This paper reviews recent theoretical and empirical work on controls over International capital movements. Theoretical contributions reviewed focus on “second-best “ arguments for capital market restrictions, as well as arguments based on multiple equilibria. The empirical literature suggests that controls have been “effective “ in the narrow sense of influencing yield differentials. But there is little evidence that controls have helped governments meet policy objectives, with the exception of reducing the governments’ debt-service costs, and no evidence that controls have enhanced economic welfare in a manner suggested by theory.

Abstract

This paper reviews recent theoretical and empirical work on controls over International capital movements. Theoretical contributions reviewed focus on “second-best “ arguments for capital market restrictions, as well as arguments based on multiple equilibria. The empirical literature suggests that controls have been “effective “ in the narrow sense of influencing yield differentials. But there is little evidence that controls have helped governments meet policy objectives, with the exception of reducing the governments’ debt-service costs, and no evidence that controls have enhanced economic welfare in a manner suggested by theory.

The volume of International private capital transactions has increased dramatically in recent years, both for developed and developing countries. Technological improvements that have reduced the cost of International financial intermediation and reductions in government interference with such transactions have pushed private investors and borrowers into International markets.

The opening of International markets has presented important challenges for policymakers. Recent examples include the series of crises that have beset the European exchange rate mechanism (ERM) since 1992, the widespread capital inflows to emerging markets through early 1994, and, most recently, the turbulence in some developing country exchange and capital markets in late 1994 and early 1995 caused by the partial reversal of these inflows. These events have raised questions concerning the social costs and benefits of private capital flows and government programs designed to limit or modify the composition of such transactions.

The private benefit from access to International capital markets for both savers and borrowers is a basic conclusion of welfare economics. Free capital movements tend to allocate capital to its most productive uses across countries and allow residents of different countries to engage in welfare-improving intertemporal consumption smoothing. In a competitive model with perfect foresight and complete markets, the welfare benefit from intertemporal trade, that is, trade in financial assets, is identical to the welfare benefit from International trade in goods and services. This general conclusion is not sensitive to the exchange rate regime (Helpman, 1981).

While this general result imposes considerable discipline upon the search for optimal limits to capital mobility, economic theory also suggests that exceptions to this general rule are possible in cases in which preexisting distortions violate the assumptions necessary to support a “first-best” competitive equilibrium. Such “second-best” arguments are dealt with in an extensive literature reviewed below. The basic idea is simple. If the economy is assumed to suffer from one distortion, it is possible to improve welfare through the judicious introduction of another distortion.

The theoretical literature that is the raw material for a survey of “second-best” policy regimes naturally focuses on models in which government programs might generate welfare-improving interventions in International capital markets. Because there are, in principle, an infinite number of possible market failures, there are also an infinite number of welfare-enhancing second-best capital control regimes.

Many of the disagreements about the desirability of capital flows can be traced to different assumptions concerning the efficiency of private intertemporal decisions. While most economists argue that markets work well for static allocation of resources, there is a strong tradition of mistrusting so-called speculative behavior as being contrary to the collective interests of the community. This mistrust has led to proposals that range from “throwing sand in the wheels” of International capital movements to prohibiting such transactions completely.

An equally strong tradition that has influenced the literature is the view that government interventions in capital markets seldom accomplish their stated objectives. While there is a well-developed literature dealing with the economic effects of capital control programs, very little work has been done to relate observed capital control programs to specific government objectives.

One conclusion drawn in this paper from the literature is that an ideal government dealing with one clear distortion could, in principle, improve welfare by intervening in International capital markets. This conclusion is not a policy recommendation, however, as the actual effectiveness of such a program is an empirical question. An easy and perhaps wise way to avoid the empirical issue is to point out that it would be better to remove the existing distortion rather than introduce another to mitigate the damage inflicted by the first. The present paper will refrain from repeating this point even in cases in which it seems to be the obvious answer.

Not all arguments for government intervention in International capital markets are based on second-best considerations. A quite different exception to the general rule that government constraints on capital mobility are welfare reducing arises in cases in which stable multiple equilibria are predicted. If multiple equilibria are possible, it follows that the first-best equilibrium might be attained or maintained through government intervention in capital markets. This idea is a much more recent contribution to the debate concerning capital controls, and it is emphasized by proponents of capital controls to protect a fixed exchange rate regime during a transition to a monetary union. In reviewing these arguments below, the paper aims to clarify the very special circumstances under which such theoretical arguments are valid. The paper also reviews attempts to relate these models to recent experience in Europe.

The first step in determining whether capital controls have been used effectively is to see whether data support the proposition that controls have had a measurable effect on economic variables. There is an extensive literature on this issue, and recent contributions are reviewed below. It is concluded from this literature that both developed and developing countries have succeeded in driving wedges between domestic and International interest rates. Moreover, governments seem to have used controls in concert with various forms of financial repression—a term suggested by McKinnon (1973) to describe heavily regulated capital markets—to generate revenue and limit debt-service payments on domestic government debt. The power of capital control programs to affect other important economic variables, such as the volume or composition of private capital flows, changes in International reserves, or the level of the exchange rate, is, however, generally not supported by the data.

One important lesson that can be drawn from the considerable evidence presented in this work is that capital control systems have not prevented successful speculative attacks on fixed exchange rate systems. The obvious problem is that, in cases in which discrete parity changes are expected, yield differentials generated by control programs are much smaller than the capital gains available to private investors who correctly anticipate the parity changes. This outcome is fully consistent with the variety of theoretical models of speculative attacks surveyed below. There is some evidence that controls prolong the life of the exchange regime; unfortunately, very little is known about the timing of speculative attacks—with or without control programs in effect—so it is difficult to evaluate the view that control programs “buy time” while governments come to grips with their policy conflicts.

The literature has generally not focused on the question of whether observed capital control programs actually mitigate the effects of well-defined distortions. Giavazzi and Giovannini (1989, p. 162), for example, conclude:

The widespread use of capital controls is not clearly justified by any widely agreed-upon economic theory; indeed, to our knowledge, there have only been a very few attempts to study capital controls using explicit second-best arguments.

Some very recent work on the political economy of capital controls has begun to ask which types of distortions seem to motivate existing control programs. The preliminary findings reviewed below suggest that governments have used controls over extended time periods to limit the cost of debt service and to maintain tax bases for inflation and financial repression.

The more important question of whether the costs of the distortions generated by controls outweigh potential benefits has not yet been addressed. A very informal test of this proposition is that enthusiasm for control programs seems to be inversely related to the observer’s experience with trying to formulate and enforce a set of administrative rules aimed at preventing participants in financial markets from maximizing the private returns.

An analogy can be drawn with the familiar “optimal tariff” of International trade theory, which might exploit a country’s market power over production of its exports. Such arguments for government intervention are clearly “correct,” given the assumptions. Nevertheless, no one in recent memory has suggested that governments could or should attempt to adopt such tariffs. All the standard arguments against the practical usefulness of an optimal tariff on exports apply with equal force to taxes or quantitative controls on intertemporal trade. These arguments include the possibility of retaliation by other countries, evasion, administrative costs, inability to quantify the distortion and, therefore, the appropriate tariff, the political temptation to intensify the preexisting distortion, and, finally, the possibility that the protected industry will “capture” the political machinery that sets the tariff.

A topic that deserves more attention is what might be called the public choice approach to controls. The idea behind this approach is that a control system, once established, is likely to take on a life of its own as the control bureaucracy and its constituency attempt to maximize their own power and wealth. Thus, controls designed to mitigate a temporary distortion might outlive the economic rationale on which they were established. Furthermore, private investors who have invested heavily in avoiding the control mechanisms are likely to welcome the protection from other investors who have not done so. Cairncross (1973), for example, argues that the British capital control system that evolved from a comprehensive system of exchange controls during the Second World War survived long after the original rationale had become irrelevant. Moreover, he argues that by the early 1970s the “bite” of controls was very uneven across investors because certain types of transactions were exempt from controls. Dornbusch (1986) argues in favor of controls in some circumstances but points to an example where the control system outlived its usefulness and became the problem rather than the solution.

There is a very large academic literature dealing with the economic effects of legal restrictions on private capital flows. This survey organizes this body of work according to the apparent objectives that might justify such restrictions. Section I of the survey examines models that relate controls to the ability of monetary and fiscal policy to stabilize output, prices, or the real exchange rate. The implicit assumption in this literature is that governments have good reasons for using these policy tools and that they do so in a welfare-improving manner. Section II considers a variety of distortions to a competitive equilibrium that might make a control program optimal. In these cases, control programs have been justified as a means of providing a tax base in an optimal fiscal regime, of counteracting distortions that limit domestic capital formation, and of insulating the economy from destabilizing capital flows. Section III considers a very different rationale for restrictions on capital flows. In the models in this section, multiple competitive equilibria are possible, and controls might be useful in maintaining a good equilibrium or in moving from a low- to a high-welfare equilibrium. Section IV considers the empirical evidence on the effectiveness of controls. It also examines recent work relating the use of controls to characteristics of individual countries. The paper closes with some conclusions.

I. Stabilization

Short-Run Stabilization of Output and Relative Prices

The classic framework for evaluating the implications of capital mobility and the effects of limiting capital mobility is the Mundell-Fleming model of a small, open economy. In commenting on Williamson’s (1993) review of the policy issues associated with recent private capital inflows, Branson (1993) notes, that while a description of the stylized facts is useful and interesting, it is difficult to evaluate the policy options in the absence of a generally agreed-upon theoretical framework. The framework suggested by Branson is the familiar Mundell-Fleming model. This paper shares the view that lessons about capital mobility drawn from simple versions of the model have proved remarkably robust to subsequent theoretical refinements and empirical evidence. In the remainder of this paper, it is argued that, although the role of capital controls in stabilization policy is only part of the story, it is a potentially important part. It follows that the Mundell-Fleming model is a good place to start an assessment of what the literature has to offer in evaluating policies that affect International capital movements.

The Mundell-Fleming tradition starts from the implicit assumption that policies designed to stabilize economic activity are useful and welfare enhancing. Early contributions focused on dual exchange rate regimes (Argy and Porter, 1972; Fleming, 1974; and Lanyi, 1975). These models show that effective segregation of financial and current account transactions, with no official intervention in the financial exchange market, is equivalent to the prohibition of net private capital flows. These authors suggested that such a control might be only partially effective. The working assumption is that the government values the ability to “distort” domestic spending decisions by manipulating the real interest rate in order to influence the growth in output and perhaps the rate of inflation.

