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Since the revival of global capital markets in the 1960s, cross-border capital flows have increased by orders of magnitude, so much so that international asset positions now outstrip global economic output.
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Regulating Global
Capital Flows for
Long-Run Development
PARDEE CENTER TASK FORCE REPORT / March 2012
Regulating Global Capital Flows
for Long-Run Development
Co-Chairs
Kevin P. Gallagher
Stephany Grif?th-Jones
José Antonio Ocampo
Task Force Members
Amar Bhattacharya
Mark Blyth
Leonardo Burlamaqui
Gerald Epstein
Kevin P. Gallagher
Ilene Grabel
Stephany Grif?th-Jones
Rakesh Mohan
José Antonio Ocampo
Dani Rodrik
Shari Spiegel
Arvind Subramanian
Shinji Takagi
Ming Zhang
ii
Occasionally, the Pardee Center convenes groups of experts on speci?c policy questions
to identify viable policy options for the longer-range future. This series of papers,
Pardee Center Task Force Reports, presents the ?ndings of these deliberations as
a contribution of expert knowledge to discussions about important issues for which
decisions made today will in?uence longer-range human development.
Report Editors: Kevin P. Gallagher, Stephany Grif?th-Jones, and José Antonio Ocampo.
The Frederick S. Pardee Center for the Study of the Longer-Range Future at Boston University
serves as a catalyst for studying the improvement of the human condition through an
increased understanding of complex trends, including uncertainty, in global interactions of
politics, economics, technological innovation, and human ecology. The Pardee Center’s per-
spectives include the social sciences, natural science, and the humanities’ vision of the natural
world. The Center’s focus is de?ned by its longer-range vision. Our work seeks to identify,
anticipate, and enhance the long-term potential for human progress—with recognition of its
complexity and uncertainties.
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The views expressed in this paper represent those of the individual authors and do not
necessarily represent the views of their home institutions, the Frederick S. Pardee Center
for the Study of the Longer-Range Future, or the Trustees of Boston University. The publica-
tions produced by the Pardee Center present a wide range of perspectives with the intent of
fostering well-informed dialogue on policies and issues critical to human development and
the longer-range future.
Produced by Boston University Creative Services
© 2012 Trustees of Boston University
ISBN 978-1-936727-04-9
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iii
TABLE OF CONTENTS
iv Acknowledgements
v Acronyms and Abbreviations
Executive Summary ..........................................................................................................1
Capital Account Regulations for Stability and Development:
A New Approach
Kevin P. Gallagher, Stephany Grif?th-Jones, and José Antonio Ocampo
Section I: The Rationale for Capital Account Regulation
1. The Case For and Experience With Capital Account Regulations .................... 13
José Antonio Ocampo
2. Capital Account Management: The Need for a New Consensus ....................... 23
Rakesh Mohan
3. Managing Capital Flows: Lessons from the
Recent Experiences of Emerging Asian Economies ........................................... 35
Masahiro Kawai, Mario B. Lamberte, and Shinji Takagi
4. Capital Out?ow Regulation:
Economic Management, Development and Transformation ............................ 47
Gerald Epstein
Section II: Implementing and Monitoring Effective Regulation
5. Dynamic Capital Regulations, IMF Irrelevance and the Crisis.......................... 59
Ilene Grabel
6. How to Evade Capital Controls…and Why They Can Still Be Effective .......... 71
Shari Spiegel
7. China’s Capital Controls: Stylized Facts and Referential Lessons ....................... 85
Ming Zhang
Section III: The Global Cooperation of Capital Account Regulations?
8. The IMF, Capital Account Regulation,
and Emerging Market Economies .......................................................................... 93
Paulo Nogueira Batista, Jr.
9. The Need for North-South Coordination .............................................................103
Stephany Grif?th-Jones and Kevin P. Gallagher
10. International Regulation of the Capital Account ...............................................111
Arvind Subramanian
11. Capital Account Regulations and the Trading System .....................................119
Kevin P. Gallagher
Biographies of Task Force Members
iv
ACKNOWLEDGEMENTS
The Pardee Center Task Force on Regulating Global Capital Flows for Long-Run Develop-
ment is a project of the Center’s Global Economic Governance Initiative (GEGI) that is
coordinated by Boston University Professor and Pardee Faculty Fellow Kevin P. Gallagher.
The Task Force is co-chaired by Stephany Grif?th-Jones and José Antonio Ocampo of
Columbia University’s Initiative for Policy Dialogue (IPD), and it is co-sponsored by IPD
and the Global Development and Environment Institute at Tufts University (GDAE).
The co-chairs sincerely thank the Frederick S. Pardee Center for the Study of the Longer-
Range Future for the support for this project. The project was made possible by the early
enthusiasm of Adil Najam, former Director of the Center. The enthusiasm has been echoed
and accentuated by James McCann, the current Director, ad interim. We particularly thank
Theresa White and Elaine Teng at the Pardee Center for making the September 16, 2011
workshop that led to this report work smoothly and ef?ciently. In addition to helping to
organize the logistics of the event, Pardee Programs Manager Cynthia Barakatt has played
a key role in producing the various publications and events stemming from the Task Force.
We also sincerely thank Tania Tzelnic, Boston University graduate student who served as
rapporteur at the workshop and provided invaluable assistance in editing the ?nal report.
The co-chairs also thank Mildred Menos, Program Manager at IPD, and Joanna Miller,
Communications Coordinator at GDAE, for coordination and support as well.
The co-chairs thank all of the Task Force participants for taking time from their busy
schedules to participate in this important endeavor. We especially thank Paulo Nogueira
Batista, Jr., Executive Director for Brazil and eight other Latin American countries at the
International Monetary Fund (IMF), for coming to the workshop, delivering the keynote
speech, and contributing to the ?nal report as well.
We thank Peter Chowla of the Bretton Woods Project and Jo Marie Griesgraber of New
Rules for Global Finance, and Bhumika Muchala of the Third World Network for assisting
us with outreach that will ensure the report gets in the right hands across the globe.
Finally, we would like to thank the foundations that have also provided support for this
effort. Leonardo Burlamaqui and the Ford Foundation support GEGI’s project on capital
?ows and development, in addition to a similar program at IPD. This Task Force signi?-
cantly builds on a Ford Foundation–United Nations workshop that occurred in August
2011. GDAE would also like to acknowledge the support of the Rockefeller Brothers Fund.
v
ACRONYMS AND ABBREVIATIONS
ADR: American Depository Receipts
AE: Advanced Economy
AEC: ASEAN Economic Community
BI: Bank Indonesia
BIT: Bilateral Investment Treaty
BOK: Bank of Korea
BOVESPA: Sao Paulo Stock Exchange
CAM: Capital Account Management
CAR: Capital Account Regulation
CBB: Central Bank Bills
CFM: Capital Flow Management
CGFS: Committee on the Global Financial System
CRR: Cash Reserve Ratio
EAE: Emerging Asian Economy
EME: Emerging Market Economy
FDI: Foreign Direct Investment
FSB: Financial Stability Board
FTA: Free Trade Agreement
GATS: General Agreement on Trade in Services
GATT: General Agreement on Tariffs and Trade
GDP: Gross Domestic Product
IMF: International Monetary Fund
NAFC: North Atlantic Financial Crisis
NDF: Non-Deliverable Forwards
OECD: Organisation for Economic Co-Operation and Development
PBC: People’s Bank of China
QFII: Quali?ed Foreign Institutional Investor
QDII: Quali?ed Domestic Institutional Investor
RBI: Reserve Bank of India
RMB: Renminbi (Chinese Currency)
SAFE: Chinese State Administration of Foreign Exchange
SBA: Stand-By Arrangement
SBV: State Bank of Viet Nam
SDA: Special Deposit Account
SWF: Sovereign Wealth Fund
URR: Unremunerated Reserve Requirement
WTO: World Trade Organization
vi
1
Executive Summary
Capital Account Regulations
for Stability and Development: A New Approach
Kevin P. Gallagher, Stephany Grif?th-Jones,
and José Antonio Ocampo
Since the revival of global capital markets in the 1960s, cross-border capital
?ows have increased by orders of magnitude, so much so that international
asset positions now outstrip global economic output. Most cross-border capital
?ows occur among industrialized nations, but emerging markets are increasing
participants in the globalization of capital ?ows. While it is widely recognized
that investment is an important ingredient for economic growth, and that capital
?ows may under certain conditions be a valuable supplement to domestic
savings for ?nancing such investment, there is a growing concern that certain
capital ?ows (such as short-term debt) can have destabilizing effects in develop-
ing countries.
During the recent ?nancial and currency crises a number of emerging market
and developing countries experimented with a variety of measures that have
traditionally been referred to as “capital controls”—de?ned as regulations on
capital ?ows. Given that capi-
tal controls have been highly
stigmatized, in this paper we
will refer to them as capital
account regulations (CARs).
Those nations that deployed CARs in the years leading to the ?nancial crisis
were among the least hard hit when the global ?nancial crisis wracked the world
economy (Ostry et al. 2011).
The 2008 global ?nancial crisis has opened a new chapter in the debate over the
proper policy responses to pro-cyclical capital ?ows. Until very recently certain
strands of the economics profession as well as industrialized country national
governments and international ?nancial institutions have remained either hostile or
The 2008 global ?nancial crisis has opened
a new chapter in the debate over the proper
policy responses to pro-cyclical capital ?ows.
2 A Pardee Center Task Force Report | March 2012
silent to regulating capital movements. Regardless, a number of emerging econo-
mies, including Brazil, Taiwan, and South Korea, have been successfully experi-
menting with CARs to manage volatile capital ?ows (Gallagher 2011; IMF 2011b).
The International Monetary Fund (IMF) has come to partially recognize the appro-
priateness of capital account regulations and has gone so far as to recommend (and
of?cially endorse) a set of guidelines regarding the appropriate use of CARs.
In September 2011, the Global Economic Governance Initiative at Boston
University’s Pardee Center for the Study of the Longer-Range Future—along with
Columbia University’s Initiative for Policy Dialogue and Tufts University’s Global
Development and Environment Institute—convened a Task Force on Regulating
Global Capital Flows for Long-Run Development. Based on discussions among
members, we argue that there is a clear rationale for capital account regulations
in the post-crisis world, that the design and monitoring of such regulations is
essential for their effectiveness, and that a limited amount of global and regional
cooperation would be useful to ensure that CARs can form an effective part of
the macroeconomic policy toolkit.
This report addresses these issues and provides a protocol for the use of CARs—
one that stands in stark contrast to a set of guidelines for the use of capital con-
trols endorsed by the board of the IMF in March 2011 (see IMF 2011b) but now
superseded by a G-20 set of “coherent conclusions” on CARs in November 2011.
Endorsed by the G-20 ?nance ministers and central bank governors in October,
then endorsed by the G-20 leaders themselves in Cannes, the G-20’s conclusions
say that “there is no ‘one-size ?ts all’ approach or rigid de?nition of conditions
for the use of capital ?ow management measures.” This Task Force report will
help policymakers and the IMF navigate their thinking under these newer G-20
recommendations.
CAPITAL FLOWS AND THE TWO-SPEED RECOVERY
A long line of prominent economists throughout history have argued that ?nan-
cial markets can be inherently unstable (see Ocampo, Spiegel, and Stiglitz 2008).
Different authors use different terms but there is a consistent concern that during
periods of growth, expectations can become extremely optimistic, leading to a
reduction in risk aversion, a rapid expansion in credit and a rise in asset prices.
Imbalances associated with excessive risk taking build up, and if there are
changes in expectations, possibly unleashed by facts that lead to a loss in asset
values, the unwinding of positions may lead to instability, panics, and crises.
Boom is then followed by bust.
Regulating Global Capital Flows for Long-Run Development 3
Cross-border capital ?ows to emerging and developing countries tend to follow a
similar pattern. Between 2002 and 2007 there were massive ?ows of capital into
emerging markets and other developing economies. After the collapse of Lehman
Brothers, there was capital ?ight to the “safety” of the U.S. market, which spread
the North Atlantic ?nancial crisis to emerging markets. As interest rates were
lowered for expansionary purposes in the industrialized world between 2008 and
2011, capital ?ows again returned to emerging markets, where interest rates and
growth were relatively higher. The carry trade was one of the key mechanisms
that triggered these ?ows. Increased liquidity induced investors to go short on the
dollar and long on currencies in nations with higher interest rates and expecta-
tions of strengthening exchange rates. With signi?cant leverage factors, investors
gained on both the interest rate differential and the exchange rate movements.
These sudden surges in capital ?ows can be de-stabilizing for four reasons. First,
if capital ?ows are large enough, such speculation can cause undue appreciation
and volatility of exchange rates and lead to a boom in asset prices in developing
economies. Second, relatively small interest rate or currency changes can trigger
an unwinding of (highly leveraged) positions, which can cause a sudden stop
of external ?nancing and capital ?ight. Third, a sudden unwinding of positions
where the investment entity is highly interconnected with other parts of the
?nancial system might cause systemic risk. Fourth, in an environment where
nations have open capital accounts, short-term capital movements reduce the
space for independent monetary policies. The dominant tool to stem in?ation
is the interest rate. However, raising interest rates would actually attract more
capital ?ows, in effect generating expansionary pressures.
Private capital ?ows to Asia and Latin America have returned to their pre-
Lehman Brothers highs. This is the case in nations like Brazil, which saw an
appreciation of its currency of more than 40 percent between the third quarter
of 2009 and September of 2011, and rising concern over asset bubbles and
in?ation. Indeed it will come as no surprise that it was Brazil’s ?nance minister
who declared the surge in capital ?ows, the subsequent appreciations, and the
myriad reactions to the surges as the beginning of a “currency war.” In the midst
of these capital ?ows, individual nations have responded in various ways. In
Brazil’s case, it has taken the form of a tax on foreign purchases of Brazilian
securities and later with a reserve requirement and taxes for ?rms going short on
the nation’s currency and holding some derivative positions in foreign currency.
Box 1 outlines the various types of capital account regulations that have been
deployed by nations in the run up to and during the crisis.
4 A Pardee Center Task Force Report | March 2012
Capital account regulations are often deployed to manage exchange rate volatil-
ity, avoid currency mismatches, limit speculative activity in an economy, and
provide the policy-space for independent monetary policy. Measures often come
in two varieties, price-based or quantity-based. Price-based measures alter the
price of foreign capital such as with a tax on in?ows or out?ows, and unremu-
nerated reserve requirements (URRs) that have been deployed by such nations as
Chile, Colombia, and Thailand. Quantity-based measures include prohibitions or
caps on certain types of transactions (for example, on foreign borrowing below
certain maturities, or for purposes other than investment or international trade),
or minimum stay periods for capital that comes into the country.
RULES OF THUMB FOR DEPLOYING CARs
With respect to CARs, in February 2010 the IMF published a staff position note
which found that capital controls on the in?ows of capital that were deployed
over the past 15 years have been fairly effective. It also found that those nations
that used capital controls were among the least hard hit during the world
?nancial crisis (Ostry et al. 2010). A comprehensive review of the literature on
Box 1: Capital Account Regulations—An Illustrative List
In?ows
• Unremunerated reserve requirements (a
proportion of new infows are kept as
reserve requirements in the central bank)
• Taxes on new debt infows, or on foreign
exchange derivatives
• Limits or taxes on net liability position in
foreign currency of fnancial intermediaries
• Restrictions on currency mismatches
• End-use limitations: borrowing abroad only
allowed for investment and foreign trade
• Limits on domestic agents that can borrow
abroad (e.g., only frms with net revenues
in foreign currency)
• Mandatory approvals for all or some capital
transactions
• Minimum stay requirements
Out?ows
• Mandatory approval for domestic agents
to invest abroad or hold bank accounts in
foreign currency
• Mandatory requirement for domestic
agents to report on foreign investments
and transactions done with their foreign
account
• Prohibition or limits on sectors in which
foreigners can invest
• Limits or approvals on how much non-
residents can invest (e.g., on portfolio
investments)
• Restrictions on amounts of principal or
capital income that foreign investors can
send abroad
• Limits on how much non-residents can
borrow in the domestic market
• Taxes on capital outfows
Regulating Global Capital Flows for Long-Run Development 5
this topic published by the National Bureau of Economic Research in the United
States found, in turn, that capital regulation on in?ows can make monetary
policy more independent, alter the composition of capital ?ows towards longer-
term ?ows and reduce real exchange rate pressures, and that regulations on
out?ows can be effective as well (Magud et al. 2011).
The IMF now recognizes that CARs should be part of the policy toolkit for
?nancial stability. Moreover, the IMF also recognizes that the very use of the term
“capital controls” can bring a stigma to some nations that may impact the way
investors perceive the investment climate in a nation. Indeed, in the 1990s credit
rating agencies would downgrade the credit of nations that deployed controls
(Abdelal 2007). Therefore, the IMF proposed a new nomenclature for capital
controls, suggesting they be referred to as capital ?ow management measures
(CFMs). Others have previously suggested the term “capital management tech-
niques” to the same end (see Epstein et al. 2003; Ocampo et al. 2008). As we have
indicated, we prefer to use the term “capital account regulations,” to underscore
the fact they belong to the broader family of ?nancial regulations.
The IMF formulated and approved at the board level a set of guidelines pertain-
ing to when a nation should and should not deploy CARs. In a nutshell, the
of?cial report recommends that CARs be used as a last resort and as a temporary
measure, and only after a
nation has accumulated suf?-
cient reserves, adjusted inter-
est rates, and let its currency
appreciate, among other mea-
sures. When capital account
regulations are used, the IMF suggests that controls be price-based and that they
not discriminate against the residence of the investor that makes the ?ow.
Though the IMF should be applauded for recognizing that CARs are useful, its
prescriptions fall short of being sound advice for developing countries on a
number of fronts. Without the advice of the IMF many nations have deployed
CARs, alongside a host of other macroeconomic and macroprudential policies
as they have seen appropriate. And, according to the IMF’s own research, CARs
have been a success even though they have sometimes not met those guidelines.
We outline an alternative set of guidelines in Box 2. In no way do we think these
should be binding protocols at the global level. Rather, we hope they can serve
as useful rules of thumb for national policymakers.
Though the IMF should be applauded for
recognizing that CARs are useful, its prescrip-
tions fall short of being sound advice for
developing countries on a number of fronts.
6 A Pardee Center Task Force Report | March 2012
First and foremost, CARs should be seen as an essential part of the macroeco-
nomic policy toolkit and not as mere measures of last resort. In the econometric
work that recognizes the utility of CARs, such regulations were part of a battery
of approaches taken in tandem to manage the capital account. CARs should
thus be seen as part of the arsenal that needs to be used to prevent and mitigate
Box 2: Guidelines for the Use of Capital Account Regulations in
Developing Countries
• Capital Account Regulations (CARs) should be seen as an essential part of the macroeco-
nomic policy toolkit and not seen as measures of last resort.
• CARs should be considered differently in nations where the capital account is still largely closed
versus those nations where CARs are prudential regulations to manage an open capital account.
• Price-based CARs have the advantage of being more market neutral, but quantity-based
CARs may be more effective, especially in nations with relatively closed capital accounts,
weaker central banks, or when incentives to bring in capital are very large.
• CARs should not only be relegated to regulations on capital infows. Capital outfow restric-
tions may be among the most signifcant deterrents of undesirable infows and can serve
other uses as well.
• CARs can be seen as alternatives to foreign exchange reserve accumulation, particularly to
reduce the costs of reserve accumulation.
• CARs should not be seen as solely temporary measures, but should be thought of as perma-
nent mechanisms to be used in a counter-cyclical way to smooth booms and busts. Their
permanence will strengthen institutional capacity to implement them effectively.
• Therefore, CARs should be seen as dynamic, requiring a signifcant degree of market monitor-
ing and ‘fne tuning.’ as investors adapt and circumvent regulation. Investors can increasingly
circumvent CARs through mis-invoicing trade fows, derivative operations, or foreign direct
investments that are in fact debt fows. Regulators constantly need to monitor and adapt.
• It may be useful for effective CARs to distinguish between residents and non-residents.
• The full burden of managing capital fows should not be on emerging market and develop-
ing countries, but the ‘source’ countries of capital fows should also play a role in capital fow
management, including supporting the effectiveness of those regulations put in place by
recipient countries.
• Neither industrialized nations nor international institutions should limit the ability of nations to
deploy CARs, whether through trade and investment treaties or through loan conditionality.
• Industrialized nations should examine more fully the global spillover effects of their own
monetary policies and evaluate measures to reduce excessive outfows of short-term capital
that can be undesirable both for them and emerging countries.
• The stigma attached to CARs should be removed, so nations have ample confdence that they
will not be rebuked for taking action. The IMF could play a valuable role in taking away the
stigma of CARs, as well as doing comparative analysis of which CARs are most effective.
Source: Pardee Task Force on Regulating Global Capital Flows for Long-Run Development
Regulating Global Capital Flows for Long-Run Development 7
crises. In turn, they should not be seen as solely temporary measures, but rather
as permanent tools that can be used in a counter-cyclical way to smooth booms
and busts.
Second, CARs should be considered differently in nations where capital accounts
remain largely closed—and in which they may be used as part of a strategy
to gradually open the capital account—versus those nations where CARs are
prudential regulations to manage an already open capital account. The IMF
report acts as if the set of nations it was talking to were nations with open capital
accounts and ?oating exchange rates, but many developing countries deploy
capital account regulations as a regular macroprudential management technique
and intervene heavily in foreign exchange markets.
Third, quantity-based CARs may be more effective than price-based CARs, espe-
cially in those nations with relatively closed capital accounts, weaker central banks
or when incentives to bring in capital are very large (large interest rate differen-
tials or strong expectations of exchange rate appreciation). This is consistent with
economic theory and some IMF staff work. Because of uncertainties and asym-
metric information about the private sector’s response, price-based measures may
be dif?cult to calibrate correctly and therefore a quantity-based measure may be
more appropriate. Indeed, IMF research has shown that quantity-based CARs have
proven to be more effective under several conditions (Ariyoshi et al. 2000).
In addition, while there has been a sea change in thinking regarding CARs on
capital in?ows, regulations on capital out?ows have largely been shunned. CARs
should not only be relegated to regulations on capital in?ows. Capital out?ow
restrictions may be among the most signi?cant deterrents of undesirable in?ows
and can serve other uses as well. Moreover, in times of acute crisis capital
controls on out?ows may be necessary to help stop the precipitous slide of a
currency and a run on banks.
Indeed, the IMF sanctioned
controls on out?ows in Ice-
land as part of its rescue pack-
age with that nation during
the ?nancial crisis. Finally, some members of our task force argued that regulat-
ing out?ows can help channel credit and investment into the “real economy.”
CARs should also be seen as alternatives to foreign exchange reserve accumula-
tion. Recent work has shown that the social costs of foreign reserve accumulation
Capital out?ow restrictions may be among
the most signi?cant deterrents of undesirable
in?ows and can serve other uses as well.
8 A Pardee Center Task Force Report | March 2012
in developing countries can reach two to three percent of GDP (Aizenman 2009;
Rodrik 2006). CARs are an instrument to reduce excessive reserve accumulation.
THE NEED FOR MONITORING AND FINE-TUNING
The IMF guidelines give scant attention to the policy design issues related to
CARs. Though IMF econometric work shows that CARs have been effective,
there is to date a lack of research regarding how nations administratively have
designed and ?ne-tuned such regulations to make them successful. Much of
the literature shows that, without the proper ?ne-tuning, capital regulations
may lose their effectiveness due to the ability of foreign investors to evade and
circumvent such regulations. This can be done by ‘misinvoicing’ trade ?ows,
disguising debt ?ows as foreign direct investment, and by using derivatives.
Nations such as Brazil and South Korea have increasingly “?ne-tuned” their
regulations in an attempt to keep up with the various levels of circumvention.
Fine-tuning of CARs is essential for their effectiveness—and may be far simpler
than some may argue, especially if they target the large actors. When regulations
are price-based and administered by the tax system, violators could see criminal
penalty—creating a strong incentive to comply. Table 1 illustrates examples of
the use of CARs in the wake of the crisis and shows how Brazil and South Korea
have been constantly strengthening and changing the composition of their capi-
tal account regulations in response to new market conditions.
Country Date Measure
Brazil 19-Oct-09 Inflows tax (2 percent)
18-Nov-09 ADR tax (1.5 percent)
3-Oct-10 Inflows tax (4 percent)
17-Oct-10 Inflows tax (6 percent)
5-Jan-11 Reserve requirement
26-Jul-11 Tax on derivatives
South Korea 30-Jun-10 Currency controls
30-Jun-10 End use limitations
18-Dec-10 Outflows tax
Capital Account Regulations and the Crisis
Source: Gallagher 2011a
Table 1
Regulating Global Capital Flows for Long-Run Development 9
THE NEED FOR INTERNATIONAL COOPERATION
Rather than a globally enforceable code of conduct that could lead to the require-
ment to open capital accounts across the globe, the IMF, G-20, the Financial
Stability Board (FSB) and other bodies should make a stronger effort to reduce
the stigma attached to CARs and protect the ability of nations to deploy CARs
to prevent and mitigate crises. Moreover, these bodies can be part of a global
dialogue about the extent to which nation states should coordinate CARs.
In the original design of the IMF, it was charged with both permitting and help-
ing to enforce CARs. Both John Maynard Keynes and Harry Dexter White saw
them as a core component of the Bretton Woods system. In those deliberations
Keynes said that, “control of capital movements, both inward and outward,
should be a permanent feature of the post-war system.” Indeed, the IMF was not
given jurisdiction over liberalization of the capital account at all under its articles
of agreement. Article VI of those articles goes further to say that members may
“exercise such controls as are necessary to regulate international capital move-
ments” (see Helleiner 1994).
The IMF, G-20, the FSB, and their respective members could clarify the new
thinking on CARs in communiques, speeches and other venues, including
of?cial reports such as the World Economic Outlook. Such continued attention
to CARs would help continue to remove the stigma associated with their use. Not
only would it calm both national governments and market participants, it may
also trickle into the legal discourse and help broaden the way the global commu-
nity legally interprets macroprudential regulations.
This is important because the policy space provided under the IMF articles of
agreement is being eroded by trade and investment agreements. Increasingly, these
agreements prohibit the use of CARs, and those treaties that have exceptions for
measures to manage balance of payments crises only allow CARs to be temporary
in nature. In Asia, where CARs on both in?ows and out?ows are the most prevalent,
ASEAN will require nations to eliminate most CARs by 2015, with relatively narrow
exceptions. Trade and investment agreements with the United States provide the
least ?exibility. In January 2011, some 250 economists from across the globe called
on the United States to recognize the recent consensus on CARs and to permit
nations the ?exibility to deploy controls to prevent and mitigate crises. The letter
was rebuked by prominent business associations and the U.S. government. In
response to the letter, U.S. Treasury Secretary Timothy Geithner replied that U.S.
policy would go unchanged. Secretary Geithner wrote:
10 A Pardee Center Task Force Report | March 2012
“In general, we believe that those risks are best managed through a mix
of ?scal and monetary policy measures, exchange rate adjustment, and
carefully designed non-discriminatory prudential measures, such as bank
reserve or capital requirements and limitations on exposure to exchange
rate risk.”
This is ironic given that the U.S. approved the guidelines for CARs at the IMF.
Finally, the global community should start a conversation regarding the extent
to which there should be coordination among national governments regarding
CARs—especially between in?ow and out?ow nations. In the meetings leading
up to the establishment of the IMF both Harry Dexter White and John Maynard
Keynes agreed that capital controls be targeted at “both ends” of a capital ?ow
(Helleiner 1994). Furthermore, the industrialized nations are more often the
source of such ?ows but
generally ignore the nega-
tive spillover effects of their
actions. The expansionary
monetary policy by the U.S.—
which is quite justi?ed in
order to generate employment
and recovery in that country—leads to the harmful carry trade effects discussed
earlier. However, despite this fact, thus far the entire burden of managing capital
?ows has fallen on those countries that are the recipients of those in?ows.
One member of the Task Force, Arvind Subramanian, goes so far as to suggest
that an entirely new global regime is needed to regulate global capital ?ows. And
moreover, the focus should not only be on North-South ?ows but South-South
and North-North as well.
There may be an alignment of interests to coordinate on capital ?ows. Indus-
trialized nations are aiming to recover from the crisis and hope that credit and
capital stays in their nations. Meanwhile the developing world has little interest
in having to receive those ?ows. There is therefore some alignment of interests
that could form the means for industrialized nations to adjust their tax codes and
deploy other types of regulation to keep capital in their countries, as emerging
markets deploy CARs to change the composition and reduce the level of those
capital ?ows that may destabilize their economies.
The global community should start a con-
versation regarding the extent to which
there should be coordination among nation-
al governments regarding CARs—especially
between in?ow and out?ow nations.
Regulating Global Capital Flows for Long-Run Development 11
REFERENCES
Abdelal, Rawi (2007). Capital Rules: The Construction of Global Finance, Cambridge, MA:
Harvard University Press.
Aizenman, Joshua (2009). “Hoarding international reserves versus a Pigovian Tax-Cum-
Subsidy scheme: re?ections on the deleveraging crisis of 2008–9, and a cost bene?t
analysis.” NBER Working Paper No. 15484. Cambridge, MA: National Bureau of
Economic Research.
Ariyoshi, Akira, Karl Habermeier, Bernard Laurens, Inci Ötker-Robe, Jorge Iván
Canales-Kriljenko, and Andrei Kirilenko (2000). “Capital Controls: Country Experi-
ences with Their Use and Liberalization.” Occasional Paper, No. 190, Washington,
D.C.: International Monetary Fund.
Epstein, Gerald, Ilene Grabel, and K. S. Jomo (2003). “Capital Management Techniques
in Developing Countries.” In Challenges to the World Bank and the IMF: Developing
Country Perspectives, Ariel Buira (ed.). London: Anthem Press, ch. 6.
Gallagher, Kevin P. (2011). “Regaining Control: Capital Controls and the Global Financial
Crisis.” Political Economy Research Institute, University of Massachusetts–Amherst.
Helleiner, Eric (1994). States and the Re-emergence of Global Finance. Ithaca: Cornell
University Press.
International Monetary Fund (2011a). World Economic Outlook, April, Washington, D.C.:
International Monetary Fund.
International Monetary Fund (2011b). Recent Experiences in Managing Capital In?ows—
Cross-Cutting Themes and Possible Policy Framework. Washington, D.C.: International
Monetary Fund.
Magud, Nicholas, Carmen Reinhart, and Kenneth Rogoff (2011). “Capital Controls: Myth
and Reality—A Portfolio Balance Approach.” Cambridge, MA: National Bureau of
Economic Research.
Ocampo, José Antonio, Shari Spiegel, and Joseph E. Stiglitz (2008). “Capital Market Lib-
eralization and Development.” In José Antonio Ocampo and Joseph E. Stiglitz (eds.).
Capital Market Liberalization and Development. New York: Oxford University Press.
Ostry, Jonathan D., Atish R. Ghosh, Karl Habermeier, Marcos Chamon, Mahvash S.
Qureshi, and Dennis B.S. Reinhardt (2010). “Capital In?ows: The Role of Controls.” In
IMF Staff Position Note. Washington, D.C.: International Monetary Fund.
12 A Pardee Center Task Force Report | March 2012
Ostry, Jonathan D., Atish R. Ghosh, Karl Habermeier, Marcos Chamon, Luc Laeven, Mah-
vash S. Qureshi, and Annamaria Kokenyne (2011). “Managing Capital In?ows: What
tools to use?” Staff Discussion Paper, Washington, D.C.: International Monetary Fund.
Rodrik, D. (2006). “The Social Cost of Foreign Exchange Reserves.” International Eco-
nomic Journal 2(3): 253–266.
Regulating Global Capital Flows for Long-Run Development 13
Section I: The Rationale for Capital Account
Regulation
1. The Case For and Experience With
Capital Account Regulations*
José Antonio Ocampo
A major agreement during the recent crisis was that deregulated ?nancial activi-
ties can be a source of major macroeconomic disruptions. The G-20 thus led a
major effort to re-regulate ?nance, mainly at the national level. However, cross-
border ?nance was left almost entirely out of the agenda, as if it did not require
any regulation—or indeed as if it was not part of ?nance. A particular twist of
terminology is also involved in traditional discussions of this issue: domestic
?nancial regulations are called by that name, but if they involve cross-border
?ows, they are called ‘controls’. We would refer to them by their appropriate
name: capital account regulations.
The essential problem here is that capital ?ows, like ?nance in general, is
pro-cyclical. Agents that are perceived to be risky borrowers are subject to the
strongest swings in the availability and costs of ?nancing. These riskier agents
include small ?rms and poor households in all domestic markets and emerging
markets and, more generally, developing country borrowers in global markets.
There is overwhelming evidence that capital ?ows to developing countries are
pro-cyclical and have become one of the major determinants (and perhaps the
major determinant) of business cycles in emerging economies (Prasad et al. 2003;
Ocampo et al. 2008a,b). Furthermore, the cyclical supply of ?nance is increas-
ingly driven by portfolio
decisions in industrial coun-
tries, which may be entirely
delinked from demand for
capital by emerging and
developing countries. These countries face further problems: their domestic
?nancial markets are signi?cantly more ‘incomplete’ and, as a result, they are
It is important to emphasize that the cyclical
behavior that characterizes capital ?ows
goes beyond volatility of short-term ?ows.
* This essay is Section 5 of the 14th WIDER Lecture given by the author on “Reforming the International Monetary System.”
14 A Pardee Center Task Force Report | March 2012
plagued by variable mixes of currency and maturity mismatches, and their capi-
tal markets are shallower and small relative to the magnitude of the speculative
pressures they face.
It is important to emphasize that the cyclical behavior that characterizes capital
?ows goes beyond volatility of short-term ?ows. Even more important are the
medium-term cycles in the availability and costs of ?nancing. Since the mid
1970s, we have experienced three full medium-term cycles—from the mid 1970s
to the end of the 1980s, from 1990 to 2002, and from 2003 to 2009—and we are
at the beginning of a fourth one. The major problem with these cyclical swings is
their strong effect on major macroeconomic variables: that is, on exchange rates,
interest rates, domestic credit, and asset prices. As a result of this, pro-cyclical
capital ?ows exacerbate major macroeconomic policy trade-offs, signi?cantly
limiting the space to undertake counter-cyclical macroeconomic policies. For
example, during a boom, countries may ?oat the exchange rate to maintain
some degree of monetary policy autonomy, but this merely displaces the effects
of pro-cyclical capital ?ows to the exchange rate. The resulting deterioration in
the current account allows these countries to ‘absorb’ the increasing ?ows but
experience indicates that it also increases the probability and costs of crises.
More exchange rate volatility generates, in turn, disincentives to invest in export
and import-competing sectors. If there is hysteresis associated to dynamic
economies of scale (e.g., if productivity tomorrow depends on production today),
there may be permanent losses in production structure during booms, and there-
fore adverse effects on growth.
1
Since a restrictive monetary policy would only exacerbate appreciation pres-
sures, an alternative for authorities to reduce the expansionary pressures gener-
ated by capital in?ows is to adopt a contractionary ?scal policy. But this makes
?scal policy hostage to capital account volatility. Fiscal policy may lack the
?exibility to respond rapidly to variations in capital ?ows, and there may not be
political backing for doing so. Authorities may also try to stabilize the exchange
rate by accumulating foreign exchange reserves while sterilizing their domestic
monetary effects. But such sterilized accumulation generates quasi-?scal losses
that are particularly costly in countries with high domestic interest rates. When
foreign exchange reserves are already high, as they are in many emerging and
developing countries, these costs are hard to justify. Such interventions also
destroy the rationale for capital in?ows in the ?rst place, which is to transfer
resources to the country. To the extent that such reserves are a way to counter-
1 See the review of the literature in Frenkel and Rapetti (2010).
Regulating Global Capital Flows for Long-Run Development 15
balance the risk of future reversals of capital ?ows, they destroy the additional
rationale for capital account liberalization, which is to diversify risks. In fact,
experience indicates that they are rather a source of additional risk.
During boom periods, capital account regulations can therefore be justi?ed as
a way to help authorities manage booms while avoiding exchange rate appre-
ciation, the risks associated with rising current account de?cits and/or useless
foreign exchange reserve accumulation. During crisis, they may also be used as
a way to avoid or mitigate capital ?ight, which has the opposite macroeconomic
effects. More generally, these regulations can play a dual role: they can be a
complementary macroeconomic policy tool and help reduce the risks associated
with liability structures tilted towards reversible capital ?ows. As a macroeco-
nomic policy tool, they provide some room for counter-cyclical monetary poli-
cies. During booms, they increase the policy space to undertake contractionary
monetary policy while reducing exchange rate appreciation pressures. In turn,
during crises, they can create some room for expansionary monetary policies.
Viewed as a liability policy, capital account regulations recognize the fact that
pro-cyclical behavior and, particularly, reversibility, varies signi?cantly according
to the nature of capital ?ows: foreign direct investment is more stable than port-
folio and debt ?ows and, among the latter, short-term debt ?ows are particularly
volatile.
2
Capital market regulations obviously segment domestic from international mar-
kets, but this recognizes the fact that markets are already segmented. Indeed,
the basic ?aw of capital account liberalization is that it does not recognize the
implications of this basic fact. As with prudential regulations, capital account
regulations can be either quantitative (or administrative) or price-based, but
there are more complex typologies (see, for example, IMF 2011a).
3
The former
include, among others, prohibitions or ceilings on certain capital ?ows, deriva-
tive operations or net exposure in foreign currencies; minimum stay periods; and
restrictions on foreign investors taking positions in domestic securities or rules
on what type of agent can undertake some capital transactions (residents versus
non-residents, and corporate versus non-corporate). In turn, price-based regula-
tions include unremunerated reserve requirements on capital in?ows, taxes on
in?ows or out?ows, and larger reserve requirements for external liabilities of net
2 See, for example, Reddy (2010: ch. 21). The classic treatment of the riskiness of short-term capital is Rodrik and
Velasco (2000).
3 There are also terminological differences. IMF (2011) coins the term ‘capital ?ow management measures’, and
Epstein et al. (2003) have suggested the term ‘capital management techniques’.
16 A Pardee Center Task Force Report | March 2012
balances in foreign currencies. Furthermore, they can be partly substituted by
domestic prudential regulations when they involve domestic ?nancial interme-
diation, though not when they entail access to external capital markets by non-
?nancial domestic agents.
4
They thus belong to the family of what have come to be called ‘macroprudential
regulations’, including particularly of counter-cyclical prudential regulations
(for an early analysis of this link, see Ocampo 2003). Indeed, they may be seen
as part of the continuum, which goes from regulation on ?nancial transactions
of domestic residents in the domestic currency (normal prudential regulation,
including now countercyclical prudential regulations), to those of domestic resi-
dents in foreign currency (e.g., managing dollar/euroized ?nancial systems, or
correcting the risks associated with currency mismatches in domestic portfolios),
to ?nally those involving domestic agents’ transactions with foreign residents
(capital account regulations).
The concrete analysis of experiences with the use of capital account regulations
leads to several conclusions.
5
First, regulations on either in?ows or out?ows can
work (though the more orthodox literature is skeptical of the effectiveness of the
latter), but the authorities must have administrative capacity to manage them,
which includes acting on time to close loopholes and respond to ‘innovations’ by
private agents aimed at circumventing regulations. As a result of the link with
administrative capacity, permanent regulatory regimes that tighten or loosen
the norms in response to external conditions may be the best choice rather than
improvising a system in the face of shocks. Second, regulations help generate a
mix of increased monetary autonomy, reduce exchange rate pressures and alter
the magnitude of ?ows, with greater skepticism on the latter effect by several
authors. Some of these effects may be temporary, largely due to greater circum-
vention of regulations as time passes, and in this sense regulations may act as
‘speed bumps’
6
rather than permanent restrictions; this implies that further
reinforcement may be required to maintain their effectiveness. Third, capital
account regulations on in?ows help improve debt pro?les and thus act as an
effective liability policy that reduces external vulnerability. Finally, and perhaps
4 In the latter case, price-based regulations can also be substituted by tax provisions applying to foreign-
currency liabilities (see, for example, Stiglitz and Bhattacharya 2000).
5 See, among others, three papers by the IMF and IMF experts (Ariyoshi et al. 2000; Ostry et al. 2010; IMF 2011),
Magud and Reinhart (2007), Kawai and Lamberte (2010) and my own work (Ocampo 2003, 2008).
6 This is the term used by Palma (2002) and Ocampo and Palma (2008).
Regulating Global Capital Flows for Long-Run Development 17
most importantly, regulations are a complement to sound macroeconomic poli-
cies, not a substitute for them.
Overall, the evidence is therefore that capital account regulations are a useful
and effective complementary instrument of counter-cyclical policy management
(IMF 2011a). There is also evidence that countries using regulations on capital
in?ows fared better during the recent global ?nancial crisis (Ostry et al. 2010),
and that the new regulations put in place by some countries since 2010 have
been at least partly effective (Gallagher 2011; IMF 2011a).
Debates on this issue since 2010 have emphasized some global dimensions of
these regulations that must be at the center of attention. The ?rst and essential
problem is the asymmetry generated between the strength of several emerging
economies and the continuing weakness of most industrial countries. This situa-
tion, which is likely to continue, implies that the latter have to maintain expan-
sionary policies, but the former are gradually moving towards more restrictive
policies, though partially constrained for doing so by massive capital in?ows.
In short, the ‘multi-speed’ character of the recovery creates a need for a mirror
asymmetry in monetary policies, which would be very dif?cult to manage with-
out some restrictions on capital ?ows.
A second problem is that monetary expansion may be largely ineffective in
industrial countries but can generate large externalities on emerging markets.
This is particularly problematic when it involves the country issuing the major
global reserve currency. Indeed, expansionary monetary policies in the U.S.,
including now quantitative easing, has had at best mixed effects in generating
a reactivation of credit, the major transmission mechanism of monetary expan-
sion to domestic economic activity, but the low dollar interest rates associated
with that policy are inducing massive capital ?ows to emerging markets, where
they are generating appreciation pressures and risks of asset price bubbles. They
may also be contributing to the weakening of the dollar, with negative effects on
trading partners.
A third problem is that unilateral actions by countries also have negative exter-
nalities on other countries; that is, regulations by some countries may generate
even stronger ?ows towards those not doing so. This is also true, of course, of
interventions in foreign exchange markets.
Thus cross-border capital account regulations are an essential part of global
monetary reform. Actually, the basic principle that should guide actions in this
18 A Pardee Center Task Force Report | March 2012
?eld is the ‘embedded liberalism’ under which the IMF was built: that it is in the
best interest of all members to allow countries to pursue their own full employ-
ment macroeconomic policies, even if this requires blocking free capital move-
ments. It is therefore positive that the Fund has recognized that capital account
regulations can play a positive role, as part of the broader family of macropru-
dential regulations, and has taken the step to openly discuss this issue and has
suggested a possible ‘policy framework’ for discussion (IMF 2011b). Furthermore,
this is the ?rst step taken to include cross-border capital ?ows within ongoing
efforts at strengthening prudential regulation worldwide.
Such policy framework should start, however, by designing mechanisms to
cooperate with countries using these policies, helping in particular make those
regulations effective. In fact this may require eliminating provisions in several
free trade agreements (particularly those signed by the U.S.) that restrict the use
of such regulations. This type of cooperation is excluded from the IMF guidelines
even while recognizing that capital account volatility is a negative externality
in?icted upon recipient countries.
The guidelines try to identify ‘best practices’ in this area. As indicated, such best
practices include the recognition that they are a complement and not a substi-
tute for counter-cyclical macroeconomic policies. However, the guidelines tend
to view them as interventions of ‘last resort’ (or a second, third, or fourth line of
defense), to be used once other macroeconomic policies have been exhausted:
exchange rate adjustments, reserve accumulation, and restrictive macroeco-
nomic policies. This is a limited view of their role. They must, therefore, be seen
as part of the normal counter-cyclical packages, and particularly as tools to avoid
excessive exchange rate appreciation and reserve accumulation.
In addition, the IMF guidelines tend to view CARs as temporary measures. This
goes against another IMF recommendation, which calls for “strengthening the
institutional framework on an ongoing basis.” This implies that regulations
should be part of the permanent toolkit of countries, which are strengthened
or weakened in a counter-cyclical way. Also, and again against the guidelines,
almost by necessity they require some discrimination between residents and
non-residents, which re?ects the segmentation that characterizes ?nancial
markets in an international system: as different moneys are used in different
territories, residents and non-residents have asymmetric demands for assets
denominated in those currencies.
Regulating Global Capital Flows for Long-Run Development 19
In any case, any guidelines in this area should recognize that there is no obliga-
tion to capital account convertibility under the IMF Articles of Agreement—an
issue that was settled in the 1997 debates—and therefore countries have full
freedom to manage their
capital account. In the words
of the Group of Twenty-Four
(G-24 2011: par. 8): “Policy
makers of countries facing
large and volatile capital ?ows
must have the ?exibility and
discretion to adopt policies
that they consider appropriate
and effective to mitigate risks.” So, although the IMF has made a positive contri-
bution by bringing the issue of capital account regulations into the global debate,
it can only be taken as a ?rst step in the necessary task of including this issue in
the efforts to re-regulate ?nance and avoid global macroeconomic imbalances.
REFERENCES
Ariyoshi, Akira, Karl Habermeier, Bernard Laurens, Inci Ötker-Robe, Jorge Iván
Canales-Kriljenko, and Andrei (2000). “Capital Controls: Country Experiences with
Their Use and Liberalization.” Washington, D.C.: International Monetary Fund.
Epstein, Gerald, Ilene Grabel, and K.S. Jomo (2003). “Capital Management Techniques
in Developing Countries.” In Ariel Buira (ed.), Challenges to the World Bank and the
IMF: Developing Country Perspectives, London: Anthem Press, ch. 6.
Frenkel, Roberto, and Martin Rapetti (2010). “Economic Development and the Inter-
national Financial System.” In Stephany Grif?th-Jones, José Antonio Ocampo and
Joseph E. Stiglitz (eds), Time for a Visible Hand: Lessons from the 2008 World Finan-
cial Crisis, New York: Oxford University Press.
Gallagher, Kevin (2011). “Regaining Control? Capital Controls and the Global Finan-
cial Crisis.” Political Economy Research Institute, University of Massachusetts at
Amherst, PERI Working Paper, No. 250.
Group of Twenty-Four (G-24) (2011). “Intergovernmental Group of Twenty-Four on
International Monetary Affairs and Development: Communiqué.” Washington D.C.,
14 April.
Although the IMF has made a positive
contribution by bringing the issue of capital
account regulations into the global debate,
it can only be taken as a ?rst step in the
necessary task of including this issue in
the efforts to re-regulate ?nance and avoid
global macroeconomic imbalances.
20 A Pardee Center Task Force Report | March 2012
International Monetary Fund (IMF) (2011a). “Recent Experiences in Managing Capital
In?ows: Cross-Cutting Themes and Possible Policy Framework,” IMF Policy Paper, 14
February.
International Monetary Fund (IMF) (2011b). “Strengthening the International Monetary
System: Taking Stock and Looking Ahead,” 23 March.
Kawai, Mashiro, and Mario B. Lamberte (eds.) (2010). Managing Capital Flows: The
Search for a Framework, Cheltenham: Edward Elgar and Asian Development Bank
Institute.
Kirilenko, Andrei et al. (2000). “Capital Controls: Country Experiences with Their Use
and Liberalization.” IMF Occasional Paper, No. 190, Washington, D.C.: International
Monetary Fund.
Magud, Nicolas, and Carmen Reinhart (2007). “Capital Controls: An Evaluation.” In
Sebastian Edwards (ed.), Capital Controls and Capital Flows in Emerging Economies:
Policies, Practices and Consequences. Ch. 14. Chicago: The University of Chicago
Press.
Ocampo, José Antonio (2003). “Capital Account and Counter-Cyclical Prudential Regula-
tion in Developing Countries.” In Ricardo Ffrench-Davis and Stephany Grif?th-Jones
(eds.), From Capital Surges to Drought: Seeking Stability for Emerging Markets.
London: Palgrave MacMillan.
Ocampo, José Antonio (2008). “A Broad View of Macroeconomic Stability.” In Narcis
Serra and Joseph E. Stiglitz (eds.), The Washington Consensus Reconsidered: Towards
a New Global Governance. New York: Oxford University Press, ch. 6.
Ocampo, José Antonio, and Gabriel Palma (2008a). “The Role of Preventive Capital
Account Regulations.” In José Antonio Ocampo and Joseph E. Stiglitz (eds.), Capital
Market Liberalization and Development. New York: Oxford University Press, ch. 7.
Ocampo, José Antonio, Shari Spiegel, and Joseph E. Stiglitz (2008b). “Capital Market
Liberalization and Development.” In José Antonio Ocampo and Joseph E. Stiglitz (eds),
Capital Market Liberalization and Development. New York: Oxford University Press.
Ostry, Jonathan D., Atish R. Ghosh, Karl Habermeier, Marcos Chamon, Mahvash S.
Qureshi, and Dennis B. S. Reinhardt (2010). “Capital In?ows: The Role of Controls.”
IMF Staff Position Note, SPN/10/04, 19 February. Available at www.imf.org.
Palma, Gabriel (2002). “The Three Routes to Financial Crises: The Need for Capital Con-
trols.” In International Capital Markets: Systems in Transition, John Eatwell and Lance
Taylor (eds). New York: Oxford University Press, pp. 297–338.
Prasad, Eswar S., Kenneth Rogoff, Shang-Jin Wei, and M. Ayhan Rose (2003). “Effects of
Financial Globalization on Developing Countries: Some Empirical Evidence.” IMF
Occasional Paper, No. 220. Washington, D.C.: International Monetary Fund.
Regulating Global Capital Flows for Long-Run Development 21
Reddy, Y.V. (2010). Global Crisis, Recession and Recovery. Andhra Pradesh: Orient Black-
Swan.
Rodrik, Dani, and Andrés Velasco (2000). “Short-Term Capital Flows.” In Proceedings of
the Annual World Bank Conference on Development Economics 1999. Washington,
D.C.: World Bank, pp. 59–90.
Stiglitz, Joseph E., and Amar Bhattacharya (2000). “The Underpinnings of a Stable
and Equitable Global Financial System: From Old Debates to a New Paradigm.” In
Proceedings of the Annual World Bank Conference on Development Economics 1999.
World Bank, Washington, D.C., pp. 91–130.
22 A Pardee Center Task Force Report | March 2012
Regulating Global Capital Flows for Long-Run Development 23
2. Capital Account Management:
The Need for a New Consensus
1
Rakesh Mohan
The North Atlantic Financial Crisis (NAFC) that started in 2008 has been an
epoch-changing one in many respects. Among its consequences is the attention
that the IMF is paying to issues related to cross-border capital ?ows and the need
for capital account management (CAM), what it calls capital ?ow management.
There has been a spate of papers on this topic, both research and policy-related
over the last couple of years (IMF 2011a, 2011b; Habermeier et al. 2011; Ostry et
al. 2010; Ostry et al. 2011). Their conclusion, broadly stated, is that capital ?ow
management measures can be considered in certain circumstances, but only
after exhausting traditional policy avenues of tighter ?scal policy, accommoda-
tive monetary policy, and exchange rate ?exibility that allows appreciation in the
face of large capital ?ows. In this paper I argue that in emerging market econo-
mies (EMEs) CAM should, instead, form part of the normal toolkit of overall
macroeconomic management, and should not be seen as an extreme measure
only to be used in speci?c special circumstances.
