Capital Inflows: The Role of Controls; by Jonathan D. Ostry, Atish R. Ghosh, Karl Habermeier, Marcos Chamon, Mahvash S. Qureshi, and Dennis B.S. Reinhardt; IMF Staff Position Note SPN/10/04; February 19, 2010.

I M F S T A F F P O S I T I O N N O T E

February 19, 2010

SPN/10/04

Capital Inflows: The Role of Controls

Jonathan D. Ostry, Atish R. Ghosh, Karl Habermeier,

Marcos Chamon, Mahvash S. Qureshi, and Dennis B.S. Reinhardt

I N T E R N A T I O N A L M O N E T A R Y F U N D

INTERNATIONAL MONETARY FUND

Research Department

Capital Inflows: The Role of Controls

Prepared by Jonathan D. Ostry, Atish R. Ghosh, Karl Habermeier, Marcos Chamon,

Mahvash S. Qureshi, and Dennis B.S. Reinhardt

February 19, 2010

JEL Classification Numbers: F21, F32

Keywords: capital inflows, capital controls, financial crisis

Authors’ E-mail Addresses: jostry@imf.org, [email protected],

, and

DISCLAIMER: The views expressed herein are those of the author(s) and should

not be attributed to the IMF, its Executive Board, or its management.

Contents Page

I. Introduction and Overview .......................................................................................................... 4

II. Responding to Capital Inflows ................................................................................................... 6

III. Inflows, Fragilities, and Controls—Some Stylized Facts ....................................................... 11

IV. Conclusions............................................................................................................................. 15

References ......................................................................................................................................25

Box

1. Country Experiences with Controls on Short-Term Capital Inflows .........................................14

Figure

1. Coping with Surges in Capital Inflows: Macroeconomic and Prudential Considerations ...........7

Table

1. Selected Cases of Control Measures on Capital Inflows ...........................................................16

Appendix 1. Inflows, Fragilities, and Controls—Some Empirics ................................................ 18

I. INTRODUCTION AND OVERVIEW

With the global economy beginning to emerge from the financial crisis, capital is flowing back to

emerging market economies (EMEs). These flows, and capital mobility more generally, allow

countries with limited savings to attract financing for productive investment projects, foster the

diversification of investment risk, promote intertemporal trade, and contribute to the

development of financial markets. In this sense, the benefits from a free flow of capital across

borders are similar to the benefits from free trade (see Reaping the Benefits of Financial

Globalization, IMF Occasional Paper 264, 2008), and imposing restrictions on capital mobility

means foregoing, at least in part, these benefits, owing to the distortions and resource

misallocation that controls give rise to (see Edwards and Ostry, 1992, for an example of how

capital controls interact with other distortions in the economy).

Notwithstanding these benefits, many EMEs are concerned that the recent surge in capital

inflows could cause problems for their economies. Many of the flows are perceived to be

temporary, reflecting interest rate differentials, which may be at least partially reversed when

policy interest rates in advanced economies return to more normal levels. Against this backdrop,

capital controls are again in the news.

A concern has been that massive inflows can lead to

exchange rate overshooting (or merely strong appreciations that significantly complicate

economic management) or inflate asset price bubbles, which can amplify financial fragility and

crisis risk. More broadly, following the crisis, policymakers are again reconsidering the view that

unfettered capital flows are a fundamentally benign phenomenon and that all financial flows are

the result of rational investing/borrowing/lending decisions. Concerns that foreign investors may

be subject to herd behavior, and suffer from excessive optimism, have grown stronger; and even

when flows are fundamentally sound, it is recognized that they may contribute to collateral

damage, including bubbles and asset booms and busts.

The question is thus how best to handle surges in inflows that may pose both prudential and

macroeconomic policy challenges. The tools are well known and include fiscal policy, monetary

policy, exchange rate policy, foreign exchange market intervention, domestic prudential

regulation, and capital controls. Clearly, the appropriate policy mix is likely to depend on the

state of the economy (i.e., how close it is to potential); the level of reserves (is further

accumulation desirable/appropriate?); the quality of existing prudential regulation (can

prudential tools effectively tackle the boom/bust credit/asset price cycle); the scope to allow the

currency to strengthen (is the currency already overvalued?); and the likely persistence of the

inflows (with permanent inflows less likely to warrant a policy response than transitory inflows).

We thank Olivier Blanchard and José Viñals for their guidance on this project and Chikako Baba, Reza Baqir,

Suman Basu, and Annamaria Kokenyne for contributions to the paper.

Recent cases include Brazil and Taiwan Province of China. The IMF’s Articles of Agreement recognize that

members generally may exercise such controls as are necessary to regulate international capital movements (Article

VI, Section 3). However, the general right of members to regulate international capital movements is qualified by

members’ obligations subject to IMF surveillance under Article IV.

This paper reviews the arguments on the appropriate management of inflow surges and focuses

in particular on the conditions under which controls may be justified. A key conclusion is that, if

the economy is operating near potential, if the level of reserves is adequate, if the exchange rate

is not undervalued, and if the flows are likely to be transitory, then use of 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.”

A key issue of course is whether capital controls have worked in practice. Our sense is that the

jury is still out on this, and it is difficult to get the data to speak loudly on the issue. Controls

seem to be quite effective in countries that maintain extensive systems of restrictions on most

categories of flows, but the present context relates mainly to the reimposition of controls by

countries that already have largely open capital accounts. The evidence appears to be stronger for

capital controls to have an effect on the composition of inflows than on the aggregate volume

(though empirical models linking aggregate inflows to controls are frequently subject to a host of

objections, most obviously, simultaneity bias). For example, in the case of Chile and Colombia,

controls do appear to have had some success in tilting the composition of inflows toward less

vulnerable liability structures (e.g., De Gregorio and others, 2000; and Cardenas and Barrera,

1997).

