Brazil and its recent capital controls Bruno Thiago Tomio Berlin School of Economics and Law Mohamed Amal Regional University of Blumenau Abstract With many turnarounds about the role and the effectiveness of capital controls throughout time, the doubt about its desirability remains to be conclusive answered. By researching the opinion of policymakers and academics, this paper aims to demonstrate the benefits and harms of capital controls, focusing on a specific country, Brazil. This goes in the direction of the current debate on capital controls, which gathers relevant issues, amongst others, the current increasing flows of international capital to developing countries. Not only Brazil, but also others countries have been raising their protection against speculative capital flows. After the 2007/08 financial crisis, the control on foreign capital has gained relevance because low interest rates are set in developed countries and high interest rates in developing countries. This global imbalance started generating a new wave of controlling mechanisms, also called macro prudential tools. Still inconclusive as well is if such measure is working or not and if is a sustainable policy. With an econometric model, we are going to test if Brazil and its flows are being affected by such measures. The aim is to estimate a model that can shed some light on these policies undertaken by Brazilian government. The results show that capital controls in the recent period have been ineffective. Table of Contents Introduction .............................................................................................................................. 1 1. Brief History of Capital Controls ....................................................................................... 1 2. Benefits, Harms, and Current Debate................................................................................ 2 3. Empirical model for Brazil ................................................................................................. 6 Conclusion .............................................................................................................................. 11 References ............................................................................................................................... 11 Introduction With many turnarounds about capital controls throughout time, the doubt about its desirability remains to be conclusive answered. The first part gives the definition of capital controls, and, most importantly, a brief history of it. Following, researching the opinion of policymakers and academics, the second part demonstrates the benefits and harms of capital controls. In the same way, and section, the current debate gathers relevant issues, amongst others, the current building up of controls of international capital in developing countries. Brazil current position of increasing capital controls is analyzed in depth with the help of an econometric model. Lastly, the final part concludes with the main insights. 1. Brief History of Capital Controls In a broad definition, capital controls are the set of policies available for countries to make the regulation of capital flows (Ocampo and Stiglitz, 2008, p.357), either inflows or outflows. According to Kose et al. (2010), they may be direct, which is more related to administrative measures (e.g. limiting the volume of inflows), or indirect, also called market- based because it focus on taxing international capitals (e.g. Brazil’s recent tax on portfolio investments by non-residents). The history of capital controls is long, notably if the restrictions to gold and silver trade in the sixteenth-century are considered as such. Their “modern form” use dates from the World War I (Cooper et al., 1999). Abdelal (2007, p.1-18) divides the recent history of capital controls into four periods, relating them to the conventional opinion about it. According to him, the world has seen capital controls as orthodoxy or heresy, depending on the rules and restrictions of the international financial system at the respective time. In between 1914-1944, capital controls were considered a heresy in the beginning, and in the end of this period, they shifted to orthodoxy. The year 1931 is the turning point because European countries, fearing the contagion of the Great Depression in 1929, lifted again barriers for international capital flows. During the years 1944 to 1961, formal rules to control capital flows, especially hot money or short-term speculative capital, were accorded by the members of three international institutions: IMF (1945), European Community (1947), and OCDE (1961). Remarkably, the change for easing the controls on capital started to occur after World War II with the Americans opposing British’s ideas, mainly from Keynes, of 1 stronger controls (Cooper et al., 1999). Consequently, the third period, from 1961 to 1986, experienced first illegal movements of capital, with the Eurodollars market, which was the lending of dollars by US banks in London; lastly, the unilateral liberalization of capital movements by the US and the United Kingdom, in the end of the 1970s. Germany and Japan joined the team of free capital movements in the middle of the 1980s; comprising the year 1986 and onwards as the last period, capital controls became more a heresy and less an orthodoxy. By the early and middle of the 1990s, the IMF widely supported free movement of capitals; despite the EU and OCDE countries, which were much liberalized, other economies controlled capitals as they wished to (Abdelal, 2007, p.12-13). Recently, the debate on the benefits and harms of international capital flows have increased because of financial crises: (a) the debt crisis in the 1980s, caused by foreign debt; (b) the Asian crisis in 1997-8, exposed the damage of rapidly movements of foreign capital; and, (c) today’s crisis (global financial crisis of 2007-8), explained by several reasons, but amongst them the mobility of huge amount of foreign capital flows (Evans, 2010). The history of capital controls shows that there is no unified view on the issue, and the debate about its benefits and harms still goes on. 2. Benefits, Harms, and Current Debate There is an immense variety of studies on the benefits and harms of financial liberalization, which in a certain way are related to capital controls. Nevertheless, this discussion passes the limits of this essay, which focus is capital controls. In the recent literature, Dooley (1996) and Magud and Reinhart (2007) elaborated a survey of works on capital controls. Dooley (1996) main conclusions are: (a) regarding theoretical works, capital controls improve welfare; and, (b) on empirical works, he says that there is evidence of successful capital controls on increasing revenue for the governments and limiting domestic government debt costs, by decreasing debt-services payments. As for the main concluding insights of Magud and Reinhart (2007), control on capital inflows tend to be good for the economy (better control of monetary policies, and diminishing pressure of real exchange rate), and, the Malaysian case (1998-9) in controlling outflows is a unique case of success in these type of controls. When it comes to the theoretical ground, the arguments for and against capital controls are closely related to those of financial liberalization. This seems logical when 2 financial liberalization is defined as a process of easing controls of capital. Modenesi and Modenesi (2008) expose that the benefits from financial liberalization, i.e. against capital controls, are: (a) capital is better allocated around the world, where the profits are higher – same allocation argument is used by free trade supporters; (b) balance-of-payments are better adjusted, in favor of deficit countries; and, (c) governments would enhance their macroeconomic discipline because capital would flow more to countries with solid economies. In addition, capital controls go against the ideal of freedom, limiting the liberty of the members of societies; in another point of view, they are seen as ineffective too, capital always knows how to cheat controls illegally. Ahmed and Islam (2009, p. 5) gather the points pro financial liberalization in a group called the Goldsmith-McKinnon-Shaw school, because of these authors earlier works on financial liberalization. By contrast, arguments against financial liberalization, thus pro capital controls, argue that: (a) macroeconomic policies become more independent; (b) financially, the economy is more stable; (c) they are a necessary instrument against the overvaluation of the exchange rate by the flood of international capital; (d) avoid capital flight, which searches for higher interest rates; and, (e) can be used to foster specific changes in the structure of target sectors in the domestic economy by FDI. The main authors of this approach are Keynes, Harry D. White, Tobin, Davidson, Rodrik, and Stiglitz (Modenesi and Modenesi, 2008). A main argument is that countries tend to lose control over its exchanges rates, and, consequently, their indebtedness in foreign currencies grows, leading to balance-of-payments crises. Even rich countries are suffering some side effects of financial globalization with the 2007-8 global financial crisis (Bresser Pereira, 2010, p. 220). In the actual scenario, sympathy for capital controls is higher worldwide. In 2007, flows and outflows of international capital for developed countries were about six or seven trillion of dollars. By 2009, they were close