In this literature, the primary existing distortion is the slow adjustment of nominal wages and prices. It follows that the assumption of flexible nominal prices (nominal prices, wages, exchange rates, and interest rates) eliminates the distortion and the rationale for welfare-improving capital controls. Such a model is considered in the subsection on stabilization with price and wage flexibility. If capital is free to move across national borders and the nominal exchange rate is fixed or heavily managed, the government loses control over domestic monetary conditions. If the exchange rate is not managed, monetary policy might still be constrained by incipient capital movements because changes in domestic interest rates can generate large changes in nominal and real exchange rates. While this flexibility ensures a powerful transmission mechanism for monetary policy, governments might consider the resulting large changes in relative prices as a constraint on monetary policy.

In contrast, fiscal policy is a powerful tool for stabilizing domestic output even if capital markets are highly integrated. If, as assumed in the Mundell-Fleming model, stabilization policy is welfare improving, increased capital mobility generated by a relaxation of capital controls should be followed by the assignation of fiscal policy to stabilize domestic output. This framework provides a simple criterion for evaluating the optimality of capital account restrictions. If a policy tool, such as fiscal policy, is available for assignment to domestic stabilization, it might be optimal to open the capital account. Thus, Branson (1993) argues that existing capital controls imply that the government faces constraints on the exercise of fiscal policy for stabilization. It follows that removal of capital controls may not be optimal unless the constraints on the effective utilization of fiscal policy are first eliminated.

The well-known arguments reviewed above start from the proposition that the failure of wages and prices to clear markets provides the rationale for stabilization policy. In an early attempt to better understand the nature of the sticky price distortion, Flood and Marion (1982) develop a model in which labor contracts generate inertia in wages. They then see whether capital controls in the form of a dual foreign exchange market can minimize the variance of employment in the face of a variety of shocks to the system. They also show that the labor contracts chosen by the private sector depend upon the policy regime in place, including the controls on capital flows. It follows that a full evaluation of the welfare implications of capital controls should consider the private reaction to the removal of controls. In some cases, the “preexisting” distortion may be an endogenous response to the controls themselves. This paper is one of a very few attempts in the literature to deal with the well-known Lucas critique of analyses that seek to predict the economic effects of policy changes without explicitly considering how the private sector’s behavior is likely to change in response to the regime change.

Long-Run Stability of the Regime: Speculative Attack Models

The Mundell-Fleming model provides a rationale for manipulating domestic interest rates, but straightforward extensions of the model also suggest that the ability to pursue an independent monetary policy over time is strictly limited. The extensions taken up in this subsection show that effective capital controls alter the channels through which the private sector responds to government policy. Thus, effective controls alter the mechanism through which an inconsistent regime is forced to collapse, but they do not change the eventual result.

Krugman (1979) and Flood and Garber (1984) provide models of speculative attacks against inconsistent policy regimes when capital is Internationally mobile. In order to finance a fiscal deficit, a government might set a rate of growth for the domestic assets of the central bank that is inconsistent with the fixed nominal exchange rate and the growth in the demand for money. With perfect capital mobility and purchasing power parity, the demand for real money balances is predetermined so that increases in the domestic part of the monetary base are instantly offset by changes in International reserves. When the central bank’s International reserves fall to a certain level, it is known that the central bank will withdraw from the foreign exchange market and the currency will float freely. This regime comes to an end when speculators calculate that a successful attack will generate a discrete depreciation of the currency. Competition among the speculators will force the speculative attack to occur at a point where no expected profit is possible. While quite simple, the Krugman and Flood and Garber models have the important feature that no apparent change in the fundamentals occurs at the time of collapse. Nevertheless, the private capital flows that generate the collapse are driven by a fully rational interpretation of the fundamentals.

The key feature of capital controls in the context of a speculative attack model is that the private sector can no longer adjust its money holdings by trading private debt for foreign exchange or, in turn, trade the foreign exchange for domestic money. With capital controls, the private sector can adjust its money holdings only through net sales or purchases of goods and services with the rest of the world. An evaluation of the effects of capital controls therefore requires a model of the current account. Because the private sector’s willingness to distort its consumption over time is probably limited, effective capital controls might considerably extend the life of an inconsistent regime.

Several authors have incorporated a partial equilibrium model of the current account into the monetary models discussed above in order to study the long-run effects of capital controls. If changes in domestic absorption are assumed to be a fraction of changes in output (an implication of a simple Keynesian consumption function), any permanent (temporary) increase in demand “causes” a permanent (temporary) increase in the trade deficit. Moreover, if the Marshall-Lerner conditions are satisfied, a real depreciation of the exchange rate “causes” a reduction in the trade balance. Using these partial equilibrium assumptions, it is straightforward to determine the long-run response of the system to a shock such as an increase in the money stock or government spending.

Delbecque (1993) develops a model of a dual exchange rate system that captures these interactions. In this model, all private capital transactions are effectively limited to the financial foreign exchange market. As the government does not participate in this market, net private capital flows are necessarily zero. Current account transactions are permitted in the commercial exchange market. The government intervenes to fix the exchange rate in this market.

An important implication of Delbecque’s model is that private net intertemporal trade in goods and services is matched by a secular change in the government’s net International reserves. The general point is that the government acts as a “financial intermediary” for the private sector in a system with capital controls. Thus, the model is closed by an assumption that the government cares about its stock of net International reserves. The inconsistent policy setting causes a deterioration of the current account that eventually exhausts the government’s stock of International reserves.

Gros (1992) also models speculative attacks hut points out that, while capital controls can limit private sector speculation in most cases, governments are forced to augment the capital control program with domestic interest rates that are much higher or lower than would be the case in the absence of speculative pressure. An important aspect of this framework is that controls are effective but can be overcome at some cost to the speculator. In this setup, the government’s commitment to maintain the peg can be easily monitored by the private sector because it is revealed in interest rate policy. When the government reveals that it is unwilling to sacrifice control over domestic interest rates, the private sector will know that a small speculative attack, and the associated low costs of avoiding the capital control program, will be successful. The welfare effects of controls are not well-defined in these models. The intuition, however, is clear: if the additional time during which the regime survives is used wisely, that is, if consistent policies are introduced, the measure of policy independence generated by the control program might be welfare improving.

The models reviewed above are designed to clarify the dynamics of a speculative attack on an inconsistent regime but do not provide insight as to why a rational government would pursue such a policy. Wyplosz (1986) develops a similar model and argues that capital controls that are only temporarily effective nevertheless make an adjustable peg regime viable. In this framework, the authorities operate a monetary policy that is inconsistent with permanently fixed exchange rates, but they overcome this potential inconsistency with discrete changes in the exchange rate peg. Wyplosz points out that capital controls play a crucial role in making such an adjustable peg system viable.

The key to the argument is that the volume of private capital flows in response to an expected profit opportunity is limited by the capital control system. In Wyplosz’s paper, controls are set so that residents of the country cannot change their holdings of foreign assets or their financial liabilities to nonresidents. Nonresidents are assumed to hold domestic money, for transactions purposes, and are free to sell these against foreign currency at the commercial exchange rate. The crisis in this model comes when nonresidents believe that selling off all then holdings of domestic money will trigger a devaluation or revaluation of the nominal exchange rate. At this point, the central bank announces a discrete change in the parity. Wyplosz does not attempt to assess the optimality of such a system, but the desire to reduce the short-run variance of exchange rates, discussed in the subsection on the stabilization of relative prices, would provide a rationale.

Regime Changes with Maximizing Models of the Current Account

The partial equilibrium approach to modeling the current account described in the previous subsection clarifies the important point that capital controls shift private adjustment from capital flows to the current account. A weakness of this approach is that, although the private sector is rearranging its intertemporal consumption in response to incentives created by the government policy, there is no forward-looking theory to explain why this might be optimal.

Econometric evidence does support the view that over a time horizon of a year or so movements in the current account are dominated by relative rates of income growth and relative prices. However, over longer time horizons, the outstanding stock of debt begins to play a dominant role. In general, the simple partial equilibrium model is not well suited to deal with issues associated with increases in indebtedness over time.

The modern literature on the macroeconomic effects of capital controls focuses on these long-run effects. Moreover, by including expectations about the long run as determinants of current economic behavior, the modem literature provides a link between capital mobility and observed short-run behavior of the economy, explaining how this behavior is affected by controls over capital flows.

Calvo (1987) develops a model that addresses the issue of the behavior of the private sector where it is known that the regime is inconsistent and will be abandoned when the government exhausts its International reserves. The model has the same building blocks as the speculative attack models discussed above, except that the current account is explicitly modeled. The model predicts, in cases in which successful speculative attacks are expected, that the public will increase its consumption (a current account deficit) until the date of the regime change and then decrease consumption (a current account surplus) thereafter. The financial counterpart of this deterioration of the current account leading up to the regime change is, of course, a decline in the government’s net International reserve assets.

The key to this result is that, after the attack, revenue from inflation must rise to balance the fiscal budget. With the higher rate of actual and expected inflation, optimal real money demand falls, the real marginal utility of money balances falls, and, therefore, the marginal utility of consumption just before the crisis must also be less than the marginal utility of consumption just after the crisis. The model is also extended to consider the effects of anticipated real exchange rate changes. This type of model makes clear that, as a distortion in the time profile of consumption is sub-optimal, there must be some offsetting benefit of prolonging the life of the inconsistent regime.

Park (1994) provides a maximizing model in which households adjust their intertemporal consumption of goods and real money balances in order to maximize expected utility over an infinite planning horizon. He asks whether a liberalization of the capital account can generate an immediate speculative attack on a fixed exchange rate regime. The model suggests that initial conditions are crucial to the answer. If the domestic real interest rate is initially below the world interest rate, the initial result of liberalization is an incipient net capital outflow and a rise in the domestic real interest rate. Park’s model assumes that the increase in debt-service cost of the government’s domestic debt will be met by an increase in the growth of domestic assets in order to finance the resulting fiscal deficit.

If the liberalization is a surprise, foreign and domestic expected yields equalize immediately; if a speculative attack is expected to be successful, the private sector reduces its demand for real money balances because of the higher rate of inflation that follows the successful attack. The resulting sale of domestic assets to the central bank might exhaust its reserves and generate an immediate attack and a regime change. If the fixed exchange rate is initially sustainable, a secular fall in reserves is anticipated and, eventually, a successful speculative attack similar to those discussed in the previous subsection. Auernheimer (1987) compares the breakdown of inconsistent regimes in a maximizing model with and without capital controls. The model suggests that with capital mobility it makes no difference whether the government chooses an inconsistent exchange rate or monetary rule at the onset of the crisis. However, like Calvo, he shows that with capital controls the inconsistent regime generates lasting suboptimal real effects on the current account.

