The Literature on Capital Controls

The Australian Economic Review, vol. 32, no. 2, pp. 185–90

The University of Melbourne, Melbourne Institute of Applied Economic and Social Research 1999Published by Blackwell Publishers Ltd, 108 Cowley Road, Oxford OX4 1JF, UK and

350 Main Street, Malden, MA 02148, USA

* The views expressed are those of the author and do notnecessarily reflect those of the Reserve Bank.

1. Introduction

This paper summarises the basic arguments forand against countries operating open capital ac-counts, with the aim of giving some flavour ofthe richness and complexity of the debate.Readers who want more detail are referred toDooley (1996a) and Fischer et al. (1998) forexcellent, more polemical, accounts.

2. The Arguments for Capital Account Convertibility

The basic argument that a country should nothave controls on its capital account is analo-gous to the argument for free trade in goodsand services—basic economic efficiency. Toquote Stanley Fischer (1998, pp. 1–2):

free capital movements facilitate an efficient glo-bal allocation of savings and help channel re-sources into their most productive uses, thusincreasing economic growth and welfare.

He goes on to explain what this means inmore detail.

From the individual country’s perspective, thebenefits take the form of increases in the pool ofinvestible funds and in access of domestic resi-dents to foreign capital markets. From the view-point of the international economy, open capital

accounts support the multilateral trading systemby broadening the channels through which coun-tries can finance trade and investment and attainhigher levels of income. International capitalflows expand the opportunities for portfolio di-versification and thereby provide investors inboth industrial and developing countries with thepotential to achieve higher risk-adjusted rates ofreturn.

Cooper (1998) recognises the efficient allo-cation of resources as the most powerful argu-ment but suggests three further reasons. Thefirst is property rights: ‘individuals should befree to dispose of their income and wealth asthey see fit, provided their doing so does notharm others’ (p. 12).

The second is that these controls do not workanyway. The basic point is that capital and fi-nancial instruments are highly fungible andmarkets are able to avoid controls when theyhave a sufficiently strong incentive to do so.Controls also only tend to be effective in theshort term, since markets can move into substi-tutes or create avoidance mechanisms overtime. Controls on foreign currency, for ex-ample, can be and are avoided by smuggling,corruption, internal transfer of funds by multi-nationals, the creation of black markets, orchanging foreign trade invoices (Mathieson &Rojas-Suarez 1993; Johnston & Ryan 1994).Capital controls are also ineffective in thesense that they do not prevent speculative at-tacks and exchange rate adjustment from oc-curring, even if they buy time before thishappens (Eichengreen, Rose & Wyplosz1994).

Policy Forum: Exchange Rates and Capital Controls

The Literature on Capital Controls

Gordon de Brouwer*Reserve Bank of Australia

186 The Australian Economic Review June 1999

The University of Melbourne, Melbourne Institute of Applied Economic and Social Research

The third argument set out by Cooper (1998)is that capital controls give rise to corruptionand favouritism. The people who have accessto these mechanisms are the rich and well-connected. This is not fair. Controls can alsogenerate collusion: firms which have investedin avoiding controls may want the controls keptin place because they serve to disadvantage anddeter potential competitors who do not knowthe avoidance mechanisms (Dooley 1996a).

Hanson (1994), Dornbusch (1998) and oth-ers discuss another reason for an open capitalaccount: high capital mobility limits discre-tionary policy and forces governments to adopt‘good’ or market-conforming policies, includ-ing sound financial supervision policies. Thebasic point is that the market reacts negativelyto inflationary or time-inconsistent policies.One echo is in the speculative attack models ofKrugman (1979) and Flood and Garber (1984),whereby attacks on a currency arise precisely

because

of policy inconsistencies, and hencetheir occurrence serves to generate sustainablepolicies.

3. The Arguments for Capital Controls

There is also a large literature which argues infavour of capital controls.

3.1 First-Best Arguments

The first argument for capital controls is thatthey can be a first-best policy response, and arevalid in their own right, because of multipleequilibria (see Dooley 1996a). A policy regimethat is otherwise viable becomes unviable be-cause of self-fulfilling private expectationswhich generate a speculative attack on the cur-rency. One equilibrium may be worse than an-other and controls may delay the change inprivate expectations which drives the market tochallenge the system in the first place.

Some analysts cite what happened to the ex-change rate mechanism (ERM) in Europe in1992 as an example of where there were multi-ple equilibria consistent with a given set of fun-damentals, and speculative attacks on certaincurrencies were validated by the subsequentpolicy actions of government (Eichengreen &

Wyplosz 1993; Eichengreen, Rose & Wyplosz1994; Portes 1993). On this view, the specula-tive attack on the ERM was justified becausethe governments that dropped out of ERM didso because they did not have sufficient com-mitment to the peg. Once the governmentsdropped out, they eased monetary policy,which was what the markets thought theywould do in the first place.

