III Effectiveness of Capital Controls
- Liliana Rojas-Suárez, and Donald Mathieson
- Published Date:
- March 1993
The ability of quantitative capital controls or a dual exchange rate system to insulate domestic financial conditions from those in international financial markets is influenced by the expected gains from, and costs associated with, evading the controls. The incentives to evade capital controls will be stimulated not only by nominal yield differentials (including expected exchange rate changes) but also by differences in the availability of credit, the types of financial products and services that are provided, and the perceived stability and soundness of the financial institutions in domestic and offshore markets. In addition, the risks of expropriation and taxation of domestically held assets can also be important incentives to evade controls. The transaction, communication, and other costs (including bribery) of evading capital controls may be significantly lower for individuals and institutions that regularly engage in (legal) international trade and financial transactions than for others. When the costs are significant, small-scale illegal capital transfers are unprofitable. The scale of disguised capital flows is also sensitive to the penalties imposed on those who try to evade the capital controls. Just how effectively these penalties inhibit illegal capital transactions will depend on the effort put into enforcing capital controls and prosecuting violators. A large and technically sophisticated bureaucracy may be required to enforce a system of complex and comprehensive capital controls.
Channels for Evading Capital Controls
These incentives and costs also play a key role in determining channels that individuals have used to evade capital controls and arbitrage between the official and financial exchange markets under dual exchange rate systems. One of the most frequently used channels has been under- and overinvoicing of export and import contracts. To shift funds abroad, for example, exporters (importers) would underinvoice (overinvoice) a foreign customer and then use these funds to invest in external assets. In this way, they exploit one of the fundamental tensions in most capital control and dual exchange rate systems, namely, the need to control unauthorized capital flows while not interfering unduly with either normal trade financing for imports and exports or the typical transfer operations between a parent firm and its subsidiary for permitted foreign direct investment.
As noted by Kamin (1988), such under- and over-invoicing can lead to a distorted view of what happens to the trade balance just before and after a devaluation. In a study of more than sixty devaluations, Kamin found that, before the typical devaluation, the rates of growth of exports and imports declined sharply, while the current account balance and reserve holdings deteriorated markedly. Immediately after the devaluation, the current account balance recovered as exports rebounded strongly, while imports continued to decline, albeit less rapidly, until they bounced back sharply in the second year after the devaluation. His empirical analysis suggests that the period before the devaluation was preceded by both a real appreciation of the exchange rate and a sharp rise in the black market (unofficial) premium on foreign exchange, which led to underinvoicing of exports and reductions in officially reported exports. These shortfalls in export receipts increased the authorities’ reserve losses and led to declines in imports as the authorities tightened restrictions on access to foreign exchange. After the devaluation, the black market premium dropped, thus reducing the incentives for underinvoicing exports, and officially measured exports rose sharply. Improved reserve inflows also allowed the central bank to loosen restrictions on access to foreign exchange, and imports recovered.
Giddy (1980) also argued that multinational companies can use transfer pricing policies to evade capital controls. Before an anticipated exchange rate adjustment, changes in transfer prices and the leading and lagging of intracompany transfers enable these companies to shift funds in and out of a country.
Another trade-related channel for unrecorded capital flows has been the leads and lags in the settlement of commercial transactions or variations in the terms offered on short-term trade credits. When the Bretton Woods system collapsed in the early 1970s, for example, some industrial countries with extensive capital controls nonetheless experienced significant capital inflows as a result of the prepayment of exports by foreign entities (often the foreign subsidiaries of domestic corporations). This experience suggests that, before a major devaluation, drastic restrictions on trade financing will be difficult to enforce; if, however, restrictions are effectively enforced, capital controls or separate foreign exchange markets will be unable to shield current account transactions from erratic exchange rate fluctuations.
The balances in nonresidents’ “commercial” accounts in the domestic financial system, especially in countries with dual exchange rate arrangements, have often been drawn down sharply before a devaluation and then rebuilt relatively quickly after the devaluation. Remittances of savings by foreign workers in the domestic economy and by domestic nationals working abroad, family remittances, and tourist expenditures, although traditionally regarded as current account transactions, have also been used as vehicles for the acquisition or remission of foreign assets.