In general, the models of Park and Calvo reinforce the lessons from the partial equilibrium model discussed above. Even perfectly effective controls on private capital transactions can at best extend the life of an inconsistent policy regime. These models add the important conclusion that the path for consumption is suboptimal during the interval in which the regime survives and that this distortion continues after the inconsistent regime has ended.

Stabilization with Price and Wage Flexibility

An important extension of the Mundell-Fleming model introduces domestic price and exchange rate flexibility. In this version of the model, changes in the domestic money stock with perfect capital mobility and flexible exchange rates generate proportional changes in all nominal prices so that the stabilization role for monetary policy disappears, along with the associated arguments for capital controls.

If the private sector’s consumption decisions are forward-looking and a number of other conditions are met, Ricardian equivalence also holds, in that the pattern of taxation and borrowing over time is unimportant. Government spending has real effects but is not useful in generating welfare-increasing changes in the level of employment.

Because effective or even partially effective capital controls limit private intertemporal trade, it follows that capital controls alter the response of the economy to policy actions. In general, the neutrality of both monetary and fiscal policy is overturned. It should be noted that in these models there is no presumption that the effects of controls are welfare improving. Instead, the objective is simply to understand the interactions of policy shocks and other shocks to the system in a second-best world.

The fundamental implications of capital controls in flexible price-maximizing models are nicely summarized by Adams and Greenwood (1985). Their model establishes the familiar results that dual exchange regimes are equivalent to a program of taxation of capital movements, and that a program of quantitative restrictions on capital movements is equivalent to a system of taxes or dual exchange markets. They also show that any effective capital control program can be manipulated to attain the government’s target for the current account balance. Finally, the government’s manipulation of the current account balance generates welfare losses that are analogous to those associated with restrictions on temporal International trade in goods and services.

This last point is an important result. In an intertemporal maximizing model with flexible prices, goods available to households at different points in time are analogous to different goods available at one point in time. Just as distortions of relative prices at one point in time are usually welfare reducing, distortions of relative prices of the same goods at different points in time—where the relative prices are interest rates—are also welfare reducing. Optimal second-best capital control programs are possible only in cases where there are some preexisting distortions to interest rates or other intertemporal prices.

The idea that effective capital controls limit the private sector’s ability to offset a government’s International borrowing is emphasized in Greenwood and Kimbrough (1985). In this model, identical households maximize intertemporal utility with perfect foresight, and monetary policy has no effects (the monetary sector is not explicitly modeled). In the absence of capital controls, fiscal deficits have no effect on the equilibrium because households anticipate future tax liabilities. But with capital controls, sales of government debt to the rest of the world are equivalent to a relaxation of the government’s prohibition of private capital flows. Moreover, because the public regards the government’s debt as equivalent to its own, the government is a perfect financial intermediary.

Guidotti and Végh (1992) present a model of a large, open economy that adds a monetary sector to the model discussed above. They start from the proposition that, with perfect capital mobility, domestic monetary disturbances have no real effects, partly because the world money supply is immediately redistributed through International capital flows following a disturbance. With capital controls, money holdings can be redistributed only as the mirror image of current account imbalances. The real effects of these imbalances are felt at home and in the rest of the world. Their model also suggests that unanticipated and permanent changes in domestic monetary and fiscal policies affect consumption, real interest rates, and the real exchange rates.

Stabilization of Relative Prices

The impact of capital flows on relative prices or real exchange rates has been at the center of much of the literature concerning the economic effects of capital mobility. A stylized fact associated with liberalization of controls over capital flows among developing countries is that the resulting adjustment includes substantial appreciation of the real exchange rate. This appreciation, in turn, may be an undesirable feature of an open capital market if temporary relative price changes and associated allocations of productive resources are welfare reducing. Krugman (1987), for example, argues that temporary real appreciation of the exchange rate may permanently injure export industries if hysteresis is a feature of the correct dynamic model of the economy. Several authors have suggested that capital mobility should be limited until policies designed to offset the real exchange rate changes are in place. The obvious choice to combat the effects of a capital inflow, for example, would be a reduction in government spending. In this subsection, it is argued that the welfare implications of these models are far from clear. Moreover, formal explanations of a relationship between capital market liberalization and real exchange rate instability can be generated by very different models.

In the spirit of the sticky price framework, a way to understand a link between liberalization and real exchange rate appreciation is to appeal to a model in which nominal shocks generate overshooting of nominal exchange rates and, therefore, changes in real exchange rates. Sussman (1992) uses a version of the Dornbusch overshooting model to help explain an apparently unsuccessful liberalization of the capital account in Israel in 1977. Liberalization of the capital account in this model takes the form of eliminating controls supporting a tax on domestic asset yields and domestic bank loans. Sussman presents evidence that the controls in place generated large differentials between onshore and offshore lending and deposit rates in Israel, both before and after the brief experiment with liberalization.

The model predicts that a reduction in the tax on loans increases investment and aggregate demand and creates an inflationary shock to the system. In addition, the elimination of the tax on domestic assets generates a decline in the demand for money. Because this decline is equivalent to an increase in the money supply, the model predicts that the domestic nominal interest rate will at first fall, prices will start to rise, and—to satisfy the rational expectations condition of interest parity—the nominal exchange rate will depreciate by more than the steady state amount.

The lesson from Sussman’s model is that the liberalization itself generates an inflationary shock to the economy and a temporary distortion of the prices of traded and nontraded goods. Clearly, an appropriate fiscal policy response could minimize the damage. But if the fiscal system is unable to respond—perhaps because the subsidy for government borrowing has been eliminated, making a contractionary fiscal shock impossible—the liberalization will involve short-run costs.

A very different way to introduce real exchange rates into a model is to assume that prices are flexible but to introduce more than one good. Van Wijnbergen (1990) develops a model in which the imposition of a tax on capital imports lowers domestic real interest rates and raises world real interest rates. As a result, current consumption is shifted today from goods consumed by residents toward goods favored by nonresidents, with a reversal of this shift in the future. The change in the composition of current and future demands generates, in turn, a depreciation of the home currency now and an expected appreciation later.

A useful framework developed by Edwards (1989a) considers an export good, an import good, and a nontraded good. The relative price of exports and imports is the terms of trade. The relative price of exports and non-traded goods in the home and foreign markets is identified as the real exchange rate. In such a model, capital flows related to liberalization of the capital account can generate real exchange rate changes because excess demand for the home nontraded good can increase its nominal price while the price of the traded good is determined in world markets.

The papers discussed above propose plausible links between capital controls and International relative prices. The next set of papers first proposes situations in which relative prices are distorted and then attempts to identify opportunities to mitigate this distortion through manipulation of capital controls. Edwards and Ostry (1992) present a model in which endogenous changes in relative prices of traded and nontraded goods interact with capital controls to affect welfare. The basic idea exploited in this model is that distortions in relative prices that are expected to change over time owing to temporary policies generate distortions in the “consumption rate of interest” faced by households. The resulting intertemporal distortion of consumption can be magnified or mitigated by capital controls. The results appear to be model specific, but the general point may be important.

Anticipated changes in relative prices alter the “interest rate” relevant for intertemporal consumption and investment decisions. Capital controls also alter intertemporal consumption and sectoral investment decisions. The message is that real exchange rate changes associated with shocks to the system (for example, terms of trade shocks) might be an important part of a comprehensive evaluation of the effects of capital controls.

This idea is developed further by the introduction of a labor market distortion in the form of a minimum real wage. This distortion generates a variable and a suboptimal level of employment. Depending on a number of factors, a subsidy to foreign borrowing (or a tax on foreign lending) could tilt demand toward time periods during which unemployment is relatively high and, in turn, improve welfare. This model is interesting because it abstracts entirely from monetary phenomena yet still manages to find a second-best role for capital controls in promoting employment. However, the level of ingenuity to which the modelers have to resort to create an intertemporal distortion to consumption and employment that can be offset by another intertemporal distortion, capital controls, seems to make the practical importance of the argument remote.

Models of Partial Effectiveness

The idea that capital controls have important economic effects because they move adjustment into the International markets for goods and services has led many authors to consider mixed systems in which controls on capital movements are only partially effective. The intuition is that, because distortions of intertemporal trade and consumption are costly to the private sector, it is worthwhile to invest in techniques to avoid controls. It follows that the decision of how to model a capital control regime is an important issue in itself.

At one end of the spectrum are models that assume complete effectiveness. In these models, there is no arbitrage of International interest differentials. In dual exchange rate models, for example, the spread between the commercial exchange rate and the financial exchange rate adjusts to equalize expected yields on domestic and foreign bonds. An alternative specification is that controls are effective but can be avoided at a cost. This model is appealing because it seems to explain the empirical finding that the ability of controls to force a wedge between expected yields on securities issued in different countries appears to erode over time.

Bhandari and Decaluwe (1987) and Gros (1987 and 1988) have emphasized the endogenous response of speculators to the incentive to avoid exchange controls. Gros (1988) assumes an increasing onetime cost faced by an investor who wishes to acquire foreign assets or liabilities. This model has the property that, although the long-run interest differential will be zero, relative interest rates can be influenced by policy during an adjustment period. Giavazzi and Giovannini (1989) develop a model in which private sector traders are permitted to acquire a stock of foreign financial assets or liabilities equal to some fraction of the annual flow of their gross exports or imports of goods. Such positions are often referred to as “leads” and “lags” and are typically exempt from capital control programs. The idea here is that controls are effective but allow traders to utilize traditional forms of trade finance, as long as the size of such transactions and their term to maturity conform to the usual parameters.

Giavazzi and Giovannini show that, in a maximizing model, such controls distort trading patterns and have long-run effects on the economy. The cost of avoiding capital controls in this model is related to the cost of switching domestic production to export markets beyond what would be the competitive equilibrium.

The effectiveness of controls and the possible real distortions to trading patterns generated by avoidance are of considerable practical importance in any decision to impose, modify, or remove a control regime. Indeed, the formal models of the economic effects of capital controls developed in this section are of little relevance if the private sector easily avoids such restrictions on their financial transactions. This essentially empirical question is taken up in the next section.

II. Other Second-Best Arguments

This section departs from questions of short-run stabilization and focuses on interaction between capital controls and a variety of distortions that might justify such policies. The work here may at first seem unrelated, but it shares the important feature that in each case some relative price is assumed to be out of line and capital controls are proposed as a second-best solution. The price distortions arise from changes in government policies, tax regimes, uncertain property rights, inefficient capital markets, and domestic capital market distortions arising from government insurance of financial intermediaries.

