Regulating capital flows through domestic controls
Capital controls are as much a means of crisis prevention as they are of crisis resolution. Controls on capital inflows, as in Chile and China, have been designed to prevent the build-up of crises. However, capital account management techniques must fit the needs of the individual nation. The extent to which countries should control the capital account continues to be a subject of debate. Economists and policy makers favoring less control have argued that liberalization allows capital to flow to projects with higher returns that have better allocative efficiency (Blecker 1999). In transferring funds to more efficient projects, investors demand better financial services and sound macroeconomic fundamentals, which put pressure on local institutions and governments to improve these structures. Arguments in favor of capital controls have been supported by empirical evidence, which shows that reduction in capital controls cultivates instability (Bruner and Ventura 2010). Data also show that reduction of capital controls does not necessarily lead to investment or growth, while it does increase output volatility. Maintaining low levels of capital controls can also reduce monetary policy autonomy; offshore banking is a prime example, in which capital outflows escape the management of domestic financial authorities. A contractionary macroeconomic policy bias may be produced with liberalization since financial capital prefers somewhat deflationary policies to preserve the value of assets. To compound matters, international capital tends to act procyclically and exacerbate downturns, leading to potential repeat of financial crises.
Capital controls went out of fashion in the early and mid-1990s, came back into fashion after the Asian financial crisis, and currently remain a subject of debate. China’s monumental economic growth while maintaining capital controls on a whole host of financial and foreign exchange transactions, including limiting residents’ ownership of foreign assets and limited foreign access to Chinese stock and asset markets, has proved that capital controls do not prevent wholesale growth per se. Chile’s experience of capital controls is also often invoked as a successful case, but its specific type of controls may not have worked altogether in its favor. The controls, which stipulated a reserve requirement on short-term financial inflows, are viewed as having worked in the short run, but not in the long run when expectations of currency appreciation grew.
In the case of capital controls on both inflows and outflows, enforcement is a major duty that must prevent the use of loopholes. Capital outflows from developed countries provide most of the inflows into developing countries, and control of these flows would stabilize less developed economies. To this end, Jane D’Arista (2002) proposes that investors use a closed-end fund for emerging markets run by an international institution like the World Bank. The fund would issue liabilities to private investors and purchase stocks and bonds of private enterprises and public agencies in developing countries in cooperation with the government. The fund could be capitalized by government securities of major industrial countries in amounts equal to the proportion of residents in those countries who hold shares of the fund. Underlying assets would not have to be sold as the value of fund shares fluctuated, protecting emerging markets from capital flow volatility.
In recent years, some Latin American countries have also used reserve requirements to control monetary policy while preventing capital from rushing into or out of the economies. Rather than implementing outright capital controls, Brazil, Columbia, and Peru have used reserve requirements as a tool in inflation targeting, which has allowed these countries to check capital flows as well (Montoro and Moreno 2011). This was useful during times of economic stress before and after the bankruptcy of Lehman Brothers. Bussiere et al. (2015) show that countries with high reserves relative to short-term debt and some capital controls suffered less from the 2008-09 global crisis. Using reserve requirements to adjust monetary policy while controlling capital flows can be effective in particular circumstances, although policy makers must weigh the use of this tool against potential side effects, including a larger spread between lending and deposit rates, which increases the cost of credit, and the necessity for banks to deposit a larger portion of their assets with the central bank, lowering bank profits.