Capital Controls: Country Experiences with Their Use and Liberalization

Aims to develop a deeper understanding of the role that capital controls may play in coping with volatile movements of capital, as well as complex issues surrounding capital account liberalization. It provides a detailed analysis of specific country cases to shed light on the potential benefits or costs of capital controls, including those used in crisis situations. It also considers the important link between prudential policies and capital controls, including the improvement of prudential practices and accelerated financial sector reform to address the risks involved in cross-border transactions.

Paper

• reviews the experience of selected countries with the use or removal of capital controls (Chapter II). Based on a detailed review and comparison of the experience of a group of fourteen countries that used various types of capital controls, often to manage episodes of unsustainable capital flows. Part II, Section I presents a review of the country experiences that form the basis for Chapter II; and Part II, Section II provides detailed studies of the experience of three countries, Chile, India, and Malaysia, which have received considerable attention in recent years.. Considers 5 themes:
  • the use and effectiveness of controls on capital inflows in limiting the potentially destabilizing effects of short-term capital flows and preserving monetary policy autonomy under tightly managed exchange rate systems (involving formal or de facto peg arrangements)
  • the potential benefits and costs of reimposing selective controls on capital outflows to reduce pressures on the exchange rate, including in the context of currency or banking crises
  • use of extensive exchange controls that may entail restrictions on both capital and current international transactions
  • long-standing and extensive capital controls and their role in reducing financial vulnerability
  • the benefits and costs of rapid and wide-ranging liberalization of previously restrictive exchange control regimes.
• examines the prudential approach to managing the risks associated with capital flows (Chapter III). This is an area that has only recently received more widespread attention, and the prudential standards themselves are under development. The chapter reviews progress in establishing prudential standards for cross-border flows and issues in their implementation, and discusses their limitations and the conditions for their effectiveness. The chapter also examines the link between capital controls and prudential policies.
• provides some conclusions (Chapter IV).

Concludes that:

• The evidence supports the conclusion that capital controls cannot substitute for sound macroeconomic policiesThe evidence presented in this paper supports the conclusion that capital controls cannot substitute for sound macroeconomic policies.
• To what degree capital controls are effective in insulating a country from external shocks or in providing a breathing space in which to adopt sound policies is a more difficult question to answer from the country case studiesCountries have tended to employ a number of policy instruments in unison toward a policy goal, so that it is difficult to disentangle the contribution of capital controls in achieving a certain objective. More flexible exchange rate policies, prudential policies, and liberalization of outflows (in case of excessive inflows) are some of the policies that have been employed in conjunction with capital controls.

Some countries that have employed capital controls appear to have been more successful than others in achieving their policy objectives; and one can draw a number of generally useful observations from the countries’ experiences:

• no single capital control measure is effective across all countries at all times Effectiveness depends on a host of factors, including the seriousness of macroeconomic imbalances, which may give rise to strong incentives for circumvention of the controls.
• selective controls on a targeted range of transactions, while possibly effective in limiting those specific transactions, tend to be quickly circumvented as market participants find means of achieving their desired ends via unrestricted channels In order to achieve their objective, controls need to be widened as market participants find new ways of circumventing the restrictions. The ease with which restrictions are circumvented is mitigated somewhat in countries that have a strong monitoring and enforcement capacity and are able to quickly adjust controls to close off avenues for circumvention. In most cases, however, regulators have encountered difficulties in -anticipating and countering the market response to controls. This is particularly true for a country with well-developed financial markets. Countries’ experiences also show that even current transactions and foreign direct investment have been vehicles for circumvention, which attests to the difficulty of targeting even at the broadest level. To be effective in the somewhat longer run, controls in most cases needed to be quite comprehensive
• administrative capacity and the level of financial market development will also have a bearing on the choice of controls and their effectivenessProperly designed market-based controls are more likely to be the less distortionary choice for a financial market that is substantially developed or liberalized. Nevertheless, measures such as the Chilean URR demand a degree of administrative sophistication to keep them effective. Direct controls have been applied with some success in relatively closed economies at an earlier stage of financial market development. However, countries such as India and China that took this course also possessed an effective administrative apparatus. While direct controls may be somewhat less administratively demanding than market-based controls, one cannot conclude that direct controls are, ceteris paribus, more effective than market-based controls. Direct controls may also be circumvented when they are not sufficiently comprehensive, or when implementation capacity is not sufficiently strong. It may also be noted that discretionary controls open up governance issues related to their fair and transparent implementation.

The need for controls to be comprehensive in order to be effective implies that more effective controls are also more distortionary and hence more costly. The benefits of effective controls thus need to be carefully weighed against their costs. Comprehensive direct controls can allow a country with a less developed financial market to insulate itself to some extent from external shocks and pressures, but such policies may impede financial market development, and may lead to a loss of the efficiencies that derive from liberalized markets. In countries with more sophisticated financial (and other) markets, very strong controls may be needed to ensure effectiveness. At some stage it may become difficult to design a set of controls that can limit ‘undesirable’ capital flows without unduly restricting ‘desirable’ transactions, seriously disrupting financial markets, and reducing access to foreign capital. The unfavorable tradeoff has prompted many countries to dismantle comprehensive controls, including those that were introduced during periods of stress.

The evidence is mixed on whether capital controls can be used to correct financial market imperfections and serve a prudential purpose. Capital controls, particularly on short-term inflows, may temporarily and partially substitute for full-fledged supervisory institutions. In particular, it is clear that building effective supervisory and regulatory institutions may take a long time. On the other hand, the experience of the countries reviewed here suggests that while prudential concerns sometimes played a role in the decision to use capital controls, macroeconomic considerations were typically more important and indeed decisive in many cases. When governments adopt and modify capital controls primarily in response to macroeconomic factors, this may detract from their usefulness in attaining prudential goals.

Strong prudential policies were found to play an important role in orderly and successful capital account liberalization and in reducing the vulnerability to external shocks; and such policies may, to some extent, be an alternative to capital controls, in addition to being an inherently valuable means of enhancing financial system stability. Of course, prudential policies alone will not be able to eliminate the risks associated with international capital flows. Properly used, however, they will contribute to lessening such risks, in conjunction with appropriate macroeconomic policies. With prudential policies, as with capital controls and other government intervention, there is a need to guard against mis-regulation and over-regulation. Moreover, as countries differ in their ability to implement and enforce various types of policies, the appropriate mix of capital controls and prudential policies to be used in moving toward capital account convertibility will also need to be tailored to a country's specific circumstances.

With regard to sequencing, both capital account liberalization and other financial sector reforms are ongoing and interrelated processes, which appear to be closely linked to the overall level of economic development. The impetus for necessary financial sector restructuring has often come from a more general opening of the economy; and improved financial sector stability is in turn conducive to further external liberalization. These processes are also complex, and involve changes in many dimensions, including market development, governance, prudential regulation and supervision, monetary operations, i.e., the entire infrastructure of finance. Against this background, is also difficult to prescribe in general the sequence in which capital controls on different types of flows should be liberalized.[author]