Sequencing of Liberalization of Capital Markets and Trade in Goods and Services

The first example of a distortion not related to stabilization policy is closely related to the discussion of relative prices in Section I. Governments considering liberalization of their capital markets are frequently also considering liberalization of trade in goods and services. The distortions that have attracted attention in the context of structural reform include real exchange rate changes associated with liberalization of trade restrictions, slow adjustment of labor markets to changes in relative prices of traded and non-traded goods, and, finally, relative price changes generated by reforms that are expected to be temporary.

As argued above, distortions in relative prices owing to trade restrictions can generate a role for capital controls under some circumstances. But the sequencing issue is much more complicated. First, there is no very clear reason for the government to have to choose to liberalize one market at a time or to liberalize markets slowly. It is possible, however, that it will take some time to dismantle trade restrictions, perhaps because of administrative problems or because the government wishes to spread out the impact on protected sectors over time.

Similar constraints might also apply to capital markets, thus making it necessary to address the sequencing problem. It should be recalled, however, that the formal models do not provide a rationale for gradual decontrol. An early argument along these lines is found in McKinnon(1973). Relaxation of trade restrictions would, other things being equal, generate a depreciation of the real exchange rate, while relaxation of the capital account is assumed to call for an appreciation of the real exchange rate, given the capital controls’ effective limiting of desired inflows of capital. This “competition of instruments” problem is resolved by delaying liberalization of the capital account until trade and other distortions have been eliminated.

Edwards and van Wijnbergen (1986) develop two ideas that are useful in this area. First, they show in a static model that capital account liberalization in the face of trade distortions can be welfare reducing. The intuition is that tariffs can distort investment decisions and capital controls can, in principle, offset this distortion. They develop a two-period model in which capital inflows are constrained. In this case, gradual liberalization of the trade account generates expected changes in relative prices that can distort investment decisions.

Calvo (1988) develops the idea that any government policy that affects relative prices and is expected to be temporary is equivalent to a distortion of intertemporal relative prices. For example, temporary tariff reform implies that the relative prices of traded goods will change when the liberalization program is abandoned. In general, it follows that liberalization of the capital account is not a good idea if the government really has reformed but the private sector does not find its commitment credible.

Edwards (1989b) provides an excellent summary of this literature and a model that pulls together a number of distortions in order to provide some guidance for policy. Not surprisingly, it is difficult when working with multiple initial distortions to evaluate the welfare implications of alternative sequences of reform. Indeed, an important implication of the model is that the first-best solution is to liberalize all markets immediately.

All these arguments are subject to doubts whether there really are good reasons to sequence reform. Quirk (1994) argues that experience with developing countries indicates that simultaneous liberalization is both feasible and manageable, given the right combination of other policies. The lesson, perhaps, is that the practical usefulness of second-best arguments is limited to those cases in which one preexisting distortion is clearly dominant and for some good reason can be removed only over time. For example, countries with records of failed structural reforms might focus on the distortion caused by lack of credibility of their efforts and on the time that it will take to convince market participants that their reforms are permanent.

Inflation Tax

Our second example is motivated by the observation that controls over capital outflows are frequently designed to prevent erosion of the financial repression and inflation tax base. Empirical evidence seems to support the view that governments that employ capital controls have higher rates of inflation, higher revenue from inflation, and lower domestic real interest rates than countries that do not employ controls. If controls are effective in maintaining a tax base, their removal implies a reduction in government revenue and, therefore, a presumably costly change in another variable that influences the fiscal deficit. Giovannini and de Melo (1993) argue that the benefits from financial liberalization emphasized by McKinnon (1973) should be compared to the potential costs in terms of tightening government revenue constraints. They provide a direct ex post measure of the differential borrowing costs on domestic and International debt of developing countries. The data support the view that financial repression is a significant source of revenue for many of these countries.

Dornbusch (1988) offers a model in which the government faces two “fiscal” problems that explain the widespread use of capital controls. First, the government’s existing domestic debt service is kept below what would be charged on world capital markets by restricting private capital outflows and thus depressing the domestic real interest rate. Second, in the absence of the implicit subsidy generated by controls over capital outflows, the government would be forced to choose revenue from inflation as the best alternative for meeting higher real debt-service costs. Similar results are derived from an overlapping-generations model developed by Sussman (1991). Aizenman and Guidotti (1994) argue that collection costs associated with taxes other than the inflation tax might make capital controls a part of an optimal tax system. Their model assumes that the government must service a domestic debt and must use a domestic lax on output that involves increasing costs of collection. The capital control that Aizenman and Guidotti have in mind is a tax on foreign capital income, and they assume that the tax is not avoided.

An interesting feature of Aizenman and Guidotti’s model is that the tax base for the foreign income tax is not only the private sector’s stock of foreign assets but also the entire domestic debt. The domestic debt is relevant because the tax on foreign income drives a wedge between the foreign interest rate and the domestic interest rate. Taxing foreign income, they argue, is equivalent to taxing private holdings of government debt, but, unlike other taxes, this one involves no collection costs. Aizenman and Guidotti show that countries with large stocks of domestic debt tend to utilize capital controls. Drazen (1989) shows that the inflation tax is an important source of revenue for several European countries. He also shows that high inflation rates are only part of the story as these countries also have unusually large inflation tax bases in the form of bank reserve ratios. If residents of these countries could freely utilize offshore financial intermediaries, this tax base would erode. It follows that capital controls are an important part of a fiscal system that relies heavily on the inflation tax. Drazen also argues that, while such a system might allow the government to avoid even more distorting taxes in the short run, taxing savings and investment will in general lead to slower growth and reduced government revenues in the long run.

Brock (1984) provides an interesting counterargument. He points out that, although opening the capital account can generate a decline in the inflation tax base, a government with a fiscal problem can offset this effect and minimize the associated loss of revenue through reserve requirements on capital inflows or through prior import deposit schemes. This is one of the arguments for capital controls that seems quite sensitive to the assumption that the existing shortcomings in the tax system are unrelated to the existence of the controls. In particular, it seems likely that a government that imposes controls over capital outflows for some other reason will be tempted to exploit the revenue from financial repression that the controls make possible.

Taxation of Resident Capital Income

Another longer-run feature of some capital control programs is that they are designed to limit secular private capital outflows. It is often argued that countries with relatively low capital-labor ratios—developing countries and countries in transition—should offset a variety of domestic distortions that induce private investors to prefer foreign investments even when the expected private yields on domestic investment exceed the private expected return in world capital markets. There are alleged to be many such distortions.

An obvious potential distortion is that capital income generated within a country can be taxed while foreign-based capital income cannot be taxed. If capital is mobile, such an optimal tax generates private capital outflows and a deterioration of the tax base, as well as underinvestment in the domestic capital stock. A limit to capital outflows, or the equivalent interest equalization tax, allows the government to tax capital at the appropriate second-best rate.

Razin and Sadka (1991) argue that empirical estimates of capital flight from developing countries suggest that a government cannot tax its residents’ income from foreign capital at the same rate at which it taxes domestic capital income. In their model, it is optimal for the government to restrict capital outflows if it cannot tax foreign assets. Dooley and Kletzer (1994) argue that simultaneous gross capital inflows and outflows are frequently the response of private investors to a variety of government guarantees and subsidies. If it is not possible for the government to credibly refuse to grant subsidies and guarantees, quantitative restrictions on some capital inflows and outflows can be welfare improving.

Several papers written after the 1982 debt crisis take up the general issue of the optimality of external debt in the face of country risk. Because individual debtors within a country are interdependent in their ability to make debt-service payments and the government can prevent private debtors from making such payments, some collective (government) tax on, or subsidy for, external borrowing might be appropriate.

Harberger (1986) presents a model in which country risk generates a risk premium that grows with a country’s external debt. This model raises the possibility that the marginal cost of additional debt might exceed the average cost, and that individual debtors might not internalize the social cost of their borrowing decisions. An important assumption in this model is that default carries costs to the debtor that are not at the same time benefits to the lenders. In these plausible circumstances, a tax on capital inflows would be optimal.

Aizenman (1990) develops a model in which different attitudes toward default on the part of the debtor country government and the debtor country private sector distort domestic capital formation. In this case, it is assumed that the government is known to discount the future at a higher rate than do households. This assumption reflects the appealing idea that elected governments may be too interested in the next election. Domestic investment will be suboptimal because the government will discount the penalties associated with future default too heavily, and private returns will exceed the world rate of interest by a political risk premium. In this environment, the government should subsidize investments in traded goods industries, as these investments increase the vulnerability of the country to penalties for default and, therefore, increase the credibility of the government’s promise not to default.

A somewhat different argument is advanced by Dellas and Galor (1992). In their paper, households located in a number of small, open economies make saving and investment decisions that generate a stable but low steady state level of income and welfare. There is no incentive for capital flows among these economies because returns on capital are the same. A government that can accomplish transfers across generations can engage in external borrowing that can move the economy to another stable growth equilibrium and, through appropriate transfers, increase welfare in all generations.

As a part of the external borrowing program outlined in Dellas and Galor’s paper, it is also necessary to limit offsetting private capital outflows through a capital control program. The intuition behind this argument is appealing. The authors suggest that, because investment in growth benefits future generations, the present generation might invest at a suboptimal rate. However, if a government has the tools and wisdom, it might be able to attain a superior equilibrium by borrowing on International capital markets. During the transition it is necessary to prevent private capital outflows, which the current generation will find optimal.

Uncertain Property Rights

Another argument develops the idea that “property rights” are often poorly defined in developing countries and perhaps even more so in formerly planned economies undergoing massive privatization. In effect, this uncertainty about property rights allows interest groups of private residents to “tax” or appropriate the capital income of both resident and nonresident investors. In contrast, investments abroad by residents of these countries are difficult for other residents to detect and appropriate. This situation leads to overinvestment in the “technically inferior” foreign capital stock in order to avoid the political risk associated with investment in a poorly organized country. In such an environment, capital controls might be optimal. Tornell and Velasco (1992) develop a formal model in which poorly defined property rights imply that investors will prefer external investment even if domestic investments have a higher social but lower private expected return.

This model also demonstrates the less obvious point that capital controls may not improve welfare even if capital outflows are reduced because the threat of free capital mobility might reduce the amount of appropriation by interest groups. This is a subtle and important point for all second-best arguments. In a complete model, it is not enough to show that a capital control can offset another distortion. It must also be shown that the existence of controls does not generate even more of the initial distortion. In the Tornell and Velasco model, it is natural to consider the endogenous response to the capital controls because it involves the behavior of private interest groups who must worry about reactions to their behavior. In the more common case in which the government introduces the initial distortion “for a good reason,” it is difficult or impossible to evaluate the possibility that the government will be tempted to exacerbate the initial distortion.