Capital ?ows to EMEs, both gross and net, have been rising in volume, along
with increasing volatility since the early 1980s (CGFS 2009). They reached their
peak in 2007 just before the NAFC broke out; and then there was a typical
sudden reversal in 2008–2009, followed by recovery in 2010 and 2011 as the
extended and continuing (almost) zero interest rate policy has been in place in
advanced economies (AEs). As funds from AEs have again ?owed to EMEs in
search of yield, the latter have experienced renewed appreciation pressures on
their real exchange rates. They have therefore had to resort to CAM measures
in a variety of ways in the interest of preserving their growth trajectories while
ensuring continued ?nancial stability. That provides the context for the IMF’s
increased interest in this issue.
The surprising feature of this ongoing NAFC has been the dog that didn’t bark:
the resilience exhibited by Asian and Latin American EMEs. The immediate
1 The paper has bene?ted from very thoughtful comments from Shinji Takagi.
24 A Pardee Center Task Force Report | March 2012
impact of the crisis during 2008–2010 on these economies was through two
channels. First, there was a sudden reversal of capital ?ows, which had been
unprecedented in magnitude during the years prior to the crisis. This reversal
in 2008–2009 had signi?cant impact on capital and foreign exchange markets
in these countries. Second, the fall in global trade far exceeded the contraction
in global GDP. Despite these setbacks no signi?cant banks or ?nancial institu-
tions in these countries exhibited substantial stress: none required a bailout.
Furthermore, in spite of stagnation in the major advanced economies, these
economies have experienced a strong recovery. Evidently, these countries have
been doing something right since the various Latin American crises of the 1980s
and 1990s, and the Asian crisis of the late 1990s. Given the volatility observed in
capital ?ows and the need to
ensure broad-based stability
of the ?nancial sector, most
Asian and Latin American
EME governments and
central banks have employed
multiple instruments related
to CAM, along with traditional
monetary and ?scal policy, and ?nancial regulation and supervision. Judging
from their performance in terms of growth, and maintenance of price and ?nan-
cial stability—both over the decade preceding the crisis and in the subsequent
period—it must be concluded that their overall policy stance, including CAM
measures has been broadly in the right direction.
The general conclusion is that for EMEs, capital account management in its
broad form should become part of the normal overall toolkit for macroeconomic
management oriented towards ensuring growth with price and ?nancial stabil-
ity. It should not be regarded as a tool that is only used as an extreme measure,
as the IMF papers tend to emphasize. Accumulation and management of forex
reserves also needs to be consistent with this overall approach.
THE NEED FOR CAPITAL ACCOUNT MANAGEMENT
Until recent years most developing countries suffered from the inadequacy of
savings relative to the investment levels needed for the economic growth that
they aspired to. Consequently the mobilization of external savings, and hence
capital ?ows, was necessary in the interest of promoting economic growth.
Thus a well-managed and somewhat steady ?ow of external capital can clearly
The general conclusion is that for EMEs,
capital account management in its broad
form should become part of the normal
overall tool kit for macroeconomic manage-
ment oriented towards ensuring growth
with price and ?nancial stability.
Regulating Global Capital Flows for Long-Run Development 25
be bene?cial to EMEs that need to enhance resources for investment. In earlier
decades most of these ?ows consisted of of?cial ?ows from multilateral and
bilateral donors, which were relatively stable.
However, after the opening of capital markets in varying degrees, the record
of capital volatility has been stark over the last three decades. Before this past
decade the previous peak of net capital ?ows to emerging-market economies
was around U.S. $190 billion in 1995. The average over the four years prior to
that was around U.S. $100 billion. There was a big reversal after the Asian crisis,
but then there was a recovery to about U.S. $240 billion, on average, during
2003–06. Net capital ?ows jumped to almost U.S. $700 billion in 2007 but then
slumped to an average of around U.S. $200 billion during 2008 and 2009 (Mohan
and Kapur 2011b). With the extended continuation of monetary accommodation
in the advanced economies after their ?nancial crisis, capital ?ows to EMEs have
surged further. The volume of gross capital ?ows has of course been even higher,
along with its volatility. There has been a continuing cycle of capital ?ows from
at least the early 1980s, with the amplitude of the cycles increasing consistently.
It is then not surprising that emerging-market economies have had to resort to
capital account management in varying degrees. It is a little dif?cult to imag-
ine what would happen if these countries had not actively resorted to capital
account management. The IMF has now begun recognition of this element of
macroeconomic management as being effective and legitimate, albeit with many
caveats. However, its approach is hierarchical, and CAM is regarded by the IMF
as a last resort. Whereas it is understandable that aggressive CAM can be seen
as disruptive from a multilateral perspective if it leads to beggar-thy-neighbor
policies, there is little evidence of such practices.
Second, on average, there is a persistent in?ation differential between advanced
economies and EMEs. It is very interesting that in the 10 or 12 years before the
crisis, there was a persistent in?ation differential of around 2 or 3 percent on
average between advanced-economy in?ation and emerging market in?ation,
though with signi?cant variance between different countries. Hence there was a
persistent interest rate differential as well, and that gave rise to huge opportuni-
ties for interest rate arbitrage, and the existence of the carry-trade on an endur-
ing basis. The differential has been persistent and is now further exacerbated by
the extended zero interest rate policy of the United States: hence, the expecta-
tion of rising capital ?ows and the enhanced need for managing them.
26 A Pardee Center Task Force Report | March 2012
Third, there has been a good deal of volatility in the monetary policies of
advanced economies, and that has also given rise to capital ?ow volatility. If we
examine the record of AE monetary policy over the past 30 years there has been
broad correspondence between episodes of accommodative monetary policy
in advanced economies and capital ?ows to emerging-market economies; and
also the reverse: each tightening produced the reversal of capital ?ows and the
crises that occurred in EMEs in the 1980s and 1990s. These episodes were well
documented in the Committee on the Global Financial System’s Report (2009) on
capital ?ows to EMEs (a report surprisingly ignored by all the IMF papers). Since
the policies of advanced economies are driven by their own domestic needs,
emerging markets need to take adequate defensive action in the interest of pre-
serving their own growth and stability.
Fourth, there is now the emergence of a persistent growth differential between
the AEs and EMEs, which has been getting starker. The two-speed recovery after
the North Atlantic Financial Crisis has only served to bring this phenomenon
to more pointed attention of both policymakers and ?nancial markets alike.
Overall, there is a huge incentive for large capital ?ows, which then lead to large
exchange rate appreciation, the possibility of credit booms, and asset-price
booms in recipient countries, followed eventually by higher trade and current
account de?cits over time. There is then a reversal of capital ?ows at some point
or other, leading to substantial output and unemployment costs. All of this could
not have been managed by ?nancial development, as shown by the United
States itself. This demonstrates the need for a combination of measures, includ-
ing CAM, particularly since markets can be irrational for extended periods.
Fifth, exchange rate ?uctuation poses greater dif?culties for economic stability in
EMEs. Typically, their export baskets are more dependent on relatively low tech-
nology labour using products that are price sensitive and which are therefore
easily substitutable; their competitiveness is much more dependent on the level
of their exchange rates. Thus even temporary real exchange rate appreciation
resulting from a surge of capital ?ows can have signi?cant effects on economic
activity in EMEs, both through a possible surge in imports and lull in such
exports. The social effects through labor displacement can be dif?cult to man-
age, particularly in the absence of appropriate social security mechanisms. With
the lack of well developed ?nancial markets it is also not easy to hedge against
such exchange rate ?uctuations. Whereas exchange rate appreciation that results
from improved competitiveness should not be resisted, the same cannot be said
Regulating Global Capital Flows for Long-Run Development 27
for exchange rate ?uctuation arising from capital ?ow volatility unrelated to host
country domestic fundamentals.
Sixth, the basic assumption behind much of the discussion on CAM, in principle,
is that the ?ow of capital across borders brings bene?ts to both capital importers
and capital exporters. The traditional view has been that EMEs are capital scarce
and AEs are capital rich so the former would only gain by greater freedom in the
?ow of cross border capital ?ows. What is different about the recent experience
with capital ?ows is that many EMEs have run signi?cant current account sur-
pluses, so net ?ows are actually in the opposite direction. Even in those countries
that do not exhibit current account surpluses, the capital in?ows have tended to
be far in excess of their ?nancing needs. Excess incoming capital ?ows have then
only added to the capital account management problem. Moreover, even with
domestic savings rates in excess of their investment rates, their investment levels
have been much higher than those of AEs, so they have exhibited relatively high
economic growth rates. The argument that more liberal capital account regimes
would have produced even higher growth rates is dif?cult to sustain.
Seventh, in any case, historical evidence, reinforced by the current North
Atlantic Financial Crisis—not the global ?nancial crisis—clearly shows that it
can create new exposures and bring new risks. The failure to understand and
analyze such risks, as well as the excessive haste that many countries have
shown over time in liberalizing capital accounts, has compromised ?nancial or
monetary stability, particularly in many EMEs. Such liberalization has usually
been done without placing adequate prudential buffers that are needed to cope
with the greater volatility characteristic of market-based capital movements.
Consequently, many EMEs in Latin America and Asia suffered repeated ?nancial
crises during the 1980s and 1990s. They appear to have learned their lessons
well, and have generally succeeded in avoiding crises since the Asian crisis of
the late 1990s. However, such failure became manifest in the current crisis in an
even more virulent form in the North Atlantic advanced economies.
ROLE OF CAPITAL ACCOUNT MANAGEMENT IN OVERALL MACRO-
ECONOMIC MANAGEMENT
In addressing issues related to capital account management, and after examining
the recent record of Asia and Latin American EMEs, I see them in the broader
context of prudent macroeconomic and monetary management, with a particu-
lar focus on maintaining ?nancial stability. I believe that some of the errors in
the approach to capital account management arise from looking at it from a very
28 A Pardee Center Task Force Report | March 2012
narrow viewpoint of capital controls. The reality of capital ?ows to emerging
markets over the past decade and a half is one of rising volumes accompanied
by high volatility. The optimal management of these large and volatile ?ows is
not one-dimensional.
Overall, my conclusion is that what is needed broadly is a combination of policies:
• sound macroeconomic policies, both ?scal and monetary
• exchange rate ?exibility with some degree of management through forex
intervention as needed, along with appropriate sterilization
• relatively open capital account but with some degree of management includ-
ing use of speci?c capital controls
• prudent debt management
• the use of micro- and macroprudential tools
• accumulation of appropriate levels of reserves as self insurance and their sym-
metric use in the face of volatility in capital ?ows
• and the development of resilient domestic ?nancial markets
That sounds like motherhood and apple pie, but it is different from looking
at CAM in extremis. Capital account management should not be discussed in
isolation: it must be seen as an integral and legitimate element of the overall
toolkit deployed in macroeconomic management. Just as different instruments
are used at different times in achieving ?scal policy and monetary policy goals,
the deployment of the various instruments available in the CAM toolkit would
depend on the extant circumstances, both domestic and external.
Much discussion on CAM is sidetracked on the use of capital account controls,
but these should be seen as only one element in the overall toolkit (as illustrated
in the menu above), which are used whenever they need to be. Just as advanced
economy central banks have used a variety of instruments to stabilize their
economies in the wake of the North Atlantic Financial Crisis, from (almost) zero
interest rate policy to aggressive quantitative easing, EMEs have used different
forms of CAM to ensure the continuance of growth with ?nancial stability in their
economies. There is increasing discussion on the use of prudential regulation for
CAM, both micro and macro. Again, I see these as legitimate tools in the CAM
armory for ensuring ?nancial stability. Similarly, there is renewed discussion
Regulating Global Capital Flows for Long-Run Development 29
on the management of exchange rates, intensi?ed by the recent action of the
Swiss National Bank announcing the initiation of aggressive intervention in the
foreign exchange market. Much of the discussion is contaminated by going to the
extremes of total ?exibility or ?xed exchange rates. In fact, what many emerg-
ing markets have practiced since the Asian crisis is a greater degree of ?exibility
in exchange rates, but with some degree of management. Similarly, emerging
markets have maintained relatively open capital accounts, but again with some
degree of management. The discussion is contaminated by going to extremes
here as well: either a totally open capital account or totally closed, when the
reality for Latin American and Asian EMEs has been somewhere in the middle
over the past decade or so.
A good deal of discussion on management of the capital account and foreign
exchange intervention has been in?uenced by the existence of the open econ-
omy trilemma. No country can simultaneously enjoy free capital mobility, oper-
ate a ?xed exchange rate, and practice independent monetary policy directed at
managing domestic objectives. In fact, most Asian countries have actually man-
aged this open economy trilemma successfully since the 1990s crisis. Whereas
they have operated managed exchange rates, they have allowed increased
?exibility: their exchange rates no longer exhibit rigidity. Similarly, whereas they
have actively managed their capital accounts, they have been neither totally
open nor totally closed at any time. This middle ground of managed but ?exible
exchange rates and managed but mostly open capital accounts have enabled
Asian EMEs to operate independent monetary policies despite high volatility in
external capital ?ows during the post-Asian crisis period. By and large, Asian
countries have been able to set their own policy for interest rates even in the
presence of persistent interest rate differentials with advanced countries. The
practice of adequate sterilization has been successful in preventing the unwar-
ranted growth of base money and other monetary aggregates in the face of rising
foreign exchange reserves. Hence, by and large, they have also been successful
in containing in?ation (Mohan and Kapur 2011b).
On the other hand, rigidities in capital account management can also lead to
dif?culties in macroeconomic and monetary management. As can be expected,
whereas theory has much to say on the conditions desirable for an end state
equilibrium, it has little guidance to offer on the sequencing of capital account
liberalization.
30 A Pardee Center Task Force Report | March 2012
INDIAN EXPERIENCE WITH CAPITAL ACCOUNT MANAGEMENT
In recent years, many EMEs have received capital ?ows much larger than their
?nancing requirements. When capital ?ows are signi?cantly in excess of a
sustainable level of current account de?cit, and the exchange rate is ?exible, it
is obvious that they cannot be absorbed domestically, howsoever ef?cient the
?nancial system may be. Real exchange rate misalignment, current account
imbalances, excesses in credit markets, asset price booms, overheating, and in?a-
tion are the most likely outcomes. It would be a question of time before ?nancial
fragility leads to crisis. Thus, surging capital ?ows should not be perceived as a
sign of strength, but as a potential source of disequilibrium (UNCTAD 2009).
Capital ?ows, therefore, need to be managed actively, particularly when ?nancial
markets are still in a nascent state of development. Absorption of capital ?ows
becomes easier as domestic ?nancial markets develop along with the emergence
of strong domestic ?nancial institutions and investors. High gross in?ows can
then also be balanced by increasing out?ows. As seen in the outbreak of the
NAFC, however, even the most developed ?nancial markets in Europe and the
United States had dif?culty in coping with the explosion of cross border capital
?ows that occurred in the years prior to the crisis (Bernanke 2011).
Capital controls can be effective, even though they may not be foolproof, and are
in fact subject to leakages in the context of the current global ?nancial market
environment. Capital controls
have to be a part of an overall
package comprising exchange
rate ?exibility, the maintenance
of adequate reserves, steriliza-
tion, and the development of
the ?nancial sector. There is a
clear need for the deployment
of multiple instruments. The current fashion of a single objective, single instrument
monetary policy is undoubtedly inadequate to deal with capital ?ows.
Against this backdrop, the Indian experience holds important lessons. Monetary
policy in India has faced growing challenges from large and volatile capital ?ows
since 1993–1994, especially during 2007–2009. In response to these capital
?ows, a multi-pronged approach was adopted including active management
of the capital account, especially of debt ?ows. Tighter prudential restrictions
Capital controls have to be a part of an
overall package comprising exchange rate
?exibility, the maintenance of adequate re-
serves, sterilization, and the development of
the ?nancial sector. There is a clear need for
the deployment of multiple instruments.
Regulating Global Capital Flows for Long-Run Development 31
were placed on access of ?nancial intermediaries to external borrowings; greater
?exibility in exchange rate movements was introduced but with capacity to
intervene in times of excessive volatility; treating capital ?ows as largely volatile
unless proven otherwise; building up of adequate reserves; sterilization of inter-
ventions in the foreign exchange market through multiple instruments, includ-
ing cash reserve requirements and issuance of new market stabilization bonds;
continuous development of ?nancial markets in terms of participants and instru-
ments, but with a cautious approach to risky instruments; strengthening of the
?nancial sector through prudential regulation while also enhancing competition;
pre-emptive tightening of prudential norms; and re?nements in the institutional
framework for monetary policy.
Policies operate symmetrically. During periods of heavy in?ows, liquidity is
absorbed through increases in the cash reserve ratio (CRR) and issuances under
the market stabilization scheme. During periods of reversal, liquidity is injected
through cuts in CRR and the unwinding of the market stabilization scheme.
Overall, rather than relying on a single instrument, many instruments have been
used in a coordinated manner. This was enabled by the fact that both monetary
policy and the regulation of banks and other ?nancial institutions and key ?nan-
cial markets are under the jurisdiction of the Reserve Bank of India (RBI), which
permitted smooth use of various policy instruments. Unlike many EMEs, India
has been running trade and current account de?cits. While the current account
de?cit is modest and manageable, the trade de?cit is high. Management of the
capital account and exchange rate is also important from this perspective.
The outcomes have been satisfactory. Growth in monetary and credit aggregates
was, by and large, contained within desired trajectories and consistent with the
overall GDP growth objective. There has been signi?cant ?nancial deepening.
Though in?ation has been high again in 2010–2011, it had been reduced signi?-
cantly in the decade prior to 2008 from its levels prevailing during the 40-year
period until the late 1990s. Growth has witnessed signi?cant acceleration on
the back of productivity gains, which are also re?ected in the growth of exports
of goods and services. Domestic investment has increased substantially since
the beginning of this decade, and this is predominantly ?nanced by domestic
savings. The surge in investment and savings was made possible by an ef?cient
allocation of resources by the domestic banking system and ?nancial markets,
despite many constraints. Overall, ?nancial stability has been maintained (see
Mohan and Kapur 2011a for details).
32 A Pardee Center Task Force Report | March 2012
The volatility in capital ?ows poses large challenges but these can be managed.
The key lessons from the Indian experience are that monetary policy needs to
move away from the narrow price stability/in?ation targeting objective. Cen-
tral banks need to be concerned not only with monetary policy but also with
development and regulation
of banks and key ?nancial
markets—money, credit,
bond, and currency. Depend-
ing on the institutional legacy
within different countries,
if these additional functions are not vested within the central bank, adequate
coordination mechanisms need to be put in place to enable the central bank to
interact with the other agencies and act on needed prudential measures. Given
the volatility and the need to ensure broader stability of the ?nancial system,
central banks need multiple instruments. Capital account management has to be
counter-cyclical, just as is the case of monetary and ?scal policies. Judgments in
capital account management are no more complex than those made in mon-
etary management.
Overall, as the CGFS (2009) concludes, it is a combination of sound macroeco-
nomic policies, prudent debt management, exchange rate ?exibility, the effec-
tive management of the capital account, the accumulation of appropriate levels
of reserves as self-insurance, purposive use of prudential regulation, and the
development of resilient domestic ?nancial markets that provides the optimal
response to the large and volatile capital ?ows to the EMEs. Individual countries
have used different combinations of measures from time to time. If the pressure
of excess ?ows is very high, as it was in India in 2007, it becomes necessary to
use almost all the possible measure available. Thus how these elements can be
best combined will depend on the country and on the period: there is no “one
size ?ts all.”
Such a discretionary approach does put great premium on the skill of policy-
makers in both ?nance ministries and central banks. It also runs the risk of
markets perceiving central bank actions to become uncomfortably unpredict-
able. If, however, as many Asian countries have demonstrated in recent years,
the actions of the authorities do result in the virtuous circle of high growth, low
in?ation and ?nancial stability, such an approach has much to commend it. One
such example is that of India.
The key lessons from the Indian experience
are that monetary policy needs to move
away from the narrow price stability/in?a-
tion targeting objective.
Regulating Global Capital Flows for Long-Run Development 33
REFERENCES
Bernanke, Ben S. (2011). “International Capital Flows and the returns to safe assets in
the United States 2003-2007.” In Banque de France, Financial Stability Review. No.
15, February 2011. pp. 13–26.
Committee on the Global Financial System (CGFS) (2009). “Report of the Working Group
on Capital Flows to Emerging Market Economies.” (Chairman: Rakesh Mohan).
Basel: Bank for International Settlements.
Habermeier, Karl, Annamaria Kokeyne and Chikako Baba (2011). “The Effectiveness
of Capital Controls and Prudential Policies in Managing Large In?ows.” Washington
D.C. IMF Staff Discussion Note SDN/11/14, August 2011.
International Monetary Fund (2011a). “Recent Experiences in Managing Capital In?ows:
Cross Cutting Themes and Possible Policy Framework.” Washington D.C. IMF Policy
Paper, April 2011.
International Monetary Fund (2011b). “International Capital Flows: Reliable or Fickle?”
Chapter 4 in World Economic Outlook. April 2011.
Mohan, Rakesh and Muneesh Kapur (2011a). “Managing the Impossible Trinity: Volatile
Capital Flows and Indian Monetary Policy.” Chapter 8 in Rakesh Mohan, Growth
with Financial Stability: Central Banking in an Emerging Market. New Delhi: Oxford
University Press.
——— (2011b). “Liberalization and Regulation of Capital Flows: Lessons for Emerging
Market Economies.” Chapter 9 in Rakesh Mohan, Growth with Financial Stability:
Central Banking in an Emerging Market. New Delhi: Oxford University Press.
Ostry, Jonathan D., Atish R. Ghosh, Karl Habermeier, Marcos Chamon, Mahvash S.
Qureshi, and Dennis B.S. Reinhardt (2010). ”Capital In?ows: The Role of Controls,”
IMF Staff Position Note SPN/10/04, February 2010.
Ostry, Jonathan D., Atish R. Ghosh, Karl Habermeier, Luc Laeven, Marcos Chamon, Mah-
vash S. Qureshi, and Annamaria Kokeyne (2011). “Managing Capital Flows: What
Tools to Use?” Washington D.C.: IMF Staff Discussion Note SDN/11/06, April 2011.
United Nations Conference on Trade and Development (UNCTAD) (2009). Trade and
Development Report, 2009. United Nations.
34 A Pardee Center Task Force Report | March 2012
Regulating Global Capital Flows for Long-Run Development 35
3. Managing Capital Flows: Lessons from the Recent
Experiences of Emerging Asian Economies
Masahiro Kawai, Mario B. Lamberte, and Shinji Takagi
1
INTRODUCTION
The essay draws lessons from the recent experiences of emerging Asian
economies (EAEs)
2
for managing capital in?ows. While capital in?ows bring
about invaluable bene?ts, large ?ows, if not managed properly, can expose
the recipients to various types of risks. EAEs collectively were a signi?cant
recipient of capital in?ows
prior to the global ?nancial
crisis. Although the Republic
of Korea (hereafter Korea)
and Indonesia were affected
by capital out?ows to some
extent, most of Asia did not
suffer as much as eastern European and Baltic countries did. Following the
crisis, they were among the ?rst to recover and are now experiencing a new
surge of in?ows. The issue of how best to manage capital in?ows is therefore
especially relevant for Asia. We frame our discussion primarily on the basis of
the country and analytical chapters of Kawai and Lamberte (2010) with some
updated information.
1 The authors are, respectively, Dean and Chief Executive Of?cer, Asian Development Bank Institute; Director of
Research, Asian Development Bank Institute; and Professor of Economics, Graduate School of Economics, Osaka Uni-
versity, and a member of the Pardee Center Task Force on Regulating Global Capital Flows for Long-Run Development.
Acknowledgement: The views expressed in this note are the authors’ alone and do not necessarily represent the
views of the Asian Development Bank, its Institute, the Executive Directors, or the countries they represent.
2 Unless noted otherwise, emerging Asian economies (EAEs) include the following 14 economies: Cambodia
(CAM); People’s Republic of China (PRC); Hong Kong, China (HKG); India (IND); Indonesia (INO); Republic of
Korea (KOR); Lao PDR (LAO); Malaysia (MAL); Myanmar (MYA); the Philippines (PHI); Singapore (SIN); Taipei,
China (TAP); Thailand (THA); and Viet Nam (VNM). Of these, we pay particular attention to nine economies for
which Kawai and Lamberte (2010) include country chapters.
Following the crisis, [Asian countries] were
among the ?rst to recover and are now
experiencing a new surge of in?ows. The
issue of how best to manage capital in?ows
is therefore especially relevant for Asia.
36 A Pardee Center Task Force Report | March 2012
CAPITAL FLOWS IN EMERGING ASIAN ECONOMIES
Degree of Capital Account Openness
Capital account openness varies across EAEs, according to both de jure and
de facto measures. First, Chinn and Ito (2009) constructed an index of ?nancial
openness based on the IMF’s Annual Report on Exchange Arrangements and
Exchange Restrictions, where a higher index value indicates greater openness
(Figure 1). Except for Hong Kong and Singapore, most EAEs maintain various
controls on cross-border capital ?ows, though many are substantially open with
respect to foreign direct investment (FDI) in?ows and portfolio in?ows through
purchases by nonresidents of domestic securities.
Second, Lane and Milesi-Ferretti (2006) developed a volume-based measure of
international ?nancial integration, de?ned as the ratio of the stock of assets and
liabilities to GDP (Table 1). We have updated data for 2005 and 2009 by using the
IMF’s International Financial Statistics stock data, where available, or capital
?ow data, where stock data are not available. For Asia, the ratio generally rose
for all economies from 1990 to 2009. Despite the relatively low overall de jure
openness (as indicated by the Chinn-Ito index), the capital account of many
economies in fact appears to have been suf?ciently open to allow a sizable
-2.50 -2.00 -1.50 -1.00 -0.50 0.00 0.50 1.00 1.50 2.00 2.50 3.00
MYA
THA
LAO
IND
PRC
VNM
MAL
PHI
KOR
INO
CAM
SIN
HKG
Figure 1: De Jure Capital Account Openness in Emerging Asia, 2009
Source: Chinn and Ito 2009.
Regulating Global Capital Flows for Long-Run Development 37
accumulation of external assets and liabilities over time, with the ratio exceeding
or close to 100 percent for all but two economies in 2009.
Patterns of Capital Flows
EAEs saw a resurgence of capital ?ows after the 1997–1998 Asian ?nancial
crisis, with in?ows reaching $856 billion in 2007, before the onset of the global
?nancial crisis (Table 2). The People’s Republic of China’s (PRC) in?ows rose
dramatically, posting $241 billion in 2007, which accounted for 28 percent of
the total in EAEs; India also saw rapid increases in in?ows, which reached $98
billion in 2007. Capital out?ows also picked up, suggesting that capital ?ows in
the region have become increasingly two-way. The PRC and Hong Kong had the
largest capital out?ows in 2007. Together, they accounted for 60 percent of the
total out?ows from EAEs, followed by Singapore and Korea.
As to the composition of capital ?ows, FDI began to take the dominant role in
the middle of the 1990s (Figure 2). By the late 1990s, FDI had accounted for
more than half of all private capital in?ows to EAEs. Portfolio equity in?ows
increased following the Asian ?nancial crisis. Most Asian economies reduced
barriers to investment on equity markets to recapitalize ailing banks and non-
?nancial corporations. As a result, equity in?ows rapidly increased in 1999, but
Chap. 3 Table 1
Economies 1990 1995 2000 2005 2009
Cambodia (CAM) 96.3 176.8 145.2 156.0
China, People's Republic of
(PRC)
38.9 58.7 84.7 90.6 108.3
Hong Kong, China HKG) 1462.9 1338.6 1246.5 1434.5 2097.1
India (IND) 30.2 39.7 42.3 49.1 64.1
Indonesia (INO) 80.6 86.2 136.8 86.1 76.9
Korea, Republic of (KOR) 35.4 50.9 82.7 107.5 161.9
Lao PDR (LAO) 215.3 147.5 198.7 148.0 153.2
Malaysia (MAL) 121.6 160.8 185.5 183.9 242.2
Philippines (PHI) 95.0 97.3 143.3 114.7 99.2
Singapore (SIN) 361.3 419.5 809.5 966.7 1216.4
Taipei, China (TAP) 103.4 97.7 132.3 257.0 369.7
Thailand (THA) 68.8 114.4 142.7 135.1 168.0
Viet Nam (VN) 96.2 110.7 100.2 129.8
Table 1: External Assets and Liabilities as a Share of GDP
in Emerging Asia, 1990–2009(%)
Sources: For 1990, 1995 and 2000, the ?gures came from Lane and Milesi-Ferretti (2006), except for Tai-
pei, China, whose ?gures were obtained from the China Economic Information Center (CEIC) database.
For 2005 and 2009, the ?gures were calculated using IMF IFS stock data, where available, or capital ?ow
data, where stock data are not available. For Lao PDR and Viet Nam, the latest data are for 2007.
38 A Pardee Center Task Force Report | March 2012
momentum was reversed in 2000. Portfolio equity in?ows resurged in 2003,
peaking at $205 billion in 2007. Equity in?ows turned negative (-$81 billion) in
2008 as the global crisis deepened, but rebounded strongly in 2009.
Unlike portfolio equity in?ows, debt securities in?ows were a relatively small
component of capital in?ows in EAEs, although they have been on the rise,
especially in Korea. Underdevelopment of the local currency bond market has
been pointed out as one of the main reasons. Currently, several policy initiatives
are under way to promote local-currency denominated bond markets, and debt
securities in?ows are expected to increase over time. Bank ?nancing in EAEs
was relatively small in the 1990s except during the three years prior to the 1997–
1998 crisis. Thereafter, bank ?nancing accounted for a negligible proportion of
capital in?ows in Asia until 2006. In 2007 it rose sharply to almost $70 billion,
with Korea accounting for almost two-thirds of the total. In 2008, bank ?nancing
turned negative (-$12 billion), with Korea accounting for almost all of it.
Impact of Capital Flows
Persistent current account surpluses and rising capital in?ows exerted upward
pressure on the exchange rates in most EAEs until right before the global ?nan-
1
Chap 3 Table 2
Year
Gross
Capital
Flows
Gross
Capital
Flows
(% of
GDP)
Capital
Inflows
Capital
Inflows
(% of
GDP)
Capital
Outflows
Capital
Outflows
(% of
GDP)
Net
Inflows
Net
Inflows
(% of
GDP)
1990 52.85 4.18 42.96 3.40 9.90 0.78 33.06 2.62
1991 55.01 4.17 50.79 3.85 4.22 0.32 46.57 3.53
1992 72.10 5.11 56.14 3.98 15.97 1.13 40.17 2.85
1993 133.06 8.63 97.91 6.35 35.15 2.28 62.76 4.07
1994 148.74 8.10 108.13 5.89 40.61 2.21 67.53 3.68
1995 209.30 9.43 155.76 7.02 53.54 2.41 102.22 4.61
1996 243.94 9.81 181.56 7.30 62.39 2.51 119.17 4.79
1997 277.68 11.00 143.10 5.67 134.58 5.33 8.52 0.34
1998 -198.11 -8.34 -128.14 -5.40 -69.97 -2.95 -58.17 -2.45
1999 151.26 5.72 73.76 2.79 77.50 2.93 -3.75 -0.14
2000 332.11 11.41 167.11 5.74 165.00 5.67 2.10 0.07
2001 47.70 1.59 32.29 1.08 15.41 0.51 16.88 0.56
2002 95.19 2.89 55.93 1.70 39.26 1.19 16.66 0.51
2003 260.85 7.04 149.21 4.03 111.65 3.01 37.56 1.01
2004 479.42 11.20 300.36 7.02 179.06 4.18 121.30 2.83
2005 571.24 11.56 310.28 6.28 260.96 5.28 49.32 1.00
2006 973.47 16.79 499.91 8.62 473.57 8.17 26.34 0.45
2007 1,595.29 22.22 855.97 11.92 739.32 10.30 116.65 1.62
2008 237.95 2.88 91.13 1.10 146.82 1.78 -55.69 -0.67
2009 318.60 3.67 271.67 3.13 46.93 0.54 224.74 2.59
Table 2: Capital Flows in Emerging Asia, 1990–2009 (US$ billion)
Sources: International Financial Statistics (IMF); World Development Indicators (World Bank); CEIC.
Regulating Global Capital Flows for Long-Run Development 39
cial crisis. In part to contain the appreciation pressure, the monetary authorities
of most economies intervened in the foreign exchange market and thereby accu-
-10.00
-5.00
0.00
5.00
10.00
15.00
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Inflow
Direct Investment Portfolio Investment Financial Derivatives Other Investment
Figure 2: Composition of Capital Flows in Emerging Asia, 1990–2009 (% GDP)
Sources: International Financial Statistics (IMF); World Development Indicators (World Bank); CEIC
accessed on 15 April 2011.
-6.00
-4.00
-2.00
0.00
2.00
4.00
6.00
8.00
10.00
12.00
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Outflow
Direct Investment Portfolio Investment Financial Derivatives Other Investment
40 A Pardee Center Task Force Report | March 2012
mulated massive foreign exchange reserves. Total reserves held by EAEs rose
from $214 billion or 5 perent of GDP in 1990 to $4.8 trillion or 44 percent of GDP
in 2010, with the PRC contributing three-?fths. In 2006 and 2007, many EAEs
experienced higher increases in money supply growth, indicating that steriliza-
tion was incomplete. Although goods and services price in?ation had generally
remained low until the global ?nancial crisis (except for what appears to be the
temporary impact of increases in world commodity prices in 2008), it has been
rising in recent months. Equity prices saw a rising trend since 2003 notably in
Indonesia, India, and the PRC. They dropped sharply at the onset of the global
?nancial crisis, but recovered quickly as foreign capital returned to the EAEs.
POLICY RESPONSES TO CAPITAL FLOWS
Policy responses by EAEs until the onset of the global ?nancial crisis can broadly be
classi?ed into sterilized intervention, interest rate reductions, and capital controls.
3
Intervention in the Foreign Exchange Market
The monetary authorities of all nine case study economies intervened in the
foreign exchange market, at least partially sterilizing its impact. Lack of suitable
government paper was often a challenge. The People’s Bank of China (PBOC),
when it ran out of treasury bonds, started selling its own low-yielding central
bank bills (CBBs) to commercial banks (while raising reserve requirements
15 times from September 2003 to end-2007). Likewise, the Reserve Bank of
India (RBI) ran out of government securities and agreed with the government
in January 2004 to put in place the Market Stabilization Scheme (MSS), which
authorizes RBI to sell bonds on behalf of the government for the purpose of
sterilization (while also raising reserve requirements).
Some economies resorted to creative ways of sterilization. The Bank of Korea
(BOK) used its own monetary stabilization bonds (MSBs), but as the balance rose
sharply, it became costly to remain so engaged. The Korean government then
initiated a scheme under which it sold securities and deposited the proceeds
with the BOK, thereby allowing the central bank to use the won for currency
market intervention. Another case is the Bangko Sentral ng Pilipinas (BSP).
After exhausting the conventional tools, in 2007, BSP opened a special deposit
account (SDA) facility to banks in order to absorb excess liquidity. Later, the
counterparties were expanded to include non-bank government corporations as
well as banks’ pension funds and trust operations.
3 This section draws on the nine country chapters of Kawai and Lamberte (2010).
Regulating Global Capital Flows for Long-Run Development 41
Sterilization created its own challenges. Bank Indonesia (BI) partially sterilized
intervention mainly using one-month and three-month Bank Indonesia Certi?-
cates (SBI), but as the SBI interest rates were more than 8 percent, the operation
attracted even more portfolio in?ows. BI was therefore compelled to allow the
exchange rate to appreciate, partially absorbing the impact of capital in?ows
thereby. The State Bank of Vietnam (SBV), ?nding open market operations and
reserve requirements less than fully effective, required commercial banks to
purchase newly introduced 365-day bills in March 2008. This measure forced
banks to run to the inter-bank market, pushing up the inter-bank rates sharply.
As banks competed intensively to mobilize deposits to comply with the compul-
sory purchase of the 365-day bills, the deposit rates also rose.
Interest Rate Policy
When a large interest rate differential attracts additional foreign capital, the
monetary authorities may need to narrow the gap by lowering domestic interest
rates. This explains why the PBOC was cautious in tightening monetary policy:
when it raised interest rates it made sure to maintain a 3 percent spread in favor
of the dollar LIBOR, with the intention of letting the renminbi appreciate at 3
percent per annum. Likewise, in India, while the RBI raised the reverse repur-
chase and repurchase rates between January 2006 and April 2007, it reduced the
interest rates on non-resident deposits. Similar interest rate cuts were observed
in Indonesia (from January 2006 to December 2007), the Philippines (from March
2007 to March 2008), and Thailand (from January to July 2007). Viet Nam was an
exception, however, as the SBV raised all of?cial interest rates in February 2007
in order to contain the acceleration of money supply growth and in?ation.
Capital Controls
Use of capital controls was exceptional. Prior to the global ?nancial crisis, only
four EAEs tightened or introduced capital controls to stem the tide of capital
in?ows. Two cases should clearly be separated. In one case, countries with a
tightly controlled regime reversed the pace of capital account liberalization. In
2006, the PRC restricted the ability of foreign banks to borrow dollars abroad
to fund dollar assets within the country, which was subsequently reinforced by
the regulation that banks meet an increase in reserve requirements with dollar
deposits with the central bank. In 2007, India tightened limits on external com-
mercial borrowing by placing a cap on the amount of foreign exchange domestic
?rms could convert into rupees; it also introduced controls against “participatory
42 A Pardee Center Task Force Report | March 2012
notes,” which are over-the-counter derivatives sold by a registered foreign institu-
tional investor to a non-registered investor.
The other case involved measures introduced by a country with a substantially
open capital account regime, especially with respect to capital in?ows. On 18
December 2006, Thailand imposed a 30 percent unremunerated reserve require-
ment (URR) on all equity and short-term securities investment in?ows with
maturities of less than one year, which was however lifted on the following day
for equity ?ows. The URR for ?xed income in?ows remained until March 2008.
There is statistical evidence to suggest that capital in?ows shifted to equity ?ows,
but the econometric analysis of Coelho and Gallagher (2010) shows that the Thai
URR reduced the overall volume of in?ows by 0.75 percent of GDP (which was
marginally signi?cant statistically).
4
In 2007, Korea re-imposed limits on lending
in foreign currency to Korean ?rms, while restricting foreign banks’ swapping
dollars borrowed abroad for won. These measures were intended to slow down
foreign banks’ funding of their branches in Korea.
MANAGING CAPITAL INFLOWS IN THE POST-CRISIS ERA
As the world’s engine of growth, Asia has seen a resumption of capital in?ows.
Conventional macroeconomic tools seem to offer limited effectiveness in managing
large capital in?ows, especially given the large balance of foreign exchange reserves
many of the economies have
accumulated. Allowing the
exchange rate to appreciate
is often the best way to cope
with large capital in?ows (this
is the standard response of
most industrial countries), but
emerging economies are naturally reluctant to allow a signi?cant appreciation of
their currencies. In view of this limited policy space, some EAEs have introduced
prudential and other regulatory measures affecting capital in?ows and foreign
exchange positions in the post-global ?nancial crisis era (Table 3).
Prudential and Other Regulatory Measures
In assessing the prospective usefulness of prudential and other regulatory measures
limiting capital in?ows or what the IMF (2011) calls capital ?ow management mea-
sures (CFMs), it is important to bear in mind the following considerations for EAEs:
4 But they show that it did not affect the real exchange rate or the composition of in?ows.
Conventional macroeconomic tools seem to
offer limited effectiveness in managing large
capital in?ows, especially given the large
balance of foreign exchange reserves many
of the economies have accumulated.
Regulating Global Capital Flows for Long-Run Development 43
• ASEAN member states are committed to creating an ASEAN Economic Com-
munity (AEC) by 2015, which is de?ned to be a region characterized by free
movement of investment and freer movement of capital. It is dif?cult for any
of these countries to reverse the process of capital account liberalization by
introducing new barriers to capital mobility except during an emergency on a
temporary basis.
• Hong Kong and Singapore, as major international ?nancial centers, cannot be
seen to be taking any measure to restrict the freedom of international inves-
tors to move funds across borders. Given the depth of their ?nancial markets
and the robust regulatory regimes in place, use of CFMs is probably not neces-
sary except during a crisis (they have recently introduced prudential measures
to contain upward pressure on real estate prices).
• Cambodia and Lao PDR have virtually no domestic ?nancial markets to speak
of. This means that, in the foreseeable future, no large portfolio in?ows are
Chap 3 Table 3
Emerging
Asian
Economies
Measures
India • June 2010: limited the amount of short-term bonds that could be sold to
foreign investors (while raising the overall ceiling for FII investment in
debt in September 2011)
Indonesia • June 2010: imposed a one-month holding period for SBIs while
announcing the introduction of longer-term (9–12 months) SBIs (from
August/September); introduced new regulations on banks’ net foreign
exchange open positions
• January 2011: re-introduced a cap (in relation to capital) on oversees short-
term borrowing by banks while requiring banks to set aside a higher
percentage of their foreign exchange holdings as reserves
• May 2011: lengthened the one-month SBI holding period to six months
• July 2011: restricted investment by banks in foreign currency bonds issued
in the domestic market in circumvention of measures to restrict foreign
currency loans
Korea,
Republic
of
• June 2010: placed limits on foreign exchange derivatives positions, in
relation to the capital base of financial institutions; further restricted the
use of foreign currency loans by banks within Korea; and tightened
regulations on the foreign currency liquidity ratio of domestic banks
• December 2010: announced the introduction of a tax on banks’ foreign
exchange borrowing and the re-instatement of withholding tax on interest
income from government bonds (from January 2011)
Thailand • October 2010: re-imposed withholding tax on interest income and capital
gains from foreign bond holdings
Table 3. Capital Flow-Affecting Prudential and Other Regulatory Measures
Announced or Adopted by Emerging Asian Economies, 2010–2011
Sources: Relevant central bank publications and press reports.
44 A Pardee Center Task Force Report | March 2012
expected, even though their capital account regime is fairly open. The same
can also be said about Myanmar, whose capital account is all but fully closed.
• The PRC and India (and, to a lesser extent, Viet Nam) still maintain extensive
restrictions on capital in?ows (as well as on capital out?ows). For these coun-
tries, use of capital controls only represents a reversal of the gradual capital
account liberalization process.
5
Just as well, they could decelerate the pace of
capital account liberalization over the coming years.
• Except for Hong Kong and Singapore, the other EAEs maintain some restric-
tions on capital in?ows, with tighter controls on out?ows. Even Indonesia,
arguably the most ?nancially open economy in the rest of the region, is known
to subject banking ?ows to tight control. In these economies, portfolio in?ows
take place mainly through purchases by nonresidents of domestic securities.
• Korea, as an OECD country, has little leeway in consistently deviating from the
policy of free capital mobility.
These considerations suggest that:
(i) use of outright capital controls (or what the IMF (2011) calls residency-based
CFMs) is relevant only for a handful of EAEs (e.g., Indonesia, Malaysia, Philip-
pines, and Thailand);
(ii) purchases by nonresidents of domestic securities are the main (or the only)
target of any potential CFMs; and
(iii) use of outright capital controls (that explicitly discriminate against foreign
investors) is increasingly ruled out as a feasible policy option, especially if it
is pursued by individual countries.
This last point is clearly borne out by the types of measures that have been
introduced by some of these countries recently to limit capital in?ows or in?ow
volatility (see Table 3). Except for the Indian measure, the other measures
(introduced by Indonesia, Korea, and Thailand) are carefully designed not to
discriminate against foreign investors. The pressing question for emerging Asia’s
policymakers is not when or in what sequence to employ CFMs. It is rather what
non-residency-based CFMs are effective in mitigating the risk of capital in?ows
5 In these countries, it is not very useful to talk about the effectiveness of any new capital control measure,
independently of the effectiveness of the overall control regime within which it is introduced. Given the extensive
administrative apparatus, they can always take measures to make capital controls work.
Regulating Global Capital Flows for Long-Run Development 45
(if not directly reducing the purchases by nonresidents of domestic securities) as
they preserve their commitment to an open capital account regime.
Collective Action
At the regional level, collective action is an insuf?ciently explored tool. For
example, if loss of international price competitiveness is the reason for not
allowing currency appreciation, a country’s authorities can cooperate with their
competitor neighbors in similar circumstances to take the action simultane-
ously (Kawai 2008). This would lead to a concerted appreciation of currencies in
the face of persistent capital in?ows in the region. Another area of cooperation
would be to coordinate the introduction of prudential and other regulatory mea-
sures, including outright capital controls, given the recognition that individual
countries are ?nding it increasingly dif?cult to do so alone. Collective action
is helpful in two ways. First, these measures are either introduced as part of
regional efforts or sanctioned by a regional decision, there would be less punitive
reaction from international investors (as was the case with Thailand in December
2006). Second, these measures, if effective in one country, would divert more
capital in?ows to its regional neighbors. Without a regional framework, use of
prudential and other regulatory measures to limit capital in?ows could turn into
a tool of beggar-thy-neighbor policy.
REFERENCES
Chinn, M.D. and H. Ito (2009). “The Chinn-Ito Index: A De Jure Measure of Financial
Openness."http://web.pdx.edu/~ito/Chinn-Ito_website.htm. (Accessed: 29 August
2009.)
Coelho, B. and K. P. Gallagher (2010). "Capital Controls and 21st Century Financial
Crises: Evidence from Colombia and Thailand," PERI Working Paper No. 213,
Political Economy Research Institute, University of Massachusetts, Amherst.
International Monetary Fund (IMF) (2011). “Recent Experiences in Managing Capital
In?ows—Cross-Cutting Themes and Possible Guidelines.” IMF Policy Paper, 14
February.
Kawai, M. (2008). “Toward a Regional Exchange Rate Regime in East Asia,” Paci?c Eco-
nomic Review 13(1): 83–103.
46 A Pardee Center Task Force Report | March 2012
Kawai, M. and M. Lamberte (eds.) (2010). Managing Capital Flows: The Search for a
Framework, Cheltenham, UK, and Northampton, MA: Edward Elgar.
Lane, P. R. and G. M. Milesi-Ferretti (2006). “The External Wealth of Nations Mark II:
Revised and Extended Estimates of Foreign Assets and Liabilities, 1970–2004,” IMF
Working Paper No. 06/69.
Regulating Global Capital Flows for Long-Run Development 47
4. Capital Out?ow Regulation: Economic
Management, Development and Transformation
Gerald Epstein
INTRODUCTION
As economic and ?nancial turmoil have rocked the foundations of the global
economy, policy makers have widened their search for policy tools to help them
manage the massive ?nancial instability they face. As events have forced them to
break out of their ideological silos in a desperate search for solutions, some are
discovering that some policies they have written off in the past might be useful
after all.
Foremost among these “new found” old tools are so-called “capital controls.” As
well recounted by Gallagher, Grabel, and Ocampo (all articles published in 2011),
even the International Monetary Fund (IMF), long a staunch opponent of such
tools, has now admitted that they can be useful under some circumstances, espe-
cially to manage capital in?ows and especially if they are used on a temporary
basis. They have even adopted a name change to make their acceptance more
palatable, appropriately dropping the term “controls” and referring to such tools
as “capital ?ow management measures” (IMF 2011).
1
Still, the IMF and other
“establishment” institutions have not completely abandoned their old ways. As
described by Grif?th-Jones and Gallagher (2011) and Ocampo (2011), the IMF
has proposed gaining more in?uence over the conditions under which capital
controls are used; and, as Gallagher and others have well documented, a web
of bilateral and multi-lateral so-called “free-trade” agreements have structured a
global “capital liberalization regime” that create barriers for countries to imple-
ment capital account regulations even as economists at the IMF say they are
useful. (Gallagher 2011a.)
1 Other more palatable names have been proposed as well: e.g., “capital management techniques” (Epstein,
Grabel, Jomo 2003) and “capital account regulations”, (Ocampo 2011). For purposes of this paper, I will adopt
Ocampo’s term: see below.
48 A Pardee Center Task Force Report | March 2012
Equally telling, most of these economists and policy makers retain their opposi-
tion to “capital controls” on out?ows.
2
Indicative is a highly in?uential paper by
Nicolas Magud, Carmen Reinhart and Kenneth Rogoff that surveys 30 academic
studies of capital controls on in?ows and out?ows. The paper concludes with
respect to out?ow controls that “As to controls on out?ows, there is Malaysia
and then there is everyone else…Absent the Malaysian experience, there is little
systemic evidence of “success” in imposing controls, however de?ned.” (Magud,
Reinhart, and Rogoff 2011, p. 2).
This conclusion is rather odd when one considers that many of the greatest
development success stories of the late 20th century have had highly articulated
regimes of capital account regulations on out?ows: South Korea, Taiwan, China
and India, among others (Amsden 2001; Chang and Grabel 2004; Nembhard
1996). Capital controls and exchange control regimes were also critical to the
recovery and industrial development of a number of countries in Europe and
also Japan following the Second World War (Zysman 1983; Epstein 2007; Eichen-
green 2007). In virtually all of these cases, capital control regimes consisted
not only of capital controls on out?ows (and in?ows), but also credit allocation
systems managed by governmental institutions including Ministries of Finance,
Central Banks and specialized planning ministries of various kinds. Yet Magud,
et al. chose not to include these cases because, they argued, “one cannot lump
together the experiences of countries that have not substantially liberalized (i.e.,
India and China) with countries that actually went down the path of ?nancial
and capital account liberalization and decided at some point to reintroduce con-
trols, as the latter have developed institutions and practices that are integrated in
varying degrees to international capital markets” (Magud et al. 2011, p. 5).
3
This decision to exclude China and India, among other countries, seems ques-
tionable in light of the fact that both India and China have liberalized to some
degree over a decade or more, and, in addition, that there have been a number
of excellent studies of the impacts of these controls on these economies, espe-
cially by Robert McCauley and his colleagues at the Bank for International Settle-
ments (BIS) (e.g., see for example, Ma and McCauley 2007).
4
2 Even here, reality sometimes wins out. The IMF encouraged even out?ow controls in some of the recent rescue
packages, including in Iceland (see Grabel, 2011). But the public resistance to controls at the IMF remains.
3 Thus, they only included studies of Malaysia, Spain and Thailand in their sample on out?ows.
4 See below for further discussion and references.
Regulating Global Capital Flows for Long-Run Development 49
In addition, the distinction between in?ow and out?ow controls is not as clean
as is often believed. For example, the regulations imposed by the Indian govern-
ment on certain kinds of derivative positions and products involves constraints
both on short positions and long positions that involve foreigners: hence they
can place limits both on “in?ows” and “out?ows.” In addition, constraints on
out?ows themselves act as a disincentive to in?ows. Indeed, one of the strongest
policies that would serve to limit in?ows involve reserve requirements, and
other limitations on out?ows (see Ocampo 2011).
Still, Magud et al. do have a point: it is important to draw distinctions
among different kinds of capital controls, especially with respect to the
policy regimes of which they are a part—including the goals set out for those
regimes—and the domestic and international context that accompany them.
Most of the recent discussion has focused on the use of capital account regula-
tions to manage the cyclical, ?nancial stability, and balance of payments
aspects of macroeconomic policy: we can refer to this as the macroeconomic
management function of capital account regulations. Less discussed recently
are the longer term developmental aspects of capital account regulations,
where capital account regulations are important complements to industrial
policy, industrial re-development, and income and wealth distributional poli-
cies that were so important in post–World War II reconstruction regimes as
mentioned above.
These developmental roles become increasingly important in times of great
structural change as we are perhaps experiencing today. One can say that
both the macroeconomic management and the developmental roles of capital
account regulations relate to the policy roles of capital account regulations.