Looking at the current crisis, our own empirical results suggest that controls aimed at achieving a

less risky external liability structure paid dividends as far as reducing financial fragility. An

interesting twist is that some foreign direct investment (FDI) flows may be less safe than usually

thought. In particular, some items recorded as financial sector FDI may be disguising a buildup

in intragroup debt in the financial sector and will thus be more akin to debt in terms of riskiness.

This point resonates well with the experience of emerging Europe during the recent crisis.

A significant caveat, however, to the use of capital controls by individual countries, relates to the

potential for adverse multilateral consequences. In the present circumstances, global recovery is

dependent on macroeconomic policy adjustment in EMEs, which could be undercut by capital

controls, notably in cases where currencies are undervalued. Widespread adoption of controls by

EMEs could exacerbate global imbalances and slow other needed reforms—a critical concern at

present, when sustained global recovery hinges on a rebalancing of global demand and the

sources of growth in individual countries. In addition, controls imposed by some countries may

lead other countries to adopt them also: widespread adoption of controls could have a chilling

longer-term impact on financial integration and globalization, with significant output and welfare

losses. Multilateral dimensions clearly need to be taken into account in assessing the merits of

controls at the individual country level.

The vulnerability of emerging Europe in the wake of the recent crisis and the region’s heavy dependence on

foreign banking groups, particularly those from western Europe for capital, necessitated efforts (culminating in the

Initiative for Coordination of European Banks) to induce parent banks to maintain exposures to their subsidiaries.

The remainder of this paper is organized as follows. Section II explains the rationale for capital

controls as part of the package of policies to cope with surges in capital inflows. Section III

examines the empirical evidence from past studies, and from the current crisis, on the

effectiveness of controls, including in buttressing prudential regulation. Section IV concludes.

II.

RESPONDING TO CAPITAL INFLOWS

Although capital flows to developing and emerging market countries are generally welcome—

providing lower-cost financing and indicating market confidence in the fundamentals of the

economy—sudden surges can complicate macroeconomic management and create financial

risks. On the macroeconomic front, the concern is that the surge will lead to an appreciation of

the exchange rate and undermine competitiveness of the tradable sector—possibly causing

lasting damage even when inflows abate or reverse. The main worry from the financial fragility

perspective is that large capital inflows may lead to excessive foreign borrowing and foreign

currency exposure, possibly fueling domestic credit booms (especially foreign-exchange-

denominated lending) and asset bubbles (with significant adverse effects in the case of a sudden

reversal). Can such concerns justify the imposition of controls on capital inflows—not only from

the individual country’s perspective, but also taking account of multilateral considerations? The

answer is yes—under certain circumstances. Although in practice, macroeconomic and financial

fragility considerations are both relevant to a decision on whether to impose capital controls, it is

analytically useful to think of each in turn (Figure 1).

Macroeconomic Implications

How should a country respond to an inflow surge? The appropriate policy response is likely to be

multifaceted, according to the circumstances facing the country:

 Exchange rate appreciation. The first question is whether the exchange rate should be

allowed to appreciate. Although countries are frequently concerned that an appreciation

will damage competitiveness of the tradable sector, the multilateral context is paramount

here: if the exchange rate is undervalued from a multilateral perspective, the appropriate

response would be to allow the nominal exchange rate to appreciate passively in response

to the capital inflows. But when the exchange rate is already overvalued (or roughly in

equilibrium), and there are concerns about the impact of an appreciation on

competitiveness, a more proactive policy response is required.

 Reserve accumulation…The next question is whether the country has a relatively low

level of foreign exchange reserves (e.g., from a precautionary perspective) and whether

some further reserve accumulation would be desirable. If so, the capital inflows may

present a useful opportunity to augment the central bank’s reserve holdings.

See Baqir and others (2010) for a related flowchart, and Ghosh and others (2008) for a discussion of appropriate

policy responses to capital inflows and positive balance of payments pressures. On how to manage inflow surges—

including major bouts of carry trade flows associated with higher equilibrium real interest rates and

Balassa-Samuelson effects in the transition economies—see Lipschitz and others (2005, 2006)

 …and sterilization. If there are inflation concerns, the resulting increase in the money

supply can be sterilized through open-market operations or, more generally, a

corresponding decrease in domestic credit.

There are, however, limits to sterilization.

Domestic financial markets may not be sufficiently deep to absorb a significant increase

in sterilization bonds, and there is a fiscal cost associated with the differential between

interest paid on domestic bonds and interest earned on reserves (particularly in the

current low-yield environment). Moreover, sterilization means that domestic interest rates

continue to be relatively high, perpetuating inflows (especially if markets believe that,

because of fiscal costs or otherwise, the policy of reserve accumulation will eventually be

abandoned and the exchange rate will be allowed to appreciate).

If the central bank has exhausted the sterilization possibilities and risks losing monetary control,

or if it does not want to accumulate further reserves (and assuming that further exchange rate

appreciation would not be appropriate), it must try to reduce inflows through macroeconomic

policies or more direct methods.

 Monetary and fiscal policies. The policy response would be to lower interest rates, thus

reducing incentives for inflows, and to tighten fiscal policy—particularly when capital

inflows are driven by fiscal expansion—thus reducing currency appreciation pressures.

However, if the economy is at risk of overheating and there are inflation pressures,

reducing interest rates is not an attractive policy option, and both political considerations

and implementation lags may limit the scope for fiscal consolidation.

 Controls on capital inflows. In the face of substantial inflows, a purely macroeconomic

policy response may not suffice in some country circumstances (as described above), and

controls on capital inflows may form a useful part of the policy toolkit.

This is

particularly true of transitory surges, because the currency appreciation is likely to be

temporary, whereas damage to the tradable sector (through hysteresis effects) may be

more permanent. If the increase in flows is expected to be more persistent, by contrast,

the economy should adjust to the (permanently) higher real exchange rate, particularly as

Keeping credit conditions constant—so that sterilized intervention of capital inflows essentially replaces domestic

credit with foreign credit—may require a greater-than-corresponding decrease in the volume of domestic credit

since foreign credit will typically be offered at a lower interest rate (even adjusting for exchange rate expectations).