Alesina and Tabellini (1989) provide a model in which the government’s incentives for distortionary taxation of capital income are explicitly set out. In this framework, an alternating sequence of political parties, one representing labor and the other capital, appropriate capital income or labor income in order to make transfers to their constituency. The model explains private capital flight in time periods when the government is borrowing on International capital markets. In the absence of capital controls, residents export capital in an effort to avoid taxation in the event that their party is forced from office. Under plausible assumptions, workers’ governments will impose capital controls while capitalist governments will allow capital outflows.

Capital Markets as a Source of Uncertainty

This class of models posits the existence of private investors who are motivated by rumors, noise trading, bandwagons, bubbles, and so forth. In a way, these arguments are the most straightforward in favor of capital controls, as they assume that the capital flows are themselves the source of the disturbance to the competitive equilibrium. It follows that controlling these kinds of capital flows restores a first-best competitive equilibrium.

The idea that transactions taxes would prevent the emergence of destabilizing speculation is nicely summarized by Eichengreen, Tobin, and Wyplosz (1995, p. 165):

The hope that transactions taxes will diminish excess volatility depends on the likelihood that Keynes’s speculators have shorter time horizons and holding periods than market participants engaged in long-term foreign investment and otherwise oriented toward fundamentals. If so, it is speculators who are the more deterred by the tax.

In foreign exchange markets, the evidence from filter rules can be interpreted to suggest that private speculation is dominated by price dynamics (Dooley and Shafer, 1983). But this evidence does not imply that a transactions tax would discourage such speculation. The problem is that, even though such trading rules are based on short-horizon forecasts, profitable trading rules do not, in general, call for frequent transactions. It is not clear that higher transactions costs would tend to discourage these speculators more than those betting on fundamentals.

The assumption that speculation, or investment, based on fundamentals is associated with long holding periods is also suspect. The image of direct investment as factories that are difficult to move from country to country or long-term bonds that are held to maturity seems to provide the inspiration for linking motives and holding periods.

In fact, direct investors are not prevented by the nature of their assets from quickly responding to changes in market conditions. Because factories are clearly difficult to move and returns to physical assets depend upon economic and political conditions in the host country, direct investors can and do hedge this exposure. Borrowing from local credit markets is the most obvious hedge. If a direct investor must exit a country quickly, she simply leaves the factory and the local bank loan behind. Moreover, as trading in equity market indices and their derivatives has developed, it is now possible in most emerging markets to hedge risks common to equity positions in that country without engaging in credit market transactions.

Direct investment may be special for many reasons including, probably, the technology transfer aspect, but direct investors are not passive investors who ignore the market and focus on long-run fundamentals. To the contrary, they are often informed and enthusiastic participants in capital markets.

Claessens, Dooley, and Warner (1995) examine the volatility of different types of capital flows for a sample of industrial and developing countries. Their interpretation of the data is that the labels assigned to various types of capital flows are of no value in predicting their time-series behavior. Direct investment is no more persistent over time than is short-term capital. Perhaps more important, knowledge of the composition of capital flows is useless in predicting the time-series behavior of net capital flows.

It is not possible to directly examine the effects of transactions costs on observed exchange rate variability. There is clear evidence that transactions costs, as measured by bid-ask spreads in foreign exchange, are positively related to the volatility of spot exchange rates. Moreover, adjusting for volatility, there has been no apparent trend in transactions costs for foreign exchange under floating rates (Glassman, 1987). It would be foolish to argue that the increases in transactions costs caused the increase in volatility of exchange rates.

In other speculative markets, however, it is possible to evaluate the effects of changes in transactions costs. Roll (1989) studies equity markets in 32 countries from 1978 to 1989 and finds no relationship between volatility of prices and transactions costs. A reasonable interpretation of this evidence is that, while transactions costs discourage short holding periods, it is not clear that short holding periods are associated with desirable (fundamental) or undesirable (speculative) investment objectives. Housing and land markets are characterized by high transactions costs but seem no less volatile than markets with low transactions costs.

A paper by Kupiec (1995) makes a point that is very damaging to the case for transactions taxes. The argument is that, even in a model in which the presence of destabilizing noise trading is assumed, the general equilibrium welfare effects of a transactions tax are likely to be negative. The model first shows that noise trading generates a more volatile path for market prices of a security that is traded between generations to smooth consumption. A transactions tax clearly reduces this volatility, bringing prices closer to the optimal path. But the model also takes into account that the transactions tax necessarily reduces the market price of the asset by the present value of expected transactions taxes. For a range of plausible tax rates, the model suggests that the reduction in price volatility is dominated by a reduction in the price of the traded asset, so that the volatility of holding-period yields is increased by the transactions tax. In almost any utility framework, volatility of returns is a better measure of welfare effects than price volatility.

In commenting on the likely effectiveness of a transactions tax, Garber and Taylor (1995) first review familiar arguments concerning the difficulty of administering such a tax; they then add the idea that taxing transfers of bank deposits would be ineffective because swaps of securities and other “synthetic” transactions are now very well-developed components of International transactions.

Dornbusch (1986) emphasizes the important point that controls designed to slow down capital flows (in this paper, dual exchange rate markets) can be used only as a “strictly transitory policy” to offset shocks to capital markets. The model developed by Dornbusch restates the familiar theme that in the long run a control program that attempts to mask an inconsistent policy regime will generate increasing distortions and ultimately fail to preserve the regime. In cases in which deviations between controlled and financial exchange rates have become large, Dornbusch (1986, p.22) notes that “the resource allocation costs outweigh any macroeconomic benefits.” This result is partly due to the realistic assumption that large differentials generate leakages of some commercial transactions to the free market. The political economy question is whether controls put in place to shield the real economy from financial shocks are likely eventually to generate misalignment in levels of exchange rates and interest rates that are politically difficult to correct.

Van Wijnbergen (1985) provides a more explicit link between variability of government policies and less-than-optimal domestic investment. The unnecessary variance in government policies causes underinvestment because investors will value the option of waiting until the uncertainty is resolved. Tornell (1990) develops a model in which the increased variance resulting from private capital transactions leads to less-than-optimal real investment because investors value the option of waiting until more-settled times before making irreversible real investments in a country. Finally, Aizenman and Marion (1993) provide some evidence that uncertainty has a measurable negative effect on capital formation in developing countries.

Domestic Capital Market Distortions

In the absence of a formal model involving capital controls, an often-discussed distortion in both domestic and International financial markets arises from government insurance of the liabilities of domestic financial intermediaries. The most obvious example of this is deposit insurance for banks; however, even in the absence of formal insurance, governments frequently intervene to protect creditors of institutions that are believed to be “too large to fail.” The usual reason for such intervention is to prevent “contagion” of doubts about the solvency of large institutions from generating runs on solvent institutions and associated general declines in asset values.

Following the debt crisis of 1982, free deposit insurance extended to banks in newly liberalized financial markets was widely cited as a source of instability in financial markets (McKinnon and Mathieson, 1981; Hanson and de Melo, 1983; Diaz Alejandro, 1985; Corbo, de Melo, and Tybout, 1986; Baliño, 1991; McKinnon, 1991; and Velasco, 1991). Diaz Alejandro (1985, pp.17–8) summarizes the idea as follows:

Southern Cone domestic financial systems of the late 1970s and early 1980s ended up with a pessimum ‘middle way’: de facto public guarantees to depositors, lenders and borrowers, and no effective supervision and control (until it was too late) of the practices of financial intermediaries. … As illustrated in the recent Chilean experience, foreign financial agents will not accept a separation of private and public debts when a crisis arrives.…

The well-known problem with this policy is that it encourages firms and financial institutions to reach for risk. Profits from favorable outcomes are paid out to owners of the institution while losses are shared with the government. The usual prudential regulations designed to limit the government’s exposure to losses include requirements that the institution maintain adequate capital, that is, not immediately pay current accounting profits to equity holders, and maintain various restrictions on the nature and concentration of assets held.

Akerlof and Romer (1993) argue that exchange risk provides a vehicle for collusion between banks and their customers. Using Chile during the 1979–81 time period as an example, they argue that the expectation that the peso might be devalued led domestic firms and domestic banks to enter into dollar-denominated loans at interest rates that did not fully reflect the risk that the firms would be unable to repay the dollar liability if the currency were devalued.

There is nothing unique about International capital flows in this context, except that new types of assets and, therefore, new types of risks are opened to insured intermediaries when they are given access to International capital transactions. Mathieson and Rojas-Suarez (1992, p. 47) assert that opening markets can generate important efficiency gains but that “potential official credit risks arising from the institutional failures that can be created by the mispricing of risk or widespread fraud provide a strong case for improving the domestic system of prudential supervision.…”

These issues are not restricted to developing countries. Dooley (1995) argues that commercial banks in the United States acquired claims on individual developing countries in the 1970s exceeding the concentration ratios that were enforced for domestic lending. The problem was that regulators did not enforce country lending limits, a decision that was justified by the erroneous view that loans to many entities within a country provided a diversified portfolio. Kane (1985) points out that the unwillingness of the authorities to force a write-down of debt following the 1982 debt crisis validated the assumption that the government would provide “free” equity to insured financial institutions.

Frankel and Rose (1996) present evidence that successful speculative attacks are less likely to occur in countries with a relatively high share of direct investment inflows. One interpretation of this evidence is that, in countries where foreign investors bypass domestic financial markets, particularly banks, foreign savings are more likely to be transformed into productive capital. This conclusion tends to support the view that imperfections in domestic financial markets justify measures that discourage portfolio capital flows. However, it is equally possible that some other feature of direct investment, for example, transfer of technology, accounts for these results.

III. Multiple Equilibria and First-Best Arguments

Speculative Attack Models

The turmoil in the ERM that emerged in 1992 and continues today has generated a resurgence of interest in models of “self-fulfilling’” speculative attacks. It has long been recognized that changes in the policy regime that are expected to prevail following a successful speculative attack can generate a successful attack, even if the government follows fully consistent policies preceding the attack.

A more stringent condition for a self-fulfilling attack is that the change in the exchange rate regime itself generates a “fundamental” change in the optimal path for monetary policy. If the private sector expects a more expansionary monetary policy following a successful attack, such expectations can generate the collapse of a system that is otherwise fully viable. Finally, a much more stringent condition is that a plausible model of the government’s behavior implies that a change in policy following a successful attack is optimal, given the change in the economic environment generated by the attack.

