the currency because the majority of flows—notably FDI—were exempt.

  • The desired effect is even more difficult to obtain when the capital market is well developed, because investors can find more ways to circumvent the measures. This might explain why policies in Brazil, with its sophisticated derivative markets, were less effective.

  • Other policies can help support effectiveness. For example, liberalizing outflow controls can increase outflows and help in maintaining higher domestic interest rates (Thailand).

  • In all cases, the impact of the policies was short-lived. This suggests that capital controls are best suited to dealing with temporary surges in capital flows. In order to remain effective in the longer run, they need to be regularly reinforced and broadened, potentially leading to a wider reregulation of capital flows. However, reinforcing controls may increase distortions.

IV. Managing the Risks of Capital Inflows—Capital Controls and Prudential Policies

In addition to using capital controls to manage capital inflow surges, countries have employed prudential policies to cope with the risks of those surges. Whereas capital controls seek to reduce inflows or change their composition, dampen currency appreciation, or gain more room for domestic interest rate policy, prudential policies have often targeted rapid credit growth, which is a common side effect of large inflows, and which has been a major issue of concern in a number of EMEs. Capital inflows have been an important source of noncore bank funding in Croatia and Korea, for example, underpinning higher bank leverage and often rapidly growing credit.17 Corporates and households may also at times borrow directly from abroad, bypassing the regulated financial sector. If excessive or poorly managed, such credit expansion can pose risks to macroeconomic and financial system stability.

As noted, prudential policies designed to influence cross-border capital flows are a subset of CFMs, but they are also often referred to as macroprudential policies. However, an emerging view holds that it is preferable to limit the use of the term “macroprudential” to measures that aim to deal with systemic risk in the financial sector rather than with macroeconomic objectives more generally.18 Here, we refer simply to prudential policies, which are taken to include both micro- and macroprudential measures.

The effect of both capital controls and prudential measures on selected variables of interest was examined in 13 country cases covering the period of 2000–2008: Q2.19 The countries were chosen based on IMF staff reports that identified countries with capital inflow surges and/or high credit growth. The period was deliberately limited to the years between the Asian crisis in 1997 and the recent global crisis that hit most emerging markets in 2008: Q3.

The effects of policies are evaluated in a VAR framework, as described in Baba and Kokenyne (forthcoming–a and b). Each country’s CFMs are summarized by four indices that track (i) changes in relevant prudential regulations; (ii) price-based capital controls on inflows; (iii) other capital controls on inflows; and (iv) capital controls on outflows.20 The changes are weighted by the number of affected types of transactions but not by their stringency. The index of price-based capital controls tracks the policy’s tax equivalent rates.

The VAR system is estimated with quarterly data for the period 2000: Q1 to 2008: Q2 with one lag, or with monthly data for the period January 2000 to August 2008 for countries in which it was available to allow for higher number of observations. Detailed results are provided in Appendix II.21

Inflow controls

Evidence for the effectiveness of controls on capital inflows show that they worked in some instances, but not in others, for reasons that are not well understood. While controls occasionally reduced flows and provided for greater room for maneuver for domestic monetary policy, their effect was small and short-lived and not sufficient to reduce appreciation pressures. The forms of the inflow control (tax, URR, or administrative) does not seem to influence effectiveness.

The URR in Colombia (2007–08) and Thailand (2006–08) and the administrative controls in Croatia (2004–06) seem to have reduced the aggregate volume of net flows. Moreover, the URR in Colombia and Russia (2004–06) and the inflow control policy in Croatia and India temporarily lengthened the maturity of inflows. The tax on foreign exchange portfolio inflows in Brazil in 2008 was a partial success. It appears to have allowed a higher interest rate differential for two to three quarters, but it did not reduce the volume of flows or change the composition of inflows or stem appreciation pressure. Other capital controls helped curb domestic credit growth in Croatia, Peru, and Philippines.22

Liberalization of outflows

The liberalization of residents’ outward capital transactions generally succeeded in increasing capital outflows temporarily, but it dampened currency appreciation pressures only in Russia. Liberalization of outflows did not affect the aggregate volume of net flows. However, it helped to stem credit growth in Korea and reduced real estate price increases in South Africa. Relaxing controls on capital outflows also contributed to maintaining higher domestic interest rates in the Philippines, Russia, Thailand, and Vietnam and often lengthened the maturity of outflows.

Prudential measures

The use of other CFMs, mainly prudential measures, in the face of capital inflow surges has been more successful in addressing concerns related to capital inflows. Prudential measures appear to have been somewhat effective in addressing the macroeconomic challenges of capital inflows. Moreover, prudential measures seem to have been effective in mitigating financial stability concerns stemming from rapid credit growth and short term inflows. Specifically:

  • Prudential measures contributed to mitigating the macroeconomic impact of capital inflows in some cases. Although they helped to ease appreciation pressures in Croatia and Peru, they appear to have reduced net inflows significantly only in Peru. Prudential measures are associated with a decrease in capital inflows in Croatia; however, the effect is not significant. The implementation of prudential measures also appears to have provided greater scope for monetary authorities to set domestic interest rates in Croatia, South Africa, Thailand, Uruguay, and Vietnam.

