VII Experience with the Use of Extensive Controls During Financial Crises
- Akira Ariyoshi, Andrei Kirilenko, Inci Ötker, Bernard Laurens, Jorge Canales Kriljenko, and Karl Habermeier
- Published Date:
- May 2000
The Romanian authorities imposed exchange controls in March 1996 in the context of heavy foreign exchange market pressures. These pressures stemmed from a relaxation of monetary policy associated with central bank liquidity support to private banks and a pre-electoral easing of fiscal policy. The 12-month rate of depreciation of the leu rose from 20 percent in September 1995 to 60 percent in March 1996, while foreign exchange reserves declined sharply.
To limit exchange rate depreciation, the authorities imposed an overnight cash limit on foreign exchange bureaus, and withdrew foreign exchange dealer licenses from all but four state-controlled banks. These measures served to further tighten the existing capital controls, which were pervasive, quantity based, and discretionary. Most capital account transactions required central bank approval and endorsement by the Ministry of Finance, with some types of transactions subject to outright prohibitions (for example, real estate). Current account restrictions were also maintained under the transitional arrangements of the IMF’s Article XIV. In addition to the new controls, the authorities decided to fix the exchange rate during the run-up to local elections in June.
The exchange controls segmented the foreign exchange markets and contributed to the emergence of considerable private external arrears. The rate of depreciation in the interbank market stabilized at about 60 percent. However, a parallel exchange market between enterprises emerged, and the bureau-interbank market spread widened increasingly over time, particularly after monetary policy was significantly relaxed in November. By end-1996, the volume of transactions in the interbank market had dwindled to one-tenth of the volume during the previous year. Net capital inflows, as measured by a positive financial account balance, actually increased despite a sharp slowdown in inward foreign direct investment relative to other transition countries.51 Errors and omissions in the balance of payments remained about the same as in 1995.
The authorities reinstated foreign exchange dealer licenses and committed to a market-determined exchange rate in February 1997 as a prior action under Romania’s 1997 stand-by arrangement with the IMF. An exchange rate depreciation in the interbank market began in January 1997 and accelerated when the controls were removed. The surplus in the financial account, and in particular foreign direct investment, increased sharply, and errors and omissions tripled in 1997, indicating that capital inflows may have been even higher.
The adoption of an IMF program shortly after the removal of controls makes it difficult to assess their effectiveness. Notwithstanding the emergence of parallel markets, the overshooting of the exchange rate when exchange controls were removed suggests that the controls may have been partly effective in containing pressures in the foreign exchange market. Both exchange rate developments and capital flows were also affected by political uncertainty during the electoral period.
Russian Federation (1998–Present)
The Russian Federation (Russia) started to slowly liberalize its capital account in the early 1990s, while reforming its banking system and foreign exchange and securities markets. Capital account liberalization started with foreign direct investment under strict rules that were eased over time. Limited nonresident portfolio investment started in 1994. Restrictions on portfolio investments by nonresidents were further relaxed in 1996, shortly after the country achieved current account convertibility. However, capital controls remained pervasive, and largely quantity based and discretionary. Most capital account transactions required prior approval from the central bank.
The gradual liberalization of restrictions on nonresident portfolio investment was completed in early 1998. From February through mid-September 1996, nonresidents were allowed to engage in foreign exchange swaps with the Central Bank of Russia. From September 1996 through January 1998, local Russian banks became the counterparties in the swap operations. Nonresidents were allowed to open special ruble-denominated bank accounts with which to buy government securities in either the primary or secondary markets. However, they were required to engage in forward contracts with these banks at a rate set by the central bank. The maturity and dollar return implicit in these forward rates were progressively reduced until they were liberalized in January 1998. From then on, foreign investors could freely repatriate their profits the day after they liquidated their investment in short-term treasury bills (GKOs). Local banks were allowed to sell foreign exchange forward contracts at freely negotiated rates.
