II Country Experiences
- Akira Ariyoshi, Andrei Kirilenko, Inci Ötker, Bernard Laurens, Jorge Canales Kriljenko, and Karl Habermeier
- Published Date:
- May 2000
General Considerations on the Use of Capital Controls
This section provides a brief summary of the general considerations involved in the use of capital controls, including the objectives they have been set to achieve, the ways in which their effectiveness has been assessed, the forms they have taken, and the potential costs that may be associated with their use. Country experiences presented in the subsequent sections are assessed in light of these general considerations.
Objectives of Capital Controls
Many arguments have been advanced in the economic literature to justify the use of capital controls. Among these, second-best arguments identify situations in which capital account restrictions improve economic welfare by compensating for financial market imperfections, including those resulting from informational asymmetries. Proposals to address these imperfections range from improved disclosure and stronger prudential standards to the imposition of controls on international capital flows.
Policy implementation arguments hold that capital controls may help to reconcile conflicting policy objectives when the exchange rate is fixed or heavily managed. These arguments include preserving monetary policy autonomy to direct monetary policy toward domestic objectives and reducing pressures on the exchange rate. An additional, related, motivation for capital controls has been to protect monetary and financial stability in the face of persistent capital flows, particularly when there are concerns about (1) the inflationary consequences of large inflows, or (2)inadequate assessment of risks by banks or the corporate sector in the context of a heavily managed exchange rate that, by providing an implicit exchange rate guarantee, encourages a buildup of unhedged foreign currency positions. Finally, capital controls have also been used to support policies of financial repression to provide cheap financing for government budgets and priority sectors. Other political economy arguments are outside the scope of this review.
Effectiveness and Potential Costs of Capital Controls
The effectiveness of capital controls has frequently been assessed on the basis of their impact on capital flows and policy objectives, such as maintaining exchange rate stability, providing greater monetary policy autonomy, or preserving domestic macroeconomic and financial stability. Much attention has been given in the literature to differentials between domestic and international interest rates, as capital controls tend to create a wedge between domestic and external financial markets. This wedge, however, may itself create incentives for circumvention; the effectiveness of controls will then depend on the size of this incentive relative to the cost of circumvention. If the controls are effective, capital flows would become less sensitive to domestic interest rates, which the authorities could then orient toward domestic economic objectives. These and other issues are considered in the country case studies, with an emphasis that varies according to the circumstances of the individual country and the availability of data and previous studies.
Econometric and statistical studies of these issues have several methodological shortcomings. In particular, no generally accepted and reliable measures of the intensity of capital controls are available, and many studies simply use dummy variables for their presence or absence. Also, it is often difficult to ascertain whether differences in the variables to be explained are attributable to capital controls or other factors, some of which are also difficult to measure (e.g., the effectiveness of prudential supervision). Moreover, it has proven difficult to distinguish in an economically meaningful way between long-term and short-term capital flows. Short-term loans are often rolled over repeatedly, while long-term instruments can be often sold at short notice in secondary markets. This applies even to foreign direct investment when the investor can borrow against his collateral and short the currency. Derivatives markets, including those for swaps and options, open up many additional avenues for changing the effective maturity of investments. The extent to which the distinction between short-term and long-term flows is erased depends primarily on the level of development of financial markets, and in particular on their depth and liquidity. These attributes of financial markets will in turn be affected by government regulation, including capital controls.
Regardless of whether capital controls are effective, their use (or reimposition) may entail some costs. (See Baker, 1996) First, restrictions on capital flows, particularly when they are comprehensive or wide-ranging, may interfere with desirable capital and current transactions along with less desirable ones. Second, controls may entail nontrivial administrative costs for effective implementation, particularly when the measures have to be broadened to close potential loopholes for circumvention. Third, there is also the risk that shielding domestic financial markets by controls may postpone necessary adjustments in policies or hamper private-sector adaptation to changing international circumstances. Finally, controls may give rise to negative market perceptions, which in turn can make it costlier and more difficult for the country to access foreign funds.2
Types of Capital Controls
Controls on cross-border capital flows encompass a wide range of diversified, and often country-specific, measures. These restrictions on and impediments to capital movements have in general taken two broad forms: (1) “administrative” or direct controls and (2) “market-based” or indirect controls. In many cases, capital controls to deal with episodes of heavy capital flows have been applied in tandem with other policy measures, rather than in isolation.
Administrative or direct controls usually involve either outright prohibitions on, or an (often discretionary) approval procedure for, cross-border capital transactions (Box 1). Market-based or indirect controls, on the other hand, attempt to discourage particular capital movements by making them more costly. Such controls may take various forms, including explicit or implicit taxation of cross-border financial flows and dual or multiple exchange rate systems. Market-based controls may affect the price, or both the price and the volume, of a given transaction.
Capital Controls to Limit Short-Term Inflows
Brazil (1993–97), Chile (1991–98), Colombia (1993–98), Malaysia (1994), and Thailand (1995–97) have all used capital controls to limit short-term capital inflows. Short-term capital flows, though typically seen as less risky from the perspective of individual banks and other investors, have often been regarded as speculative and destabilizing at the aggregate level. Long-term flows, by contrast, are usually considered to be more closely related to the real economy and hence more stable and desirable. It is not always straightforward to distinguish between short-term and long-term flows in an economically meaningful way. Figures 1-9 illustrate developments in key economic indicators during these episodes. Part II, Chapter V, provides further details of the country experiences.
Figure 1.Countries with Controls on Short-Term Capital Inflows: Net Private Capital Flows
Source: IMF’s World Economic Outlook database.