  • Targeted prudential measures often appear to be effective in reducing credit growth. The speed limits and high liquidity and reserve ratios used in Croatia in 2003–07 are a case in point. Tighter loan classification and provisioning requirements and a hike in marginal reserve requirements helped slow credit expansion in Peru in 2007–08. Korea successfully tightened prudential rules, including the extension of thin capitalization rules on foreign bank branches in 2007–08, to reduce credit growth. In India, credit growth decreased following the gradual tightening of prudential policies in 2007, but the effectiveness of these measures may have been offset by a concurrent liberalization of capital controls.23 There are also some counterexamples, however. A significant strengthening of prudential measures in Colombia in 2007 and Romania in 2003–08 did not stem credit growth.24 The wide-ranging tightening of prudential policies in Uruguay following the 2006–03 banking crisis did not prevent the inflow-induced rapid credit expansion that began in late 2006, although it has likely reduced credit risk in the banking sector.

  • The effectiveness of prudential measures often depends on the accompanying macroeconomic policies. In Romania in 2003–08, prudential measures reduced the share of bank-intermediated flows from abroad, but strong credit growth continued as increased FDI in the banking sector funded lending to the economy against the backdrop of an open capital account and macroeconomic policies that did not rein in domestic demand.25

  • Adding capital inflow controls to prudential measures often seems to have little additional effect on credit growth. The lowering of the maturity-dependent all-in cost ceiling on external borrowing and of the ceiling on interest rates on nonresidents’ deposits in India, and the tax and the URR in Brazil, Colombia and Thailand, did not contribute noticeably to restraining credit growth. By contrast, inflow controls in Philippines and a hike in differentiated reserve requirements and marginal reserve requirements on nonresident liabilities in Peru and Croatia seems to have further dampened credit growth.

  • The effectiveness of prudential measures in reducing foreign currency lending is mixed. Stronger prudential measures decreased banks’ lending to residents in foreign currency in some countries (Croatia, Uruguay). However, prudential tightening in Korea in 2008, which also aimed to reduce unhedged foreign currency lending to households, did not result in a significant decrease in such lending to residents by local banks.

  • Prudential measures usually did little to restrain asset prices. Several countries (Croatia, India, Romania, and Vietnam) introduced prudential measures to rein in stock market or real estate price increases, but these did not prove to be effective. In Vietnam, prudential policies may possibly have helped to moderate the stock market boom. The gradual tightening of targeted prudential policies began in 2005 and intensified in 2007, and they contributed to a temporary reduction in the stock price index. In addition, portfolio inflows turned negative from 2008: Q1, when the securities-related prudential regulations took effect.

  • Prudential measures have helped to address some other financial stability concerns. The measures taken in a number of countries (for example, Brazil, Korea, Peru, and Romania) appear to have lengthened the maturity of capital inflows, thus helping to reduce maturity mismatches in the banking sector. Prudential measures in Colombia and Croatia may have moderated financial stability risks by reducing bank-intermediated capital inflows. The measures introduced in 2009–10 in Korea may have contributed to restraining banks’ foreign borrowing, although they did not stem capital inflows overall.26 In Uruguay, the composition of inflows shifted from external borrowing to portfolio and FDI inflows, thereby improving the maturity structure and reducing the exposure of the financial sector, but leaving overheating concerns unaddressed.

V. Conclusions

Capital inflow surges can give rise to significant risks, notably excessive currency appreciation that can damage export sectors, and credit booms and asset price bubbles that may imperil financial stability. These risks have spawned a vigorous debate on the appropriate policy response to inflow surges, and in particular on the conditions under which it would be appropriate to use capital controls and other, mostly prudential, measures that are designed to influence inflows. These two sets of measures are grouped together under the broader heading of CFMs.

A key question in this connection is how effective CFMs are likely to be once a decision has been made to use them. On this score, the evidence is mixed, although prudential measures in our country sample appear to have been somewhat more successful than capital controls. Both the economic literature, and a review of recent country experiences, support the view that these measures are successful in addressing the risks associated with inflow surges in some cases, but not in others. Moreover, their effect is usually not long-lasting.

Of course, CFMs could be repeatedly strengthened and expanded to cover additional types of transactions, with stronger enforcement. However, this might eventually result in a heavily controlled foreign exchange and financial system such as many emerging markets had in the past, and for example, China and India still have to some extent. Such an approach must therefore carefully consider the costs of overregulation or even financial repression, which include a much less efficient allocation of savings and lower long-run economic growth.

Two key areas for future research will thus be to (i) understand better which types of CFMs are effective, and which are not, along with the reasons, and (ii) develop a more reliable framework for assessing the effectiveness of CFMs in relation to the distortions and costs they give rise to. While it is feasible to achieve significant progress on the theoretical front, as in Ostry and others (2011), the economic literature suggests that it may prove far more difficult to confront any theories with the data in a way that yields clear-cut results. The number of variables at play is large, and the number of episodes available for review is quite limited. It is probable that, as in the past, decisions on whether or not to use CFMs will require considerable judgment.