Other forms of sterilization include raising reserve requirements, which does not incur a fiscal cost (especially if

reserves are not remunerated), though their excessive use can lead to undesirable financial disintermediation.

Cardarelli, Elekdag, and Kose (2007) provide evidence that real appreciation and demand growth was more

contained in countries that responded to capital inflows by pursuing a tighter fiscal policy. However, there is often a

political temptation to avoid making necessary fiscal adjustments and to rely instead on capital controls.

The literature does not provide unambiguous evidence on the relative effectiveness/distortedness of price-based

versus administrative controls. Countries tend to use the types of controls they are most familiar with from past

practice—the obvious advantage being easier implementation for both the authorities and the banking sector.

controls lose their effectiveness over time, and thus need to be continually strengthened,

leading to increasing distortions.

Financial Fragility

Beyond their macroeconomic effects, capital inflows—especially certain types of liabilities—can

make the country more vulnerable to financial crisis. An obvious example is debt versus equity

flows, where the latter allows for greater risk sharing between creditor and borrower. Capital

inflows might also fuel domestic lending booms, including foreign-exchange-denominated

credit, which is especially dangerous if extended to borrowers lacking a natural hedge (e.g.,

households rather than exporters). More generally, it is not implausible that herd behavior and

excessive optimism on the part of foreign lenders, coupled with myopic borrowers who

underestimate foreign exchange and liquidity risks, can lead to foreign borrowing that is

suboptimal from a financial fragility perspective. Based on these considerations, the theoretical

literature yields a pecking order of capital inflows, in decreasing order of riskiness, with short-

term instruments more risky than long-term ones within each category:

 Foreign-currency debt,

 Consumer-price-indexed local currency debt,

 Local-currency debt,

 Portfolio equity investment, and

 Foreign direct investment.

During “normal” times, prudential regulation of the domestic banking system, such as (possibly

cyclical) capital requirements and limits on foreign exchange lending to unhedged borrowers,

may suffice. But again, in the face of large capital inflows that may fuel credit booms, controls

on inflows can buttress prudential regulations—particularly if it is possible to target the flows

that lead to the greatest vulnerabilities.

For example, unremunerated reserve requirements on

foreign exchange debt can be used to reduce external foreign exchange borrowing, and even if

this encourages substitution into other forms of external debt, the risks are reduced.

Inflow

taxes on short-term debt reduce the price differential between short- and long-term debt and

induce longer maturities. The optimal size of the tax depends on the risk of liquidity panics, the

size and social cost of the associated fiscal adjustment, and the elasticity of substitution between

debt of different maturities. Financial transaction taxes are relatively more costly for short-term

carry trades and may deter such flows. Minimum-stay requirements are a direct method of

lengthening the maturity of liabilities.

Excessive limits on banks could lead to disintermediation and proliferation of nonregulated financial institutions

(Wakeman-Linn, 2007).

Such a policy will be less effective if foreign investors circumvent the restrictions, for example, by writing

currency swap contracts.

Other Considerations

Even if an analysis along the lines sketched above points to the adoption of capital controls,

several other factors need to be considered:

Effectiveness

The first and most obvious issue concerns the effectiveness of controls. This depends on whether

the country has some existing controls and therefore the administrative apparatus is already in

place. For countries that have a substantially closed capital account, strengthening controls will

be easier (but there may be less need for such countries to further impede capital inflows). More

relevant for present purposes is the case of countries with substantially open capital accounts,

which will need to design and implement new controls and likely strengthen them over time in

the face of circumvention, without creating excessive distortions. The importance of this factor is

often underestimated.

Controls on outflows

Second, though the discussion here is confined to controls on inflows, relaxing controls on

outflows may also have an impact on aggregate net inflows, and hence on the exchange rate and

other macroeconomic variables. But the direction of that impact is unclear. On the one hand,

liberalizing capital outflows can reduce net inflows as some of the inflows are offset by outflows.

On the other hand, greater assurance that capital can be repatriated may make the country an

even more attractive destination for foreign investors.

Multilateral considerations

As emphasized above, any decision to impose capital controls needs to take account of their

multilateral repercussions.

At a most basic level, the greatest concern is that widespread use of

capital controls by EMEs could have deleterious effects on the efficient allocation of investment

across countries, reducing gains from intertemporal (asset) trade much as tariffs limit the gains

from goods (within-period) trade.

Widespread use of controls, especially by systemically important countries, could also impede

necessary steps to address global imbalances. It might allow countries to avoid appreciation

where currencies are undervalued and where appreciation is needed to support global demand

rebalancing. Clearly, to the degree that currencies in some countries are undervalued relative to

some notion of medium-term equilibrium (see, for example, Exchange Rate Assessments: CGER

Methodologies, IMF Occasional Paper 264, 2008), the first-best policy—as argued above—

would be to allow currencies to strengthen in response to capital inflows; this would also have

the welcome effect from a multilateral perspective of increasing current account deficits

(reducing surpluses) in a manner consistent with reducing the extent of global current account

imbalances. By contrast, adoption of controls by countries with undervalued currencies would be

To the extent that capital inflows to EMEs are driven by the policy environment in advanced economies, they too

need to take account of the multilateral implications of their policies.

likely to redirect flows to countries less able to absorb them, thus adding to systemic pressures

and running the clear risk of a bandwagon response in the form of generalized financial

protectionism.

In addition, the adoption of controls by some countries might lead others to follow suit: controls

may thus be contagious. To the degree that capital controls complicate the management of

inflows for other countries, which will likely see even more capital flowing in their direction,

they can be considered a beggar-thy-neighbor policy. Finally, while these considerations

generally caution against the imposition of controls, it bears emphasizing that multilateral

considerations do not militate unambiguously against the imposition of controls. For instance,

inasmuch as controls curtail especially risky forms of capital inflows, they may also reduce

countries’ precautionary demand for reserves, thus serving to reduce global imbalances and

contributing to systemic stability.