Figure 2.Countries with Controls on Short-Term Capital Inflows: Foreign Exchange Reserves
Source: IMF’s International Financial Statistics database.
Figure 3.Countries with Controls on Short-Term Capital Inflows: Current Account Balance
Source: IMF’s World Economic Outlook database.
Figure 4.Countries with Controls on Short-Term Capital Inflows: Real Effective Exchange Rate
Source: IMF’s Information Notice System database. Based on relative CPIs. Increase means an appreciation
Figure 5.Countries with Controls on Short-Term Capital Inflows: Nominal Exchange Rate
Source: IMF’s International Financial Statistics database.
Figure 6.Countries with Controls on Short-Term Capital Inflows: Inflation
Source: IMF’s International Financial Statistics database.
Figure 7.Countries with Controls on Short-Term Capital Inflows: Monetary Aggregates
Source: IMF’s International Financial Statistics database.
Figure 8.Countries with Controls on Short-Term Capital Inflows: Short-Term Interest Rate Differentials
Sources: Various, including IMF’s International Financial Statistics database and country authorities. The charts show the simple and depreciation-adjusted short-term interest rate differentials with the United States. Owing to data availability, the type of domestic currency–denominated financial instrument varies by country.
1 Q1-Q2 1994 observations removed to limit chart scale
Figure 9.Countries with Controls on Short-Term Capital Inflows: Local Stock Exchange Index
Source: International Finance Corporation’s Emerging Markets database.
Motivations for Capital Controls on Short-Term Inflows
In all five countries, capital controls to limit short-term inflows were imposed in response to concerns about the macroeconomic implications of the increasing size and volatility of capital inflows, within the broader context of abundant capital flows to emerging economies during the 1990s. Longer-term inflows generally reflected structural factors, notably wide-ranging economic reform (Chile, Colombia, and Malaysia) or the liberalization of external transactions (Brazil, Colombia, and Thailand). Short-term inflows reflected high domestic interest differentials in the context of pegged (Thailand) or heavily managed exchange rate regimes (Brazil, Chile, Colombia, and Malaysia), which had often given markets a false sense of security. The large and persistent inflows complicated the implementation of monetary policy, at times owing to a lack of adequate monetary instruments (Thailand). In most cases, sterilization operations were the first policy response to the inflows. However, such operations typically entailed costs to the central bank owing to differentials between the cost of issuing securities and the return on foreign assets. Furthermore, sterilization operations may have attracted further inflows as they tended to keep interest rates high.
Box 1.Types of Capital Controls
Capital controls have generally taken two main forms: direct or administrative controls, and indirect or market-based controls.
Direct or administrative capital controls restrict capital transactions and/or the associated payments and transfers of funds through outright prohibitions, explicit quantitative limits, or an approval procedure (which may be rule-based or discretionary). Administrative controls typically seek to directly affect the volume of the relevant cross-border financial transactions. A common characteristic of such controls is that they impose administrative obligations on the banking system to control flows.
Indirect or market-based controls discourage capital movements and the associated transactions by making them more costly to undertake. Such controls may take various forms, including dual or multiple exchange rate systems, explicit or implicit taxation of cross-border financial flows (e.g., a Tobin tax), and other predominantly price-based measures. Depending on their specific type, market-based controls may affect only the price or both the price and volume of a given transaction.
- In dual (two-tier) or multiple exchange rate systems, different exchange rates apply to different types of transactions. Two-tier foreign exchange markets have typically been established in situations in which the authorities have regarded high short-term interest rates as imposing an unacceptable burden on domestic residents, and have attempted to split the market for domestic currency by either requesting or instructing domestic financial institutions not to lend to those borrowers engaged in speculative activity. Foreign exchange transactions associated with trade flows, foreign direct investment, and usually equity investment are excluded from the restrictions. In essence, the two-tier market attempts to raise the cost to speculators of the domestic credit needed to establish a net short domestic currency position, while allowing nonspeculative domestic credit demand to be satisfied at normal market rates. Two-tier systems can also accommodate excessive inflows and thus prevent an overshooting exchange rate for current account transactions. Such systems attempt to influence both the quantity and the price of capital transactions. Like administrative controls, they need to be enforced by compliance rules and thus imply administration of foreign exchange transactions of residents and domestic currency transactions of nonresidents to separate current and capital transactions.
- Explicit taxation of cross-border flows involves imposition of taxes or levies on external financial transactions, thus limiting their attractiveness, or on income resulting from the holding by residents of foreign financial assets or the holding by nonresidents of domestic financial assets, thereby discouraging such investments by reducing their rate of return or raising their cost. Tax rates can be differentiated to discourage certain transaction types or maturities. Such taxation could be considered a restriction on cross-border activities if it discriminates between domestic and external assets or between nonresidents and residents.
- Indirect taxation of cross-border flows, in the form of non-interest-bearing compulsory reserve/deposit requirements (hereafter referred to as unremunerated reserve requirement (URR)) has been one of the most frequently used market-based controls. Under such schemes, banks and nonbanks dealing on their own account are required to deposit at zero interest with the central bank an amount of domestic or foreign currency equivalent to a proportion of the inflows or net positions in foreign currency. URRs may seek to limit capital outflows by making them more sensitive to domestic rates. For example, when there is downward pressure on the domestic currency, a 100 percent URR imposed on banks would double the interest income forgone by switching from domestic to foreign currency. URRs may also be used to limit capital inflows by reducing their effective return, and they may be differentiated to discourage particular types of transactions.
