Info Service on Finance and Development (Jan12/01)
25 January 2012
Third World Network
Capital controls an important macroeconomic policy tool
Published in SUNS #7289 dated 18 January 2012
Geneva, 17 Jan (Kanaga Raja) -- Contrary to claims in the popular press,
by some in the economics profession as well as by some policymakers
that capital controls are inherently protectionist measures, such controls
can be justified ways to perform counter-cyclical balance to boom-and-bust
cycles, to maintain monetary independence, and to support exchange rate
and financial stability.
This is the main conclusion of a working paper by professor Kevin P.
Gallagher of Boston University, released this month by the Political
Economy Research Institute (PERI). The paper, titled "The Myth
of Financial Protectionism: The New (and Old) Economics of Capital Controls",
argues that capital controls are justified as an important part of the
macroeconomic toolkit from a wide variety of theoretical perspectives
Controls can be seen as the means to these ends through the Keynesian
and structuralist traditions, as well as through neo-classical based
theories, it says.
Indeed, the paper adds, the newest wave of neo-classical research on
the topic would brand controls not as protectionist policies, but as
"correctionist" policies that make global capital markets
work more efficiently.
According to the paper, unstable global capital flows to developing
countries have been characteristic of the world economy in the wake
of the global financial crisis.
"Such flows have triggered asset bubbles and exchange rate appreciation
in a number of emerging and developing country markets, especially from
2009 until the Eurozone jitters in the fourth quarter of 2011. In response,
some individual nations have deployed capital controls."
Resort to these measures has met a mixed response, says the paper. On
the one hand, institutions such as the International Monetary Fund have
supported the use of controls in limited circumstances. On the other
hand, however, there has been a vociferous response by leading politicians,
distinguished economists, and in the blogosphere claiming that the use
of capital controls amounts to financial protectionism.
The paper notes that former UK Prime Minister Gordon Brown referred
to the use of controls by emerging markets in 2010 as protectionist,
as has former Nobel laureate Michael Spence.
However, the paper argues, such claims are unfounded.
"There is a longstanding strand of modern economic theory that
dates back to [John Maynard] Keynes and [Raul] Prebisch, and continues
to this day, that sees the use of capital controls as essential to financial
stability, the ability to deploy an independent monetary policy, and
to maintain exchange rate stability. These theories were supplanted
in the 1980s and 1990s by theories of capital market liberalization."
However, the empirical record has shown that capital market liberalization
was not associated with growth in developing countries. In a most recent
development, mainstream economists have developed a "new welfare
economics" of capital controls that sees controls as measures to
correct for market failures due to imperfect information, contagion,
uncertainty and beyond.
Taken as a whole then, rather than the "new protectionism,"
capital controls should be seen as the "new correctionism"
that re-justifies a tool that has long been recognized to promote stability
and growth in developing countries, the paper emphasises.
According to professor Gallagher, capital controls are regulations on
capital flows that buffer from a number of risks that come with financial
integration. Chief among those risks are currency risk, capital flight,
financial fragility, contagion, and sovereignty.
Cross-border capital flows to emerging and developing countries tend
to follow a similar pattern. Between 2002 and 2007, there were massive
flows of capital into emerging markets and other developing economies.
After the collapse of Lehman Brothers, there was capital flight to the
"safety" of the US market, which spread the North Atlantic
financial crisis to emerging markets. As interest rates were lowered
for expansionary purposes in the industrialized world between 2008 to
2011, capital flows again returned to emerging markets, where interest
rates and growth were relatively higher.
Finally with Eurozone jitters in the final quarter of 2011, capital
flight occurred to the "safety" of the US and beyond. The
carry trade was one of the key mechanisms that triggered these flows.
Increased liquidity induced investors to go short on the dollar and
long on currencies in nations with higher interest rates and expectations
of strengthening exchange rates.
With significant leverage factors, investors gained on both the interest
rate differential and the exchange rate movements. Many nations deployed
capital controls to regulate the negative effects of cross-border capital
The paper notes that economists usually differentiate between capital
controls on capital inflows and controls on outflows. Moreover, measures
are usually categorized as being "price-based" or "quantity-based"
Listing examples of controls on inflows and outflows, the paper finds
that sometimes the distinction can be murky. Examples of quantity-based
controls are restrictions on currency mismatches, and minimum stay requirements
and end-use limitations.