To summarize, there are two main reasons why governments might want to impose capital

controls—to limit the appreciation of the exchange rate and to limit crisis vulnerability due to

excessive or particularly risky forms of foreign borrowing. While other tools—macroeconomic

policies and prudential regulations—should always be deployed, logic suggests that

appropriately designed controls on capital inflows could usefully complement them in certain

circumstances, especially in the face of temporary inflow surges. Controls would normally be

temporary, as a means to counter surges. More permanent increases in inflows tend to stem from

more fundamental factors and will require more fundamental economic adjustment—though of

course it is not always easy to tell whether a surge is temporary or portends a persistent trend.

III. INFLOWS, FRAGILITIES, AND CONTROLS—SOME STYLIZED FACTS

The discussion above suggests certain circumstances under which capital controls might be

useful for macroeconomic management or prudential purposes. But are they effective in

practice? This section takes a look at the stylized facts, surveying existing studies and exploiting

the “natural experiment” of the global financial crisis to see whether capital controls and the

nature of precrisis capital flows had any bearing on how individual EMEs fared in the current

crisis (further details of the empirical results are included in an appendix to this paper).

Existing Empirical Evidence

The effectiveness of capital controls needs to be judged against the objectives in imposing them,

which may include reducing the volume of inflows and limiting the appreciation of the exchange

See Ghosh, Ostry, and Tsangarides (2010) for a discussion of how reducing the precautionary demand for reserves

would contribute to systemic stability by helping narrow global imbalances and avoid a sudden tipping point in the

demand for major reserve assets.

One rule of thumb is that flows that push the real exchange rate toward equilibrium are more likely to be

persistent than flows that contribute to overshooting. For an analysis of the cyclical behavior of different types of

capital flows, see Country Insurance: The Role of Domestic Policies (IMF Occasional Paper 254, 2007), pp. 8–9,

which argues that banking flows are much more prone to reversal than other types of inflows (portfolio and FDI).

rate, altering the maturity composition of inflows to reduce financial fragility, and providing

additional monetary policy independence.

Although individual country studies often find little or no impact of capital controls on the

aggregate volume of inflows (Table 1), some cross-country analyses suggest that, at least among

countries that faced some surge in inflows, those with controls experienced smaller surges.

Obviously, all other things being equal, a country with a closed capital account will experience

smaller inflows than a country with a largely open capital account. The effectiveness of controls

in regulating inflows thus depends on how extensive they are, whether the country maintains the

necessary administrative and institutional infrastructure to enforce the controls, and the

incentives investors have to try to circumvent them. The lack of convincing evidence on the

effectiveness of controls in reducing the total volume of inflows therefore likely reflects (1) the

relatively marginal control measures adopted by EMEs in recent years; (2) the fact that capital

controls are often imposed or strengthened as part of an overall package of policy responses,

making it difficult to isolate their effect; (3) difficulty in measuring the intensity of capital

controls; and (4) econometric identification problems—for instance, if countries that are facing

large inflows are the ones that impose controls, it is not surprising that econometric studies find

no, or even a positive, relationship between controls and the magnitude of capital inflows.

Further, the recent wave of capital controls has also included restrictions on derivative positions

(for example, in Colombia), which highlights the deepening and sophistication of financial

markets in EMEs and the potential complexity in assessing the effects of controls. Since most

studies do not find much impact of controls on aggregate volumes of inflows, they usually do not

find much effect on exchange rate appreciation either.

Evidence from the Current Global Financial Crisis

Empirical studies are typically more successful at finding some impact of capital controls on

monetary policy autonomy

and on the composition of inflows—particularly, lengthening their

maturity (Box 1, Figure 1).

This raises the question of whether limiting (certain types) of

See Cardarelli, Elekdag, and Kose (2007), who find that, among countries facing inflow surges, those with

controls experienced smaller inflows—2 percent of GDP in episodes with “high” capital controls compared with 4

percent of GDP in instances where the country had no or low controls. In a panel of emerging market economies,

Kim, Qureshi and Zalduendo (2010) likewise find that controls are associated with smaller surges.

See Gallego, Hernández, and Schmidt-Hebbel (1999) and De Gregorio and others (2002) for Chile; and Clements

and Kamil (2009) for Colombia. Using a GARCH model, however, Edwards and Rigobon (2009) find that a

tightening of controls led to depreciation of the nominal exchange rate within its band in Chile.

De Gregorio and others (2002) find that capital controls allowed Chile’s central bank to target a higher domestic

interest rate over a period of 6 to12 months; Ma and McCauley (2008) and Hutchison and others (2009) find that

interest differentials are significant and persistent in China and India, which maintain more extensive capital controls.

However, Ghosh, Ostry and Tsangarides (2010) find significantly lower monetary autonomy in countries with fixed

exchange rates compared with more flexible regimes, even in countries with relatively closed capital accounts.

See Ariyoshi and others (2000), which examined the experience with capital controls of five countries (Brazil,

Chile, Colombia, Malaysia, and Thailand) in the 1990s to limit short-term inflows. De Gregorio and others (2002),

Cardoso and Goldfajn (1998), Cardenas and Barrera (1997), and Goh (2005) find that controls can lengthen the

(continued)

capital inflows is useful for reducing financial fragility. The recent global financial crisis

provides a natural experiment in this regard, with differences in how EMEs have fared possibly

shedding light on whether certain types of capital inflows pose greater risk of financial fragility,

and whether controls on inflows have indeed been associated with reduced vulnerabilities.

