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Home , Capital account, Capital control

NOVEMBER/DECEMBER1999

Christopher J. Neely is a senior economist at the Bank of St. Louis. Kent Koch provided research assistance.

study of controls. First, the resump- An Introduction tion of large capital flows—trade in assets— to developing countries during the late to Capital 1980s and early 1990s created new prob- lems for policymakers. Second, a string of Controls /financial crises during the 1990s—the European Monetary System Christopher J. Neely crises of 1992-93, the Mexican crisis of 1994 and the Asian financial crisis of Moreover, it may well be asked whether 1997-98—focused attention on the asset we can take it for granted that a return transactions that precipitated them. In to freedom of exchanges is really a ques- particular, ’s adoption of capital tion of time. Even if the reply were in the controls on September 1, 1998, has affirmative, it is safe to assume that after prompted increased media attention and a period of freedom the regime of control has renewed debate on the topic. will be restored as a result of the next Modern capital controls were devel- economic crisis. oped by the belligerents in —Paul Einzig, Exchange Control, to maintain a tax base to finance wartime MacMillan and Company, 1934. expenditures. Controls began to disappear after the war, only to return during the Currency controls are a risky, stopgap of the 1930s. At that measure, but some gaps desperately time, their purpose was to permit coun- need to be stopped. tries greater ability to reflate their econo- —Paul Krugman, “Free Advice: mies without the danger of capital flight. A Letter to Malaysia’s Prime Minister,” In fact, the International Monetary Fund Fortune, September 28, 1998. (IMF) Articles of Agreement (Article VI, section 3) signed at the Bretton-Woods conference in 1944 explicitly permitted nlike many topics in international eco- capital controls.1 One of the architects of nomics, capital controls—taxes or those articles, , was Urestrictions on international transac- a strong proponent of capital controls and tions in assets like stocks or bonds—have the IMF often was seen as such during its received cursory treatment in textbooks and early years. During the Bretton-Woods era scant attention from researchers. The con- of fixed-exchange rates, many countries sensus among economists has been that cap- limited asset transactions to cope with bal- ital controls—like tariffs on goods—are ance-of-payments difficulties. But, recog- 1 “Article VI. Section 3. Controls obviously detrimental to economic efficiency nition of the costs and distortions created of capital transfers: Members because they prevent productive resources by these restrictions led to their gradual may exercise such controls as from being used where they are most need- removal in developed countries over the are necessary to regulate inter- ed. As a result, capital controls gradually last 30 years. The United States, for exam- national capital movements, had been phased out in developed countries ple, removed its most prominent capital but no member may exercise during the 1970s and 1980s, and by the controls in 1974 (Congressional Quarterly these controls in a manner which will restrict payments for 1990s there was substantial pressure on less- Service, 1977). During the last 10 years current transactions or which developed countries to remove their restric- even less-developed countries began to will unduly delay transfers of tions, too (New York Times, 1999). The topic liberalize trade in assets. funds in settlement of commit- almost had been relegated to a curiosity. The purpose of this article is to intro- ments, except as provided in Several recent developments, however, duce Review readers to the debate on capi- Article VII, Section 3(b) and in have rekindled interest in the use and tal controls, to explain the purposes Article XIV, Section 2.”

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and costs of controls and why some advo- outflow. Accumulating claims on the rest cate their reintroduction. To lay the ground- of the world is a form of national saving. work for understanding restrictions on Conversely, a country is said to have a sur- capital flows, the next section of the article plus in the —or a capital describes capital flows and their benefits. inflow—if the rest of the world is accumu- The third section characterizes the most lating net claims on it, as is the case with common objectives of capital controls with the United States.5 Just as individuals an emphasis on the recent debate about must avoid borrowing excessively, policy- using controls to foster macroeconomic makers must make sure that the rest of the stability. Then the many types of capital world does not accumulate too many net controls are distinguished from each other claims on their countries—in other words, 2 The U.S. Department of and their effectiveness and costs are con- that their countries do not sell assets/bor- 6 Commerce does not recognize sidered. In addition, accompanying shad- row at an unsustainable rate. “real” assets as a separate ed inserts outline specific case studies in class. The purchase of assets capital controls: the U.S. Interest Equali- such as foreign production facili- zation Tax of 1963, the Chilean encajeof Benefits of Capital Flows ties is recorded under financial the 1990s, and the restrictions imposed Economists have long argued that assets in their accounts by Malaysia in September 1998. trade in assets (capital flows) provides (Department of Commerce, substantial economic benefits by enabling 1990). residents of different countries to capitalize 3 The capital account records CAPITAL FLOWS on their differences. Fundamentally, capi- both loans and asset purchases To understand what capital controls do, tal flows permit nations to trade consump- because both involve buying a it is useful to examine capital flows—trade tion today for consumption in the future— claim on future income. A in real and financial assets. International to engage in intertemporal trade (Eichen- bank making a car loan obtains purchases and sales of existing real and green, et al. 1999). Because Japan has a a legal claim on the borrower’s financial assets are recorded in the capital population that is aging more rapidly than future income. account of the .2 Real that of the United States, it makes sense 4 Equity investment is considered assets include production facilities and real for Japanese residents to purchase more portfolio investment in national estate while financial assets include stocks, U.S. assets than they sell to us. This allows accounts until it exceeds 10 bonds, loans, and claims to bank deposits.3 the Japanese to save for their retirement by percent of the market capital- Capital account transactions often are classi- building up claims on future income in the ization of the firm, then it is fied into portfolio investment and direct United States while permitting residents of considered direct investment. investment. Portfolio investment encom- the United States to borrow at lower inter- 5 The current accountrecords passes trade in securities like stocks, bonds, est rates than they could otherwise pay. trade in goods, services, and bank loans, derivatives, and various forms A closely related concept is that capital unilateral transfers. A nation’s of credit (commercial, financial, guaran- flows permit countries to avoid large falls capital account balance must tees). Direct investment involves the pur- in national consumption from economic be equal to and opposite in chase of real estate, production facilities, downturn or natural disaster by selling sign from its current account or substantial equity investment.4 When a assets to and/or borrowing from the rest of balance because a nation that German corporation, BMW, for example, the world. For example, after an earth- imports more goods and ser- vices than it exports must pay builds an automobile factory in South quake devastated southern Italy on Novem- for those extra imports by sell- Carolina, that is direct investment. On the ber 23, 1980, leaving 4,800 people dead, ing assets or borrowing money. other hand, when U.S. investors buy Italians borrowed from abroad (ran a capi- The sum of the current account Mexican government bonds, that is portfo- tal account surplus) to help repair the balance and the capital account lio investment. damage. Figure 1 illustrates the time balance is the balance of pay- A country is said to have a deficit in series of the Italian capital account from ments. the capital account if it is accumulating net 1975 through 1985. 6 The composition as well as the claims on the rest of the world by purchas- A third benefit is that capital flows magnitude of capital flows also ing more assets and/or making more loans permit countries as a whole to borrow in may influence the sustainability to the rest of the world than it is receiving. order to improve their ability to produce of policies, as will be discussed A country, like Japan, with a capital account goods and services in the future—like in section 3. deficit is also said to experience a capital individuals borrowing to finance an educa-

