Chapter

IV Implications of the Reduced Effectiveness of Capital Controls

Author(s):
Liliana Rojas-Suárez, and Donald Mathieson
Published Date:
March 1993
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As structural changes in the international financial system and other factors have reduced the ability of capital controls to insulate domestic financial market conditions from those in external markets, they may also have increased some of the explicit and implicit costs of using controls, imposed new constraints on the formulation of stabilization and structural reform policies, and raised the question of whether countries should respond to the reduced effectiveness of capital controls by tightening them or by adapting to a more open capital account.

Cost of Maintaining Capital Controls

Even if capital controls become less effective over time, they can still inhibit or heavily “tax” certain classes of external financial transactions, limit the access of some individuals or institutions to international financial markets, restrict competition in domestic financial markets, and discourage the repatriation of capital flight. Capital controls can thereby create inefficiencies in the domestic financial system and inhibit risk diversification, which can, in turn, weaken the competitive position of domestic producers in international trade and increase the vulnerability of domestic spending and wealth to domestic financial shocks.

As new channels have developed for moving funds abroad, the costs of enforcing capital controls, investigating suspected violations of the controls, and prosecuting violators of the capital controls code have risen. Kamin (1991a) has also argued that capital controls can add to an economy’s adjustment costs if they create the illusion that the authorities can target nominal variables (such as the exchange rate) without addressing the fundamental causes of inflation and balance of payments problems. As the effectiveness of capital controls erodes, moreover, inappropriate macroeconomic policies can be sustained only if capital controls are further tightened, thereby increasing the distortions they can potentially create.

Capital controls also create an implicit market value for the licenses for approved but restricted capital account transactions. These licenses are seldom sold at public auctions but are usually allocated to individuals and institutions according to a set of rules administered by the capital controls bureaucracy. A dual exchange rate system can be regarded in some respects as one in which the rights to engage in external financial transactions are auctioned to the highest bidder. However, to the extent that certain types of approved (and licensed) capital transactions are allowed to take place at the official exchange rate, then a market value for these licenses will also be created. These arrangements, therefore, often provide a strong incentive for individuals to attempt to capture the “rent” inherent in these licenses through bribery, corruption, and political influence. Rent-seeking activities may be viewed as highly profitable from an individual’s perspective; however, they have been identified as an important source of economic inefficiency in many economies with extensive controls on external trade and financial transactions (Bhagwati and Brecher, 1984). As macroeconomic instability in many developing countries in the 1980s increased the attractiveness of holding external assets, the implicit rents associated with licenses rose.

A more subtle cost is associated with the spillover effects of efforts to evade capital controls in other areas. The techniques used to evade capital controls and move funds to a parallel exchange market or abroad could often be used to evade taxes and restrictions on other types of activities as well. Exchange controls in some countries reportedly provided an impetus for the expansion of the underground economy.

Constraints on the Formulation of Macroeconomic and Structural Policies

When the effectiveness of capital controls erodes, the formulation of macroeconomic and structural policies may be further constrained. Even when external financial market conditions are unchanged, for example, an increasing willingness and ability of domestic residents to evade capital controls implies that unstable domestic monetary and financial policies that create a large differential between the expected real returns on domestic and external assets typically lead to increased capital flight, a growing dollarization of the economy, and a smaller domestic monetary system and domestic tax base. As the domestic financial system shrinks, the revenues that the authorities can obtain from an inflation tax (at a given rate of inflation) will also be reduced.

The reduced effectiveness of capital controls can also make it more difficult for the authorities to tax financial income, transactions, and wealth. For example, high taxes on financial income and wealth can create a strong incentive for domestic residents to hold a significant proportion of their wealth as external assets, which are often subject to much lower taxes or none at all. As a result, new taxes and/or cuts in government spending will be needed as the effectiveness of capital controls erodes and leads to a decline in real tax revenues.

Even if capital controls are not relaxed, there can be strong incentives for residents to repatriate their external assets during the initial phase of stabilization and structural reform programs. Moreover, as a result of the capital flight that occurred during the 1970s and 1980s, residents of many developing countries now hold external assets whose estimated value (measured in U.S. dollars) at either the official or the parallel market exchange rate is larger than the size of their domestic financial systems (see Table 4). Thus, even if residents repatriated only a modest proportion of their external assets, relatively large capital inflows could result. These, in turn, could cause the real exchange rate to appreciate and potentially undermine the trade reform.

Table 4.Stocks of Capital Flight and Broad Money in Selected Developing Countries1
YearCapital Flight2 (1)Broad Money3 (Official Exchange Rate)4 (2)Broad Money (Parallel Market Exchange Rate)5 (3)Ratio of Column (1) to Column (2) (4)Ratio of Column (1) to Column (3) (5)
(In billions of U.S. dollars)(In percent)
197613.794.086.414.615.9
197729.2113.9104.725.727.9
197845.5143.1131.631.834.6
197962.2184.3171.233.736.3
198073.6235.1215.731.334.1
198182.5238.0211.434.739.0
198296.8175.2135.855.371.3
1983121.5171.5103.770.8117.1
1984134.7160.3112.584.0119.7
1985145.7150.5100.196.8145.5
1986152.1127.299.5119.6152.9
1987181.3125.091.6145.0197.8
1988183.9145.7104.8126.2175.5
1989182.4121.3101.8150.4179.2
1990175.8146.9116.5119.6150.9

Argentina, Bolivia, Chile, Colombia, Ecuador, Gabon, Jamaica, Mexico, Morocco, Nigeria, Peru, Philippines, Venezuela, and Yugoslavia.