A first look at the foreign liability structure of the EMEs and their resilience in the current crisis

suggests that larger stocks of debt liabilities and of FDI in the financial sector (“financial FDI”)

are associated with worse growth slowdowns (Figure A1). More formal regression analysis

supports this finding: countries with larger stocks of debt liabilities or financial FDI fared worse

in the current crisis, whereas those with larger stocks of nonfinancial FDI fared better (Table

A1). The findings in regard to debt and nonfinancial FDI conform to conventional wisdom: debt

represents fixed obligations for the borrower, with limited risk sharing with the creditor, whereas

FDI—especially greenfield FDI—is not only less likely to flee in a crisis, it may also be a source

of fresh financing. More surprising is the greater vulnerability associated with financial FDI.

Although financial FDI can be useful (many studies—e.g., Kose and others, 2006—find benefits

of foreign bank ownership), the results indicate that some components of financial FDI bring

added risks—for example, financial FDI may reflect lending from a parent bank to a branch or

local affiliate, which may be more in the nature of debt flows than greenfield FDI.

Why are debt and some components of financial FDI more risky? Both are strongly associated

with credit booms and foreign-exchange-denominated lending by the domestic banking system,

which in turn is associated with greater vulnerability (Figure A2; Table A2). This is likely to be a

key channel through which such flows make the country more susceptible to crisis. Interestingly,

however, the greater crisis vulnerability associated with debt liabilities holds, even when

controlling for credit booms and foreign-exchange-denominated lending—perhaps because

households and firms may borrow directly from abroad (or flows are intermediated through

nonbank financial institutions). Accordingly, controls that limit debt inflows (and debt flows

recorded as financial FDI) might usefully supplement prudential regulations aimed at curtailing

domestic credit booms and unhedged foreign-exchange-denominated lending.

Empirically, there does appear to be a negative association between capital controls that were in

place prior to the global financial crisis and the output declines suffered during the crisis

(Table A3). Although causation is far from established, the empirical evidence suggests that the

use of capital controls was associated with avoiding some of the worst growth outcomes

associated with financial fragility.

Moreover, consistent with the discussion above, it is controls

maturity of inflows. Of course, a finding of an effect on the composition of inflows belies the lack of a finding on

aggregate volumes, unless one is willing to believe that substitution between different types of capital inflows is

perfect.

Note that FDI includes loans between a parent and subsidiary, as long as the parent has a controlling interest,

where controlling interest is usually taken to be an ownership stake of at least 10 percent.

In a sample of about 200 crisis episodes in about 90 countries over 1970–2007, Gupta, Mishra, and Sahay (2007)

report a similar result, namely, that drops in output during crisis episodes are significantly lower if capital controls

existed before the crisis.

Fig 1. Net private financial flow s (% of GDP)

-7

-2

1990 1993 1996 1999 2002 2005 2008

Brazil Chile Colombia

Chile controls (1991-98)

Brazil controls (1993-97)

Colo mbia contro ls (1993-98)

100

1990 1993 1996 1999 2002 2005 2008

Fig 2. Chile: Composition of foreign liabilities

(in percent)

Other Debt FDI Portfolio

Inflow controls

Box 1. Country Experiences with Controls on Short-Term Capital Inflows

Recourse to capital controls to counter surges in capital inflows has been pervasive in emerging markets. Controls are often

imposed to maintain monetary control while reducing pressures on the exchange rate and to address prudential concerns in the

presence of large, short-term inflows. The effectiveness of such controls is, however, a much debated issue—country

experiences have varied, depending largely on the motivation and nature of controls and on country-specific characteristics

such as the administrative capacity to implement them.

Volume of inflows: In general, capital controls are found to have little

impact on the total volume of capital inflows and thus on currency

appreciation. For example, the imposition of inflow restrictions by Brazil,

Chile, and Colombia in the 1990s had no significant impact on total capital

inflows, nor were pressures on the exchange rate alleviated (Figure 1). In

fact, over the course of their capital controls, the real effective exchange rate

appreciated by about 5 and 4 percent annually in Brazil and Chile,

respectively. In Thailand, the real exchange rate started appreciating within

a week after controls on short-term flows were imposed in December 2006.

The most recent episode of controls in Colombia (during 2007–08) was also

ineffective in reducing the volume of non-FDI inflows or in moderating the

currency appreciation (Clements and Kamil, 2009).

Composition of inflows: Controls on inflows, however, may alter the

maturity structure and composition of inflows. In Chile, for example,

controls seem to have been effective in altering the composition of

inflows—short-term debt as a proportion of total liabilities declined,

whereas the stock of FDI increased from about 34 percent in 1991 to 53

percent in 1998 (Figure 2). Cardoso and Laurens (1998) and Gregorio,

Edwards, and Valdes (2000) find that the Chilean unremumnerated reserve

requirement (URR) was also effective in tilting the composition of inflows

away from short-term maturities. Similarly, after the URR was imposed in

Colombia in 1993, the maturity structure of the private external debt stock

changed significantly—the share of medium- and long-term debt increased

to 70 percent of the total external debt stock in 1996, from 40 percent in

1993 (Ariyoshi and others, 2000).

Prudential concerns: Domestic financial stability concerns raised by large capital inflows are often addressed by introducing

prudential measures either with traditional (administrative and market based) capital controls or as stand-alone measures. Such

measures could be effective in reducing currency mismatches as well as in limiting debt inflows. For example, Malaysia

introduced prudential requirements (such as the asymmetric open-position limits of banks) along with temporary capital

controls to limit short-term inflows in 1994. The measures were effective in influencing the volume as well as composition of

inflows in the short term. Similarly, the strong prudential framework in place in Chile is considered to have played an

important role in complementing capital controls to affect the composition of inflows (Ariyoshi and others, 2000). Croatia’s

imposition of prudential measures—including the marginal reserve requirement on bank foreign financing during 2004–08—in

response to concerns pertaining to the high credit growth triggered by capital inflows—was also effective in reducing external

bank debt in 2006–08 (Jankov, 2009).