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tion. To cite just one example, between Figure 1 1960 and 1980 Koreans borrowed funds from the rest of the world equal to about 4.3 Italian Capital Account Surplus percent of gross domestic product (GDP) as a Percentage of GDP annually to finance investment during Korea’s Percent 2 period of very strong growth (see Figure 2). November 23, 1980 These arguments for free capital mobili- 1.5 Earthquake ty are similar to those that are used to sup- 1 port . Countries with different age 0.5 structures, saving rates, opportunities for investment, or risk profiles can benefit from 0 trade in assets. More recently, economists –0.5 have emphasized other benefits of capital –1 flows such as the technology transfer that –1.5 often accompanies foreign investment, or 1975 1977 1979 1981 1983 1985 the greater competition in domestic mar- SOURCE: International Financial Statistics kets that results from permitting foreign firms to invest locally (Eichengreen, et al. 1999). The benefits of capital flows do not Figure 2 come without a price, however. Because capital flows can complicate economic poli- South Korean Growth cy or even be a source of instability them- and Capital Surplus selves, governments have used capital Percent controls to limit their effects (Johnston 20 and Tamirisa, 1998). 15 Real GDP Growth

10

PURPOSES OF 5 CAPITAL CONTROLS A is any policy 0 designed to limit or redirect capital –5 Capital Account Balance account transactions. This broad defini- as a percentage of GDP –10 tion suggests that it will be difficult to gen- 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 eralize about capital controls because they SOURCE: International Financial Statistics and Mitchell (1998) can take many forms and may be applied for various purposes (Bakker, 1996). Controls may take the form of taxes, price or quantity controls, or outright prohibi- restrictions raised revenues in two ways. tions on international trade in assets.7 First, by keeping capital in the domestic economy, it facilitated the taxation of wealth and interest income (Bakker, 1996). Revenue Generation and Second, it permitted a higher inflation rate, Credit Allocation which generated more revenue. Capital The first widespread capital controls controls also reduced interest rates and were adopted in WWI as a method to therefore the government’s borrowing costs finance the war effort. At the start of the on its own debt (Johnston and Tamirisa, war, all the major powers suspended their 1998). Since WWI, controls on capital participation in the gold standard for the outflows have been used similarly in other 7 Alesina, Grilli, and Milesi- duration of the conflict but maintained —mostly developing—economies to gen- Ferretti (1994) and Grilli and fixed-exchange rates. All the belligerents erate revenue for governments or to permit Milesi-Ferretti (1995) empiri- restricted capital outflows, the purchase of them to allocate credit domestically with- cally examine factors associat- foreign assets or loans abroad. These out risking capital flight (Johnston and ed with capital controls.

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Table 1

Purposes of Capital Controls

Purpose of Direction Control Method of Control Example

Generate Revenue/ Controls on capital outflows permit a country to run Outflows Most belligerents Finance War Effort higher inflation with a given fixed-exchange rate and during WWI also hold down domestic interest rates. and WWII

Financial Repression/ Governments that use the financial system to reward Outflows Common in Credit Allocation favored industries or to raise revenue, may use capital developing controls to prevent capital from going abroad to seek countries higher returns.

Correct a Balance of Controls on outflows reduce demand for foreign assets Outflows U.S. interest Payments Deficit without contractionary or devalua- equalization tax, tion. This allows a higher rate of inflation than other- 1963-74 wise would be possible.

Correct a Balance of Controls on inflows reduce foreign demand for domes- Inflows German Bardepot Payments Surplus tic assets without expansionary monetary policy or scheme, 1972-74 revaluation. This allows a lower rate of inflation than would otherwise be possible.

Prevent Potentially Restricting inflows enhances macroeconomic stability Inflows Chilean encaje, Volatile Inflows by reducing the pool of capital that can leave a coun- try during a crisis. 1991-98

Prevent Financial Capital controls can restrict or change the composition Inflows Chilean encaje, Destabilization of international capital flows that can exacerbate dis- torted incentives in the domestic financial system. 1991-98

Prevent Real Restricting inflows prevents the necessity of monetary Inflows Chilean encaje, Appreciation expansion and greater domestic inflation that would cause a real appreciation of the currency. 1991-98

Restrict Foreign Foreign ownership of certain domestic assets—espe- Inflows Article 27 of Ownership of cially natural resources—can generate resentment. the Mexican Domestic Assets constitution Preserve Savings The benefits of investing in the domestic economy Outflows for Domestic Use may not fully accrue to savers so the economy, as a whole, can be made better off by restricting the outflow of capital.

Protect Domestic Controls that temporarily segregate domestic financial Inflows and Financial Firms sectors from the rest of the world may permit domestic Outflows firms to attain economies of scale to compete in world markets.

