IV Conclusions

Akira Ariyoshi, Andrei Kirilenko, Inci Ötker, Bernard Laurens, Jorge Canales Kriljenko, and Karl Habermeier
Published Date:
May 2000
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This review of the use and liberalization of capital controls in 14 countries cannot be considered exhaustive. It illustrates the difficulty of precisely assessing the effects of capital controls, which may have benefits as well as costs. The analysis of the relationship between prudential policies and capital controls is a first step, and considerable further work would be needed to fully clarify their respective roles, interdependencies, and limitations. This paper nonetheless sheds some light on arguments previously advanced in the literature, on some of the operational issues related to the design of capital controls, and on the relationship between capital controls and prudential policies. Despite the diversity of the country experiences examined in this paper and the absence of a single best approach to capital account liberalization, a number of apparent regularities may prove useful in formulating policy.

The evidence presented in this paper supports the conclusion that capital controls cannot substitute for sound macroeconomic policies. Countries with serious macroeconomic imbalances and no credible prospect for improvement in the short run were regularly unable to address large-scale capital flows, or their adverse economic effects, with capital controls. Not even comprehensive and strictly enforced administrative controls have always protected countries from balance of payments or financial crises.

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 studies. Countries 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.

First, 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.

Second, 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 ways to achieve their desired ends through unrestricted channels. 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 that 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.

Third, administrative capacity and the level of financial market development also have a bearing on the choice of controls and their effectiveness. Properly 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 if they are to be 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, other things equal, 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. Also, 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 trade-off 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.

The converse of the previous question is whether prudential regulation and supervision of financial institutions can help in managing the risks from international capital flows, by influencing the volume, composition, and hence the volatility of such flows. The evidence on this point seems more persuasive. 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 misregulation and overregulation. 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.

Finally, 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—the entire infrastructure of finance. Against this background, it is difficult to prescribe in general the sequence in which capital controls on different types of flows should be liberalized.

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