An important issue highlighted by the experience of the EMEs is that the effectiveness of capital controls and prudential

measures in terms of limiting inflows, changing their composition, and achieving the desired macroeconomic objectives hinges

critically on countries’ implementation capacity. In general, the controls’ impact is short lived as markets adjust to them. A

strong enforcement capacity as, for example, in Chile, is therefore needed to identify loopholes and prevent circumvention.

Sources: WEO database, and Lane and Milesi-

Ferretti (2007) updated database.

on debt flows that are significantly associated with avoiding crises. Although further study is

needed, these controls are not associated with lower average growth in the precrisis period as

well.

IV. CONCLUSIONS

There is no surefire one-size-fits-all way to deal with the impact of potentially destabilizing

short-term capital inflows. From an individual-country point of view, the usual elements of the

toolkit to manage inflows include currency appreciation, reserves accumulation, adjustments in

fiscal and monetary policy, and strengthening the prudential framework. In some circumstances,

however, the usual macro policy remedies will not be appropriate (e.g., because inflation is a

concern, so lowering domestic policy rates will be ill advised, the currency is already too strong,

or reserves are more than adequate). In others, it may not be possible to quickly address financial

fragility concerns through the domestic prudential framework alone. For both macroeconomic

and prudential reasons, therefore, there may be circumstances in which capital controls are a

legitimate component of the policy response to surges in capital inflows.

Multilateral dimensions, however, are integral to a balanced perspective on the appropriateness

of using capital controls to manage inflows. While controls can be helpful to individual countries

under certain conditions, their widespread use could have deleterious effects on the efficient

allocation of investment across countries, and harm prospects for global recovery and growth.

Greater use of controls could also lead to crowding out of less distortionary policies to manage

inflows, and contribute to contagion, with countries whose individual circumstances do not

justify the use of controls choosing to adopt restrictions on inflows. Widespread adoption of

controls could also contribute to widening of global imbalances, especially if restrictions were

implemented by countries with undervalued currencies as a means to resist appreciation.

Conversely, however, inasmuch as controls reduce countries’ precautionary demand for reserves

by curtailing inflows of “hot money” and especially risky forms of liabilities, they could

contribute to reducing global imbalances and thus enhance systemic stability. A multilateral

framework governing the reimposition of controls, balancing the various considerations, could

be helpful in managing possible cross-country spillovers.

The perspective of this note is thus that capital controls are a legitimate part of the toolkit to

manage capital inflows in certain circumstances, but that a decision on their use should reflect a

comparison of the distortions and implementation costs that they may impose and the benefits

from regaining macro policy control and reducing financial fragility. There is a need for a regular

reassessment to ensure that capital controls remain the appropriate response as long as these are

maintained. Moreover, this note also emphasizes that any use of capital controls should

internalize to the extent possible the systemic dangers that could result from widespread adoption

of controls by a large number of countries.

Table 1. Selected Cases of Control Measures on Capital Inflows

Country Year Controls Did controls on inflows:

Study Reduce the volume

of net flows

Alter the

composition

Reduce real exchange

rate pressures

Brazil

1993–97 - Explicit tax on capital flows on stock

market investments, foreign loans, and

certain foreign exchange transactions.

- Administrative controls (outright

prohibitions against, or minimum maturity

requirements for, certain types of inflows).

Cardoso and Goldfajn (1998)

Reinhart and Smith (1998)

Ariyoshi and others (2000)

Edison and Reinhart (2001)

Carvalho and Garcia (2008)

Yes (ST)

Chile

1991–98 - Introduced URR on foreign borrowing,

later extended to cover nondebt flows,

American Depository Receipts, and

potentially speculative FDI.

- Raised the discount rate.

Valdes-Prieto and Soto (1998)

Le Fort and Budnevich (1997)

Larrain, Laban, and Chumacero (1997)

Cardoso and Laurens (1998)

Reinhart and Smith (1998)

Edwards (1999)

Gallego and Schmidt-Hebbel (1999)

Ariyoshi and others (2000)

De Gregorio, Edwards, and Valdes

(2000)

Edwards and Rigobon (2009)

Yes (ST)

Yes

Yes (ST)

Yes

Yes (ST)

Yes

Yes (ST)

Yes

Colombia

1993–98 - Introduced URR on external borrowing

(limited to loans with maturities up to 18

months) and later extended to cover

certain trade credits.

Le Fort and Budnevich (1997)

Cardenas and Barrera (1997)

Reinhart and Smith (1998)

Ariyoshi and others (2000)

Yes (ST)

Yes

2007–08 - Introduced URR of 40 percent on foreign

borrowing and portfolio inflows.

- Imposed limits on the currency derivative

positions of banks (500 percent of capital).

Concha and Galindo (2008)

Cardenas (2007)

Clements and Kamil (2009)

Yes

Yes (ST)

Yes

Croatia

2004–08 - Introduced prudential marginal reserve

requirements on bank foreign financing.

Jankov (2009) Yes

Table 1. Selected Cases of Control Measures on Capital Inflows (concluded)

Country Year Controls Did controls on inflows:

Study Reduce the volume of

net flows

Alter the

composition

Reduce real exchange

rate pressures

Malaysia

1994 - Prohibition against sale of short-term debt

securities and money market instruments to

nonresidents, and against commercial banks’

engagement in non-trade-related swaps or

forward transactions with nonresidents.

- Ceilings on banks’ net liability position.

- Non-interest-bearing deposit requirement

for commercial banks against ringgit funds of

foreign banks.

Ariyoshi and others (2000)

Tamirisa (2004)

Yes Yes Yes (ST)

Thailand

1995–96 - URR imposed on banks’ nonresident baht

accounts.

- Introduced asymmetric open-position limits

to discourage foreign borrowing.

- Imposed reporting requirements for banks

on risk-control measures in foreign exchange

and derivatives trading.