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Tamirisa). Table 1 summarizes the pur- than foreigners purchase from domestic poses of capital controls. residents, the exchange rate (the price of foreign currency) tends to rise. If the exchange rate is flexible, the foreign cur- Balance of Payments Crises rency tends to appreciate and the domestic During the Great Depression, controls currency tends to depreciate. The depreci- simultaneously were used to achieve greater ation of the domestic currency raises prices 8 Often, the term “balance of freedom for monetary policy and exchange of imported goods and assets to domestic payments deficit” describes an rate stability—goals that have remained residents and lowers the prices of domestic imbalance in the current popular. To understand why controls have goods and assets on world markets, reduc- account (goods, services, fac- been used in this way, it is necessary to ing the relative demand for foreign goods tor payments, and unilateral understand balance of payments problems and assets until the imbalance in the bal- transfers). Here, it describes and their solutions (Johnston and Tamirisa, ance of payments is eliminated. A country the sum of the current account 1998). At a given exchange rate, a country with a fixed exchange rate similarly may and the capital account. often will want to collectively purchase more correct a balance of payments deficit by Countries also may demand goods, services and assets than the rest of changing the exchange rate peg—devalu- fewer goods and assets from the world will buy from it. Such an imbal- ing the currency—but this option foregoes the rest of the world—balance of payments surpluses—but ance is called a balance of payments deficit the benefits of exchange rate stability for this article concentrates on bal- and may come about for any one of a number international trade and policy discipline. ance of payments deficits of reasons: 1) The domestic In addition, it may reduce the public’s con- because most countries find may be out of sync with that of the rest of fidence in the monetary authorities’ anti- balance of payments surpluses the world; 2) There may have been a rapid inflation program. easier to manage. change in the world price of key com- If a government is committed to main- 9 When a flexible exchange rate modities like oil; 3) Expansionary domes- taining a particular fixed exchange rate, on currency gains or loses value, it tic policy may have increased demand for the other hand, its can pre- is said to appreciate or depreci- the rest of the world’s goods; 4) Large for- vent the depreciation of its currency with ate, respectively. Fixed-rate eign debt interest obligations may surpass contractionary monetary policy—by sell- currencies are said to be reval- the value of the domestic economy’s exports; ing domestic bonds.11 Alternatively, the ued or devalued when their 5) Or, a perception of deteriorating eco- central bank might sell foreign exchange price rises or falls. nomic policy may have reduced interna- to affect the monetary base, in which case 10 There are other policies— 8 tional demand for domestic assets. In the the action is known as unsterilized foreign fiscal and regulatory—that absence of some combination of exchange exchange intervention. In either case, such may be used to manage the rate and monetary policy by the deficit a sale lowers the domestic money supply effects of capital flows but they country, excess demand for foreign goods and raises domestic interest rates—lower- will be ignored to simplify the and assets would bid up their prices—typi- ing domestic demand for imports—while discussion. cally through a fall in the foreign exchange reducing the prices of domestic goods, ser- 11Foreign exchange operations value (a devaluation or depreciation) of vices, and assets relative to their foreign that do not affect the domestic the domestic currency—until the deficit counterparts. The reduced demand and monetary base are called “ster- was eliminated.9 higher prices for foreign goods, services, ilized,” while those that do There are four policy alternatives to and assets would eliminate a balance of affect the monetary base are correct an imbalance in international pay- payments deficit. However, this defense of called “unsterilized.” Sales of ments: 1) Permit the exchange rate to the exchange rate requires that monetary any asset would tend to lower change, as described above; 2) Use mone- policy be devoted solely to maintaining the the domestic money supply and tary policy—unsterilized foreign exchange exchange rate; it cannot be used to achieve raise interest rates because intervention—to correct the imbalance independent domestic inflation or employ- when the monetary authority through domestic demand; 3) Attempt to ment goals. In this case, for example, the receives payment for the asset, the payment ceases to be part sterilize the monetary changes to isolate contraction temporarily will reduce of the money supply. Fiscal the domestic economy from the capital domestic demand and employment, which policy also may have an effect 10 flows; and 4) Restrict capital flows. may be undesirable. A country that uses on exchange rates but taxing Each alternative has disadvantages. monetary policy to defend the exchange and spending decisions usually When domestic residents purchase rate in the face of imbalances in interna- are more constrained than more goods and assets from foreigners tional payments is said to subordinate monetary decisions.

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domestic monetary policy to exchange controls on capital outflows allow a coun- rate concerns. try to maintain fixed-exchange rates and Rather than subordinate monetary pol- an independent domestic monetary policy icy to maintaining the exchange rate, some while alleviating a balance-of-payments central banks have attempted to recapture deficit.13 The monetary authorities can some monetary independence by steriliz- meet both their internal goals (employ- ing—or reversing—the effect of foreign ment and inflation) and their external exchange operations on the domestic goals (balance of payments).14 Thus, capi- money supply. Sterilization of sales of for- tal controls are sometimes described in eign exchange (foreign bonds), for exam- terms of the choices they avoid: to prevent ple, would require the central bank to buy capital outflows that, through their effect an equal amount of domestic bonds, leav- on the balance of payments, might either ing domestic interest rates unchanged after endanger fixed-exchange rates or indepen- the inflow. It generally is believed that dence of monetary policy. sterilized intervention does not affect the exchange rate and so it is not very effective 12 Of course, capital outflows are in recapturing monetary independence Real Appreciation of the not necessary to force devalua- (Edwards, 1998b). Exchange Rate tion. If the domestic economy If international investors don’t believe While capital outflows can create bal- still demands more goods and that the monetary authorities will defend ance-of-payments deficits, capital inflows services than it supplies to the the exchange rate with tighter monetary can cause real appreciation of the exchange rest of the world, the exchange policy, they will expect devaluation—a fall rate.15 During the 1980s and 1990s a rate cannot be maintained with- out a monetary contraction. in the relative price of domestic goods and number of developing countries completed assets—and will sell domestic assets to important policy reforms that made them 13 Countries that face balance of avoid a loss. Such a sale increases relative much more attractive investment environ- payments surpluses—the demand for foreign assets, exacerbating ments. Eichengreen, et al. (1999) report desire to purchase fewer goods the balance of payments deficit, and speeds that net capital flows to developing coun- and services from the rest of the devaluation.12 tries tripled from $50 billion in 1987-89 to the world at the fixed-exchange rate—would restrict capital Capital flows play a crucial role in bal- more than $150 billion in 1995-97. These inflows, rather than outflows, ance of payments crises in two ways. large capital inflows to the reforming to reduce demand for their own Swings in international capital flows can countries tended to drive up the prices of assets. create both a balance-of-payments problem domestic assets. For countries with flexi- and—if the exchange rate is not defend- ble exchange rates, the exchange rates 14 If there is still excess demand ed—expedite devaluation under fixed- appreciated, raising the relative prices of for foreign goods, the fixed- exchange rate will still be only exchange rates. Thus, in the presence of the domestic countries’ goods. For coun- temporarily sustainable. free capital flows, a country wishing to tries with fixed-exchange rates, the maintain a fixed-exchange rate must use increased demand for domestic assets led 15 A nominal appreciation is a rise monetary policy solely for that purpose. the monetary authorities to buy foreign in the foreign exchange value As McKinnon and Oates (1966) argued, no exchange (sell domestic currency), increas- of a country’s currency. A real government can maintain fixed-exchange ing the domestic money supply and ulti- appreciation is a rise in the rela- tive price of domestic goods rates, free capital mobility, and have an mately the prices of domestic goods and and services compared to for- independent monetary policy; one of the assets. In either case, the prices of domes- eign goods and services. This three options must give. This is known as tic goods and assets rose relative to those may result from a nominal the “incompatible trinity” or the trilemma in the rest of the world—a real apprecia- appreciation, domestic inflation (Obstfeld and Taylor, 1998). Policymakers tion—making domestic exported goods that is higher than foreign infla- wishing to avoid exchange-rate fluctuation less competitive on world markets and tion, or some combination of and retain scope for independent monetary hurting exporting and import-competing the two. policy must choose the fourth option, industries.16 Because of these effects, the 16 Empirically, Edwards (1998b) restrict capital flows. problem of real exchange-rate appreciation finds a consistent, but limited, By directly reducing demand for for- from capital inflows is described variously tendency toward real apprecia- eign assets and the potential for specula- as real exchange-rate instability, real appre- tion from capital inflows. tion against the fixed-exchange rate, ciation, or loss of competitiveness.