In addition, historically, capital controls have played a deeper, transformative
role as well. Here, capital controls accompany more profound changes in the
underlying political and economic structure of society, often by facilitating
a major shift in economic and political power from one group in society to
another, thereby making feasible a more dramatic change in the overall struc-
ture of the political economy which, in some cases, can (but do not necessar-
ily) lead to a more egalitarian and sustainable order (Epstein 2010). Examples
of these transformative roles include the case of South Korea following the
Second World War when controls on out?ows complemented their crucial
50 A Pardee Center Task Force Report | March 2012
land reform policies that transformed the agrarian and political structure in
the country.
5
Of course, the transformational, the macroeconomic, and the developmental
roles of capital out?ow regulation need not and, indeed, are usually not mutually
exclusive. Keynes’ views, as described by James Crotty, are especially instruc-
tive here. In his 1983 Journal of Economic Literature article titled “On Keynes
and Capital Flight,” Crotty showed that in a period spanning the 1930s and into
the 1940s—virtually up to the time of his death—Keynes was very skeptical that
nations could achieve full employment and social transformation as long as they
were integrated into a world of highly mobile capital. He therefore thought that
controlling international capital mobility was a requirement for bringing about
both better macroeconomic management and achieving social transformation.
Crotty quoted Keynes: “Indeed, the transformation of society, which I preferably
envisage, may require a reduction in the rate of interest towards the vanish-
ing point within the next thirty years. But under a system by which the rate of
interest ?nds a uniform level, after allowing for risk and the like throughout the
world under the operation of normal ?nancial forces, this is most unlikely to
occur” (Keynes 1933, p. 762). Earlier in the essay Keynes argued that: “Advisable
domestic policies might be easier to compass if the phenomenon known as the
‘?ight of capital’ could be ruled out” (Keynes 1933, p. 757).
Apart from the distinction among macroeconomic, developmental and transfor-
mational capital account regulations, it also makes a difference who is imple-
menting these policies. Here we have two distinctions: 1) the ?rst is whether
they are being implemented on a national or an international (or internationally
coordinated) basis; and the second, is whether these out?ow regulations are
being implemented by economically small countries or regions, or whether they
are being implemented by countries or regions that are large with respect to the
world economy.
5 Checci was perhaps the ?rst economist to look at the relationship between capital controls and income distri-
bution. He found that in countries that had capital controls, income distribution were more equal. (Checci 1996).
The most thorough study of the relationship between capital controls and income distribution is that of Lee and
Jayadev (2005). They ?nd that capital account liberalization reduces the labor share of income in most parts of the
world (and therefore, capital controls, all else equal, increase the labor share of income). Epstein and Schor (1992)
showed the capital out?ow (and in?ow) controls in the OECD were associated with lower unemployment. Hence,
there is good evidence that capital mobility represents the power of capital relative to labor.
Regulating Global Capital Flows for Long-Run Development 51
Again, as with the transformational function of regulations, these issues of coor-
dination and who is implementing the regulations are likely to be particularly
important at a time of widespread crisis and structural change.
In what follows, I brie?y discuss the macroeconomic policy roles of out?ow
regulations, turn to the developmental roles, and ?nish up with a brief discus-
sion of possible out?ow regulations by the United States to enhance the bene?ts
and limit the costs of expansionary monetary policy in the current context.
MACROECONOMIC POLICY ROLE OF CAPITAL OUTFLOW REGULATIONS
While it is dif?cult to neatly separate out the macroeconomic policy role and the
developmental role of capital out?ow regulations, one can identify a number of
key macroeconomic objectives of these regulations (see Table 1, and Epstein,
Grabel and Jomo 2008).
These include:
• Preserving scarce foreign exchange to avoid foreign exchange or balance of
payments crisis.
• Protecting monetary policy autonomy to facilitate lower interest rates than
are prevailing internationally to promote higher investment and higher
employment. For example, this would make it easier for a country to pursue
an expansionary monetary and credit policy in a global slump without losing
excessive amounts of foreign exchange.
• The threat of putting on out?ow controls could limit excessive in?ows.
• Reducing out?ows of hot money that would leave the country saddled with
foreign denominated liabilities and that could contribute to domestic insolven-
cies and debt problems more generally.
• To help protect ?nancial stability by limiting the build-up of risky counter-
party obligations with respect to complex derivative positions.
6
• To help prevent corruption, tax evasion and other illegal activities that involve
capital ?ight (see Boyce and Ndikumana, 2011, for the case of African countries).
• To help manage multinational corporation domestic obligations with respect
to re-investment and pro?t allocations.
6 See Crotty and Epstein (2010) especially with respect to the case of India. Thanks due to Governor Reddy for
sharing his expertise on these regulations.
52 A Pardee Center Task Force Report | March 2012
Studies of the response of both China and India to the Asian ?nancial crisis and
the 2007–2008 global economic crisis indicate that their controls on out?ows, as
well as in?ows, contributed
to their ability to weather the
slump more effectively than
other countries. (e.g., Icard
2002; Ocampo in this volume).
Of course, other factors played
an important role, includ-
ing large foreign exchange
reserves, and the limitations
on foreign liabilities. These points suggest that sensible macroeconomic policies,
as well as effective capital in?ow regulations, can be important complements to
the successful use of capital out?ow tools.
An additional reason for capital out?ow regulations is to reduce capital ?ight
that is associated with corruption and tax evasion. For example, Ndikumana and
Boyce document that sub-Saharan Africa experienced an exodus of more than
$700 billion in capital ?ight since 1970, a sum that far surpasses the region’s
external debt outstanding of roughly $175 billion. Some of the money wound up
in private accounts at the same banks that were making loans to African govern-
ments. (Ndikumana and Boyce 2011; Boyce and Ndikumana 2011.)
DEVELOPMENTAL ROLE OF CAPITAL OUTFLOW REGULATIONS
The development role of capital out?ow regulation is arguably even more
important than the macroeconomic policy role, important as this can be in
certain circumstances. Nembhard’s study of South Korea and Brazil, Zysman’s
work on Western Europe and Japan, and Hersh’s work on China are particularly
illuminating. The key lesson of this work is that capital out?ow regulations are
an essential part of a policy regime that involves industrial policy or industrial
targeting and the use of credit allocation techniques to promote investment and
productivity in particular areas. Without such capital out?ow regulations, it is dif-
?cult to use subsidized credit to promote investment without risking the massive
leakage of the credit abroad.
Nembhard documents how, in the case of South Korea, these capital controls
worked because they were part of an entire policy regime of industrial policy,
credit allocation, and seriously enforced capital out?ow controls. Similar regimes
held sway in China, Japan, India, and several European countries following the
Studies of the response of both China and
India to the Asian ?nancial crisis and the
2007–2008 global economic crisis indicate
that their controls on out?ows, as well
as in?ows, contributed to their ability to
weather the slump more effectively than
other countries.
Regulating Global Capital Flows for Long-Run Development 53
Second World War. As Alice Amsden details, combined with development banks
and key monitoring tools to reduce the leakages, corruption and inef?ciency,
such as export targets and associated sticks and carrots, these policies were
often very effective in promoting developmental goals (Amsden 2001).
As Nembhard details, these are not always successful of course. She recounts
the case of Brazil in the 1970s and ‘80s where poor design and lack of follow
Country Achievements Supporting Factors Costs
Malaysia 1998 -facilitated
macroeconomic
reflation
-helped to maintain
domestic economic
sovereignty
-public support for
policies
-strong state and
administrative
capacity
-dynamic capital
management
-possibly contributed
to cronyism and
corruption
India -facilitated incremental
liberalization
-insulated from
financial contagion
-helped preserve
domestic saving
-helped maintain
economic sovereignty
-strong state and
administrative
capacity
-strong public support
for policies
-experience with state
governance of the
economy
-success of broader
economic policy
regime
-gradual economic
liberalization
-possibly hindered
development of
financial sector
-possibly facilitated
corruption
China -facilitated industrial
policy
-insulated economy
from financial
contagion
-helped preserve
savings
-helped manage
exchange rate and
facilitate export-led
growth
-helped maintain
expansionary macro-
policy
-helped maintain
economic sovereignty
-strong state and
administrative
capacity
-strong economic
fundamentals
-experience with state
governance of the
economy
-gradual economic
liberalization
-dynamic capital
management
-possibly constrained
the development of
the financial sector
-possibly encouraged
non-performing loans
-possibly facilitated
corruption
Chap 4 Table 1
Table 1: Summary: Assessment of the Capital Management Techniques
Employed During the 1990s
Source: Epstein, Grabel and Jomo, 2008.
54 A Pardee Center Task Force Report | March 2012
through hindered these policies with results much less favorable than those of
South Korea.
INTEREST EQUALIZATION TAX: CAPITAL OUTFLOW CONTROLS AND
EXPANSIONARY POLICY BY THE RESERVE CURRENCY COUNTRY?
The Federal Reserve’s expansionary monetary and credit policy—the only expan-
sionary policy currently undertaken by the United States despite the high unem-
ployment and stagnant economy—has raised controversy in developing countries,
out of concern that a ?ood of U.S. capital is ?owing abroad and generating
over-valued exchange rates, ?nancial instability, and in?ation risks elsewhere.
Gallagher (2011a) has proposed that the U.S. implement capital out?ow regula-
tions to limit the harmful out?ow of credit and make the expansionary monetary
policy more effective in the U.S. itself. Like in the case of other developmentally
oriented out?ow regulations discussed above, these could complement credit
allocation policies designed to generate more employment and investment (see
Pollin 2011, for example).
In the late 1960s the U.S. government imposed an interest equalization tax (IET)
to reduce dollar out?ows to complement more expansionary monetary and
?scal policy. Most economists who studied the capital out?ow regulations con-
cluded that they were ineffective. But careful archival work showed that part of
the reason was that there were bank and MNC lobby-induced loopholes created
that made the policy porous (Conybeare 1988).
With the United States’ ?nancial institutions awash in excess liquidity that spills
over into speculative investments abroad, policies to channel domestic liquidity
in employment creating, productive investments in the U.S. would be desirable,
both from the point of view of the bulk of the U.S. population and of those coun-
tries outside of the U.S. who are receiving large amounts of “hot money” ?ows.
As an element of such a policy toolkit, it is time for the United States govern-
ment to consider an interest equalization tax to reduce the debilitating carry-
trade emanating from relatively low interest rates in the United States.
Regulating Global Capital Flows for Long-Run Development 55
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Money and Lost Lives.” Triple Crisis blog, 20 October. Available athttp://triplecrisis.
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Development. New York: Oxford University Press.
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Keynes, and Crotty. eds. New York: Routledge.
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nomic and Political Weekly. 7 May.
Gallagher, Kevin (2011b). “Regaining Control? Capital Controls and the Global Financial
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755–69.
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the Labor Share of Income: Reviewing and Extending the Cross-Country Evidence,”
in Gerald Epstein, ed. Capital Flight and Capital Controls in Developing Countries.
Northampton, MA: E. Elgar Press.
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Implications for Monetary Autonomy and Capital Liberalization,” BIS Working
Paper, No. 233. August. Basel, Switzerland: Bank for International Settlements.
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South Korea and Brazil. Westport, Conn: Praeger.
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58 A Pardee Center Task Force Report | March 2012
Regulating Global Capital Flows for Long-Run Development 59
Section II: Implementing and Monitoring
Effective Regulation
5. Dynamic Capital Regulations, IMF Irrelevance
and the Crisis
Ilene Grabel
In this essay, I focus on the resurrection of capital controls during the on-going
global ?nancial crisis.
1
The new capital controls that are emerging across devel-
oping countries have three attributes:
(1) They vary within and across countries.
(2) They have been deployed in a dynamic fashion. By this I mean that the scope
and modality of the controls have been adjusted in response to changes in the
national and global economic environment, and identi?ed channels of evasion.
(3) Controls have often ?gured into multi-pronged efforts to address diverse and
serious economic challenges.
In some cases (such as Iceland), policymakers have used controls on out?ows
to slow the implosion of the economy. In other cases (such as Latvia) controls
have been used to address a narrow but acute vulnerability. And in others (such
as Brazil and South Korea), policymakers have deployed and “?ne-tuned” in?ow
controls to mitigate the appreciation of their currencies, cool asset bubbles,
and reduce ?nancial fragility and in?ation.
2
These latter challenges have been
aggravated by the large capital in?ows to rapidly growing economies, which
have resulted in part from low interest rates in the U.S. and the Eurozone and
divergent growth prospects across the globe. And in still other cases (e.g., China),
the ?ne-tuning of controls on both in?ows and out?ows during the crisis is con-
sistent with long-standing commitments to manage ?nancial ?ows in the service
of broader development objectives.
1 The discussion here of capital controls, policy space and the IMF draws heavily on Grabel (2011a). See this
paper as well for citations to the literature.
2 Indeed, capital controls have emerged as a key weapon of choice in the modern day “currency war.” See Grabel
(2011b, 2011c, 2010).
60 A Pardee Center Task Force Report | March 2012
Policymakers in a signi?cant group of developing countries have availed them-
selves of the new policy space that they enjoy to regulate international capital
?ows. This change in the policy landscape has occurred against the backdrop
of the rise of increasingly
autonomous states in the
developing world, geographi-
cally curtailed IMF in?u-
ence, and recognition (albeit
inconsistent at times) by Fund
staff that capital controls are a “legitimate part of the policy toolkit” (to invoke a
now frequently used phrase in Fund reports).
3
As each country deploys capital
controls with no ill effects on investor sentiment and no ?nger wagging by the
IMF, it becomes easier for policymakers elsewhere to deploy the controls they
deem appropriate. And they are doing so. Indeed, capital controls have emerged
during the crisis as the “new normal.”
One aspect of the autonomy that some states now enjoy is their resistance to the
IMF’s new interest in developing a code or guidelines governing the appropri-
ate use of capital controls. Indeed, the Fund’s position on capital controls has
become increasingly irrelevant as developing countries now enjoy the policy
space to introduce and adjust capital controls without waiting for the institution.
It is, in my view, critical that efforts be made to maintain and expand the oppor-
tunity that has emerged in the crisis environment for national policymakers to
experiment with capital controls and other measures.
DYNAMIC CAPITAL CONTROLS DURING THE CURRENT CRISIS:
A BRIEF SURVEY
The current crisis has achieved in a hurry something that heterodox economists
have been unable to do for a quarter-century. It has provoked policymakers in
a large number of developing countries to experiment with a variety of types of
capital controls, often framing them simply as prudential policy tools (akin to
what Epstein, Grabel and Jomo (2004) termed “capital management techniques”
and what the IMF (Ostry et al. 2011; IMF 2011a; Habermeirer et al. 2011) now
calls “capital ?ow management”).
3 See Grabel (2011a) on the productive incoherence that has emerged in the context of the current crisis. Also
note that more broadly, this rupturing of the old ?nancial order is consistent with broader changes that suggest
that the global ?nancial architecture is becoming multi-nodal and heterogeneous (see Grabel, 2012).
Policymakers in a signi?cant group of de-
veloping countries have availed themselves
of the new policy space that they enjoy to
regulate international capital ?ows.
Regulating Global Capital Flows for Long-Run Development 61
Controls in Countries in Distress
Iceland was the ?rst country to sign a Stand-by-Arrangement (SBA) during the
current crisis. What is most notable about the Icelandic SBA is that it includes
provisions regarding the need for stringent capital controls, something that we do
not ?nd in earlier SBAs that the IMF signed in connection with East Asian coun-
tries or in other crises during the neo-liberal era. Even more surprising, the SBA
provided for controls even on capital out?ows. Iceland’s controls were initially
imposed prior to the signing of the SBA in October 2008, though the agreement
with the Fund made a very strong case for their necessity and maintenance as
means to restore ?nancial stability and to protect the krona from collapsing.
The IMF’s stance with respect to Iceland’s capital controls initially appeared
anomalous. But it soon became clear that it marked a dramatic precedent. For
example, the SBA with Latvia of December 2008 allowed for the maintenance
of pre-existing restrictions arising from a partial deposit freeze at Parex, the
largest domestic bank in the country (IMF 2009a). Soon thereafter, a joint World
Bank-IMF report (2009: Table 1.4) on the current crisis notes without evaluation
that six countries (China, Colombia, Ecuador, Indonesia, the Russian Federa-
tion, and Ukraine) all imposed some type of capital control during the crisis.
Another Fund report acknowledges that Iceland, Indonesia, the Russian Fed-
eration, Argentina, and Ukraine all put capital controls on out?ows in place to
“stop the bleeding” related to the crisis (IMF 2009b). These reports neither offer
details on the nature of these controls nor commentary on their ultimate ef?cacy,
something that further suggests that capital controls—even and most notably on
out?ows—are increasingly taken for granted by the Fund.
Controls in Countries Faced with Too Much of a Good Thing
Policymakers in a far larger set of developing countries have deployed and
adjusted capital controls in response to the macroeconomic pressures and
vulnerabilities aggravated by large capital in?ows. These controls illustrate the
policy space that is increasingly being appropriated in developing countries that
remain independent of the Fund.
Brazil is a particularly interesting case since the country’s government (particu-
larly its Finance Minister, Guido Mantega) has been such a strong voice on the
matter of policy space for capital controls. The IMF’s changing stance regarding
Brazil’s capital controls also provides a window on both the evolution and con-
tinued equivocation in the views of Fund staff on the matter of capital controls.
62 A Pardee Center Task Force Report | March 2012
In late October 2009, Brazil imposed capital controls via a tax on portfolio
investment. The controls were self-described as modest, temporary, and market-
friendly; they were intended to slow the appreciation of the currency in the face
of signi?cant international capital in?ows to the country. Initially they involved
a 2 percent tax on money entering the country to invest in equities and ?xed-
income investments, while leaving foreign direct investment untaxed. Once it
became clear that foreign investors were using purchases of American Depository
Receipts (ADRs) issued by Brazilian corporations to avoid the tax, the country’s
Finance Ministry imposed a 1.5 percent tax on certain trades involving ADRs.
The IMF’s initial reaction to Brazil’s controls on capital in?ows was ever so mildly
disapproving. A senior of?cial said: “These kinds of taxes provide some room
for maneuver, but it is not very much, so governments should not be tempted
to postpone other more fundamental adjustments. Second, it is very complex to
implement those kinds of taxes, because they have to be applied to every pos-
sible ?nancial instrument,” adding that such taxes have proven to be “porous”
over time in a number of countries. In response, John Williamson and Arvind
Subramanian indicted the IMF for its doctrinaire and wrong-headed position on
the Brazilian capital controls, taking the institution to task for squandering the
opportunity to think reasonably about the types of measures that governments
can use to manage surges in international private capital in?ows (Subramanian
and Williamson 2009). A week later the IMF’s Dominique Strauss-Kahn reframed
the message on Brazil’s capital controls. The new message was, in a word, stun-
ning: “I have no ideology on this”; capital controls are “not something that come
from hell” (cited in Guha 2009).
The Brazilian government has continued to strengthen and indeed layer new types
of controls over existing ones in its ongoing effort to deal with a high volume of
in?ows and as of?cials seek to close new channels of evasion. For example, in
October 2010, Brazil twice strengthened the capital controls it ?rst put in place
in October 2009. The new Brazilian controls triple (from 2 to 6 percent) the tax it
charges foreign investors on investments in ?xed-income bonds. The Brazilian
controls tax foreign equity purchases at a lower rate (i.e., the same 2 percent rate
that has been in place since 2009), and foreign direct investment is still not taxed at
all. This is a particularly good example of ?ne-tuning controls so that they affect the
composition, rather than the level of foreign investment. (Indeed, numerous recent
IMF reports, as well as those by scholars such as Gallagher 2011a, make note of a
composition effect in Brazil.) In March 2011 Brazil imposed new capital controls,
this time on foreign purchases of domestic farmland, a measure that analysts
Regulating Global Capital Flows for Long-Run Development 63
suggest was aimed at curbing China’s growing land purchases in the country. In
the same month, Brazil increased to 6 percent a tax on repatriated funds that are
raised abroad through international bond sales and new, renewed, renegotiated,
or transferred loans with a maturity of up to two years (the previous limit was up
to 360 days). In August 2011, policymakers added to its existing array of controls
a 1 percent tax on bets against the U.S. dollar in the futures market, after the real
reached a 12-year high. Brazilian of?cials are also set to provide $16 billion in
tax breaks and to tighten trade barriers to protect manufacturers hurt by imports
from China (which have been stimulated by the strength of the real). Notably, in an
August 2011 review of Brazil, IMF economists called the government’s use of capital
controls “appropriate” (Ragir 2011).
4
Brazil is one among many developing countries wherein policymakers are imple-
menting and dynamically adjusting capital controls against a backdrop of large
in?ows. For example, in December 2008, Ecuador implemented a number of
measures governing in?ows and out?ows. In terms of out?ows, it doubled the tax
on currency out?ows, established a monthly tax on the funds and investments
that ?rms kept overseas, and also sought to discourage ?rms from transferring
U.S. dollar holdings abroad by granting tax reductions to ?rms that re-invest their
pro?ts domestically. In terms of in?ow controls, the government established a
reserve requirement tax (Tussie 2010).
5
In December 2009, Taiwan imposed new
restrictions on in?ows in order to reduce speculative pressures from overseas
investors. The controls preclude foreign investors from placing funds in time
deposits. In the same month, China added to its existing controls on in?ows and
out?ows. In June 2010, Indonesia announced what its of?cials awkwardly term a
“quasi capital control” that governs short-term investment. Indonesia’s in?ow con-
trols seek to dampen speculation in the country via a one-month holding period
for central bank money market securities, the introduction of longer maturity
instruments, and new limits on the sales of central bank paper by investors and
on the interest rate on funds deposited at the central bank.
South Korean of?cials also began to introduce capital controls on in?ows in June
2010. Regulators have since continued to widen them to reduce the risks associated
with a possible sudden reversal of in?ows, rising short-term foreign borrowing,
and the use of derivative instruments. The controls limit the amount of currency
4 Curiously in the same month Canadian Prime Minister Harper used some of his time in the country inexplicably
to lecture the government about the need to dismantle capital controls (Mayeda 2011).
5 As Tussie (2010) notes, what is particularly interesting about Ecuador’s measures is that they demonstrate that
even a dollarized country has more policy space than is usually understood.
64 A Pardee Center Task Force Report | March 2012
forward and derivatives trading in which ?nancial institutions can engage, and
limit the foreign currency loans extended by banks to local companies. Since
October of 2010, regulators have audited lenders working with foreign currency
derivatives. Finally, in April 2011 South Korea levied a tax of up to 0.2 percent
on holdings of short-term foreign debt by domestic banks (with a lower tax
levied against longer term debts). In August 2011, South Korea’s government
announced that it is reviewing “all possibilities” on curbing capital in?ows.
Thailand also began to deploy capital controls in October 2010: authorities intro-
duced a 15 percent withholding tax on capital gains and interest payments on
foreign holdings of government and state-owned company bonds. In the same
month, Argentina and Venezuela implemented controls on out?ows: in Argen-
tina they involve stricter limits on U.S. dollar purchases, and in Venezuela they
involve new restrictions on access to foreign currency. Peru has been deploying
a variety of in?ow controls since early 2008. The country’s reserve requirement
tax (which is a type of control on capital in?ows) has been raised three times
between June and August 2010. Finally, in August 2011, of?cials in the Philip-
pines announced that they are prepared to impose new controls (in the form of
prudential limits on certain kinds of transactions by banks) to reduce the volatil-
ity in the peso after it rose to a three-year high.
National Policy Divergence
It bears noting that not all policymakers are responding to the pressures of large
capital in?ows with capital controls. Turkish, Chilean, Mexican, and Colombian
policymakers have publicly rejected capital controls as a means of dealing with
the appreciation of their currencies.
6
This is not to suggest that policymakers in
these countries are sitting on the sidelines while their currencies appreciate and
asset values balloon. Instead, they have stepped up their purchases of dollars
and, in some cases, are using monetary policy to try to stem the appreciation of
their currencies.
National divergences in response to similar pressures re?ect many factors, not
least of which are differing internal political economies, the continued sway
of neo-liberal ideas in some countries, and perhaps also pride associated with
dealing with the problem of an excessively strong currency in countries that
have so long faced the opposite problem. There may also be skepticism about
the ef?cacy of these measures, especially since—until quite recently—Brazil’s real
6 Interestingly, in October 2010 the director of the IMF’s Western Hemispheric department made a case (unsuc-
cessfully) for the use of controls in Colombia owing to the rapid appreciation of its currency (Crowe 2010).
Regulating Global Capital Flows for Long-Run Development 65
appeared almost unstoppable in its appreciation despite the many measures
taken since 2009.
ARE NATIONAL MEASURES SUFFICIENT?
Will the range of strategies deployed by governments and central banks across
the developing world solve the problem they aim to address? No, and indeed,
in the absence of viable, representative, and coordinated mechanisms of global
economic management, we may descend into a period of nationalist, beggar-thy-
neighbor policies. But in the short-term at least the strategies help protect (even
if only modestly) developing countries from the negative trade effects of cur-
rency appreciation and the other risks associated with large capital in?ows. And
evidence suggests that these measures have at least partly achieved their chief
objectives (IMF, various reports, 2010, 2011; Gallagher 2011a). More importantly,
the unilateral steps that policymakers are taking help to solidify the growing
international sentiment against unregulated capital ?ows and light touch ?nan-
cial regulation.
The current crisis is exposing clearly the dangers associated with a unilateral
policy free-for-all in ?nancial matters, and the need for a new regime of coordi-
nated monetary and exchange rate policy and the protection of national policy
space. It may be that more
common ground on policy
space is emerging between
some Northern and Southern
policymakers, owing to the
fact that policymakers in
wealthy “safe haven countries”
(namely, Canada, Switzerland,
Australia, New Zealand, and Singapore), are confronting some of the challenges
that have frustrated their Southern counterparts. As a consequence, coordinated
cross-national responses to managing the surges in international capital ?ows
may yet be coming, as new alliances form among the diverse countries now fac-
ing the hardships attending currency appreciation.
FOR ADVOCATES OF ENHANCED POLICY SPACE
In late 2010 and 2011 the IMF provided us with an interesting vantage point
from which to observe the continuing tension within the institution on capital
controls. In several reports, Fund staff note that the institution is seeking to
The current crisis is exposing clearly the
dangers associated with a unilateral policy
free-for-all in ?nancial matters, and the need
for a new regime of coordinated monetary
and exchange rate policy and the protection
of national policy space.
66 A Pardee Center Task Force Report | March 2012
develop standards for the appropriateness of different types of controls (IMF
2010, 2011a, 2011b; Ostry et al. 2011; Habermeirer et al. 2011). The current
discussion of developing standards for controls was also given life by the French
government, which seemed eager to use its new leadership of the G-20 and G-8
in early 2011 to give the Fund a role in coordinating capital controls via a code
or mandate on the subject (Hollinger and Giles 2011). The issue has since fallen
off the European agenda as the Eurozone lurches from one crisis to the next.
But the fact that the IMF tested the waters on the matter of controlling capital
controls is instructive. Far more instructive is the fact that Brazil and numerous
developing countries in the G-24 unequivocally and quite publicly rejected any
such role for the Fund (Wagstyl 2011; Reddy 2011; G-24 2011; Gallagher 2011b).
Notably, the Fund has not issued a public response to this rebuke by developing
countries.
Whether the IMF seizes this opportunity and how it comes to interpret this pos-
sible new charge is of critical importance to advocates of national policy space
for capital controls (and other measures). It will be important for Fund watchers
to stay on this issue and continue to advocate coordination that does not pre-
sume a norm of liberalization. We can also hope that those developing countries
that have used capital controls so successfully will resist any effort to expand the
IMF’s authority around such a norm. Certainly there is much in the IMF’s own
actions and of?cial statements by the institution’s key ?gures during the current
crisis to call upon should we ?nd that momentum builds around rewriting the
institution’s new position on capital controls.
Any new regime that attempts to coordinate capital controls must preserve the
policy autonomy to make continued ?ne-tuning possible. The two fundamental
challenges for any new regime is to preserve and indeed maximize national
policy space for experimentation and to ?nd ways to extend this policy space to
less autonomous states in the global South (see Rodrik 2001, 2007: ch. 8 on the
WTO). Barring any substantial change in the global political economy, only some
developing countries will be positioned to take advantage of the new policy
autonomy that has emerged at present. The most dif?cult policy challenge will
therefore be to address the most pressing needs of those states that lack the
resources, geopolitical power and/or inclination to pursue an equitable, stable
developmentalist path.
Regulating Global Capital Flows for Long-Run Development 67
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70 A Pardee Center Task Force Report | March 2012
Regulating Global Capital Flows for Long-Run Development 71
6. How to Evade Capital Controls . . . and Why They
Can Still Be Effective
Shari Spiegel
There is a growing consensus that capital account regulations can be used by
developing countries to help promote economic stability. The IMF, which used
to promote open capital markets, now supports the use of capital ?ows manage-
ment, at least under certain circumstances (Ostry et al. 2010, 2011). Many coun-
tries, including the U.S., have used regulations to restrict cross border ?ows in
the past. With the increase in global liquidity following the 2008 economic crisis,
a number of developing and emerging market countries have implemented, or
are considering implementing, such regulations.
In designing capital account regulations, policymakers generally try to target
short-term capital ?ows, while leaving the current account, areas of the capital
account, and sometimes the derivatives markets unregulated. However, leav-
ing some external accounts open leaves room for circumvention of regulations
through these areas. The goal of this paper is to present some of the mechanisms
used for circumvention,
to better understand their
impact on the effectiveness
of regulations. Although
more research is needed, our
analysis indicates that coun-
tries with successful capital
account management regimes
have been able to dynamically adapt regulations to correct loopholes, and that
better monitoring of open areas of external accounts and derivatives markets
can give policymakers the necessary tools.
There is an ongoing debate on the impact of this circumvention, with some
economists claiming that it makes the regulations ineffective. There are, how-
ever, costs associated with circumvention, which are an implicit tax on the inves-
tor. Circumvention will likely occur whenever the incentives for evasion exceed
The question for policymakers should not
be whether regulations can be circumvent-
ed, but what the cost of circumvention is,
and whether or not the cost is large enough
to serve as a disincentive to a signi?cant
portion of short-term investors.
72 A Pardee Center Task Force Report | March 2012
these costs. The question for policymakers should not be whether regulations
can be circumvented, but what the cost of circumvention is, and whether or
not the cost is large enough to serve as a disincentive to a signi?cant portion of
short-term investors. More broadly, capital account regulations should be seen
as tools to reduce surges in short-term cross-border ?ows rather than necessarily
stopping these ?ows altogether.
Research on mechanisms to circumvent regulations is limited, in large part
because market participants who engage in these practices do not want to pub-
licize their activities. In one of the few studies in this area, Carvalho and Garcia
(2008) interview investors in Brazil in the 1990s and document some of the mea-
sures used to evade capital controls during this period. In their analysis, the cost
of circumvention is based on estimates of the administrative costs of setting up
the vehicles used for evasion. We argue, however, that administrative costs are
just one element of the actual cost to the investor. The cost of circumvention is
ultimately dependent on supply and demand, with the gain from evading regula-
tions often shared between the investor and a ?nancial intermediary.
The rest of this paper is divided into three sections. The ?rst section discusses
the cost of evasion. The second presents three types of mechanisms used for
circumvention:
1) traditional forms of evasion through the current account, including over- or
under-invoicing of trade receivables;
2) evasion through open areas of the capital account, focused on disguising
restricted ?ows as unrestricted ?ows;
3) evasion through derivatives markets, by which investors create synthetic
instruments.
The ?nal section concludes with policy recommendations, emphasizing the
importance of simple, but ?exible, regulations that allow policymakers to adapt
interventions to changing circumstances. Regulations should be designed to cut
the link between cross-border ?ows and the domestic market and dis-incentivize
domestic agents from becoming ?nancial intermediaries. Monitoring of ?ows
throughout the ?nancial system—something regulators should be doing anyway
to maintain stability in other areas of the ?nancial system—is key to designing an
effective regulatory regime.
Regulating Global Capital Flows for Long-Run Development 73
The Cost of Circumvention
1
Assume that country Z is attracting large in?ows of short-term capital due to
high growth coupled with high relative interest rates. Three-month interest
rates in the investors’
2
home country are 1 percent for the year (or .25 perent for
a 3-month period), whereas the expected return on a three-month investment
in country Z is 5 percent, re?ecting higher interest rates and expected currency
appreciation. To limit the surge in in?ows the government of country Z imposes
a 4.5 percent tax on short term ?xed income capital in?ows. After-tax returns on
the three-month investment are now only slightly higher than the .25 percent
return in the home country, but with greater risk since the expected currency
appreciation might not materialize due to the foreign exchange tax, as well as
counterparty, local settlement, legal, and other risks. The investors, who still
want to capture high country Z domestic returns, look for ways to get around the
tax, and ?nd a local counterparty that is willing to facilitate circumvention at a
cost of around 2 percent. The expected return on the new investment would now
be just under 3 percent, which is still signi?cantly above home country expected
returns. However, the 3 percent return doesn’t necessarily compensate investors
for local market risks. It deters some, but not all, investors.
From the government’s perspective, the tax is marginally successful. The govern-
ment doesn’t earn signi?cant tax revenue, but it does succeed in slowing the
pace of in?ows. However, if the currency starts to strengthen, expected returns
might increase and investors will be tempted to put the trade back on, weaken-
ing the regulations further. In order to understand how to respond to a new wave
of capital ?ows, the government has to better understand how the 2 percent cost
is derived.
The cost of evasion is a function of three factors: administrative costs, the number
of intermediaries, and the size of any penalties. Administrative costs represent
the costs of setting up the vehicles for evasion, such as shell companies, listings
on stock exchanges, etc. This is often a ?xed cost, and represents the minimum
cost of evasion. Although there are exceptions, many foreign investors,
3
especially
large hedge funds, pension funds and mutual funds, lack the local knowledge and
personnel to set up these vehicles on their own. They rely on local intermediaries
1 This section focuses on costs associated with taxes on in?ows, but quantity restrictions and restrictions on
out?ows will have similar effects.
2 We use the term “investors” to cover the wide range of ?nancial market players, including short-term
speculators.
3 We generally refer to foreign investors, though the pool of investors also includes domestic investors.
74 A Pardee Center Task Force Report | March 2012
for this role. In general, the intermediary charges the foreign investor a mark-up
on the administrative costs. Though it varies by country, there is often a limited
group of local intermediaries that are considered creditworthy enough for foreign
investors to be willing to use them as their counterparties. Local intermediaries
are therefore often able to maintain monopoly power and charge rents. In the
example above, the 2 percent cost represents the administrative costs plus this
rent. If the currency starts weakening and foreign in?ows decline, the intermedi-
ary might lower his price from 2 to 1 percent. If, on the other hand, the currency
continues to strengthen, attracting additional in?ows, the ‘monopoly price’
might be raised to 3 percent, which is still lower than the of?cial tax. This simple
example represents how the ‘gray’ market works, with the government tax being
split between the foreign investor and the intermediary.
One way to decrease circumvention is to reduce incentives for local institutions
to act as intermediaries. Many forms of circumvention are illegal and have high
penalties associated with them, often at multiple times the potential gain. Even
when circumvention is completely legal, governments can put pressure on local
agents, such as local ?nancial institutions, to reduce their willingness to act as
intermediaries. The question for policymakers is how to identify the loopholes,
and design policies to increase the cost of circumvention. The answer to this
question depends on the methods of evasion used.
How to Evade Controls
As discussed above, we divide mechanisms for circumvention into three
categories: current account transactions; capital account transactions, such as
disguising restricted ?ows to look like unrestricted ?ows; and derivatives. In the
following section we discuss a range of mechanisms in each category. We note
that for each mechanism discussed, authorities across countries were able to
dynamically respond by strengthening regulations to address the loopholes. In
particular, as the size of evasion grows so that circumvention becomes a more
signi?cant problem, regulators are able to track it more easily, and adapt regula-
tions in response.
CIRCUMVENTION THROUGH THE CURRENT ACCOUNT:
OVER- AND UNDER-INVOICING
Over- and under-invoicing is the most typical form of circumventing capital con-
trols via the current account. This mechanism has generally been used as a way
for domestic entities to evade restrictions on capital out?ows. An importer who
Regulating Global Capital Flows for Long-Run Development 75
wants access to foreign exchange can over-invoice his or her imports to obtain
more foreign exchange than he or she needs, which would then be invested
abroad. Over-invoicing
imports would imply higher
tariff payments at customs,
but would also imply lower
reported net income, and
therefore lower income tax
payments. Similarly, export-
ers could under-invoice, thus obtaining foreign exchange to invest abroad while
reducing their income for tax purposes.
This method can also be used to evade restrictions on in?ows. Under-invoicing
imports and over-invoicing exports allows ?rms to bring additional foreign
exchange into the country, but it also raises pro?ts and therefore subjects the ?rms
to higher taxes. In many countries this tax loss can be signi?cant. For example, with
a corporate tax of 20–25 percent, an investor would need the investment to return
25–33 percent to just break even on the trade (assuming zero funding costs)
4
. None-
theless, there is evidence that this mechanism became increasingly used, especially
in countries with strong administrative controls, such as China (The Economist
2008), which have fewer alternative opportunities for circumvention.
However, as this form of evasion became increasingly signi?cant, it also became
easier for of?cials to identify and respond. In 2008, Chinese of?cials tightened
restrictions on loopholes, even though China was in the process of liberalizing
its capital account in other areas at the time. To prevent companies making false
claims, Chinese regulators, the commerce ministry, and customs authorities
linked their computer systems to check underlying transactions and eliminate
discrepancies between proceeds from exports and reported receipts for foreign
exchange, and forbid banks from buying the foreign exchange when large dis-
crepancies are identi?ed (Yu 2009).
CIRCUMVENTION THROUGH THE CAPITAL ACCOUNT:
DISGUISING RESTRICTED INVESTMENTS
A major form of circumvention through the capital account has been to disguise
restricted investments (i.e., the short-term ?ows) as unrestricted investments
(such as FDI, trade ?nance, or sometimes tradable equity).
4 This also assumes that the investor doesn’t engage in other forms of tax evasion, such as creating false
expenses to reduce pro?ts.
Over- and under-invoicing is the most typical
form of circumventing capital controls via the
current account. This mechanism has gener-
ally been used as a way for domestic entities
to evade restrictions on capital out?ows.
76 A Pardee Center Task Force Report | March 2012
Foreign Direct Investment and Tradable Equity
Carvalho and Garcia (2008) documented how this mechanism was used in Brazil
in the 1990s, through FDI and listed equities. Financial intermediaries created
wholly-owned shell companies as public corporations listed on the Sao Paulo
Stock Exchange (BOVESPA). International capital ?ows were invested in equity
of the company, which was not subject to controls. The shell company then pur-
chases short-term ?xed income instruments, with the earnings sent back abroad
as pro?t or dividends. The ?nancial intermediary also declared the investment
as FDI to take advantage of tax holidays. A similar scheme was to set up a
wholly-owned company listed on the BOVESPA and to manipulate the price so
that there would be a loss for tax purposes. Disguising short-term investments
as FDI has also been used to circumvent restrictions in other countries, such as
Chile and China. For example, in China foreign investors would bring in funds in
excess of what was needed for investment purposes. These funds would then be
invested in short-term Chinese interest rates.
As in the current account example, regulators should be able to detect this type
of evasion, especially when it becomes signi?cant enough to reduce the effec-
tiveness of regulations. For example, the stock market in Brazil, the BOVESPA,
is one of the largest stock exchanges in the world. Nonetheless, even on the
BOVESPA, shell transactions might stand out. For example, since 2004, there
was only one issue with less than 5 investors and brokers.
5
Similarly, the central
bank of Chile detected this type of activity in the Chilean market and subjected
any investment that was a “potentially speculative direct investment” to the cur-
rency tax, which had the effect of reducing evasion (Carvalho and Garcia 2008;
Stiglitz et al. 2006). In China, as part of the 2008 reforms, regulators tightened
requirements on how foreign exchange entering via the FDI account can be
used, and enacted strict sanctions and penalties for evasion (Yonding 2009). It is
interesting to note that prior to the strengthening of regulations, analysts warned
that stricter regulations on FDI would limit investment in China. Yet, despite the
tightened controls in 2008, China experienced record amounts of FDI in 2010
(Bloomberg News 2011).
More broadly, there has been growing evidence of ‘?nancialization’ of FDI
(including investments by the companies into ?xed income instruments and
loans between parents and subsidiaries), which appear to carry greater risks
than green?eld FDI (Ostry et al. 2010). Rather than responding on a piecemeal
5 Calculations based on the BOVESPA website.
Regulating Global Capital Flows for Long-Run Development 77
basis, appropriate policy response might be to expand regulations to incorporate
these types of in?ows, which are ?nancial in nature, but are categorized as FDI.
For example, companies could pay an up-front tax on all investment, but be able
to recoup the payment after a period of time deemed to be ‘long-term.’ Although
this could add to the cost of doing business in a country, the impact would be
small in the context of the bigger investment. Alternatively, policymakers could
tax dividends or pro?ts sent abroad, which could be targeted to short-term gains
or to gains from ?xed income investments. More broadly, policymakers should
better monitor FDI ?ows, to better distinguish between ?nancial FDI and longer-
term green?eld investment.
Trade Finance
Another example of disguising ?ows in Brazil in the 1990s was through trade
?nance (Carvalho and Garcia 2008). This case is particularly interesting since it
illustrates how the gains from circumvention are often shared between the local
intermediary and the foreign investor. Exporters in Brazil could set up accounts
to borrow funds for up to one year before shipping merchandise, at low rates.
Foreign investors who bought the rights to these accounts had access to the low
interest loans, and could invest the proceeds in short-term securities without
having to bring money on-shore. Demand for this mechanism led to a black
market in trade ?nance rights for short-term investing, and a few banks actually
set up trading companies specialized in trade ?nancing to take advantage of this
strategy (Carvalho and Garcia 2008). However, the rate earned on these accounts
was below the government interest rate. Carvallo and Garcia point out that
one reason for this was that “foreign investors seeking the high return in Brazil
offered capital at interest rates below the country’s base rate due to restrictions
on other investment means.” In other words, the exporters acted as the ?nancial
intermediaries, and shared the gains from circumvention with the foreign inves-
tor. However, this form of circumvention was less of an issue for regulators since
the trades were ?nanced by local currency loans and did not affect the exchange
rate, or bring dollars into the domestic market. The trades did increase leverage
in the system, but this should be dealt with through prudential regulations.
Similarly, in China, export ?rms often receive an advance from foreign buyers
for up to a year, which could be invested on-shore in short-term interest rate
products. To prevent this access from being sold for a pro?t, the 2008 regulations
required ?rms to present contracts to show that the advance is necessary, and
ceilings have been imposed on the maximum advance size.
78 A Pardee Center Task Force Report | March 2012
Derivatives Markets
Derivatives are particularly potent instruments for circumvention because inves-
tors can create synthetic instruments to mimic domestic investments without
actually moving funds across borders. While authorities can monitor and regu-
late domestic derivatives markets, offshore markets are harder to assess. None-
theless, trades in offshore markets are generally offset in the domestic market,
which means that local regulations can still effect these investments.
Non-deliverable Forwards (NDFs)
The simplest derivative product used to access local market interest rates
offshore are NDFs. An NDF is a forward currency trade whereby the investor
buys one currency (say the Brazilian real) and sells another currency (the base
currency, which is often USD, EUR, or JPY) at an agreed-upon rate for settlement
at some point in the future, say one, three or six months. However, instead of
exchanging currencies at the settlement date, the counterparties calculate the
gain or loss in the base currency, e.g., USDs, and settle the trade in that currency
offshore. The NDF creates a synthetic short-term interest rate investment, funded
by borrowing in the base currency. The difference between onshore interest rates
and those implied in the NDF market is a good indicator of how well exchange
controls are working. If the two rates are relatively close, this is a sign that
foreigners are able to offset their risk with local counterparties fairly easily and
gain access to local market interest rates. If the implied interest rate in the NDF
market is signi?cantly below the local market rate, as was the case, for example,
in Indian rates during the 1990s, it is a sign that controls are effective at keeping
foreign investors from accessing the domestic short-term ?xed income market.
If an offshore derivatives market were to have signi?cant interest from both buy-
ers and sellers, it is possible that an offshore market could develop separately
from the domestic market. However, in most cases, investors in these markets
are speculating, with most investors on the same side of a trade—either putting
on a carry trade, buying local currency during bubbles, or shorting a currency
during a crisis. A 2005 Federal Reserve Bank of New York study (Lipscomb 2005)
found that 60 to 80 percent of NDF volume is generated by speculative interests,
with increasing participation from hedge funds. International ?nancial institu-
tions generally act as market-makers, which means they tend to offset their
positions either through the brokers market, or directly with onshore institu-
tions, often with their local branches. For example, a New York branch of a
major international bank could enter an NDF with a hedge fund, by which the
Regulating Global Capital Flows for Long-Run Development 79
fund buys 100 million dollars worth of Thai Bahts (THB). The bank would then
be short THB, which it might buy from its local branch. However this trade can
be done via internal accounting without actually bringing the dollars on-shore.
In other words, an important loophole exists when transactions between foreign
banks and their branches are not monitored and regulated.
The local branch is now short THB and long USD, so it would go into the local
market and sell USD and buy THB Treasuries to cover its short position. In the
end, the NDF position is transferred to the books of the local bank. The goal of
the regulators is to break the link between the offshore and onshore markets.
During the Asian crisis Malaysia did just this. Malaysia initially experienced cir-
cumvention of its controls through the offshore NDF market. In response, authori-
ties instituted regulations on domestic banks, which restricted them from trans-
acting directly with foreign institutions. These regulations cut the link between
the domestic and offshore market, and successfully limited the transfer of risk
from local balance sheets to offshore players. More recently Korea took a ?rst step
at limiting open FX derivative positions of local banks with the goal of limiting
the transmission from the offshore market, though the measures were somewhat
narrow in scope as they allowed corporates to hedge their risk offshore, and
didn’t completely sever the link between the onshore and offshore markets.
An alternative structure that’s similar to an NDF is a structured note. These are usually
issued at an off-shore banking center and can be designed to give the foreign investor
offshore access to domestic interest rates. Further, these measures can be designed to
include embedded additional leverage that is not necessarily obvious to regulators.
American Depository Receipts (ADRs) and Equity Swaps
Back-to-back operations can also be done in the equities market through ADRs.
6
In this case, the foreign investor buys an ADR ?nanced with a repurchase agree-
ment—known as a “repo”—in New York. At the same time, the local intermediary
sells the same stock with a reverse repo in the local market.
7
The difference in
?nancing rates between the repo and the reverse repo captures the difference
between U.S. and foreign rates.
6 ADRs represent equity in a foreign stock, but are traded on a U.S. exchange.
7 A repurchase agreement, or repo is, is the sale of securities with an agreement for the seller to buy back the
securities at a later date. In essence the seller is borrowing short-term funds at an agreed upon interest rate. A re-
verse repo is the same transaction from the buyer’s perspective. The buyer is lending short-term funds at an agreed
upon interest rate. In this example, the repo is ?nanced in USD while the reverse repo is invested in local currency.
80 A Pardee Center Task Force Report | March 2012
A similar structure exists in the equity swap market. In this market, a foreign
investor can buy an offshore equity swap from a domestic resident who can
hedge without the tax. Such offshore equity swap markets exist for Malaysia,
Korea, and Thailand.
In all of these examples, investments are made offshore, but ultimately hedged
locally. Authorities monitoring the domestic market should be able to respond
to these types of circumvention by regulating the onshore activities. For exam-
ple, in response to widespread use of the ADR arbitrage, the Brazilian central
bank instituted high penalties on this trade. However, it is not necessary for
authorities to target a particular trade. In Colombia, regulators used prudential
regulations to restrict foreign currency exposure and gross positions in foreign
currency derivatives of the domestic ?nancial intermediaries (Ostry et al. 2011),
thus limiting the ability of domestic ?nancial institutions to engage in these
types of trades. Monitoring transactions between banks and their subsidiaries,
and subjecting these to regulations, would help reduce the ability of agents to
circumvent restrictions. Insisting that all such off-balance-sheet transactions with
foreign investors are reported on the balance sheet of ?nancial market players
could help to monitor these types of transactions.
Onshore Derivatives Markets
Local derivatives markets provide more direct opportunities for circumvention,
especially when these markets are open to foreign investors. A foreign investor
who wants exposure to domestic interest rates can purchase a derivative instru-
ment without bringing funds onshore.
8
An example of derivatives that could be
used to circumvent restrictions on short-term investments would be deliverable
forward currency contracts and options strategies. Similar to forwards, option
strategies can be used to create a synthetic investment in local market instru-
ments.
9
Another example of a structure to get around restrictions on short-term
debt would be a long-term bond with embedded options that can be exercised in
the short-term.
Many developing and emerging markets still have relatively undeveloped deriva-
tives markets. Countries that have more developed derivatives markets, such as
Brazil, have taken measures to incorporate this market in the broader regulatory
environment. In response to a growth in some of these strategies in the 1990s,
8 Or bringing only small portion of the notional value of the trade onshore for margin requirements.
9 For example, ‘box options’, which are two puts and two calls, with the price on the strike date ?xed create a
synthetic local market investment.
Regulating Global Capital Flows for Long-Run Development 81
the Brazilian central bank initially subjected synthetic ?xed income trades to
the same regulations as direct ?xed income investments (Carvallo and Garcia
2008). In 2011, Brazil attempted to regulate the derivatives market more broadly
by subjecting all derivatives trades to a 2 percent tax. Although this tax is low
relative to expected returns, it represents an initial step in regulating derivatives
and has the added bene?t of helping regulators collect better information about
positions and be able to better monitor the market.
CONCLUSION
There is still an open debate on whether capital account regulations should be
temporary mechanisms (Ostry et al. 2011) or part of a permanent regime to be
strengthened or weakened depending on the economic environment. Those who
support temporary measures argue that capital account regulations become inef-
fective over the long run and are, at best, short-term tools to deal with temporary
surges in in?ows (Ostry et al. 2011). We argue that a permanent but ?exible
regime, based on simple rules, may be the best choice for many countries.
The effectiveness of capital account regulatory regimes has varied, with some
experiences more successful than others. Regulations have been most effective
in countries with stricter controls across different types of capital ?ows and in
countries with existing controls so that the administrative apparatus is already in
place (Ostry et al. 2010). The cost of building necessary administrative support is
not negligible, and it’s often dif?cult to design and implement effective programs
during crises or bubbles, when vested interests are apt to oppose them.
Although more research is needed, our preliminary analysis of different forms
of circumvention seems to indicate that countries are able to dynamically
strengthen regulations over time in ways that enhance stability. In general,
countries that are thought of as having the most successful regimes have all
maintained ?exible regulations, which they adapted to changes in the economic
environments, as well as to opening of loopholes. In both Chile and Colombia in
the 1990s, policymakers reacted strongly to new loopholes in existing regula-
tions by modifying the details of the framework (Stiglitz et al. 2006). In China
and Brazil, policymakers strengthened regulations when various forms of eva-
sion become more signi?cant. In Malaysia, policymakers responded to evasion
through the offshore market by strengthening regulations on domestic banks.
Dynamic management of regulations does not mean that policymakers should be
expected to always respond to changes in markets in a timely manner; markets
82 A Pardee Center Task Force Report | March 2012
move quickly and it usually takes regulators time to adjust to the changes,
even in developed markets. Nonetheless, markets give signals when evasion is
increasing. Monitoring is crucial to this process; when circumventions grow, an
alert regulatory body should
be able to detect them and
adjust regulations accord-
ingly. By monitoring ?nancial
markets—something regula-
tors should already be doing
to maintain the stability of
the ?nancial system in other
areas—they should be better able to dynamically adjust regulations in response to
market developments over time. It is often argued that circumvention is particu-
larly a problem in better-developed markets, such as those with active derivative
markets. While this is true, these markets should give regulators more tools (such
as clearing houses) to monitor ?ows and thus dynamically design interventions.