Ariyoshi and others (2000) Yes Yes Yes

2006–08 - URR of 30 percent imposed on foreign

currencies sold or exchanged against baht

with authorized financial institutions (except

for FDI and amounts not exceeding

US$20,000). Equity investments in

companies listed on the stock exchange were

made exempt from the URR.

Cross-country evidence

Reinhart and Smith (1998)

Montiel and Reinhart (1999)

Edison and Reinhart (2001)

Binici, Hutchison, and

Schindler (2009)

Yes (ST)

Sources: Magud, Reinhart, and Rogoff (2007), and IMF staff.

Note: A blank entry refers to the cases where the study in question did not analyze the particular relationship. (ST) refers to cases where only short-term effects were detected.

APPENDIX 1. INFLOWS, FRAGILITIES, AND CONTROLS—SOME EMPIRICS

This appendix looks at some simple empirics on how EMEs have fared in the current global

financial crisis to infer (1) whether certain types of capital inflows pose greater risk of financial

fragility, (2) the reasons these inflows are more risky, and (3) whether capital controls on these

inflows are indeed associated with reduced vulnerabilities. The sample consists of some

37 EMEs, and their performance in the current crisis is measured as average growth in 2008 and

2009 relative to the country’s historical average (real GDP growth, 2003–07).

Vulnerable foreign liability structures

Is there any relationship between a country’s foreign liability structure and its resilience in the

current crisis? Table A1 (column [1]) uses regression analysis to compare growth resilience in

the crisis against the structure of foreign liabilities (stocks, in percent of GDP, as of end-2007)—

financial FDI, nonfinancial FDI, debt, and equity. To some degree, the results conform to

conventional wisdom: on average, countries with larger stocks of debt liabilities fared worse,

while countries with nonfinancial FDI fared better. This is not surprising inasmuch as debt

liabilities (especially in foreign exchange) imply fixed obligations for the borrower, with more

limited risk sharing with the creditor. FDI, especially greenfield FDI, is not only less likely to

flee in a crisis, it may also be a source of additional financing. This is not to suggest that FDI in

the financial sector is necessarily bad: on the contrary, a number of studies have found positive

effects of foreign bank presence in both crisis and more tranquil periods (see, e.g., Kose, Rogoff,

and Wei, 2006). Nevertheless, it would appear that at least some components of financial FDI

bring added risks. One reason is that, in the sample, financial FDI may be capturing lending from

a parent bank to a subsidiary, which brings risks similar to those of debt flows.

Channels of risk

Why are debt and some (presumably the debt-like) components of financial FDI more risky?

First, credit booms and a larger stock of foreign-exchange-denominated credit are strongly

associated with greater vulnerability, as measured by a larger decline in output growth (Table

A1, columns [4]–[5]). Second, these inflows are strongly correlated with both credit booms and

greater foreign-exchange-denominated lending by the domestic banking system (Table A2,

columns [1]–[2]).

It follows that one channel through which financial FDI and debt flows contribute to financial

fragility could be by fueling domestic credit booms, including in foreign exchange. Accordingly,

The full sample consists of 50 EMEs, but data limitations restrict the usable sample to a maximum of

37 countries. The results reported here are robust to the exclusion of outliers, and to alternate definitions of the

dependent variable (for example, using the average real growth rate in 2008–09 as the crisis variable).

Note that foreign direct investment includes loans between a parent and subsidiary, as long as the parent has a

controlling interest, where controlling interest is usually taken to be an ownership stake of at least 10 percent.

efforts at limiting flows of debt liabilities and debt flows recorded as financial FDI can

supplement prudential regulations aimed at curtailing domestic credit booms and unhedged

foreign exchange lending.

Moreover, it is noteworthy that foreign debt liabilities remain significantly associated with worse

growth resilience, even after controlling for domestic-banking-system credit booms and foreign-

exchange-denominated lending (Table A1, columns [6]–[7]). This is because the nonfinancial

private sector (corporations, households) may be able to borrow abroad directly (or

intermediated through the nonbank domestic financial sector). As such, even if prudential

regulation were perfectly able to curtail lending booms (including in foreign currency) by

domestic banks, there could be a case for curtailing debt liabilities on the grounds that they

contribute to crisis risk.

Capital controls and financial fragility

The discussion above suggests that certain types of capital flows—debt and certain forms of

financial FDI—contribute to crisis vulnerability, partly (though not exclusively) by helping fuel

domestic lending booms. But is there any indication that capital controls have helped limit

financial fragility? Specifically, did countries that had controls on inflows in place during the years

leading up to the crisis turn out to be less vulnerable in the global financial crisis?

Although the results should not be taken as anything more than suggestive correlations, it does

appear that such countries indeed fared better in the current crisis. This association shows up

more clearly when considering crises—that is, large declines in output growth rates (Table A3,

columns [1]–[3]).

Although causation is far from established, the empirical evidence suggests

that the use of capital controls was associated with avoiding some of the worst growth outcomes

associated with financial fragility.

Moreover, consistent with the discussion above, it is controls

on debt flows that are significantly associated with avoiding crises. Although further study is

needed, these controls are also not associated with lower average growth in the precrisis period.

Gallego and Hernandez (2003) find that controls are associated with lower leverage and greater reliance on

retained earnings. However, they may have greater impact on some firms than others; Forbes (2007) argues that

inflow controls in Chile imposed a financial constraint mainly on small firms.

Table A3 reports the results of a probit regression, where the dependent variable “crisis” is defined as a real GDP

growth slowdown that is in the sample’s lowest decile, corresponding to a decline in real GDP growth (average

2008–09 relative to 2003–07) of about 10 percentage points.

In a sample of about 200 crisis episodes in about 90 countries over 1970–2007, Gupta, Mishra, and Sahay (2007)

report a similar result. Specifically, they find that the fall in output during episodes of crisis is significantly lower if

capital controls existed before the crisis.