- Other indirect regulatory controls have the characteristics of both price- and quantity-based measures and involve discrimination between different types of transactions or investors. Though they may influence the volume and nature of capital flows, such regulations may at times be motivated by domestic monetary control considerations or prudential concerns. Such controls include provisions for the net external position of commercial banks, asymmetric open position limits that discriminate between long and short currency positions or between residents and nonresidents, and certain credit rating requirements to borrow abroad. While not a regulatory control in the strict sense, reporting requirements for specific transactions have also been used to monitor and control capital movements (e.g., derivative transactions, non-trade-related transactions with nonresidents).
Controls on capital inflows were imposed to reduce reliance on sterilization, and in some cases to postpone other adjustment. These controls were typically accompanied by other policies, including a liberalization of outflow controls (Chile and Colombia), an adjustment or progressive increase in the flexibility of the exchange rate (Chile and Colombia), and a further strengthening of the prudential framework for the financial system (Chile, Colombia, and Malaysia). In some countries, fiscal policy remained tight (Chile and Malaysia); in others, further tightening was limited (Brazil and Thailand); and in some it remained loose, putting even greater pressure on monetary policy (Colombia).
All five countries used inflow controls to preserve or enhance monetary policy autonomy. The controls were seen as a means of resolving the classic policy dilemma that results from having more objectives than independent policy instruments. Typically, monetary policy was oriented toward reducing inflation while also attempting to stabilize the exchange rate under relatively free capital movements that made it difficult to set monetary and exchange rate policies independently.
Prudential concerns also motivated the adoption of controls on capital inflows, though in most cases, macroeconomic considerations appeared to be dominant. The controls were intended to alter the maturity composition of the inflows toward less volatile flows, in addition to reducing their overall volume. Short-term flows were seen to have potential adverse effects on macroeconomic and financial system stability, particularly as the ability of financial institutions to safely intermediate the inflows was uncertain (Colombia, Malaysia, and Thailand). The case has also been made that these countries faced a “systemic” shock (owing to the abundance of capital flows to emerging economies) that could not be addressed by conventional policies (Chile).
Design of the Short-Term Capital Inflow Controls
Although in all cases the controls were adopted for broadly similar reasons, the design of the measures varied. All five countries used some form of market-based controls (mainly in the form of direct or indirect taxation of inflows and other regulatory measures, such as asymmetric open position limits and reporting requirements). In some cases, these controls were supplemented by administrative or direct controls (Brazil, Chile, and Malaysia).
Brazil adopted an explicit tax on capital flows (the “entrance tax” on certain foreign exchange transactions and foreign loans),3 in combination with a number of administrative controls (outright prohibitions of or minimum maturity requirements on certain types of inflows). The coverage of the measures was extended as the market adopted derivatives strategies based on exempted inflows to circumvent the controls; and the tax rates were successively raised or differentiated by maturity to target short-term inflows. The regulations were also adjusted at times of downward pressures on exchange rates, to reduce pressure on the capital account (for example, during the Mexican and Asian crises).
Chile combined market-based controls (indirect taxation of inflows through an unremunerated reserve requirement (URR)) with direct (minimum stay requirement for direct and portfolio investment) and other regulatory measures (minimum rating requirement for domestic corporations borrowing abroad and extensive reporting requirements on banks for all capital account transactions). The URR was initially imposed on foreign loans (except for trade credits), but subsequently rates were raised and coverage extended to those inflows that became potential channels for short-term inflows, including foreign direct investment of a potentially speculative nature. Similarly, in Colombia, the URR was imposed on external borrowing with a maturity of less than 18 months (including certain trade credits), but was later adjusted by imposing higher rates for shorter maturities, changing the deposit term, and extending the coverage of inflows subject to the URR. Malaysia adopted a combination of administrative (prohibition of nonresident purchases of money market securities and non-trade-related swap transactions with nonresidents) and regulatory measures (asymmetric limits on banks’ external liability positions for nontrade purposes and reserve requirements on ringgit funds of foreign banks). And Thailand adopted a number of indirect, market-based measures (asymmetric open position limits, detailed information requirements, and reserve requirements on nonresident bank accounts and baht borrowing, finance company promissory notes, and banks’ offshore short-term borrowing).
Effectiveness and Costs of Controls on Short-Term Capital Inflows
The effectiveness of the controls in achieving their intended objectives was mixed.4 The principal macroeconomic motivation for inflow controls was to maintain a suitable wedge between domestic and foreign interest rates while reducing pressures on the exchange rate. Controls seem to have had some effect initially, but in none of the five countries do they appear to have achieved both objectives. Most countries were able to maintain a large interest rate differential, but some had to adjust their exchange rates gradually under sustained upward market pressures (Brazil, Chile, and Colombia). Real exchange rates appreciated significantly in all five countries (to a lesser extent in Thailand and Malaysia), with more or less deterioration in the external current balances. The controls did not seem to be effective in reducing the total level of net inflows (except in Malaysia and Thailand), but seemed to be at least partly successful in reducing short-term capital inflows. Sterilization operations also had to continue in some countries to absorb the continuing inflows, with their associated costs to the central bank (Brazil and Chile). In sum, there is some evidence that the inflow controls were partly effective (1) in Malaysia and Thailand, in reducing the level and affecting the maturity of the inflows while curtailing sterilization operations, and (2) in Colombia and possibly in Chile, in maintaining a wedge between domestic and foreign interest rates and affecting somewhat the composition of the inflows.5 The controls maintained by Brazil appear to have been largely ineffective in achieving their stated objectives (as detailed in Part II, Chapter V).