More broadly, cross-border ?ows represent only one set of risk factors in the
?nancial system, and should not be treated as any less of an issue for surveil-
lance than other ?nancial market transactions. Monitoring open areas of the cur-
rent account, capital account, and derivatives markets where circumvention can
occur, is crucial to being able to identify circumvention as it becomes signi?cant.
Many cross-border ?ows go through the banking system, but other non-bank
institutions, such as the big trading companies, which often have their own capi-
tal ?nancing groups are also part of the market. Regulators need to include all
institutions that act as ?nancial intermediaries under their regulatory umbrella.
Better monitoring of capital account ?ows can have the added bene?t of reduc-
ing tax evasion more broadly, as well as providing information to policymakers
on other risks in the economy.
By monitoring ?nancial markets—some-
thing regulators should already be doing to
maintain the stability of the ?nancial system
in other areas—they should be better able to
dynamically adjust regulations in response
to market developments over time.
Regulating Global Capital Flows for Long-Run Development 83
REFERENCES
Auguste, Sebastion and Katherine Dominguez, Herman Kamil, and Linda Tesar (2005).
“Cross-Border Trading as a Mechanism for Implicit Capital Flight: ADRs and the
Argentine Crisis.” Research Seminar in International Economics, University of Michi-
gan, Discussion Paper No. 533.
Bloomberg News (2011). “Foreign Direct Investment in China in 2010 Rises to Record
$105.7 Billion,” 17 January. Available at Bloomberg.com,http://www.bloomberg.
com/news/2011-01-18/foreign-direct-investment-in-china-in-2010-rises-to-record-
105-7-billion.html.
Carvalho, Bernardo S. de M., and Márcio G. P. Garcia (2008). “Ineffective Controls on
Capital In?ows under Sophisticated Financial Markets: Brazil in the Nineties,” in S.
Edwards and M. Garcia (eds.), Financial Markets Volatility and Performance in Emerg-
ing Markets. Cambridge, Mass: National Bureau of Economic Research.
Clements, Benedict, and Herman Kamil (2009). “Are Capital Controls Effective in the
21st Century? The Recent Experience of Colombia,” IMF Working Paper, WP/09/30.
Washington, D.C.: International Monetary Fund.
Coelho, Bruno and Kevin Gallagher (2010). “Capital Controls and 21st Century Financial
Crises: Evidence from Colombia and Thailand,” PERI Working Paper No. 213. Uni-
versity of Massachusetts–Amherst: Political Economy Research Institute.
The Economist (2008). “Capital In?ows to China; Hot and Bothered,” 26 June. Available
athttp://www.economist.com/node/11639442.
Garber, Peter M. (1998). “Derivatives in international capital ?ow.” NBER Working Paper
No. 6623, June. Cambridge, MA: National Bureau of Economic Research.
Habermeier, Karl, Annamaria Kokenyne, and Chikako Baba (2011). “The Effectiveness
of Capital Controls and Prudential Policies in Managing Large In?ows,” IMF Staff
Position Note SDN 11/14 Washington, D.C.: International Monetary Fund.
Lipscomb, Laura (2005). “An Overview of Non-Deliverable Foreign Exchange Forward
Markets,” 25 May. Federal Reserve Bank of New York. Available athttp://www.bis.
org/publ/cgfs22fedny5.pdf.
Magud, Nicolas, Carmen Reinhart, and Kenneth Rogoff (2006). “Capital Controls: Myth
and Reality: A Portfolio Balance Approach to Capital Controls,” unpublished, Cam-
bridge, Mass.: Harvard University.
Ocampo, José Antonio and Camilo Tovar (2003). “Colombia’s Experience with Reserve
Requirements on Capital In?ows.” CEPAL Review Nº 81: 7–31.
84 A Pardee Center Task Force Report | March 2012
Ocampo, José Antonio, Shari Spiegel, and Joseph E. Stiglitz (2008). “Capital Market Lib-
eralization and Development,” in J. A. Ocampo and J. E. Stiglitz (eds.), Capital Market
Liberalization and Development,” New York: Oxford University Press.
Ostry, Jonathan D., Atish R. Ghosh, Karl Habermeier, Luc Laeven, Marcos Chamon,
Mahvash S. Qureshi, and Annamaria Kokenyne (2011). “Managing Capital In?ows:
What Tools to Use,” IMF Staff Position Note 11/06. Washington, D.C.: International
Monetary Fund.
Ostry, Jonathan D., Atish R. Ghosh, Karl Habermeier, Marcos Chamon, Mahvash S.
Qureshi,and Dennis B. S. Reinhardt (2010). “Capital In?ows: The Role of Controls,”
IMF Staff Position Note 10/04. Washington, D.C.: International Monetary Fund.
Ostry, Jonathan, Ghosh, Atish R. and Chamon, Marcos (2011). “Managing Capital
In?ows: The Role of Capital Controls and Prudential Policies.” NBER Working Paper
No. w17363. Cambridge, Mass.: National Bureau of Economic Research. Available at
SSRN:http://ssrn.com/abstract=1919437.
Stiglitz, Joseph E., José Antonio Ocampo, Shari Spiegel, Ricardo Ffrench Davis, and
Deepak Nayyar (2006). Stability with Growth: Macroeconomics, Liberalization and
Development. New York: Oxford University Press.
Yu, Yongding (2009). “The Management of Cross-Border Capital Flows and Macroeco-
nomic Stability in China,” TWN Global Economy Series. Penang, Malaysia: Third
World Network.
Regulating Global Capital Flows for Long-Run Development 85
7. China’s Capital Controls:
Stylized Facts and Referential Lessons
Ming Zhang
After the full liberalization of its current account in 1996, China began to liberal-
ize its capital account in a gradual and cautious way. From the capital ?ow cat-
egory perspective, the control on direct investment has already been removed,
but portfolio investment and short-term debt are still regulated tightly. From
the capital ?ow direction perspective, the intention of the Chinese government
on capital control is determined by the real direction of capital ?ow at current
stage. For example, during the 1990s when China had a limited foreign exchange
reserve and faced capital out?ow pressure, the government adopted an “easy in,
dif?cult out” strategy. However, during the 2000s when China had already accu-
mulated a huge foreign exchange reserve and had been facing dramatic capital
in?ow, the government turned to an alternative “easy out, dif?cult in” strategy.
The counter-cyclical style of China’s capital control strategy demonstrates the
government’s effort to avoid vast capital out?ow or in?ows.
China’s capital account has already been partially opened (Table 1). According
to People’s Bank of China (PBC), by the end of 2010, inside the 40 speci?c items
under capital account transactions classi?ed by IMF, 12 percent had been fully
opened, 20 percent had been basically opened, 43 percent had been partially
opened, and the remaining 25 percent had not been opened yet (Ge 2011).
The Chinese government has already removed the major obstacles on inward
and outward direct investment, thinking that direct investment is very stable
and productive. FDI can ?ow in freely as long as the foreign enterprises get
permission from the Ministry of Commerce, and the FDI companies can remit
their legal pro?ts to their home country as they want. By the end of 2010, the
Chinese government had approved the establishment of over 680 thousand FDI
companies and had utilized over $1.1 trillion USD foreign capitals (Sun 2011).
The Chinese government began to allow domestic enterprise to make overseas
direct investment in 2001, whereas China’s outbound direct investment has been
accelerated since 2008. By the end of 2010, Chinese enterprises had established
86 A Pardee Center Task Force Report | March 2012
over 160 thousand ?rms overseas, and the accumulated investment amount
reached $259 billion USD (Sun 2011).
The Chinese government has been very cautious to loosen the control of port-
folio investment, let alone ?nancial derivatives, because portfolio capital ?ow
tends to be more volatile and speculative. The experience of Southeast Asia’s
?nancial crisis had strengthened the above belief. The typical approach has been
to set quotas for inward and outward portfolio investment. On the one hand, a
Quali?ed Foreign Institutional Investor mechanism (QFII) was established in late
2002 to introduce overseas portfolio investment. By the end of 2010, the Chinese
State Administration of Foreign Exchange (SAFE) had approved 97 foreign inves-
tors to enter domestic capital markets and the cumulative investment reached
$19.7 billion USD (Sun 2011). On the other hand, a Quali?ed Domestic Institu-
tional Investor mechanism (QDII) was founded in early 2006 to allow domestic
?nancial institutions to invest in global ?nancial markets. By the end of 2010,
Market
Inflow Outflow
Money Market Residents Prior approval by PBC and
SAFE
No permission except for
authorized entities
Non-Residents No permission No permission
Stock Market Residents List H/N/S shares abroad,
repatriate of QDII
QDII
Non-residents B shares, QFII, RMB QFII Sell B shares, repatriate of
QFII and RMB QFII
Bond and
Other Debts
Residents Prior approval by PBC and
SAFE
No permission except for
authorized entities
Non-residents QFII, RMB QFII Repatriate of QFII and
RMB QFII
Derivatives
and Other
Instruments
Residents Operations by financial
institutions are subject to
review of qualifications
and to limit on foreign
exchange position
Operations by financial
institutions are subject to
review of qualifications
and to limit on foreign
exchange position
Non-residents No permission No permission
Note to typesetting: This table goes in Chapter 7 as Table 1
Table 1: China’s Capital Account Controls (As of September 2011)
Sources: Yu 2007 and we made some revisions.
Note: H/N/S refers to Hong Kong/New York/Singapore stock markets. RMB is the Chinese currency.
See page v for full list of abbreviations.
Regulating Global Capital Flows for Long-Run Development 87
SAFE had approved 88 domestic investors to invest overseas and the accumula-
tive scale reached $68.4 billion USD.
The Chinese government has been employing different treatments to foreign and
domestic enterprises in cross-border debt ?nancing. As for debt in?ows, foreign
enterprises are allowed to borrow freely for many years as long as total foreign
liability does not exceed the gap between the registered capital and the invest-
ment amount, but quali?ed domestic enterprises did not get the permission to
borrow short-term foreign debt under quotas until early 2010. As for debt out-
?ows, Chinese commercial banks have been authorized to lend overseas since
2008, and quali?ed domestic enterprises have been approved to lend money to
their overseas subsidiaries since 2009.
After the global ?nancial crisis, the Chinese government has been promoting
RMB internationalization aggressively. Therefore, the further liberalization of the
Chinese capital account from then on has been overlapping with the measures
to develop an offshore RMB ?nancial center. The existing and potential progress
includes: First, Chinese ?nancial institutions were allowed to issue RMB bonds in
Hong Kong in 2007, and the issuers have gradually expanded to domestic enter-
prises, Chinese Ministry of Finance, Hong Kong’s ?nancial institutions and enter-
prises, and even transnational companies. Second, certain RMB-holding foreign
?nancial investors (including foreign central banks, Hong Kong’s RMB settlement
banks and participation banks) were allowed to invest on China’s domestic bond
market. Third, a RMB QFII mechanism will be established to facilitate foreign
institutional investors to invest on China’s domestic ?nancial markets with RMB.
Fourth, Chinese households will be authorized to invest exchange-traded funds
based on Hong Kong’s stock market.
Why has China taken a gradual and cautious approach to liberalize its capital
account? First, the Chinese government prefers a more independent monetary
policy because China is a large economy and has a different business cycle
compared with United States. Considering the RMB exchange rate is still in?ex-
ible against U.S. dollar, if China’s capital account is fully opened, PBC could do
nothing but import the Fed’s monetary policy. Second, Chinese ?nancial markets
are still underdeveloped and domestic investors are signi?cantly inexperienced.
They could not afford the drastic boom and bust of asset prices resulting from
huge capital in?ow and out?ow. If there is a similar ?nancial crisis in China, the
consequence will be much more serious than in the United States. Third, capital
control has been a key element in Chinese characteristic ?nancial repression,
88 A Pardee Center Task Force Report | March 2012
which underpins the dominating investment-driven growth strategy. By limit-
ing Chinese households and corporations to invest on overseas portfolios, the
Chinese government could maintain very low deposit and loan interest rates,
which boosts the heavy investment of state-owned enterprises and local govern-
ment on manufactures and infrastructures. Fourth, China’s economic reform has
not been completed and the property rights still need to be de?ned more clearly.
Lots of Chinese wealthy people (some of them are corrupted of?cials or entrepre-
neurs with ‘original sin,’ a situation where nations are not able to borrow abroad
in their domestic currency) fear that their properties may be nationalized some
day. Once the capital account is fully opened, there might be a massive capital
out?ow, even accompanied by money laundering and asset stripping (Yu 2007).
Is China’s capital control still effective? The majority voice from the recent
literatures shows that, although there are some leakages, China’s capital account
control is still effective to a large extent. For example, Ma and McCauley (2008)
found the sustained and signi?cant gaps between onshore and offshore RMB
interest rates and persistent USD/RMB interest rate differentials, which re?ected
the ef?cacy of China’s capital account control. In another example, Otani et al.
(2011) discovered that the empirically quanti?ed strength of capital control (by
increasing the transaction costs of cross-border ?nancial transactions) was con-
sistent with the Chinese government’s intention to in?uence capital movements.
There is other evidence about the ef?cacy of China’s capital control. In the ?rst
half of 2008, China faced a dramatic short-term capital in?ow (Figure 1). To
mitigate the capital in?ow, the Chinese government has adopted three measures:
?rst, a data exchange program was established between the Customs, the Minis-
try of Commerce, and SAFE to screen the capital in?ow through transfer pricing
in foreign trade, namely high export-invoicing and low import-invoicing; second,
anther data exchange program was founded between the Ministry of Commerce,
SAFE, and commercial banks to check whether the registered capitals or loans
of foreign enterprises ?ow into domestic asset markets; third, the government
began to investigate and punish cross-border underground banking businesses
extensively and severely. These measures achieved an instant and signi?cant
effect. From June of 2008, the short-term capital in?ow declined dramatically.
After the bankruptcy of Lehman Brothers, China began to face short-term capital
out?ows, and therefore the government loosened them. However, under the global
excess liquidity exacerbated by collective quantitative easing, China has been fac-
Regulating Global Capital Flows for Long-Run Development 89
ing a new wave of short-term capital in?ow since late 2009. Therefore the focus of
Chinese capital control turned to dealing with massive capital in?ow again.
Are there any referential lessons that could be drawn from China’s experience
of capital control for other developing countries? First, in comparison with other
emerging market economies such as Chile or Brazil that prefer price measures
in capital control, China prefers quantitative measures instead, especially on
quotas and administrative approvals. On the one hand, this demonstrated that
China’s liberalization of capital accounts still lags behind the above economies
signi?cantly. On the other hand, because the quantitative measures tend to make
more distortions than price measures, China is suffering a much higher welfare
cost than Chile or Brazil in executing capital controls. Therefore, in the future
China may turn to more price-oriented capital control tools such as unremuner-
ated reserve requirements and withholding taxes.
Second, it seems that the Chinese government does not follow the prescriptions
made by the IMF about how to deal with capital in?ow. The IMF suggested that
the countries should take a three-tool approach to handle capital in?ow: the
macroeconomic policies, the macroprudential regulations, and the capital con-
trols. Capital control should not be a replacement but a complement to proper
macroeconomic and macroprudential policies (IMF 2011). However, China does
Figure 1: China’s Short-term International Capital Flow
Notes: The monthly short-term international capital ?ow is calculated by the monthly foreign ex-
change purchase by PBC minus the sum of monthly trade surplus and FDI utilized, which is a very
rough estimation of high frequency short-term capital in?ow.
Sources: CEIC and the author’s calculation.
90 A Pardee Center Task Force Report | March 2012
not satisfy the criteria of using capital control tools directly. On the one hand, the
Chinese government hasn’t utilized all the necessary macroeconomic tools to
manage capital in?ow, especially the exchange rate appreciation. According to
the IMF, the systematic macroeconomic policy responses toward capital in?ow
include: tight ?scal policy, interest rate cut, exchange rate appreciation and
sterilized intervention. As for China, in order to mitigate the negative impacts of
the global ?nancial crisis and promote domestic structural adjustment, the ?scal
policy should be properly expansionary. To ?ght in?ation pressure, PBC has to
raise interest rates. PBC has been doing sterilized intervention heavily in the past
several years.
The only available tool for PBC to adopt now is a faster appreciation of the RMB
exchange rate. However, the concerns that a fast RMB appreciation might hurt
export and employment, and a fast RMB appreciation may result in an even
higher appreciation expectation thus leading to exchange rate overshooting,
dominated the debate among policymakers. The probability for a signi?cantly
faster appreciation of RMB remains low. On the other hand, China has a long
way to go in operating appropriate macroprudential regulations. Although the
Chinese major commercial banks got a good overhaul in the early 2000s, after
the burst of global ?nancial crises, the banks lent heavily to local government to
make infrastructure investments, which might bury the seed of a new wave of
non-performing loans after several years. Besides that, there are still lots of ?nan-
cial fragilities in domestic ?nancial sectors, and this may be why the Chinese
government could not afford faster capital account liberalization.
Third, China still faces the challenge of sequencing capital account openness
and the liberalization of the interest rates and exchange rates. Some economists
argue that, due to the resistance of interest groups, it is very dif?cult to complete
the liberalization of interest rates and exchange rates in the short-term, there-
fore the Chinese government should speed up the opening of its capital account
?rst. Ideally and theoretically, the fast liberalization of the capital account will
exert external pressure on the government to further liberalize interest rates and
exchange rates. However, if the capital account is fully opened before the liber-
alization of interest rates and exchange rates, there will be a signi?cant interest
rate spread between domestic and overseas markets and a strong RMB apprecia-
tion expectation, which will no doubt arouse more dramatic short-term capital
in?ow. The volatile and speculative capital in?ow will exacerbate the domestic
excess liquidity, thus leading to asset price bubbles and in?ation pressure ?rst. If
the capital in?ow suddenly stops or even reverses in the future, there will prob-
Regulating Global Capital Flows for Long-Run Development 91
ably be a devastating ?nancial crisis. Therefore, the liberalization of interest rates
and exchange rates should be a prerequisite for fully opening the Chinese capital
account. Moreover, the liberalization of interest rates and exchange rates could
improve resource allocation and promote the transition of growth model. The
Chinese government should try to overcome the resistance of interest groups,
and liberalize interest rates and exchange rates as soon as possible.
REFERENCES
Ge, Huayong (2011). “The Prerequisites and Strategies to Promote the Basically Convert-
ibility of Capital Account,” China Finance, No. 14, July.
International Monetary Fund (IMF) (2011). “Recent Experiences in Managing Capital
In?ows: Cross-Cutting Themes and Possible Policy Framework,” IMF Policy Paper,
February. Washington, D.C.: International Monetary Fund.
Ma, Guonan and McCauley, Robert N. (2008). “Ef?cacy of China’s Capital Control: Evi-
dence from Price and Flow Data,” Paci?c Economic Review, 13(1): 104–123.
Otani, Ichiro, Fukumoto, Tomoyuki and Tsuyuguchi, Yosuke (2011). “China’s Capital
Controls and Interest Rate Parity: Experience during 1999–2010 and Future Agenda
for Reforms,” Bank of Japan Working Paper Series, No.11-E-8, August. Tokyo: Bank of
Japan.
Sun, Lujun (2011). “The Openness of China’s Capital Account and Its Future Trajectory,”
China Finance, No. 14, July.
Yu, Yongding (2007). “Managing Capital Flows: The Case of the People’s Republic of
China.” Paper prepared for the Asian Development Bank Institute (ADBI) Project on
Capital Controls, December 12.
92 A Pardee Center Task Force Report | March 2012
Regulating Global Capital Flows for Long-Run Development 93
Section III: The Global Cooperation of Capital
Account Regulations?
8. The IMF, Capital Account Regulation, and
Emerging Market Economies
Paulo Nogueira Batista, Jr.
1
The international ?nancial crisis has led to a major revision of economic policy
recommendations since 2008. This revision, albeit un?nished, has affected a
large number of policy issues, including of course regulation and supervision.
The previous preference for light touch regulation and the faith in the self-
correcting virtues of free markets have been replaced by a renewed emphasis
on the role of governments and central banks in preventing speculative excesses
and the build-up of risks.
An important part of this debate is, or should be, the regulation of international
capital ?ows. Prior to the crisis, capital account liberalization was almost an
article of faith in some circles. The bene?ts of free capital ?ows were accepted
with no major reservations by many policymakers and international organiza-
tions. Capital controls were stigmatized.
This has changed to some extent. However, as José Antonio Ocampo pointed
out, there is a curious dichotomy in what is now mainstream thinking. The need
for strong regulation and supervision is generally recognized—and how could
it not be after what happened in the ?nancial systems of the United States and
Europe? But, curiously, this recognition does not extend in the same degree to
the regulation of international ?nancial ?ows. As Ocampo observed, cross-border
?nance has received much less attention, as if it did not require regulation—or
indeed as if it was not part of ?nance. I will come back to this point when I
1 Executive Director at the International Monetary Fund for Brazil, Colombia, Dominican Republic, Ecuador, Guy-
ana, Haiti, Panama, Suriname and Trinidad and Tobago. The views expressed in this paper should not be attributed
to the IMF or to the governments the author represents at the IMF’s Executive Board.
94 A Pardee Center Task Force Report | March 2012
address the hesitant nature of the International Monetary Fund’s recent shift
toward the acceptance of capital account regulations.
THE STANDARD APPROACH
Before the crisis broke out in 2007–2008, the standard approach recommended
to countries facing large-scale capital in?ows involved basically two aspects:
?scal adjustment and exchange rate appreciation. In addition, it was suggested
that restrictions on out?ows of capital be relaxed. That was the message that
countries received from the IMF, for example, but little else. Even international
reserve accumulation was frowned upon.
For example, Brazil had begun to accumulate reserves in earnest in 2006. This
would serve us well during the crisis. However, staff of the Fund in annual Article
IV consultations warned Brazil against excessive reserve growth.
Even at that time, the insuf?ciency of the standard approach—let the currency
rise and adjust ?scal policy—was relatively clear. Emerging market countries had
ample experience of the dangers of exchange rate overvaluation. A persistently
strong currency undermined the economy’s international competitiveness and
could lead to dangerously high current account de?cits. A sudden reversal of
capital ?ows—as often happened—forced economies to undergo painful adjust-
ment. In Latin America, perhaps more than in most other regions, boom-bust
cycles driven by international capital movements were an often-recurring
phenomenon.
Fiscal policy was not well placed to respond to large and volatile capital move-
ments. In theory, ?scal adjustment could allow looser monetary policy, lowering
the attractiveness of domestic ?nancial assets for foreign investors. In practice,
?scal policy is a slow, heavy, and clumsy instrument to deploy against fast-
moving and ?ckle capital ?ows. It is always subject to political constraints and
largely dependent on legislative approval. Also, one must bear in mind that
?scal policy has other objectives; it seems to make little sense to tie it to the
?uctuating moods of international investors.
Moreover, as has been noted by several analysts, there is what we could call “the
paradox of good fundamentals.” Fiscal adjustment, leading to an improvement in
public accounts and ?scal fundamentals, may strengthen con?dence and attract
further ?ows of capital from abroad.
Regulating Global Capital Flows for Long-Run Development 95
Removing restrictions on out?ows can help to somewhat alleviate upward pres-
sure on the exchange rate, if residents do take the opportunity to invest outside
the country. But this can also increase external vulnerability at a later stage,
facilitating capital ?ight in times of uncertainty and crisis.
OUTBREAK OF THE CRISIS
The weakness of the standard approach became glaring with the outbreak of
the crisis. The wall of liquidity produced by the expansionary monetary poli-
cies of the reserve currency issuing central banks—the Federal Reserve ?rst and
foremost, but also the European Central Bank, the Bank of Japan and the Bank
of England—contributed to create formidable problems for emerging market
countries. Emerging markets suffered less and recovered faster from the crisis—a
factor that reinforced their attractiveness for international investors. Growth and
interest rate differentials between emerging markets and advanced economies
combined to generate large ?ows of capital from the latter to the former.
Beyond these cyclical factors, there seems to be occurring a fundamental reas-
sessment of international risks in favor of emerging markets, i.e., a reallocation
of portfolios that may be leading to a longer-lasting increase in the supply of
capital to emerging markets. This has its positive sides of course, but many
emerging market countries will be dealing with an “embarras de richesses.”
One has spoken of the “curse of natural resources.” One could equally speak of
the “curse of the overabundance of capital ?ows.” One of the worst things that can
happen to a country is to fall into the good graces of international capital markets.
Since mid-2011, the worsening of the economic and ?nancial situation in the
advanced economies, notably in the euro area, highlights yet again that capital
in?ows can be a very mixed blessing. Changes in the availability of external
loans and investments can
happen quickly and unex-
pectedly. If the country receiv-
ing in?ows is unprepared,
these sudden reversals can
cause great damage to the economy and the ?nancial system. The euro area cri-
sis has not hit emerging markets with full force so far, but it led to an increase in
risk aversion and to a ?ight to so-called safe havens, generating some turbulence
and exchange rate depreciation.
One of the worst things that can happen to
a country is to fall into the good graces of
international capital markets.
96 A Pardee Center Task Force Report | March 2012
Now, there is still a widespread view that capital ?ows are of bene?t to recipient
countries. This view is not entirely wrong; one may well be able to construct a
plausible case in its favor. But the least one can say is that it often ?ies in the face
of experience. Quite a number of economies have been severely hurt, sometimes
literally destroyed, by imprudent capital account liberalization and surges in
capital ?ows. One has only to look to emerging countries in Eastern Europe for
recent examples. Iceland is another shocking case.
I would like to mention, in passing, that an often-unnoticed aspect of the euro
area crisis is the role played by the boom-bust cycle associated to free capital
movements. Abundant capital in?ows allowed pro-cyclical ?scal policies, rapid
credit growth, and high current account de?cits in the periphery of the euro
zone, as well as in Iceland and several emerging market countries in Eastern
Europe. The sharp reversal of ?ows after the 2008 crisis forced these economies
to undergo a wrenching adjustment process. As time goes by, we will probably
come to realize that capital account management policies may be necessary not
only in emerging markets but also in advanced economies.
THE NEED FOR CAPITAL ACCOUNT MANAGEMENT
Policymakers in emerging markets seem to be aware of the risks associated to
capital movements. Painful experiences have made them acutely conscious of
the dangers of external indebtedness and foreign capital. On the other hand, the
temptation remains to enjoy the good times, in the hope that “this time it will
be different.” In any case, many countries have been adopting measures to curb
in?ows or to safeguard against risks brought by them. The task, as we know, is
far from easy.
Reserve accumulation is an alternative. For many emerging market economies, it
has been extremely important as a mechanism of self-insurance against external
shocks. It has drawbacks, however. First, costs may be substantial, especially
when interest rate differentials are persistently high. With low interest rates in
the reserve currency issuing countries, the remuneration of reserves has fallen
substantially. Interest rates in developing countries tend to be higher. When ster-
ilized interventions fail to avoid appreciation of the national currency, losses for
the central banks tend to be high. This is particularly the case for Brazil, where
interest rates have been chronically very high.
Regulating Global Capital Flows for Long-Run Development 97
Moreover, reserve accumulation is yet another example of the paradox of strong
fundamentals: high reserves increase the perception that the country is safe and
this attracts further in?ows.
The conclusion seems inescapable: macroeconomic policies—?scal, monetary,
exchange rate, reserve accumulation—alone do not suf?ce. There is increasing
recognition that countries blessed or cursed with an overly abundant supply
of international capital will be well advised to resort to macroprudential mea-
sures and capital controls. To avoid the stigma attached to capital controls, the
IMF staff has recently used the expression “capital ?ow measures” (CFMs) that
encompass both macroprudential measures and capital controls.
IMF AND G-20 DISCUSSIONS OF CAPITAL ACCOUNT REGULATION
In 2010, the IMF belatedly recognized that capital controls and macroprudential
measures are “part of the toolkit” available to policymakers. This was a welcome
step. The Brazilian chair in the IMF had repeatedly called for a reconsideration
of the institution´s reluctance to accept that ?scal adjustment plus exchange rate
?exibility would not take care of the problems faced by countries overwhelmed
by surges in capital in?ows.
That said, the IMF´s recognition is still somewhat hesitant. In March 2011, the
Executive Board of the Fund discussed a “possible framework” for capital ?ow
management that was broadly endorsed by a majority of the Board, as a ?rst
round articulation of the institution´s views. This tentative framework leaves
much to be desired. For instance, capital account regulations are seen as a last
resort to be used after everything else has been tried. They are presented as
a possible complement and not a substitute for “sound macroeconomic poli-
cies.” They are recommended as temporary instruments, given that they can be
evaded as times go by. At the same time, and in contradiction to the previous
point, a big deal is made of possible externalities or spillovers of capital controls.
None of these quali?cations seem persuasive. For instance, macroprudential
measures and capital account regulations, adopted at a relatively early stage,
preferably in combination with other measures such as reserve accumulation,
may avoid the build-up of problems that become increasingly dif?cult to deal
with. Tools that can be used quickly, such as prudential measures and controls,
are instrumental in avoiding the development of such situations.
98 A Pardee Center Task Force Report | March 2012
Even amongst Fund staff, there is no consensus on these points. As the Fund’s
chief economist, Olivier Blanchard, observed in May, when he summarized a Rio
de Janeiro conference on capital ?ows, “we should move away from strict policy
orderings toward a more ?uid approach of using ‘many or most of the tools most
of the time’ instead of ‘this now, that later.’” This observation contradicts ?atly
one of the features of the “possible framework” endorsed by the Executive Board
in March. Blanchard also observed that evidence presented at the Rio conference
suggested that spillovers across recipient countries were not very large. “Theo-
retical and further empirical work is badly needed here,” he added.
In so far as effectiveness is concerned, the experiences of Brazil and other coun-
tries seem to show that prudential measures and capital account regulations can
at the very least moderate appreciation, lengthen the pro?le of external liabili-
ties, and improve the composition of capital in?ows. IMF staff has tended to
support this sort of preliminary conclusion in its studies of country experiences.
Despite the lack of ?rm knowledge in the staff of the IMF about many issues and
the lack of consensus in the Executive Board, Fund Management, supported by
most advanced countries, jumped the gun in March and had the Board endorse
the “possible framework” that I have alluded to. Does this help the membership
in any way? Not much I would say. It may even be counterproductive in the
end. Under the pretext of allowing capital account regulations in some limited
circumstances, the Fund may be seeking to extend its jurisdiction to the capital
account.
Under the Articles of Agreement of the IMF, member countries have no obliga-
tion whatsoever to liberalize capital account transactions. Legally speaking, they
enjoy full freedom to regulate capital movements. This does not apply to coun-
tries that have given up this freedom, in part or in total, by their membership of
the OECD, of the euro area, or that have signed bilateral investment agreements
or free trade agreements with the United States. Those cases apart, member
countries are entirely free, under Article VI of the Articles of Agreement, to
adopt capital controls. This Article states that “members may exercise such
controls as are necessary to regulate international capital movements.” Under
some circumstances, the Fund may even require them to adopt controls to avoid
the use of the institution´s resources to ?nance capital ?ight. This is exactly what
happened in the case of Iceland, a country hard hit by the severe impact of the
international crisis on its overblown ?nancial sector. Iceland requested ?nancial
Regulating Global Capital Flows for Long-Run Development 99
assistance from the Fund and controls on out?ows of capital became an impor-
tant part of the IMF’s program for Iceland.
Some advanced countries have been calling on the Fund to establish codes of
conduct or guidelines for the management of capital ?ows. President Nicolas
Sarkozy of France was particularly blunt about this when he launched the
agenda for the French presidency of the G-20 and the G-8 in January 2011. He
called for the establishment by the G-20 of a code of conduct and criticized
the “recent multiplication of unilateral measures” affecting capital movements.
President Sarkozy came back to the subject in even more forceful terms at the
opening of a G-20 Seminar in China, last March:
A code of good conduct, strong guidelines and a common framework gov-
erning the possibility of implementing capital controls where necessary
must de?ne the conditions under which restrictions on capital movements
are legitimate, effective and appropriate to a given situation. If we agree on
these rules, ladies and gentlemen, it will be a major evolution in the doc-
trine of the IMF, to the bene?t of the emerging countries, which suffer from
excessive volatility of capital movements. Is it reasonable, today, given the
increasing impact of capital movements, that the IMF can issue recom-
mendations to a country only as concerns its current account balance of
payments and not concerning its capital account? I would like someone to
explain to me why a recommendation about one is legitimate and a rec-
ommendation concerning the other is illegitimate. Expanding the super-
vision of the IMF to include theses aspects strikes me as crucial. In the
longer term, France—and I’m saying this now—is favorable to a modi?ca-
tion of the IMF’s Articles of Agreement to broaden its supervision mandate.
Yet if we decide on more coordination, more rules and more supervision,
we then need to decide which organization is in charge of enforcing such
rules and conducting such supervision. For France, it’s clear. It’s the IMF.
The Brazilian chair at the Fund and in the G-20 has been very critical of these
attempts to establish a framework or a “code of conduct” for capital account
management. The debate is still ongoing, but has lost some of its steam since
the beginning of the year. Time has shown that the focus of the IMF and some
advanced countries on guidelines or even a “code of conduct” for capital ?ow
measures was ill-timed and unnecessary. In that discussion, among many other
problems, insuf?cient consideration was given to “push” factors or to the poli-
cies in major advanced economies that produced large and often disruptive
100 A Pardee Center Task Force Report | March 2012
?nancial ?ows. As the IMF and the G-20 wasted precious time on this, the crisis
reemerged in the advanced countries, especially in the euro area, due to unsus-
tainable debt levels, fragile banking systems and, ironically, the after-effects of
the collapse of a credit boom driven by free capital ?ows.
The Brazilian chair in the IMF has argued that it would be highly inappropriate
and politically unsustainable to attempt to use the Fund´s skewed voting power,
which gives undue weight to advanced countries, to impose their agenda on
developing countries that are not willing to face any restrictions on the liberty to
manage the capital account.
There is a further irony here. Some of the countries that are at the epicentre of
the worst crisis since the Depression of the 1930s, and are still far from having
solved their own problems, seem very eager to promote the establishment of
codes of conduct for the rest
of the world, including for
emerging market countries
that are currently dealing
with overabundant liquidity
generated by the monetary
policies of these very same
countries. One is tempted to
say: put your own house in order before you start preaching to others again. It is
too early to forget that the previous round of preaching by developed countries—
deregulate, liberalize, trust markets, etc.—ended in tears for them and for those
developing countries that followed that preaching all too eagerly.
KEYNES AND WHITE
Free capital movements were not part of the IMF´s original mandate. Article
VI of the Articles of Agreement was there from the very beginning. Misguided
attempts to amend or suppress this Article in the late 1990s came to nothing.
At the time, the Brazilian chair at the IMF was among those who opposed the
attempt to impose capital account liberalization as an obligation.
Those who know the history of the IMF are aware that the founding fathers of
the institution, John Maynard Keynes and Harry Dexter White, had learned from
the acute instability caused by laissez-faire with respect to international capital
movements in the period between the World Wars. Keynes explained at the time
of the creation of the Fund that members would have “full liberty to control such
It is too early to forget that the previous
round of preaching by developed coun-
tries—deregulate, liberalize, trust markets,
etc.—ended in tears for them and for those
developing countries that followed that
preaching all too eagerly.
Regulating Global Capital Flows for Long-Run Development 101
movements.” Each country was given the choice to leave all transactions free or
to enforce controls. If it chose the latter, Keynes was of the view that it should be
left “to discover its own technique.”
Keynes and White were right, I believe. Since the global crisis, the pendulum has
swung again away from laissez-faire and towards recognition that strong regula-
tion and supervision of ?nancial activities are indispensable to the smooth and
ef?cient functioning of a market economy. Capital movements are no exception.
REFERENCES
Blanchard, Olivier (2011). “What I Learnt in Rio: Discussing Ways to Manage Capital
Flows,” summary of the conference on Managing Capital In?ows in Emerging Mar-
kets, organized by the Ministry of Finance of Brazil and the International Monetary
Fund, Rio de Janeiro, May.
Eyzaguirre, Nicolás, Martin Kaufman, Steven Phillips, and Rodrigo Valdés (2011).
“Managing Abundance to Avoid a Bust in Latin America,” IMF Staff Discussion Note,
SDN/11/07, April. Washington, D.C.: IMF.
Gallagher, Kevin P. (2011). “The IMF, Capital Controls and Developing Countries,” Eco-
nomic & Political Weekly, Vol. XLVI, No 19. May.
Habermeier, Karl, Annamaria Kokelyne, Chikako Baba (2011). “The Effectiveness of
Capital Controls and Prudential Policies in Managing Large In?ows,” IMF Staff Dis-
cussion Note, SDN/11/14, August. Washington, D.C.: IMF.
International Monetary Fund (1969). The International Monetary Fund 1945–1965,
Twenty Years of International Monetary Cooperation, Volume III: Documents, edited
by J. Keith Horse?eld, Washington, D.C.: IMF.
International Monetary Fund (2011). “Recent Experiences in Managing Capital In?ows:
Cross-Cutting Themes and Possible Policy Framework,” IMF Policy Paper, February.
Washington D.C.: IMF.
Keynes, John Maynard (1980). The Collected Writings of John Maynard Keynes, Volume
XXV, Activities, 1940–1944, Shaping the Post-War World: The Clearing Union, pub-
lished for The Royal Economic Society.
Keynes, John Maynard (1980). The Collected Writings of John Maynard Keynes, Volume
XXVI, Activities, 1941–1946. Shaping the Post-War World: Bretton Woods and Repara-
tions, published for The Royal Economic Society.
102 A Pardee Center Task Force Report | March 2012
Ocampo, José Antonio (2011). “Reforming the International Monetary System,” Wider
Annual Lecture 14, United Nations University, World Institute for Development
Economics Research (UNU-WIDER).
Ostry, Jonathan D., Atish R. Ghosh, Karl Habermeier, Marcos Chamon, Mahvash S.
Qureshi, and Dennis B. S. Reinhardt (2010). “Capital In?ows: The Role of Controls.”
IMF Staff Position Note, SPE/10/04, February. Washington, D.C.: International Mon-
etary Fund.
Pradhan, Mahmood, Ravi Balakrishnan, Reza Baqir, Geoffrey Heenan, Sylwia Novak,
Ceyda Oner, and Sanjaya Panth (2011). “Policy Responses to Capital Flows in
Emerging Markets,” IMF Staff Discussion Note, SDN/11/10, April. Washington, D.C.:
International Monetary Fund.
Sarkozy, Nicolas (2011). “Lancement de la présidence française du G-20 e du G-8,” Palais
de l’Elysée, January.
Sarkozy, Nicolas (2011). “Address by the President of the French Republic.” Opening of
the G20 Seminar on Reform of the International Monetary System, Nanking (China),
March.
Uribe E., José Darío (2011). “Managing Capital In?ows in Emerging Markets: the Case
of Colombia,” paper presented in the conference on Managing Capital In?ows in
Emerging Markets, organized by the Ministry of Finance of Brazil and the Interna-
tional Monetary Fund, Rio de Janeiro, May.
Regulating Global Capital Flows for Long-Run Development 103
9. The Need for North-South Coordination
Stephany Grif?th-Jones and Kevin P. Gallagher
Developing countries have in recent years become again the destination for
speculative capital ?ows, with in?ows reaching pre-crisis levels. Many of these
nations are deploying prudential capital regulations to stem these ?ows. Such
measures could be coupled with action by developed countries in order to dis-
courage capital out?ows and risk taking from their economies, so as to encour-
age capital to productive use within their own economies; such measures would
simultaneously avoid excessive exchange rate strengthening in developing
economies, both supporting their own growth and helping avoid possible future
crises within these developing economies.
Indeed, one important aim of regulating cross-border capital ?ows in both recipi-
ent and source countries is the reduction of systemic risk build up in both of
them, thus reducing risk of future crises.
We will argue therefore that such measures of managing excessive capital
out?ows from developed countries, and especially from the U.S., could be a rare
“win-win” opportunity, as they would bene?t both the U.S. and the developing
economies. The only ones to lose would possibly be ?nancial institutions, mak-
ing short-term pro?ts; however, we have seen the disastrous results of de?ning
economic policies only to maximize pro?ts for the ?nancial industry, while
neglecting their impact on systemic ?nancial and macroeconomic stability and
on the real economy.
CAPITAL FLOWS IN THE WAKE OF THE CRISIS
As nations across Asia and Latin America still have a long way to go in terms
of income growth, foreign investment is quite welcome. The problem is, the
sheer volume and composition of these ?ows implies that a large part of them
are short-term, volatile, and do not go into productive investment. Indeed, mass
in?ows of short-term capital have been causing asset bubbles and currency
appreciation in developing countries, making macroeconomic policy dif?cult
and increasing the risk of future crises.
104 A Pardee Center Task Force Report | March 2012
Short in?ows have been ?ocking to the developing world largely through the
mechanism of the carry trade and other mechanisms, usually using derivatives.
Since the crisis began, interest rates have been very low in the U.S. and other
industrialized nations. As Mohan in this volume shows, there is clear evidence
over the last 30 years that there is broad correspondence between periods of
accommodative monetary policy in advanced economies and capital ?ows to
emerging market economies, as well as the reverse; each monetary tightening
produces capital ?ows reversals and often crises in emerging countries.
In the recent period, increased U.S. liquidity and low interest rates have trig-
gered U.S. ?nancial institutions to decrease their risk-taking in the U.S., thus
leading to little or no credit creation, which is the main transmission channel of
monetary expansion to domestic economic activity; it has, however, increased
risk taking abroad, channelling it to nations with higher interest rates for rapid
return, as well as better growth prospects in the medium term. Speculative short-
term ?ows push up the value of emerging market currencies and create asset
bubbles. For this reason, the U.S. was criticized at the G-20 meeting in Seoul in
late 2010. For example, Brazil, with high interest rates, had seen an appreciation
of over 40 percent due in part to the carry trade, and was most vocal in Seoul.
But this is a problem in many emerging and even low-income developing coun-
tries, like Uganda, with excessive short-term in?ows.
PRUDENTIAL REGULATIONS IN DEVELOPING COUNTRIES
Emerging and developing economies have a “new” set of options to stem the
tide. One of them, which several are now pursuing, is to engage in prudential
capital account management, by taxing, putting unremunerated reserve require-
ments or discouraging by other means, excessive capital in?ows. This is not a
panacea on its own, but does help provide greater monetary policy autonomy
to those countries; this is essential, as their growth rates are at present high, and
it is essential for them not only to avoid in?ation in goods and services, but also
asset price bubbles and overvalued exchange rates.
Many nations such as Brazil, China, Argentina, Taiwan, Thailand, South Korea,
Peru, and Indonesia have put in place various forms of capital account regula-
tions to limit excessive in?ows. Such controls have been recently sanctioned
by the IMF—a very signi?cant shift. However, the support by the IMF for capital
account regulations has some limitations (as discussed by Nogueira Batista and
Ocampo in this volume).
Regulating Global Capital Flows for Long-Run Development 105
Indeed, capital account management measures follow a mountain of economic
evidence in academia and by the international ?nancial institutions—most
notably the National Bureau of Economic Research in the U.S., the International
Monetary Fund, the United Nations, and the Asian Development Bank—that
capital account management
by developing countries
is a useful tool of policy, if
accompanied by broadly
prudent macro-economic poli-
cies. In February 2010, IMF
economists published a staff
position note titled, “Capital
In?ows: The Role of Controls,”
empirically showing that
capital controls not only work
but “were associated with
avoiding some of the worst growth outcomes” of the current economic crisis. The
paper concludes that the “use of capital controls—in addition to both prudential
and macroeconomic policy—is justi?ed as part of the policy toolkit.”
That IMF report singles out measures such as taxes on short-term debt (like Bra-
zil’s) or requirements whereby in?ows of short-term debt need to be accompa-
nied by an unremunerated deposit to be placed in the central bank for a certain
period of time (as practiced in the past by nations such as Chile, Colombia, and
Thailand). The goal of these measures—which are often turned on when capital
?ows start to overheat and turned off when such ?ows cool—is to prevent mas-
sive in?ows of hot money that can appreciate the exchange rate and threaten the
macroeconomic stability of a nation.
The IMF’s ?ndings came at an appropriate time. In the wake of the U.S. Federal
Reserve’s quantitative easing and other measures to loosen monetary policy, the
carry trade again started bringing speculative capital to developing countries
that could disrupt their recovery from the crisis (even though there have been
episodes in autumn 2011 of brief reversals of such ?ows).
To make the proper deployment of capital account management effective how-
ever, at least four obstacles need to be overcome:
Capital account management measures
follow a mountain of economic evidence in
academia and by the international ?nancial
institutions—most notably the National Bureau
of Economic Research in the U.S., the Inter-
national Monetary Fund, the United Nations,
and the Asian Development Bank—that capital
account management by developing countries
is a useful tool of policy, if accompanied by
broadly prudent macro-economic policies.
106 A Pardee Center Task Force Report | March 2012
First, after a while investors creatively evade prudential capital management
through derivatives and other instruments. Second, U.S. trade and investment
agreements make capital controls dif?cult to implement. Third, speculative capital
can still wreak havoc because hot money bypasses countries that successfully
deploy controls and goes instead to nations that do not. Fourth, the massive scale of
capital ?owing from source countries may overwhelm even those countries using
capital account management of their in?ows, given their relatively small size.
Brazil started imposing a tax on hot money in?ows in 2009, and has been ?ne-
tuning it ever since, in part because of the volume of ?ows but also because the
regulation was being evaded. Some investors have bypassed controls by disguis-
ing short-term capital as foreign direct investment, through currency swaps and
other derivatives, and by purchasing American Depositary Receipts (ADRs).
ADRs are issued by U.S. banks and allow investors to buy shares of ?rms outside
the U.S.—enabling investors to purchase Brazilian shares but in New York and
thereby skirt controls in Brazil. In a step in the right direction, Brazil moved to
put a 1.5 percent tax on ADRs to stem speculating around the controls. Thus,
a Brazilian bank or investor that deposits shares with foreign banks will be
charged the tax. Most recently (mid-2011), Brazil has started taxing net foreign
exchange derivative positions above a certain level, which is an interesting
measure as it may help curb excessive pressure on the national currency to
become too strong, and help avoid evasion of other capital account management
measures. It would be helpful for emerging economies to exchange experiences
on regulating capital ?ows to see to it that controls are not evaded.
Since 2003, U.S. trade and investment treaties have made prudential manage-
ment of the capital account by developing-country trading partners dif?cult if not
impossible by mandating the free ?ow of capital to and from a country, regard-
less of its level of development—for instance, in trade deals with Chile, Peru,
and Singapore. (In Singapore’s and Chile’s cases, the countries resisted these
measures, but ultimately agreed to the treaties.) Recently rati?ed deals with
Colombia and South Korea would also ban prudential capital controls. Other
higher-income countries and trade partners—such as Canada and Japan—grant
countries the right to use the macroeconomic tool, or at least grant exemptions
to prevent or mitigate crises.
The third and perhaps most dif?cult problem is that capital will simply ?ow by
those nations that successfully deploy controls to nations that do not, (imply-
Regulating Global Capital Flows for Long-Run Development 107
ing negative externalities for the latter). Some economists, such as former
IMF economist Arvind Subramanian propose full-?edged coordinated capital
controls among all emerging market economies to circumvent the problem. This
idea has merit, but of course not all emerging markets will agree to coordinate.
We propose attacking the problem at its source.
The fourth, and also serious, problem is that if interest differentials are impor-
tant, the incentive for investors to come into emerging economies is very large,
and thus the scale of capital account management effort by the emerging
country would have to be very large; this is particularly the case because global
capital markets are so large and so mobile, and can thus overwhelm relatively
small emerging and developing economies and ?nancial markets. Again comple-
mentary measures in the source countries would help tackle the issue. Though
we propose below measures to be taken in the U.S. currently the main source
of carry trade, such measures would be more effective if they were coordinated
with other countries that are sources of short-term capital out?ows or risk taking.
REGULATE THE CARRY TRADE IN THE UNITED STATES
As pointed out, actions taken by developing countries on their capital accounts
may not be enough, as the wall of money at times coming towards them is so
large. Therefore, it may be desirable to complement these measures with action
by the countries where the capital is coming from, especially the U.S. Given that
the majority of the carry trade effect will in the near future come from the U.S.,
the United States could start regulating the out?ow of capital due to the carry
trade. As pointed out, though the scale may be greater now, there have been
several previous episodes where very loose U.S. monetary policy contributed
to surges in capital ?ows to developing economies, episodes that have mostly
ended in tears. Already in 1998, one of the authors of this essay, writing with
Jane D’Arista (D’Arista and Grif?th-Jones 2008) argued for measures to discourage
excessively large portfolio out?ows from source countries, such as unremuner-
ated reserve requirements on such out?ows.
At present, the U.S. could introduce measures to discourage the carry trade
?ows going from that country to the rest of the world, and especially developing
countries, when these are excessive; this could be done for example by taxing
such ?ows (on the spot market) and excessive risk taking abroad. Thus, foreign
exchange derivatives that mimic spot transactions could have higher margin
requirements, to discourage them. Alternatively, such foreign exchange deriva-
tives could also be taxed at a level equivalent to the tax on foreign exchange spot
108 A Pardee Center Task Force Report | March 2012
transactions, on the notional value of that derivative, such as non-deliverable
forwards. Interesting lessons could be drawn, for example, from the recent expe-
rience of Brazil in taxing foreign exchange derivatives, which also seems to show
the feasibility of such taxes. There are two routes through which U.S. monetary
easing is transmitted abroad:
(a) the money and credit supply channel, which implies higher capital out?ows
and less credit creation in the U.S., and
(b) the derivatives channel, whereby the ?xed risk budget of U.S. banks or hedge
funds is allocated more towards emerging economies risk and therefore less to
risk taking in the U.S.
The above sketched proposal would attempt to curb both routes, when and if
desirable, that is if excessive capital and risk taking was going abroad.
Such a measure would bene?t the U.S. economy, as the purpose of monetary
easing is precisely to encourage increased lending and risk-taking in the U.S.,
and not for funds to be channeled abroad; it would bene?t emerging countries,
whose economies are being harmed by excessive short-term in?ows that could
cause future crises. It would thus be a big win-win for the world economy.
The results of the most recent U.S. Congressional elections unfortunately make
it dif?cult in the near future for the U.S. to pursue the best policy to keep its
economy recovering: further ?scal expansion. As Keynes taught us—and as we
have seen during numerous crises—private investment and consumption will
not recover on their own (due both to over-leveraging and lack of con?dence),
without the stimulus of aggregate demand, which only governments can give in
these particular circumstances. Once the recovery is on track, ?scal policy needs
to contract, to avoid both overheating and excessive public debt.
On its own, loose U.S. monetary policy seems, indeed, not to be enough to restore
the U.S. economy to growth; supportive ?scal policy would be highly desirable, as
would other measures to stimulate aggregate demand. Furthermore, easy mon-
etary policy may contribute to further overheating of asset prices and exchange
rates in the emerging economies, which could not just complicate macroeco-
nomic management for them now, but also increase the risk of future crises.
