Fortsetzung: Capital Controls in Emerging Market Economies - A Review of the Chilean and Malaysian Experiences

Matthias Müller

Capital controls

Capital controls affect the capital account of a country's balance of payments through administrative procedures (e.g. prohibitions, quantitative limits, approval requirements) or market-based measures (e.g. dual exchange rate systems, direct and indirect taxation). The rationales that have been advanced to justify the use of capital controls include the non-exclusive categories of first-best arguments, second-best arguments and policy implementation arguments.

First-best arguments apply in the presence of multiple equilibria, where the first-best equilibrium might be attained or maintained through government intervention in capital markets. Even if the regime remained vulnerable to changes in private expectations through current account transactions, the extended life for the good equilibrium made possible by capital controls would be desirable.

Second-best arguments identify situations in which capital account restrictions improve economic welfare by compensating for financial market imperfections, including those attributable to incomplete and asymmetric information.

Policy implementation, eventually, has motivated restrictions on capital account convertibility by three principal considerations. First, the Mundell-Fleming framework suggests that a country cannot simultaneously maintain a fixed (or quasi fixed) exchange rate and pursue an independent monetary policy when capital is perfectly mobile. Capital account restrictions are a way of resolving this trade-off in favour of government control over interest and exchange rates. Second, during the 1990s, a consensus emerged that because of the moral hazard associated with the financial sector, controls on international capital movements should only be relaxed after adequate domestic financial institutions are in place (sequencing argument). Third, to the extent that capital controls limit excessive foreign exchange exposure of domestic institutions, or lengthen the maturity of their liabilities, they protect the stability of the financial system by reducing the causes of short-term capital volatility.

The objection frequently raised against capital controls is that they are ineffective and costly. The ability of capital controls to insulate domestic financial conditions from those abroad is influenced by the expected gains from, and the costs associated with, evading the controls -- for instance by over-invoicing (under-invoicing) of imports (exports) or by mislabelling the nature of the capital movement. The incentives to evade capital controls will be stimulated by factors such as nominal yield differentials or penalties imposed on those who try to default. Licences for approved, but restricted capital account transactions provide another strong incentive for investors with huge sums of money at stake to attempt to capture the "rent" inherent in those licences through corruption and political influence. As agents find ways to avoid restrictions, the costs of enforcing capital controls have risen. And as the effectiveness of capital controls erodes, inappropriate macroeconomic policies can be sustained only if capital controls are further tightened, thereby increasing the distortions they can potentially create.

Chile's controls on capital inflows

Since the aftermath of the East Asian crisis, there has been increasing support for the imposition of controls on capital inflows as prudential measures to prevent future financial crises. Some of the countries that have relied on controls on capital inflows during the last decade include Brazil (1993-97), Chile (1991-98), Columbia (1993-98), Malaysia (1994) and Thailand (1995-97). It has been Chile's experience, however, that has attracted the greatest attention from economists, policy advisers and the specialised media.

In 1989, in response to an overheating of the economy, the Chilean authorities tightened monetary policy which, combined with a fall in world interest rates and an improvement of market sentiment toward Chile, resulted in a surge of private capital inflows. The Chilean policymakers faced a classical policy dilemma where the internal balance required domestic interest rates that were higher than those abroad, while the external balance was inconsistent with the appreciation of the currency. In response to continued capital inflows intruding with macroeconomic policy, Chile introduced restrictions on capital inflows in June 1991. Originally, all portfolio inflows were subject to a 20% unremunerated reserve requirement (URR). For maturities of less than a year, the deposit applied for the duration of the inflow, while for longer maturities the reserve requirement was for one year. As the private sector quickly found ways to avoid the controls, in July 1992, the rate of the reserve requirement was raised to 30%, and its holding period was set at one year, independently of the length of stay of the flow. At the same time, its coverage was extended to trade credit and to loans related to FDI. In 1995, in an effort to close additional loopholes, the controls were extended to Chilean stocks traded on the New York Stock Exchange and to international bond issues. In June 1998, to reduce the risk that the capital flows to Chile would decline as part of contagion from the East Asian crisis, the rate of the reserve requirement was lowered to 10%, and in September 1998, the rate was reduced to zero.

The Chilean capital controls were employed to achieve three explicit macroeconomic and macroprudential goals. First, to slow down the volume of capital flowing into the country, and to alter its composition towards longer maturities. Second, to reduce any real exchange rate appreciation that stemmed from these inflows. And third, to allow Chile's central bank to maintain a high differential between domestic and international interest rates, and thus to expand the autonomy of monetary policy. Econometric studies suggest that Chile's controls had only a very small effect on interest rates, and no significant effect on real exchange rates. However, the controls seem to have affected the maturity composition of inflows in favour of medium- and long-term capital flows, though not their overall volume. Given that short-term capital flows are a potential cause of financial crises, the Chilean experience appears to support the case for policies that lengthen the maturity of such movements.

Chile's financial stability, however, probably had less to do with its system of capital controls, than with the country's relatively well-developed system of prudential banking regulation. The country had previously relied on inflow controls in 1978-82, when a large fraction of capital entered the country. Though capital controls were particularly stringent, Chile nonetheless went through a severe financial crisis in 1981-82, when the peso was devaluated by almost 90% and a large number of banks had to be bailed out by the government. As a largely unregulated banking sector had been at the heart of the crisis, the Chilean authorities initiated comprehensive structural reforms to upgrade the prudential framework of the financial system. In 1986, the General Banking Law and the Organic Law of Superintendency of Banks and Financial Institutions were revised and implemented to strengthen prudential regulations and to minimise the need for state intervention in the financial system. In 1989, Congress enacted a constitutional law establishing legal independence for the central bank, which received the mandate to ensure stability of the financial system. Finally, in 1997, a new banking law was enacted that increased banks' capital requirements in line with recommendations of the Basle Committee. In addition to financial sector reforms, in December 1983, the fixed exchange rate was replaced by a crawling peg regime, which allowed for an orderly appreciation of the currency after 1989.

This earlier episode provides a key element in the evaluation of the effectiveness of the 1989-98 restrictions on capital mobility in Chile. It strongly suggests that in the absence of appropriate banking regulations, restrictions on capital inflows are unlikely to reduce a country's degree of vulnerability. Arguably, the financial sector and exchange rate reforms have enabled Chile to withstand the global financial turmoil in the second half of the 1990s.

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