A number of factors may have played a role in the effectiveness (or lack thereof) of the controls in realizing their intended objectives, though it is not possible to be certain. In Brazil, well-developed and sophisticated financial markets (with active trading of currency futures and other derivatives) seem to have reduced the cost of circumventing the continuously widening coverage of the regulations. Incentives to do so were strong owing to large interest rate differentials and expectations of a stable exchange rate. Similarly, in Chile, the dynamic response of optimizing agents in a sophisticated financial system seems to have reduced the effectiveness of the initial set of regulations and facilitated the exploitation of loopholes in the system. The Chilean authorities in turn were obliged to continuously extend the coverage of the regulations to the extent permitted by legal and political considerations. While strong enforcement capacity through a comprehensive information and disclosure system between the central bank of Chile and the commercial banks may have been instrumental in identifying the loopholes, the exemption of trade credits from the controls and political constraints on closing all potential loopholes seem to have weakened the effectiveness of the controls over time. In Colombia, subjecting certain trade credits to the URR may have eliminated a significant channel for circumvention, but the shift from debt creating inflows to other financing sources (e.g., foreign direct investment) opened another potential channel for circumvention.
Factors other than controls may also have played a role in reducing the volume of inflows or changing their maturity composition in some cases. These included (1) adjustments in monetary policy to narrow interest rate differentials and curtail sterilization operations (Malaysia); (2) a somewhat more flexible exchange rate arrangement to discourage speculative inflows (Chile and Colombia); (3) further strengthening of prudential regulations and supervision (Chile, Colombia, and Malaysia); and (4) a deterioration in investor confidence (Thailand). In addition, potential data problems—as well as an increase in short-term inflows channeled through exempted inflows and thus not recorded as such (trade credit in Chile and foreign direct investment flows in the case of Colombia)—may potentially hide the magnitude of short-term inflows and give a misleading picture in terms of the effectiveness of the controls.
The foregoing suggests the following tentative conclusions. First, to be effective, the coverage of the controls needs to be comprehensive, and the controls need to be forcefully implemented. Considerable administrative costs are incurred in continuously extending, amending, and monitoring compliance with the regulations. Even then, controls may lose effectiveness over time as markets exploit the potential loopholes in the system to channel the “un-desired” inflows through the exempted ones. The effectiveness of the controls seems to be limited by sophisticated financial markets, which reduce the cost of circumvention relative to the incentives.6 Second, although capital controls appeared to be effective in some countries, it is difficult to be certain of their role given the problems involved in disentangling the impact of the controls from that of the accompanying policies, which included the strengthening of prudential regulations, greater exchange rate flexibility, and adjustment in monetary policies. Third, inflow controls may not be ideally suited as instruments of prudential policy, as they are often imposed and modified for macroeconomic rather than micro-economic reasons, for example at times of downward pressure on exchange rates (Brazil during the Mexican and Asian crises and Chile and Colombia during the Asian crisis).
The experience of a number of countries (e.g., Brazil and Thailand) also suggests that the use of controls on inflows may not provide lasting protection against reversals in capital flows if they are not accompanied by necessary adjustments in macro-economic policies and strengthening of the financial system. In these cases (as well as in Colombia), resorting to capital controls may actually have delayed the necessary policy adjustments, making the eventual adjustment more severe. Moreover, in countries with weak prudential and supervisory frameworks, banking systems took on excessive risks despite the controls (Thailand).
Capital Outflow Controls During Financial Crises
This section examines the experiences of Malaysia (1998–present), Spain (1992), and Thailand (1997–98) with the use and effectiveness of selective controls on capital outflows, with a focus on the role that the controls may have played in coping with crisis situations. Figures 10–18 illustrate developments in key economic indicators during these episodes, and Part II, Chapter VI, provides further details of the country experiences.
Figure 10.Countries with Selective Controls on Outflows (left column) and with Extensive Controls (right column): Net Private Capital Flows
Source: IMF’s World Economic Outlook database.
Figure 11.Countries with Selective Controls on Outflows (left column) and with Extensive Controls (right column): Foreign Exchange Reserves
Source: IMF’s International Financial Statistics database.
Figure 12.Countries with Selective Controls on Outflows (left column) and with Extensive Controls (right column): Current Account Balance
Source: IMF’s World Economic Outlook database.
Figure 13.Countries with Selective Controls on Outflows (left column) and with Extensive Controls (right column): Real Effective Exchange Rate
Source: IMF’s Information Notice System database.
Figure 14.Countries with Selective Controls on Outflows (left column) and with Extensive Controls (right column): Real Effective Exchange Rate
Source: IMF’s International Financial Statistics database. For Spain, the exchange rate is computed with respect to the deutsche mark.
Figure 15.Countries with Selective Controls on Outflows (left column) and with Extensive Controls (right column): Inflation
Source: IMF’s International Financial Statistics database.
Figure 16.Countries with Selective Controls on Outflows (left column) and with Extensive Controls (right column): Monetary Aggregates
Source: IMF’s International Financial Statistics database.
Figure 17.Countries with Selective Controls on Outflows (left column) and with Extensive Controls (right column): Short-Term Interest Rate Differentials
Sources: Various, including IMF’s International Financial Statistics database and country authorities. The charts show the simple and depreciation-adjusted short-term interest rate differentials with the reference country (Germany for Spain and United States for all others). Due to data availability, the type of domestic currency–denominated financial instrument varies by country.