To ensure loose monetary policy helps the U.S. economy to grow, institutional
mechanisms and a broader framework need to be found to channel the addi-
tional liquidity created by the Fed as credit to the real economy. The key is to
Regulating Global Capital Flows for Long-Run Development 109
expand credit to small and medium-sized enterprises, starved of funds at pres-
ent, and to ?nance large investments in infrastructure, including that required to
generate clean energy and energy conservation. Institutional innovations may be
necessary to achieve this, such as the creation of an Infrastructure Fund, as well
as possibly special institutions dedicated to lending to small and medium enter-
prises. Indeed, in the U.S., the Federal Reserve could, for example, possibly use
some of the liquidity it creates to purchase bonds of a U.S. Infrastructure Fund or
Bank; this would both provide credit to a sector key for future development, as
well as lead to an increase in aggregate investment and demand.
Internationally, if the U.S. dug into the emergency toolbox again, it could place
prudent capital regulations or taxation on the out?ow of speculative capital from
the U.S. via mechanisms such as the carry trade; this might help avoid future
crises in those countries, which would harm not only them, but also the U.S.
and the world economy. Taxation may have some important advantages. First,
taxes are more dif?cult to avoid or evade, as they involve not just authorities
like the Federal Reserve, but also the Internal Revenue Service, with the latter
having possibly stronger enforcement mechanisms. Second, such taxation could
generate some additional revenue for a U.S. government with a large budget
de?cit, surely an attractive feature. However, the tax would need some ex-ante
?exibility on rates, so it could be modi?ed according to the level of out?ows and
derivatives positions. Complementary to introducing measures like new taxes to
discourage out?ows of capital or increased risk taking abroad, it seems clearly
desirable—in the U.S. and elsewhere—to reduce existing tax biases in favor of
such ?ows, like tax loopholes; indeed, this could be a ?rst step to discourage
excessive short-term out?ows.
Measures to discourage short-term out?ows would facilitate the liquidity created
by the Fed to stay in the U.S. and have a better chance of going toward produc-
tive investment.
THE ROAD AHEAD
Re-orienting capital ?ows for productive development, leading to growth, should
be a key priority. Prudential capital account regulations, deployed in both the
industrialized and developing world, should be examined as one instrument to
achieve this aim. Coordination between developed and developing countries
on this issue would be desirable; this should be eased by the fact that often the
aims of both developed and developing countries may coincide. However, it
does not seem desirable for such coordination to be imposed multilaterally, as
110 A Pardee Center Task Force Report | March 2012
no institution at present seems to have the appropriate, well-trusted governance
ability to represent the collective interests of all countries. Nevertheless, the IMF
could continue to be a useful forum to exchange experiences on capital account
management (by both developed and developing countries) and possibly provide
a useful voluntary forum for informal coordination, in cases where all countries
involved desire such a role to be played.
To rectify some of the problems related to capital ?ows, industrialized nations
(especially the U.S.) should consider regulating the carry trade and providing
safeguards in their trade treaties to allow developing nations to deploy pruden-
tial regulation. Developing countries should also put in place prudential regula-
tions. The Financial Stability Board, or another relevant body, as well as national
regulatory authorities, should watchdog those who evade these regulations.
REFERENCES
D’Arista, J. and Grif?th-Jones, S. (1998). “The boom of portfolio ?ows to emerging mar-
kets and its regulatory implications,” in: A. Montes, A. Nasution, and S. Grif?th-Jones
(eds,) Short Term Capital Flows and Economic Crises, pp. 52–69. Helsinki: World
Institute for Development Economics Research.
Regulating Global Capital Flows for Long-Run Development 111
10. International Regulation of the Capital Account
Arvind Subramanian
This short essay, which is based on Jeanne, Subramanian, and Williamson (forth-
coming), argues that there is a growing need for an international regime to regu-
late capital account transactions. Such a regime should allow nations to deploy
capital controls that are deemed ‘corrective’ but should also provide mechanisms
for disciplining capital controls where they have spillover effects via facilitating
undervalued exchange rates and hence beggar-thy-neighbor trade effects on
partner countries. Cooperation between the International Monetary Fund (IMF)
and the World Trade Organization (WTO) might be necessary to implement such
a regime.
CORRECTIVE VERSUS STRUCTURAL CAPITAL CONTROLS
A new wave of theoretical research shows that capital controls, in certain situ-
ations, can be seen as correcting for market failure, rather than being seen as
distortionary in the market (Korinek 2009; Jeanne and Korinek 2010; Bianchi
2010; etc.). This new work provides a rigorous, welfare-based basis for public
intervention. The rationale is essentially the same as for “macroprudential”
regulation to deal with booms and busts in credit and asset prices in a domes-
tic context (Brunnermeier 2009; Adrian and Shin 2009). In a new book I have
authored with Olivier Jeanne and John Williamson, we argue that there should
be a global regime that allows for corrective capital controls. A current example
of a corrective capital control might be Brazil’s tax on foreign currency purchases
of equities that was put in place in 2010.
However, capital controls can also be used to sustain undervalued exchange
rates as an instrument of mercantilism, with beggar-thy-neighbor effects on trad-
ing. The obvious present-day example of a nation that deploys structural controls
is that of China, where capital controls play a part in an elaborate regime to keep
the nation’s currency undervalued in order to support an export-led growth strat-
egy. Our view is that there is a need to regulate these structural controls, not least
because the freedoms of smaller countries are affected by spillovers from these
112 A Pardee Center Task Force Report | March 2012
distortive controls. We must also consider multilateral rules on capital ?ows even
within the IMF.
AN ALTERNATIVE APPROACH FOR AN INTERNATIONAL REGULATORY
REGIME
Although some nations may currently bene?t from the status quo, a global
regulatory regime for the use of capital controls would make more nations better
off than under current circumstances. Why so, if non-regulation is appealing
for some states because the status quo provides policy space and freedom? But
the current debate seems to suggest that non-regulation might mean less policy
space for some. This is especially evident in the pre-2008, intellectual zeitgeist
which created stigma from national and uncoordinated action. For example,
Brazil in 2009 suffered from the worst of both possible worlds: out of fear of the
stigma, it imposed weak controls, which ended up being ineffective in restricting
in?ows but that incurred the stigma anyway.
In addition, non-regulation has led to abuse of structural controls, and these,
in turn, create negative global externalities. We need to regulate capital in?ows
nationally, especially from
a cyclical/prudential per-
spective (Ostry et al. 2010),
but there is no consensus
regarding multilateral rules on
permissible curbs on ?ows.
A starting point for a new
regime would be the recogni-
tion of the need for corrective controls while at the same time seeing that capital
controls/undervalued exchange rates are potentially as big a problem as capital
in?ows and overly ambitious capital ?ows.
Thus, the case for an international regime is:
• Because there can be circumstances in which unconstrained national actions
are collectively damaging;
• Because a lack of rules stigmatizes countries for not abiding by whatever hap-
pens to be the conventional wisdom, which in recent years has favored free
capital mobility, and countries that impose capital controls therefore often do
so apologetically and with less-than-optimal vigor;
A starting point for a new regime would be
the recognition of the need for corrective
controls while at the same time seeing that
capital controls/undervalued exchange rates
are potentially as big a problem as capital
in?ows and overly ambitious capital ?ows.
Regulating Global Capital Flows for Long-Run Development 113
• Because the lack of a rule fails to give countries a pointer of what they should
be aiming for; and
• To try in a different way to persuade China to revalue its exchange rate.
PROPOSAL: SYMMETRY WITH TRADE
Of course the full details would need attention, but for the sake of argument
a regime for capital account regulations could be set up that is analogous to
the global trade regime. In trade, as in the WTO, nations are permitted to have
contingent protections for a variety of reasons, with a long-run commitment
to phase those out and replace them with safeguards for extraordinary events.
When a nation’s measures adversely affect another nation however, the affected
nation can dispute the measure and convene a tribunal whereby the party found
to be in violation with stated codes of conduct has to change that measure or
face economic retaliation.
In our book we ?nd no evidence that capital account liberalization is good for
growth: hence rules on structural capital regulations should in principle be more
permissive than those, say, on goods. But, as was the case in the WTO, we sug-
gest that all quantitative restrictions on capital ?ows be converted to price-based
measures and that there be a “binding” of the amount of controls that can be
deployed.
The main features of course would be “optimal” or corrective controls that tax on
in?ows independent of duration of investment. This tax ought to be:
• differentiated according to the type of ?ow (debt versus equity, versus foreign
exchange, etc.).
• the tax rate ought to be set at a level which is countercyclical: from 0 to 15
percent in a calibrated model.
To summarize, corrective controls should be price-based, countercyclical, with
a maximum effective tax rate of 15 percent, and, crucially, with a “structural
exemption” that would be negotiated down or disciplined. Such a new regime
would be housed at the IMF and should institute cooperation between IMF and
WTO (Mattoo and Subramanian 2008).
The IMF has been able to in?uence member countries that have borrowed from
it, but it has not been successful in affecting economic policy in countries that do
not need IMF money. Moreover, the IMF lacks an effective enforcement mecha-
114 A Pardee Center Task Force Report | March 2012
nism. Compounding these problems is the IMF’s eroding legitimacy. It lost its
status as a trusted interlocutor in emerging markets, particularly in Asia, after
the Asian ?nancial crisis of 1997–1998. There, the IMF was seen as having failed
to provide enough money to countries in need and as having attached unneces-
sarily tough conditions to its loans, which many believe aggravated the effects of
the crisis. The IMF’s governance structure is also outdated; it re?ects the receding
realities of the Atlantic-centered world of 1945 rather than the rise of Asia in the
21st century.
One possibility going forward would be for the IMF and the WTO to cooperate
on exchange-rate issues. The IMF would continue to provide technical expertise
to assess the valuation of currencies. But because undervalued currencies have
serious consequences for global trade, it would make sense to take advantage of
the WTO’s enforcement mechanism, which is credible and effective. The WTO
would not displace the IMF; rather, this arrangement would harness the com-
parative advantages of each institution.
OBJECTIONS
A few objections to controls are commonly raised. I will address each of these
objections, in turn, and argue why they are not good arguments against the type
of global governance system that we are proposing.
The ?rst argument against controls is that controls are always distortive. Here,
we must draw a distinction between controls which might create a distortion,
and ones that correct for a current distortion. Another common objection is that
controls are easily evaded. Evidence for this is mixed, and evasion depends
largely on the types of controls enacted. Nonetheless, destigmatizing the use of
capital controls, and therefore giving their use legitimacy, may go a long way
towards cutting down some forms of evasion. Another objection is that controls
have costly unintended consequences. Here too the evidence is mixed. On bal-
ance, capital controls can be a legitimate tool and not just the last option as was
previously suggested by the IMF.
One of the few good arguments for allowing blunt instruments, such as quantita-
tive controls, is related to implementation capacity. Where regulatory regimes
are weak, blunt instruments might often have to take precedence over more
?nely tuned ones.
Regulating Global Capital Flows for Long-Run Development 115
One current problem with introducing a regulatory regime that phases out
structural capital controls would be inducing cooperation from China. We have
already some analogues from the WTO for how to approach this issue. These
analogues involve invoking carrots and sticks, both in trade in goods and in
capital.
Carrots in the trade arena could take the form of eventually granting China the
status of a market economy, which would make it less vulnerable to arbitrary
unilateral action—especially antidumping duties—by its trading partners (Messer-
lin 2004). At the moment, the disciplines on such actions are less stringent when
the target is a non-market economy.
In trade in assets, carrots could take the form of securing investment opportu-
nities for its sovereign wealth funds (SWF) in an environment where Chinese
investments could increasingly be subject to national regulations with a protec-
tionist slant. Clear rules on SWF-related investments could thus be one of the
inducements for China to cooperate (see Mattoo and Subramanian 2008). It is
worth noting here that China’s huge stockpile of reserves (which is not likely to
be eliminated any time soon) will mean that the Chinese state will be a foreign
investor for some considerable time, so guaranteeing an outlet for these invest-
ments could be important for China (and also for the oil-exporting countries).
The nature of the carrots in this area is spelled out in Mattoo and Subramanian
(2008).
Sticks in trade in goods could of course take the form of imposing tariffs on
countries that do not agree to bring their capital account restrictions in line with
new rules. Sticks in trade in assets could take the form of a broad reciprocity
requirement whereby capital importing countries declare that they will limit
sales of their public debt henceforth to only include of?cial institutions from
countries in which they themselves are allowed to buy and hold public debt.
CONCLUSION
Intellectually, the ground has shifted in favor of cyclical, prudentially based
measures to restrict surges in capital in?ows. But that is now a given. The issues
going forward are ?rst, whether this shift to allow corrective controls should be
codi?ed in an international regime for capital account regulation; and second,
whether there should also be regulation of structural controls which facilitate
beggar-thy-neighbor practices.
116 A Pardee Center Task Force Report | March 2012
Some American economists and lawmakers have called for imposing a duty on
imports from countries with undervalued exchange rates. But any such unilat-
eral action would be, by de?nition, partial and hence ineffective. Undervalued
currencies affect more than just one country: China’s cheap yuan, for example,
has an impact not only on the United States and the European Union but also
on emerging economies and African countries, whose products compete with
China’s on the world market.
A multilateral approach to such distortions may prove more fruitful. Under the
historical division of labor between the International Monetary Fund and the
WTO, the IMF has jurisdiction over questions relating to exchange rates. But its
oversight has been weak at best. Surely a better approach would be to imple-
ment a comprehensive regulatory regime that addresses the problem of excess
capital ?ows in addition to distortive controls, such as structural exchange rate
regimes which lead to broad spillovers in the global economy. An analogue to
the WTO, but administered by the IMF, would be one possible mechanism for
such regulation.
Regulating Global Capital Flows for Long-Run Development 117
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Bianchi, J. (2010). “Credit Externalities: Macroeconomic Effects and Policy Implications.”
American Economic Review: Papers & Proceedings, 100 (May 2010): 398–402.
Brunnermeier, M. (2009). “Deciphering the Liquidity and Credit Crunch 2007–2008.”
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Regulatory Responses.” Working Paper, University of Maryland.
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Funds: A New Role for the World Trade Organization.” Working Paper 08-2. Washing-
ton, D.C.: Peterson Institute for International Economics. Available athttp://www.iie.
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Messerlin, P.A. (2004). “China in the World Trade Organization: Antidumping and Safe-
guards.” World Bank Economic Review, 18(1): 105–130.
Ostry, J., Ghosh, A., Habermeier, K., Chamon, M., Qureshi, M., and D. Reinhardt (2010).
“Capital In?ows: The Role of Controls.” IMF Staff Position Note, February. Washing-
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pubs/ft/spn/2010/spn1004.pdf.
118 A Pardee Center Task Force Report | March 2012
Regulating Global Capital Flows for Long-Run Development 119
11. Capital Account Regulations
and the Trading System
Kevin P. Gallagher
The global community has not made a conscious effort to coordinate measures
to regulate global capital ?ows. In the absence of such an effort, a patchwork
de-facto regime has arisen—including global, regional, and bilateral trade and
investment treaties—that may complicate efforts to coordinate capital account
regulations in the 21st century. This short essay discusses how capital ?ows are
treated in the trading system and outlines practical measures that nations may
take to create the policy space for CARs in new and existing treaties.
Table 1 summarizes the extent to which capital account regulations are permit-
ted under various trade and investment arrangements.
Under the World Trade Organization, if a nation has committed to granting
market access in cross-border trade in ?nancial services or committed to allow-
ing foreign investment in ?nancial services, it must liberalize its capital account
in order to honor those speci?c commitments. The WTO does have a prudential
exception and a balance of payments exception, but it is not clear that such
WTO US BITS/FTAs Other BITS/FTAs
Permissible Capital Controls
Current no no no
Capital
inflows no* no sometimes
outflows no* no sometimes
Safeguard Provisions
Current yes** no yes**
Capital
inflows no no yes
outflows yes no yes
Number of Countries Covered 69 58
Dispute Resolution format State-to-State Investor-State Investor-State
Enforcement instrument Retaliation Investor compensation Investor compensation
*Capital controls fully permissible for nations that have not committed to liberalize cross-border trade in financial services
**Permitted only under IMF approval
Policy Space for Capital Controls: A Comparison
Table 1: Policy Space for Capital Controls: A Comparison
Source: Gallagher 2011
120 A Pardee Center Task Force Report | March 2012
safeguards will apply to all types of capital controls. In any event, at this writing
most developing countries have not yet agreed to grant market access in the
?nancial services sectors that would require open capital accounts. However,
developed countries see the liberalization of ?nancial services in developing
countries as the cornerstone of a new WTO agreement under the Doha Round.
Some, but not all, Free Trade Agreements (FTAs) and Bilateral Investment Trea-
ties (BITs) also restrict the ability of developing nations to deploy capital controls.
Virtually all U.S. agreements require the free ?ow of capital to and from the U.S.
and its trading partner, without exception. In contrast to the WTO where when a
dispute arises, such a dispute has to be brought by a state (and can thus be diplo-
matically “screened”), FTAs allow the foreign ?rm to directly ?le a claim against
a host state for such measures. If a claim is lost the host state has to change its
policy and pay damages to the private ?rm. Such a claim was rendered under
the U.S.-Argentina BIT when, in the aftermath of Argentina’s ?nancial crisis
Argentina sought to impose a tax on out?ows that was deemed to be tantamount
to an “expropriation” (Salacuse 2010).
However, while U.S. FTAs and BITs strictly forbid the use of capital account
regulations, the agreements of other major capital exporting nations allow for
more ?exibility. Most BITs and FTAs conducted by Japan, the European Union,
and Canada either have a safeguard measure whereby a nation is able to pursue
its domestic regulations related to capital account regulations, or a safeguard
measure to prevent and mitigate ?nancial crises. For instance, the EU-Chile and
Canada-Chile agreements have annexes that allow Chile to deploy its infamous
unremunerated reserve requirements (URRs), whereas the U.S.-Chile agreement
does not.
These examples of ?exibility among many of the world’s larger capital exports
can provide the basis and example for global reform.
THE WORLD TRADE ORGANIZATION
The General Agreement on Trade in Services (GATS) is currently the only bind-
ing multilateral pact that disciplines capital account regulations, though speci?c
countries may have certain freedoms if the governments in place in the 1990s
did not make widespread commitments in the ?nancial services sector. More
speci?cally:
Regulating Global Capital Flows for Long-Run Development 121
• A member is most protected from a WTO challenge over capital account
regulations if it committed no ?nancial services sectors to GATS coverage in
any mode.
• However, even nations that have made widespread commitments in ?nancial
services may have—if challenged—recourse to various exceptions, although
these have not been tested and the record of WTO exceptions in other con-
texts is not reassuring.
• The policy space for controls on current account transactions defers to the IMF.
The GATS is part of the Marrakesh Treaty that serves as an umbrella for the vari-
ous agreements reached at the end of the Uruguay Round of GATT negotiations
that established the WTO. The GATS provides a general framework disciplining
policies “affecting trade in services” and establishes a commitment for periodic
future negotiations. The GATS is divided on the one hand into a part on “General
Obligations,” which binds all members. These include the obligation to pro-
vide most favored nation treatment to all WTO members (Article II), and some
disciplines on non-discriminatory domestic regulations that are still being fully
developed (Article VI).
On the other hand, the GATS also includes a part dealing with “Speci?c Com-
mitments,” which apply only to the extent that countries choose to adopt them
by listing them in their country-speci?c schedules. These cover primarily the
disciplines of Market Access (Article XVI) and National Treatment (Article XVII)
(Raghavan 2009).
Numerous annexes cover rules for speci?c sectors: the Annexes on Financial Ser-
vices are of particular relevance for capital account regulations. Trade in services
occurs across the four services ‘modes’ discussed in the GATS in general: Mode 1
(Cross-border supply), Mode 2 (Consumption abroad), Mode 3 (Commercial Pres-
ence) and Mode 4 (Presence of natural persons). With respect to capital account
regulations, Modes 1 and 3 are most important:
122 A Pardee Center Task Force Report | March 2012
IMF analysts have found that about 16 countries have signi?cant Mode 1 com-
mitments in ?nancial services, while around 50 each have signi?cant Mode 2
and 3 commitments for the sector—this includes most OECD countries. (Valckx
2002, Kireyev 2002.)
The IMF has articulated how commitments in Modes 1 and 3 can impact the
capital account and related regulations:
Of course, if a nation has not made commitments then it is free to pursue any
and all capital account regulations that it sees ?t. If a nation has made com-
mitments, a distinction needs to be made with respect to ?nancial services
and capital ?ows. Under the GATS nations liberalize speci?c types of ?nancial
services, such as banking, securities, insurance, and so forth. That said, if a
nation has made a commitment in a particular sector and capital account regula-
tions restrict the ability of WTO members to make capital movements linked to
Box 1: Relevant De?nitions in GATS
Mode 1: Cross-border supply is defned to cover services fows from the territory of one
Member into the territory of another Member (e.g., banking or architectural services transmit-
ted via telecommunications or mail).
Mode 3: Commercial presence occurs when the user of a fnancial service is immobile and
the provider is mobile, implying that the fnancial service supplier of one WTO Member estab-
lishes a territorial presence, possibly through ownership or lease, in another Member’s territory
to provide a fnancial service (e.g., subsidiaries of foreign banks in a domestic territory).
Box 2: Capital Account Liberalization and GATS Commitments
WTO members must allow cross-border (inward and outward) movements of capital if these
are an essential part of a service for which they have made liberalization commitments regard-
ing its cross-border supply (without establishment). For example, international capital transac-
tions are an integral part of accepting deposits from or making loans to nonresidents (mode
1). International capital transactions are also usually associated with fnancial services such as
securities trading on behalf of a customer residing in another country. The establishment of a
commercial presence (mode 3) in a host country by a foreign services supplier involves both
trade in services and international capital transactions. In permitting the establishment of a
commercial presence, WTO members must allow inward (but not outward) capital transfers
related to the supply of the service committed.
Source: IMF 2010
Regulating Global Capital Flows for Long-Run Development 123
the particular ?nancial service, then those nations may be brought to the WTO
under its dispute resolution mechanism (WTO 2010).
WTO members have recourse to binding dispute settlement procedures, where
perceived violations of GATS commitments can be challenged and retaliatory
sanctions or payments authorized as compensation. The process for disputes
is “state-to-state” dispute resolution where a party has to demonstrate damage
from a particular policy to that party’s government and the government decides
whether or not to enter into a dispute on behalf of the affected party. Such a
dispute is carried out at the WTO with the “defending” government representing
the party from which the dispute originated.
If a nation’s capital account regulations were found in violation of its GATS com-
mitments, it could invoke one or more exceptions in the GATS text. A ?rst option
would be to claim that the measure was taken for prudential reasons under
Article 2(a) of the Annex on Financial Services. This exception reads:
In?ows controls such as unremunerated reserve requirements or in?ows taxes
could be argued to be of a prudential nature, especially given the new IMF report
discussed earlier. However, the sentence stating that prudential measures “shall
not be used as a means of avoiding the Member’s commitments or obligations
under the Agreement” is regarded by some as self-cancelling and thus of limited
utility (Tucker and Wallach 2009; Raghavan 2009). Others however do not see
the measure to be second-guessing but rather “as a means of catching hidden
opportunistic and protectionist measures masquerading as prudential” (Van
Aaken and Kurtz 2009). Still others point out that, in contrast with other parts
of the GATS that require a host nation to defend the “necessity” of the measure,
there is no necessity test for the prudential exception in the GATS. This arguably
gives nations more room to deploy controls. Indeed, Argentina lost cases related
Box 3: Prudential Exception in GATS
Notwithstanding any other provisions of the Agreement, a Member shall not be prevented
from taking measures for prudential reasons, including for the protection of investors, deposi-
tors, policy holders or persons to whom a fduciary duty is owed by a fnancial service supplier,
or to ensure the integrity and stability of the fnancial system. Where such measures do not
conform with the provisions of the Agreement, they shall not be used as a means of avoiding
the Member’s commitments or obligations under the Agreement.
124 A Pardee Center Task Force Report | March 2012
to controls under BITs because they failed such a “necessity test.” Nations have
requested that the WTO elaborate on what is and is not covered in the prudential
exception, but such requests have fallen on deaf ears (Cornford 2004). And as of
this writing, the prudential exception has not been tested.
If a country’s capital account regulations were found in violation of its GATS
commitments in ?nancial services, it could also invoke Article XII “Restrictions
to Safeguard the Balance of Payments.” Paragraph 1 of Article XII states:
The next paragraph speci?es that such measures can be deployed as long as
they do not discriminate among other WTO members, are consistent with the
IMF Articles (thus pertain only to capital account controls), “avoid unnecessary
damage” to other members, do “not exceed those necessary” to deal with the bal-
ance of payments problem, and are temporary and phased out progressively.
It may be extremely dif?cult for a capital control to meet all of these conditions,
especially the hurdles dealing with the notion of “necessity,” a slippery concept
in trade law that countries have had dif?culty proving. Moreover, concern has
been expressed about the extent to which the Balance of Payments exception
provides nations with the policy place for restrictions on capital in?ows that are
more preventative in nature and may occur before “serious” balance of payments
dif?culties exist (Hagan 2000). If a nation does choose to use this derogation, the
nation is required to notify the WTO’s Balance of Payments Committee.
FTAs AND BITs
U.S. BITs and FTAs do not permit restrictions on in?ows or out?ows. If a nation
does restrict either type of capital ?ow they can be subject to investor-state
arbitration whereby the government of the host state would pay for the “dam-
Box 4: Balance of Payments Exception in GATS
In the event of serious balance-of-payments and external fnancial diffculties or threat thereof,
a Member may adopt or maintain restrictions on trade in services on which it has undertaken
specifc commitments, including on payments or transfers for transactions related to such com-
mitments. It is recognized that particular pressures on the balance of payments of a Member
in the process of economic development or economic transition may necessitate the use of
restrictions to ensure, inter alia, the maintenance of a level of fnancial reserves adequate for the
implementation of its programme of economic development or economic transition.
Regulating Global Capital Flows for Long-Run Development 125
ages” accrued to the foreign investor. The BITs and FTAs of other major capital
exporters such as those negotiated by the EU, Japan, China, and Canada, either
completely “carve out” host country legislation on capital account regulations
(therefore permitting them) or allow for a temporary safeguard on in?ows and
out?ows to prevent or mitigate a ?nancial crisis. The U.S. does not have either
measure. However, a handful of FTAs have recently allowed for a grace period
whereby foreign investors are not allowed to ?le claims against a host state until
after the crisis period has subsided.
Capital Controls and U.S. Treaties
In contrast with the treaties of many other industrialized nations, the template
for United States trade and investment treaties does not leave adequate ?exibil-
ity for nations to use capital account regulations to prevent and mitigate ?nancial
crises (Gallagher 2011). At their core, U.S. treaties see restrictions on the move-
ment of speculative capital as a violation of their terms. The safeguards in U.S.
treaties were not intended to cover capital account regulations.
U.S. trade and investment treaties explicitly deem capital account regulations as
actionable measures that can trigger investor-state claims. The Transfers provi-
sions in the investment chapters of trade treaties, or in stand alone BITs, require
that capital be allowed to ?ow between trading partners “freely and without
delay.” This is reinforced in trade treaties’ chapters on ?nancial services that
often state that nations are not permitted to pose “limitations on the total value
of transactions or assets in the form of numerical quotas” across borders.
In the ?nancial services chapters of U.S. trade treaties, and in U.S. BITs, there is
usually a section on “exceptions.” One exception, informally referred to as the
“prudential exception,” usually has language similar to the following from the
U.S.-Peru trade treaty:
126 A Pardee Center Task Force Report | March 2012
Capital account regulations are not seen as permissible under this exception.
This has been communicated by the United States Trade Representative and
in 2003 testimony by the Under Secretary of Treasury for International Affairs
to the U.S. Congress and reiterated in a recent letter by U.S. Treasury Secretary
Timothy Geithner in response to a letter signed by more than 250 economists
requesting that the U.S. reform its treaties (see Taylor 2003; Geithner, 2011). In
general this is because the term “prudential reasons” is usually interpreted in a
much narrower fashion, pertaining to individual ?nancial institutions. Concern
has also been expressed that the last sentence is “self-canceling,” making many
measures not permissible.
The prudential exception in services chapters or BITs is usually followed by an
exception for monetary policy that often reads like (again to use the U.S.-Peru
Trade treaty):
Box 5: Prudential Exception for U.S.
Financial Services chapter: Article 12.10: Exceptions
1. Notwithstanding any other provision of this Chapter or Chapter Ten (Investment), Four-
teen (Telecommunications), or Fifteen (Electronic Commerce), including specifcally Articles
14.16 (Relationship to Other Chapters) and 11.1 (Scope and Coverage) with respect to the
supply of fnancial services in the territory of a Party by a covered investment, a Party shall not
be prevented from adopting or maintaining measures for prudential reasons, including for the
protection of investors, depositors, policy holders, or persons to whom a fduciary duty is owed
by a fnancial institution or cross-border fnancial service supplier, or to ensure the integrity
and stability of the fnancial system. Where such measures do not conform with the provisions
of this Agreement referred to in this paragraph, they shall not be used as a means of avoiding
the Party’s commitments or obligations under such provisions.
Box 6: More Exceptions in U.S. FTAs?
Nothing in this Chapter or Chapter Ten (Investment), Fourteen (Telecommunications), or
Fifteen (Electronic-Commerce), including specifcally Articles 14.16 (Relationship to Other
Chapters) and 11.1 (Scope and Coverage) with respect to the supply of fnancial services in the
territory of a Party by a covered investment, applies to non-discriminatory measures of general
application taken by any public entity in pursuit of monetary and related credit or exchange
rate policies. This paragraph shall not affect a Party’s obligations under Article 10.9 (Perfor-
mance Requirements) with respect to measures covered by Chapter Ten (Investment) or under
Article 10.8 (Transfers) or 11.10 (Transfers and Payments).
Regulating Global Capital Flows for Long-Run Development 127
This second exception could be seen as granting nations the ?exibility to pursue
necessary monetary and exchange rate policy (of which capital account regu-
lations are part). Yet the last sentence in that paragraph speci?cally excludes
transfers.
These provisions were very controversial with the U.S.-Chile and U.S.-Singapore
trade treaties in the early 2000s. U.S. trading partners repeatedly asked for a
safeguard that would include capital account regulations but the United States
has denied that request (Vandevelde 2008). In a few instances, U.S. negotia-
tors granted special annexes that allowed U.S. trading partners to receive an
extended grace period before investor-state claims can be ?led with respect to
capital account regulations, as well as limits on damages related to certain types
of controls.
These annexes are still inadequate in the wake of the ?nancial crisis for at least
four reasons. First, the annexes still allow for investor-state claims related to
capital account regulations—they just require investors to delay the claims for
compensation. An investor has to wait one year to ?le a claim related to capital
account regulations to prevent and mitigate crises, but that claim can be for a
measure taken during the cooling-off year. The prospect of such investor-state
cases could discourage the use of controls that may be bene?cial to ?nancial
stability.
Second, many other nations’ treaties allow for capital account regulations.
Indeed, the Canada-Chile FTA, the EU-Korea FTA, the Japan-Peru BIT, and the
Japan-Korea BIT (just to name a few) all grant greater ?exibility for capital account
regulations. This gives incentives for nations to apply controls in a discriminatory
manner (applying controls on EU investors but not on U.S. investors).
Third, the IMF has expressed concerns that restrictions on capital controls in
U.S. agreements, even those with the special annexes, may con?ict with the
IMF’s authority to recommend capital controls in certain country programs, as
they have done in Iceland and several other countries. Finally, the special dis-
pute settlement procedure included in the U.S.-Chile and Singapore FTAs did not
become a standard feature of U.S. agreements. It is not in CAFTA, any U.S. BIT,
or the recently rati?ed U.S.-Korea FTA.
128 A Pardee Center Task Force Report | March 2012
Capital Account Regulations and BITs and FTAs for Major Capital Exporters
The EU, Japan, Canada, and increasingly China are major capital exporters. Each of
these capital exporters has numerous BITs and FTAs with nations across the world.
And loosely, the BITs of these nations have the same general characteristics found in
U.S. BITs. However, in the case of the use of capital account regulations to prevent
and mitigate ?nancial crises, the BITs and investment provisions of all BITs and
FTAs by these exporters either contain a broad “balance of payments” temporary
safeguard exception or a “controlled entry” exception that allows a nation to deploy
its domestic laws pertaining to capital account regulations.
Examples of the balance-of-payments approach can be found in the EU-South
Africa and Mexico FTAs (remember Mexico negotiated such a provision in
NAFTA), the Japan-South Korea BIT, and the ASEAN agreements. The Korea-
Japan BIT has language that clearly allows for restrictions on both in?ows and
out?ows, presumably inspired by the 1997 crisis. The BIT states:
Another way capital account regulations are treated by capital exporters in
FTAs and BITs is referred to as ‘controlled entry’ whereby a nation’s domestic
laws regarding capital account regulations are deferred to. Canada and the EU’s
FTAs with Chile and Colombia each have a balance-of-payments safeguard and
a controlled entry deferment. As an example of controlled entry, the invest-
ment chapter of the FTA between Canada and Colombia has an Annex, which
states “Colombia reserves the right to maintain or adopt measures to maintain
or preserve the stability of its currency, in accordance with Colombian domestic
legislation,” and lists speci?c laws and resolutions in Colombia that pertain to
capital account regulations.
Controlled entry provisions are to be found in BITs as well. The EU does not
sign many BITs as a union, but individual countries do. The China-Germany BIT
Box 7: Exception in Korea-Japan BIT
a. in the event of serious balance-of-payments and external fnancial diffculties or threat
thereof; or
b. in cases where, in exceptional circumstances, movements of capital cause or threaten to cause
serious diffculties for macroeconomic management, in particular, monetary or exchange
rate policies
Source: Salacuse 2010, 268.
Regulating Global Capital Flows for Long-Run Development 129
states that transfers must comply with China’s laws on exchange controls (Ander-
son 2009). In the case of China, that nation has to approve all foreign in?ows and
out?ows of short-term capital (see Zhang in this group of essays).
Interestingly, EU member BITs vary a great deal. Some, like the China-Germany
BIT and the UK-Bangladesh BIT, allow for a nation to defer to its own laws
governing capital account regulations. On the other hand, Sweden and Austria
had U.S.-style BITs with no exceptions whatsoever. However, the European Court
of Justice ruled in 2009 that Sweden’s and Austria’s BITs with several developing
countries were in violation to their obligations under the EU treaty. While the EU
treaty requires EU members to allow for free transfers, it also allows members
to have exceptions. The court found that Sweden’s and Austria’s treaties were
incompatible with the EU treaty and that such treaties would need to be renego-
tiated to include exceptions to the transfer provisions (Salacuse 2010). In 2011,
the EU ordered its members to re-negotiate their bilateral investment treaties
with developing countries. The predominant reason for their wish to re-negotiate
was due to a recent decision of the European Court of Justice (ECJ) regarding the
free transfer of capital clauses included in many EU member state BITs. Indeed,
the ECJ concluded that these clauses are in contradiction with EU law and need
to be re-negotiated. The decision is based on the fact that the EU treaty, while
demanding the free transfer of capital, also provides for the possibility to regu-
late and restrict the free transfer of capital if the economic situation so requires.
OPTIONS FOR REFORM
Reforming treaties in order to grant individual nations and the global community
the policy space to deploy capital account regulations to prevent and mitigate
?nancial crises is fairly simple
at the technical level but quite
dif?cult at the political level.
Box 8 outlines the technical
measures that could be made
to future or existing treaties in
order for such treaties to allow
nations and the global com-
munity to deploy and coordinate capital account regulations to manage global
capital ?ows in such a manner that enhances ?nancial stability and economic
development.
Reforming treaties in order to grant indi-
vidual nations and the global community
the policy space to deploy capital account
regulations to prevent and mitigate ?nancial
crises is fairly simple at the technical level
but quite dif?cult at the political level.
130 A Pardee Center Task Force Report | March 2012
Box 8: Reforming Trade and Investment Treaties
for Capital Account Regulation
National-level
• Draft and pass a law or resolution that allows the nation’s fnancial authorities to put capital
account regulations in place during periods of anticipated or actual fnancial instability.
WTO
• Critically assess the benefts of “listing” cross border trade in fnancial services (Mode 1) or
commercial presence of foreign services (Mode 3) under GATS commitments.
• If a nation chooses to make Mode 1 and Mode 3 commitments, opt for “limiting” such
liberalization with exception to national laws regarding capital account regulations.
• If a nation has existing commitments to liberalize their fnancial sector through Mode 1 or
Mode 3, seek clarifying language under the exceptions in the GATS.
FTAs/BITs
• Remove short-term debt obligations and portfolio investments from the list of investments
covered in treaties.
• Create ‘controlled entry’ Annexes in BITs and FTAs that provide full exception for when a
nation deploys a national law pertaining to capital account regulations.
• Design a balance-of-payments exception that covers both infows and outfows such as the
provisions found in the Japan-South Korea BIT.
• Clarify that the Essential Security exceptions cover fnancial crises, and that measures taken
by host nations are self-judging.
• Resort to a State-to-State dispute resolution process for claims related to fnancial crises,
analogous to the WTO and the other chapters in most FTAs.
• If a nation has an existing FTA or BIT that does not permit capital account regulations, seek
to negotiate interpretive notes that clarify existing exceptions in the treaties.
Regulating Global Capital Flows for Long-Run Development 131
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Gallagher, Kevin P. (2011). “Losing Control: Policy Space for Capital Controls in Trade
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Geithner, Timothy (2011). Letter to Economists Regarding Trade Treaties and Capital
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van Aaken, Anne and Jurgen Kurtz (2009). “Prudence or Discrimination? . . . Challenges
Ahead in International Economic Law.” Journal of International Economic Law, 12(1):
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Vandevelde, Kenneth (2008). U.S. International Investment Agreements. Oxford: Oxford
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Regulating Global Capital Flows for Long-Run Development 133
Task Force Members
Amar Bhattacharya
Director, The Intergovernmental Group of Twenty-Four on International
Monetary Affairs and Development (G-24)
Amar Bhattacharya is Director of the Group of 24. The Intergovernmental Group
of Twenty-Four on International Monetary Affairs and Development (G-24) was
established in 1971 with the objective of helping to articulate and support the
position of developing countries in the discussions of the International Monetary
Fund, the World Bank, and other relevant fora. Prior to his current position, Mr.
Bhattacharya had a long-standing career at the World Bank. His last position was
as Senior Advisor and Head of the International Policy and Partnership Group
in the Poverty Reduction and Economic Management Network of the World
Bank. In this capacity, he was the focal point for the Bank’s engagement with key
international groupings and institutions such as the G-7/G-8, G-20, International
Monetary Fund, Organisation for Economic Co-operation and Development,
and the Commonwealth Secretariat. Mr. Bhattacharya has had a long-standing
engagement on issues of global governance and reform of the international
?nancial system as well as aid architecture.
Mark Blyth
Professor of International Political Economy, Brown University
Mark Blyth researches how uncertainty and randomness impact economic
systems, and how the ideas we have about how such systems work are them-
selves causally important within them. He was a member of the Anglo-German
Warwick Commission on International Financial Reform that made a case
for post-crisis macroprudential regulation. He is the author of several books
including Great Transformations: Economic Ideas and Institutional Change in
the Twentieth Century (Cambridge University Press, 2002), and most recently,
Austerity: The History of a Dangerous Idea (Oxford University Press, 2012) that
interrogates the return to prominence of ?nancial orthodoxy following the global
?nancial crisis.
134 A Pardee Center Task Force Report | March 2012
Leonardo Burlamaqui
Program Of?cer, Ford Foundation and Associate Professor of Economics,
State University of Rio de Janeiro
Leonardo Burlamaqui has written and published widely on innovation and com-
petition, knowledge governance, development economics, intellectual property
rights, globalization and institutional change, and the political economy of global
trade and ?nance. Recent publications include “Intellectual Property, Innova-
tion and Development” published in the Brazilian Journal of Political Economy
(Fall 2010), and the essay “Governing Finance and Knowledge,” published in the
special issue of the Journal Homo Oeconomicos, “Schumpeter for Our Time”
(Spring 2010). His forthcoming publications include the chapter “From Intellec-
tual Property to Knowledge Governance” (with Mario Cimoli) in J. Stiglitz et al.
(eds): Intellectual Property Rights: Legal and Economic Challenges for Develop-
ment (Oxford University Press, 2011), and “Knowledge Governance: An Analyti-
cal Perspective and Its Policy Implications,” to be published in Burlamaqui, L.,
Castro, A.C. and Kattel, R. (eds): Knowledge Governance: Reasserting the Public
Interest (Anthem Press, 2012).
Gerald Epstein
Professor of Economics and Founding Co-Director of the Political Economy
Research Institute (PERI) at the University of Massachusetts, Amherst
Gerald Epstein has written articles on numerous topics including ?nancial
regulation, alternative approaches to central banking for employment genera-
tion and poverty reduction, and capital account management and capital ?ows.
He also has worked with several UN organizations. Some of his recent work
includes “Avoiding Group Think and Con?icts of Interest: Widening the Circle of
Central Bank Advice” with Jessica Carrick-Hagenbarth, in Central Banking, May
2011 and Beyond In?ation Targeting: Assessing the Impacts and Policy Alterna-
tives (Elgar Press, 2009), co-edited with Erinc Yeldan. Professor Epstein is also
co-coordinator of SAFER, a group of economists and other analysts working for
?nancial restructuring and reform.
Regulating Global Capital Flows for Long-Run Development 135
Kevin P. Gallagher
Associate Professor of International Relations, and Faculty Fellow, Frederick
S. Pardee Center for the Study of the Longer-Range Future, Boston University
Kevin Gallagher is the author of The Dragon in the Room: China and the Future of
Latin American Industrialization (with Roberto Porzecanski), The Enclave Economy:
Foreign Investment and Sustainable Development in Mexico’s Silicon Valley (with
Lyuba Zarsky), and Free Trade and the Environment: Mexico, NAFTA, and Beyond.
He has been the editor or co-editor for a number of books, including Putting Devel-
opment First: the Importance of Policy Space in the WTO and IFIs, and Rethink-
ing Foreign Investment for Development: Lessons from Latin America. Professor
Gallagher is also a research associate at the Global Development and Environment
Institute at Tufts University. In 2009 he served on the U.S. Department of State
Advisory Committee on International Economic Policy.
Ilene Grabel
Professor, Josef Korbel School of International Studies, University of Denver
Ilene Grabel has been a research scholar at the Political Economy Research
Institute of the University of Massachusetts since 2007, and was a lecturer at
the Cambridge University Advanced Programme on Rethinking Development
Economics since its founding. She has worked as a consultant to United Nations
Development Programme/International Poverty Centre, United Nations Con-
ference on Trade and Development/G-24, United Nations University—World
Institute for Development Economics Research (UNU WIDER), and with Action-
Aid and the NGO coalition, “New Rules for Global Finance.” She has published
widely on ?nancial policy and crises, the political economy of international capi-
tal ?ows to the developing world, the relationship between ?nancial liberaliza-
tion and macroeconomic performance in developing countries, central banking,
exchange rate regimes, the political economy of remittances and, most recently
on the normalization of capital controls and the effect of the global ?nancial cri-
sis on policy space for development. Professor Grabel is co-author (with Ha-Joon
Chang) of Reclaiming Development: An Alternative Policy Manual (Zed Books,
2004). Grabel also blogs for the TripleCrisis (www.triplecrisis.com).
136 A Pardee Center Task Force Report | March 2012
Stephany Grif?th-Jones
Financial Markets Program Director at the Initiative for Policy Dialogue,
Columbia University
Stephany Grif?th-Jones is a member of the Warwick Commission on Financial
Regulation and was a Professorial Fellow, Institute of Development Studies. She
has published widely on the international ?nancial system and its reform. Her
research interests include global capital ?ows, with special reference to ?ows
to emerging markets; macro-economic management of capital ?ows in Latin
America, Eastern Europe and sub-Saharan Africa; proposals for international
measures to diminish volatility of capital ?ows and reduce likelihood of currency
crises; analysis of national and international capital markets; and proposals for
international ?nancial reform.
Rakesh Mohan
Professor of the Practice of International Economics and Finance at the
School of Management and Senior Fellow, Jackson Institute for Global
Affairs, Yale University
Rakesh Mohan serves as chairman of the National Transport Development Policy
Committee of the Government of India, with rank of Minister of State, (non exec-
utive) Vice Chairman of the Indian Institute of Human Settlements; and Senior
Adviser, McKinsey Global Institute, McKinsey and Company. He is also a non
resident Senior Research Fellow of Stanford University. He has researched exten-
sively in the areas of economic reforms and liberalisation, industrial economics,
urban economics, infrastructure studies, economic regulation, monetary policy
and the ?nancial sector. He was secretary of the Indian Ministry of Finance, and
also Deputy Governor of the Reserve Bank of India between 2002 and 2009. In
this capacity he co-chaired the G-20 Working Group “Enhancing Sound Regula-
tion and Strengthening Transparency” (2009), and the Committee on the Global
Financial System (CGFS) Working Group on Capital Flows (2008–2009). He is
the author of Monetary Policy in a Globalized Economy: A Practitioner’s View
(Oxford University Press, 2009), which focuses on the issues relating to the evolu-
tion of banking and ?nance, the conduct of monetary policy, the management
of the ?nancial sector, and the role of central banking. His latest book is Growth
with Financial Stability: Central Banking in an Emerging Market (Oxford Uni-
versity Press, 2011).
Regulating Global Capital Flows for Long-Run Development 137
José Antonio Ocampo
Professor, Director of the Economic and Political Development Program in
the School of International and Public Affairs, and Fellow of the Committee
on Global Thought, Columbia University
José Antonio Ocampo has held numerous positions at the United Nations and in
his native Colombia, including UN Under-Secretary-General for Economic and
Social Affairs, Executive Secretary of the UN Economic Commission for Latin
America and the Caribbean (ECLAC), and Minister of Finance of Colombia. He
has received many distinguished awards, including the 2008 Leontief Prize for
Advancing the Frontiers of Economic Thought and the 1988 Alejandro Angel
Escobar National Science Award of Colombia. He has published extensively, and
his latest books include Growth and Policy in Developing Countries: A Structur-
alist Approach, with Lance Taylor and Codrina Rada (2009), and Time for a Vis-
ible Hand: Lessons from the 2008 World Financial Crisis, edited with Stephany
Grif?th-Jones and Joseph E. Stiglitz (2010).
Dani Rodrik
Ra?q Hariri Professor of International Political Economy, John F. Kennedy
School of Government, Harvard University
Dani Rodrik has published widely in the areas of international economics, eco-
nomic development, and political economy. He is the recipient of the inaugural
Albert O. Hirschman Prize of the Social Science Research Council in 2007. He
has also received the Leontief Award for Advancing the Frontiers of Economic
Thought, and honorary doctorates from the University of Antwerp and the
Catholic University of Peru. He is af?liated with the National Bureau of Economic
Research (Cambridge, Mass.), Centre for Economic Policy Research (London),
Center for Global Development, and Council on Foreign Relations, among others.
138 A Pardee Center Task Force Report | March 2012
Shari Spiegel
Senior Economic Affairs Of?cer, World Economic and Social Survey (WESS)
team at the United Nations Department of Social and Economic Affairs,
Development Policy and Analysis Division
Shari Spiegel is co-author and co-editor of several of books and articles on capi-
tal and ?nancial markets, debt, and macroeconomics. She served as Executive
Director of the Initiative for Policy Dialogue (IPD), a think-tank presided over
by Joseph Stiglitz at Columbia University. She has extensive experience in the
private sector, most recently as a principal at New Holland Capital and as head
of ?xed-income emerging markets at Lazard Asset Management. She also served
as an advisor to the Hungarian Central Bank in the early 1990s.
Arvind Subramanian
Senior Fellow jointly at the Peterson Institute for International Economics
and the Center for Global Development
Arvind Subramanian previously served as Assistant Director in the Research
Department of the International Monetary Fund. During his career at the Fund,
he worked on trade, development, Africa, India, and the Middle East. He served
at the GATT (1988–1992) during the Uruguay Round of trade negotiations, and
taught at Harvard University’s Kennedy School of Government (1999–2000) and
at Johns Hopkins’ School for Advanced International Studies (2008–2010).
He has written on growth, trade, development, institutions, aid, oil, India,
Africa, the WTO, and intellectual property. He has published widely in academic
and other journals and has also published or been cited in leading magazines
and newspapers. He is currently a columnist for India’s leading ?nancial daily,
Business Standard. He advises the Indian government in different capacities,
including as a member of the Finance Minister’s Expert Group on the G-20. He is
the author of India’s Turn: Understanding the Economic Transformation (Oxford
University Press, 2008) and the forthcoming book Eclipse: Living in the Shadow
of China’s Economic Dominance. He is co-editor of Ef?ciency, Equity, and Legiti-
macy: The Multilateral Trading System at the Millennium with Roger Porter and
Pierre Sauvé (Brookings/Harvard University Press, 2002).
Regulating Global Capital Flows for Long-Run Development 139
Shinji Takagi
Professor of Economics, Osaka University
Shinji Takagi has taught at Osaka University since 1990. He has held numerous pro-
fessional appointments, including: Economist at the International Monetary Fund
(1983–1990); Senior Economist, Japanese Ministry of Finance (1992–1994); Visiting
Professor of Economics, Yale University (2000–2001); advisor in the IMF Inde-
pendent Evaluation Of?ce (IEO, 2002–2006); Macro-Financial Expert at the Asian
Development Bank (2007–2008; 2009–2010); Visiting Fellow at the ADB Institute
(2007–2009); and consultant for ASEAN central banks (2010–2011). He is a special-
ist in international monetary economics and has authored or co-authored more
than 100 publications, including books, articles in international journals, and book
chapters. While at the IEO, he managed a project to evaluate the IMF’s approach to
capital account liberalization; while at the ABD Institute, he collaborated with Mario
Lamberte and Masahiro Kawai on a project on managing capital ?ows in Asia.
Ming Zhang
Senior Research Fellow and Deputy Director of Department of Interna-
tional Finance, Institute of World Economics and Politics (IWEP), Chinese
Academy of Social Science (CASS)
Ming Zhang is also the Deputy Director of the Research Center for International
Finance (RCIF) of CASS. His research covers international ?nance and Chinese
macro-economy. In the past several years his ?elds of interest have included the
global ?nancial crisis, management of China’s foreign exchange reserves, cross-
border capital ?ow, and RMB internationalization. He is the author of six books
and more than 60 papers in academic journals. He also writes columns for news-
papers and magazines. Before joining in IWEP, he worked as an auditor in KPMG,
and a PE fund manager in Asset Managers Group, a Japanese listed company.
140 A Pardee Center Task Force Report | March 2012
Regulating Global Capital Flows for Long-Run Development 141
OTHER PARDEE CENTER PUBLICATIONS
Pardee Center Task Force Reports
Latin America 2060: Consolidation or Crisis?