Dooley (1996a) argues that the existence ofmultiple equilibria does not necessarily meritthe use of capital controls, since they may de-stabilise expectations. For example, the impo-sition of controls may lead the market toreassess the stability of the system and hencechallenge it. In addition, Obstfeld (1986)shows that controls themselves may generatemultiple equilibria when none exist otherwise.

3.2 Second-Best Arguments

The other arguments in favour of capital con-trols are essentially second-best arguments,that the ideal world described by Fischer at thestart of this paper does not exist and that capitalcontrols can offset some other existing distor-tion. There are basically four types of distor-tions: fiscal, legal, trade and financial. They aregenerally analysed with respect to developingor transitional economies and in relation to thesequencing and speed of reform. That is, mostof the proponents of capital controls argue thatthey have a temporary role until other reformsare in place. They also tend to be raised with re-spect to fixed or pegged exchange rate regimes.

There are four arguments that capital con-trols can be used to offset an existing fiscaldistortion. The first relates to the efficacy offiscal policy in the basic sticky-price Mundell-Fleming model. Suppose an economy is at lessthan full capacity. Under fixed exchange ratesand capital mobility, fiscal policy is effectivebut monetary policy is not. But if there are con-straints on fiscal policy—typically meaning thetax system does not function well—then it maybe desirable to use monetary policy with con-trols on capital outflow. In this case, a mone-tary expansion does not lead to a capitaloutflow and self-correcting rise in interestrates. The capital controls give the authorities

de Brouwer: Literature on Capital Controls 187


power to set interest rates independently ofworld rates.

The second fiscal argument is essentially a‘which tax works best?’ argument. Capital con-trols often take the form of taxes on particulartransactions. If the tax base is weak, as it oftenis in developing countries, then capital controlsmay be less distortionary than some other tax.Similarly, as capital controls are removed, thegovernment has to extend its tax base to main-tain revenue (Giovanni & de Melo 1993). Oneoption may be higher debt or monetisation ofthe fiscal deficit, but these may be more costlyto economic efficiency than capital controls. Inthis context, the argument may be which typeof capital control is most effective and efficient.

Third, capital mobility induces tax evasionwhen tax systems and rates differ betweencountries, which may be socially suboptimal(Cooper 1998). Fourth, if the government isless able to tax domestic-based capital incomethan foreign-based capital income, and if capi-tal is mobile, then there may be domestic un-derinvestment and hence lower growth.Controls on capital outflow may correct thisdistortion.

The second set of arguments relates to thelegal system. If property rights are not well de-fined, domestic firms may prefer to investoverseas rather than locally, which may be so-cially or economically suboptimal (Tornell &Velasco 1992). Controls in this case may pro-mote efficiency.

Capital mobility can also misallocate re-sources if there are significant distortions intrade. If capital flows to a country with a lot oflabour and protected capital-intensive indus-tries (like steel or cars), for example, the worldcapital stock is misallocated, national productis lower, and national income is reduced by thepayment on foreign capital (Brecher & Diaz-Alejandro 1977). Edwards and van Wijnbergen(1986) also present a model in which capitalcontrols are optimal if there are trade distor-tions. Edwards (1987) uses a model to showthat opening the capital account in the presenceof tariffs directs capital flows to the import-competing sector, expanding capital and outputin that sector, complicating the political econ-omy of trade reform.

Finally, there is a large literature on capitalaccount liberalisation and domestic financialdistortions. If the domestic financial sector isdistorted, then the unimpeded entry of foreigncapital may be costly. This has been explored indetail in relation to the Latin American debt cri-ses of the early 1980s, where the problem wasidentified as various guarantees given to finan-cial institutions and associated problems ofmoral hazard. Foreign capital may also engagein excessive risk taking based on these implicitguarantees (see Dooley 1996a). There is also aconcern about countries overborrowing in theearly stages of openness, as may occur if the in-terest rate on debt increases with foreign bor-rowing and borrowers overextend themselvesin anticipation of this (Edwards 1984). More re-cently, domestic financial distortions have beenraised in relation to the East Asian financial cri-sis—the willingness of foreign capital to lend tothese countries and mis-price risk, and the will-ingness of banks and business to take on largeunhedged and short-term foreign exposures.