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Countries have a number of policy fare in this way is called a “theory of the options to prevent real appreciation in the second best.”17 face of capital inflows (Goldstein, 1995; Capital controls preserve domestic Corbo and Hernandez, 1996). Permitting savings for domestic use. From a national the exchange rate to change still results in point of view, there might be benefits from nominal and real appreciation but avoids a greater rate of domestic investment that domestic inflation. A very common tactic do not fully accrue to the investors. For for fixed exchange-rate regimes is to steril- example, domestic savers might invest dis- ize the monetary effects of the inflows, pre- proportionately overseas because of politi- venting an expansion of the money supply cal risk of expropriation or a desire to by reversing the effect on the domestic escape taxation. In either case, the nation money market (Edwards, 1998b). It gener- as a whole could be made better off by lim- ally is believed that sterilization is not very iting or taxing domestic investment abroad effective in recapturing monetary indepen- (Harberger, 1986). dence as it keeps domestic real interest The infant industry argument—an old rates high and leads to continued inflows. idea often used to justify tariffs in goods Sterilization of inflows also is a potentially markets —has been resurrected to ratio- expensive strategy for the government as nalize the use of capital controls on both the domestic bonds that the central bank inflows and outflows. This idea starts with sells may pay higher interest than the for- the premise that small, domestic firms are eign bonds the central bank buys. Fiscal less efficient than larger, foreign firms and contraction is an effective way to prevent so will be unable to compete on an equal real appreciation because it lowers domes- basis. To permit small domestic firms to tic interest rates, and likewise, the demand grow to the efficient scale that they need to for domestic assets; but raising taxes and/or enjoy to compete in world markets, they reducing government spending may be must be protected temporarily from inter- politically unpalatable. Because of the national competition by trade barriers. As problems associated with these first three applied to capital markets, the argument policies, countries like , , and urges that capital controls be used to protect Columbia chose to use capital controls— underdeveloped financial markets from restricting purchase of domestic assets foreign competition. The problem with (inflows)—to try to prevent real apprecia- this argument, as in goods markets, is that tion and substitute for fiscal policy flexibil- protected industries often never grow up 17 ity in the face of heavy inflows. and end up seeking perpetual protection. The classic example of a tax that improves welfare is the one imposed on a polluting Theories of the Second Best Financial Sector Distortions industry. Because a polluting industry imposes non-market More recently, economists have con- In reality, capital controls rarely have costs on others, for which it sidered other circumstances—other than been imposed in a well-thought-out way to does not compensate them, a balance-of-payments needs or real appreci- correct clearly defined pre-existing distor- government could improve ation—under which capital controls might tions. Instead, capital controls most often everyone’s well being if it were be a useful policy. As a rule, economists have been used as a tool to postpone diffi- to tax pollution. The factory emphasize that restrictions on trade and cult decisions on monetary and fiscal poli- would produce less pollution investment impose costs on the economy. cies. Recently, however, the case has been and people would be happier. There are exceptions to that rule, however. made that capital controls may be the least The desire to meet employment Taxes and quantitative restrictions may be disadvantageous solution to the destabiliz- goals with an independent monetary policy is really a ver- good for the economy—welfare improving, ing effects of capital flows on inadequately sion of a “second best” story in in technical jargon—if they are used to regulated financial systems. which the pre-existing distortion correct some other, pre-existing distortion Recall that when a country with a is price inertia (or a similar fric- to free markets that cannot be corrected fixed-exchange rate has a net capital out- tion) in the real economy that otherwise. The idea that a tax or quantita- flow, the increase in relative demand for causes monetary policy to have tive restriction can improve economic wel- foreign assets means that there is insuffi- real effects (Dooley, 1996).

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19 N OVEMBER/DECEMBER 1999 cient demand for domestic goods and depositors’ incentive to monitor their banks’ assets at the fixed-exchange rate. The loan portfolio for excessive risk. Deposit domestic monetary authorities may con- insurance, in turn, exists precisely because duct contractionary monetary policy— depositors can not easily monitor the riskiness raise domestic interest rates to make their of their banks. In the absence of deposit assets more attractive—or lower the prices insurance, depositors would find it diffi- of their goods and assets (devalue the cur- cult to tell good banks from bad banks and rency). This is a special case of a balance- would withdraw their money at any sign of of-payments deficit and presents the same danger to the bank. Once some depositors choice—to raise interest rates or devalue— began to withdraw their money from the but in the case of a sudden capital outflow, bank, all depositors would try to do so, the crisis manifests itself in large sudden forcing the bank to close, even if its under- capital outflows rather than more gradual lying assets were productive (Diamond and balance-of-payments pressures from other Dybvig, 1983). This puts the whole bank- causes. Governments must choose ing system at risk. between high interest rates coupled with To avoid this problem, most developed some capital outflows or an exchange rate countries combine implicit or explicit insur- devaluation that provokes fear of inflation ance of bank deposits with government reg- and policy instability leading to greater ulation of depository institutions, especially capital outflows. In either case, a serious their asset portfolios (loans). In emerging recession seems unavoidable. markets, however, banking regulation is The recent case for capital controls much more difficult as the examiners are recognizes that a monetary contraction not less experienced, have fewer resources and only slows economic activity through the less strict accounting standards by which to normal interest-rate channels, but also can operate. Thus, banking problems are more threaten the health of the economy through serious in emerging markets. the banking system (Kaminsky and Reinhart, Large international capital inflows, 1999). If the monetary authorities raise especially short-term foreign borrowing, interest rates, they increase the costs of funds can exacerbate these perverse incentives for banks and—by slowing economic and pose a real danger to banking systems. growth—reduce the demand for loans and Domestic banks often view borrowing from increase the number of nonperforming loans. abroad in foreign currency sources as a Choosing to devalue the currency rather than low-cost source of funds—as long as the raising interest rates does not necessarily domestic currency is not devalued. With help banks either, as they may have bor- this additional funding, banks expand into rowed in foreign currency. A devaluation unfamiliar areas, generating risky loans would increase the banks’ obligations to that potentially create systemic risk to the their foreign creditors. Thus, capital out- banking system (Eichengreen, 1999; flows from the banking system pose spe- Garber, 1998; Goldstein, 1995; Dorn- cial problems for the monetary authorities, busch, 1998). If capital outflows force a as banks’ liabilities are usually implicitly or devaluation, the foreign-currency denomi- explicitly guaranteed by the government. nated debts of the banking system increase Indeed, the very nature of the financial when measured in the domestic currency, system creates perverse incentives (distor- possibly leading to bank failures. The tions) that international capital flows often banking system is a particularly vulnerable exacerbate (Mishkin, 1998). For example, conduit by which capital flows can desta- in a purely domestic context, banks have bilize an economy because widespread incentives to make risky loans, as their bank failures impose large costs on taxpay- losses are limited to the owners’ equity ers and can disrupt the payments system capital, but their potential profits are and the relationships between banks and unlimited. The existence of deposit insur- firms who borrow from them (Friedman ance worsens this problem by reducing and Schwartz, 1963; Bernanke, 1983). The