During the 1960s and 1970s, forward foreign exchange operations in industrial countries with capital controls and/or dual exchange rates provided residents with another channel for moving capital. When a major exchange rate depreciation was anticipated, the forward net foreign asset position of domestic residents often changed dramatically as many exporters responded by hedging a much smaller (or zero) proportion of their anticipated foreign exchange receipts and importers tried to obtain more cover.
Experiences with Capital Controls
While there are clearly many channels for evading capital controls, there are still the empirical questions of just how important these channels have been and under what conditions they may undermine the effectiveness of capital controls. To examine these questions, this section first reviews the experiences of industrial countries with capital controls since World War II and then presents an empirical analysis of the effectiveness of capital controls in developing countries.
Immediately after World War II, most industrial countries used exchange, trade, and capital controls to limit both current and capital account convertibility and their residents’ net foreign asset and liability positions (Greene and Isard, 1991). However, because current account controls created a variety of distortions, the industrial countries in Western Europe formally restored current account convertibility (by accepting the obligations of Article VIII of the IMF’s Articles of Agreement) by 1961, followed by Japan in 1964. Nonetheless, many major industrial countries continued to maintain capital controls (including dual exchange rates) throughout the 1960s and 1970s, with some (such as France and Italy) abolishing the last of their major capital controls only during the late 1980s. Although many studies have focused on the experiences of industrial countries with capital controls after World War II,3 the experience of Japan in the period 1945-80 and that of Ireland in the early 1980s can illustrate the typical conclusions of these studies. It has been argued that Japan had the most effective and efficiently administered system of capital controls up to the late 1970s;4 Japan’s experience can thus be used to identify some of the variables that contributed to the effectiveness as well as to the breakdown of capital controls. Ireland’s experience, in turn, illustrates the difficulties encountered by countries attempting to reimpose capital controls on previously integrated financial markets.
The legal basis for Japan’s post-World War II capital controls was initially provided by the Foreign Exchange and Foreign Trade Control Law, passed in 1949, under which foreign exchange transactions were prohibited in principle and permitted only in exceptional cases according to the directives and notifications of government ministries. Initially, private holdings of foreign exchange were restricted, and export receipts had to be sold to authorized foreign exchange banks. The authorities also specified a standard settlement period and required approval of prepayments or acceptance of advance receipts. Holdings of yen by nonresidents were subject to controls, and private capital movements were, in effect, prohibited. As noted by Fukao (1990), one indication of the effectiveness of these controls was that there was an almost one-to-one relationship between the level of Japan’s foreign exchange reserves and its cumulative current account balance between 1945 and 1962. Supplement A in Fukao’s article provides a detailed listing of the various controls Japan used between 1945 and 1990.
In 1960, the authorities announced a trade and exchange liberalization plan, one of whose goals was to achieve Article VIII status. This program included abolition of foreign exchange controls on current account transactions, creation of “free” yen accounts for nonresidents, liberalized use of foreign exchange for tourist travel, and some relaxation of the controls on capital account transactions related to exports and imports. With this partial liberalization, the scale of capital flows in the 1960s expanded relative to those in the 1950s, and periods of monetary tightening in the summers of 1961 and 1967 were accompanied by capital inflows that required the imposition or tightening of capital controls.
After the deutsche mark was allowed to float in May 1971, Japan initially attempted to maintain a fixed U.S. dollar-yen exchange rate and, as a result, experienced large capital inflows. Official foreign exchange reserves rose from $4.4 billion at the end of 1970 to $7.9 billion at the end of July 1971. Moreover, capital inflows in the 11 days between August 16 and August 27, 1971 amounted to $4 billion. The foreign subsidiaries of Japanese firms were an important source of inflows inasmuch as they used U.S. dollar-denominated loans to make prepayments on exports from the parent company or to purchase yen-denominated securities. The authorities responded initially by severely tightening capital controls—which disrupted trade financing—and, eventually, by floating the exchange rate. Thus, the system of capital controls, which had been highly effective when the exchange rate was viewed as stable and interest rate differentials were limited,5 was unable to stem a large-scale inflow once the expectation of a large exchange rate adjustment took hold.