Figure 18.Countries with Selective Controls on Outflows (left column) and with Extensive Controls (right column): Local Stock Exchange Index
Sources: International Finance Corporation’s Emerging Markets database, Reuters, and country authorities
Motivations for Imposing Capital Outflow Controls During Financial Crises
The desire of the authorities to limit downward pressure on their currencies has been one of the most frequent motives in imposing controls on capital outflows. Earlier reviews of country experiences indicated that such restrictions have mainly been applied to short-term capital transactions to counter volatile speculative flows that threatened to undermine the stability of the exchange rate and deplete foreign exchange reserves. These restrictions have also served at times as an alternative to the prompt adjustment of economic policies and thus helped the authorities “buy time.” They have also been employed to insulate the real economy from volatility in the international financial markets (see Bakker, 1996, p. 20).
All three countries reimposed controls on capital outflows in the context of significant downward pressure on the exchange rate: Spain during the European currency turmoil of the fall of 1992, and Malaysia and Thailand in the context of the Asian financial crisis of 1997–99. Spain was a member of the European Monetary System’s ERM (exchange rate mechanism), where decisions on exchange rate realignments were subject to agreement with the other members of the system; Thailand was maintaining a pegged exchange rate regime when the controls were imposed; and Malaysia had been following a managed float, before fixing the ringgit vis-à-vis the U.S. dollar along with the imposition of the controls in September 1998. In all three countries, the controls aimed at containing speculation against the currencies and stabilizing the foreign exchange markets against a backdrop of sharply declining official foreign exchange reserves. Room to use interest rates in defense of the exchange rate was limited in all three countries—in Spain, by market concerns about adverse macroeconomic fundamentals, including a large fiscal burden, and in Malaysia and Thailand, by concerns about the adverse impact of high interest rates on fragile domestic economies and banking systems. In Spain, the peseta had been devalued by 5 percent before the imposition of the controls, but market pressures had not subsided. A further realignment of the exchange rate appeared necessary but could not be carried out immediately given high tensions within the ERM, which also ruled out interest rate increases, while the authorities’ strong commitment to European Monetary Union (EMU) precluded an exit from the ERM.
In all three countries, the controls were imposed in an environment where capital account transactions had already been largely liberalized. Spain’s capital account had been completely liberalized seven months before the reintroduction of the capital controls, while those of the other two countries had been fairly open (mainly on the inflow side in Thailand). Malaysia had liberalized most portfolio outflows, except for corporations with domestic borrowing, and had adopted a liberal approach to portfolio inflows. Malaysia had also liberalized cross-border transactions in ringgit, including for trade-related transactions, and financial transactions with nonresidents; offshore trading of ringgit securities was tolerated. In Thailand, nonresidents were free to obtain baht credit from domestic banks and operate in well-developed spot and forward markets. As a result, an active offshore market had developed for both the ringgit and the baht.
Design of Capital Outflow Controls During Financial Crises
While the design of the controls imposed by the three countries varied significantly, in all cases they mainly targeted the activities of nonresidents (identified as “speculators”), by restricting their access to domestic currency funds that could be used to take speculative positions against the domestic currencies. The controls explicitly exempted current international transactions, foreign direct investment flows, and certain portfolio investments. In Spain, the controls took the form of a compulsory, non-interest-bearing 100 percent deposit requirement on domestic banks, to discourage speculation by making it costly for banks to engage in certain transactions with nonresidents. The requirement initially applied to increases in banks-long foreign currency positions, peseta-denominated deposits and loans to nonresidents, and peseta-denominated liabilities of domestic banks with their branches and subsidiaries. These requirements were subsequently limited to a single deposit requirement on increases in banks’ swap transactions with nonresidents (seen as the most likely avenue for speculation). In Thailand, a two-tier currency market was created, with the goal of segmenting the onshore market from its offshore counterpart through a mix of direct and market-based measures. In particular, the Thai banks were required to suspend all transactions with nonresidents that could facilitate a buildup of baht positions in the offshore market (involving spot and forward sales, and lending via swaps); the repatriation of proceeds from asset sales in baht were prohibited and their conversion had to be on the basis of onshore exchange rates.
In Malaysia, the controls were more wide-ranging and combined capital controls with exchange controls, but without restricting payments and transfers for current international transactions and foreign direct investment. After an initial (and in effect unsuccessful) attempt in August 1997 to isolate the domestic market from the off shore market,7 a number of direct controls were adopted to stabilize the onshore ringgit market by eliminating its offshore counterpart, where speculative pressures on the ringgit had been putting pressure on domestic interest rates. Practically all legal channels for a possible buildup of ringgit funds offshore were eliminated. Offshore ringgit were required to return onshore, limits were imposed on imports and exports of ringgit currency, the use of ringgit in trade payments and offshore trading of ringgit assets were prohibited, and transfers between external accounts of nonresidents and ringgit credit facilities between residents and nonresidents were prohibited. To contain the outflows, transfers of capital by residents were also limited, and repatriation of nonresident portfolio capital was blocked for 12 months. In February 1999, the latter measure was replaced with exit levies on the repatriation of portfolio capital that decline with the holding period of the investment. The controls were supported by additional measures to eliminate potential loopholes, including an amendment of the Company Act to limit distribution of dividends while still complying with Malaysia’s obligations under Article VIII of the IMF’s Articles of Agreement, and the demonetization of large denominations of ringgit notes to limit the outflow of ringgit funds.