September 2011
Beyond Rio+20: Governance for a Green Economy
March 2011
The Future of North American Trade Policy: Lessons from NAFTA
November 2009
The Pardee Papers series
The Future of Agriculture in Africa
Julius Gutane Kariuki (No. 15), August 2011
Africa’s Technology Futures: Three Scenarios
Dirk Swart (No. 14), July 2011
The Global Land Rush: Implications for Food, Fuel, and the Future of Development
Rachel Nalepa (No. 13), May 2011
Energy Transitions
Peter A. O’Connor (No. 12), November 2010
Issues in Brief series
Capital Account Regulation for Stability and Development: A New Approach
Kevin P. Gallagher, José Antonio Ocampo and Stephany Grif?th-Jones (No. 22),
November 2011
Adulthood Denied: Youth Dissatisfaction and the Arab Spring
M. Chloe Mulderig (No. 21), October 2011
Perceptions of Climate Change: The Role of Art and the Media
Miquel Muñoz and Bernd Sommer (No. 20), February 2011
The Future of Corporate Social Responsibility Reporting
(No. 19), January 2011
142 A Pardee Center Task Force Report | March 2012
Pardee Center Conference Reports
Africa 2060: Good News from Africa
April 2010
Sustainable Development Insights
Rio+20: Accountability and Implementation as Key Goals
Adil Najam and Miquel Muñoz (No. 8), August 2011
Global Environment Governance: The Role of Local Governments
Konrad Otto-Zimmerman (No. 7), March 2011
Green Revolution 2.0: A Sustainable Energy Path
Nalin Kulatilaka (No. 6), October 2010
Global Environment Governance: The Challenge of Accountability
Adil Najam and Mark Halle (No. 5), May 2010
The Role of Cities in Sustainable Development
David Satterthewaite (No. 4), May 2010
All publications are available for download as PDF ?les at www.bu.edu/pardee/publications.
Hard copies are available by email request to [email protected].
Pardee House
67 Bay State Road
Boston, Massachusetts 02215
www.bu.edu/pardee
ISBN 978-1-936727-04-9
The Frederick S. Pardee Center for the Study of the Longer-Range Future at Boston University
serves as a catalyst for studying the improvement of the human condition through an increased
understanding of complex trends, including uncertainty, in global interactions of politics, econom-
ics, technological innovation, and human ecology. The Pardee Center’s perspectives include the
social sciences, natural science, and the humanities’ vision of the natural world. The Center’s focus
is de?ned by its longer-range vision. Our work seeks to identify, anticipate, and enhance the long-
term potential for human progress—with recognition of its complexity and uncertainties.
Occasionally, the Pardee Center convenes groups of experts on speci?c policy questions to identify
viable policy options for the longer-range future. The Pardee Center Task Force Reports present the
?ndings of these deliberations as a contribution of expert knowledge to discussions about impor-
tant issues for which decisions made today will in?uence longer-range human development.
Pardee Center Task Force on Regulating Global Capital Flows for Long-Run Development
The Pardee Center Task Force on Regulating Global Capital Flows for Long-Run Development
was convened on behalf of the Pardee Center’s Global Economic Governance Initiative by Kevin
P. Gallagher, Associate Professor of International Relations at Boston University, along with
Stephany Grif?th-Jones and José Antonio Ocampo of the Initiative for Policy Dialogue (IPD) at
Columbia University. The Task Force is co-sponsored by IPD and the Global Development and
Environment Institute at Tufts University. The Task Force, which includes leading scholars and
practitioners from across the globe, ?rst met at Boston University in September 2011. The goal
of the Task Force and this report is to contribute expert knowledge to the debate among national
and global policymakers and other economists concerning whether and how nations can use
what have been traditionally referred to as capital controls (which we classify as ‘capital account
regulations’ or CARs) to prevent and mitigate ?nancial crises caused by short-term speculative
capital ?ows in developing countries.
Based on discussions among members, this report posits that there is a clear rationale for capital
account regulations in the wake of the ?nancial crisis, that the design and monitoring of such reg-
ulations is essential for their effectiveness, and that a limited amount of global and regional co-
operation would be useful to ensure that CARs can form an effective part of the macroeconomic
policy toolkit. The protocol for deploying capital account regulations in developing countries that
is put forth in this report stands in stark contrast to a set of guidelines for the use of capital con-
trols endorsed by the board of the International Monetary Fund (IMF) in March 2011. However,
the Task Force’s recommendations are more in sync with the set of “coherent conclusions” on
capital account regulations endorsed by the G-20 in November 2011. Our hope is that this Pardee
Center Task Force Report will help inform the discussions and decisions of policymakers and the
IMF as they move forward on this issue under the rubric of the G-20 recommendations.
Task Force Co-Sponsors
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Regulating Global
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PARDEE CENTER TASK FORCE REPORT / March 2012
Regulating Global Capital Flows
for Long-Run Development
Co-Chairs
Kevin P. Gallagher
Stephany Grif?th-Jones
José Antonio Ocampo
Task Force Members
Amar Bhattacharya
Mark Blyth
Leonardo Burlamaqui
Gerald Epstein
Kevin P. Gallagher
Ilene Grabel
Stephany Grif?th-Jones
Rakesh Mohan
José Antonio Ocampo
Dani Rodrik
Shari Spiegel
Arvind Subramanian
Shinji Takagi
Ming Zhang
ii
Occasionally, the Pardee Center convenes groups of experts on speci?c policy questions
to identify viable policy options for the longer-range future. This series of papers,
Pardee Center Task Force Reports, presents the ?ndings of these deliberations as
a contribution of expert knowledge to discussions about important issues for which
decisions made today will in?uence longer-range human development.
Report Editors: Kevin P. Gallagher, Stephany Grif?th-Jones, and José Antonio Ocampo.
The Frederick S. Pardee Center for the Study of the Longer-Range Future at Boston University
serves as a catalyst for studying the improvement of the human condition through an
increased understanding of complex trends, including uncertainty, in global interactions of
politics, economics, technological innovation, and human ecology. The Pardee Center’s per-
spectives include the social sciences, natural science, and the humanities’ vision of the natural
world. The Center’s focus is de?ned by its longer-range vision. Our work seeks to identify,
anticipate, and enhance the long-term potential for human progress—with recognition of its
complexity and uncertainties.
The Frederick S. Pardee Center for the Study of the Longer-Range Future
Boston University
Pardee House
67 Bay State Road
Boston, Massachusetts 02215
Tel: +1 617-358-4000 Fax: +1 617-358-4001
www.bu.edu/pardee
Email: [email protected]
Cover photograph via iStock.com.
The views expressed in this paper represent those of the individual authors and do not
necessarily represent the views of their home institutions, the Frederick S. Pardee Center
for the Study of the Longer-Range Future, or the Trustees of Boston University. The publica-
tions produced by the Pardee Center present a wide range of perspectives with the intent of
fostering well-informed dialogue on policies and issues critical to human development and
the longer-range future.
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iii
TABLE OF CONTENTS
iv Acknowledgements
v Acronyms and Abbreviations
Executive Summary ..........................................................................................................1
Capital Account Regulations for Stability and Development:
A New Approach
Kevin P. Gallagher, Stephany Grif?th-Jones, and José Antonio Ocampo
Section I: The Rationale for Capital Account Regulation
1. The Case For and Experience With Capital Account Regulations .................... 13
José Antonio Ocampo
2. Capital Account Management: The Need for a New Consensus ....................... 23
Rakesh Mohan
3. Managing Capital Flows: Lessons from the
Recent Experiences of Emerging Asian Economies ........................................... 35
Masahiro Kawai, Mario B. Lamberte, and Shinji Takagi
4. Capital Out?ow Regulation:
Economic Management, Development and Transformation ............................ 47
Gerald Epstein
Section II: Implementing and Monitoring Effective Regulation
5. Dynamic Capital Regulations, IMF Irrelevance and the Crisis.......................... 59
Ilene Grabel
6. How to Evade Capital Controls…and Why They Can Still Be Effective .......... 71
Shari Spiegel
7. China’s Capital Controls: Stylized Facts and Referential Lessons ....................... 85
Ming Zhang
Section III: The Global Cooperation of Capital Account Regulations?
8. The IMF, Capital Account Regulation,
and Emerging Market Economies .......................................................................... 93
Paulo Nogueira Batista, Jr.
9. The Need for North-South Coordination .............................................................103
Stephany Grif?th-Jones and Kevin P. Gallagher
10. International Regulation of the Capital Account ...............................................111
Arvind Subramanian
11. Capital Account Regulations and the Trading System .....................................119
Kevin P. Gallagher
Biographies of Task Force Members
iv
ACKNOWLEDGEMENTS
The Pardee Center Task Force on Regulating Global Capital Flows for Long-Run Develop-
ment is a project of the Center’s Global Economic Governance Initiative (GEGI) that is
coordinated by Boston University Professor and Pardee Faculty Fellow Kevin P. Gallagher.
The Task Force is co-chaired by Stephany Grif?th-Jones and José Antonio Ocampo of
Columbia University’s Initiative for Policy Dialogue (IPD), and it is co-sponsored by IPD
and the Global Development and Environment Institute at Tufts University (GDAE).
The co-chairs sincerely thank the Frederick S. Pardee Center for the Study of the Longer-
Range Future for the support for this project. The project was made possible by the early
enthusiasm of Adil Najam, former Director of the Center. The enthusiasm has been echoed
and accentuated by James McCann, the current Director, ad interim. We particularly thank
Theresa White and Elaine Teng at the Pardee Center for making the September 16, 2011
workshop that led to this report work smoothly and ef?ciently. In addition to helping to
organize the logistics of the event, Pardee Programs Manager Cynthia Barakatt has played
a key role in producing the various publications and events stemming from the Task Force.
We also sincerely thank Tania Tzelnic, Boston University graduate student who served as
rapporteur at the workshop and provided invaluable assistance in editing the ?nal report.
The co-chairs also thank Mildred Menos, Program Manager at IPD, and Joanna Miller,
Communications Coordinator at GDAE, for coordination and support as well.
The co-chairs thank all of the Task Force participants for taking time from their busy
schedules to participate in this important endeavor. We especially thank Paulo Nogueira
Batista, Jr., Executive Director for Brazil and eight other Latin American countries at the
International Monetary Fund (IMF), for coming to the workshop, delivering the keynote
speech, and contributing to the ?nal report as well.
We thank Peter Chowla of the Bretton Woods Project and Jo Marie Griesgraber of New
Rules for Global Finance, and Bhumika Muchala of the Third World Network for assisting
us with outreach that will ensure the report gets in the right hands across the globe.
Finally, we would like to thank the foundations that have also provided support for this
effort. Leonardo Burlamaqui and the Ford Foundation support GEGI’s project on capital
?ows and development, in addition to a similar program at IPD. This Task Force signi?-
cantly builds on a Ford Foundation–United Nations workshop that occurred in August
2011. GDAE would also like to acknowledge the support of the Rockefeller Brothers Fund.
v
ACRONYMS AND ABBREVIATIONS
ADR: American Depository Receipts
AE: Advanced Economy
AEC: ASEAN Economic Community
BI: Bank Indonesia
BIT: Bilateral Investment Treaty
BOK: Bank of Korea
BOVESPA: Sao Paulo Stock Exchange
CAM: Capital Account Management
CAR: Capital Account Regulation
CBB: Central Bank Bills
CFM: Capital Flow Management
CGFS: Committee on the Global Financial System
CRR: Cash Reserve Ratio
EAE: Emerging Asian Economy
EME: Emerging Market Economy
FDI: Foreign Direct Investment
FSB: Financial Stability Board
FTA: Free Trade Agreement
GATS: General Agreement on Trade in Services
GATT: General Agreement on Tariffs and Trade
GDP: Gross Domestic Product
IMF: International Monetary Fund
NAFC: North Atlantic Financial Crisis
NDF: Non-Deliverable Forwards
OECD: Organisation for Economic Co-Operation and Development
PBC: People’s Bank of China
QFII: Quali?ed Foreign Institutional Investor
QDII: Quali?ed Domestic Institutional Investor
RBI: Reserve Bank of India
RMB: Renminbi (Chinese Currency)
SAFE: Chinese State Administration of Foreign Exchange
SBA: Stand-By Arrangement
SBV: State Bank of Viet Nam
SDA: Special Deposit Account
SWF: Sovereign Wealth Fund
URR: Unremunerated Reserve Requirement
WTO: World Trade Organization
vi
1
Executive Summary
Capital Account Regulations
for Stability and Development: A New Approach
Kevin P. Gallagher, Stephany Grif?th-Jones,
and José Antonio Ocampo
Since the revival of global capital markets in the 1960s, cross-border capital
?ows have increased by orders of magnitude, so much so that international
asset positions now outstrip global economic output. Most cross-border capital
?ows occur among industrialized nations, but emerging markets are increasing
participants in the globalization of capital ?ows. While it is widely recognized
that investment is an important ingredient for economic growth, and that capital
?ows may under certain conditions be a valuable supplement to domestic
savings for ?nancing such investment, there is a growing concern that certain
capital ?ows (such as short-term debt) can have destabilizing effects in develop-
ing countries.
During the recent ?nancial and currency crises a number of emerging market
and developing countries experimented with a variety of measures that have
traditionally been referred to as “capital controls”—de?ned as regulations on
capital ?ows. Given that capi-
tal controls have been highly
stigmatized, in this paper we
will refer to them as capital
account regulations (CARs).
Those nations that deployed CARs in the years leading to the ?nancial crisis
were among the least hard hit when the global ?nancial crisis wracked the world
economy (Ostry et al. 2011).
The 2008 global ?nancial crisis has opened a new chapter in the debate over the
proper policy responses to pro-cyclical capital ?ows. Until very recently certain
strands of the economics profession as well as industrialized country national
governments and international ?nancial institutions have remained either hostile or
The 2008 global ?nancial crisis has opened
a new chapter in the debate over the proper
policy responses to pro-cyclical capital ?ows.
2 A Pardee Center Task Force Report | March 2012
silent to regulating capital movements. Regardless, a number of emerging econo-
mies, including Brazil, Taiwan, and South Korea, have been successfully experi-
menting with CARs to manage volatile capital ?ows (Gallagher 2011; IMF 2011b).
The International Monetary Fund (IMF) has come to partially recognize the appro-
priateness of capital account regulations and has gone so far as to recommend (and
of?cially endorse) a set of guidelines regarding the appropriate use of CARs.
In September 2011, the Global Economic Governance Initiative at Boston
University’s Pardee Center for the Study of the Longer-Range Future—along with
Columbia University’s Initiative for Policy Dialogue and Tufts University’s Global
Development and Environment Institute—convened a Task Force on Regulating
Global Capital Flows for Long-Run Development. Based on discussions among
members, we argue that there is a clear rationale for capital account regulations
in the post-crisis world, that the design and monitoring of such regulations is
essential for their effectiveness, and that a limited amount of global and regional
cooperation would be useful to ensure that CARs can form an effective part of
the macroeconomic policy toolkit.
This report addresses these issues and provides a protocol for the use of CARs—
one that stands in stark contrast to a set of guidelines for the use of capital con-
trols endorsed by the board of the IMF in March 2011 (see IMF 2011b) but now
superseded by a G-20 set of “coherent conclusions” on CARs in November 2011.
Endorsed by the G-20 ?nance ministers and central bank governors in October,
then endorsed by the G-20 leaders themselves in Cannes, the G-20’s conclusions
say that “there is no ‘one-size ?ts all’ approach or rigid de?nition of conditions
for the use of capital ?ow management measures.” This Task Force report will
help policymakers and the IMF navigate their thinking under these newer G-20
recommendations.
CAPITAL FLOWS AND THE TWO-SPEED RECOVERY
A long line of prominent economists throughout history have argued that ?nan-
cial markets can be inherently unstable (see Ocampo, Spiegel, and Stiglitz 2008).
Different authors use different terms but there is a consistent concern that during
periods of growth, expectations can become extremely optimistic, leading to a
reduction in risk aversion, a rapid expansion in credit and a rise in asset prices.
Imbalances associated with excessive risk taking build up, and if there are
changes in expectations, possibly unleashed by facts that lead to a loss in asset
values, the unwinding of positions may lead to instability, panics, and crises.
Boom is then followed by bust.
Regulating Global Capital Flows for Long-Run Development 3
Cross-border capital ?ows to emerging and developing countries tend to follow a
similar pattern. Between 2002 and 2007 there were massive ?ows of capital into
emerging markets and other developing economies. After the collapse of Lehman
Brothers, there was capital ?ight to the “safety” of the U.S. market, which spread
the North Atlantic ?nancial crisis to emerging markets. As interest rates were
lowered for expansionary purposes in the industrialized world between 2008 and
2011, capital ?ows again returned to emerging markets, where interest rates and
growth were relatively higher. The carry trade was one of the key mechanisms
that triggered these ?ows. Increased liquidity induced investors to go short on the
dollar and long on currencies in nations with higher interest rates and expecta-
tions of strengthening exchange rates. With signi?cant leverage factors, investors
gained on both the interest rate differential and the exchange rate movements.
These sudden surges in capital ?ows can be de-stabilizing for four reasons. First,
if capital ?ows are large enough, such speculation can cause undue appreciation
and volatility of exchange rates and lead to a boom in asset prices in developing
economies. Second, relatively small interest rate or currency changes can trigger
an unwinding of (highly leveraged) positions, which can cause a sudden stop
of external ?nancing and capital ?ight. Third, a sudden unwinding of positions
where the investment entity is highly interconnected with other parts of the
?nancial system might cause systemic risk. Fourth, in an environment where
nations have open capital accounts, short-term capital movements reduce the
space for independent monetary policies. The dominant tool to stem in?ation
is the interest rate. However, raising interest rates would actually attract more
capital ?ows, in effect generating expansionary pressures.
Private capital ?ows to Asia and Latin America have returned to their pre-
Lehman Brothers highs. This is the case in nations like Brazil, which saw an
appreciation of its currency of more than 40 percent between the third quarter
of 2009 and September of 2011, and rising concern over asset bubbles and
in?ation. Indeed it will come as no surprise that it was Brazil’s ?nance minister
who declared the surge in capital ?ows, the subsequent appreciations, and the
myriad reactions to the surges as the beginning of a “currency war.” In the midst
of these capital ?ows, individual nations have responded in various ways. In
Brazil’s case, it has taken the form of a tax on foreign purchases of Brazilian
securities and later with a reserve requirement and taxes for ?rms going short on
the nation’s currency and holding some derivative positions in foreign currency.
Box 1 outlines the various types of capital account regulations that have been
deployed by nations in the run up to and during the crisis.
4 A Pardee Center Task Force Report | March 2012
Capital account regulations are often deployed to manage exchange rate volatil-
ity, avoid currency mismatches, limit speculative activity in an economy, and
provide the policy-space for independent monetary policy. Measures often come
in two varieties, price-based or quantity-based. Price-based measures alter the
price of foreign capital such as with a tax on in?ows or out?ows, and unremu-
nerated reserve requirements (URRs) that have been deployed by such nations as
Chile, Colombia, and Thailand. Quantity-based measures include prohibitions or
caps on certain types of transactions (for example, on foreign borrowing below
certain maturities, or for purposes other than investment or international trade),
or minimum stay periods for capital that comes into the country.
RULES OF THUMB FOR DEPLOYING CARs
With respect to CARs, in February 2010 the IMF published a staff position note
which found that capital controls on the in?ows of capital that were deployed
over the past 15 years have been fairly effective. It also found that those nations
that used capital controls were among the least hard hit during the world
?nancial crisis (Ostry et al. 2010). A comprehensive review of the literature on
Box 1: Capital Account Regulations—An Illustrative List
In?ows
• Unremunerated reserve requirements (a
proportion of new infows are kept as
reserve requirements in the central bank)
• Taxes on new debt infows, or on foreign
exchange derivatives
• Limits or taxes on net liability position in
foreign currency of fnancial intermediaries
• Restrictions on currency mismatches
• End-use limitations: borrowing abroad only
allowed for investment and foreign trade
• Limits on domestic agents that can borrow
abroad (e.g., only frms with net revenues
in foreign currency)
• Mandatory approvals for all or some capital
transactions
• Minimum stay requirements
Out?ows
• Mandatory approval for domestic agents
to invest abroad or hold bank accounts in
foreign currency
• Mandatory requirement for domestic
agents to report on foreign investments
and transactions done with their foreign
account
• Prohibition or limits on sectors in which
foreigners can invest
• Limits or approvals on how much non-
residents can invest (e.g., on portfolio
investments)
• Restrictions on amounts of principal or
capital income that foreign investors can
send abroad
• Limits on how much non-residents can
borrow in the domestic market
• Taxes on capital outfows
Regulating Global Capital Flows for Long-Run Development 5
this topic published by the National Bureau of Economic Research in the United
States found, in turn, that capital regulation on in?ows can make monetary
policy more independent, alter the composition of capital ?ows towards longer-
term ?ows and reduce real exchange rate pressures, and that regulations on
out?ows can be effective as well (Magud et al. 2011).
The IMF now recognizes that CARs should be part of the policy toolkit for
?nancial stability. Moreover, the IMF also recognizes that the very use of the term
“capital controls” can bring a stigma to some nations that may impact the way
investors perceive the investment climate in a nation. Indeed, in the 1990s credit
rating agencies would downgrade the credit of nations that deployed controls
(Abdelal 2007). Therefore, the IMF proposed a new nomenclature for capital
controls, suggesting they be referred to as capital ?ow management measures
(CFMs). Others have previously suggested the term “capital management tech-
niques” to the same end (see Epstein et al. 2003; Ocampo et al. 2008). As we have
indicated, we prefer to use the term “capital account regulations,” to underscore
the fact they belong to the broader family of ?nancial regulations.
The IMF formulated and approved at the board level a set of guidelines pertain-
ing to when a nation should and should not deploy CARs. In a nutshell, the
of?cial report recommends that CARs be used as a last resort and as a temporary
measure, and only after a
nation has accumulated suf?-
cient reserves, adjusted inter-
est rates, and let its currency
appreciate, among other mea-
sures. When capital account
regulations are used, the IMF suggests that controls be price-based and that they
not discriminate against the residence of the investor that makes the ?ow.
Though the IMF should be applauded for recognizing that CARs are useful, its
prescriptions fall short of being sound advice for developing countries on a
number of fronts. Without the advice of the IMF many nations have deployed
CARs, alongside a host of other macroeconomic and macroprudential policies
as they have seen appropriate. And, according to the IMF’s own research, CARs
have been a success even though they have sometimes not met those guidelines.
We outline an alternative set of guidelines in Box 2. In no way do we think these
should be binding protocols at the global level. Rather, we hope they can serve
as useful rules of thumb for national policymakers.
Though the IMF should be applauded for
recognizing that CARs are useful, its prescrip-
tions fall short of being sound advice for
developing countries on a number of fronts.
6 A Pardee Center Task Force Report | March 2012
First and foremost, CARs should be seen as an essential part of the macroeco-
nomic policy toolkit and not as mere measures of last resort. In the econometric
work that recognizes the utility of CARs, such regulations were part of a battery
of approaches taken in tandem to manage the capital account. CARs should
thus be seen as part of the arsenal that needs to be used to prevent and mitigate
Box 2: Guidelines for the Use of Capital Account Regulations in
Developing Countries
• Capital Account Regulations (CARs) should be seen as an essential part of the macroeco-
nomic policy toolkit and not seen as measures of last resort.
• CARs should be considered differently in nations where the capital account is still largely closed
versus those nations where CARs are prudential regulations to manage an open capital account.
• Price-based CARs have the advantage of being more market neutral, but quantity-based
CARs may be more effective, especially in nations with relatively closed capital accounts,
weaker central banks, or when incentives to bring in capital are very large.
• CARs should not only be relegated to regulations on capital infows. Capital outfow restric-
tions may be among the most signifcant deterrents of undesirable infows and can serve
other uses as well.
• CARs can be seen as alternatives to foreign exchange reserve accumulation, particularly to
reduce the costs of reserve accumulation.
• CARs should not be seen as solely temporary measures, but should be thought of as perma-
nent mechanisms to be used in a counter-cyclical way to smooth booms and busts. Their
permanence will strengthen institutional capacity to implement them effectively.
• Therefore, CARs should be seen as dynamic, requiring a signifcant degree of market monitor-
ing and ‘fne tuning.’ as investors adapt and circumvent regulation. Investors can increasingly
circumvent CARs through mis-invoicing trade fows, derivative operations, or foreign direct
investments that are in fact debt fows. Regulators constantly need to monitor and adapt.
• It may be useful for effective CARs to distinguish between residents and non-residents.
• The full burden of managing capital fows should not be on emerging market and develop-
ing countries, but the ‘source’ countries of capital fows should also play a role in capital fow
management, including supporting the effectiveness of those regulations put in place by
recipient countries.
• Neither industrialized nations nor international institutions should limit the ability of nations to
deploy CARs, whether through trade and investment treaties or through loan conditionality.
• Industrialized nations should examine more fully the global spillover effects of their own
monetary policies and evaluate measures to reduce excessive outfows of short-term capital
that can be undesirable both for them and emerging countries.
• The stigma attached to CARs should be removed, so nations have ample confdence that they
will not be rebuked for taking action. The IMF could play a valuable role in taking away the
stigma of CARs, as well as doing comparative analysis of which CARs are most effective.
Source: Pardee Task Force on Regulating Global Capital Flows for Long-Run Development
Regulating Global Capital Flows for Long-Run Development 7
crises. In turn, they should not be seen as solely temporary measures, but rather
as permanent tools that can be used in a counter-cyclical way to smooth booms
and busts.
Second, CARs should be considered differently in nations where capital accounts
remain largely closed—and in which they may be used as part of a strategy
to gradually open the capital account—versus those nations where CARs are
prudential regulations to manage an already open capital account. The IMF
report acts as if the set of nations it was talking to were nations with open capital
accounts and ?oating exchange rates, but many developing countries deploy
capital account regulations as a regular macroprudential management technique
and intervene heavily in foreign exchange markets.
Third, quantity-based CARs may be more effective than price-based CARs, espe-
cially in those nations with relatively closed capital accounts, weaker central banks
or when incentives to bring in capital are very large (large interest rate differen-
tials or strong expectations of exchange rate appreciation). This is consistent with
economic theory and some IMF staff work. Because of uncertainties and asym-
metric information about the private sector’s response, price-based measures may
be dif?cult to calibrate correctly and therefore a quantity-based measure may be
more appropriate. Indeed, IMF research has shown that quantity-based CARs have
proven to be more effective under several conditions (Ariyoshi et al. 2000).
In addition, while there has been a sea change in thinking regarding CARs on
capital in?ows, regulations on capital out?ows have largely been shunned. CARs
should not only be relegated to regulations on capital in?ows. Capital out?ow
restrictions may be among the most signi?cant deterrents of undesirable in?ows
and can serve other uses as well. Moreover, in times of acute crisis capital
controls on out?ows may be necessary to help stop the precipitous slide of a
currency and a run on banks.
Indeed, the IMF sanctioned
controls on out?ows in Ice-
land as part of its rescue pack-
age with that nation during
the ?nancial crisis. Finally, some members of our task force argued that regulat-
ing out?ows can help channel credit and investment into the “real economy.”
CARs should also be seen as alternatives to foreign exchange reserve accumula-
tion. Recent work has shown that the social costs of foreign reserve accumulation
Capital out?ow restrictions may be among
the most signi?cant deterrents of undesirable
in?ows and can serve other uses as well.
8 A Pardee Center Task Force Report | March 2012
in developing countries can reach two to three percent of GDP (Aizenman 2009;
Rodrik 2006). CARs are an instrument to reduce excessive reserve accumulation.
THE NEED FOR MONITORING AND FINE-TUNING
The IMF guidelines give scant attention to the policy design issues related to
CARs. Though IMF econometric work shows that CARs have been effective,
there is to date a lack of research regarding how nations administratively have
designed and ?ne-tuned such regulations to make them successful. Much of
the literature shows that, without the proper ?ne-tuning, capital regulations
may lose their effectiveness due to the ability of foreign investors to evade and
circumvent such regulations. This can be done by ‘misinvoicing’ trade ?ows,
disguising debt ?ows as foreign direct investment, and by using derivatives.
Nations such as Brazil and South Korea have increasingly “?ne-tuned” their
regulations in an attempt to keep up with the various levels of circumvention.
Fine-tuning of CARs is essential for their effectiveness—and may be far simpler
than some may argue, especially if they target the large actors. When regulations
are price-based and administered by the tax system, violators could see criminal
penalty—creating a strong incentive to comply. Table 1 illustrates examples of
the use of CARs in the wake of the crisis and shows how Brazil and South Korea
have been constantly strengthening and changing the composition of their capi-
tal account regulations in response to new market conditions.
Country Date Measure
Brazil 19-Oct-09 Inflows tax (2 percent)
18-Nov-09 ADR tax (1.5 percent)
3-Oct-10 Inflows tax (4 percent)
17-Oct-10 Inflows tax (6 percent)
5-Jan-11 Reserve requirement
26-Jul-11 Tax on derivatives
South Korea 30-Jun-10 Currency controls
30-Jun-10 End use limitations
18-Dec-10 Outflows tax
Capital Account Regulations and the Crisis
Source: Gallagher 2011a
Table 1
Regulating Global Capital Flows for Long-Run Development 9
THE NEED FOR INTERNATIONAL COOPERATION
Rather than a globally enforceable code of conduct that could lead to the require-
ment to open capital accounts across the globe, the IMF, G-20, the Financial
Stability Board (FSB) and other bodies should make a stronger effort to reduce
the stigma attached to CARs and protect the ability of nations to deploy CARs
to prevent and mitigate crises. Moreover, these bodies can be part of a global
dialogue about the extent to which nation states should coordinate CARs.
In the original design of the IMF, it was charged with both permitting and help-
ing to enforce CARs. Both John Maynard Keynes and Harry Dexter White saw
them as a core component of the Bretton Woods system. In those deliberations
Keynes said that, “control of capital movements, both inward and outward,
should be a permanent feature of the post-war system.” Indeed, the IMF was not
given jurisdiction over liberalization of the capital account at all under its articles
of agreement. Article VI of those articles goes further to say that members may
“exercise such controls as are necessary to regulate international capital move-
ments” (see Helleiner 1994).
The IMF, G-20, the FSB, and their respective members could clarify the new
thinking on CARs in communiques, speeches and other venues, including
of?cial reports such as the World Economic Outlook. Such continued attention
to CARs would help continue to remove the stigma associated with their use. Not
only would it calm both national governments and market participants, it may
also trickle into the legal discourse and help broaden the way the global commu-
nity legally interprets macroprudential regulations.
This is important because the policy space provided under the IMF articles of
agreement is being eroded by trade and investment agreements. Increasingly, these
agreements prohibit the use of CARs, and those treaties that have exceptions for
measures to manage balance of payments crises only allow CARs to be temporary
in nature. In Asia, where CARs on both in?ows and out?ows are the most prevalent,
ASEAN will require nations to eliminate most CARs by 2015, with relatively narrow
exceptions. Trade and investment agreements with the United States provide the
least ?exibility. In January 2011, some 250 economists from across the globe called
on the United States to recognize the recent consensus on CARs and to permit
nations the ?exibility to deploy controls to prevent and mitigate crises. The letter
was rebuked by prominent business associations and the U.S. government. In
response to the letter, U.S. Treasury Secretary Timothy Geithner replied that U.S.
policy would go unchanged. Secretary Geithner wrote:
10 A Pardee Center Task Force Report | March 2012
“In general, we believe that those risks are best managed through a mix
of ?scal and monetary policy measures, exchange rate adjustment, and
carefully designed non-discriminatory prudential measures, such as bank
reserve or capital requirements and limitations on exposure to exchange
rate risk.”
This is ironic given that the U.S. approved the guidelines for CARs at the IMF.
Finally, the global community should start a conversation regarding the extent
to which there should be coordination among national governments regarding
CARs—especially between in?ow and out?ow nations. In the meetings leading
up to the establishment of the IMF both Harry Dexter White and John Maynard
Keynes agreed that capital controls be targeted at “both ends” of a capital ?ow
(Helleiner 1994). Furthermore, the industrialized nations are more often the
source of such ?ows but
generally ignore the nega-
tive spillover effects of their
actions. The expansionary
monetary policy by the U.S.—
which is quite justi?ed in
order to generate employment
and recovery in that country—leads to the harmful carry trade effects discussed
earlier. However, despite this fact, thus far the entire burden of managing capital
?ows has fallen on those countries that are the recipients of those in?ows.
One member of the Task Force, Arvind Subramanian, goes so far as to suggest
that an entirely new global regime is needed to regulate global capital ?ows. And
moreover, the focus should not only be on North-South ?ows but South-South
and North-North as well.
There may be an alignment of interests to coordinate on capital ?ows. Indus-
trialized nations are aiming to recover from the crisis and hope that credit and
capital stays in their nations. Meanwhile the developing world has little interest
in having to receive those ?ows. There is therefore some alignment of interests
that could form the means for industrialized nations to adjust their tax codes and
deploy other types of regulation to keep capital in their countries, as emerging
markets deploy CARs to change the composition and reduce the level of those
capital ?ows that may destabilize their economies.
The global community should start a con-
versation regarding the extent to which
there should be coordination among nation-
al governments regarding CARs—especially
between in?ow and out?ow nations.
Regulating Global Capital Flows for Long-Run Development 11
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and Reality—A Portfolio Balance Approach.” Cambridge, MA: National Bureau of
Economic Research.
Ocampo, José Antonio, Shari Spiegel, and Joseph E. Stiglitz (2008). “Capital Market Lib-
eralization and Development.” In José Antonio Ocampo and Joseph E. Stiglitz (eds.).
Capital Market Liberalization and Development. New York: Oxford University Press.
Ostry, Jonathan D., Atish R. Ghosh, Karl Habermeier, Marcos Chamon, Mahvash S.
Qureshi, and Dennis B.S. Reinhardt (2010). “Capital In?ows: The Role of Controls.” In
IMF Staff Position Note. Washington, D.C.: International Monetary Fund.
12 A Pardee Center Task Force Report | March 2012
Ostry, Jonathan D., Atish R. Ghosh, Karl Habermeier, Marcos Chamon, Luc Laeven, Mah-
vash S. Qureshi, and Annamaria Kokenyne (2011). “Managing Capital In?ows: What
tools to use?” Staff Discussion Paper, Washington, D.C.: International Monetary Fund.
Rodrik, D. (2006). “The Social Cost of Foreign Exchange Reserves.” International Eco-
nomic Journal 2(3): 253–266.
Regulating Global Capital Flows for Long-Run Development 13
Section I: The Rationale for Capital Account
Regulation
1. The Case For and Experience With
Capital Account Regulations*
José Antonio Ocampo
A major agreement during the recent crisis was that deregulated ?nancial activi-
ties can be a source of major macroeconomic disruptions. The G-20 thus led a
major effort to re-regulate ?nance, mainly at the national level. However, cross-
border ?nance was left almost entirely out of the agenda, as if it did not require
any regulation—or indeed as if it was not part of ?nance. A particular twist of
terminology is also involved in traditional discussions of this issue: domestic
?nancial regulations are called by that name, but if they involve cross-border
?ows, they are called ‘controls’. We would refer to them by their appropriate
name: capital account regulations.
The essential problem here is that capital ?ows, like ?nance in general, is
pro-cyclical. Agents that are perceived to be risky borrowers are subject to the
strongest swings in the availability and costs of ?nancing. These riskier agents
include small ?rms and poor households in all domestic markets and emerging
markets and, more generally, developing country borrowers in global markets.
There is overwhelming evidence that capital ?ows to developing countries are
pro-cyclical and have become one of the major determinants (and perhaps the
major determinant) of business cycles in emerging economies (Prasad et al. 2003;
Ocampo et al. 2008a,b). Furthermore, the cyclical supply of ?nance is increas-
ingly driven by portfolio
decisions in industrial coun-
tries, which may be entirely
delinked from demand for
capital by emerging and
developing countries. These countries face further problems: their domestic
?nancial markets are signi?cantly more ‘incomplete’ and, as a result, they are
It is important to emphasize that the cyclical
behavior that characterizes capital ?ows
goes beyond volatility of short-term ?ows.
* This essay is Section 5 of the 14th WIDER Lecture given by the author on “Reforming the International Monetary System.”
14 A Pardee Center Task Force Report | March 2012
plagued by variable mixes of currency and maturity mismatches, and their capi-
tal markets are shallower and small relative to the magnitude of the speculative
pressures they face.
It is important to emphasize that the cyclical behavior that characterizes capital
?ows goes beyond volatility of short-term ?ows. Even more important are the
medium-term cycles in the availability and costs of ?nancing. Since the mid
1970s, we have experienced three full medium-term cycles—from the mid 1970s
to the end of the 1980s, from 1990 to 2002, and from 2003 to 2009—and we are
at the beginning of a fourth one. The major problem with these cyclical swings is
their strong effect on major macroeconomic variables: that is, on exchange rates,
interest rates, domestic credit, and asset prices. As a result of this, pro-cyclical
capital ?ows exacerbate major macroeconomic policy trade-offs, signi?cantly
limiting the space to undertake counter-cyclical macroeconomic policies. For
example, during a boom, countries may ?oat the exchange rate to maintain
some degree of monetary policy autonomy, but this merely displaces the effects
of pro-cyclical capital ?ows to the exchange rate. The resulting deterioration in
the current account allows these countries to ‘absorb’ the increasing ?ows but
experience indicates that it also increases the probability and costs of crises.
More exchange rate volatility generates, in turn, disincentives to invest in export
and import-competing sectors. If there is hysteresis associated to dynamic
economies of scale (e.g., if productivity tomorrow depends on production today),
there may be permanent losses in production structure during booms, and there-
fore adverse effects on growth.
1
Since a restrictive monetary policy would only exacerbate appreciation pres-
sures, an alternative for authorities to reduce the expansionary pressures gener-
ated by capital in?ows is to adopt a contractionary ?scal policy. But this makes
?scal policy hostage to capital account volatility. Fiscal policy may lack the
?exibility to respond rapidly to variations in capital ?ows, and there may not be
political backing for doing so. Authorities may also try to stabilize the exchange
rate by accumulating foreign exchange reserves while sterilizing their domestic
monetary effects. But such sterilized accumulation generates quasi-?scal losses
that are particularly costly in countries with high domestic interest rates. When
foreign exchange reserves are already high, as they are in many emerging and
developing countries, these costs are hard to justify. Such interventions also
destroy the rationale for capital in?ows in the ?rst place, which is to transfer
resources to the country. To the extent that such reserves are a way to counter-
1 See the review of the literature in Frenkel and Rapetti (2010).
Regulating Global Capital Flows for Long-Run Development 15
balance the risk of future reversals of capital ?ows, they destroy the additional
rationale for capital account liberalization, which is to diversify risks. In fact,
experience indicates that they are rather a source of additional risk.
During boom periods, capital account regulations can therefore be justi?ed as
a way to help authorities manage booms while avoiding exchange rate appre-
ciation, the risks associated with rising current account de?cits and/or useless
foreign exchange reserve accumulation. During crisis, they may also be used as
a way to avoid or mitigate capital ?ight, which has the opposite macroeconomic
effects. More generally, these regulations can play a dual role: they can be a
complementary macroeconomic policy tool and help reduce the risks associated
with liability structures tilted towards reversible capital ?ows. As a macroeco-
nomic policy tool, they provide some room for counter-cyclical monetary poli-
cies. During booms, they increase the policy space to undertake contractionary
monetary policy while reducing exchange rate appreciation pressures. In turn,
during crises, they can create some room for expansionary monetary policies.
Viewed as a liability policy, capital account regulations recognize the fact that
pro-cyclical behavior and, particularly, reversibility, varies signi?cantly according
to the nature of capital ?ows: foreign direct investment is more stable than port-
folio and debt ?ows and, among the latter, short-term debt ?ows are particularly
volatile.
2
Capital market regulations obviously segment domestic from international mar-
kets, but this recognizes the fact that markets are already segmented. Indeed,
the basic ?aw of capital account liberalization is that it does not recognize the
implications of this basic fact. As with prudential regulations, capital account
regulations can be either quantitative (or administrative) or price-based, but
there are more complex typologies (see, for example, IMF 2011a).
3
The former
include, among others, prohibitions or ceilings on certain capital ?ows, deriva-
tive operations or net exposure in foreign currencies; minimum stay periods; and
restrictions on foreign investors taking positions in domestic securities or rules
on what type of agent can undertake some capital transactions (residents versus
non-residents, and corporate versus non-corporate). In turn, price-based regula-
tions include unremunerated reserve requirements on capital in?ows, taxes on
in?ows or out?ows, and larger reserve requirements for external liabilities of net
2 See, for example, Reddy (2010: ch. 21). The classic treatment of the riskiness of short-term capital is Rodrik and
Velasco (2000).
3 There are also terminological differences. IMF (2011) coins the term ‘capital ?ow management measures’, and
Epstein et al. (2003) have suggested the term ‘capital management techniques’.
16 A Pardee Center Task Force Report | March 2012
balances in foreign currencies. Furthermore, they can be partly substituted by
domestic prudential regulations when they involve domestic ?nancial interme-
diation, though not when they entail access to external capital markets by non-
?nancial domestic agents.
4
They thus belong to the family of what have come to be called ‘macroprudential
regulations’, including particularly of counter-cyclical prudential regulations
(for an early analysis of this link, see Ocampo 2003). Indeed, they may be seen
as part of the continuum, which goes from regulation on ?nancial transactions
of domestic residents in the domestic currency (normal prudential regulation,
including now countercyclical prudential regulations), to those of domestic resi-
dents in foreign currency (e.g., managing dollar/euroized ?nancial systems, or
correcting the risks associated with currency mismatches in domestic portfolios),
to ?nally those involving domestic agents’ transactions with foreign residents
(capital account regulations).
The concrete analysis of experiences with the use of capital account regulations
leads to several conclusions.
5
First, regulations on either in?ows or out?ows can
work (though the more orthodox literature is skeptical of the effectiveness of the
latter), but the authorities must have administrative capacity to manage them,
which includes acting on time to close loopholes and respond to ‘innovations’ by
private agents aimed at circumventing regulations. As a result of the link with
administrative capacity, permanent regulatory regimes that tighten or loosen
the norms in response to external conditions may be the best choice rather than
improvising a system in the face of shocks. Second, regulations help generate a
mix of increased monetary autonomy, reduce exchange rate pressures and alter
the magnitude of ?ows, with greater skepticism on the latter effect by several
authors. Some of these effects may be temporary, largely due to greater circum-
vention of regulations as time passes, and in this sense regulations may act as
‘speed bumps’
6
rather than permanent restrictions; this implies that further
reinforcement may be required to maintain their effectiveness. Third, capital
account regulations on in?ows help improve debt pro?les and thus act as an
effective liability policy that reduces external vulnerability. Finally, and perhaps
4 In the latter case, price-based regulations can also be substituted by tax provisions applying to foreign-
currency liabilities (see, for example, Stiglitz and Bhattacharya 2000).
5 See, among others, three papers by the IMF and IMF experts (Ariyoshi et al. 2000; Ostry et al. 2010; IMF 2011),
Magud and Reinhart (2007), Kawai and Lamberte (2010) and my own work (Ocampo 2003, 2008).
6 This is the term used by Palma (2002) and Ocampo and Palma (2008).
Regulating Global Capital Flows for Long-Run Development 17
most importantly, regulations are a complement to sound macroeconomic poli-
cies, not a substitute for them.
Overall, the evidence is therefore that capital account regulations are a useful
and effective complementary instrument of counter-cyclical policy management
(IMF 2011a). There is also evidence that countries using regulations on capital
in?ows fared better during the recent global ?nancial crisis (Ostry et al. 2010),
and that the new regulations put in place by some countries since 2010 have
been at least partly effective (Gallagher 2011; IMF 2011a).
Debates on this issue since 2010 have emphasized some global dimensions of
these regulations that must be at the center of attention. The ?rst and essential
problem is the asymmetry generated between the strength of several emerging
economies and the continuing weakness of most industrial countries. This situa-
tion, which is likely to continue, implies that the latter have to maintain expan-
sionary policies, but the former are gradually moving towards more restrictive
policies, though partially constrained for doing so by massive capital in?ows.
In short, the ‘multi-speed’ character of the recovery creates a need for a mirror
asymmetry in monetary policies, which would be very dif?cult to manage with-
out some restrictions on capital ?ows.
A second problem is that monetary expansion may be largely ineffective in
industrial countries but can generate large externalities on emerging markets.
This is particularly problematic when it involves the country issuing the major
global reserve currency. Indeed, expansionary monetary policies in the U.S.,
including now quantitative easing, has had at best mixed effects in generating
a reactivation of credit, the major transmission mechanism of monetary expan-
sion to domestic economic activity, but the low dollar interest rates associated
with that policy are inducing massive capital ?ows to emerging markets, where
they are generating appreciation pressures and risks of asset price bubbles. They
may also be contributing to the weakening of the dollar, with negative effects on
trading partners.
A third problem is that unilateral actions by countries also have negative exter-
nalities on other countries; that is, regulations by some countries may generate
even stronger ?ows towards those not doing so. This is also true, of course, of
interventions in foreign exchange markets.
Thus cross-border capital account regulations are an essential part of global
monetary reform. Actually, the basic principle that should guide actions in this
18 A Pardee Center Task Force Report | March 2012
?eld is the ‘embedded liberalism’ under which the IMF was built: that it is in the
best interest of all members to allow countries to pursue their own full employ-
ment macroeconomic policies, even if this requires blocking free capital move-
ments. It is therefore positive that the Fund has recognized that capital account
regulations can play a positive role, as part of the broader family of macropru-
dential regulations, and has taken the step to openly discuss this issue and has
suggested a possible ‘policy framework’ for discussion (IMF 2011b). Furthermore,
this is the ?rst step taken to include cross-border capital ?ows within ongoing
efforts at strengthening prudential regulation worldwide.
Such policy framework should start, however, by designing mechanisms to
cooperate with countries using these policies, helping in particular make those
regulations effective. In fact this may require eliminating provisions in several
free trade agreements (particularly those signed by the U.S.) that restrict the use
of such regulations. This type of cooperation is excluded from the IMF guidelines
even while recognizing that capital account volatility is a negative externality
in?icted upon recipient countries.
The guidelines try to identify ‘best practices’ in this area. As indicated, such best
practices include the recognition that they are a complement and not a substi-
tute for counter-cyclical macroeconomic policies. However, the guidelines tend
to view them as interventions of ‘last resort’ (or a second, third, or fourth line of
defense), to be used once other macroeconomic policies have been exhausted:
exchange rate adjustments, reserve accumulation, and restrictive macroeco-
nomic policies. This is a limited view of their role. They must, therefore, be seen
as part of the normal counter-cyclical packages, and particularly as tools to avoid
excessive exchange rate appreciation and reserve accumulation.
In addition, the IMF guidelines tend to view CARs as temporary measures. This
goes against another IMF recommendation, which calls for “strengthening the
institutional framework on an ongoing basis.” This implies that regulations
should be part of the permanent toolkit of countries, which are strengthened
or weakened in a counter-cyclical way. Also, and again against the guidelines,
almost by necessity they require some discrimination between residents and
non-residents, which re?ects the segmentation that characterizes ?nancial
markets in an international system: as different moneys are used in different
territories, residents and non-residents have asymmetric demands for assets
denominated in those currencies.
Regulating Global Capital Flows for Long-Run Development 19
In any case, any guidelines in this area should recognize that there is no obliga-
tion to capital account convertibility under the IMF Articles of Agreement—an
issue that was settled in the 1997 debates—and therefore countries have full
freedom to manage their
capital account. In the words
of the Group of Twenty-Four
(G-24 2011: par. 8): “Policy
makers of countries facing
large and volatile capital ?ows
must have the ?exibility and
discretion to adopt policies
that they consider appropriate
and effective to mitigate risks.” So, although the IMF has made a positive contri-
bution by bringing the issue of capital account regulations into the global debate,
it can only be taken as a ?rst step in the necessary task of including this issue in
the efforts to re-regulate ?nance and avoid global macroeconomic imbalances.
REFERENCES
Ariyoshi, Akira, Karl Habermeier, Bernard Laurens, Inci Ötker-Robe, Jorge Iván
Canales-Kriljenko, and Andrei (2000). “Capital Controls: Country Experiences with
Their Use and Liberalization.” Washington, D.C.: International Monetary Fund.
Epstein, Gerald, Ilene Grabel, and K.S. Jomo (2003). “Capital Management Techniques
in Developing Countries.” In Ariel Buira (ed.), Challenges to the World Bank and the
IMF: Developing Country Perspectives, London: Anthem Press, ch. 6.
Frenkel, Roberto, and Martin Rapetti (2010). “Economic Development and the Inter-
national Financial System.” In Stephany Grif?th-Jones, José Antonio Ocampo and
Joseph E. Stiglitz (eds), Time for a Visible Hand: Lessons from the 2008 World Finan-
cial Crisis, New York: Oxford University Press.
Gallagher, Kevin (2011). “Regaining Control? Capital Controls and the Global Finan-
cial Crisis.” Political Economy Research Institute, University of Massachusetts at
Amherst, PERI Working Paper, No. 250.
Group of Twenty-Four (G-24) (2011). “Intergovernmental Group of Twenty-Four on
International Monetary Affairs and Development: Communiqué.” Washington D.C.,
14 April.
Although the IMF has made a positive
contribution by bringing the issue of capital
account regulations into the global debate,
it can only be taken as a ?rst step in the
necessary task of including this issue in
the efforts to re-regulate ?nance and avoid
global macroeconomic imbalances.
20 A Pardee Center Task Force Report | March 2012
International Monetary Fund (IMF) (2011a). “Recent Experiences in Managing Capital
In?ows: Cross-Cutting Themes and Possible Policy Framework,” IMF Policy Paper, 14
February.
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Kawai, Mashiro, and Mario B. Lamberte (eds.) (2010). Managing Capital Flows: The
Search for a Framework, Cheltenham: Edward Elgar and Asian Development Bank
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Policies, Practices and Consequences. Ch. 14. Chicago: The University of Chicago
Press.
Ocampo, José Antonio (2003). “Capital Account and Counter-Cyclical Prudential Regula-
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Serra and Joseph E. Stiglitz (eds.), The Washington Consensus Reconsidered: Towards
a New Global Governance. New York: Oxford University Press, ch. 6.
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Account Regulations.” In José Antonio Ocampo and Joseph E. Stiglitz (eds.), Capital
Market Liberalization and Development. New York: Oxford University Press, ch. 7.
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Liberalization and Development.” In José Antonio Ocampo and Joseph E. Stiglitz (eds),
Capital Market Liberalization and Development. New York: Oxford University Press.
Ostry, Jonathan D., Atish R. Ghosh, Karl Habermeier, Marcos Chamon, Mahvash S.
Qureshi, and Dennis B. S. Reinhardt (2010). “Capital In?ows: The Role of Controls.”
IMF Staff Position Note, SPN/10/04, 19 February. Available at www.imf.org.
Palma, Gabriel (2002). “The Three Routes to Financial Crises: The Need for Capital Con-
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Taylor (eds). New York: Oxford University Press, pp. 297–338.
Prasad, Eswar S., Kenneth Rogoff, Shang-Jin Wei, and M. Ayhan Rose (2003). “Effects of
Financial Globalization on Developing Countries: Some Empirical Evidence.” IMF
Occasional Paper, No. 220. Washington, D.C.: International Monetary Fund.
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Reddy, Y.V. (2010). Global Crisis, Recession and Recovery. Andhra Pradesh: Orient Black-
Swan.
Rodrik, Dani, and Andrés Velasco (2000). “Short-Term Capital Flows.” In Proceedings of
the Annual World Bank Conference on Development Economics 1999. Washington,
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Stiglitz, Joseph E., and Amar Bhattacharya (2000). “The Underpinnings of a Stable
and Equitable Global Financial System: From Old Debates to a New Paradigm.” In
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World Bank, Washington, D.C., pp. 91–130.
22 A Pardee Center Task Force Report | March 2012
Regulating Global Capital Flows for Long-Run Development 23
2. Capital Account Management:
The Need for a New Consensus
1
Rakesh Mohan
The North Atlantic Financial Crisis (NAFC) that started in 2008 has been an
epoch-changing one in many respects. Among its consequences is the attention
that the IMF is paying to issues related to cross-border capital ?ows and the need
for capital account management (CAM), what it calls capital ?ow management.