Japan shifted from a fixed to a floating exchange rate in the spring of 1973, and Fukao (1990) argues that the degree of short-term capital mobility declined because of both strict capital controls and the elimination of the prospect of a near-certain capital gain when a large discrete exchange rate adjustment took place. Moreover, the differentials between domestic and offshore money market interest rates after 1974 were much smaller, even during the first and second oil price shocks, than in the period surrounding the collapse of the Bretton Woods system. Fukao shows that the differentials (in absolute value) between the three-month gensaki (repo) interest rate and the three-month Euroyen interest rate were, at most, 6 percent a year during 1974-87 but had reached 20-40 percent a year during 1971-74.
Japan’s policies toward capital controls underwent a fundamental change at the end of 1980, when the Law Revising Partially the Foreign Exchange and Foreign Trade Control Law was implemented. Whereas under the old law all foreign exchange transactions were prohibited in principle unless exempted by the authorities, the new law allowed all foreign exchange transactions unless specifically restricted. This change in policy was motivated by a number of factors, including the recognition that Japanese financial institutions were continuing to expand their operations in other major domestic and offshore markets and that “the maintenance of a legal framework that prohibited overseas transactions in principle raised difficulties such as giving the impression to foreign countries that Japan was implementing regulations that were not transparent” (Fukao (1990, p. 43)).
The Japanese experience with capital controls up to 1980 suggests a number of conclusions about their effectiveness. When exchange, trade, and capital controls restricted both current and capital account convertibility in the 1950s, the authorities were able to limit residents’ accumulation of net foreign asset positions effectively. The establishment of current account convertibility and the relaxation of controls on trade-related capital flows in the 1960s created new difficulties for conducting an independent monetary policy with a fixed exchange rate. Nonetheless, as long as there was the expectation that the fixed exchange rate would be maintained and domestic and external financial market conditions did not differ markedly, the capital controls continued to limit residents’ net foreign asset positions effectively. In the early 1970s, however, the expectation of a large discrete adjustment in exchange rates during the collapse of the Bretton Woods system led to large capital flows (often seemingly trade-related) that overwhelmed the capital control system. Moreover, measures designed to tighten capital controls so as to prevent the capital flows soon began to reduce the volume of international trade.
Ireland’s experience in the late 1970s exemplifies the effects of introducing capital controls between previously integrated financial markets. Before December 1978, relatively few official restrictions were imposed on transactions between financial markets in Ireland and those in the United Kingdom. The Irish authorities then imposed a set of exchange controls that included (1) limitations on the accounts of U.K. residents in Irish bank and nonbank financial institutions, (2) a prohibition against Irish residents’ holding accounts with financial institutions in the United Kingdom, (3) prior approval for all foreign borrowing, (4) prior approval for portfolio investment inflows and out-flows, and (5) limitations on the provision of forward cover by authorized banks to nonbank residents except for trade-related transactions.
Browne and McNelis (1990) have recently examined the effectiveness of the Irish capital controls in restoring the authorities’ control over domestic interest rates. They based their analysis on an empirical model that correlated quarterly changes in various domestic Irish interest rates with (1) the differential between the sum of the comparable world interest rate, the expected rate of depreciation of the Irish pound and a risk premium, and the previous quarter’s domestic interest rate; and (2) the current and lagged values of the domestic excess demand for money. The excess demand for money was represented, in turn, by the gap between the demand for money and the cumulative stock of domestic credit expansion. The demand for money was taken as a positive function of the level of permanent income and the “own” yield on the interest-bearing component of the money stock and a negative function of the expected rate of inflation and the return on government securities. In the empirical analysis, only the excess demand for money in the current and preceding quarters was used. In considering the likely effects of an unanticipated increase in the domestic money supply, Browne and McNelis also differentiated between an initial liquidity effect (which would drive domestic interest rates down) and a subsequent inflation premium effect (which would drive domestic interest rates up). A unique feature of their analysis was that they allowed the effects of external interest rates and domestic money market conditions to vary over time, using a Kalman filter technique to estimate these time-varying coefficients. In particular, they argued that, if economic agents learn how to evade capital controls over time, then the influence of external financial market conditions on domestic interest rates should grow relative to that of domestic money market conditions.