The lesson from these models is that the exchange rate regime is secondary to the monetary policy that the government is expected to pursue, not just in the short run but over the indefinite future. If the speculative attack is interpreted by the private sector as a signal that the government will abandon monetary restraint in the future, speculation in financial markets will, by the usual arguments, result in capital movements today in anticipation of this perhaps distant event. It seems to follow that capital controls might significantly slow the onset of the attack. Moreover, an optimistic assessment of the potential role of capital controls might be that their adoption will change the conditions that generate the multiple equilibrium. For example, the government might find a way to recommit to not altering its behavior following an attack.

It is ironic that the first clear statement of these issues was heavily conditioned by the warning that an announced commitment to a regime—in this model, a commodity “standard” rather than an exchange rate “standard”—was unlikely to alter the private sector’s expectations about monetary policy over the long run. Flood and Garber’s (1984, pp.104–05) warning is worth repeating at length:

Behind the sequential transitions from one monetary scheme to another … must lie a political economy that we have ignored. Such political economic forces determine the complete dynamic panorama of the monetary process…. A commodity system can be interpreted as a discipline-imposing rule only if the commodity standard’s permanence is somehow guaranteed. As there is no means to ensure such permanence, the notion of a commodity standard as a stabilizing rule is a chimera.

Flood and Garber (1984) and Obstfeld (1986b) show that, if governments are assumed to follow more expansionary monetary policies following successful speculative attacks on their fixed exchange rate regimes, policy regimes that are otherwise viable can be forced to collapse through self-fulfilling private expectations. Obstfeld (1994a) refines the argument by specifying the political economy that might account for the government’s behavior before and after an attack. The analysis sets out a rational government that seeks to maximize a plausible objective function. Because the government’s objectives are the same in any exchange rate regime, policy setting under different regimes must reflect changes in the economic environment rather than arbitrary assumptions concerning the government’s behavior.

Both Obstleld models suggest that the source of self-fulfilling speculative attacks is multiple equilibria consistent with a given set of fundamentals. The 1986 model develops the idea that private expectations concerning devaluation generate high domestic interest rates for long-maturity government bonds in the first period of a two-period model. High domestic interest rates generate a larger fiscal deficit carried into the second period. The government in the second time period minimizes a loss function that balances a higher tax rate on income against a higher tax rate on money balances, that is, a higher rate of money creation and inflation. Given the large fiscal deficit, the government chooses to inflate, thereby validating the private sector’s expectations. If the government could commit to a low rate of inflation, the nominal interest rate would fall in the first period, the fiscal deficit would likewise fall, and the optimal inflation rate in the second period would be low, again validating private expectations. An interesting feature of this model is that the government could avoid the commitment problem by denominating all its debt in foreign currency.

The 1994 Obstfeld model assumes that government values price stability and the ability to offset negative shocks to output. A sudden shift in expectations concerning the government’s preferences for full employment can trigger an attack on a regime that is viable under different expectations. These models are interesting because the government’s decision to abandon the peg is fully consistent with an objective function that is the same under both regimes. The only thing that changes over time is private expectations concerning the viability of the regime.

Eichengreen and Wyplosz (1993) and Portes (1993) argue that self-fulfilling models offer a reasonable interpretation of recent ERM crises. They contend that the ERM members that were forced to abandon their exchange rate commitments played by the rules of the game for a viable system as long as entry into the European Monetary Union was a feasible objective. Eichengreen and Wyplosz argue that the benefits of membership in the European Monetary Union made it rational for governments to pursue conservative monetary policies. An important condition for membership was the maintenance of a stable exchange rate for two years preceding membership.

Thus, for such a member, a successful speculative attack made membership in the first round impossible and perhaps implied that future membership would be more costly to attain. Once this opportunity was removed by the successful attack, it was then rational for the authorities to relax monetary policy. The speculative attack generated the subsequent government behavior that validated the attack.

To buttress this interpretation. Eichengreen, Rose, and Wyplosz (1994) offer empirical evidence that the fundamentals behaved differently in the months leading up to the ERM crisis than in a sample of crises in other fixed exchange rate regimes. In particular, they argue that the ERM crisis was not preceded by excessive money growth, growth in domestic assets, fiscal deficits, or a number of other variables usually associated with inconsistent policies.

A weakness in their interpretation of the evidence, as the authors acknowledge, is that a variety of factors might rationally lead to an expected change in the government’s behavior but leave no evidence in the run-up to the attack. In particular, they consider hut are not persuaded by the possibility that the rising unemployment associated with tight monetary policy in Germany might have generated expectations that monetary policy in other countries would be eased in the future as the political cost of unemployment accumulated.

Speculative Attacks and Capital Controls

The role of capital controls in preventing self-fulfilling speculative attacks seems obvious. It is plausible that effective controls would delay the end of a regime that suffered a spontaneous change in private expectations. If the regime remained vulnerable through current account transactions, the extended life for the good equilibrium made possible by capital controls would presumably be desirable. This assumption is reinforced if the ultimate destination for the regime is assumed to be a credible common currency.

Nevertheless, the contrary argument is equally plausible. If the private sector knows that the system is protected by controls, it will be less impressed by observed stability. Lane and Rojas-Suarez (1992), for example, argue that the use of controls has ambiguous implications for the credibility of a monetary policy regime.

The role of capital controls is also problematic because self-fulfilling attacks can go in the opposite direction. For example, a spontaneous decline in private inflationary expectations could set in motion a sequence of falling interest rates and fiscal deficits that generates a good equilibrium. It is perhaps informative that there seem to be few examples of changes in private expectations generating self-fulfilling virtuous responses by governments. Countries that start from bad equilibria should shun capital controls as these controls would delay adjustment to the new, more optimistic private expectations.

A number of papers have exploited the idea that controls themselves might be powerful signals of the government’s future policies, Dellas and Stockman (1993) show that a speculative attack might be generated by the expectation that capital controls will be introduced. If the government can commit not to introduce controls, the fixed rate regime is sustainable. In this model, a regime that is otherwise viable becomes vulnerable to expectations that controls will be imposed in response to an attack. This expectation increases interest rates before the attack and generates the conditions for a self-fulfilling devaluation.

Laban and Larrain (1993) argue that removing controls on capital outflows generates capital inflows because controls on outflows make investment irreversible. Thus, by altering expectations concerning the terms on which investments can be reversed, the decontrol of capital flows helps generate welfare-increasing capital inflows.

Bartolini and Drazen (1996) develop the idea that controls themselves are a signal that affects private sector expectations concerning the government’s future treatment of investors. In their model, the removal of controls signals to investors that the government is less likely to tax foreign capital income or to reimpose controls once the capital inflow is in place.

Finally, Obstfeld (1986a) shows that capital controls can generate multiple equilibria where none exist with capital mobility. In this model, multiple equilibria are a feature of a maximizing model with effective capital controls. Residents of the controlled economy maximize the utility of real money holdings and consumption over time, subject to their balance sheet constraint. Owing to effective capital controls, residents can accumulate real money balances only through current account surpluses, which mirror increases in the central bank’s net foreign assets. Because the net foreign asset position of the central bank earns the world interest rate, a current account surplus generates an increase in the expected permanent income of residents. An unstable equilibrium occurs if the increase in real money balances, as well as the associated increase in expected income, is not more than matched by an increase in current consumption. If it is not, the current account surplus increases, and money balances and income continue to rise until a stable equilibrium is reached. This model does not argue for or against capital controls; it only demonstrates that, when the domestic interest rate is distorted through a capital control program, the usual assumptions that generate convergence to a unique steady state equilibrium are not sufficient.

This literature presents a genuine problem for anyone attempting to understand the policy implications of capital controls. On the one hand, an effective capital control program might buy enough time for the government to move the fundamentals to a region where self-fulfilling speculative attacks are less likely. Controls could thus be seen as a temporary measure to buy time for a virtuous government to establish its reputation. On the other hand, it is easy to show that the possibility that controls might be introduced in the future can generate attacks where none would be observed otherwise. The removal of controls on capital outflows might also be interpreted by the market as a commitment not to penalize foreign investors and, therefore, as an attempt to generate capital inflows. A practical implication of this type of model is that the government probably must he prepared to maintain its fundamental policy stance even if it is temporarily forced to abandon the exchange rate peg. Maintaining this stance may involve significant short-run costs in terms of employment or distorting taxes necessary to finance debt-service payments on domestic debt. Unfortunately, the role of capital controls in reducing the costs of maintaining the fundamentals is much less clear. On the surface, it appears that controls might delay or even prevent a speculative attack and the associated costs. But the typical policy of imposing controls as the attack occurs—implemented probably because the authorities believe that the controls are not effective for long—can also be a powerful catalyst of speculative attacks. Finally, a careful treatment of expectations can suggest that policies designed to limit net capital inflows might have just the opposite effect.

IV. Effectiveness and Objectives of Controls

Effectiveness of Controls

Empirical work on the “effectiveness” of capital controls has suffered from the lack of a widely accepted definition of what constitutes an effective control program. At one end of the spectrum, effectiveness has been defined as differences observed over extended time periods in the average behavior of selected economic variables between countries with capital controls and countries without them. At the other extreme, effectiveness has been defined as a government’s ability to maintain an inconsistent macroeconomic policy regime indefinitely.

For this reason, observers have examined the same or similar data sets and reached very different qualitative conclusions concerning the effectiveness of controls. Those who see controls as a short-term device to allow the government time to react and adjust other policy tools generally argue that controls can be effective. Those who have observed that the collapse of regimes is often preceded by the imposition of controls argue that controls are not effective. The reading here of the extensive empirical literature for the industrial and developing countries is that it generally supports the conclusion that governments can drive a “small” wedge between domestic and International yields on similar short-term financial instruments for extended time periods. This conclusion is similar to those of recent surveys by Epstein and Schor (1992) and Obstfeld (1995). Thus, capital control programs have had measurable “effects” on economic variables. Control programs have also generated “large” yield differentials for a few weeks or months, but these seem to diminish over time as the private sector invests in techniques to avoid the controls.

The more important issue is whether these yield differentials are large enough and last long enough to enhance the effectiveness of a policy regime in attaining the government’s economic objectives. Unfortunately, effectiveness in this sense cannot be evaluated without constructing a structural model encompassing the government’s objectives and the economic constraints that it faces.

Dual Exchange Rate Premiums

Perhaps the most direct evidence for the effects of a control program in the more limited short-term sense described above is the spread between the commercial and financial spot exchange rates in dual exchange rate systems. Gros (1988) reports the spread for the Belgian franc from 1979 to 1987 and for the Mexican peso from 1982 to 1986. His interpretation of both these data sets is that the authorities were able to sustain a sizable differential for about one year before the private sector found ways to avoid the controls.