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20 N OVEMBER/DECEMBER 1999 difficulty of effective banking regulation cre- changing the composition of that inflow is ates an argument for capital controls as a just as important. For example, it often is second-best solution to the existence of the claimed that direct investment is likely to distorted incentives in the banking system.18 be more stable than portfolio investment There are two ways in which capital because stocks or bonds can be sold more controls might be imposed to limit capital easily than real assets (like production flow fluctuations and achieve economic facilities) can be liquidated (Dixit and stability. First, capital controls may be Pindyck, 1994; Frankel and Rose, 1996; used to discourage capital outflows in the Dornbusch, 1998). In contrast, Garber event of a crisis—as Malaysia did in (1998) argues that tracking portfolio and September 1998—permitting looser direct investment data may be misleading; domestic monetary policy. Controls on derivatives (options, futures, swaps, etc.) outflows are ideally taken as a transitional can disguise the source of a crisis, making measure to buy time to achieve goals, as an it look like the source is excessive short- aid to reform rather than as a substitute term debt. Goldstein (1995) says there is (Krugman, 1998). Second, controls can little evidence that direct investment is less prevent destabilizing outflows by discourag- “reversible” than portfolio investment. For ing or changing the composition of capital example, foreign firms with domestic pro- inflows, as Chile did for most of the 1990s. duction facilities abroad can use those The second method—to discourage or facilities as collateral for bank loans that change the composition of capital inflows then can be converted to assets in another with controls—requires some explanation. currency, effectively moving the capital A prime fear of those who seek to limit back out of the country. capital flows is that sudden outflows may endanger economic stability because investors are subject to panics, fads, and TYPES OF CAPITAL bubbles (Kindleberger, 1978; Krugman, CONTROLS 1998; Wade and Veneroso, 1998). To meet the many possible objectives Investors may panic because they, as indi- described for them, there are many types viduals, have limited information about of capital controls, distinguished by the the true value of the assets they are buying type of asset transaction they affect and or selling. They can, however, infer infor- whether they tax the transaction, limit it, mation from the actions of others. For or prohibit it outright. This section distin- example, one might assume that a crowd- guishes the many types of capital controls ed restaurant serves good food, even if one by this taxonomy. has never eaten there. In financial mar- Capital controls are not, strictly speak- kets, participants learn about other partici- ing, the same as exchange controls, the pants’ information by watching price restriction of trade in currencies, although the 18 The capital adequacy standards movements. An increase in the price of an two are closely related (Bakker, 1996). of the Basle accords penalize asset might be interpreted as new informa- Although currency and bank deposits are one long-term international inter- tion that the asset had been underpriced, type of asset—money—exchange controls bank lending relative to short- for example. Such a process might lead to may be used to control the current account term lending, exacerbating the “herding” behavior, in which asset price rather than the capital account. For example, problem (Corsetti, Pesenti, and changes tend to cause further changes in by requiring importers to buy foreign Roubini, 1998b). Although the same direction, creating a boom-bust exchange from the government for a stated banks are important and heavi- cycle and instability in financial markets, purpose, exchange controls may be used to ly regulated almost every- where, banks play an especially potentially justifying capital controls. By prohibit the legal importation of “luxury” important role in developing discouraging inflows of foreign capital, goods, thereby rationing “scarce” foreign countries because information governments can limit the pool of volatile exchange for more politically desirable problems tend to be more capital that may leave on short notice. purposes. So, while exchange controls are important in the developing Instead of limiting the total quantity of inherently a type of limited capital control, world than they are in the capital inflows, some would argue that they are neither necessary to restrict capital developed world.

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MALAYSIA’S CAPITAL CONTROLS: 1998-99 The devaluation of the Thai baht in The Malaysian government and July 1997 sparked significant capital business community claimed to be outflows from Southeast Asia, leading pleased with the effect of the controls to a fall in local equity prices and in increasing demand and returning sta- plunging exchange rates. To counter bility to the economy. Even economists these outflows of capital, the IMF urged who oppose capital controls believe many of the nations of the region to that they may have been of some use in raise interest rates, making their securi- buying time to implement fundamental ties more attractive to international reforms (Barro, 1998). investors. Unfortunately, the higher Others fear, however, that the capi- interest rates also slowed the domestic tal controls have replaced reform, economies.1 rather than buying time for reform. As In response to this dilemma, of May 1999, the Malaysian govern- Malaysia imposed capital controls on ment does not appear to be using the September 1, 1998. The controls breathing space purchased by the capi- banned transfers between domestic and tal controls to make fundamental foreign accounts and between foreign adjustments to its fragile and highly accounts, eliminated credit facilities to leveraged financial sector. Rather, offshore parties, prevented repatriation Prime Minister Mahathir has sacked of investment until September 1, 1999, policymakers who advocate reform and fixed the exchange rate at M3.8 per while aggressively lowering interest dollar. Foreign exchange transactions rates, loosening nonperforming loan were permitted only at authorized insti- classification regulation and setting tutions and required documentation to minimum lending targets for banks. show they were for current account pur- This strategy may prove short-sighted, poses. The government enacted a fairly as much of the capital outflow was intrusive set of financial regulations caused by the recognition that asset designed to prevent evasion. In prices were overvalued and the banking February 1999, a system of taxes on out- sector was weak (Global Investor, flows replaced the prohibition on repa- 1998b). Although monetary stimulus triation of capital. While the details are may be helpful in the short run, it may complex, the net effect was to discour- exacerbate the underlying problems. In age short-term capital flows but to freely addition, the government must be con- permit longer-term transactions cerned about the long-term impact that (Blustein, 1998). By imposing the capi- the controls will have on investors’ will- tal controls, Malaysia hoped to gain ingness to invest in the country. some monetary independence, to be able to lower interest rates without provok- 1 For an overview of the causes and policy options in the Asian ing a plunge in the value of the currency financial crisis, see Corsetti, Pesenti, and Roubini (1998a and as investors fled Malaysian assets. 1998b). movement nor are they necessarily intended ment and equity—often are imposed for to control capital account transactions. different reasons than those on short-term inflows—bank deposits and money market instruments. While the recent trend has Controls on Inflows vs. Outflows been to limit short-term capital flows Capital controls on some long-term because of their allegedly greater volatility (more than a year) inflows—direct invest- and potential to destabilize the economy,