Many of these have been used by nations such as China and India. Examples
of price-based controls include taxes on inflows (Brazil) or on outflows
(Malaysia). Un-remunerated reserve requirements are both. On one hand
they are price-based restrictions on inflows, but they also include
a minimum stay requirement which can act like a quantity-based restriction
The paper underscores that controls are most often targeting foreign-currency
and local currency debt, equity, and currency trading of a short-term
Foreign direct investment is often considered less volatile and less
worrisome from a macroeconomic stability standpoint. Inflow restrictions
on currency debt can reduce the overall level of such borrowing and
steer investment toward longer-term productive investments and thus
Taxes on such investment cut the price differential between short- and
long-term debt and thus discourage investment in shorter-term obligations.
Outflows restrictions and measures are usually deployed to "stop
the bleeding" and keep capital from leaving the host nation too
A variety of these techniques have been used during the global financial
crisis but have been branded as protectionist measures, the paper notes.
It points out that two major economists of the early 20th century were
among the first to discuss the need for capital controls in modern economic
theory. Raul Prebisch and John Maynard Keynes each articulated the need
for regulating cross-border capital as a macroeconomic management tool
in order to allow for national policy autonomy to generate productive
Each of these economists spawned "post-structuralist" and
"post-Keynesian" approaches to economic policy. Leaders in
these fields, as well as policymakers have further developed and justified
these early contributions by Prebisch and Keynes.
New archival work by economists Esteban Perez and Matias Vernengo (2012)
has unearthed how Prebisch in particular had, "a preoccupation
with the management of the balance of payments and the need for capital
controls as a macroeconomic management tool, considerably before Keynes
and White's plans led to the Bretton Woods agreement."
Professor Gallagher adds: "Of course the name that most would say
is the intellectual antecedent of the contemporary use of capital controls
is Keynes. Keynes saw the regulation of speculative capital as essential
to maintain national autonomy for productive growth and employment."
In a statement that foreshadows much of the concerns of today that relate
the carry trade to excessive capital flows in the wake of the financial
crisis (with an unregulated carry trade raising the interest rate to
cool off asset bubbles will actually attract more speculative capital,
not less), Keynes said: "In my view the whole management of the
domestic economy depends on being free to have the appropriate rate
of interest without reference to the rates prevailing elsewhere in the
world. Capital controls is a corollary to this."
According to the Gallagher paper, Paul Davidson points out that Keynes
also says controls as a means to manage capital flow booms and busts:
If there is a sudden shift in the private-sector's bull-bear disposition,
what can be called the bandwagon effect, then price stability requires
regulations constraining capital flows into and/or out of the market
to prevent the bears from liquidating their position too quickly (or
the bulls from rushing in) and overcoming any single agent (private
or public) who has taken on the responsible task of market maker to
During the Bretton Woods negotiations that established a fixed but adjustable
pegged exchange rate system, the International Monetary Fund (IMF),
and the World Bank, Britain's chief negotiator, Keynes, and his US counterpart
Harry Dexter White both agreed that a distinction should be made between
"speculative" capital and "productive" capital,
and that speculative "hot money" capital was to be scrutinized.
Indeed, says the paper, at those meetings, Keynes argued that, "control
of capital movements, both inward and outward, should be a permanent
feature of the post-war system." Capital controls (on capital account
transactions) were made fully permissible under the Articles of the
International Monetary Fund and remain so, despite efforts to the contrary,
to this day. As Keynes said, "What used to be a heresy is now endorsed
Both Post-Keynesian and Structuralist economists have continued to emphasize
that uncontrolled capital flows unleash serious financial risks and
macroeconomic constraints, which render economies vulnerable to financial
crises, exchange rate instabilities, slower output growth and greater
While the paper says that a full survey of this literature is beyond
its scope, it underlines that a handful of the core and more contemporary
examples are necessary to note in order to show that these schools have
long seen controls as a cornerstone of macroeconomic policy.