Starting in late 1997, Russia experienced increasing foreign exchange market pressures, reflecting growing concern about the fiscal situation. The pressure on the ruble began with a run from the Russian stock exchange shortly after the beginning of the Asian crisis, and was initially contained by massive foreign exchange intervention, which was partially sterilized. The drain on central bank net foreign assets, however, seemed to have been contained between January and June 1998. Nevertheless, the fiscal situation remained fragile, with a continuing large deficit and a relatively large stock of GKOs to roll over. A shift in investor sentiment made it difficult to place new issues, and net financing from these securities became negative in May, when interest rates rose sharply.52
In August 1998, Russia introduced a series of emergency measures, including a reintensification of capital controls and the announcement of a selective debt moratorium. After an unsuccessful attempt to ease the government debt burden in July, including a voluntary debt conversion program and a Fund program, speculative attacks ensued. The Central Bank of Russia defended the exchange rate band, and net foreign assets became negative. The government froze secondary trading of GKOs and tightened the range of existing capital controls. By mid-August, the government compulsorily lengthened the maturities of federal domestic debt instruments due by end-1999, including all outstanding GKOs, but stated its intention to honor its sovereign external debt. In addition, the government declared a unilateral 90-day moratorium on private sector external obligations (including forward contracts) with maturity over 180 days. This action was taken primarily to protect official reserves in the face of an acute balance of payments crisis and to aid the domestic banking sector, whose liquidity position was sharply diminished on account of the unilateral conversion of GKOs-OFZs (Russian long-term federal bonds) and the suspension of trade in these instruments. In principle, the moratorium did not affect transfers in foreign currency into and out of Russia by nonresidents, but in practice nonresidents faced restrictions on transfers of funds from their S-accounts (special nonresident bank accounts used for GKO-OFZ transactions), as these transfers required a forward transaction of three days, which was covered by the moratorium. (See IMF, 1999c.)
The authorities also terminated the fixing of the exchange rate in the Moscow Interbank Currency Exchange (MICEX) auctions and temporarily closed the foreign exchange market. However, after mounting pressures in the foreign exchange markets, the authorities in September 1998 abolished the horizontal exchange rate band that had been adjusted upward and widened in mid-August, and established two trading sessions per day in early October 1998 with a view to limiting the use of export proceeds to payments for imports and reserve accumulation.53 These arrangements gave rise to several restrictions and potential multiple currency practices subject to IMF jurisdiction under Article VIII of the IMF’s Articles of Agreement.54
The events of August were followed by a full-blown financial crisis. In September, the exchange rate depreciated by about 50 percent, and monthly inflation rose to 40 percent. A large expansion of central bank financing to the budget and support to ailing banks later validated the sharp exchange rate depreciation. There was large-scale support to commercial banks, including a reduction in reserve requirements, outright credit to banks, and central bank purchases of government securities from banks. Large foreign exchange losses had accumulated in the banking system with the sharp depreciation of the currency, as banks had acquired large unhedged foreign exchange positions on the false assumption that the exchange rate would remain stable. Liquidity problems in the banking system (which had invested heavily in government securities) temporarily paralyzed the payment system.
Despite the default and the adoption of the controls, international reserves remained under pressure and the exchange rate continued to depreciate until early 1999. In 1998, the curtailment of government borrowing from private external sources, accompanied by an acceleration of capital flight, resulted in a swing in the capital account of some $16 billion (from a surplus of $6.3 billion to a deficit of $9.7 billion, mainly reflecting the capital outflows of $17.1 billion in the second half of the year, compared with a capital account surplus of $7.4 billion in the first half of the year). This was reflected in the abandonment of the exchange rate band and a subsequent sharp depreciation of the ruble (which led to a more than 45 percent depreciation of the real effective exchange rate between July 1998 and January 1999); a sharp import contraction; a fall in net international reserves of about $10 billion; and an accumulation of external official and private sector arrears.
Despite their comprehensiveness, therefore, the August measures do not appear to have achieved their intended objectives against the background of continued economic and structural imbalances in the economy. The post-August 1998 pattern of capital outflows continued until the first quarter of 1999. At this point the tightening of monetary policy, possibly reinforced by the imposition of a number of capital outflow controls, was reflected in a decline and then stabilization in net private capital outflows, followed by a resumption of growth in the level of reserves, and a broad stabilization of the nominal effective exchange rate between January and June 1999 (IMF, 1999c). From April 1999 onward, there were also signs that the causes of the August 1998 crisis were being addressed, including efforts to correct the underlying fiscal imbalance through several new revenue enhancing tax measures, unification of the interbank currency markets, and passing of legislation to facilitate bank restructuring. Recent reviews of the exchange control regulations in Russia also suggest that there were some difficulties in enforcing the controls. In particular, there is no legal basis for banks to stop suspicious transactions, if the accompanying documents appear to be legitimate. Moreover, it is difficult for the authorities to prosecute in dividuals for violations of the foreign exchange regulations, since there are few provisions in the penal code punishing such acts.
