Sunday, November 22, 2009

Capital controls are back?

The Brazilian government's decision last month to impose a 2% tax on all capital inflows into equities and fixed income instruments to slow the appreciation of its currency, the real (which has gained 36% against the US dollar this year), has re-opened the debate on capital controls and proposals like Tobin tax on cross-border capital flows. Apart from containing the appreciation of the real, it is hoped that the tax will also prick any asset bubbles building up in the financial markets due to the mis-allocation of resources from the massive capital inflows of the past few months.

The markets reacted with dismay at the Brazilian decision, and opponents, which includes the IMF (see this response to the IMF's position by Dani Rodrik), immediately claimed that the tax would end up being circumvented and the capital flows continue unabated. They point to the examples from even recent times that appear to indicate that in the absence of a blanket ban on all capital inflows, it is almost impossible to control capital inflows, and that such selective controls may only end up generating distortions in the financial markets.

The recent turmoil in the global financial markets in the aftermath of the bursting of the sub-prime bubble and its disastrous impact on national economies has naturally heightened the apprehensions surrounding financial market events and the build-up of systemic risks. Since March, buoyed by signs of strong recovery in the emerging economies and continuing economic weakness among the developed economies, and to take advantage of a weakening dollar, there has been a massive inflow of capital into the emerging economies.

These inflows flows into emerging economies, which have nearly doubled their equity markets, have also contributed to appreciation of the domestic currencies against the US dollar. The continued weakness of the US economy, its bleak short to medium-term prospects, and the near certainty of a loose monetary policy for the foreseeable future by the Fed means that the dollar looks set to decline further. The resultant appreciation of their currencies, coupled with the Chinese refusal to let the renminbi find its value against the dollar, will adversely affect the export competitiveness of emerging economies (especially against the Chinese exports). This will invariably put pressure on these countries to intervene in the forex markets with dollar purchases to stem the appreciation of their currencies. This forex market intervention would necessitate sterilization measures to keep the money supply and inflationary pressures under control. The additional burdens on fiscally strained governments would be considerable.

In this context, it would be instructive to take a look at a growing chorus of opinion that appears to favor some form of controls on cross-border capital flows. As Arvind Subramanian and John Williamson have written in a brilliant article, the Brazilian decision may be "signaling an end to an era in which emerging markets were enamored with foreign finance, and in expressing willingness to take action to moderate inflows of foreign finance". Accordingly, they advocate "a less doctrinaire approach to foreign capital flows", one that abandons "sanctifying, implicitly or explicitly, foreign finance" and acknowledging the seriousness of the problems posed by surges in capital flows.

They feel that instead of blindly opposing all capital controls (as was the response of IMF to the Brazilian decision), these countries, with help of agencies like the IMF, should look at the "best ways of designing these measures (Should they be price-based or quantity-based? What kinds of flows are best addressed, debt or portfolio? Over what duration are limits most effective? When should they be withdrawn?) so that the benefits are maximized and risks minimized".

They argue that while pursuit of more open capital flows should be a long-term, structural objective of all economies, it needs to be recognized that surges in capital inflows can pose serious macroeconomic challenges that may require a different cyclical response. They write, "For emerging markets, the policy arsenal against future crises must cover measures to restrict credit growth and leverage countercyclically, notably surging capital flows."

They also call on the IMF to accept such measures so as to eliminate the stigma associated with such actions, which in turn adversely affects the market confidence and credibility of the nations introducing such controls. They write, "By recognizing that in some instances sensible curbs on inflows might be a reasonable and pragmatic policy response, the Fund can eliminate the market-unfriendly stigma that actions of the Brazilian type might otherwise risk incurring."

In a blog post, Arvind Subramanian even calls for co-ordinated restrictions on capital flows by a set of emerging markets. He writes that since "the cause of the increased flows is common to all countries, namely Fed policy, it will be a policy challenge not just for individual countries but for emerging markets as a group".