Browne and McNelis based their empirical analysis on data from the first quarter of 1971 to the fourth quarter of 1986 and used data on interest rates on financial instruments of various expected degrees of international tradability. These interest rates included (in order of expected international tradability) (1) the 3-month Dublin interbank market rate, (2) the 90-day exchequer bill rate, (3) the 5-year-to-maturity government security yield, (4) the clearing banks’ rate on deposits in the range of £Ir 5,000-£Ir 25,000, (5) the clearing banks’ prime lending rate, (6) the building societies’ share account rate, and (7) the building societies’ mortgage rate. One empirical result was that there were significant liquidity effects (in the first quarter) following an increase in the money supply and inflation premium effects (in the second quarter) from domestic monetary policy; moreover, the size of these effects increased for five of the seven interest rates considered after capital controls were imposed. However, those two effects canceled each other out within half a year. Moreover, the liquidity and inflation premium effects on the interbank and mortgage rates decayed rapidly over time to zero. As a result, the interbank market continues to be highly integrated with the external market;6 and the degree of integration in the mortgage market, which initially declined when capital controls were imposed, eventually recovered and exceeded its initial level. Exchange controls drove a permanent wedge in the interest rate parity relationship only in the markets for small deposits in clearing banks and share accounts in the building societies.
These empirical results suggest that, even when capital controls drive a wedge between the levels of domestic and external interest rates, they may only temporarily break the correlation between movements in domestic and international interest rates over time. Browne and McNelis argued that, whereas firms and individuals may initially be surprised by the timing and intensity of new capital controls, significant interest rate differentials between domestic and external markets can make it profitable for some firms and individuals to incur the costs of establishing new channels for moving funds abroad. “Thus the authorities may find that the only way to make controls effective in the long run is to add new and tighter controls intermittently” (Browne and McNelis (1990, p. 45)).
Gros (1988, p. 438) reached a similar conclusion regarding Belgium’s dual exchange rate system:
Taking private arbitrage activity into account leads to the conclusion that dual exchange rates (as well as capital controls) could succeed only temporarily in dampening the effects (on the domestic goods market) of shocks to financial or other markets. To offset such effects permanently, the authorities would have to induce a steadily increasing differential between the two exchange rates. But a steadily increasing differential would also lead to a steadily increasing incentive for private operators to circumvent the regulations that separate the two markets by buying foreign exchange at the lower rate (usually the controlled or commercial rate) and selling it at the higher rate (usually the free or financial rate).
Moreover, because quantitative capital controls that restrict capital outflows are, in many respects, equivalent to a tax on the ownership of foreign assets, the incidence of this tax depends crucially on the ability of different groups of residents to evade the controls. Browne and McNelis’s results imply that such a tax falls most heavily on those residents who have the least power in domestic financial markets and the weakest links or access to international markets (often because of high transaction costs). In a public finance sense, capital controls are thus likely to be a regressive tax.
Most developing countries have employed capital controls since World War II with the objectives of limiting the acquisition of foreign assets by domestic residents (to keep domestic savings available to finance domestic investment) and moderating or eliminating short-term speculative capital flows during and after a balance of payments crisis. To gauge how effective capital controls have been in achieving these objectives, this section presents an empirical analysis of the effectiveness of capital controls in preventing capital flight and reviews some evidence on the linkages between external and domestic financial conditions in developing countries.
Since the emergence of the debt-servicing difficulties of many heavily indebted developing countries in the early 1980s, capital flight has been of particular concern because of the implied loss of resources for domestic investment. In this discussion, capital flight is equated with the fraction of a country’s stock of external claims that does not generate recorded income. This approach is known as the “derived” measure of capital flight and was first suggested by Dooley (1986). The estimated stock of capital flight7 for a group of heavily indebted developing countries increased from $45 billion at the end of 1978 to $184 billion by the end of 1988 before declining to $176 billion at the end of 1990 (Table 2). However, the pace of capital flight varied throughout the period. For example, expansionary fiscal and monetary policies, as well as increasing overvaluation of the exchange rates, resulted in rapid increases in the stock of capital flight during 1978-83, with a 25 percent increase occurring in 1983. In contrast, the stock of capital declined during 1989-90 as a number of countries in the sample initiated successful stabilization programs.8 Although several empirical studies9 found a significant relationship between capital flight and domestic macroeconomic variables, there is little evidence as to whether such linkages depend on the extent of a country’s capital controls.
|Year||Capital Flight2(1)||External Debt (2)||Ratio of Capital Flight to|
Total External Debt (l)/(2)
Argentina, Bolivia, Chile, Colombia, Ecuador, Gabon, Jamaica Mexico, Morocco, Nigeria, Peru, Philippines, Venezuela, and Yugoslavia. The selection was based on availability of data for the entire period under study.