Cairncross (1973) provides data for the United Kingdom investment currency market from 1961 to 1972. These data indicate that the control system was effective in the narrow sense, in that the investment currency premium remained in excess of 20 percent for several years and at times reached nearly 50 percent. Nevertheless, Cairncross finds little evidence that the intended restriction on private capital outflows was effective. Cairncross and others also looked unsuccessfully for evidence that controls instituted by the United States to control private direct investment and portfolio capital outflows resulted in lower private capital flows. For these episodes, the lack of control over alternative forms of capital flows seemed to render the controls ineffective.

Covered Interest Rate Differentials and Eurocurrency interest Rate Differentials

For currencies with extensive offshore markets for bank deposits, another simple and informative test of the effects of controls is to compare returns on domestic bank deposits with similar deposits offered by offshore branches of the same or very similar banks. An early attempt to measure the effectiveness of controls using these data is reported in Dooley and Isard (1980). This paper presents a model in which onshore and offshore interest rates on bank deposits denominated in the same currency are related to the extensive capital control program introduced by the German government over 1970 to 1974, and to the risk that such controls might be intensified.

A problem for testing the effectiveness of control programs is that they are complicated legal programs that are difficult to quantify. In Dooley and Isard’s paper, the controls are quantified by evaluating both the size of the penalties or taxes on individual types of transactions and the extent of the coverage of the various transactions. These data suggest that the authorities managed to generate a 4 percentage point differential for a brief time, during which virtually all private capital inflows were prohibited.

In this respect, the controls in Dooley and Isard’s paper had clearly measurable effects. Nevertheless, a speculative attack on the currency generated a very large—by standards of the 1970s—increase in Germany’s International reserves, and the fixed exchange rate was abandoned. In line with the models reviewed above, the control program described in this paper appears to have slowed down the demise of the par value system but could not preserve it.

Gros (1987) reports spreads between Eurocurrency and domestic deposits for Italy and France from 1979 to 1986. He interprets these differentials, which were for short time periods as large as 20–24 percentage points, as consistent with his model that predicts that controls are temporarily effective in restraining large changes in investors’ positions. That is, during times of turbulence in the ERM, private speculators were not able to adjust their open positions without cost. Nevertheless, the interest differentials rapidly returned over longer horizons to very low levels.

Similar evidence for five industrial countries from 1982 to 1992 is reported in Obstfeld (1995). Obstfeld (1995, p. 217) concludes that for industrial countries the links between onshore and offshore markets are very close but that “[t]he data also show … that actual or prospective government interventions remain a significant factor in times of turbulence.” These data decisively reject the view that capital controls are always ineffective. However, the data also suggest that either the governments involved quickly removed the incentives for speculation through policy changes or speculators simply retreated to await another attack.

Chinn and Frankel (1994) report covered differentials for a group of developing countries in Asia. They find that, while these markets are not as integrated as the industrial countries, covered differentials seem to have narrowed during the 1980s even though capital controls were generally utilized by the countries studied. Melvin and Schlagenhauf (1985) extend this approach by explicitly adding the threat of controls or government-enforced default to controls already in place in the model. They find that controls had a significant effect on capital flows in Mexico in the early 1980s. In considering the same episode, Spiegel (1990) also finds that political risk was important but estimates it to have the opposite sign of that reported in Melvin and Schlagenhauf. Both papers indicate that the controls in place were effective.

Browne and McNelis (1990) provide a careful study of the imposition of controls over capital flows in Ireland from 1979 to 1986. Forward exchange rates are available for this data set, and the study is unusual in that it considers a number of domestic and International interest rates. The relative importance of domestic monetary conditions is assessed, and the yield on similar U.K. instruments is compared with the yield on Irish instruments before and after the imposition of controls in December 1978.

Brown and McNelis’s results suggest that the importance of domestic monetary factors in determining some interest rates in Ireland increased immediately after controls were imposed. However, as in the other studies, the effects of monetary conditions were short-lived, averaging only about six months. The usual story emerges that the central bank gained some independence for a short time. The evidence also suggests that interest rates in domestic financial markets that are poorly integrated with other domestic markets are much more sensitive to domestic money shocks than are rates in bank deposit markets. For example, Browne and McNelis find that changes in “domestic” monetary conditions had no impact on yields on bank deposits. Yet they find that domestic conditions significantly influenced rates of return in relatively noncompetitive domestic loan and mortgage markets.

Fieleke (1994) compares short-term Eurocurrency interest rates with similar domestic interest rates for Spain, Ireland, and Portugal during the 1992 FRM crisis. In each country, the authorities enforced controls on capital outflows as part of a defense of the exchange rate arrangement. Although the controls did result in measurable deviations between onshore and offshore interest rates, the controls did not in the end prevent changes in these countries’ exchange rates.

Fieleke (1994, p.34) also points out that the ERM members that did not utilize controls, Norway and Sweden, experienced much larger fluctuations in domestic interest rates while trying to maintain their exchange rate targets. He concludes that “… it may be that Spain and Portugal did acquire some temporary insulation.” Fieleke offers an interesting alternative test of the expected efficacy of controls by comparing the prices of equities for traded and nontraded goods industries leading up to the exchange rate crisis. If controls are expected to fail, in the sense that there is no change in the probability of devaluation, the market value of nontraded goods industries should not rise following an unexpected imposition of controls. Data for Portugal during 1992 and 1993 offer conflicting evidence. The value of nontraded goods equities did rise relative to export-oriented industries but declined relative to import-competing industries. The short sample period and the difficulty in identifying the orientation of firms cloud the results.

Eichengreen, Rose, and Wyplosz (1994) challenge this interpretation of the ERM experience. They make the point that focusing on actual devaluations biases the sample toward episodes in which capital control programs have failed. To overcome this bias, they examine the behavior of a number of economic variables during crisis and noncrisis periods to see whether the experience of countries with controls differs systematically from that of countries without controls. This comparison, they argue, is a more useful measure of the effectiveness of controls. During crisis periods, countries with controls experienced higher inflation, higher rates of money growth, and higher growth of domestic assets. Controls did not seem to affect the loss of reserves, interest rate differentials, or fiscal imbalances. During non-crisis periods, controls appear to affect all the macroeconomic variables tested except reserves.

Eichengreen, Rose, and Wyplosz’s conclusion (1994, p. 8) is quite consistent with the literature surveyed above:

Controls do not allow countries which pursue policies inconsistent with a peg to keep their exchange rate unchanged forever. They do not prevent attacks, nor do they permit countries to avoid reserve losses or interest rate increases when attacks occur. Controls merely render expansionary monetary policies viable for a longer period by attenuating the link between crises and exchange rate regime collapse.

Tests Where Forward Exchange Rates and Eurocurrency Interest Rates Are Unavailable

An important limitation of the methodology reviewed above is that well-developed forward exchange markets or offshore deposit markets are needed to control for expected exchange rate changes. For many markets where liberalization is now a policy option, historical controls have inhibited the development of such markets. Thus, empirical research must rely on an alternative estimate of expected exchange rate changes. Phylaktis (1988) reports results for Argentina based on the model discussed above but uses realized spot rates as a proxy for expected changes in exchange rates. Some types of controls were found to influence the uncovered interest differential. The interesting aspect of these results is that the controls might have contributed to the effective taxation of foreign assets and a political risk premium, as well as perhaps to the exchange risk premium. The difficulty in sorting out these effects in the absence of forward exchange markets has led researchers to explore alternative models.

Edwards and Khan (1985) propose a direct test for the relative importance of a domestic interest rate and an uncovered foreign rate in determining the demand for money. They find that for relatively open economies (such as, in their model, Singapore) only the uncovered foreign expected yield was important in determining money demand. For countries with controls (such as, in their model, Colombia), both the foreign rate and domestic “market-clearing” rates were important.

Haque and Montiel (1990) develop an empirical test for developing countries for which market-clearing domestic interest rate data are not available. This research utilizes an instrumental variable approach to control for the endogeneity of the observed monetary base. The authors find that the degree of capital mobility among developing countries is quite high and conclude from this finding that the pervasive controls over capital flows in place in most of the countries studied provided little scope for an independent monetary policy.

Dooley and Mathieson (1994) extend this model in order to test for changes in the degree of capital mobility over time. They also find that capital is quite mobile for countries that have extensive control programs and that in most cases this degree of mobility has increased over time. In general, this line of research suggests that control programs in developing countries have been of limited effectiveness.

Other authors using similar techniques have reported mixed results. Reisen and Yeches (1993) utilize curb market rates as a measure of effective domestic interest rates and find that capital mobility remained roughly constant for a group of Asian countries, while Faruqee (1992) finds that integration between developing countries in Asia and Japan seems to have increased in recent years. Kwack (1994) develops a model that identifies the exogenous part of the change in the base using a policy reaction function and reports plausible estimates of the effectiveness of capital controls in Korea.

Each of the papers discussed in this category attempts to measure a counterfactual monetary base that the authorities are assumed to set for an extended time period. However, the observed change in the domestic part of the monetary base is some combination of the exogenous policy change and the response during the time period studied to offsetting private capital flows. As the response to a policy-induced change in the monetary base can be literally instantaneous, it is difficult to identify the policy-induced pan of observed changes, short of developing a complete model of government behavior. It appears that different techniques for dealing with the endogenous nature of the regressors have important consequences for the results of these studies.

Edwards (1989c) provides a qualitative evaluation of capital control programs leading up to 34 devaluations in developing countries. He concludes that governments typically intensified their control programs in the year before devaluations. He also reports data on premiums in financial exchange markets as devaluations approached. While there are exceptions, the financial rate premiums in most cases increased sharply in the one to three months before the exchange crisis led to devaluation. Nevertheless, data for these same episodes show that current accounts weakened and reserve assets declined despite the controls. Edwards (1989c, pp.189–90) concludes that “[a]t most one can argue that these heightened impediments to trade managed to slow down the unavoidable balance of payments crisis unleashed by the inconsistent macroeconomic policies.” This evidence seems consistent with the more thoroughly researched data for industrial countries.

Direct Measures of Capital Flows

Johnston and Ryan (1994) examine the effects of capital control programs for recorded capital flows (including errors and omissions) for a cross section of 52 developing and industrial countries for the period 1985 to 1992. With this approach, controlling for factors other than capital controls that shape the structure of capital flows is quite difficult. As the authors point out, models of the capital account typically relate economic fundamentals, such as yield differentials and changes in wealth, to total net capital flows (that is, the mirror image of the current account balance). Within this constraint, the proportion of the capital account allotted to net official flows and net private flows then depends on the behavior of the government. If that behavior is not consistent over time, the behavior of net private capital flows will not appear to be related to economic fundamentals. Moreover, to the extent that control programs respond to capital flows, it would not be surprising to observe that new controls over capital inflows are associated with increased inflows.