One of the more novel applications is in the Minsky tradition. To capture
the financial fragility inherent in a regime of free capital flows,
Weller (2001) and Arestis and Glickman (2002) extend Hyman Minsky's
financial instability hypothesis to an open and financially liberalized
In a financially liberalized open economy without capital controls,
an economic boom will significantly "import the drive towards financial
innovation" by attracting capital inflows from foreign investors
looking for new investment opportunities and enabling households, firms,
the government and banks to seek foreign sources of finance.
The initial economic euphoria, reflected in rising asset prices, investments
and profits, acts to validate and encourage these foreign borrowings.
Capital inflows produce an appreciation of the domestic currency, and
thus encourage the taking of short-term positions in foreign currency.
The euphoria also causes economic units to become more reckless in the
risks they undertake, and resort to greater speculative financing.
However, says the Gallagher paper, over time, the initial economic boom
and resulting increase in demand also acts to increase costs in the
domestic capital goods industries. These rising costs, combined with
the surge in speculative financing act to generate present-value reversals,
and a decline in asset prices. With an erosion of their profit margin,
over time, some speculatively financed units are likely to begin to
default, and the chances of more units following suit increases.
Furthermore, the increase in foreign borrowings, particularly short-term
liabilities, results in a rising debt-to-reserves ratio. Without capital
controls, and given the rapid reversal tendency of short-term capital
flows, both these developments will generate a panic among foreign investors,
resulting in a rapid flight towards liquidity and a heavy selling of
the domestic currency. Capital flight acts to reduce the values of assets,
and through possible spillover effects in other sectors, it tends to
aggravate the risk of a sharp depreciation in the domestic currency,
making a country vulnerable to a financial crisis.
Given the volatile and pro-cyclical nature of free capital flows and
their destabilizing effects, Post-Keynesian and Structuralist economists
(e. g., Davidson, Eatwell and Taylor, Ocampo, Helleiner, Saad-Filho,
Palma and Grabel) have argued for a permanent system of capital account
regulation, which not only regulates capital outflows during financial
crises, but also controls capital inflows during economic booms.
The paper says: "This could involve regulating the international
exposure of domestic banks, regulating the availability of foreign exchange
to domestic banks and private sector residents, and reducing real deposit
rates. By helping to avoid over-borrowing, such a system provides a
means of exercising monetary and domestic credit restraint during economic
booms, and thereby guards against unsustainable exchange rate appreciations,
and thus against the very occurrence of crises. In the event that a
crisis nevertheless occurs, regulating capital outflows can help to
avoid a sharp currency depreciation, and unmanageable increases in debt-service
With respect to the threat of capital flight, Grabel (2006) emphasizes
that policies restricting capital account convertibility help to reduce
this risk by discouraging foreign investors from buying short-term assets
that are most vulnerable to capital flight and by restricting their
ability to liquidate such investments and send the proceeds out of the
Furthermore, says the paper, by reducing a country's vulnerability to
sharp exchange rate fluctuations, capital flight and financial fragility,
capital controls can guard against the risk of contagion due to financial
and macroeconomic instability in another economy.
According to the paper, Frenkel (2002) argues that the destabilizing
effects of unregulated capital inflows (e. g., unsustainable expansions
in credit and liquidity, exchange rate appreciations and appreciation
of financial and real assets) will be exacerbated in developing countries
when financial markets are small, and not sufficiently diversified.
He cites the Latin American experience, where liberalization was introduced
in an environment in which the degree of monetization and financial
depth was low, banking systems were weak, the menu of financial assets
was poor and credit for the private sector was scarce.
The Post-Keynesian and Structuralist literature also draws attention
to the fact that free capital flows severely reduce the degrees of freedom
for macroeconomic management and policy autonomy since sustaining private
foreign capital inflows require a strong exchange rate and high interest
rates. A high interest rate acts to discourage domestic investment,
while an appreciating exchange rate reduces the competitiveness of a
country's exports. Thus, the ability to stimulate domestic investment
(in accordance with national priorities of output and employment) is
curtailed, and it becomes difficult for a country to use the exchange
rate as a strategic device for gaining entry into the world market for
Moreover, as pointed out by Davidson (2000), besides a loss of export-market
share, an appreciating exchange rate also threatens domestic firms with
a loss of home-market share since imports become cheaper. By making
it more difficult for domestic entrepreneurs to gauge the potential
profitability of large investment projects involving significant irreversible
sunk costs, exchange rate volatility can have serious adverse effects
on domestic investment.