Effectiveness and Costs of Controls on Capital Outflows During Financial Crises
The effectiveness of the controls in realizing their intended objectives was mixed. In Malaysia, elimination of most potential sources of access to ringgit by nonresidents effectively eliminated the offshore ringgit market, and, together with the restrictions on nonresidents’ repatriation of portfolio capital and on residents’ outward investments, contributed to the containment of capital outflows. In conjunction with other macroeconomic and financial policies, the controls helped to stabilize the exchange rate. Since the introduction of the controls, there have been no signs of speculative pressures on the exchange rate, despite the marked relaxation of fiscal and monetary policies to support weak economic activity. Nor have there been signs that a parallel or nondeliverable forward market is emerging; and no significant circumvention efforts have been reported. In Spain, initially the large deviation of onshore from offshore interest rates and the stabilization of the peseta within its ERM bands suggested that the controls had succeeded in curtailing access to peseta funds by speculators, in segregating the onshore and offshore markets, and thus in limiting speculation against the peseta. However, once the scope of controls was reduced and clarified, the differentials narrowed. The peseta again came under pressure in November, which recurred as weekends approached until the peseta was devalued in a negotiated realignment of the ERM in late November 1992, after which the controls were lifted and the authorities moved to raise interest rates. In Thailand, large differentials initially emerged between offshore and onshore interest rates, trading in the swap market virtually stopped, and speculative attacks temporarily ceased. However, the controls soon began to develop leaks, pressure on the baht resumed, and within two months after the controls were imposed, the authorities floated the baht. Most of the controls were abolished or substantially modified at the end of January 1998; the prohibition of banks’ noncommercial transactions with nonresidents was replaced with limits; and the two-tier market was unified.
A number of factors may have played a role in the relative effectiveness of the measures. In Spain, the wide-ranging and restrictive measures as first introduced effectively curbed not only speculative activities, but a much broader range of transactions, including financial operations associated with the hedging of exchange rate risk by nonresident importers and exporters. Initial uncertainty about the precise scope of the measures may also have dampened activity in the market. The authorities subsequently clarified the regulation and narrowed the coverage of the deposit requirement to swap operations, which were identified as the preferred method of speculative financing. Market participants took advantage of additional loopholes, given the expectations of further peseta depreciation. Similarly, the controls seem to have been initially effective in Thailand, reflecting the absence of extensive sales by domestic holders of baht assets and the strict application of the controls by the central bank and commercial banks. The effectiveness of the measures was eventually undermined by the persistently large return differentials in the still active offshore market and expectations of baht depreciation. The controls may have delayed the implementation of a comprehensive structural reform and stabilization package, and thus worsened the crisis.
In Malaysia, the wide-ranging nature of the measures and their strict and effective enforcement by the authorities and the commercial banks seem to have been instrumental in effectively eliminating the offshore ringgit market and thus in contributing to the containment of the speculative pressures. The relatively favorable economic fundamentals of Malaysia at the outset, the authorities’ efforts to disseminate information to increase the transparency of the controls, and their efforts to accelerate the strengthening of the financial sector also seem to have played an important role in improving the acceptability of the measures both domestically and internationally. The general return of confidence in the region, the sharp improvement in Malaysia’s external balance, and the ex post undervaluation of the ringgit following its peg to the U.S. dollar (while other currencies in the region started to appreciate) also seem to have reduced the incentives for circumvention. It is too early to judge at this stage whether the controls will have long-run adverse effects on investor sentiment.
In short, the reimposition of controls on capital outflows during episodes of financial crisis seems to have provided only a temporary respite of varying duration to the authorities. The controls gave the Malaysian authorities some breathing space to address the macroeconomic imbalances and implement banking system reforms. In Spain, the measures did not avoid a second realignment of the peseta, though they may have provided some additional time in negotiating the realignment within the ERM. The experiences of the three countries suggest that (1) to be effective, the controls must be comprehensive, strongly enforced, and accompanied by necessary reforms and policy adjustments; (2) controls do not provide lasting protection in the face of sufficient incentives for circumvention, in particular attractive return differentials in the offshore markets and strong market expectations of exchange rate depreciation; (3) the ability to control offshore market activity may have been instrumental in containing outflows and stemming speculative pressures; and (4) effective measures risk discouraging legitimate transactions, including foreign direct investment (Malaysia) and trade-related hedging transactions (Spain), and may raise the cost of accessing international capital markets (as indicated by the rise in Malaysia’s relative risk premium following the controls). The effectiveness of Malaysia’s controls was probably further enhanced by the strengthening of controls over residents’ outward investment.
Extensive Exchange Controls During Financial Crises
This section draws on the experiences of three countries, Romania (1996–97), Russia (1998–present), and Venezuela (1994–96), that resorted to extensive systems of controls on both current and capital transactions in connection with crises. These crises entailed severe downward pressure on exchange rates and a sharp reduction in foreign exchange reserves owing to extensive official foreign exchange intervention. Part II, Chapter VII, provides further details of the country experiences.
Motivations and Design of Extensive Exchange Controls During Financial Crises
All three countries resorted to extensive exchange controls to stabilize their foreign exchange markets. The controls involved administrative measures to close or significantly restrict access to the foreign exchange market for both current international payments and transfers, and capital movements. Romania and Russia had been maintaining fairly restrictive capital account regimes prior to the imposition of the controls. By contrast, Venezuela’s capital account was highly liberalized; and the imposition of controls was thus a sharp reversal of policy. Both Russia and Venezuela had achieved current account convertibility prior to the episodes under consideration.
In Romania, the measures took the form of a suspension of the foreign exchange dealer licenses of all but four state-controlled banks, and limits on the overnight cash position of foreign exchange bureaus, which severely constrained the operation of the foreign exchange market. In Venezuela, the measures consisted of restrictions on the availability of foreign exchange for import and export payments, and for invisible transactions; surrender requirements on export receipts and certain capital inflows; and a prohibition on the repatriation of nonresident investments and all other capital transactions, except for the repayment of external debt.