Nevertheless, some interesting empirical regularities emerge from the data. The removal of controls on capital outflows by industrial countries did seem to influence the overall volume and structure of net private flows; direct investment and recorded long-term portfolio investment seem to have been particularly sensitive to changes in control programs. In contrast, control programs in developing countries do not seem to have affected either overall private capital flows or their composition. The authors plausibly conclude that the administration of control programs in developing countries has been less effective than in industrial countries.

A related empirical literature has attempted to measure private capital outflows from developing countries that are not captured by balance of payments reporting systems. Such outflows, generally identified as capital flight, are presumed to be unrecorded because the residents of these countries wish to avoid legal restrictions on outflows, taxes on earnings from legal outflow, or both. Dooley (1988) tests the idea that such flows reflect efforts of residents to avoid financial repression. Mathieson and Rojas-Suarez (1992) test the relationship between programs to control capital flight and other fundamental determinants of capital flight. They find that, during episodes of capital outflows in response to increased risk from inflation and default risk, countries with capital controls did not prevent capital flight; at the same time, the private sector’s reaction to a deterioration of the fundamentals was delayed.

Kamin (1988) develops the related idea that capital movements are concealed by misinvoicing of trade transactions. Kamin (1991) suggests in a case study of the Argentine dual exchange rate mechanism during the 1981–90 period that controls were made ineffective through export underinvoicing and a variety of other leakages.

Tests of the Political Economy of Capital Controls

Recent empirical work has attempted to relate countries’ use of capital market restrictions to a variety of structural characteristics of the economy. This literature views policy regimes as endogenous responses to institutional and political features of the economy. Alesina, Grilli, and Milesi-Ferretti (1994) test the relevance of a number of rationalizations for the use of capital controls outlined above by looking for common characteristics of members of the Organization for Economic Cooperation and Development (OECD) that seem related to the utilization of controls. Their reading of the theoretical literature suggests that the use of controls should be related to the exchange rate regime and to the desire to tax capital income and money balances. They find that highly managed exchange rate regimes seem to be associated with the use of controls.

Preferences for taxing capital income and money balances are, in turn, related to a variety of attributes of the political system. For example, inflation might result from weak governments that cannot enforce other types of taxes deciding to tax capital income, or from strong governments deciding to apply the same kind of tax. Governments with independent central banks might resist both inflation and controls designed to preserve the inflationary tax base. The findings of Alesina, Grilli, and Milesi-Ferretti suggest that countries with strong governments and dependent central banks are likely to utilize controls, presumably to generate revenue from inflation and to reduce real debt service.

Alesina, Grilli, and Milesi-Ferretti also test the impact of capital controls on other macroeconomic variables. Controlling for political stability, they find that controls have a negative effect on the stock of government debt. This finding is consistent with models discussed above that suggest that revenue from inflation is enhanced by controls and that domestic real interest rates kept below the world rate might limit debt-service costs. The structure of the economy also seems to be an important determinant of the use of controls. The data also suggest (controlling for initial income levels and political stability) that controls do not influence growth rates. Grilli and Milesi-Ferretti (1995) find similar results for a sample of 16 developing and developed countries. In particular, countries with controls seem to experience over an extended time period high rates of inflation, relatively high shares of government revenue from seigniorage, and relatively low real interest rates. These results suggest that fiscal considerations are the most important determinants of the use of capital controls and that the controls, or some factor highly correlated with the use of controls, have measurable effects on government revenues.

Integration and Net Capital Flows

The consensus from the empirical work reviewed above is that capital markets of industrial countries and many developing countries are highly integrated and that integration has increased substantially over the past 30 years. Capital controls or dual exchange rate systems have been effective in generating yield differentials, covered for exchange risk, for short periods of time, but they have had little power to stop speculative attacks on regimes that were seen by the market as inconsistent.

It is surprising in light of this evidence that so little supporting evidence is found in the nonfinancial data. What has become known as the Feldstein-Horioka puzzle is the lack of savings-investment imbalances among countries with apparently integrated financial markets. As argued in Dooley, Frankel, and Mathieson (1987), tests of savings-investment correlations are joint tests of several hypotheses, most of which have little to do with capital mobility or capital controls. The test of market integration might fail for several reasons: purchasing power parity does not hold; exchange rate risk is a powerful barrier to International investment; domestic financial markets are poorly integrated; the economies studied are near a steady state in which imbalances are very small; or government policies other than capital controls generate small current account imbalances.

In a recent survey of this literature, Obstfeld (1994c) suggests that the puzzle is real in the sense that current account imbalances in recent years appear to be too small relative to historical periods when capital accounts were apparently open, or to net capital movements within national boundaries. Several observers have concluded that the most plausible reason for this departure from the expected pattern of International investments is that governments have targets for the current account and manipulate macroeconomic policies to attain these targets. There appears to he no evidence that would suggest that capital controls are an important part of the apparent barriers to real capital mobility.

While not directly relevant to this paper’s exploration of capital account restrictions, this observation is interesting and important. Recall that an effective control program is closely related to a government target for the current account balance. If governments are pursuing current account targets by using other distortionary policy tools, the welfare effects of imposing controls are much less clear. In this case, the alternative to capital controls is not free trade in financial assets but distortion of another policy tool to eliminate private incentives for intertemporal trade. A few studies of the real-side evidence have looked directly at the effects of capital controls on real capital mobility. Razin and Rose (1994) create a measure of capital controls from the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions and test the impact of these controls for a cross section of industrial and developing countries. They test the hypothesis that changes in consumption should be correlated among countries with open capital markets, and that investment should be more variable over time. Neither of these predictions is supported by the data. Like all these studies, Razin and Rose’s test complicated joint hypotheses. But the data seem to support the view that capital control programs are not the main reason for the low level of integration of real capital markets.

Gross Capital Flows and Capital Controls: Theory and Evidence

The implicit assumption in the literature reviewed in the previous subsection is that net capital flows and the associated redistribution of savings and investment across countries determine the welfare consequences of capital mobility. Gross private capital flows and the structure of International financial intermediation are by implication less important for evaluating the economic consequences of International capital flows and controls on these flows. This subsection suggests that such models ignore important considerations in balancing costs and benefits of capital control programs.

Some of the literature already reviewed is relevant for gross capital flows, but this subject is not in general well developed in the literature. Nevertheless, the evidence cited above suggests that the welfare gains from liberalizing International credit markets are more likely to come from better utilization of available domestic savings than from net flows of foreign savings. The important point is that direct investment and other International capital transactions might be welfare improving even if no net capital flow is associated with free trade in financial services. Obstfeld (1994b) develops the idea that closed national credit markets might be very unlikely to finance high-risk investments because of risk aversion among domestic savers and the inability to diversify within the domestic markets. If high-risk investment projects also have relatively large payoffs in terms of endogenous economic growth, the closed capital market implies that the growth rate of the country is limited. Opening the capital account in this model allows nonresident investors with lower levels of risk aversion to hold high-return investments in the country while residents hold relatively safe foreign assets. Thus, with no net capital flow, domestic savings are channeled into investments that generate a higher growth rate. As demonstrated in a simulation exercise, the welfare benefits of a higher growth path can be very large.

Partial equilibrium models of the potential benefits for investors of greater access to equity markets in developing countries also suggest that significant welfare gains are available (Lessard, 1973; and Harvey, 1994). These models employ an International capital asset pricing model to evaluate the possibility that opening equity markets would improve the risk return trade-off faced by an investor currently limited to industrial country equities. Recent work has also tested the effects of restrictions on foreign investment as measured by an investability index compiled by the International Finance Corporation (Bekeart, 1995; and Claessens, Dasgupta, and Glen, 1995). These analyses suggest that existing controls have had significant effects on yields of equities and that removal of such restrictions would benefit investors.

The apparent benefits from International diversification have also led to research that compares optimal to observed portfolios. While there are many problems with the data on gross International capital flows—and even more with the calculation of stocks of cross-border private financial claims and liabilities—this research suggests a very clear “home bias” in portfolios of residents of industrial countries. Tesar and Werner (1992) report that residents of industrial countries hold almost all their wealth in the form of claims on residents of their home countries. Golub (1990) argues from evidence of gross capital flows that a very minor part of the capital stock of OECD countries reflects gross foreign ownership and concludes that this measure of capital mobility is even more puzzling than the data on current account imbalances (which were discussed in the previous subsection).

V. Conclusions

In this paper, we review the academic literature setting out the effects of controls predicted by a variety of economic models and testing the empirical relevance of such models.

The traditional theoretical work on capital controls starts from the premise that free intertemporal trade is welfare enhancing. Controls are welfare reducing unless they are a second-best policy that mitigates the effects of another market failure. Our survey considers a wide variety of the market failures that have been analyzed in the literature, including sticky prices in goods and labor markets, distortionary tax policies, anticipated trade reforms, and naive private speculation. A recent addition to the list that seems to deserve closer attention is the possibility that distortions in the domestic capital markets of economies receiving private capital inflows encourage inefficient investment and consumption decisions.

The conclusion that we draw from this literature is that an ideal government dealing with one clear distortion could, in principle, improve welfare by intervening in International capital markets. Whether control programs have been or could be used in this manner is an empirical question.

A quite different exception to the general rule that government constraints on capital mobility are welfare reducing arises in cases in which stable multiple equilibria are predicted. In reviewing these arguments, we have attempted to clarify the very special circumstances under which such theoretical arguments are valid. Empirical work that attempts to relate these models to recent experience in Europe lends some support to these models.

We then turn to evidence concerning the effects of control programs on economic variables. We conclude from this literature that both developed and developing countries have succeeded in driving wedges between domestic and International interest rates. Moreover, governments seem to have used controls in concert with various forms of financial repression to generate revenue and limit debt-service payments on domestic government debt.

The power of capital control programs to affect other important economic variables, such as the volume or composition of private capital flows, changes in International reserves, or the level of the exchange rate, is, however, generally not supported by the data. In particular, there is little evidence that controls have proved capable of heading off successful speculative attacks on inconsistent policy regimes.

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*

Michael P. Dooley is Professor of Economics at the University of California, Santa Cruz. The paper was prepared while the author was a Consultant in the Exchange Regime and Market Operations Division of the Monetary and Exchange Affairs Department. The author is grateful to Robert P. Flood and Peter J. Quirk for helpful comments.

IMF Staff papers: Volume 43 No. 4
Author: International Monetary Fund. Research Dept.