There is enough evidence now, in light of the forex market crises of the past two decades, to question the utility of removing all capital controls, especially in case of developing countries. Eswar S. Prasad, Raghuram G. Rajan, and Arvind Subramanian find that there is enough evidence to "suggest that insofar as the need to avoid overvaluation is important and the domestic financial sector is underdeveloped, greater caution towards certain forms of foreign capital inflows might be warranted". They write,

"Contrary to the predictions of standard theoretical models, non-industrial countries that have relied more on foreign finance have not grown faster in the long run. By contrast, growth and the extent of foreign financing are positively correlated in industrial countries... the reason for this difference may lie in the limited ability of non-industrial countries to absorb foreign capital – especially because of the difficulty their financial systems have to allocate it to productive uses, and because of the proneness of these countries to exchange rate appreciation (and, often, overvaluation) when faced with such inflows... there is no evidence that providing additional financing in excess of domestic savings is the channel through which financial integration delivers its benefits."

They however underline the importance of financial integration and ensuing competition to spur domestic financial development. They therefore suggest an approach that involves providing "a firm commitment to integrate financial markets at a definite future date, thus giving time for the domestic financial system to develop without possible adverse effects from capital inflows, even while giving participants the incentive to press for it by suspending the sword of future foreign competition over their heads".

In another paper, Dani Rodrik and Arvind Subramanian too come to much the same conclusions. They find that the "benefits of financial globalization are hard to find", "financial globalization has not generated increased investment or higher growth in emerging markets", and that the "countries that have grown most rapidly have been those that rely less on capital inflows". They also find that "financial globalization has not led to better smoothing of consumption or reduced volatility". They write, "Depending on context and country, the appropriate role of policy will be as often to stem the tide of capital flows as to encourage them. Policymakers who view their challenges exclusively from the latter perspective will get it badly wrong."

Interestingly, evidence from Chile's experience with capital controls in the form of "imposition of reserves requirements on capital inflows", indicates that "while they have allowed the Central Bank to have a greater degree of control over short term interest rates, they have failed in avoiding real exchange rate appreciation". This brings us to Mundell's impossible trinity which claims the impossibility of simultaneously having a policy mix of free capital inflows, stable (fixed or an adjustable peg) exchange rates and interest rate autonomy.

Under any macroeconomic situation, only two of these objectives can be met simultaneously. In the circumstances, especially in light of the events of the past few months, conventional wisdom would dictate that the choice for Central Banks is easy. Selective capital controls would give Central Banks and governments, much needed room to manouvre with their interest rates and foreign exchange rates in an uncertain environment.

The ET has a nice graphic which captures the dilemma facing the RBI and policy makers in India on the issue of capital controls.

As part of its capital controls policy and in the face of a flood of capital inflows ($16 bn in FPI till date against $20 bn for full 2007, $17.74 bn for H1 2009-10 against $35.2 bn for 2007-08), the Indian government is working on a proposal to auction corporate entitlements to make external commercial borrowings (ECBs).

Update 1
An IMF working paper has advocated that capital controls are a "legitimate" tool in some cases for governments facing surges in external investments that threaten to destabilize their economies. It writes, "Even when flows are fundamentally sound, it is recognized that they may contribute to collateral damage, including bubbles and asset booms and busts... Capital controls on certain types of inflows might usefully complement prudential regulations to limit financial fragility and can be part of the toolkit... If the economy is operating near potential, if the level of reserves is adequate, if the exchange rate is not undervalued, and if the flows are likely to be transitory, then use of capital controls - in addition to both prudential and macroeconomic policy - is justified as part of the policy toolkit to manage inflows".

Simon Johnson draws attention to Lord Adair Turner's lecture at the RBI where he argued that "the case that short term capital liberalization is beneficial is... based more on ideology and argument by axiom than on any empirical evidence" and implicitly favored the use of capital controls when situation warranted.

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