The imposition of the August measures, in particular the moratorium, also involved some costs, though it may have provided some breathing space for Russian banks and nonbank corporations in meeting their external obligations (see IMF, 1999c.). Some Russian debtors reportedly circumvented the moratorium and serviced their external obligations. There is also anecdotal evidence that a number of other Russian bank and nonbank corporations used the debt moratorium as a cover for asset stripping and as an excuse for not settling their domestic obligations to other Russian creditors, with adverse implications for the banking and payment systems. Moreover, there was an adverse international response to the unilateral debt restructuring and moratorium, evidenced by a sharp rise in the yield differential on Russian securities until early March, a downgrading of Russia’s sovereign credit ratings in February 1999, and a complete halt in access to international capital markets. Foreign direct investment inflows also declined sharply, from $3.6 billion in 1997 to $1.2 billion in 1998. Finally, several of the August measures, which restricted certain current international transactions (including the establishment of the two trading sessions in the foreign exchange market and restrictions on nonresidents’ ability to transfer funds from their S-accounts) gave rise to exchange restrictions under IMF jurisdiction, representing a reversal of current account convertibility that had been achieved prior to the crisis.
The Russian experience illustrates how closely related a government default can be to a devaluation and the adoption of capital controls. In principle, devaluation or capital controls can be used instead of government default. Both devaluation and government default can reduce the dollar value of outstanding domestic currency–denominated debt; and both capital controls and government default can limit the capital outflows directly associated with servicing short-term government debt. Of course, default would involve a breach of contract, while neither devaluation nor the adoption of capital controls would. The Russian experience shows, however, that a default does not necessarily eliminate the need for devaluation or capital controls.
To limit the severe pressures on the bolívar resulting from the efforts to cope with the banking crisis, Venezuela imposed price controls, fixed the exchange rate, and adopted exchange control measures on June 27, 1994. (The exchange controls remained in place until April 1996.) In the first half of 1994, the central bank, through the deposit insurance agency (FOGADE), began to finance the recapitalization of several banks in financial difficulty (9.5 percent of GDP, reaching 13 percent of GDP for 1994 as a whole). This large injection of liquidity complicated monetary management and led to a noticeable widening of the overall fiscal deficit. In the event, the central bank lost $3.7 billion or 45 percent of its foreign exchange reserves, and it let the bolívar depreciate by 70 percent against the U.S. dollar between April and June 1994, abandoning the de facto crawling peg vis-à-vis the U.S. dollar that had been in place since 1993.
The exchange and capital controls were comprehensive and comprised restrictions on both current and capital account transactions to reduce the scope for circumvention. The controls were quantity based, and included direct prohibitions limits, and surrender requirements. The regulations restricted the availability of foreign exchange for import payments and established surrender requirements on foreign exchange receipts from exports of goods and services (exporters were allowed to retain up to 10 percent of their export proceeds to meet commitments abroad). Capital outflows not related to the amortization of external debt and the repatriation of capital by foreigners were prohibited, and surrender requirements were imposed on capital inflows. Foreign direct investment in the petroleum and iron ore sectors continued to be subject to specific regulations. Substantial penalties were imposed for black market trading.
Despite the introduction of the exchange controls, short-term private capital registered outflows in 1994 and 1995. Short-term capital shifted from an inflow of 2 percent of GDP in 1993 to an outflow of 2.2 percent in 1994 and 3 percent in 1995, suggesting that despite efforts to make the controls comprehensive, there were still loopholes in the regulations that were exploited by the well-developed offshore market. (See García-Herrero, 1997.) The controls also created a de facto dual exchange rate market, with the parallel market premium fluctuating around 40 percent before rising to 100 percent by end-1995.
The controls may have given the central bank some room for maneuver on monetary policy in the context of a fixed exchange rate regime. The controls supported financial repression without depleting central bank reserves: real interest rates were significantly negative over the period, and the central bank was able to reconstitute, albeit temporarily, some of the foreign exchange reserves that it lost in the defense of the currency.
The effect of the controls and the associated financial repression on the ultimate cost of the banking crisis is ambiguous. Financial repression may have reduced the fiscal cost of the banking crisis, with disintermediation almost halving the real value of the assets and liabilities of the troubled banking sector as well as the real value of the government’s deposit insurance liabilities. On the other hand, financial repression may have delayed an effective resolution of the banking crisis, contributing to an increased cost of bank restructuring.
The controls may also have curtailed Venezuela’s access to international financial markets. Venezuela’s share in total foreign direct investment to Latin America was systematically lower in 1995 than in the five years preceding the financial crisis (1989–93). It is difficult to determine whether this decline reflects foreign investors’ concern about the health of the banking system and political turmoil, or about the exchange controls themselves.55
Capital controls might have contributed to the increase in the cost of servicing Venezuela’s floating-interest rate external debt and rolling over maturing external debt; secondary market yields on Venezuelan Brady bonds were higher than those of other important Latin American countries, and this differential was eliminated shortly after the controls were removed. These developments may, however, have also reflected a market assessment that Venezuela’s general economic problems were relatively more severe than elsewhere in Latin America; and the narrowing of the differential coincides in time not only with the elimination of the controls, but with the adoption of an IMF program in April 1996 and intensified macroeconomic and structural adjustment.