See footnote 7 on page 12 for the definition of capital flight.

Broad money is taken as money plus quasi money (lines 34 and 35 in the IMF’s International Financial Statistics) totaled across all countries in the sample.

The official exchange rate is line ae in International Financial Statistics.

The parallel market exchange rate is taken from various issues of the International Currency Analysis, World Currency Yearbook (Brooklyn, New York).

Argentina, Bolivia, Chile, Colombia, Ecuador, Gabon, Jamaica, Mexico, Morocco, Nigeria, Peru, Philippines, Venezuela, and Yugoslavia.

See footnote 7 on page 12 for the definition of capital flight.

Broad money is taken as money plus quasi money (lines 34 and 35 in the IMF’s International Financial Statistics) totaled across all countries in the sample.

The official exchange rate is line ae in International Financial Statistics.

The parallel market exchange rate is taken from various issues of the International Currency Analysis, World Currency Yearbook (Brooklyn, New York).

Policy recommendations have generally focused on three alternatives for dealing with capital flows: (1) “sterilizing” capital inflows, (2) tightening capital controls, and (3) implementing measures that allow the country to live with the capital inflow and limit the potentially adverse effects of any real exchange rate appreciation. When the exchange rate is fixed or less than perfectly flexible, open market sales of government debt by the central bank and the issuance of new government debt by the fiscal authorities have been viewed as ways of offsetting the effects of capital inflows on the domestic monetary base. Such operations would increase the stock of government debt in private portfolios but would do little to satisfy a generalized demand for increased holdings of a broad range of domestic assets, given the configuration of yields on domestic securities (including equities and private debt instruments) when the capital inflow began. Indeed, for the private sector to be satisfied with placing all of its repatriated funds into government securities, it would probably expect a high real return on them, which could drive up government borrowing costs substantially.

If capital inflows cannot be effectively sterilized, another policy alternative is to tighten capital controls at the beginning of the stabilization and reform program. The effectiveness of tighter capital controls is likely to depend on whether the capital inflows are motivated primarily by short-run speculative considerations representing attempts to take temporary advantage of high domestic real interest rates or by a desire to repatriate a portion of the residents’ external assets over the medium term because of a credible reform program. By tightening capital controls, the authorities could gain additional short-term control over capital inflows and thereby some influence on the real exchange rate. As has been discussed, however, the effectiveness of additional control might be short-lived, and, if residents are motivated primarily by medium-term considerations, historical experience suggests that they will eventually find channels for evading the new controls. Moreover, if the authorities’ objective was to limit capital inflows over the entire period during which the structural reforms (especially the trade reform) were being phased in, then they might have to tighten capital controls repeatedly to maintain the same level of control. This kind of action could interfere with the financing of normal trade transactions and thereby undermine a trade reform as seriously as would a real exchange rate appreciation.

The potentially adverse effects of a severe tightening of capital controls raise two questions: (1) what are the potential benefits of a more open capital account, and (2) are there fiscal, financial, and structural policies that would allow a country initially to live with the capital inflows and limit the potentially adverse effects of any real exchange rate appreciation and, eventually, help the country achieve and sustain an open capital account?

Potential Benefits of a More Open Capital Account

While much of the discussion on the use of capital controls has focused on the difficulties that can be created by capital flows (Section II), recent discussions about removing capital controls in the European Community have pointed to the potential benefits of an open capital account. Capital account convertibility is likely to be sustainable only if supported by appropriate macroeconomic, financial, and structural policies.14 However, the potential benefits of an open account, as well as the costs of maintaining capital controls, will influence whether countries respond to the growing ineffectiveness of capital controls by moving toward more restrictive controls or more open capital accounts. The following efficiency and welfare gains are associated with the removal of capital controls (Crockett, 1991). First, free capital flows allow the international economy to attain the efficiency gains created by specialization in the production of financial services.15 As with trade in goods, countries will find it more efficient to import than to produce some financial services. Many wholesale financial services, whose production entails economies of scope, scale, or risk pooling (for example, marine insurance), may often be obtained most efficiently through importation.

Second, capital account convertibility can promote dynamic efficiency in the financial sector. Increased competition from abroad will force domestic producers to become more efficient and can stimulate innovation and improve productivity.

Removing capital controls can also improve the global intermediation of resources from savers to investors if international financial markets price the risks and returns inherent in financial claims appropriately. Under such conditions, global savings can be allocated to the most productive investments. In addition, enterprises will be able to diversify their activities abroad more easily and adopt new technologies and managerial techniques, especially those involving the use of new financial products to manage risks and finance investments.

In addition, capital account convertibility allows residents to hold an internationally diversified portfolio of assets, which reduces the vulnerability of their income streams and wealth to domestic financial and real shocks. Furthermore, the removal of capital controls may facilitate an economy’s access to international financial markets and reduce borrowing costs. For a lender to extend credit over the medium term, the expected yield on the loan must cover any potential default on, or disruption to, debt-service payments. Thus, if, in a crisis, a country is expected to tighten controls or impose limits on debt-service payments during the period of the loan, lenders may either refrain from lending or incorporate a risk premium into their lending rate.

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