In Russia, the measures were even more extensive, and combined a reintensification of capital controls (tightening of existing restrictions and reimposition of inflow controls) with restrictions on current international transactions (temporary closing of the interbank foreign exchange market and creation of a dual market), and debt default. The combination of capital controls with debt default may have been motivated by concerns about a massive capital outflow, the accompanying depreciation of the ruble, and a fragile banking system with large unhedged foreign exchange positions. The authorities abandoned the exchange rate band as downward pressures persisted after the adoption of the measures. By contrast, in Venezuela and Romania, the controls were accompanied by a temporary fixing of the exchange rate.
Effectiveness and Costs of Extensive Exchange Controls During Financial Crises
It is not fully clear whether the controls achieved their intended objectives. In Romania and Venezuela, the controls seem to have contained some of the initial pressures in the foreign exchange market, allowing the authorities to maintain relatively stable exchange rates for some time. Access to foreign exchange was severely constrained and parallel foreign exchange markets emerged. These markets were characterized by substantial premiums over the official rate, reflecting continued macroeconomic imbalances and problems in the financial system. In Russia, the full impact of the control measures remains to be seen, as the economic situation has not yet been durably stabilized. Despite the pervasiveness of the measures, foreign exchange market pressures did not subside until the first quarter of 1999, reserves continued to decline, and outflows increased sharply. This deterioration took place against the background of continued fiscal problems and a further weakening of the banking system. The sharp depreciation of the ruble contributed to a full-scale financial crisis, as banks’ large unhedged foreign currency positions, which had been accumulated under the tightly managed exchange rate regime, caused large foreign exchange losses. In none of the three countries did the measures fully succeed in stemming capital outflows.
It seems, however, that in Venezuela the controls increased the degree of monetary policy autonomy in the context of a fixed exchange rate system. The lower interest rates associated with the controls may have enabled the government to reduce the immediate cost of the banking crisis and improve its fiscal balance, possibly at the expense of higher external debt service and more limited access to international financial markets. In this regard, it is noteworthy that Venezuela’s share in total foreign direct investment in Latin America fell while the controls were in effect, and increased when they were lifted. However, these developments may also reflect foreign investors’ views on the banking system and the political situation. Similarly, the interest rate differential on Venezuela’s Brady bonds fell sharply following the lifting of the controls. Difficulties in accessing foreign capital were also observed in Romania, and foreign direct investment declined relative to other transition economies. More severe problems of this type were observed in Russia, where access to international capital markets halted, foreign direct investment inflows fell sharply, and the yield differential on Russian securities rose significantly, though these developments may have largely reflected the chilling effect of debt default.
Extensive controls on capital and current international transactions may temporarily relieve pressures on the balance of payments, but they do not provide lasting protection when the fundamental causes of the imbalances remain unaddressed. As with the more targeted controls discussed in the section on capital outflow controls during crises, the controls in Romania, Russia, and Venezuela may have reduced access to foreign capital. Difficulties of this sort seem to have motivated the authorities in Romania and Venezuela to remove the restrictions (with Venezuela opting for a big bang approach), and to address macroeconomic and financial sector imbalances.
Long-Standing and Extensive Controls and Their Liberalization
While China and India were not been immune to the Asian crisis of 1997–98, they were less affected by it than other countries in the region. The relatively closed capital account regimes of these two countries have been credited with helping to limit vulnerability to financial contagion, though other factors may have played a role as well, including most notably large and relatively closed economies and strong foreign exchange reserves positions. While the Asian countries most affected by the crisis suffered severe recessions and major banking problems, both India and China experienced only a minor slowdown in their strong growth, and the impact of the crisis on their financial systems was limited. China was able to maintain the de facto peg of its currency to the U.S. dollar. India continued to follow a flexible exchange rate policy, which appears to have further reduced the impact of the crisis. Part II, Chapter VIII, provides further details of these country experiences.
Given the relatively early stages of financial market development and some structural shortcomings in their financial systems, both countries have followed a gradual and cautious approach to liberalizing their capital accounts. The restrictive capital account regimes in India and China have historically been just one facet of a generally closed and heavily state-controlled economic system. Nevertheless, economic liberalization, including external liberalization, has become an important medium-term goal in both countries. India in particular has made large strides toward reversing several decades of state domination of the economy, though the financial sector is still largely publicly owned and directed lending remains extensive. Capital controls have been quantity based, rather than price based, and have been administratively enforced. In both countries, the capital control regimes in place during the 1990s encouraged longer-term flows (in particular, foreign direct investment) over short-term ones, with the controls oriented toward limiting reliance on short-term and debt-creating flows. As a result, capital controls in both countries have shifted the composition of measured capital inflows toward longer-term flows and more creditworthy borrowers, partly by curtailing access of noncreditworthy domestic borrowers to foreign financing.
Effectiveness and Costs of Controls
While the capital controls in both China and India are believed to have been effective in limiting measured capital flows, there also seems to be some evidence of evasion and avoidance, for example, through the misinvoicing of trade transactions or large errors and omissions in the balance of payments statistics. In both countries, the extensive restrictions gave rise to significant administrative costs, burdened legitimate transactions, and may have reduced the efficiency of resource allocation.