There has been a spate of papers on this topic, both research and policy-related
over the last couple of years (IMF 2011a, 2011b; Habermeier et al. 2011; Ostry et
al. 2010; Ostry et al. 2011). Their conclusion, broadly stated, is that capital ?ow
management measures can be considered in certain circumstances, but only
after exhausting traditional policy avenues of tighter ?scal policy, accommoda-
tive monetary policy, and exchange rate ?exibility that allows appreciation in the
face of large capital ?ows. In this paper I argue that in emerging market econo-
mies (EMEs) CAM should, instead, form part of the normal toolkit of overall
macroeconomic management, and should not be seen as an extreme measure
only to be used in speci?c special circumstances.
Capital ?ows to EMEs, both gross and net, have been rising in volume, along
with increasing volatility since the early 1980s (CGFS 2009). They reached their
peak in 2007 just before the NAFC broke out; and then there was a typical
sudden reversal in 2008–2009, followed by recovery in 2010 and 2011 as the
extended and continuing (almost) zero interest rate policy has been in place in
advanced economies (AEs). As funds from AEs have again ?owed to EMEs in
search of yield, the latter have experienced renewed appreciation pressures on
their real exchange rates. They have therefore had to resort to CAM measures
in a variety of ways in the interest of preserving their growth trajectories while
ensuring continued ?nancial stability. That provides the context for the IMF’s
increased interest in this issue.
The surprising feature of this ongoing NAFC has been the dog that didn’t bark:
the resilience exhibited by Asian and Latin American EMEs. The immediate
1 The paper has bene?ted from very thoughtful comments from Shinji Takagi.
24 A Pardee Center Task Force Report | March 2012
impact of the crisis during 2008–2010 on these economies was through two
channels. First, there was a sudden reversal of capital ?ows, which had been
unprecedented in magnitude during the years prior to the crisis. This reversal
in 2008–2009 had signi?cant impact on capital and foreign exchange markets
in these countries. Second, the fall in global trade far exceeded the contraction
in global GDP. Despite these setbacks no signi?cant banks or ?nancial institu-
tions in these countries exhibited substantial stress: none required a bailout.
Furthermore, in spite of stagnation in the major advanced economies, these
economies have experienced a strong recovery. Evidently, these countries have
been doing something right since the various Latin American crises of the 1980s
and 1990s, and the Asian crisis of the late 1990s. Given the volatility observed in
capital ?ows and the need to
ensure broad-based stability
of the ?nancial sector, most
Asian and Latin American
EME governments and
central banks have employed
multiple instruments related
to CAM, along with traditional
monetary and ?scal policy, and ?nancial regulation and supervision. Judging
from their performance in terms of growth, and maintenance of price and ?nan-
cial stability—both over the decade preceding the crisis and in the subsequent
period—it must be concluded that their overall policy stance, including CAM
measures has been broadly in the right direction.
The general conclusion is that for EMEs, capital account management in its
broad form should become part of the normal overall toolkit for macroeconomic
management oriented towards ensuring growth with price and ?nancial stabil-
ity. It should not be regarded as a tool that is only used as an extreme measure,
as the IMF papers tend to emphasize. Accumulation and management of forex
reserves also needs to be consistent with this overall approach.
THE NEED FOR CAPITAL ACCOUNT MANAGEMENT
Until recent years most developing countries suffered from the inadequacy of
savings relative to the investment levels needed for the economic growth that
they aspired to. Consequently the mobilization of external savings, and hence
capital ?ows, was necessary in the interest of promoting economic growth.
Thus a well-managed and somewhat steady ?ow of external capital can clearly
The general conclusion is that for EMEs,
capital account management in its broad
form should become part of the normal
overall tool kit for macroeconomic manage-
ment oriented towards ensuring growth
with price and ?nancial stability.
Regulating Global Capital Flows for Long-Run Development 25
be bene?cial to EMEs that need to enhance resources for investment. In earlier
decades most of these ?ows consisted of of?cial ?ows from multilateral and
bilateral donors, which were relatively stable.
However, after the opening of capital markets in varying degrees, the record
of capital volatility has been stark over the last three decades. Before this past
decade the previous peak of net capital ?ows to emerging-market economies
was around U.S. $190 billion in 1995. The average over the four years prior to
that was around U.S. $100 billion. There was a big reversal after the Asian crisis,
but then there was a recovery to about U.S. $240 billion, on average, during
2003–06. Net capital ?ows jumped to almost U.S. $700 billion in 2007 but then
slumped to an average of around U.S. $200 billion during 2008 and 2009 (Mohan
and Kapur 2011b). With the extended continuation of monetary accommodation
in the advanced economies after their ?nancial crisis, capital ?ows to EMEs have
surged further. The volume of gross capital ?ows has of course been even higher,
along with its volatility. There has been a continuing cycle of capital ?ows from
at least the early 1980s, with the amplitude of the cycles increasing consistently.
It is then not surprising that emerging-market economies have had to resort to
capital account management in varying degrees. It is a little dif?cult to imag-
ine what would happen if these countries had not actively resorted to capital
account management. The IMF has now begun recognition of this element of
macroeconomic management as being effective and legitimate, albeit with many
caveats. However, its approach is hierarchical, and CAM is regarded by the IMF
as a last resort. Whereas it is understandable that aggressive CAM can be seen
as disruptive from a multilateral perspective if it leads to beggar-thy-neighbor
policies, there is little evidence of such practices.
Second, on average, there is a persistent in?ation differential between advanced
economies and EMEs. It is very interesting that in the 10 or 12 years before the
crisis, there was a persistent in?ation differential of around 2 or 3 percent on
average between advanced-economy in?ation and emerging market in?ation,
though with signi?cant variance between different countries. Hence there was a
persistent interest rate differential as well, and that gave rise to huge opportuni-
ties for interest rate arbitrage, and the existence of the carry-trade on an endur-
ing basis. The differential has been persistent and is now further exacerbated by
the extended zero interest rate policy of the United States: hence, the expecta-
tion of rising capital ?ows and the enhanced need for managing them.
26 A Pardee Center Task Force Report | March 2012
Third, there has been a good deal of volatility in the monetary policies of
advanced economies, and that has also given rise to capital ?ow volatility. If we
examine the record of AE monetary policy over the past 30 years there has been
broad correspondence between episodes of accommodative monetary policy
in advanced economies and capital ?ows to emerging-market economies; and
also the reverse: each tightening produced the reversal of capital ?ows and the
crises that occurred in EMEs in the 1980s and 1990s. These episodes were well
documented in the Committee on the Global Financial System’s Report (2009) on
capital ?ows to EMEs (a report surprisingly ignored by all the IMF papers). Since
the policies of advanced economies are driven by their own domestic needs,
emerging markets need to take adequate defensive action in the interest of pre-
serving their own growth and stability.
Fourth, there is now the emergence of a persistent growth differential between
the AEs and EMEs, which has been getting starker. The two-speed recovery after
the North Atlantic Financial Crisis has only served to bring this phenomenon
to more pointed attention of both policymakers and ?nancial markets alike.
Overall, there is a huge incentive for large capital ?ows, which then lead to large
exchange rate appreciation, the possibility of credit booms, and asset-price
booms in recipient countries, followed eventually by higher trade and current
account de?cits over time. There is then a reversal of capital ?ows at some point
or other, leading to substantial output and unemployment costs. All of this could
not have been managed by ?nancial development, as shown by the United
States itself. This demonstrates the need for a combination of measures, includ-
ing CAM, particularly since markets can be irrational for extended periods.
Fifth, exchange rate ?uctuation poses greater dif?culties for economic stability in
EMEs. Typically, their export baskets are more dependent on relatively low tech-
nology labour using products that are price sensitive and which are therefore
easily substitutable; their competitiveness is much more dependent on the level
of their exchange rates. Thus even temporary real exchange rate appreciation
resulting from a surge of capital ?ows can have signi?cant effects on economic
activity in EMEs, both through a possible surge in imports and lull in such
exports. The social effects through labor displacement can be dif?cult to man-
age, particularly in the absence of appropriate social security mechanisms. With
the lack of well developed ?nancial markets it is also not easy to hedge against
such exchange rate ?uctuations. Whereas exchange rate appreciation that results
from improved competitiveness should not be resisted, the same cannot be said
Regulating Global Capital Flows for Long-Run Development 27
for exchange rate ?uctuation arising from capital ?ow volatility unrelated to host
country domestic fundamentals.
Sixth, the basic assumption behind much of the discussion on CAM, in principle,
is that the ?ow of capital across borders brings bene?ts to both capital importers
and capital exporters. The traditional view has been that EMEs are capital scarce
and AEs are capital rich so the former would only gain by greater freedom in the
?ow of cross border capital ?ows. What is different about the recent experience
with capital ?ows is that many EMEs have run signi?cant current account sur-
pluses, so net ?ows are actually in the opposite direction. Even in those countries
that do not exhibit current account surpluses, the capital in?ows have tended to
be far in excess of their ?nancing needs. Excess incoming capital ?ows have then
only added to the capital account management problem. Moreover, even with
domestic savings rates in excess of their investment rates, their investment levels
have been much higher than those of AEs, so they have exhibited relatively high
economic growth rates. The argument that more liberal capital account regimes
would have produced even higher growth rates is dif?cult to sustain.
Seventh, in any case, historical evidence, reinforced by the current North
Atlantic Financial Crisis—not the global ?nancial crisis—clearly shows that it
can create new exposures and bring new risks. The failure to understand and
analyze such risks, as well as the excessive haste that many countries have
shown over time in liberalizing capital accounts, has compromised ?nancial or
monetary stability, particularly in many EMEs. Such liberalization has usually
been done without placing adequate prudential buffers that are needed to cope
with the greater volatility characteristic of market-based capital movements.
Consequently, many EMEs in Latin America and Asia suffered repeated ?nancial
crises during the 1980s and 1990s. They appear to have learned their lessons
well, and have generally succeeded in avoiding crises since the Asian crisis of
the late 1990s. However, such failure became manifest in the current crisis in an
even more virulent form in the North Atlantic advanced economies.
ROLE OF CAPITAL ACCOUNT MANAGEMENT IN OVERALL MACRO-
ECONOMIC MANAGEMENT
In addressing issues related to capital account management, and after examining
the recent record of Asia and Latin American EMEs, I see them in the broader
context of prudent macroeconomic and monetary management, with a particu-
lar focus on maintaining ?nancial stability. I believe that some of the errors in
the approach to capital account management arise from looking at it from a very
28 A Pardee Center Task Force Report | March 2012
narrow viewpoint of capital controls. The reality of capital ?ows to emerging
markets over the past decade and a half is one of rising volumes accompanied
by high volatility. The optimal management of these large and volatile ?ows is
not one-dimensional.
Overall, my conclusion is that what is needed broadly is a combination of policies:
• sound macroeconomic policies, both ?scal and monetary
• exchange rate ?exibility with some degree of management through forex
intervention as needed, along with appropriate sterilization
• relatively open capital account but with some degree of management includ-
ing use of speci?c capital controls
• prudent debt management
• the use of micro- and macroprudential tools
• accumulation of appropriate levels of reserves as self insurance and their sym-
metric use in the face of volatility in capital ?ows
• and the development of resilient domestic ?nancial markets
That sounds like motherhood and apple pie, but it is different from looking
at CAM in extremis. Capital account management should not be discussed in
isolation: it must be seen as an integral and legitimate element of the overall
toolkit deployed in macroeconomic management. Just as different instruments
are used at different times in achieving ?scal policy and monetary policy goals,
the deployment of the various instruments available in the CAM toolkit would
depend on the extant circumstances, both domestic and external.
Much discussion on CAM is sidetracked on the use of capital account controls,
but these should be seen as only one element in the overall toolkit (as illustrated
in the menu above), which are used whenever they need to be. Just as advanced
economy central banks have used a variety of instruments to stabilize their
economies in the wake of the North Atlantic Financial Crisis, from (almost) zero
interest rate policy to aggressive quantitative easing, EMEs have used different
forms of CAM to ensure the continuance of growth with ?nancial stability in their
economies. There is increasing discussion on the use of prudential regulation for
CAM, both micro and macro. Again, I see these as legitimate tools in the CAM
armory for ensuring ?nancial stability. Similarly, there is renewed discussion
Regulating Global Capital Flows for Long-Run Development 29
on the management of exchange rates, intensi?ed by the recent action of the
Swiss National Bank announcing the initiation of aggressive intervention in the
foreign exchange market. Much of the discussion is contaminated by going to the
extremes of total ?exibility or ?xed exchange rates. In fact, what many emerg-
ing markets have practiced since the Asian crisis is a greater degree of ?exibility
in exchange rates, but with some degree of management. Similarly, emerging
markets have maintained relatively open capital accounts, but again with some
degree of management. The discussion is contaminated by going to extremes
here as well: either a totally open capital account or totally closed, when the
reality for Latin American and Asian EMEs has been somewhere in the middle
over the past decade or so.
A good deal of discussion on management of the capital account and foreign
exchange intervention has been in?uenced by the existence of the open econ-
omy trilemma. No country can simultaneously enjoy free capital mobility, oper-
ate a ?xed exchange rate, and practice independent monetary policy directed at
managing domestic objectives. In fact, most Asian countries have actually man-
aged this open economy trilemma successfully since the 1990s crisis. Whereas
they have operated managed exchange rates, they have allowed increased
?exibility: their exchange rates no longer exhibit rigidity. Similarly, whereas they
have actively managed their capital accounts, they have been neither totally
open nor totally closed at any time. This middle ground of managed but ?exible
exchange rates and managed but mostly open capital accounts have enabled
Asian EMEs to operate independent monetary policies despite high volatility in
external capital ?ows during the post-Asian crisis period. By and large, Asian
countries have been able to set their own policy for interest rates even in the
presence of persistent interest rate differentials with advanced countries. The
practice of adequate sterilization has been successful in preventing the unwar-
ranted growth of base money and other monetary aggregates in the face of rising
foreign exchange reserves. Hence, by and large, they have also been successful
in containing in?ation (Mohan and Kapur 2011b).
On the other hand, rigidities in capital account management can also lead to
dif?culties in macroeconomic and monetary management. As can be expected,
whereas theory has much to say on the conditions desirable for an end state
equilibrium, it has little guidance to offer on the sequencing of capital account
liberalization.
30 A Pardee Center Task Force Report | March 2012
INDIAN EXPERIENCE WITH CAPITAL ACCOUNT MANAGEMENT
In recent years, many EMEs have received capital ?ows much larger than their
?nancing requirements. When capital ?ows are signi?cantly in excess of a
sustainable level of current account de?cit, and the exchange rate is ?exible, it
is obvious that they cannot be absorbed domestically, howsoever ef?cient the
?nancial system may be. Real exchange rate misalignment, current account
imbalances, excesses in credit markets, asset price booms, overheating, and in?a-
tion are the most likely outcomes. It would be a question of time before ?nancial
fragility leads to crisis. Thus, surging capital ?ows should not be perceived as a
sign of strength, but as a potential source of disequilibrium (UNCTAD 2009).
Capital ?ows, therefore, need to be managed actively, particularly when ?nancial
markets are still in a nascent state of development. Absorption of capital ?ows
becomes easier as domestic ?nancial markets develop along with the emergence
of strong domestic ?nancial institutions and investors. High gross in?ows can
then also be balanced by increasing out?ows. As seen in the outbreak of the
NAFC, however, even the most developed ?nancial markets in Europe and the
United States had dif?culty in coping with the explosion of cross border capital
?ows that occurred in the years prior to the crisis (Bernanke 2011).
Capital controls can be effective, even though they may not be foolproof, and are
in fact subject to leakages in the context of the current global ?nancial market
environment. Capital controls
have to be a part of an overall
package comprising exchange
rate ?exibility, the maintenance
of adequate reserves, steriliza-
tion, and the development of
the ?nancial sector. There is a
clear need for the deployment
of multiple instruments. The current fashion of a single objective, single instrument
monetary policy is undoubtedly inadequate to deal with capital ?ows.
Against this backdrop, the Indian experience holds important lessons. Monetary
policy in India has faced growing challenges from large and volatile capital ?ows
since 1993–1994, especially during 2007–2009. In response to these capital
?ows, a multi-pronged approach was adopted including active management
of the capital account, especially of debt ?ows. Tighter prudential restrictions
Capital controls have to be a part of an
overall package comprising exchange rate
?exibility, the maintenance of adequate re-
serves, sterilization, and the development of
the ?nancial sector. There is a clear need for
the deployment of multiple instruments.
Regulating Global Capital Flows for Long-Run Development 31
were placed on access of ?nancial intermediaries to external borrowings; greater
?exibility in exchange rate movements was introduced but with capacity to
intervene in times of excessive volatility; treating capital ?ows as largely volatile
unless proven otherwise; building up of adequate reserves; sterilization of inter-
ventions in the foreign exchange market through multiple instruments, includ-
ing cash reserve requirements and issuance of new market stabilization bonds;
continuous development of ?nancial markets in terms of participants and instru-
ments, but with a cautious approach to risky instruments; strengthening of the
?nancial sector through prudential regulation while also enhancing competition;
pre-emptive tightening of prudential norms; and re?nements in the institutional
framework for monetary policy.
Policies operate symmetrically. During periods of heavy in?ows, liquidity is
absorbed through increases in the cash reserve ratio (CRR) and issuances under
the market stabilization scheme. During periods of reversal, liquidity is injected
through cuts in CRR and the unwinding of the market stabilization scheme.
Overall, rather than relying on a single instrument, many instruments have been
used in a coordinated manner. This was enabled by the fact that both monetary
policy and the regulation of banks and other ?nancial institutions and key ?nan-
cial markets are under the jurisdiction of the Reserve Bank of India (RBI), which
permitted smooth use of various policy instruments. Unlike many EMEs, India
has been running trade and current account de?cits. While the current account
de?cit is modest and manageable, the trade de?cit is high. Management of the
capital account and exchange rate is also important from this perspective.
The outcomes have been satisfactory. Growth in monetary and credit aggregates
was, by and large, contained within desired trajectories and consistent with the
overall GDP growth objective. There has been signi?cant ?nancial deepening.
Though in?ation has been high again in 2010–2011, it had been reduced signi?-
cantly in the decade prior to 2008 from its levels prevailing during the 40-year
period until the late 1990s. Growth has witnessed signi?cant acceleration on
the back of productivity gains, which are also re?ected in the growth of exports
of goods and services. Domestic investment has increased substantially since
the beginning of this decade, and this is predominantly ?nanced by domestic
savings. The surge in investment and savings was made possible by an ef?cient
allocation of resources by the domestic banking system and ?nancial markets,
despite many constraints. Overall, ?nancial stability has been maintained (see
Mohan and Kapur 2011a for details).
32 A Pardee Center Task Force Report | March 2012
The volatility in capital ?ows poses large challenges but these can be managed.
The key lessons from the Indian experience are that monetary policy needs to
move away from the narrow price stability/in?ation targeting objective. Cen-
tral banks need to be concerned not only with monetary policy but also with
development and regulation
of banks and key ?nancial
markets—money, credit,
bond, and currency. Depend-
ing on the institutional legacy
within different countries,
if these additional functions are not vested within the central bank, adequate
coordination mechanisms need to be put in place to enable the central bank to
interact with the other agencies and act on needed prudential measures. Given
the volatility and the need to ensure broader stability of the ?nancial system,
central banks need multiple instruments. Capital account management has to be
counter-cyclical, just as is the case of monetary and ?scal policies. Judgments in
capital account management are no more complex than those made in mon-
etary management.
Overall, as the CGFS (2009) concludes, it is a combination of sound macroeco-
nomic policies, prudent debt management, exchange rate ?exibility, the effec-
tive management of the capital account, the accumulation of appropriate levels
of reserves as self-insurance, purposive use of prudential regulation, and the
development of resilient domestic ?nancial markets that provides the optimal
response to the large and volatile capital ?ows to the EMEs. Individual countries
have used different combinations of measures from time to time. If the pressure
of excess ?ows is very high, as it was in India in 2007, it becomes necessary to
use almost all the possible measure available. Thus how these elements can be
best combined will depend on the country and on the period: there is no “one
size ?ts all.”
Such a discretionary approach does put great premium on the skill of policy-
makers in both ?nance ministries and central banks. It also runs the risk of
markets perceiving central bank actions to become uncomfortably unpredict-
able. If, however, as many Asian countries have demonstrated in recent years,
the actions of the authorities do result in the virtuous circle of high growth, low
in?ation and ?nancial stability, such an approach has much to commend it. One
such example is that of India.
The key lessons from the Indian experience
are that monetary policy needs to move
away from the narrow price stability/in?a-
tion targeting objective.
Regulating Global Capital Flows for Long-Run Development 33
REFERENCES
Bernanke, Ben S. (2011). “International Capital Flows and the returns to safe assets in
the United States 2003-2007.” In Banque de France, Financial Stability Review. No.
15, February 2011. pp. 13–26.
Committee on the Global Financial System (CGFS) (2009). “Report of the Working Group
on Capital Flows to Emerging Market Economies.” (Chairman: Rakesh Mohan).
Basel: Bank for International Settlements.
Habermeier, Karl, Annamaria Kokeyne and Chikako Baba (2011). “The Effectiveness
of Capital Controls and Prudential Policies in Managing Large In?ows.” Washington
D.C. IMF Staff Discussion Note SDN/11/14, August 2011.
International Monetary Fund (2011a). “Recent Experiences in Managing Capital In?ows:
Cross Cutting Themes and Possible Policy Framework.” Washington D.C. IMF Policy
Paper, April 2011.
International Monetary Fund (2011b). “International Capital Flows: Reliable or Fickle?”
Chapter 4 in World Economic Outlook. April 2011.
Mohan, Rakesh and Muneesh Kapur (2011a). “Managing the Impossible Trinity: Volatile
Capital Flows and Indian Monetary Policy.” Chapter 8 in Rakesh Mohan, Growth
with Financial Stability: Central Banking in an Emerging Market. New Delhi: Oxford
University Press.
——— (2011b). “Liberalization and Regulation of Capital Flows: Lessons for Emerging
Market Economies.” Chapter 9 in Rakesh Mohan, Growth with Financial Stability:
Central Banking in an Emerging Market. New Delhi: Oxford University Press.
Ostry, Jonathan D., Atish R. Ghosh, Karl Habermeier, Marcos Chamon, Mahvash S.
Qureshi, and Dennis B.S. Reinhardt (2010). ”Capital In?ows: The Role of Controls,”
IMF Staff Position Note SPN/10/04, February 2010.
Ostry, Jonathan D., Atish R. Ghosh, Karl Habermeier, Luc Laeven, Marcos Chamon, Mah-
vash S. Qureshi, and Annamaria Kokeyne (2011). “Managing Capital Flows: What
Tools to Use?” Washington D.C.: IMF Staff Discussion Note SDN/11/06, April 2011.
United Nations Conference on Trade and Development (UNCTAD) (2009). Trade and
Development Report, 2009. United Nations.
34 A Pardee Center Task Force Report | March 2012
Regulating Global Capital Flows for Long-Run Development 35
3. Managing Capital Flows: Lessons from the Recent
Experiences of Emerging Asian Economies
Masahiro Kawai, Mario B. Lamberte, and Shinji Takagi
1
INTRODUCTION
The essay draws lessons from the recent experiences of emerging Asian
economies (EAEs)
2
for managing capital in?ows. While capital in?ows bring
about invaluable bene?ts, large ?ows, if not managed properly, can expose
the recipients to various types of risks. EAEs collectively were a signi?cant
recipient of capital in?ows
prior to the global ?nancial
crisis. Although the Republic
of Korea (hereafter Korea)
and Indonesia were affected
by capital out?ows to some
extent, most of Asia did not
suffer as much as eastern European and Baltic countries did. Following the
crisis, they were among the ?rst to recover and are now experiencing a new
surge of in?ows. The issue of how best to manage capital in?ows is therefore
especially relevant for Asia. We frame our discussion primarily on the basis of
the country and analytical chapters of Kawai and Lamberte (2010) with some
updated information.
1 The authors are, respectively, Dean and Chief Executive Of?cer, Asian Development Bank Institute; Director of
Research, Asian Development Bank Institute; and Professor of Economics, Graduate School of Economics, Osaka Uni-
versity, and a member of the Pardee Center Task Force on Regulating Global Capital Flows for Long-Run Development.
Acknowledgement: The views expressed in this note are the authors’ alone and do not necessarily represent the
views of the Asian Development Bank, its Institute, the Executive Directors, or the countries they represent.
2 Unless noted otherwise, emerging Asian economies (EAEs) include the following 14 economies: Cambodia
(CAM); People’s Republic of China (PRC); Hong Kong, China (HKG); India (IND); Indonesia (INO); Republic of
Korea (KOR); Lao PDR (LAO); Malaysia (MAL); Myanmar (MYA); the Philippines (PHI); Singapore (SIN); Taipei,
China (TAP); Thailand (THA); and Viet Nam (VNM). Of these, we pay particular attention to nine economies for
which Kawai and Lamberte (2010) include country chapters.
Following the crisis, [Asian countries] were
among the ?rst to recover and are now
experiencing a new surge of in?ows. The
issue of how best to manage capital in?ows
is therefore especially relevant for Asia.
36 A Pardee Center Task Force Report | March 2012
CAPITAL FLOWS IN EMERGING ASIAN ECONOMIES
Degree of Capital Account Openness
Capital account openness varies across EAEs, according to both de jure and
de facto measures. First, Chinn and Ito (2009) constructed an index of ?nancial
openness based on the IMF’s Annual Report on Exchange Arrangements and
Exchange Restrictions, where a higher index value indicates greater openness
(Figure 1). Except for Hong Kong and Singapore, most EAEs maintain various
controls on cross-border capital ?ows, though many are substantially open with
respect to foreign direct investment (FDI) in?ows and portfolio in?ows through
purchases by nonresidents of domestic securities.
Second, Lane and Milesi-Ferretti (2006) developed a volume-based measure of
international ?nancial integration, de?ned as the ratio of the stock of assets and
liabilities to GDP (Table 1). We have updated data for 2005 and 2009 by using the
IMF’s International Financial Statistics stock data, where available, or capital
?ow data, where stock data are not available. For Asia, the ratio generally rose
for all economies from 1990 to 2009. Despite the relatively low overall de jure
openness (as indicated by the Chinn-Ito index), the capital account of many
economies in fact appears to have been suf?ciently open to allow a sizable
-2.50 -2.00 -1.50 -1.00 -0.50 0.00 0.50 1.00 1.50 2.00 2.50 3.00
MYA
THA
LAO
IND
PRC
VNM
MAL
PHI
KOR
INO
CAM
SIN
HKG
Figure 1: De Jure Capital Account Openness in Emerging Asia, 2009
Source: Chinn and Ito 2009.
Regulating Global Capital Flows for Long-Run Development 37
accumulation of external assets and liabilities over time, with the ratio exceeding
or close to 100 percent for all but two economies in 2009.
Patterns of Capital Flows
EAEs saw a resurgence of capital ?ows after the 1997–1998 Asian ?nancial
crisis, with in?ows reaching $856 billion in 2007, before the onset of the global
?nancial crisis (Table 2). The People’s Republic of China’s (PRC) in?ows rose
dramatically, posting $241 billion in 2007, which accounted for 28 percent of
the total in EAEs; India also saw rapid increases in in?ows, which reached $98
billion in 2007. Capital out?ows also picked up, suggesting that capital ?ows in
the region have become increasingly two-way. The PRC and Hong Kong had the
largest capital out?ows in 2007. Together, they accounted for 60 percent of the
total out?ows from EAEs, followed by Singapore and Korea.
As to the composition of capital ?ows, FDI began to take the dominant role in
the middle of the 1990s (Figure 2). By the late 1990s, FDI had accounted for
more than half of all private capital in?ows to EAEs. Portfolio equity in?ows
increased following the Asian ?nancial crisis. Most Asian economies reduced
barriers to investment on equity markets to recapitalize ailing banks and non-
?nancial corporations. As a result, equity in?ows rapidly increased in 1999, but
Chap. 3 Table 1
Economies 1990 1995 2000 2005 2009
Cambodia (CAM) 96.3 176.8 145.2 156.0
China, People's Republic of
(PRC)
38.9 58.7 84.7 90.6 108.3
Hong Kong, China HKG) 1462.9 1338.6 1246.5 1434.5 2097.1
India (IND) 30.2 39.7 42.3 49.1 64.1
Indonesia (INO) 80.6 86.2 136.8 86.1 76.9
Korea, Republic of (KOR) 35.4 50.9 82.7 107.5 161.9
Lao PDR (LAO) 215.3 147.5 198.7 148.0 153.2
Malaysia (MAL) 121.6 160.8 185.5 183.9 242.2
Philippines (PHI) 95.0 97.3 143.3 114.7 99.2
Singapore (SIN) 361.3 419.5 809.5 966.7 1216.4
Taipei, China (TAP) 103.4 97.7 132.3 257.0 369.7
Thailand (THA) 68.8 114.4 142.7 135.1 168.0
Viet Nam (VN) 96.2 110.7 100.2 129.8
Table 1: External Assets and Liabilities as a Share of GDP
in Emerging Asia, 1990–2009(%)
Sources: For 1990, 1995 and 2000, the ?gures came from Lane and Milesi-Ferretti (2006), except for Tai-
pei, China, whose ?gures were obtained from the China Economic Information Center (CEIC) database.
For 2005 and 2009, the ?gures were calculated using IMF IFS stock data, where available, or capital ?ow
data, where stock data are not available. For Lao PDR and Viet Nam, the latest data are for 2007.
38 A Pardee Center Task Force Report | March 2012
momentum was reversed in 2000. Portfolio equity in?ows resurged in 2003,
peaking at $205 billion in 2007. Equity in?ows turned negative (-$81 billion) in
2008 as the global crisis deepened, but rebounded strongly in 2009.
Unlike portfolio equity in?ows, debt securities in?ows were a relatively small
component of capital in?ows in EAEs, although they have been on the rise,
especially in Korea. Underdevelopment of the local currency bond market has
been pointed out as one of the main reasons. Currently, several policy initiatives
are under way to promote local-currency denominated bond markets, and debt
securities in?ows are expected to increase over time. Bank ?nancing in EAEs
was relatively small in the 1990s except during the three years prior to the 1997–
1998 crisis. Thereafter, bank ?nancing accounted for a negligible proportion of
capital in?ows in Asia until 2006. In 2007 it rose sharply to almost $70 billion,
with Korea accounting for almost two-thirds of the total. In 2008, bank ?nancing
turned negative (-$12 billion), with Korea accounting for almost all of it.
Impact of Capital Flows
Persistent current account surpluses and rising capital in?ows exerted upward
pressure on the exchange rates in most EAEs until right before the global ?nan-
1
Chap 3 Table 2
Year
Gross
Capital
Flows
Gross
Capital
Flows
(% of
GDP)
Capital
Inflows
Capital
Inflows
(% of
GDP)
Capital
Outflows
Capital
Outflows
(% of
GDP)
Net
Inflows
Net
Inflows
(% of
GDP)
1990 52.85 4.18 42.96 3.40 9.90 0.78 33.06 2.62
1991 55.01 4.17 50.79 3.85 4.22 0.32 46.57 3.53
1992 72.10 5.11 56.14 3.98 15.97 1.13 40.17 2.85
1993 133.06 8.63 97.91 6.35 35.15 2.28 62.76 4.07
1994 148.74 8.10 108.13 5.89 40.61 2.21 67.53 3.68
1995 209.30 9.43 155.76 7.02 53.54 2.41 102.22 4.61
1996 243.94 9.81 181.56 7.30 62.39 2.51 119.17 4.79
1997 277.68 11.00 143.10 5.67 134.58 5.33 8.52 0.34
1998 -198.11 -8.34 -128.14 -5.40 -69.97 -2.95 -58.17 -2.45
1999 151.26 5.72 73.76 2.79 77.50 2.93 -3.75 -0.14
2000 332.11 11.41 167.11 5.74 165.00 5.67 2.10 0.07
2001 47.70 1.59 32.29 1.08 15.41 0.51 16.88 0.56
2002 95.19 2.89 55.93 1.70 39.26 1.19 16.66 0.51
2003 260.85 7.04 149.21 4.03 111.65 3.01 37.56 1.01
2004 479.42 11.20 300.36 7.02 179.06 4.18 121.30 2.83
2005 571.24 11.56 310.28 6.28 260.96 5.28 49.32 1.00
2006 973.47 16.79 499.91 8.62 473.57 8.17 26.34 0.45
2007 1,595.29 22.22 855.97 11.92 739.32 10.30 116.65 1.62
2008 237.95 2.88 91.13 1.10 146.82 1.78 -55.69 -0.67
2009 318.60 3.67 271.67 3.13 46.93 0.54 224.74 2.59
Table 2: Capital Flows in Emerging Asia, 1990–2009 (US$ billion)
Sources: International Financial Statistics (IMF); World Development Indicators (World Bank); CEIC.
Regulating Global Capital Flows for Long-Run Development 39
cial crisis. In part to contain the appreciation pressure, the monetary authorities
of most economies intervened in the foreign exchange market and thereby accu-
-10.00
-5.00
0.00
5.00
10.00
15.00
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Inflow
Direct Investment Portfolio Investment Financial Derivatives Other Investment
Figure 2: Composition of Capital Flows in Emerging Asia, 1990–2009 (% GDP)
Sources: International Financial Statistics (IMF); World Development Indicators (World Bank); CEIC
accessed on 15 April 2011.
-6.00
-4.00
-2.00
0.00
2.00
4.00
6.00
8.00
10.00
12.00
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Outflow
Direct Investment Portfolio Investment Financial Derivatives Other Investment
40 A Pardee Center Task Force Report | March 2012
mulated massive foreign exchange reserves. Total reserves held by EAEs rose
from $214 billion or 5 perent of GDP in 1990 to $4.8 trillion or 44 percent of GDP
in 2010, with the PRC contributing three-?fths. In 2006 and 2007, many EAEs
experienced higher increases in money supply growth, indicating that steriliza-
tion was incomplete. Although goods and services price in?ation had generally
remained low until the global ?nancial crisis (except for what appears to be the
temporary impact of increases in world commodity prices in 2008), it has been
rising in recent months. Equity prices saw a rising trend since 2003 notably in
Indonesia, India, and the PRC. They dropped sharply at the onset of the global
?nancial crisis, but recovered quickly as foreign capital returned to the EAEs.
POLICY RESPONSES TO CAPITAL FLOWS
Policy responses by EAEs until the onset of the global ?nancial crisis can broadly be
classi?ed into sterilized intervention, interest rate reductions, and capital controls.
3
Intervention in the Foreign Exchange Market
The monetary authorities of all nine case study economies intervened in the
foreign exchange market, at least partially sterilizing its impact. Lack of suitable
government paper was often a challenge. The People’s Bank of China (PBOC),
when it ran out of treasury bonds, started selling its own low-yielding central
bank bills (CBBs) to commercial banks (while raising reserve requirements
15 times from September 2003 to end-2007). Likewise, the Reserve Bank of
India (RBI) ran out of government securities and agreed with the government
in January 2004 to put in place the Market Stabilization Scheme (MSS), which
authorizes RBI to sell bonds on behalf of the government for the purpose of
sterilization (while also raising reserve requirements).
Some economies resorted to creative ways of sterilization. The Bank of Korea
(BOK) used its own monetary stabilization bonds (MSBs), but as the balance rose
sharply, it became costly to remain so engaged. The Korean government then
initiated a scheme under which it sold securities and deposited the proceeds
with the BOK, thereby allowing the central bank to use the won for currency
market intervention. Another case is the Bangko Sentral ng Pilipinas (BSP).
After exhausting the conventional tools, in 2007, BSP opened a special deposit
account (SDA) facility to banks in order to absorb excess liquidity. Later, the
counterparties were expanded to include non-bank government corporations as
well as banks’ pension funds and trust operations.
3 This section draws on the nine country chapters of Kawai and Lamberte (2010).
Regulating Global Capital Flows for Long-Run Development 41
Sterilization created its own challenges. Bank Indonesia (BI) partially sterilized
intervention mainly using one-month and three-month Bank Indonesia Certi?-
cates (SBI), but as the SBI interest rates were more than 8 percent, the operation
attracted even more portfolio in?ows. BI was therefore compelled to allow the
exchange rate to appreciate, partially absorbing the impact of capital in?ows
thereby. The State Bank of Vietnam (SBV), ?nding open market operations and
reserve requirements less than fully effective, required commercial banks to
purchase newly introduced 365-day bills in March 2008. This measure forced
banks to run to the inter-bank market, pushing up the inter-bank rates sharply.
As banks competed intensively to mobilize deposits to comply with the compul-
sory purchase of the 365-day bills, the deposit rates also rose.
Interest Rate Policy
When a large interest rate differential attracts additional foreign capital, the
monetary authorities may need to narrow the gap by lowering domestic interest
rates. This explains why the PBOC was cautious in tightening monetary policy:
when it raised interest rates it made sure to maintain a 3 percent spread in favor
of the dollar LIBOR, with the intention of letting the renminbi appreciate at 3
percent per annum. Likewise, in India, while the RBI raised the reverse repur-
chase and repurchase rates between January 2006 and April 2007, it reduced the
interest rates on non-resident deposits. Similar interest rate cuts were observed
in Indonesia (from January 2006 to December 2007), the Philippines (from March
2007 to March 2008), and Thailand (from January to July 2007). Viet Nam was an
exception, however, as the SBV raised all of?cial interest rates in February 2007
in order to contain the acceleration of money supply growth and in?ation.
Capital Controls
Use of capital controls was exceptional. Prior to the global ?nancial crisis, only
four EAEs tightened or introduced capital controls to stem the tide of capital
in?ows. Two cases should clearly be separated. In one case, countries with a
tightly controlled regime reversed the pace of capital account liberalization. In
2006, the PRC restricted the ability of foreign banks to borrow dollars abroad
to fund dollar assets within the country, which was subsequently reinforced by
the regulation that banks meet an increase in reserve requirements with dollar
deposits with the central bank. In 2007, India tightened limits on external com-
mercial borrowing by placing a cap on the amount of foreign exchange domestic
?rms could convert into rupees; it also introduced controls against “participatory
42 A Pardee Center Task Force Report | March 2012
notes,” which are over-the-counter derivatives sold by a registered foreign institu-
tional investor to a non-registered investor.
The other case involved measures introduced by a country with a substantially
open capital account regime, especially with respect to capital in?ows. On 18
December 2006, Thailand imposed a 30 percent unremunerated reserve require-
ment (URR) on all equity and short-term securities investment in?ows with
maturities of less than one year, which was however lifted on the following day
for equity ?ows. The URR for ?xed income in?ows remained until March 2008.
There is statistical evidence to suggest that capital in?ows shifted to equity ?ows,
but the econometric analysis of Coelho and Gallagher (2010) shows that the Thai
URR reduced the overall volume of in?ows by 0.75 percent of GDP (which was
marginally signi?cant statistically).
4
In 2007, Korea re-imposed limits on lending
in foreign currency to Korean ?rms, while restricting foreign banks’ swapping
dollars borrowed abroad for won. These measures were intended to slow down
foreign banks’ funding of their branches in Korea.
MANAGING CAPITAL INFLOWS IN THE POST-CRISIS ERA
As the world’s engine of growth, Asia has seen a resumption of capital in?ows.
Conventional macroeconomic tools seem to offer limited effectiveness in managing
large capital in?ows, especially given the large balance of foreign exchange reserves
many of the economies have
accumulated. Allowing the
exchange rate to appreciate
is often the best way to cope
with large capital in?ows (this
is the standard response of
most industrial countries), but
emerging economies are naturally reluctant to allow a signi?cant appreciation of
their currencies. In view of this limited policy space, some EAEs have introduced
prudential and other regulatory measures affecting capital in?ows and foreign
exchange positions in the post-global ?nancial crisis era (Table 3).
Prudential and Other Regulatory Measures
In assessing the prospective usefulness of prudential and other regulatory measures
limiting capital in?ows or what the IMF (2011) calls capital ?ow management mea-
sures (CFMs), it is important to bear in mind the following considerations for EAEs:
4 But they show that it did not affect the real exchange rate or the composition of in?ows.
Conventional macroeconomic tools seem to
offer limited effectiveness in managing large
capital in?ows, especially given the large
balance of foreign exchange reserves many
of the economies have accumulated.
Regulating Global Capital Flows for Long-Run Development 43
• ASEAN member states are committed to creating an ASEAN Economic Com-
munity (AEC) by 2015, which is de?ned to be a region characterized by free
movement of investment and freer movement of capital. It is dif?cult for any
of these countries to reverse the process of capital account liberalization by
introducing new barriers to capital mobility except during an emergency on a
temporary basis.
• Hong Kong and Singapore, as major international ?nancial centers, cannot be
seen to be taking any measure to restrict the freedom of international inves-
tors to move funds across borders. Given the depth of their ?nancial markets
and the robust regulatory regimes in place, use of CFMs is probably not neces-
sary except during a crisis (they have recently introduced prudential measures
to contain upward pressure on real estate prices).
• Cambodia and Lao PDR have virtually no domestic ?nancial markets to speak
of. This means that, in the foreseeable future, no large portfolio in?ows are
Chap 3 Table 3
Emerging
Asian
Economies
Measures
India • June 2010: limited the amount of short-term bonds that could be sold to
foreign investors (while raising the overall ceiling for FII investment in
debt in September 2011)
Indonesia • June 2010: imposed a one-month holding period for SBIs while
announcing the introduction of longer-term (9–12 months) SBIs (from
August/September); introduced new regulations on banks’ net foreign
exchange open positions
• January 2011: re-introduced a cap (in relation to capital) on oversees short-
term borrowing by banks while requiring banks to set aside a higher
percentage of their foreign exchange holdings as reserves
• May 2011: lengthened the one-month SBI holding period to six months
• July 2011: restricted investment by banks in foreign currency bonds issued
in the domestic market in circumvention of measures to restrict foreign
currency loans
Korea,
Republic
of
• June 2010: placed limits on foreign exchange derivatives positions, in
relation to the capital base of financial institutions; further restricted the
use of foreign currency loans by banks within Korea; and tightened
regulations on the foreign currency liquidity ratio of domestic banks
• December 2010: announced the introduction of a tax on banks’ foreign
exchange borrowing and the re-instatement of withholding tax on interest
income from government bonds (from January 2011)
Thailand • October 2010: re-imposed withholding tax on interest income and capital
gains from foreign bond holdings
Table 3. Capital Flow-Affecting Prudential and Other Regulatory Measures
Announced or Adopted by Emerging Asian Economies, 2010–2011
Sources: Relevant central bank publications and press reports.
44 A Pardee Center Task Force Report | March 2012
expected, even though their capital account regime is fairly open. The same
can also be said about Myanmar, whose capital account is all but fully closed.
• The PRC and India (and, to a lesser extent, Viet Nam) still maintain extensive
restrictions on capital in?ows (as well as on capital out?ows). For these coun-
tries, use of capital controls only represents a reversal of the gradual capital
account liberalization process.
5
Just as well, they could decelerate the pace of
capital account liberalization over the coming years.
• Except for Hong Kong and Singapore, the other EAEs maintain some restric-
tions on capital in?ows, with tighter controls on out?ows. Even Indonesia,
arguably the most ?nancially open economy in the rest of the region, is known
to subject banking ?ows to tight control. In these economies, portfolio in?ows
take place mainly through purchases by nonresidents of domestic securities.
• Korea, as an OECD country, has little leeway in consistently deviating from the
policy of free capital mobility.
These considerations suggest that:
(i) use of outright capital controls (or what the IMF (2011) calls residency-based
CFMs) is relevant only for a handful of EAEs (e.g., Indonesia, Malaysia, Philip-
pines, and Thailand);
(ii) purchases by nonresidents of domestic securities are the main (or the only)
target of any potential CFMs; and
(iii) use of outright capital controls (that explicitly discriminate against foreign
investors) is increasingly ruled out as a feasible policy option, especially if it
is pursued by individual countries.
This last point is clearly borne out by the types of measures that have been
introduced by some of these countries recently to limit capital in?ows or in?ow
volatility (see Table 3). Except for the Indian measure, the other measures
(introduced by Indonesia, Korea, and Thailand) are carefully designed not to
discriminate against foreign investors. The pressing question for emerging Asia’s
policymakers is not when or in what sequence to employ CFMs. It is rather what
non-residency-based CFMs are effective in mitigating the risk of capital in?ows
5 In these countries, it is not very useful to talk about the effectiveness of any new capital control measure,
independently of the effectiveness of the overall control regime within which it is introduced. Given the extensive
administrative apparatus, they can always take measures to make capital controls work.
Regulating Global Capital Flows for Long-Run Development 45
(if not directly reducing the purchases by nonresidents of domestic securities) as
they preserve their commitment to an open capital account regime.
Collective Action
At the regional level, collective action is an insuf?ciently explored tool. For
example, if loss of international price competitiveness is the reason for not
allowing currency appreciation, a country’s authorities can cooperate with their
competitor neighbors in similar circumstances to take the action simultane-
ously (Kawai 2008). This would lead to a concerted appreciation of currencies in
the face of persistent capital in?ows in the region. Another area of cooperation
would be to coordinate the introduction of prudential and other regulatory mea-
sures, including outright capital controls, given the recognition that individual
countries are ?nding it increasingly dif?cult to do so alone. Collective action
is helpful in two ways. First, these measures are either introduced as part of
regional efforts or sanctioned by a regional decision, there would be less punitive
reaction from international investors (as was the case with Thailand in December
2006). Second, these measures, if effective in one country, would divert more
capital in?ows to its regional neighbors. Without a regional framework, use of
prudential and other regulatory measures to limit capital in?ows could turn into
a tool of beggar-thy-neighbor policy.
REFERENCES
Chinn, M.D. and H. Ito (2009). “The Chinn-Ito Index: A De Jure Measure of Financial
Openness."http://web.pdx.edu/~ito/Chinn-Ito_website.htm. (Accessed: 29 August
2009.)
Coelho, B. and K. P. Gallagher (2010). "Capital Controls and 21st Century Financial
Crises: Evidence from Colombia and Thailand," PERI Working Paper No. 213,
Political Economy Research Institute, University of Massachusetts, Amherst.
International Monetary Fund (IMF) (2011). “Recent Experiences in Managing Capital
In?ows—Cross-Cutting Themes and Possible Guidelines.” IMF Policy Paper, 14
February.
Kawai, M. (2008). “Toward a Regional Exchange Rate Regime in East Asia,” Paci?c Eco-
nomic Review 13(1): 83–103.
46 A Pardee Center Task Force Report | March 2012
Kawai, M. and M. Lamberte (eds.) (2010). Managing Capital Flows: The Search for a
Framework, Cheltenham, UK, and Northampton, MA: Edward Elgar.
Lane, P. R. and G. M. Milesi-Ferretti (2006). “The External Wealth of Nations Mark II:
Revised and Extended Estimates of Foreign Assets and Liabilities, 1970–2004,” IMF
Working Paper No. 06/69.
Regulating Global Capital Flows for Long-Run Development 47
4. Capital Out?ow Regulation: Economic
Management, Development and Transformation
Gerald Epstein
INTRODUCTION
As economic and ?nancial turmoil have rocked the foundations of the global
economy, policy makers have widened their search for policy tools to help them
manage the massive ?nancial instability they face. As events have forced them to
break out of their ideological silos in a desperate search for solutions, some are
discovering that some policies they have written off in the past might be useful
after all.
Foremost among these “new found” old tools are so-called “capital controls.” As
well recounted by Gallagher, Grabel, and Ocampo (all articles published in 2011),
even the International Monetary Fund (IMF), long a staunch opponent of such
tools, has now admitted that they can be useful under some circumstances, espe-
cially to manage capital in?ows and especially if they are used on a temporary
basis. They have even adopted a name change to make their acceptance more
palatable, appropriately dropping the term “controls” and referring to such tools
as “capital ?ow management measures” (IMF 2011).
1
Still, the IMF and other
“establishment” institutions have not completely abandoned their old ways. As
described by Grif?th-Jones and Gallagher (2011) and Ocampo (2011), the IMF
has proposed gaining more in?uence over the conditions under which capital
controls are used; and, as Gallagher and others have well documented, a web
of bilateral and multi-lateral so-called “free-trade” agreements have structured a
global “capital liberalization regime” that create barriers for countries to imple-
ment capital account regulations even as economists at the IMF say they are
useful. (Gallagher 2011a.)
1 Other more palatable names have been proposed as well: e.g., “capital management techniques” (Epstein,
Grabel, Jomo 2003) and “capital account regulations”, (Ocampo 2011). For purposes of this paper, I will adopt
Ocampo’s term: see below.
48 A Pardee Center Task Force Report | March 2012
Equally telling, most of these economists and policy makers retain their opposi-
tion to “capital controls” on out?ows.
2
Indicative is a highly in?uential paper by
Nicolas Magud, Carmen Reinhart and Kenneth Rogoff that surveys 30 academic
studies of capital controls on in?ows and out?ows. The paper concludes with
respect to out?ow controls that “As to controls on out?ows, there is Malaysia
and then there is everyone else…Absent the Malaysian experience, there is little
systemic evidence of “success” in imposing controls, however de?ned.” (Magud,
Reinhart, and Rogoff 2011, p. 2).
This conclusion is rather odd when one considers that many of the greatest
development success stories of the late 20th century have had highly articulated
regimes of capital account regulations on out?ows: South Korea, Taiwan, China
and India, among others (Amsden 2001; Chang and Grabel 2004; Nembhard
1996). Capital controls and exchange control regimes were also critical to the
recovery and industrial development of a number of countries in Europe and
also Japan following the Second World War (Zysman 1983; Epstein 2007; Eichen-
green 2007). In virtually all of these cases, capital control regimes consisted
not only of capital controls on out?ows (and in?ows), but also credit allocation
systems managed by governmental institutions including Ministries of Finance,
Central Banks and specialized planning ministries of various kinds. Yet Magud,
et al. chose not to include these cases because, they argued, “one cannot lump
together the experiences of countries that have not substantially liberalized (i.e.,
India and China) with countries that actually went down the path of ?nancial
and capital account liberalization and decided at some point to reintroduce con-
trols, as the latter have developed institutions and practices that are integrated in
varying degrees to international capital markets” (Magud et al. 2011, p. 5).
3
This decision to exclude China and India, among other countries, seems ques-
tionable in light of the fact that both India and China have liberalized to some
degree over a decade or more, and, in addition, that there have been a number
of excellent studies of the impacts of these controls on these economies, espe-
cially by Robert McCauley and his colleagues at the Bank for International Settle-
ments (BIS) (e.g., see for example, Ma and McCauley 2007).
4
2 Even here, reality sometimes wins out. The IMF encouraged even out?ow controls in some of the recent rescue
packages, including in Iceland (see Grabel, 2011). But the public resistance to controls at the IMF remains.
3 Thus, they only included studies of Malaysia, Spain and Thailand in their sample on out?ows.
4 See below for further discussion and references.
Regulating Global Capital Flows for Long-Run Development 49
In addition, the distinction between in?ow and out?ow controls is not as clean
as is often believed. For example, the regulations imposed by the Indian govern-
ment on certain kinds of derivative positions and products involves constraints
both on short positions and long positions that involve foreigners: hence they
can place limits both on “in?ows” and “out?ows.” In addition, constraints on
out?ows themselves act as a disincentive to in?ows. Indeed, one of the strongest
policies that would serve to limit in?ows involve reserve requirements, and
other limitations on out?ows (see Ocampo 2011).