Data refer to net capital flight, that is, the unrecorded stock of capital outflows less the unrecorded stock of capital inflows.
Argentina, Bolivia, Chile, Colombia, Ecuador, Gabon, Jamaica Mexico, Morocco, Nigeria, Peru, Philippines, Venezuela, and Yugoslavia. The selection was based on availability of data for the entire period under study.
Data refer to net capital flight, that is, the unrecorded stock of capital outflows less the unrecorded stock of capital inflows.
To determine the effectiveness of capital controls in stemming capital flight, a two-step methodology was employed. First, for the developing countries represented in Table 2, episodes of high and/or accelerating rates of inflation and large balance of payments disequilibria were identified during 1978-90. Most countries experienced these episodes two or three years before implementing IMF-supported adjustment programs (Table 3), including those involving either stand-by or extended arrangements. Table 3 also includes the stabilization programs initiated by the Government of Brazil in February 1986 and March 1990, which were not supported by IMF arrangements.
|Country||Initiation Date of the Program and Type of Program||Period Included in the Regressions|
|I. Countries with strong or increasing capital controls:|
|Argentina||Nov. 10, 1989 (stand-by)||1987–88|
|Bolivia||Feb. 01, 1980 (stand-by)||1978–79|
|Bolivia||June 19, 1986 (stand-by)||1985|
|Chile||Jan. 10, 1983 (stand-by)||1981–82|
|Ecuador||Jan. 04, 1989 (stand-by)||1987–88|
|Gabon||Sept. 15, 1989 (stand-by)||1988–89|
|Honduras||July 27, 1990 (stand-by)||1988–89|
|Mexico||May 26, 1989 (extended)||1987–88|
|Morocco||Sept. 12, 1985 (stand-by)||1983–84|
|Morocco||July 20, 1990 (stand-by)||1988–89|
|Nigeria||Jan. 30, 1987 (stand-by)||1985–86|
|Nigeria||Apr. 30, 1990 (stand-by)||1988–89|
|Uruguay||Dec. 12, 1990 (stand-by)||1989|
|II. Countries with strong or increasing capital controls:|
|Argentina||Dec. 28, 1984 (stand-by)||1982–84|
|Brazil||Mar. 01, 1983 (stand-by)||1981–82|
|Brazil||Feb. 1986 (no IMF disbursement)||1984–85|
|Brazil||Mar. 1990 (no IMF program)||1987–89|
|Ecuador||July 25, 1983 (stand-by)||1981–82|
|Mexico||Jan. 01, 1983 (extended)||1981–82|
|Mexico||Nov. 19, 1986 (stand-by)||1984–85|
|Morocco||Apr. 26, 1982 (stand-by)||1980–81|
|Philippines||June 11, 1979 (stand-by)||1978|
|Philippines||Dec. 14, 1984 (stand-by)||1983|
|Philippines||May 23, 1989 (extended)||1987–88|
|Poland||Feb. 05, 1990 (stand-by)||1988–89|
|Yugoslavia||May 23, 1979 (stand-by)||1978|
|Yugoslavia||Jan. 30, 1981 (stand-by)||1979–80|
|Yugoslavia||Mar. 16, 1990 (stand-by)||1988–89|
During each of these episodes, a country was further characterized as having either relatively modest capital controls (which, in a few cases, were relaxed) or extensive controls (which were sometimes increased during the crisis period). Modest restrictions were those that did not eliminate capital transactions but only restricted them by requiring government approval. Restrictions were extensive if, in addition to requiring government approval, a country imposed strict limits on, or prohibited, the inward or outward movements of capital. (Only these two categories were used because classifications of countries based on the degree of capital controls are subjective.) If capital controls were effective, then macroeconomic fundamentals should be less important in explaining capital flight in the group of countries with stringent capital controls than in those countries with either much less stringent or loosened capital controls.