While the effects on India of the Asian crisis in 1997–98 have not been severe, the country has nonetheless proven vulnerable to external shocks during periods of large domestic imbalances (in 1980 and 1990–91), though this vulnerability may have been lessened by the reorientation of capital controls since 1991 to discourage volatile foreign financing. In China, the authorities have noted that illegitimate current account transactions had facilitated substantial capital flight (about $11 billion during the first half of 1998), reflecting the outbreak of the Asian crisis. Concerns about large outflows—driven in part by fears of an imminent devaluation of the renminbi, the falling interest rate differential, and increased evasion—prompted the authorities to intensify the enforcement of the existing controls during the second half of 1998. Administrative screening of capital account transactions was enhanced and documentation and verification requirements for current international transactions were tightened. The authorities considered these measures to be necessary in view of their commitment to a stable exchange rate. In mid-1999, the authorities restricted overseas yuan transactions by prohibiting domestic banks from accepting inward remittances in domestic currency. The measure may have helped to prevent the illegal movement of yuan out of China, and to clamp down on offshore trading of the yuan by Chinese financial institutions. These measures were accompanied by other initiatives to facilitate the efficient operation of exchange controls, and in particular reduce the delays in approving legitimate transactions. The regulatory framework was made more transparent, and new technology was adopted to facilitate screening and enforcement.
The experiences of China and India seem to suggest that the long-standing and extensive controls on capital transactions may have had some role in reducing the vulnerability of these countries to the effects of the recent regional crisis. In particular, they helped shift the composition of capital inflows toward longer– term flows. However, other factors may have played a role as well in reducing their financial vulnerability. These include, for both countries, a strong external position with ample foreign exchange reserves; larger sizes of the domestic markets; relatively weak trade and financial linkages with the rest of the world compared with the other countries in the region; relatively earlier stages of financial market development, with a lower level of financial intermediation by the banking systems; and a flexible exchange rate policy in the case of India. In both India and China, enforcement of the controls was facilitated by strong administrative capacity.
Rapid Liberalization of Capital Controls
This section draws on the experiences with capital account liberalization of Argentina (1991), Kenya (1991–95), and Peru (1990–91)—all of which implemented a relatively rapid liberalization of the capital account. Argentina and Peru liberalized all capital transactions using a big-bang approach, and in Kenya the liberalization was also relatively rapid but spread over five years. Part II, Chapter IX, provides further details on these country experiences.
Earlier reviews of country experiences with the capital account liberalization have suggested that orderly liberalization required not only a proper sequencing and pace of changes in capital account regulations, but also strong and consistent supporting policies. The speed and sequencing of capital account liberalization have generally reflected a country’s initial conditions and its broader economic development and restructuring. As a consequence, countries have followed diverse approaches. Big-bang approaches have usually been part of programs intended to signal a strong commitment to reform.
Initial Circumstances and Motivations for Rapid Liberalization of Capital Controls
In all three countries, the liberalization of the capital account was preceded by a period of severe imbalances in the domestic economy. In the case of Argentina, liberalization took place following a period of hyperinflation, an almost complete loss of policy credibility, and a collapse in demand for money and banking services. These developments prompted the authorities to adopt the Convertibility Plan in 1991, which involved the establishment of a currency board, and the elimination of all restrictions on current and capital account transactions. Similarly, in Peru, liberalization followed a period of hyperinflation, depletion of foreign exchange reserves, and a sharp decline in output and investment in the late 1980s. In Kenya, liberalization followed a period of large fiscal deficits, a deteriorating balance of payments, severe shortages of foreign exchange reserves, high inflation, and a slowdown in economic growth.
Capital account liberalization was intended to signal a strong precommitment to reform and was motivated by a desire to create conditions that would attract foreign financing and achieve sustained growth. In all three countries, the liberalization of the capital account was just one part of a wide-ranging liberalization program that included the deregulation of the financial system (in particular, of interest rate and credit controls), trade liberalization, and privatization of public enterprises. In Argentina and Peru, attempts have also been made to strengthen the supervisory and regulatory frameworks for the financial system, maintain tight monetary and fiscal policies to make further progress in reducing inflation, and enhance labor market flexibility.
Effects of Rapid Liberalization of Capital Controls
Liberalization of the capital account was followed by an increase in foreign investment in Argentina and Peru, but only to a lesser extent in Kenya, where some initial pickup in capital inflows was reversed sharply from 1992. In Argentina, foreign direct investment and portfolio inflows reached 11 percent of GDP in 1993, compared with less than 1 percent in 1990. Subsequent capital outflows related to the Mexican crisis of 1994–95 were managed without resort to capital controls, with the authorities instead opting to tighten fiscal policy and provide some liquidity assistance to the banking system within the confines of the currency board. Further measures were also taken to strengthen the banking system and lengthen the maturity structure of the public debt.
In Peru, significant capital inflows were associated with an appreciation of the exchange rate and some deterioration in the current account. Current account deficits were financed partly by an increasing share of short-term inflows in total inflows. The increased reliance on short-term financial credit by banks made the financial system somewhat vulnerable, as evidenced by a weakening in the financial condition of several institutions. However, the authorities’ efforts to strengthen prudential regulations helped increase the resilience of the banking system. In the period following liberalization, growth resumed and inflation was reduced sharply.
The liberalization of the capital account failed to prevent a sharp economic downturn in Kenya, with the onset of an economic crisis, a significant rise in money supply and inflation, the emergence of external payment arrears, and a sharp depreciation of the currency. The crisis took place against the background of inconsistent economic policies ahead of the election period in the early 1990s, with governance problems in the financial system, weaknesses in prudential supervision, and delays in structural reform.
The experiences with rapid liberalization of the capital account highlight the importance of sound macroeconomic policies combined with ongoing efforts to strengthen the financial system and implement associated reforms. In the absence of adequate macroeconomic and financial policies, capital account liberalization may increase vulnerability to external and domestic shocks.