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Appendix I Review of the Literature

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Source: Magud and others (2011), Ostry and others (2010) and IMF staff.Note: A blank entry refers to the cases where the study in question did not analyze the particular relationship. (ST) refers to cases where only short-term effects were detected.

The study finds that inflow controls were binding as evidenced by the deviation in the domestic and international price of cross-listed stock.

The entry refers to the effect of capital outflow liberalization.

The study finds that inflow controls were effective in 2003-05 by allowing wider interest rate differential.

Appendix II Effectiveness of Capital Control and Prudential Policies in Selected Emerging Economies in the 2000s

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The macroeconomic impact on the total volume of flows, interest rate differentials, exchange rates, and credit growth, are evaluated by VAR model assuming these variables as potentially endogenous. The impact on the composition of capital flows is estimated in a separate VAR by replacing the total volume of flows with its disaggregated flows. Asset prices and foreign exchange loans are further added individually to the benchmark VAR when a country had associated concerns. The table reports “yes” if a shock to the respective policy index finds a statistically significant impact on a target variable at the 5 percent (**) or 10 percent (*) level. Reported results indicate if the measures had a statistically significant impact on (i) decreasing the volume of net flows; (ii) increasing long-term inflows or decreasing short term inflows; (iii) maintaining the interest rate differential between international and domestic interest rates; (iv) reducing the appreciation of the currency; and (v) stemming credit growth. In the case of outflow liberalization, the reported results indicate the existence of statistically significant impact on short and long term outflows.

Throughout the analyzed period, India pursued general liberalization of inflow controls, so the reported impact is in response to a liberalizing shock.

The country liberalized its inflow controls with no or marginal tightening throughout the period. Hence, no result are reported for the liberalization shock.

The results of the GMM analysis on the impact of capital controls on the volume of capital flows in Brazil, Colombia, Korea, and Thailand confirm the results of the VAR analysis. However, they also indicate that outflow liberalization had significant impact (at the 10 percent level) on the volume of net flows by increasing outflows in Thailand.

Dollarization is measured by the share of foreign currency credits in total private credit by private banks.

The impact on stock price index was analyzed with a shorter sample period with fewer control variables due to data constraints.

Appendix III Selected Capital Account Management Measures

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2

For example, a measure that prevents nonresidents from buying domestic government securities would be considered a capital control.

3

This prioritization of measures takes into account institutional and political economy concerns flowing from the general standard of fairness that a member expects that its nationals will enjoy as a result of its participation in a multilateral framework. For further details, see IMF (2011b), paragraph 53.

4

While there are important differences between the capital controls in the two countries, they both restrict most cross-border capital transactions.

7

Coelho and Gallagher (2010) for Colombia and Thailand; Gallego, Hernández, and Schmidt-Hebbel (2006) for Chile; Campion and Neumann (2004) for a cross-country study.

11

A URR on inflows is a capital control because it applies only to non-residents’ financial transactions.

16

See the note to Table 1 for the variables included in the GMM estimates. The VARs included the following endogenous variables: (i) all three indices of controls (price-based inflow controls, other inflow controls, and outflow controls); (ii) a short-term interest rate differential with the United States; (iii) net capital flows; (iv) the real exchange rate; and (v) credit growth. They also included several exogenous variables, notably domestic and U.S. business cycle indicators, the EMBI spread, ICRG index, the VIX, and the lagged current account balance.

17

See, for example, Shin and Shin (2011).

19

Brazil, Colombia, Croatia, India, Korea, Peru, Philippines, Romania, Russia, South Africa, Thailand, Uruguay, and Vietnam.

20

Changes in prudential regulations include all prudential measures implemented during the period and may thus also include some measures that may not have been designed to influence capital flows, in the sense of IMF (2011b). This may result in some downward bias in the estimated effectiveness of prudential measures.

21

The countries’ major capital control and prudential measures implemented in the period are summarized in Appendix III.

22

Other capital controls in Croatia include reserve requirements that are differentiated according to the residency of the depositor/creditor. These reserve requirements contributed to the building up of liquidity buffers that successfully insulated the county’s banking system from liquidity stress during the global crisis.

23

In India, the 2007 credit boom and the associated risks for banks’ asset quality from surging asset prices were primarily addressed using prudential measures and adjustments in the cash reserve ratio. The analysis did not find a statistically significant effect of the prudential policies on credit growth.

24

In Colombia, the measures included, for example, dynamic provisioning, marginal reserve requirements, and limits on banks’ gross derivative positions.

25

Romania’s speed limit on credit growth was expressed as a percentage of the bank’s capital, and could thus be circumvented by increasing banks’ equity.

26

These measures were implemented following the period examined here.

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Cover Staff Discussion Notes
The Effectiveness of Capital Controls and Prudential Policies in Managing Large Inflows
Author: Mr. Karl F Habermeier, Annamaria Kokenyne, and Chikako Baba
Volume/Issue:
Volume 2011: Issue 014
Publisher:
International Monetary Fund
ISBN:
9781463902896
ISSN:
2617-6750
Pages:
35
DOI:
https://doi.org/10.5089/9781463902896.006

Indices of Capital Controls