Capital Controls

• Author: Natalia Tamirisa
• Pages: 2-3

Page 2

Capital controls prevailed during much of the twentieth century. By limiting capital outflows, controls were used to facilitate the financing of the two world wars. Controls were also seen as a means to achieve greater monetary policy independence during the Great Depression and to support the functioning of the Bretton Woods system of fixed exchange rates.

Beginning in the 1970s, the developed countries gradually phased out capital controls and, in the 1990s, even the developing countries started to liberalize their capital accounts. This trend reflected a growing acceptance that capital controls (with the exception of prudential ones) tend to be inefficient and costly. Controls are also hard to sustain when domestic financial transactions are liberalized, and they run counter to the aims of a macroeconomic management framework that is designed to work through market forces. The easing of capital controls, along with the revolutions in information and communication technologies, led to a dramatic increase in international capital flows in the 1990s.¹

Capital flows provide substantial benefits to individual countries and the international economy as a whole, but these benefits may not be fully realized if serious imperfections exist in capital markets (Eichengreen and others, 1998). ² These imperfections have never been more obvious than during financial crises in emerging markets in the late 1990s, when questions about the role of capital controls were once again brought to the forefront of policy debates.

Capital control regulations are multifaceted, and quantifying them for comparisons across countries and over time is a challenge. Most studies have relied on the use of dummy variables from the IMF's Annual Report on Exchange Arrangements and Exchange Restrictions (following Grilli and Milesi-Ferretti, 1995). ³ Using new and more disaggregated information in this report, Johnston and others (1999) construct indices that take into account the diversity of capital controls. ⁴ Edison and Warnock (forthcoming) propose a new measure of the intensity of capital controls for emerging market economies-the ratio of the market capitalizations underlying a country's International Financial Corporation Investable and Global indices (IFCI and IFCG). ⁵

Countries set up capital controls for a variety of reasons. Controls are often associated with fixed or managed exchange rate regimes, lower per capita incomes, larger shares of government consumption in GDP, less independent central banks, and larger current account deficits (Alesina, Grilli and Milesi-Ferretti, 1994; Grilli and Milesi-Ferretti, 1995). ⁶ Generally, different types of controls serve different purposes. Macroeconomic reasons appear to motivate controls on capital inflows, balance of payments management usually motivates controls on capital outflows, while institutional and market structures typically motivate financial regulations related to the operation of banks and institutional investors (Johnston and Tamirisa, 1998). ⁷

Evidence on the effectiveness of capital controls is mixed. Country experiences suggest that capital controls may be useful in dealing with volatile capital flows and may provide some "breathing room" for implementing economic reforms, but they are difficult to administer and cannot substitute for proper macroeconomic policies (Ariyoshi and others, 2000; Ishii, Ötker-Robe, and Cui, 2001). ⁸ Not surprisingly, more effective controls tend to be more distortionary as well.

Page 3

Temporary controls on capital inflows, for example, appear to be effective only when they are highly punitive, and may even lower welfare if the government...