The evaluation of the degree of capital control was based on information contained in IMF, Exchange Arrangements and Exchange Restrictions Annual Report, various issues. Information on payments restrictions on current transactions and the restrictions on capital transactions are provided under the headings of “payments for invisibles,” “proceeds from invisibles,” and “capital.”
Following Rojas-Suárez (1991), the fundamentals that influence capital flight are taken as those that affect residents’ perceptions regarding the risks associated with holding domestic assets. There are two major sources of risk: (1) the prospect that large, unexpected devaluations and/or high rates of inflation will erode the real value of assets denominated in the domestic currency, and (2) the possibility that private or official borrowers will default on their debt-service obligations or will expropriate domestically owned assets. Because a large fiscal deficit financed through central bank credits to the government typically leads to high inflation and/or a large exchange rate depreciation, the fiscal deficit as a proportion of GDP is taken as a proxy for the risks of macroeconomic instability. The central government deficit was used so that the data would be comparable across all of the countries in the sample. A more comprehensive measure would be the nonfinancial public sector deficit.
If economic agents do not perceive a difference in the default risk between domestic and external debts, then a measure of default risk based on either domestic or external debt markets can be used. For a country with access to international capital markets, the spread between its borrowing costs and the London Interbank Offered Rate (LIBOR) is traditionally used to measure default risk. However, since the emergence of the debt crisis, the countries in the sample (Table 3) have had very limited access to international financial markets, and, therefore, no representative interest rate exists.
An alternative measure of the default risk can nonetheless be obtained from the secondary market price of external debt: LIBOR is subtracted from the implicit yield evident in the secondary market price for that debt. This latter measure is denoted rk. The implicit yield to maturity for external debt (is) was obtained from the observed secondary market price on the country’s external debt (P) and the application of the following present value formula:
where the face value (FV) is set at 100 because the discount quoted in the secondary markets applies to $100 worth of contractual debt; the contractual coupon payment (C) is the interest rate on six-month U.S. treasury bills (as a measure of the risk-free interest rate) plus the average interest rate spread agreed to by the country on signature of the contract; and n is the average maturity of the contract. The risk of default on external obligations during 1985-90 was estimated by subtracting the six-month LIB OR from the calculated implicit yield on external debt. The risk of default on external obligations during 1982-84 was approximated by using data on spreads between the loan rates charged to indebted developing countries on external bank loans and LIBOR provided by the Deutsche Bundesbank (spreads between public sector deutsche mark bonds issued by nonresidents and LIBOR) and the Bank of England. However, the implicit yield evident in the secondary market price for external debt cannot fully represent the cost of borrowing because it is derived under conditions of credit rationing.
In the empirical relationship between capital flight and fundamentals in the two subgroups of countries, capital flight was assumed to represent the portfolio decisions of domestic residents regarding the proportions of their wealth that they hold in domestic or foreign assets. The desired proportions of wealth held in these assets are taken as depending on the expected real returns and risks associated with holding each type of asset.
The regression analysis presented in the Appendix implies that, although highly restrictive capital controls did not break the linkages between macro-economic fundamentals and the scale of capital flight, they did delay the response of economic agents to perceived increases in fiscal imbalances. Although the coefficient associated with the default risk variable was larger for the countries with less restrictive capital controls than for those with highly restrictive controls, it was significant for both groups. Thus, although capital controls were effective in reducing the response of capital flight to increases in default risk, economic agents still managed to react in the same period to the increased probability of default.
Kamin’s (1988, 1991a, and 1991b) recent work indicates that under- and overinvoicing trade transactions and changes in the terms and conditions under which trade financing is extended were often key vehicles for large-scale capital flows in developing countries with extensive capital controls. In his 1988 study, Kamin examined the behavior of exports and imports just before more than forty major exchange rate depreciations in developing countries. He argued that, when higher inflation was accompanied by a real appreciation of the official exchange rate and a rising black market exchange rate premium, then increased export underinvoicing typically led to reductions in officially measured exports. These shortfalls in export revenues led to reserve losses and, eventually, to declines in imports as the authorities tightened foreign exchange rationing.