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22 N OVEMBER/DECEMBER 1999 bans on long-term capital flows often would collect the tax or for what purposes reflect political sensitivity to foreign own- the revenue would be used. And, most ership of domestic assets. For example, dauntingly, a would have to be Article 27 of the Mexican constitution lim- enacted by widespread international agree- its foreign investment in Mexican real ment to be successful. estate and natural resources. A mandatory reserve requirementis a Controls on capital inflows and outflows price-based capital control that commonly provide some slack for monetary policy discre- has been implemented to reduce capital tionunder fixed exchange rates, but in oppo- inflows. Such a requirement typically oblig- site directions. Controls on capital inflows, ates foreign parties who wish to deposit which allow for higher interest rates, have money in a domestic bank account—or use been used to try to prevent an expansionof another form of inflow—to deposit some the money supply and the accompanying percentage of the inflow with the central inflation, as were those of Germany in 1972-74 bank for a minimum period.For example, (Marston, 1995) or Chile during the 1990s.19 from 1991 to 1998, Chile required foreign In contrast, controls on capital outflows permit investors to leave a fraction of short-term lower interest rates and higher money growth bank deposits with the central bank, earn- than otherwise would be possible (Marston, ing no interest.20As the deposits earn no 1995). They most often have been used to interest and allow the central bank to buy postpone a choice between devaluation or foreign money market instruments, the tighter monetary policy, as they have beenin effectively functions Malaysia, for example (see the shaded insert). as a tax on short-term capital inflows (Edwards, 1998b). See the shaded insert on the Chilean encajeof the 1990s. Price vs. Quantity Controls Quantity restrictions on capital flows Capital controls also may be distin- may include rules mandating ceilings or guished by whether they limit asset trans- requiring special authorization for new or actions through price mechanisms (taxes) existing borrowing from foreign residents. or by quantity controls (quotas or outright There may be administrative controls on prohibitions). Price controls may take the cross-border capital movements in which a form of special taxes on returns to interna- government agency must approve transac- tional investment (like the U.S. interest tions for certain types of assets. Certain types equalization tax of the 1960s—see the of investment might be restricted altogether shaded insert), taxes on certain types of as in Korea, where the government has, until transactions, or a mandatory reserve recently, restricted long-term foreign invest- requirement that functions as a tax. ment (Eichengreen, et al. 1999). Forbidding One type of price mechanism to dis- or requiring special permission for repatria- 19 Recall that capital inflows entail courage short-term capital flows is the tion of profits by foreign enterprises operat- foreign purchases of domestic “Tobin” tax. Proposed by Nobel laureate ing domestically may restrict capital outflows. assets or foreign loans to James Tobin in 1972, the Tobin tax would Capital controls may be more subtle: Domes- domestic residents while out- flows entail domestic purchases charge participants a small percentage of tic regulations on the portfolio choice of insti- of foreign assets or loans to for- all foreign exchange transactions (ul Haq, tutional investors also may be used as a type eign residents by domestic resi- Kaul and Grunberg, 1996; Kasa, 1999). of capital control, as they have been in Italy dents. Under a fixed exchange Advocates of such a tax hope that it would and in South Korea in the past (Bakker, 1996; rate, persistent capital inflows diminish volatility Park and Song, 1996). will require an expansion of the by curtailing the incentive to switch posi- money supply or a revaluation tions over short horizons in the foreign while substantial capital out- exchange market. There are many prob- EVALUATING CAPITAL flows will require a contraction. lems with a Tobin tax, however. The tax CONTROLS 20The Chilean reserve require- might reduce liquidity in foreign exchange The conventional wisdom of the eco- ment applied not only to bank markets or be evaded easily through deriv- nomics profession has been—whatever the deposits but to many types of ative instruments. It is uncertain who problems with destabilizing capital flows or capital inflows.

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THE U.S. INTEREST EQUALIZATION TAX: 1963-74

During the late 1950s and early firms in Europe and Japan jumped from 1960s, the United States had both a $150 million during the first half of fixed-exchange rate regime for the dol- 1963 to $400 million during the second lar (the Bretton-Woods system) and half (Economist, 1964b). chronic pressures toward balance-of- To check bank loans to foreign payments deficits. These strains result- countries, the U.S. Congress enacted ed partly from the fact that interest the Voluntary Foreign Credit Restraint rates in the rest of the world—especial- Program (VFCRP) in February 1965, ly those in Europe—tended to be high- broadening it in 1966 to limit U.S. er than those in the United States, short-term capital outflows to other making foreign assets look attractive to developed countries. In addition, U.S. U.S. residents.1 Faced with the corporations were asked to voluntarily unpalatable alternatives of devaluing limit their direct foreign investment. the dollar or conducting contractionary The program was made mandatory in policies, on July 19, 1963, President 1968 (Laffer and Miles, 1982; Kreinin, Kennedy proposed the Interest 1971). U.S. capital controls were Equalization Tax (IET) to raise the relaxed in 1969 and phased out in prices that Americans would have to 1974, after the United States left the pay for foreign assets (Economist, Bretton-Woods system of fixed-exchange 1964a).2 rates (Congressional Quarterly Service, The IET imposed a variable sur- 1973a, 1973b, 1977). charge, ranging from 1.05 percent on One unintended consequence of one-year bills to 15 percent on equity the IET was the growth of foreign and bonds of greater than 28.5 years financial markets—at the expense of maturity, on U.S. purchases of stocks U.S. markets—as they inherited the job and bonds from Western Europe, Japan, of intermediating international capital Australia, South Africa, and New flows. For example, the volume of Zealand (Congressional Quarterly international borrowing in London rose Service, 1969). Canada and the devel- from $350 million in 1962 to more oping world were exempted from the than $1 billion in 1963 while the vol- tax out of consideration for their spe- ume of foreign flotations in New York cial dependence on U.S. capital mar- fell from $2 billion in the first half of kets. By raising the prices of foreign 1963 to just over $600 million in the assets, it was hoped that demand for next nine months (Economist, 1964b). those assets—and the consequent bal- ance-of-payments deficit—would be 1 At this time, the United States had a current account surplus that reduced or eliminated. failed to fully offset private demand for foreign assets—the capi- The IET reduced direct outflows to tal account deficit—resulting in the need for temporary mea- the targeted countries but didn’t change sures to close the gap. total outflows much because investors 2 In August 1964, the U.S. Congress enacted this tax, making it were able to evade the tax through third retroactive to the date it was proposed. countries, like Canada (Pearce, 1995; Kreinen, 1971; Stern, 1973). In addi- tion, because the tax did not cover loans, investment was diverted initially from bond and stock purchases to bank loans. Loans from American banks to