Using a panel of 50 EMEs over 1995–2005, both simple correlations between real GDP growth and capital

controls yield positive but mostly statistically insignificant results; augmenting the regression with standard growth

determinants (income convergence, investment, human capital, terms-of-trade shocks, trade openness, fiscal

balance, population growth) also yields insignificant coefficients on capital controls; usual econometric caveats

apply.

To summarize, capital controls on certain types of inflows might usefully complement prudential

regulations to limit financial fragility and can be part of the toolkit. In particular, by helping fuel

credit booms, especially in foreign currency, debt liabilities, including debt recorded as financial

FDI, seem to bring significant vulnerabilities to the economy. Although it is difficult to find

definitive evidence, notably on the causal linkages among the various variables, the simple

empirics presented above are at least suggestive of these conclusions.

[1] [2] [3] [4] [5] [6] [7]

Foreign Liabilities 2/

Non-Financial FDI (% of GDP, 2007) -0.071** -0.086*** -0.087*** -0.090*** -0.087***

(0.031) (0.030) (0.027)

(0.028) (0.024)

Financial FDI (% of GDP, 2007) 0.195** 0.134 0.002 0.021

-0.045

(0.087) (0.087) (0.145)

(0.106) (0.157)

Debt Liabilities (% of GDP, 2007) 0.116*** 0.116*** 0.102**

0.091*** 0.084*

(0.036) (0.032) (0.042)

(0.032) (0.042)

Equity Liabilities (% of GDP, 2007)

-0.047 -0.039 -0.057 -0.040 -0.061

(0.064) (0.051) (0.065)

(0.041) (0.053)

Domestic Banking System Credit

FX Credit (% of GDP, 2007) 0.153*** 0.043 0.008

(0.0534) (0.069)

(0.057)

Change in Credit/GDP from 2003 to 2007 0.151*** 0.101* 0.100

(0.051) (0.051)

(0.064)

Other regressors:

Growth in trading partners 3/ -0.048** -0.018 -0.038** -0.054**

-0.047** -0.053**

(0.022) (0.019) (0.016) (0.025)

(0.020) (0.022)

Change in terms of trade 4/ -0.122 -0.017 0.0162 -0.084

-0.068 -0.029

(0.099) (0.122) (0.100) (0.102)

(0.101) (0.113)

Constant 3.49 0.873 2.857** 1.814 1.532 1.64

2.253

(2.19) (1.545) (1.269) (1.138) (1.785)

(1.495) (1.504)

Observations 35 34 30 33 30 33 29

R-squared 0.43 0.608 0.411 0.473 0.619 0.717

0.727

Table A1. Composition of Flows and Output Growth Decline, 2008–09 1

2/ End-2007 stock (in percent of GDP) based on Lane and Milesi-Ferretti (2007) updated database. Breakdown of FDI into Financial and

Non-Financial sectors based on Reinhardt (2009) estimates.

1/ Dependent variable defined as average growth in 2003-07 minus average growth in 2008-09. Positive coefficient indicates that the

regressor is associated with a larger decline in the real GDP growth rate.

4/ Average annual percentage change in terms of trade over 2008-09.

3/ Average annual real growth rate in trading partners over 2008-09 weighted by average export to GDP ratio in 2003-07 (in percent).

Note: Robust standard errors in parentheses.*,**, and *** denote statistical significance at the 1, 5, and 10 percent levels,

respectively.

FX Credit (% of GDP 2007) 1/ Change in Credit/GDP 2/

Financial FDI (% of GDP, 2007)

1.305*** 0.914**

(0.346) (0.398)

Debt Liabilities (% of GDP, 2007) 0.389*** 0.258**

(0.071) (0.104)

Constant -8.044*** -0.031

(2.838) (0.045)

Observations 31 34

R-squared 0.75 0.31

2/ Change in banking system credit/GDP over 2003-07.

Table A2. Foreign Liabilities and Banking System FX-Credit and Credit Booms 1

Dependent variable

1/ FX-denominated banking system credit (in % of GDP).

Note: Robust standard errors in parentheses. *,**, and *** denote statistical significance at the 1, 5,

and 10 percent levels, respectively.

[1] [2] [3] [4]

Controls on 2/

Overall Inflows -2.026* -2.644**

(1.043) (1.329)

FDI Inflows -0.032 1.939

(1.206) (1.583)

Equity Inflows 2.057 3.443**

(1.376) (1.722)

Bond Inflows -4.054* -8.548**

(2.294) (3.708)

Growth in trading partners 3/ -0.010 -0.030**

(0.012) (0.014)

Change in terms of trade 4/ -0.107** -0.145*

(0.054) (0.085)

Constant -0.712* -1.480* -0.900** -3.097***

(0.385) (0.812) (0.351) (0.882)

Observations 37 37 37 37

Pseudo R-squared 0.117 0.240 0.168 0.368

Note: Robust standard errors in parentheses. *,**, and *** denote statistical significance at

the 10, 5 and 1 percent levels, respectively.

Table A3. Capital Controls and Growth Crisis 1/

2/ Capital controls based on the Schindler (2009) index averaged over 2000-05 (the last

year covered in the database is 2005).

1/ Crisis is coded as equal to one if the decline in the country's real GDP growth (2008-09

relative to 2003-07) is in the lowest 10th percentile of the sample.

4/ Average annual percentage change in terms of trade over 2008-09.

3/ Average annual real growth rate in trading partners over 2008-09 weighted by average

export to GDP ratio in 2003-07 (in percent).

Figure A1. Foreign Liabilities and Growth Decline (in percentage points)

Sources: IMF World Economic Outlook database, Lane and Milesi-Ferretti (2007) updated database, Reinhardt

(2009) and staff calculations.

Note: *Growth decline defined as average growth rates in 2008–09 relative to 2003–07.

Figure A2. Foreign Liabilities and Banking System

Source: IMF World Economic Outlook database, Lane and Milesi-Ferretti (2007) updated database, Reinhardt (2009),

IMF Country Desk data, Reinhardt (2009), and IMF staff calculations.

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