While Kamin’s (1988) results suggest that extensive underinvoicing of exports before a major exchange rate depreciation is quite common, there is still the question of how large disguised capital flows are likely to be. In a later study, Kamin (1991b) examined the scale of disguised capital flows in Argentina during 1981-90. He maintained that, by mid-1981, the Argentine authorities faced a highly overvalued exchange rate, extensive private capital flight, a growing fiscal deficit (reaching nearly 17 percent of GDP in 1981), rising inflation, declining real GDP, and high levels of domestic and external indebtedness in both the financial and nonfinancial sectors. One element of the authorities’ adjustment program was a dual exchange rate system, which combined a fixed commercial exchange rate for trade transactions with a floating exchange rate for capital account transactions. In late June 1981, the authorities applied a fixed commercial exchange rate to all imports and traditional exports, 90 percent of “promoted” exports, and repayments of previously contracted external debt. All remaining transactions were to take place at the floating financial exchange rate. The authorities also initiated an exchange rate guarantee program for private entities willing to reschedule their external debts to relieve the balance of payments pressures on the central bank and to protect enterprises with large external debts from future exchange rate depreciations. The firms’ real domestic debt burden was also reduced when the authorities imposed nominal ceilings upon loan and deposit interest rates at levels below the rate of inflation. In practice, however, three exchange rates were in effect during this period: the legal commercial rate, the legal financial rate, and the illegal parallel rate.
The capital controls and the dual exchange rate system were circumvented through a variety of channels. First, there was a diversion of export receipts from the commercial market to the parallel foreign exchange market through export under-invoicing. During 1982-86, export underinvoicing was estimated to total about $4 billion, or about 10 percent of merchandise exports. A second source of foreign funds was occasional central bank intervention in the parallel market to support the local currency. Third, the central bank’s pre-export financing facility provided subsidized credit to exporters of specific merchandise categories. Users of this facility were allowed to borrow foreign exchange from external sources, convert it at the official exchange rate up to 540 days before the time of exportation, use the local currency proceeds to pay export expenses, and repay the external loan with the proceeds of the exports rather than surrender them to the central bank. When domestic interest rates were high relative to the expected rate of depreciation of the exchange rate, the pre-export facility became an attractive vehicle for legally repatriating capital with the assurance that it could legally be withdrawn again through the sale of exports abroad. Another potential source of funds for the parallel market would have been import overinvoicing, which would have allowed importers to declare more imports than they actually purchased in order to sell their excess foreign exchange at a profit in the parallel market. However, Kamin found that Argentine importers were just as likely to underinvoice as to overinvoice their transactions. He argued that, when unstable macroeconomic conditions, high inflation, and at times large interest rate differentials between domestic and offshore markets created strong incentives for Argentine residents to move funds abroad, the channels described above allowed them to do so. As a result, “…the controls offered few benefits, were largely ineffectual, and encouraged both poor policymaking by the government and poor legal compliance by the populace.”10
Developing countries’ experience with capital flight has raised the issue of the extent of the linkages between their external and domestic financial markets during the 1970s and 1980s. Although it has often been suggested that the lack of access of the residents of many developing countries to credits from international financial markets implies low interdependence between the two markets, a growing number of studies suggest that the influence of external financial conditions has been increasing over time.
Haque and Montiel (1990 and 1991) and Haque, Lahiri, and Montiel (1990), for example, have recently provided empirical estimates that imply a high degree of capital mobility for a large set of developing countries, most of which have extensive capital controls. Haque and Montiel (1991) examined the factors influencing domestic interest rates during 1969-87 for 15 developing countries, including 6 from Asia, 4 from Africa, 3 from Latin America, and 2 from Europe. They based their analysis on the assumption that any domestic market-clearing interest rate (it) could be expressed as a weighted average of the uncovered interest parity interest rate (it*)11 and the domestic market-clearing interest rate that would be observed if the private capital account were completely closed (i’).12 Hence,
If g = 1, the domestic market-clearing interest rate would equal its uncovered parity value, whereas if g = 0, external factors would play no role in determining the domestic interest rate. Because most of the countries in the data sample had “repressed” financial systems with legal ceilings on interest rates, Haque and Montiel first considered the determinants of the unobserved interest rate (it’) that would have cleared the domestic money market if the capital account had been completely closed13 and then estimated (with a nonlinear instrumental variables technique) the parameters of the demand for money and the capital mobility parameter (g). In 10 of the 15 countries, g was statistically significantly different from zero and insignificantly different from one, suggesting a relatively high degree of capital mobility. Only India had a value of g that was significantly different from one and insignificantly different from zero, which would be consistent with capital immobility. As a result, Haque and Montiel concluded that, on average, domestic market-determined interest rates for this diverse group of countries tended to move quite closely with uncovered parity interest rates. However, they did not test how the degree of capital mobility evolved over time.
