In 1994, the Bretton Woods conference recognized the fundamental link between exchange and capital controls1 and international trade. One of the purposes of the International Monetary Fund, which was created at the conference, was to assist in “the elimination of foreign exchange restrictions which hamper the growth of world trade.” 2 However, the maintenance of capital controls was not viewed as inconsistent with this objective, partly because capital controls were considered necessary for supporting the system of fixed exchange rates and thus fostering trade. More than 50 years later, the question about the economic effects of exchange and capital controls is again at the forefront of economic policy debates. Most countries have liberalized controls on current payments and transfers, and the focus of economic policy is increasingly shifting toward liberalizing capital account transactions.
The effect of exchange and capital controls on international trade depends on the structure and effectiveness of controls and their interaction with other distortions in the economy. Exchange controls act as a tax on the foreign currency required for purchasing foreign goods and services and. by raising the domestic price of imports, they tend to reduce trade. Besides this basic effect, exchange and capital controls can influence trade through other channels, for example, transaction costs, exchange rates, foreign exchange risk hedging, and trade financing. Capital controls, in particular, can affect trade in goods by reducing intertemporal trade and portfolio diversification, which may substitute or complement intertemporal trade. Given the importance and ambiguity of the link between exchange and capital controls and trade, the systematic empirical evidence on the matter is critical, but it remains limited.
This paper examines the effect of exchange and capital controls on trade for 1996 in the empirical gravity-equation framework, in which bilateral exports depend on the distance separating the countries, the countries’ size and wealth, tariff barriers, and exchange and capital controls. The extent of exchange and capital controls is measured by unique indices, which aggregate information on 142 individual types of control based on the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions.
Overall, the paper finds that exchange and capital controls have a significant negative impact on bilateral exports. However, this result varies depending on the level of development in the country and the type of exchange and capital control. Controls on current payments and transfers are a minor barrier to trade. In contrast, capital controls significantly reduce exports into developing and transition economies and not into industrial countries. These results may reflect the extent to which restrictions on current payments and transfers have been liberalized generally, while the liberalization of controls on capital flows have so far been focused largely on industrial countries.
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)| false Johnston, R. Barry, and Chris Ryan, 1994, The Impact of Controls on Capital Movements on the Private Capital Accounts of Countries’ Balance of Payments: Empirical Estimates and Policy Implications, IMF Working Paper 94/78 ( Washington: International Monetary Fund).
Lee, Jong-Wha, 1993, International Trade, Distortions, and Long-Run Economic Growth, Staff Papers, International Monetary Fund, Vol. 40 (June), pp. 299–328.
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Natalia Tamirisa is an Economist in the IMF’s Policy Development and Review Department. She was an Economist in the IMF’s Monetary and Exchange Affairs Department when this paper was written. The author is grateful to Barry Johnston for encouragement and insights. She appreciates useful discussions with Giovanni Dell’Ariccia, Brad McDonald, Mark Swinburne, and Athanasios Vamvakidis and valuable comments from Gian Maria Milesi-Ferretti and two anonymous referees. The author also thanks Virgilio Sandoval for assistance with data collection and Natalie Baumer for helpful editorial suggestions.
Hereinafter, the term “controls on current payments and transfers” refers to exchange controls over current international transactions, while “capital controls” encompasses controls pertaining to capital account transactions. The term “exchange and capital controls” covers both of the above types of controls.
In the balance of payments, the sum of the current account, the capital account, and the change in reserves is by definition equal to zero. If exchange and capital controls are effective and have a statistically significant impact on the capital account, the balance of payments identity implies that they must also affect the current account and/or reserves in a regime of managed or fixed exchange rates, and the current account under the floating exchange rate regime. The author is grateful to an anonymous referee for underscoring this point. For a detailed review of the literature on capital controls, see Dooley (1996).
For a discussion of the relationship between the intensity of capital controls and net capital flows, see Johnston and others (forthcoming). The study developed a methodology for constructing simple, yet comprehensive, indices of exchange and capital controls and found that the intensity of the controls is negatively correlated with net direct, portfolio, and other capital flows. The present paper uses these indices to examine the impact of exchange and capital controls on trade flows.
It can be shown that dual exchange rates are equivalent to capital controls, while exchange controls are similar to trade restrictions, according to Adams and Greenwood (1985) and Greenwood and Kimbrough (1987), respectively.
For the review of the literature on foreign direct investment, see, for example, World Trade Organization (1996).
See Dooley (1996) for a review of the literature on capital controls. The empirical literature suggests that capital controls may affect yield differentials, but their role in improving the balance of payments is limited (see, for example, Johnston and Ryan, 1994).
In 1997, the information in the AREAER was presented for the first time in a new tabular format, which classified and standardized the information on members’ exchange systems and expanded the coverage of capital controls. The classification of the AREAER information with this new tabular format has made it possible to develop and apply more comprehensive indices of the extent of exchange and capital controls for 1996.
For more details on the indices of exchange and capital controls, see Johnston and others (forthcoming).
Although the intensity of exchange and capital controls is not taken into account explicitly, the indices are found to be robust to weighing by subjective intensity measures.
Under Article VIII of the IMF’s Articles of Agreement, members undertake obligations to avoid imposing restrictions on the making of payments and transfers for current international transactions, without the approval of the IMF.
The study uses the IMF’s classification of industrial, developing, and transition countries.
For the analysis of correlation between the indices and measures of economic development, the efficiency of the financial system, foreign direct and portfolio investment, exchange rate volatility, and trade policy, see Johnston and others (forthcoming).
Including both CCI and KCI in the model intensifies multicollinearity, since the indices are highly correlated with each other (correlation coefficients of 0.8-0.9). Testing for redundant coefficients shows that CCI is redundant. Testing for the stability of coefficients suggests that they are unstable at the 5 percent level of significance.
Since heteroscedasticity may be a problem due to differences in the country size, standard errors and covariances are calculated on the basis of the White heteroscedasticity-consistent matrix.
The former variable is constructed on the basis of the AREAER, and figures for the latter come from the International Financial Statistics.
The trade policy database is compiled by the IMF’s Trade Policy Division of the Policy Development and Review Department, on the basis of various sources (among others, the International Monetary Fund, the World Trade Organization, and the United Nations Conference on Trade and Development). The author thanks Robert Sharer and the staff of the Trade Policy Division for providing the data.
The findings concern the relationship between exchange and capital controls and bilateral exports and thus cannot be interpreted to judge the effect of controls on net trade, net capital flows, or the balance of payments; the latter issues are a topic for future research.
Under the IMF’s jurisdiction, registration or licensing used to monitor rather than restrict payments and verification requirements, such as a requirement to submit documented evidence that a payment is bona fide, does not constitute an exchange restriction, unless the process results in undue delays. With indicative limits, authorities approve all requests for foreign exchange for bona fide current international transactions in excess of limits or for transactions for which there is no basic allocation of foreign exchange. If the public is made aware of such a policy, indicative limits do not constitute a restriction.
On average, 99 percent of the AREAER data on exchange and capital controls are available for the countries in the sample. Nonetheless, the baseline indices are defined as the averages of the indices calculated under two alternative assumptions about missing data: controls and no controls.