A number of analysts have also questionedthe basic efficiency of financial markets ingeneral (Argy 1996; Cooper 1998; Rodrik1998). They argue that the improved allocationof capital implied in the basic neoclassicalmodel only occurs if information is adequateand reliable, which does not necessarily hap-pen when markets ‘herd’, trade on noise andrumours, or overreact. Herding is not necessar-ily irrational, as, when, for example, traders arerewarded for where they stand in relation to themarket as a whole. Garber (1998) also arguesthat herding can in fact be exaggerated by goodrisk management practices in open financialmarkets. For example, risk control mechanismsand margin calls based on the

international

variance–covariance of market prices cancause volatility in one market to spread toother, similar, markets.

Rodrik (1998) states the polemic moststrongly. After referring to Kindleberger’s ob-servation that financial crises have occurred onroughly 10-year intervals for the past 400years, he argues that ‘boom and bust cycles arehardly a sideshow or a minor blemish in inter-national capital flows; they are the main story’(p. 56). He argues that markets may have the



wrong model and send the wrong signals, andthat capital mobility can pressure countries toadopt lowest-common-denominator prudentialstandards which may generate financial andmacroeconomic instability.

This has led some to argue for a broader, in-ternationally based, set of controls (which canbe applied to a floating exchange regime).Tobin (1978), for example, has argued for abroad-sweeping tax on international financialtransactions aimed at slowing the adjustmentspeed of international capital. He argues thatthis would increase monetary autonomy and re-duce destabilising capital flows. Dooley(1996a, 1996b) argues against this on fourgrounds: it may interfere with ‘proper’—thatis, trade-based—private commercial decisions;transactions taxes applied in other marketshave not been shown to affect volatility; spec-ulation can still occur with low-frequencytrades; and such a tax must be enforced bymost, if not all, countries if it is to be effective.

4. Putting the Arguments in Perspective

Controls are not, of course, an all-or-nothingproposition. Countries face a menu of differenttypes of controls—controls on inflow or out-flow, and applied to foreign direct investment(FDI), long-term capital (bank loans, bonds,equities) or short-term capital (money marketinstruments). This allows for a more sophisti-cated debate.

Consider, for example, the inflow and out-flow argument. Polak (1998) argues that thecurrent consensus among economists is thatcontrols on outflows are ineffective, apart fromthe short run, and that controls on inflows ofFDI and portfolio investment are harmful, re-ducing the supply of capital and managerial/technical innovation. But he also argues thatcontrols on short-term capital inflows can infact help prevent excess demand and preventovershooting behaviour in developing coun-tries. Chile is the often-cited example; see Mas-sad (1998) for the Chilean authorities’ view.

But even here there is considerable debateabout how meaningful these classifications are.Claessons, Dooley and Warner (1995), for ex-ample, present evidence that the classifications

are uninformative about the durability or vola-tility of the particular type of capital flow, sincethey have similar predictability and variabilityproperties. Also, long-term instruments, likebonds and equities, can be traded on short timehorizons which, they argue, makes the short–long distinction meaningless.

Industrialised countries now generally re-gard open capital accounts as a basic elementof their market structure. In their study on theeffects of financial liberalisation on OECDeconomies, Edey and Hviding (1995) arguethat liberalisation has provided three generalbenefits to industrialised countries. First, it hasimproved internal efficiency in banking firms,as shown by declining operating costs andsome fall in interest margins. It has improvedallocative efficiency by removing distortions inrelative funding costs and providing greater op-portunities for international portfolio diver-sification. Finally, it has reduced liquidityconstraints and so enabled households to bettersmooth consumption over time. But the broadevidence on macroeconomic and microeco-nomic gains is mixed; de Brouwer (1999) pro-vides a general review of the costs and benefitsof financial openness.

Even if an open capital account is the aim ofpolicymakers, there is considerable debateabout the speed with which controls should beremoved. This is often tied to the country’sstage of development. Massad (1998), for ex-ample, summarises one stream of the literaturewhich argues that full openness can inducestrong capital inflow which appreciates thenominal and real exchange rates, generates ex-cess demand and inflation, and leads to a build-up of foreign debt which leaves the countryvulnerable to changes in investor sentiment.McKinnon (1973, 1982) and Edwards (1989),for example, argue for gradual liberalisation.Others, such as Kreuger (1984), Hanson (1994)and Dornbusch (1998), argue for rapid reform.To quote Dornbusch, ‘a persuasive case forgradualism has never been made’ because thatpolicy is liable to be ‘hijacked by political pres-sures adverse to the best use of resources’ (p.22). On this matter, there is no consensus.

February 1999

de Brouwer: Literature on Capital Controls 189


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The Literature on Capital Controls