Recently, Faruqee (1991) examined the evolution of capital mobility in several Asian developing countries during the 1980s, focusing on the differentials between money market interest rates in Korea, Malaysia, Singapore, and Thailand and the three-month LIBOR on Japanese yen deposits. From September 1978 to December 1990, the mean (in absolute value) and variances of the interest rate differentials were uniformly smaller in the second half of the sample period than in the first half. To examine the behavior of these differentials over time, Faruqee employed an autoregressive conditional heteroscedasticity framework, which tested for greater capital mobility by considering whether the conditional variance of the interest rate differentials had declined over time. The results implied a uniform decline in the conditional variance for Singapore and a similar decline for Malaysia, apart from an upswing in 1984-86. In contrast, Korea showed a sharp decline in its conditional variance between 1980 and 1988 but then an upswing in the following years (although the value during 1989-90 remained below that in 1980). Thailand showed alternating periods of increasing and decreasing openness without a clear tendency toward either direction.
Using these results, Faruqee also considered how the interest rate differentials would respond to a “typical” monetary disturbance in 1980 and in 1990. A monetary expansion in Singapore would have created an interest rate differential of about ½ of 1 percentage point in 1990 versus one of almost 2 percentage points in 1980. Moreover, the deviation from interest rate parity would have lasted for between three and four quarters in 1990 and for between four and five quarters in 1980. In Malaysia, the initial interest rate differentials would have been 50 basis points in 1990 and more than 200 basis points in 1980. However, the elimination of these differentials would have been much more gradual than in Singapore. For Korea, the initial interest rate differential was smaller in 1990 (a little more than 100 basis points) than in 1980 (nearly 200 basis points), and the differential decayed more rapidly in 1990. In contrast, Thailand did not exhibit a more rapid dampening of interest rate differentials in 1990 than in 1980. These results led Faruqee to conclude that there was strong support for the notion that financial market liberalization in the Asian countries in his sample had raised the level of integration between domestic and international financial markets. Moreover, this increased integration occurred even in countries that had not significantly relaxed their capital controls (for example, Korea).
Taken together, these studies suggest that, typically, significant linkages existed between domestic and external financial market conditions even in many developing countries with extensive capital controls and that capital controls may have been less effective in the 1980s than in earlier periods. A number of variables may have helped either to increase the incentives for, or to reduce the costs of, moving funds across borders, including the large differentials that the residents of many developing countries observed in the real rates of return on holding domestic and external assets during the 1980s. Figure 4.2 of the World Bank’s World Development Report 1989 (Washington) indicates the extent of these interest rate differentials. In addition, the upsurge in capital flight during the late 1970s may have created a “learning-by-doing” effect that helped reduce the cost of evading capital controls. Moreover, holding assets in offshore or industrial country markets may have become more attractive as the extensive financial liberalizations undertaken in the major industrial countries stimulated the development of a variety of new financial products and services. In some industrial countries, the reduction or elimination of withholding taxes on nonresidents’ financial income may also have increased the attractiveness of capital flight. More-over, deposits in the banking systems of the major industrial countries may have been viewed as entailing less risk of financial loss than were deposits in the domestic banking systems in many developing countries, especially those experiencing financial crises and restructurings. A final factor may have been associated with the financing of the growing illicit trade in drugs and other goods. There is some evidence that money laundering techniques became increasingly sophisticated as the 1980s progressed. Channels that were developed to move funds derived from illicit activities could just as readily be used to move funds derived from other activities.