It has been a decade since the global financial crisis effectively ended opposition to the use of capital controls. The IMF’s drive towards capital account deregulation had been blunted by the Asian financial crisis of 1997-98, but there was still a belief in some quarters that complete capital mobility was an appropriate long-run goal for emerging markets once their financial markets sufficiently matured. The meltdown in financial markets in advanced economies in 2008-09 ended that aspiration. Several recent papers have summarized subsequent research on the justification for capital controls and the evidence on their effectiveness.
Bilge Erten of Northeastern University, Anton Korinek of the University of Virginia and José Antonio Ocampo of Columbia University have a paper, “Capital Controls: Theory and Evidence,” that was prepared for the Journal of Economic Literature and summarizes recent work on this topic. In this literature, the micro-foundations for the use of capital controls to improve welfare are based on externalities that private agents do not internalize. The first type of externality is pecuniary, which can lead to a change in the value of collateral and a redistribution between agents. In such cases, private agents may borrow more than is optimal for society, which suffers the consequences in the event of a financial shock. Policymakers can restrict capital flows to limit financial fragility.
The second justification of capital controls is due to aggregate demand externalities, which are associated with unemployment. Private agents may borrow in international markets and fuel a domestic boom that leaves the domestic economy vulnerable to a downturn. If there are domestic frictions and constraints on the use of monetary policy that limit the response to an economic contraction, then capital controls may be useful in mitigating the downturn.
Alessandro Rebucci of Johns Hopkins and Chang Ma of Fudan University also summarize this literature in “Capital Controls: A Survey of the New Literature,” prepared for the Oxford Research Encyclopedia of Economics and Finance. They discuss the use capital controls in the case of both pecuniary and demand externalities, and capital controls in the context of the trilemma. In their review of the empirical literature on capital controls, they summarize two lines of research. The first deals with the actual use of capital controls, and the second their relative effectiveness.
Whether or not capital controls are used as a countercyclical instrument together with other macroprudential tools has been an issue of dispute. Rebucci and Ma report there is recent evidence that indicates that such instruments have been utilized in this manner, as the recent theoretical literature proposes. There are also cross-country studies of capital control effectiveness that are consistent with the theoretical justification for the use of such measures. For example, capital controls can limit financial vulnerability by shifting the composition of a country’s external balance sheet away from debt.
Some recent papers from the IMF investigate the actual use of capital controls and other policy tools in emerging market economies. Atish R. Ghosh, Jonathan D. Ostry and Mahvash S. Qureshi of the IMF investigated the response of emerging markets to capital flows in a 2017 working paper, “Managing the Tide: How Do Emerging Markets Respond to Capital Flows?” They report that policymakers in a sample of 51 countries over the period of 2005-13 used a number of instruments to deal with capital flows. In addition to foreign exchange market intervention and central bank policy rates, capital controls were utilized, particularly when the inflows took the form of portfolio and other flows. Tightening of capital inflow controls was more likely during periods of credit growth and real exchange rate appreciation. The authors’ finding that several major emerging markets have used capital controls to deal with risks to financial and macroeconomic stability is consistent with the theoretical literature cited above. However, the authors caution that their results do not indicate whether managing capital flows actually prevents or dampens instability.
This subject has been addressed by Gaston Gelos, Lucyna Gornicka, Robin Koepke, Ratna Sahay and Silvia Sgherri in their new IMF working paper, “Capital Flows at Risk: Taming the Ebbs and Flows.” They examine the policy responses to sharp portfolio flow movements in 35 emerging market and developing economies during the 1996-2018 period, using a rise in BBB-rated U.S. corporate bond yields as a global shock. The authors look at the structural characteristics and policy frameworks of the countries as well as their policy actions. Among their results they find that more open capital accounts at the time of the shock are associated with fewer large inflows after the shock. Moreover, a tightening of capital flow measures is linked to larger outflows in the short-run. They also find that monetary and macroprudential policies have limited effectiveness in shielding countries from the risks associated with global shocks.
Capital controls have become an important tool for many developing economies, and there are ample grounds to justify their implementation. Recent empirical literature seems to show that the actual implementation of such measures is undertaken in a manner that meets the criteria outlined in the theoretical literature. However, whether regulatory limits on capital mobility actually achieve their financial and macroeconomic goals is still not proven. The Federal Reserve has signaled its intention to maintain the Federal Funds Rate at its current level, but shocks can come from many sources. Policymakers may find themselves drawing upon all the tools available to them in the case of a new global disruption to capital flows.