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CHILE’S ENCAJE: 1991-98

During the late 1980s and early 1990s, appreciation of the exchange rate. Larraín B., international capital began to return to Chile as Labán M., and Chumacero (1997) studied the a result of slow growth and low interest rates in same issue with different methods and found the developed world and sound macroeconomic that, although there was considerable substitu- policies, including reduced debt, in Chile tion in the short run, the controls did change the (Edwards, 1998a). The Chilean authorities magnitude of the inflows in the long run. feared that these capital inflows would compli- There is even more disagreement about cate monetary policy decisions—perhaps caus- whether the capital controls were important in ing real appreciation of the exchange rate—and keeping Chile insulated from the Asian crisis. they also were wary of the danger of building up Many observers have cited Chile’s capital con- short-term debt. trols in advocating more widespread restrictions Chile had long restricted capital flows and on capital controls for other developing coun- these limits were updated in the early 1990s to tries (Bhagwati, 1998). Edwards (1998a), on deal with the surge in capital inflows. Direct the other hand, points out that Chile also had investment was made subject to a 10-year stay substantial capital controls during the late 1970s requirement in 1982; this period was reduced to and early 1980s, before its major banking crisis three years in 1991 and to one-year in 1993. that cost Chileans more than 20 percent of GDP Portfolio flows were made subject to the during 1982-83. The major difference between encaje—a one-year, mandatory, non-interest pay- then and now is that Chile now has a modern ing deposit with the central bank—created in and efficient system of banking regulation. 1991 to regulate capital inflows.1 The encaje was Others credit the participation of foreign banks initially 20 percent but was increased to 30 per- in strengthening the Chilean banking system by cent in 1992. The penalty for early withdrawal providing experience and sophistication in was 3 percent.2 assessing risks and making loans. At the time of The effect of the encaje was to tax foreign the crisis, Chile had a high percentage of domes- capital inflows, with short-term flows being tic loans from foreign-owned banks—20 per- taxed much more heavily than long-term flows. cent, about the same as the United States and far For example, consider the choice of an higher than South Korea, Thailand, and American buying a one-year discount bond with Indonesia (5 percent) (Economist, 1997). In a face value of 10,000 pesos for a price of 9,091 addition, Edwards (1998a) claims that the encaje pesos, or a 10-year discount bond with the same harmed the domestic financial services industry face value and a price of 3,855 pesos. Either and the small firms that could not borrow long bond, if held to maturity, would yield a 10 per- term on international markets to avoid the tax. cent per annum return.3 In the presence of a 30 If Chile’s capital controls helped, it was to buy percent one-year reserve requirement, however, time for structural reforms and effective finan- the one-year bond’s annual yield would be 7.7 cial regulation. percent and the 10-year bond’s annual yield 1 The word encaje means “strongbox” in Spanish. would be 9.7 percent. Hence, the encaje acted as a graduated tax on capital inflows. 2 The encaje was reduced to 10 percent and the early withdrawal Researchers disagree about the effectiveness penalty from 3 percent to 1 percent in June 1998. The encaje was of Chile’s capital controls. Valdes and Soto eliminated entirely on September 16, 1998 (Torres, 1998). (1996) concluded that they changed the compo- 3 The yield to maturity on a bond equates the initial outlay with the sition but not the magnitude of the inflows. In present discounted value of its payoffs. The yields on the bonds are other words, investors substituted from heavily determined by solving the following equations fori: taxed short-term flows to more lightly taxed 9091 = 10,000/(1+i), 3855 = 10,000/(1+i)10, ∗ ∗ long-term inflows. They also found that the 1.3 9091 = .3 9091/(1+i)+10,000/(1+i) and ∗ ∗ controls were ineffective in preventing a real 1.3 3855 = .3 3855/(1+i) + 10,000/(1+i)10.

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fixed exchange rates—that capital controls rates—subject to capital controls—differ are ineffective and impose substantial costs from those found in offshore markets or on economies that outweigh any benefits. domestic currency returns on foreign That generalization ignores distinctions assets. Such tests assume that returns on among types of capital controls and varied comparable investments in the same cur- criteria for success, however. Capital con- rency should be equal in the absence of trols have many potential purposes and effective capital controls. To the extent thus many potential standards by which to that they differ, the capital controls are judge their efficacy. Difficulties in separat- effective (Harberger, 1980; Edwards, ing the effects of capital controls from the 1998b). This research has shown that cap- balance of payments or capital flow prob- ital controls have been able to create mod- lems they were intended to alleviate com- est “wedges” of one to several percentage plicates the empirical study of the effects of points between returns on similar domes- capital controls (Johnston and Tamirisa, tic and international assets (Marston, 1998). Also, generalizing about the effec- 1995).22 A related test to determine mone- tiveness of capital controls from one coun- tary autonomy is to measure the effective- try—or even one period—to another is ness of sterilization in preventing an risky because the effectiveness of capital appreciation of the real exchange rate. controls depends on the rigor with which Generally, controls on inflows have they are enforced (Obstfeld and Taylor, been found to be more effective than those 1998). Governments that control substan- on outflows because there is less incentive tial aspects of their citizens’ lives (e.g., to evade controls on inflows (Reinhart and Cuba) find it easier to enforce controls on Smith, 1998; Eichengreen, et al. 1999).23 trade in assets (Minton, 1999). Evading controls on inflows ordinarily will provide only marginal benefits for foreign investors, as the expected risk-adjusted Are Capital Controls Effective? domestic return usually will be compara- Keeping in mind these difficulties, ble to that on alternative international there are several possible ways to gauge the investments. On the other hand, in the effectiveness of capital controls. Perhaps event of an expected devaluation, there is 21An (American) put option con- the most direct way is to measure whether enormous incentive to avoid such a loss by fers on the holder the right, but the imposition of capital controls changes evading controls on capital outflows. The not the obligation, to sell a the magnitude or composition of capital expected loss on holding domestic assets specified quantity of pesos at a flows, using some assumption about what can be several hundred percent in annual- specified price, called the strike flows would have been without the capital ized terms over a short horizon. For price or exercise price, on or controls. Measuring the composition of example, if one expects the Malaysian before a given date. capital flows always has been difficult, ringgit to be devalued 10 percent in one 22Fieleke (1994) finds that capi- however, and it has become more so since the week, the expected continuously com- tal controls were of very limited advent of derivatives that can be used to pounded annual return associated with effectiveness in creating inter- disguise capital flows. For example, a U.S. holding the currency through such a est differentials during the firm may build a production facility in Mexico devaluation is almost –550 percent.24 European Monetary System but the risk that the peso will decline— Therefore, researchers like Obstfeld (1998) crises of 1992-93. reducing the dollar value of the invest- and Eichengreen (1999) have found the 23As will be discussed in the next ment—by buying put options on the peso, idea of preventing destabilizing outflows subsection, capital controls which will increase in value if the peso by limiting inflows to be more promising often are evaded by changing falls.21 The direct investment will be mea- than directly trying to stop outflows. from prohibited to permitted surable as an inflow, but the corresponding In sum, the consensus of the research assets or by falsifying invoices outflow—the put contract to potentially on capital controls has been that they can for traded goods. sell pesos—may not be (Garber, 1998). alter the composition of capital flows or 24The continuously compounded If capital controls are designed to per- drive a small, permanent wedge between annual return is computed from mit monetary autonomy, one can examine domestic and offshore interest rates but 52* ln(.9/1). the extent to which onshore interest they cannot indefinitely sustain inconsis-