Nayyar (2002) also argues that when short-term inflows such as portfolio
investment become a major means of financing trade and current account
deficits, the resulting appreciation of the real effective exchange
rate acts to further widen these deficits. A vicious circle emerges,
with these larger deficits requiring even greater portfolio investment
inflows. Persistent large deficits may, over time, reduce investor confidence,
and thus generate adverse expectations, ultimately resulting in a reversal
of inflows and speculative attacks on the domestic currency.
The paper says that besides constraining policies in normal times, free
capital mobility also severely constrains policy autonomy during a financial
crisis, therefore exacerbating problems of falling output, reduced domestic
investment and unemployment. As Grabel (2006) argues, a crisis forces
a government to resort to contractionary monetary and/or fiscal policies
(through higher interest rates and reduced social spending) so as to
reverse a capital flight. This curtails the ability to use expansionary
policies (such as government deficits or low interest rates) to stimulate
aggregate demand and domestic investment.
Epstein and Schor (1992) develop a macroeconomic model which captures
how capital controls allow for macroeconomic management and policy autonomy
by controlling the links between the domestic real interest rate, capital
flows and real exchange rate. By providing a safeguard against capital
flight, a system of effective capital controls allows a government to
pursue an expansionary monetary policy by lowering the domestic real
interest rate without significantly affecting the real exchange rate
or foreign exchange reserves. By stimulating domestic investment, an
expansionary monetary policy can therefore be used to raise domestic
output and employment.
Similarly, says the paper, even if an expansionary fiscal policy raises
the domestic real interest rate, by restricting capital inflows, capital
controls will cause the real exchange rate to appreciate less than it
would in the case of unrestricted inflows. Less exchange rate appreciation
in turn would mean that export competitiveness is less adversely affected.
Finally, by regulating capital outflows, capital controls also insulate
an economy from adverse effects on domestic investment and/or export
competitiveness due to changes in foreign real interest rates or foreign
The paper adds: "Backed by new developments in economic theory
and interest groups that sought to deepen global capital markets, capital
account liberalization became vogue in the 1980s and 1990s. While capital
market liberalization seemed to be correlated with economic growth in
the industrialized world during this period, the same cannot be said
in developing country contexts. Towards the end of this liberalization
in the early 1990s, however, currency crises erupted and many developing
nations became afflicted with financial crises. In lieu of this, the
merits of capital account liberalization in developing countries came
under great scrutiny in the early 2000s and even more so in the wake
of the financial crisis."
In terms of empirical evidence, it has been shown that capital market
liberalization in developing countries is not associated with economic
growth. Indeed, the most recent research has shown that capital market
liberalization is only associated with growth in nations that have reached
a certain institutional threshold - a threshold that most developing
nations are yet to achieve. This is partly due to the fact that the
binding constraint for some developing country growth trajectories is
not the need for external investment, but the lack of investment demand.
This constraint can be accentuated through foreign capital flows because
such flows appreciate the real exchange rate, thus reducing the competitiveness
of goods and reducing private sector willingness to invest.
The paper goes on to address the new welfare economics of capital controls,
saying that the demise of capital market liberalization has only been
accentuated by the global financial crisis. As global capital flows
became recognized as having adverse effects in the wake of the crisis,
UN agencies and governments with Post-Keynesian and Post-Structuralist
tendencies have regained their legitimacy.
"What is equally remarkable is a new strand of economic theory
has arisen in response to the inadequacies of capital market liberalization
and the recognition of the inherent instability of capital flows to
developing countries. ‘New' Keynesians working in a general equilibrium
context have begun to see capital controls as measures to correct for
market failures in the world economy - thus arguing that controls are
market correcting rather than distortionary or protectionist. This has
been referred to as the ‘new welfare economics of capital controls'."
Citing the Mundell-Fleming model, the paper says that one main conclusion
of Robert Mundell (1963) is that perfect capital mobility, a fixed exchange
rate regime, and independent monetary policy cannot all coexist; countries
can maintain at most two of the three. This so-called "trilemma,"
continues to be reinforced by empirical studies and thereby remains
a central assumption of studies on capital flows.