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26 N OVEMBER/DECEMBER 1999 tent policies, and their effectiveness tends recently, financial innovation has spawned to erode over time as consumers and firms financial instruments—derivatives—that become better at evading the controls may be used to mislead banking and finan- (Marston, 1995). Outflow restrictions, in cial regulators to evade prudential regula- particular, may buy breathing space, but tion and/or capital controls (Garber, that is all. There are more researchers will- 1998). For example, derivatives may con- ing to defend inflow restrictions, however. tain clauses that change payouts in the Eichengreen (1999) argues that, to restrain event of defaults or the imposition of inflows, controls do not have to be perfect, exchange controls (Garber, 1998). they just need to make avoidance costly Improvements in information technology enough to reduce destabilizing flows. make it easier to buy and sell assets and reduce the effectiveness of capital controls (Eichengreen, et al. 1999). How Are Capital Controls Evaded? Capital controls also induce substitu- Over time, consumers and firms real- tion from prohibited to permitted assets ize that they can evade capital controls (Goldstein, 1995). So, for example, the through the channels used to permit trade U.S. interest equalization tax was evaded in goods. Firms, for example, may evade through trade in assets with Canada while controls on capital flows by falsifying heavy Chilean taxes on short-term inflows invoices for traded goods; they apply to may have induced a (desired) substitution buy or sell more foreign exchange than the to more lightly taxed longer-term inflows transaction calls for. For example, a (Valdes, 1998). Capital controls have been domestic firm wishing to evade limits on more successful in changing the composi- capital inflows might claim that it export- tion of asset trade than the volume. ed $10 million worth of goods when it only, in fact, exported $9 million. It may use the excess $1 million to invest in Costs of Capital Controls domestic assets and split the proceeds with Although they often are evaded success- the foreign firm providing the capital. fully, capital controls nonetheless impose Perhaps the most common method to substantial costs in inhibiting international evade controls on capital flows is through trade in assets. Foremost among these costs “leads and lags” in which trading firms are limiting the benefits of capital flows as hasten or delay payments for imports or described in Section 2: risk-sharing, diver- exports (Einzig, 1968). To evade controls sification, growth, and technology transfer on outflows, for example, importers pay (Global Investor, 1998a). Capital export- early for imports (leads), in exchange for a ing countries see a lower return on their discount, and exporters allow delayed pay- savings while capital importers receive less ments for their goods (lags), in return for a investment and grow more slowly with higher payment. This permits importers capital controls. Krugman (1998) argues and exporters to effectively lend money to that capital controls do the most harm the rest of the world, a capital outflow. To when they are used to defend inconsistent evade controls on inflows, importers delay policies that produce an overvalued cur- payments while exporters demand acceler- rency—a currency that would tend to ated payments. Thus, leads and lags permit depreciate or be devalued in the absence of trade credit to substitute for short-term the controls. This attempt to free govern- capital flows. Governments often attempt ments from the discipline of the market to close the leads/lags loophole on short- permits poor or inconsistent policies to be term capital flows with administrative con- maintained longer than they otherwise trols on import/export financing. would, increasing the costs of these policies. Travel allowances for tourists are Poorly designed or administered capi- another method by which capital controls tal controls often adversely affect direct may be evaded (Bakker, 1996). More investment and the ordinary financing of

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trade deals (Economist, 1998). Controls with capital controls. Controls most often can even worsen the problem of destabiliz- have been used to permit more freedom ing capital flows. For example, the Korean for monetary policy during balance of pay- government has acknowledged that the ments crises in the context of fixed restriction on offshore borrowing by exchange rates. Restrictions on inflows Korean corporations contributed to its bal- have been implemented to prevent real ance of payments and banking crises in appreciation of the exchange rate or to 1997 (Global Investor, 1998a). The cor- correct other pre-existing distortions, like ruption created by evasion and the admin- the incentives for financial institutions to istrative costs of controls also is an take excessive risk. Although controls on unintended cost of the controls. Even as capital flows may change the composition the costs accumulate and their original of flows, they impose substantial costs on purpose has ended, capital controls, like the economy and cannot be used to indefi- any regulation, develop their own con- nitely sustain inconsistent policies. Under stituencies and become difficult to phase most circumstances, it is better to attack out. The resumption of free capital flows the source of the distortion or inconsistent does not always end the costs of capital policy at the source rather than treating controls. Specifically, blocking the depar- symptoms through capital controls. ture of capital temporarily subsidizes Although the worst of the Asian finan- investment but raises the perception of cial crisis seems to be over, it—like the peso risk, increasing a risk premium and/or crisis of December 1994—has been a sober- deterring future investment (Economist, ing lesson in the volatility of capital flows 1998; Goldstein, 1995). and the fragility of finan- Partly because the costs of capital con- cial systems. It also has raised questions trols are serious and tend to worsen over for future research: Are limits on capital time, economists have suggested attacking inflows the best solution to protecting problems at their source rather than with domestic financial systems from the distor- capital controls (Krugman, 1998; Mishkin, tions inherent in banking? What is the 1998). For example, to cope with banks’ proper sequence for economic reforms of incentive to take on excessive risk, a gov- the capital account, the current account, ernment might concentrate on reforming and the banking system? and strengthening the domestic financial structure—especially regulations on foreign REFERENCES borrowing—as it slowly phases out capital controls to derive the benefits of capital Alesina, Alberto, Vittorio Grilli, and Gian Maria Milesi-Ferretti. “The flows (Goldstein, 1995).25Or, to fight a real of Capital Controls,” in Capital Mobility: The Impact appreciation brought on by a capital inflow, on Consumption, Investment, and Growth, Leonardo Leiderman and a government might conduct contractionary Assaf Razin, eds., Cambridge University Press, 1994, pp. 289-321. 25An important but unresolved fiscal policy. In all circumstances, better Bakker, Age F.P. The Liberalization of Capital Movements in Europe, issue is the sequencing of macroeconomic policy is needed to avoid Kluwer Academic Publishers, 1996. reforms of the current account, financial crises, such as those that affected Barro, Robert. “Malaysia Could Do Worse than this Economic Plan,” the capital account, and the Asia in 1997. Countries must eschew over- Business Week, November 2, 1998, p. 26. financial sector. Many blame valued currencies, excessive foreign debt, the recent Asian crisis on the and unsustainable consumption. Bernanke, Ben S. “Nonmonetary Effects of the Financial Crisis in fact that the Asian governments Propagation of the Great Depression,” American Economic Review moved faster to liberalize inter- (June 1983), pp. 257-76. national capital flows than they CONCLUSION Bhagwati, Jagdish. “Why Free Capital Mobility may be Hazardous to did to regulate their financial Your Health: Lessons from the Latest Financial Crisis,” NBER system. In contrast, Sweeney Recently, a number of opinion leaders, Conference on Capital Controls, November 7, 1998. (1997) argues for early liberal- including some prominent economists, ization of the capital account to have suggested that developing countries Blustein, Paul. “Is Malaysia’s Reform Working? Capital Controls Appear provide accurate pricing infor- should reconsider capital controls. This to Aid Economy, but Doubts Remain,” Washington Post, November mation for business decisions. article has reviewed the issues associated 21, 1998, p. G01.

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