The global financial crisis and the role that capital mobility played
in the crisis and its aftermath has attracted a burgeoning level of
theoretical attention not seen on this issue since the days of Mundell
and Fleming. Indeed, recent studies of capital controls directly model
the welfare implications of controls by focusing on the externalities
of capital flows. These studies focus on the macro-prudential role of
capital controls. A Pigouvian tax on capital inflows is one such macro-prudential
policy that corrects for the externalities associated with highly integrated
Theoretical analysis with emphasis on externalities and welfare effects
can be described as the "new welfare economics" of capital
controls, as stated in Jeanne, Subramanian and Williamson (2012). The
main motivation of this literature stems from the recent global financial
crisis and the capital flow behaviour in emerging markets. In the recent
decade, emerging markets have been subject to substantial capital inflows
and a buildup of international reserves. Such high levels of external
borrowing raise the probability of sudden stops and capital flight.
As observed during the 2008-2009 financial crisis, de-leveraging and
fire sales of assets can result. Such are externalities associated with
financial contagion, yet on the international level.
According to the paper, the externalities arise because borrowers do
not internalize the impact of their behaviour on aggregate instability,
e. g. systemic risk and the likelihood of fire sales. The purpose of
the prudential capital control is then to induce private agents (borrowers)
to internalize the externalities. The optimal capital control is effectively
a Pigouvian tax on capital inflows, which will enhance welfare and restore
efficiency of the decentralized market equilibrium. This type of control
may then improve financial stability and prevent sudden stops or capital
flight. Indeed, emerging market economies such as Brazil have implemented
controls in the form of taxes on foreign debt; hence, their welfare
implications are highly relevant to current public policy.
The paper notes that rising capital market liberalization and the recent
global financial crisis has motivated many studies to examine the adverse
consequences of highly integrated markets. Joseph E. Stiglitz has been
a significant skeptic of capital market liberalization and has presented
arguments for intervention in capital flows based on empirical and theoretical
findings. The main arguments against full capital market capitalization
arise from the following outcomes of open markets: increased risk diversification,
more pro-cyclical capital flows, increased risk of contagion, increased
risk of capital flight, increased financial instability.
The paper also highlights that another newly designed theory examines
controls on capital flows in a portfolio allocation approach. Motivated
by the lack of a unified theoretical framework to analyse capital controls,
Magud, Reinhart, and Rogoff (2011) present a model to examine the effects
of controls on short-term capital flows.
Before presenting their model, Magud, Reinart, and Rogoff (2011) outline
four "fears" caused by open capital markets, describe the
measures and empirical results of existing studies, and provide results
from their standardization technique. The four fears pertain to financial
instability and thus explain the use of capital controls. All four are:
fear of appreciation or of a floating exchange rate, fear of "hot
money" flows, fear of large inflows, and fear of loss of monetary
In its overall conclusions, the paper notes that one objection to the
use of controls that has remained outside of theoretical discussions
is the efficacy of controls.
While stressing that a full review of this literature is beyond the
scope of the paper, it says that it is important to note that a mountain
of high-level research has recently shown that capital controls have
been effective in the 21st century.
In a February 2010 Staff Position Note, the IMF staff reviewed all the
evidence on capital controls on inflows, pre- and post-crisis and concluded:
"capital controls - in addition to both prudential and macroeconomic
policy - is justified as part of the policy toolkit to manage inflows.
Such controls, moreover, can retain potency even if investors devise
strategies to bypass them, provided such strategies are more costly
than the expected return from the transaction: the cost of circumvention
strategies acts as ‘sand in the wheels'".
To come to this conclusion, this recent and landmark IMF study reviews
the experiences of post-Asian crisis capital controls. The IMF also
conducted its own cross-country analysis in this study, which also has
profound findings, says professor Gallagher.
The econometric analysis conducted by the IMF examined how countries
that used capital controls fared versus countries that did not use them
in the run-up to the current crisis. They found that countries with
controls fared better: "the use of capital controls was associated
with avoiding some of the worst growth outcomes associated with financial
fragility". This work has been echoed by National Bureau of Economic
These landmark developments in theory and practice can be built upon.
Further research and policy is needed within and outside of economics,
the paper concludes. +
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