Still, Magud et al. do have a point: it is important to draw distinctions
among different kinds of capital controls, especially with respect to the
policy regimes of which they are a part—including the goals set out for those
regimes—and the domestic and international context that accompany them.
Most of the recent discussion has focused on the use of capital account regula-
tions to manage the cyclical, ?nancial stability, and balance of payments
aspects of macroeconomic policy: we can refer to this as the macroeconomic
management function of capital account regulations. Less discussed recently
are the longer term developmental aspects of capital account regulations,
where capital account regulations are important complements to industrial
policy, industrial re-development, and income and wealth distributional poli-
cies that were so important in post–World War II reconstruction regimes as
mentioned above.
These developmental roles become increasingly important in times of great
structural change as we are perhaps experiencing today. One can say that
both the macroeconomic management and the developmental roles of capital
account regulations relate to the policy roles of capital account regulations.
In addition, historically, capital controls have played a deeper, transformative
role as well. Here, capital controls accompany more profound changes in the
underlying political and economic structure of society, often by facilitating
a major shift in economic and political power from one group in society to
another, thereby making feasible a more dramatic change in the overall struc-
ture of the political economy which, in some cases, can (but do not necessar-
ily) lead to a more egalitarian and sustainable order (Epstein 2010). Examples
of these transformative roles include the case of South Korea following the
Second World War when controls on out?ows complemented their crucial
50 A Pardee Center Task Force Report | March 2012
land reform policies that transformed the agrarian and political structure in
the country.
5
Of course, the transformational, the macroeconomic, and the developmental
roles of capital out?ow regulation need not and, indeed, are usually not mutually
exclusive. Keynes’ views, as described by James Crotty, are especially instruc-
tive here. In his 1983 Journal of Economic Literature article titled “On Keynes
and Capital Flight,” Crotty showed that in a period spanning the 1930s and into
the 1940s—virtually up to the time of his death—Keynes was very skeptical that
nations could achieve full employment and social transformation as long as they
were integrated into a world of highly mobile capital. He therefore thought that
controlling international capital mobility was a requirement for bringing about
both better macroeconomic management and achieving social transformation.
Crotty quoted Keynes: “Indeed, the transformation of society, which I preferably
envisage, may require a reduction in the rate of interest towards the vanish-
ing point within the next thirty years. But under a system by which the rate of
interest ?nds a uniform level, after allowing for risk and the like throughout the
world under the operation of normal ?nancial forces, this is most unlikely to
occur” (Keynes 1933, p. 762). Earlier in the essay Keynes argued that: “Advisable
domestic policies might be easier to compass if the phenomenon known as the
‘?ight of capital’ could be ruled out” (Keynes 1933, p. 757).
Apart from the distinction among macroeconomic, developmental and transfor-
mational capital account regulations, it also makes a difference who is imple-
menting these policies. Here we have two distinctions: 1) the ?rst is whether
they are being implemented on a national or an international (or internationally
coordinated) basis; and the second, is whether these out?ow regulations are
being implemented by economically small countries or regions, or whether they
are being implemented by countries or regions that are large with respect to the
world economy.
5 Checci was perhaps the ?rst economist to look at the relationship between capital controls and income distri-
bution. He found that in countries that had capital controls, income distribution were more equal. (Checci 1996).
The most thorough study of the relationship between capital controls and income distribution is that of Lee and
Jayadev (2005). They ?nd that capital account liberalization reduces the labor share of income in most parts of the
world (and therefore, capital controls, all else equal, increase the labor share of income). Epstein and Schor (1992)
showed the capital out?ow (and in?ow) controls in the OECD were associated with lower unemployment. Hence,
there is good evidence that capital mobility represents the power of capital relative to labor.
Regulating Global Capital Flows for Long-Run Development 51
Again, as with the transformational function of regulations, these issues of coor-
dination and who is implementing the regulations are likely to be particularly
important at a time of widespread crisis and structural change.
In what follows, I brie?y discuss the macroeconomic policy roles of out?ow
regulations, turn to the developmental roles, and ?nish up with a brief discus-
sion of possible out?ow regulations by the United States to enhance the bene?ts
and limit the costs of expansionary monetary policy in the current context.
MACROECONOMIC POLICY ROLE OF CAPITAL OUTFLOW REGULATIONS
While it is dif?cult to neatly separate out the macroeconomic policy role and the
developmental role of capital out?ow regulations, one can identify a number of
key macroeconomic objectives of these regulations (see Table 1, and Epstein,
Grabel and Jomo 2008).
These include:
• Preserving scarce foreign exchange to avoid foreign exchange or balance of
payments crisis.
• Protecting monetary policy autonomy to facilitate lower interest rates than
are prevailing internationally to promote higher investment and higher
employment. For example, this would make it easier for a country to pursue
an expansionary monetary and credit policy in a global slump without losing
excessive amounts of foreign exchange.
• The threat of putting on out?ow controls could limit excessive in?ows.
• Reducing out?ows of hot money that would leave the country saddled with
foreign denominated liabilities and that could contribute to domestic insolven-
cies and debt problems more generally.
• To help protect ?nancial stability by limiting the build-up of risky counter-
party obligations with respect to complex derivative positions.
6
• To help prevent corruption, tax evasion and other illegal activities that involve
capital ?ight (see Boyce and Ndikumana, 2011, for the case of African countries).
• To help manage multinational corporation domestic obligations with respect
to re-investment and pro?t allocations.
6 See Crotty and Epstein (2010) especially with respect to the case of India. Thanks due to Governor Reddy for
sharing his expertise on these regulations.
52 A Pardee Center Task Force Report | March 2012
Studies of the response of both China and India to the Asian ?nancial crisis and
the 2007–2008 global economic crisis indicate that their controls on out?ows, as
well as in?ows, contributed
to their ability to weather the
slump more effectively than
other countries. (e.g., Icard
2002; Ocampo in this volume).
Of course, other factors played
an important role, includ-
ing large foreign exchange
reserves, and the limitations
on foreign liabilities. These points suggest that sensible macroeconomic policies,
as well as effective capital in?ow regulations, can be important complements to
the successful use of capital out?ow tools.
An additional reason for capital out?ow regulations is to reduce capital ?ight
that is associated with corruption and tax evasion. For example, Ndikumana and
Boyce document that sub-Saharan Africa experienced an exodus of more than
$700 billion in capital ?ight since 1970, a sum that far surpasses the region’s
external debt outstanding of roughly $175 billion. Some of the money wound up
in private accounts at the same banks that were making loans to African govern-
ments. (Ndikumana and Boyce 2011; Boyce and Ndikumana 2011.)
DEVELOPMENTAL ROLE OF CAPITAL OUTFLOW REGULATIONS
The development role of capital out?ow regulation is arguably even more
important than the macroeconomic policy role, important as this can be in
certain circumstances. Nembhard’s study of South Korea and Brazil, Zysman’s
work on Western Europe and Japan, and Hersh’s work on China are particularly
illuminating. The key lesson of this work is that capital out?ow regulations are
an essential part of a policy regime that involves industrial policy or industrial
targeting and the use of credit allocation techniques to promote investment and
productivity in particular areas. Without such capital out?ow regulations, it is dif-
?cult to use subsidized credit to promote investment without risking the massive
leakage of the credit abroad.
Nembhard documents how, in the case of South Korea, these capital controls
worked because they were part of an entire policy regime of industrial policy,
credit allocation, and seriously enforced capital out?ow controls. Similar regimes
held sway in China, Japan, India, and several European countries following the
Studies of the response of both China and
India to the Asian ?nancial crisis and the
2007–2008 global economic crisis indicate
that their controls on out?ows, as well
as in?ows, contributed to their ability to
weather the slump more effectively than
other countries.
Regulating Global Capital Flows for Long-Run Development 53
Second World War. As Alice Amsden details, combined with development banks
and key monitoring tools to reduce the leakages, corruption and inef?ciency,
such as export targets and associated sticks and carrots, these policies were
often very effective in promoting developmental goals (Amsden 2001).
As Nembhard details, these are not always successful of course. She recounts
the case of Brazil in the 1970s and ‘80s where poor design and lack of follow
Country Achievements Supporting Factors Costs
Malaysia 1998 -facilitated
macroeconomic
reflation
-helped to maintain
domestic economic
sovereignty
-public support for
policies
-strong state and
administrative
capacity
-dynamic capital
management
-possibly contributed
to cronyism and
corruption
India -facilitated incremental
liberalization
-insulated from
financial contagion
-helped preserve
domestic saving
-helped maintain
economic sovereignty
-strong state and
administrative
capacity
-strong public support
for policies
-experience with state
governance of the
economy
-success of broader
economic policy
regime
-gradual economic
liberalization
-possibly hindered
development of
financial sector
-possibly facilitated
corruption
China -facilitated industrial
policy
-insulated economy
from financial
contagion
-helped preserve
savings
-helped manage
exchange rate and
facilitate export-led
growth
-helped maintain
expansionary macro-
policy
-helped maintain
economic sovereignty
-strong state and
administrative
capacity
-strong economic
fundamentals
-experience with state
governance of the
economy
-gradual economic
liberalization
-dynamic capital
management
-possibly constrained
the development of
the financial sector
-possibly encouraged
non-performing loans
-possibly facilitated
corruption
Chap 4 Table 1
Table 1: Summary: Assessment of the Capital Management Techniques
Employed During the 1990s
Source: Epstein, Grabel and Jomo, 2008.
54 A Pardee Center Task Force Report | March 2012
through hindered these policies with results much less favorable than those of
South Korea.
INTEREST EQUALIZATION TAX: CAPITAL OUTFLOW CONTROLS AND
EXPANSIONARY POLICY BY THE RESERVE CURRENCY COUNTRY?
The Federal Reserve’s expansionary monetary and credit policy—the only expan-
sionary policy currently undertaken by the United States despite the high unem-
ployment and stagnant economy—has raised controversy in developing countries,
out of concern that a ?ood of U.S. capital is ?owing abroad and generating
over-valued exchange rates, ?nancial instability, and in?ation risks elsewhere.
Gallagher (2011a) has proposed that the U.S. implement capital out?ow regula-
tions to limit the harmful out?ow of credit and make the expansionary monetary
policy more effective in the U.S. itself. Like in the case of other developmentally
oriented out?ow regulations discussed above, these could complement credit
allocation policies designed to generate more employment and investment (see
Pollin 2011, for example).
In the late 1960s the U.S. government imposed an interest equalization tax (IET)
to reduce dollar out?ows to complement more expansionary monetary and
?scal policy. Most economists who studied the capital out?ow regulations con-
cluded that they were ineffective. But careful archival work showed that part of
the reason was that there were bank and MNC lobby-induced loopholes created
that made the policy porous (Conybeare 1988).
With the United States’ ?nancial institutions awash in excess liquidity that spills
over into speculative investments abroad, policies to channel domestic liquidity
in employment creating, productive investments in the U.S. would be desirable,
both from the point of view of the bulk of the U.S. population and of those coun-
tries outside of the U.S. who are receiving large amounts of “hot money” ?ows.
As an element of such a policy toolkit, it is time for the United States govern-
ment to consider an interest equalization tax to reduce the debilitating carry-
trade emanating from relatively low interest rates in the United States.
Regulating Global Capital Flows for Long-Run Development 55
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Amsden, Alice. (2001). The Rise of the Rest; Challenges to the West of the Late Industrial-
izing Economies. New York: Oxford University Press.
Block, Fred. (1977). The Origins of International Economic Disorder: A Study of U.S.
International Monetary Policy from World War II to the Present. Berkeley: University
of California Press.
Boyce, James and Léonce Ndikumana (2011). “How Capital Flight Drains Africa: Stolen
Money and Lost Lives.” Triple Crisis blog, 20 October. Available athttp://triplecrisis.
com/how-capital-?ight-drains-africa.
Chang, Ha Joon and Ilene Grabel (2004). Reclaiming Development, London Zed Books.
Checchi, Daniele (1992). “Capital controls and income distribution: empirical evidence
for Great Britain, Japan and Australia,” Weltwirtschftliches Archiv 3/1992.
Conybeare, J. A. C. (1988). United States Foreign Economic Policy and the International
Capital Markets; The Case of Capital Export Controls, 1963–1974, New York: Garland
Publishing.
Crotty, James (1983). “Review: Keynes and Capital Flight,” Journal of Economic Litera-
ture, Vol. 21, No. 1, March, pp. 56–65.
Crotty, James and Gerald Epstein (1996). “In Defense of Capital Controls,” Socialist
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Regulating Global Capital Flows for Long-Run Development 59
Section II: Implementing and Monitoring
Effective Regulation
5. Dynamic Capital Regulations, IMF Irrelevance
and the Crisis
Ilene Grabel
In this essay, I focus on the resurrection of capital controls during the on-going
global ?nancial crisis.
1
The new capital controls that are emerging across devel-
oping countries have three attributes:
(1) They vary within and across countries.
(2) They have been deployed in a dynamic fashion. By this I mean that the scope
and modality of the controls have been adjusted in response to changes in the
national and global economic environment, and identi?ed channels of evasion.
(3) Controls have often ?gured into multi-pronged efforts to address diverse and
serious economic challenges.
In some cases (such as Iceland), policymakers have used controls on out?ows
to slow the implosion of the economy. In other cases (such as Latvia) controls
have been used to address a narrow but acute vulnerability. And in others (such
as Brazil and South Korea), policymakers have deployed and “?ne-tuned” in?ow
controls to mitigate the appreciation of their currencies, cool asset bubbles,
and reduce ?nancial fragility and in?ation.
2
These latter challenges have been
aggravated by the large capital in?ows to rapidly growing economies, which
have resulted in part from low interest rates in the U.S. and the Eurozone and
divergent growth prospects across the globe. And in still other cases (e.g., China),
the ?ne-tuning of controls on both in?ows and out?ows during the crisis is con-
sistent with long-standing commitments to manage ?nancial ?ows in the service
of broader development objectives.
1 The discussion here of capital controls, policy space and the IMF draws heavily on Grabel (2011a). See this
paper as well for citations to the literature.
2 Indeed, capital controls have emerged as a key weapon of choice in the modern day “currency war.” See Grabel
(2011b, 2011c, 2010).
60 A Pardee Center Task Force Report | March 2012
Policymakers in a signi?cant group of developing countries have availed them-
selves of the new policy space that they enjoy to regulate international capital
?ows. This change in the policy landscape has occurred against the backdrop
of the rise of increasingly
autonomous states in the
developing world, geographi-
cally curtailed IMF in?u-
ence, and recognition (albeit
inconsistent at times) by Fund
staff that capital controls are a “legitimate part of the policy toolkit” (to invoke a
now frequently used phrase in Fund reports).
3
As each country deploys capital
controls with no ill effects on investor sentiment and no ?nger wagging by the
IMF, it becomes easier for policymakers elsewhere to deploy the controls they
deem appropriate. And they are doing so. Indeed, capital controls have emerged
during the crisis as the “new normal.”
One aspect of the autonomy that some states now enjoy is their resistance to the
IMF’s new interest in developing a code or guidelines governing the appropri-
ate use of capital controls. Indeed, the Fund’s position on capital controls has
become increasingly irrelevant as developing countries now enjoy the policy
space to introduce and adjust capital controls without waiting for the institution.
It is, in my view, critical that efforts be made to maintain and expand the oppor-
tunity that has emerged in the crisis environment for national policymakers to
experiment with capital controls and other measures.
DYNAMIC CAPITAL CONTROLS DURING THE CURRENT CRISIS:
A BRIEF SURVEY
The current crisis has achieved in a hurry something that heterodox economists
have been unable to do for a quarter-century. It has provoked policymakers in
a large number of developing countries to experiment with a variety of types of
capital controls, often framing them simply as prudential policy tools (akin to
what Epstein, Grabel and Jomo (2004) termed “capital management techniques”
and what the IMF (Ostry et al. 2011; IMF 2011a; Habermeirer et al. 2011) now
calls “capital ?ow management”).
3 See Grabel (2011a) on the productive incoherence that has emerged in the context of the current crisis. Also
note that more broadly, this rupturing of the old ?nancial order is consistent with broader changes that suggest
that the global ?nancial architecture is becoming multi-nodal and heterogeneous (see Grabel, 2012).
Policymakers in a signi?cant group of de-
veloping countries have availed themselves
of the new policy space that they enjoy to
regulate international capital ?ows.
Regulating Global Capital Flows for Long-Run Development 61
Controls in Countries in Distress
Iceland was the ?rst country to sign a Stand-by-Arrangement (SBA) during the
current crisis. What is most notable about the Icelandic SBA is that it includes
provisions regarding the need for stringent capital controls, something that we do
not ?nd in earlier SBAs that the IMF signed in connection with East Asian coun-
tries or in other crises during the neo-liberal era. Even more surprising, the SBA
provided for controls even on capital out?ows. Iceland’s controls were initially
imposed prior to the signing of the SBA in October 2008, though the agreement
with the Fund made a very strong case for their necessity and maintenance as
means to restore ?nancial stability and to protect the krona from collapsing.
The IMF’s stance with respect to Iceland’s capital controls initially appeared
anomalous. But it soon became clear that it marked a dramatic precedent. For
example, the SBA with Latvia of December 2008 allowed for the maintenance
of pre-existing restrictions arising from a partial deposit freeze at Parex, the
largest domestic bank in the country (IMF 2009a). Soon thereafter, a joint World
Bank-IMF report (2009: Table 1.4) on the current crisis notes without evaluation
that six countries (China, Colombia, Ecuador, Indonesia, the Russian Federa-
tion, and Ukraine) all imposed some type of capital control during the crisis.
Another Fund report acknowledges that Iceland, Indonesia, the Russian Fed-
eration, Argentina, and Ukraine all put capital controls on out?ows in place to
“stop the bleeding” related to the crisis (IMF 2009b). These reports neither offer
details on the nature of these controls nor commentary on their ultimate ef?cacy,
something that further suggests that capital controls—even and most notably on
out?ows—are increasingly taken for granted by the Fund.
Controls in Countries Faced with Too Much of a Good Thing
Policymakers in a far larger set of developing countries have deployed and
adjusted capital controls in response to the macroeconomic pressures and
vulnerabilities aggravated by large capital in?ows. These controls illustrate the
policy space that is increasingly being appropriated in developing countries that
remain independent of the Fund.
Brazil is a particularly interesting case since the country’s government (particu-
larly its Finance Minister, Guido Mantega) has been such a strong voice on the
matter of policy space for capital controls. The IMF’s changing stance regarding
Brazil’s capital controls also provides a window on both the evolution and con-
tinued equivocation in the views of Fund staff on the matter of capital controls.
62 A Pardee Center Task Force Report | March 2012
In late October 2009, Brazil imposed capital controls via a tax on portfolio
investment. The controls were self-described as modest, temporary, and market-
friendly; they were intended to slow the appreciation of the currency in the face
of signi?cant international capital in?ows to the country. Initially they involved
a 2 percent tax on money entering the country to invest in equities and ?xed-
income investments, while leaving foreign direct investment untaxed. Once it
became clear that foreign investors were using purchases of American Depository
Receipts (ADRs) issued by Brazilian corporations to avoid the tax, the country’s
Finance Ministry imposed a 1.5 percent tax on certain trades involving ADRs.
The IMF’s initial reaction to Brazil’s controls on capital in?ows was ever so mildly
disapproving. A senior of?cial said: “These kinds of taxes provide some room
for maneuver, but it is not very much, so governments should not be tempted
to postpone other more fundamental adjustments. Second, it is very complex to
implement those kinds of taxes, because they have to be applied to every pos-
sible ?nancial instrument,” adding that such taxes have proven to be “porous”
over time in a number of countries. In response, John Williamson and Arvind
Subramanian indicted the IMF for its doctrinaire and wrong-headed position on
the Brazilian capital controls, taking the institution to task for squandering the
opportunity to think reasonably about the types of measures that governments
can use to manage surges in international private capital in?ows (Subramanian
and Williamson 2009). A week later the IMF’s Dominique Strauss-Kahn reframed
the message on Brazil’s capital controls. The new message was, in a word, stun-
ning: “I have no ideology on this”; capital controls are “not something that come
from hell” (cited in Guha 2009).
The Brazilian government has continued to strengthen and indeed layer new types
of controls over existing ones in its ongoing effort to deal with a high volume of
in?ows and as of?cials seek to close new channels of evasion. For example, in
October 2010, Brazil twice strengthened the capital controls it ?rst put in place
in October 2009. The new Brazilian controls triple (from 2 to 6 percent) the tax it
charges foreign investors on investments in ?xed-income bonds. The Brazilian
controls tax foreign equity purchases at a lower rate (i.e., the same 2 percent rate
that has been in place since 2009), and foreign direct investment is still not taxed at
all. This is a particularly good example of ?ne-tuning controls so that they affect the
composition, rather than the level of foreign investment. (Indeed, numerous recent
IMF reports, as well as those by scholars such as Gallagher 2011a, make note of a
composition effect in Brazil.) In March 2011 Brazil imposed new capital controls,
this time on foreign purchases of domestic farmland, a measure that analysts
Regulating Global Capital Flows for Long-Run Development 63
suggest was aimed at curbing China’s growing land purchases in the country. In
the same month, Brazil increased to 6 percent a tax on repatriated funds that are
raised abroad through international bond sales and new, renewed, renegotiated,
or transferred loans with a maturity of up to two years (the previous limit was up
to 360 days). In August 2011, policymakers added to its existing array of controls
a 1 percent tax on bets against the U.S. dollar in the futures market, after the real
reached a 12-year high. Brazilian of?cials are also set to provide $16 billion in
tax breaks and to tighten trade barriers to protect manufacturers hurt by imports
from China (which have been stimulated by the strength of the real). Notably, in an
August 2011 review of Brazil, IMF economists called the government’s use of capital
controls “appropriate” (Ragir 2011).
4
Brazil is one among many developing countries wherein policymakers are imple-
menting and dynamically adjusting capital controls against a backdrop of large
in?ows. For example, in December 2008, Ecuador implemented a number of
measures governing in?ows and out?ows. In terms of out?ows, it doubled the tax
on currency out?ows, established a monthly tax on the funds and investments
that ?rms kept overseas, and also sought to discourage ?rms from transferring
U.S. dollar holdings abroad by granting tax reductions to ?rms that re-invest their
pro?ts domestically. In terms of in?ow controls, the government established a
reserve requirement tax (Tussie 2010).
5
In December 2009, Taiwan imposed new
restrictions on in?ows in order to reduce speculative pressures from overseas
investors. The controls preclude foreign investors from placing funds in time
deposits. In the same month, China added to its existing controls on in?ows and
out?ows. In June 2010, Indonesia announced what its of?cials awkwardly term a
“quasi capital control” that governs short-term investment. Indonesia’s in?ow con-
trols seek to dampen speculation in the country via a one-month holding period
for central bank money market securities, the introduction of longer maturity
instruments, and new limits on the sales of central bank paper by investors and
on the interest rate on funds deposited at the central bank.
South Korean of?cials also began to introduce capital controls on in?ows in June
2010. Regulators have since continued to widen them to reduce the risks associated
with a possible sudden reversal of in?ows, rising short-term foreign borrowing,
and the use of derivative instruments. The controls limit the amount of currency
4 Curiously in the same month Canadian Prime Minister Harper used some of his time in the country inexplicably
to lecture the government about the need to dismantle capital controls (Mayeda 2011).
5 As Tussie (2010) notes, what is particularly interesting about Ecuador’s measures is that they demonstrate that
even a dollarized country has more policy space than is usually understood.
64 A Pardee Center Task Force Report | March 2012
forward and derivatives trading in which ?nancial institutions can engage, and
limit the foreign currency loans extended by banks to local companies. Since
October of 2010, regulators have audited lenders working with foreign currency
derivatives. Finally, in April 2011 South Korea levied a tax of up to 0.2 percent
on holdings of short-term foreign debt by domestic banks (with a lower tax
levied against longer term debts). In August 2011, South Korea’s government
announced that it is reviewing “all possibilities” on curbing capital in?ows.
Thailand also began to deploy capital controls in October 2010: authorities intro-
duced a 15 percent withholding tax on capital gains and interest payments on
foreign holdings of government and state-owned company bonds. In the same
month, Argentina and Venezuela implemented controls on out?ows: in Argen-
tina they involve stricter limits on U.S. dollar purchases, and in Venezuela they
involve new restrictions on access to foreign currency. Peru has been deploying
a variety of in?ow controls since early 2008. The country’s reserve requirement
tax (which is a type of control on capital in?ows) has been raised three times
between June and August 2010. Finally, in August 2011, of?cials in the Philip-
pines announced that they are prepared to impose new controls (in the form of
prudential limits on certain kinds of transactions by banks) to reduce the volatil-
ity in the peso after it rose to a three-year high.
National Policy Divergence
It bears noting that not all policymakers are responding to the pressures of large
capital in?ows with capital controls. Turkish, Chilean, Mexican, and Colombian
policymakers have publicly rejected capital controls as a means of dealing with
the appreciation of their currencies.
6
This is not to suggest that policymakers in
these countries are sitting on the sidelines while their currencies appreciate and
asset values balloon. Instead, they have stepped up their purchases of dollars
and, in some cases, are using monetary policy to try to stem the appreciation of
their currencies.
National divergences in response to similar pressures re?ect many factors, not
least of which are differing internal political economies, the continued sway
of neo-liberal ideas in some countries, and perhaps also pride associated with
dealing with the problem of an excessively strong currency in countries that
have so long faced the opposite problem. There may also be skepticism about
the ef?cacy of these measures, especially since—until quite recently—Brazil’s real
6 Interestingly, in October 2010 the director of the IMF’s Western Hemispheric department made a case (unsuc-
cessfully) for the use of controls in Colombia owing to the rapid appreciation of its currency (Crowe 2010).
Regulating Global Capital Flows for Long-Run Development 65
appeared almost unstoppable in its appreciation despite the many measures
taken since 2009.
ARE NATIONAL MEASURES SUFFICIENT?
Will the range of strategies deployed by governments and central banks across
the developing world solve the problem they aim to address? No, and indeed,
in the absence of viable, representative, and coordinated mechanisms of global
economic management, we may descend into a period of nationalist, beggar-thy-
neighbor policies. But in the short-term at least the strategies help protect (even
if only modestly) developing countries from the negative trade effects of cur-
rency appreciation and the other risks associated with large capital in?ows. And
evidence suggests that these measures have at least partly achieved their chief
objectives (IMF, various reports, 2010, 2011; Gallagher 2011a). More importantly,
the unilateral steps that policymakers are taking help to solidify the growing
international sentiment against unregulated capital ?ows and light touch ?nan-
cial regulation.
The current crisis is exposing clearly the dangers associated with a unilateral
policy free-for-all in ?nancial matters, and the need for a new regime of coordi-
nated monetary and exchange rate policy and the protection of national policy
space. It may be that more
common ground on policy
space is emerging between
some Northern and Southern
policymakers, owing to the
fact that policymakers in
wealthy “safe haven countries”
(namely, Canada, Switzerland,
Australia, New Zealand, and Singapore), are confronting some of the challenges
that have frustrated their Southern counterparts. As a consequence, coordinated
cross-national responses to managing the surges in international capital ?ows
may yet be coming, as new alliances form among the diverse countries now fac-
ing the hardships attending currency appreciation.
FOR ADVOCATES OF ENHANCED POLICY SPACE
In late 2010 and 2011 the IMF provided us with an interesting vantage point
from which to observe the continuing tension within the institution on capital
controls. In several reports, Fund staff note that the institution is seeking to
The current crisis is exposing clearly the
dangers associated with a unilateral policy
free-for-all in ?nancial matters, and the need
for a new regime of coordinated monetary
and exchange rate policy and the protection
of national policy space.
66 A Pardee Center Task Force Report | March 2012
develop standards for the appropriateness of different types of controls (IMF
2010, 2011a, 2011b; Ostry et al. 2011; Habermeirer et al. 2011). The current
discussion of developing standards for controls was also given life by the French
government, which seemed eager to use its new leadership of the G-20 and G-8
in early 2011 to give the Fund a role in coordinating capital controls via a code
or mandate on the subject (Hollinger and Giles 2011). The issue has since fallen
off the European agenda as the Eurozone lurches from one crisis to the next.
But the fact that the IMF tested the waters on the matter of controlling capital
controls is instructive. Far more instructive is the fact that Brazil and numerous
developing countries in the G-24 unequivocally and quite publicly rejected any
such role for the Fund (Wagstyl 2011; Reddy 2011; G-24 2011; Gallagher 2011b).
Notably, the Fund has not issued a public response to this rebuke by developing
countries.
Whether the IMF seizes this opportunity and how it comes to interpret this pos-
sible new charge is of critical importance to advocates of national policy space
for capital controls (and other measures). It will be important for Fund watchers
to stay on this issue and continue to advocate coordination that does not pre-
sume a norm of liberalization. We can also hope that those developing countries
that have used capital controls so successfully will resist any effort to expand the
IMF’s authority around such a norm. Certainly there is much in the IMF’s own
actions and of?cial statements by the institution’s key ?gures during the current
crisis to call upon should we ?nd that momentum builds around rewriting the
institution’s new position on capital controls.
Any new regime that attempts to coordinate capital controls must preserve the
policy autonomy to make continued ?ne-tuning possible. The two fundamental
challenges for any new regime is to preserve and indeed maximize national
policy space for experimentation and to ?nd ways to extend this policy space to
less autonomous states in the global South (see Rodrik 2001, 2007: ch. 8 on the
WTO). Barring any substantial change in the global political economy, only some
developing countries will be positioned to take advantage of the new policy
autonomy that has emerged at present. The most dif?cult policy challenge will
therefore be to address the most pressing needs of those states that lack the
resources, geopolitical power and/or inclination to pursue an equitable, stable
developmentalist path.
Regulating Global Capital Flows for Long-Run Development 67
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03/brazilian-capital-controls-are-appropriate-tool-imf-says.html.
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Regulating Global Capital Flows for Long-Run Development 69
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70 A Pardee Center Task Force Report | March 2012
Regulating Global Capital Flows for Long-Run Development 71
6. How to Evade Capital Controls . . . and Why They
Can Still Be Effective
Shari Spiegel
There is a growing consensus that capital account regulations can be used by
developing countries to help promote economic stability. The IMF, which used
to promote open capital markets, now supports the use of capital ?ows manage-
ment, at least under certain circumstances (Ostry et al. 2010, 2011). Many coun-
tries, including the U.S., have used regulations to restrict cross border ?ows in
the past. With the increase in global liquidity following the 2008 economic crisis,
a number of developing and emerging market countries have implemented, or
are considering implementing, such regulations.
In designing capital account regulations, policymakers generally try to target
short-term capital ?ows, while leaving the current account, areas of the capital
account, and sometimes the derivatives markets unregulated. However, leav-
ing some external accounts open leaves room for circumvention of regulations
through these areas. The goal of this paper is to present some of the mechanisms
used for circumvention,
to better understand their
impact on the effectiveness
of regulations. Although
more research is needed, our
analysis indicates that coun-
tries with successful capital
account management regimes
have been able to dynamically adapt regulations to correct loopholes, and that
better monitoring of open areas of external accounts and derivatives markets
can give policymakers the necessary tools.
There is an ongoing debate on the impact of this circumvention, with some
economists claiming that it makes the regulations ineffective. There are, how-
ever, costs associated with circumvention, which are an implicit tax on the inves-
tor. Circumvention will likely occur whenever the incentives for evasion exceed
The question for policymakers should not
be whether regulations can be circumvent-
ed, but what the cost of circumvention is,
and whether or not the cost is large enough
to serve as a disincentive to a signi?cant
portion of short-term investors.
72 A Pardee Center Task Force Report | March 2012
these costs. The question for policymakers should not be whether regulations
can be circumvented, but what the cost of circumvention is, and whether or
not the cost is large enough to serve as a disincentive to a signi?cant portion of
short-term investors. More broadly, capital account regulations should be seen
as tools to reduce surges in short-term cross-border ?ows rather than necessarily
stopping these ?ows altogether.
Research on mechanisms to circumvent regulations is limited, in large part
because market participants who engage in these practices do not want to pub-
licize their activities. In one of the few studies in this area, Carvalho and Garcia
(2008) interview investors in Brazil in the 1990s and document some of the mea-
sures used to evade capital controls during this period. In their analysis, the cost
of circumvention is based on estimates of the administrative costs of setting up
the vehicles used for evasion. We argue, however, that administrative costs are
just one element of the actual cost to the investor. The cost of circumvention is
ultimately dependent on supply and demand, with the gain from evading regula-
tions often shared between the investor and a ?nancial intermediary.
The rest of this paper is divided into three sections. The ?rst section discusses
the cost of evasion. The second presents three types of mechanisms used for
circumvention:
1) traditional forms of evasion through the current account, including over- or
under-invoicing of trade receivables;
2) evasion through open areas of the capital account, focused on disguising
restricted ?ows as unrestricted ?ows;
3) evasion through derivatives markets, by which investors create synthetic
instruments.
The ?nal section concludes with policy recommendations, emphasizing the
importance of simple, but ?exible, regulations that allow policymakers to adapt
interventions to changing circumstances. Regulations should be designed to cut
the link between cross-border ?ows and the domestic market and dis-incentivize
domestic agents from becoming ?nancial intermediaries. Monitoring of ?ows
throughout the ?nancial system—something regulators should be doing anyway
to maintain stability in other areas of the ?nancial system—is key to designing an
effective regulatory regime.
Regulating Global Capital Flows for Long-Run Development 73
The Cost of Circumvention
1
Assume that country Z is attracting large in?ows of short-term capital due to
high growth coupled with high relative interest rates. Three-month interest
rates in the investors’
2
home country are 1 percent for the year (or .25 perent for
a 3-month period), whereas the expected return on a three-month investment
in country Z is 5 percent, re?ecting higher interest rates and expected currency
appreciation. To limit the surge in in?ows the government of country Z imposes
a 4.5 percent tax on short term ?xed income capital in?ows. After-tax returns on
the three-month investment are now only slightly higher than the .25 percent
return in the home country, but with greater risk since the expected currency
appreciation might not materialize due to the foreign exchange tax, as well as
counterparty, local settlement, legal, and other risks. The investors, who still
want to capture high country Z domestic returns, look for ways to get around the
tax, and ?nd a local counterparty that is willing to facilitate circumvention at a
cost of around 2 percent. The expected return on the new investment would now
be just under 3 percent, which is still signi?cantly above home country expected
returns. However, the 3 percent return doesn’t necessarily compensate investors
for local market risks. It deters some, but not all, investors.
From the government’s perspective, the tax is marginally successful. The govern-
ment doesn’t earn signi?cant tax revenue, but it does succeed in slowing the
pace of in?ows. However, if the currency starts to strengthen, expected returns
might increase and investors will be tempted to put the trade back on, weaken-
ing the regulations further. In order to understand how to respond to a new wave
of capital ?ows, the government has to better understand how the 2 percent cost
is derived.
The cost of evasion is a function of three factors: administrative costs, the number
of intermediaries, and the size of any penalties. Administrative costs represent
the costs of setting up the vehicles for evasion, such as shell companies, listings
on stock exchanges, etc. This is often a ?xed cost, and represents the minimum
cost of evasion. Although there are exceptions, many foreign investors,
3
especially
large hedge funds, pension funds and mutual funds, lack the local knowledge and
personnel to set up these vehicles on their own. They rely on local intermediaries
1 This section focuses on costs associated with taxes on in?ows, but quantity restrictions and restrictions on
out?ows will have similar effects.
2 We use the term “investors” to cover the wide range of ?nancial market players, including short-term
speculators.
3 We generally refer to foreign investors, though the pool of investors also includes domestic investors.
74 A Pardee Center Task Force Report | March 2012
for this role. In general, the intermediary charges the foreign investor a mark-up
on the administrative costs. Though it varies by country, there is often a limited
group of local intermediaries that are considered creditworthy enough for foreign
investors to be willing to use them as their counterparties. Local intermediaries
are therefore often able to maintain monopoly power and charge rents. In the
example above, the 2 percent cost represents the administrative costs plus this
rent. If the currency starts weakening and foreign in?ows decline, the intermedi-
ary might lower his price from 2 to 1 percent. If, on the other hand, the currency
continues to strengthen, attracting additional in?ows, the ‘monopoly price’
might be raised to 3 percent, which is still lower than the of?cial tax. This simple
example represents how the ‘gray’ market works, with the government tax being
split between the foreign investor and the intermediary.
One way to decrease circumvention is to reduce incentives for local institutions
to act as intermediaries. Many forms of circumvention are illegal and have high
penalties associated with them, often at multiple times the potential gain. Even
when circumvention is completely legal, governments can put pressure on local
agents, such as local ?nancial institutions, to reduce their willingness to act as
intermediaries. The question for policymakers is how to identify the loopholes,
and design policies to increase the cost of circumvention. The answer to this
question depends on the methods of evasion used.
How to Evade Controls
As discussed above, we divide mechanisms for circumvention into three
categories: current account transactions; capital account transactions, such as
disguising restricted ?ows to look like unrestricted ?ows; and derivatives. In the
following section we discuss a range of mechanisms in each category. We note
that for each mechanism discussed, authorities across countries were able to
dynamically respond by strengthening regulations to address the loopholes. In
particular, as the size of evasion grows so that circumvention becomes a more
signi?cant problem, regulators are able to track it more easily, and adapt regula-
tions in response.
CIRCUMVENTION THROUGH THE CURRENT ACCOUNT:
OVER- AND UNDER-INVOICING
Over- and under-invoicing is the most typical form of circumventing capital con-
trols via the current account. This mechanism has generally been used as a way
for domestic entities to evade restrictions on capital out?ows. An importer who
Regulating Global Capital Flows for Long-Run Development 75
wants access to foreign exchange can over-invoice his or her imports to obtain
more foreign exchange than he or she needs, which would then be invested
abroad. Over-invoicing
imports would imply higher
tariff payments at customs,
but would also imply lower
reported net income, and
therefore lower income tax
payments. Similarly, export-
ers could under-invoice, thus obtaining foreign exchange to invest abroad while
reducing their income for tax purposes.
This method can also be used to evade restrictions on in?ows. Under-invoicing
imports and over-invoicing exports allows ?rms to bring additional foreign
exchange into the country, but it also raises pro?ts and therefore subjects the ?rms
to higher taxes. In many countries this tax loss can be signi?cant. For example, with
a corporate tax of 20–25 percent, an investor would need the investment to return
25–33 percent to just break even on the trade (assuming zero funding costs)
4
. None-
theless, there is evidence that this mechanism became increasingly used, especially
in countries with strong administrative controls, such as China (The Economist
2008), which have fewer alternative opportunities for circumvention.
However, as this form of evasion became increasingly signi?cant, it also became
easier for of?cials to identify and respond. In 2008, Chinese of?cials tightened
restrictions on loopholes, even though China was in the process of liberalizing
its capital account in other areas at the time. To prevent companies making false
claims, Chinese regulators, the commerce ministry, and customs authorities
linked their computer systems to check underlying transactions and eliminate
discrepancies between proceeds from exports and reported receipts for foreign
exchange, and forbid banks from buying the foreign exchange when large dis-
crepancies are identi?ed (Yu 2009).
CIRCUMVENTION THROUGH THE CAPITAL ACCOUNT:
DISGUISING RESTRICTED INVESTMENTS
A major form of circumvention through the capital account has been to disguise
restricted investments (i.e., the short-term ?ows) as unrestricted investments
(such as FDI, trade ?nance, or sometimes tradable equity).
4 This also assumes that the investor doesn’t engage in other forms of tax evasion, such as creating false
expenses to reduce pro?ts.
Over- and under-invoicing is the most typical
form of circumventing capital controls via the
current account. This mechanism has gener-
ally been used as a way for domestic entities
to evade restrictions on capital out?ows.
76 A Pardee Center Task Force Report | March 2012
Foreign Direct Investment and Tradable Equity
Carvalho and Garcia (2008) documented how this mechanism was used in Brazil
in the 1990s, through FDI and listed equities. Financial intermediaries created
wholly-owned shell companies as public corporations listed on the Sao Paulo
Stock Exchange (BOVESPA). International capital ?ows were invested in equity
of the company, which was not subject to controls. The shell company then pur-
chases short-term ?xed income instruments, with the earnings sent back abroad
as pro?t or dividends. The ?nancial intermediary also declared the investment
as FDI to take advantage of tax holidays. A similar scheme was to set up a
wholly-owned company listed on the BOVESPA and to manipulate the price so
that there would be a loss for tax purposes. Disguising short-term investments
as FDI has also been used to circumvent restrictions in other countries, such as
Chile and China. For example, in China foreign investors would bring in funds in
excess of what was needed for investment purposes. These funds would then be
invested in short-term Chinese interest rates.
As in the current account example, regulators should be able to detect this type
of evasion, especially when it becomes signi?cant enough to reduce the effec-
tiveness of regulations. For example, the stock market in Brazil, the BOVESPA,
is one of the largest stock exchanges in the world. Nonetheless, even on the
BOVESPA, shell transactions might stand out. For example, since 2004, there
was only one issue with less than 5 investors and brokers.
5
Similarly, the central
bank of Chile detected this type of activity in the Chilean market and subjected
any investment that was a “potentially speculative direct investment” to the cur-
rency tax, which had the effect of reducing evasion (Carvalho and Garcia 2008;
Stiglitz et al. 2006). In China, as part of the 2008 reforms, regulators tightened
requirements on how foreign exchange entering via the FDI account can be
used, and enacted strict sanctions and penalties for evasion (Yonding 2009). It is
interesting to note that prior to the strengthening of regulations, analysts warned
that stricter regulations on FDI would limit investment in China. Yet, despite the
tightened controls in 2008, China experienced record amounts of FDI in 2010
(Bloomberg News 2011).
More broadly, there has been growing evidence of ‘?nancialization’ of FDI
(including investments by the companies into ?xed income instruments and
loans between parents and subsidiaries), which appear to carry greater risks
than green?eld FDI (Ostry et al. 2010). Rather than responding on a piecemeal
5 Calculations based on the BOVESPA website.
Regulating Global Capital Flows for Long-Run Development 77
basis, appropriate policy response might be to expand regulations to incorporate
these types of in?ows, which are ?nancial in nature, but are categorized as FDI.
For example, companies could pay an up-front tax on all investment, but be able
to recoup the payment after a period of time deemed to be ‘long-term.’ Although
this could add to the cost of doing business in a country, the impact would be
small in the context of the bigger investment. Alternatively, policymakers could
tax dividends or pro?ts sent abroad, which could be targeted to short-term gains
or to gains from ?xed income investments. More broadly, policymakers should
better monitor FDI ?ows, to better distinguish between ?nancial FDI and longer-
term green?eld investment.
Trade Finance
Another example of disguising ?ows in Brazil in the 1990s was through trade
?nance (Carvalho and Garcia 2008). This case is particularly interesting since it
illustrates how the gains from circumvention are often shared between the local
intermediary and the foreign investor. Exporters in Brazil could set up accounts
to borrow funds for up to one year before shipping merchandise, at low rates.
Foreign investors who bought the rights to these accounts had access to the low
interest loans, and could invest the proceeds in short-term securities without
having to bring money on-shore. Demand for this mechanism led to a black
market in trade ?nance rights for short-term investing, and a few banks actually
set up trading companies specialized in trade ?nancing to take advantage of this
strategy (Carvalho and Garcia 2008). However, the rate earned on these accounts
was below the government interest rate. Carvallo and Garcia point out that
one reason for this was that “foreign investors seeking the high return in Brazil
offered capital at interest rates below the country’s base rate due to restrictions
on other investment means.” In other words, the exporters acted as the ?nancial
intermediaries, and shared the gains from circumvention with the foreign inves-
tor. However, this form of circumvention was less of an issue for regulators since
the trades were ?nanced by local currency loans and did not affect the exchange
rate, or bring dollars into the domestic market. The trades did increase leverage
in the system, but this should be dealt with through prudential regulations.
Similarly, in China, export ?rms often receive an advance from foreign buyers
for up to a year, which could be invested on-shore in short-term interest rate
products. To prevent this access from being sold for a pro?t, the 2008 regulations
required ?rms to present contracts to show that the advance is necessary, and
ceilings have been imposed on the maximum advance size.
78 A Pardee Center Task Force Report | March 2012
Derivatives Markets
Derivatives are particularly potent instruments for circumvention because inves-
tors can create synthetic instruments to mimic domestic investments without
actually moving funds across borders. While authorities can monitor and regu-
late domestic derivatives markets, offshore markets are harder to assess. None-
theless, trades in offshore markets are generally offset in the domestic market,
which means that local regulations can still effect these investments.
Non-deliverable Forwards (NDFs)
The simplest derivative product used to access local market interest rates
offshore are NDFs. An NDF is a forward currency trade whereby the investor
buys one currency (say the Brazilian real) and sells another currency (the base
currency, which is often USD, EUR, or JPY) at an agreed-upon rate for settlement
at some point in the future, say one, three or six months. However, instead of
exchanging currencies at the settlement date, the counterparties calculate the
gain or loss in the base currency, e.g., USDs, and settle the trade in that currency
offshore. The NDF creates a synthetic short-term interest rate investment, funded
by borrowing in the base currency. The difference between onshore interest rates
and those implied in the NDF market is a good indicator of how well exchange
controls are working. If the two rates are relatively close, this is a sign that
foreigners are able to offset their risk with local counterparties fairly easily and
gain access to local market interest rates. If the implied interest rate in the NDF
market is signi?cantly below the local market rate, as was the case, for example,
in Indian rates during the 1990s, it is a sign that controls are effective at keeping
foreign investors from accessing the domestic short-term ?xed income market.
If an offshore derivatives market were to have signi?cant interest from both buy-
ers and sellers, it is possible that an offshore market could develop separately
from the domestic market. However, in most cases, investors in these markets
are speculating, with most investors on the same side of a trade—either putting
on a carry trade, buying local currency during bubbles, or shorting a currency
during a crisis. A 2005 Federal Reserve Bank of New York study (Lipscomb 2005)
found that 60 to 80 percent of NDF volume is generated by speculative interests,
with increasing participation from hedge funds. International ?nancial institu-
tions generally act as market-makers, which means they tend to offset their
positions either through the brokers market, or directly with onshore institu-
tions, often with their local branches. For example, a New York branch of a
major international bank could enter an NDF with a hedge fund, by which the
Regulating Global Capital Flows for Long-Run Development 79
fund buys 100 million dollars worth of Thai Bahts (THB). The bank would then
be short THB, which it might buy from its local branch. However this trade can
be done via internal accounting without actually bringing the dollars on-shore.
In other words, an important loophole exists when transactions between foreign
banks and their branches are not monitored and regulated.
The local branch is now short THB and long USD, so it would go into the local
market and sell USD and buy THB Treasuries to cover its short position. In the
end, the NDF position is transferred to the books of the local bank. The goal of
the regulators is to break the link between the offshore and onshore markets.
During the Asian crisis Malaysia did just this. Malaysia initially experienced cir-
cumvention of its controls through the offshore NDF market. In response, authori-
ties instituted regulations on domestic banks, which restricted them from trans-
acting directly with foreign institutions. These regulations cut the link between
the domestic and offshore market, and successfully limited the transfer of risk
from local balance sheets to offshore players. More recently Korea took a ?rst step
at limiting open FX derivative positions of local banks with the goal of limiting
the transmission from the offshore market, though the measures were somewhat
narrow in scope as they allowed corporates to hedge their risk offshore, and
didn’t completely sever the link between the onshore and offshore markets.
An alternative structure that’s similar to an NDF is a structured note. These are usually
issued at an off-shore banking center and can be designed to give the foreign investor
offshore access to domestic interest rates. Further, these measures can be designed to
include embedded additional leverage that is not necessarily obvious to regulators.
American Depository Receipts (ADRs) and Equity Swaps
Back-to-back operations can also be done in the equities market through ADRs.
6
In this case, the foreign investor buys an ADR ?nanced with a repurchase agree-
ment—known as a “repo”—in New York. At the same time, the local intermediary
sells the same stock with a reverse repo in the local market.
7
The difference in
?nancing rates between the repo and the reverse repo captures the difference
between U.S. and foreign rates.
6 ADRs represent equity in a foreign stock, but are traded on a U.S. exchange.
7 A repurchase agreement, or repo is, is the sale of securities with an agreement for the seller to buy back the
securities at a later date. In essence the seller is borrowing short-term funds at an agreed upon interest rate. A re-
verse repo is the same transaction from the buyer’s perspective. The buyer is lending short-term funds at an agreed
upon interest rate. In this example, the repo is ?nanced in USD while the reverse repo is invested in local currency.
80 A Pardee Center Task Force Report | March 2012
A similar structure exists in the equity swap market. In this market, a foreign
investor can buy an offshore equity swap from a domestic resident who can
hedge without the tax. Such offshore equity swap markets exist for Malaysia,
Korea, and Thailand.
In all of these examples, investments are made offshore, but ultimately hedged
locally. Authorities monitoring the domestic market should be able to respond
to these types of circumvention by regulating the onshore activities. For exam-
ple, in response to widespread use of the ADR arbitrage, the Brazilian central
bank instituted high penalties on this trade. However, it is not necessary for
authorities to target a particular trade. In Colombia, regulators used prudential
regulations to restrict foreign currency exposure and gross positions in foreign
currency derivatives of the domestic ?nancial intermediaries (Ostry et al. 2011),
thus limiting the ability of domestic ?nancial institutions to engage in these
types of trades. Monitoring transactions between banks and their subsidiaries,
and subjecting these to regulations, would help reduce the ability of agents to
circumvent restrictions. Insisting that all such off-balance-sheet transactions with
foreign investors are reported on the balance sheet of ?nancial market players
could help to monitor these types of transactions.
Onshore Derivatives Markets
Local derivatives markets provide more direct opportunities for circumvention,
especially when these markets are open to foreign investors. A foreign investor
who wants exposure to domestic interest rates can purchase a derivative instru-
ment without bringing funds onshore.
8
An example of derivatives that could be
used to circumvent restrictions on short-term investments would be deliverable
forward currency contracts and options strategies. Similar to forwards, option
strategies can be used to create a synthetic investment in local market instru-
ments.
9
Another example of a structure to get around restrictions on short-term
debt would be a long-term bond with embedded options that can be exercised in
the short-term.
Many developing and emerging markets still have relatively undeveloped deriva-
tives markets. Countries that have more developed derivatives markets, such as
Brazil, have taken measures to incorporate this market in the broader regulatory
environment. In response to a growth in some of these strategies in the 1990s,
8 Or bringing only small portion of the notional value of the trade onshore for margin requirements.
9 For example, ‘box options’, which are two puts and two calls, with the price on the strike date ?xed create a
synthetic local market investment.
Regulating Global Capital Flows for Long-Run Development 81
the Brazilian central bank initially subjected synthetic ?xed income trades to
the same regulations as direct ?xed income investments (Carvallo and Garcia
2008). In 2011, Brazil attempted to regulate the derivatives market more broadly
by subjecting all derivatives trades to a 2 percent tax. Although this tax is low
relative to expected returns, it represents an initial step in regulating derivatives
and has the added bene?t of helping regulators collect better information about
positions and be able to better monitor the market.
CONCLUSION
There is still an open debate on whether capital account regulations should be
temporary mechanisms (Ostry et al. 2011) or part of a permanent regime to be
strengthened or weakened depending on the economic environment. Those who
support temporary measures argue that capital account regulations become inef-
fective over the long run and are, at best, short-term tools to deal with temporary
surges in in?ows (Ostry et al. 2011). We argue that a permanent but ?exible
regime, based on simple rules, may be the best choice for many countries.
The effectiveness of capital account regulatory regimes has varied, with some
experiences more successful than others. Regulations have been most effective
in countries with stricter controls across different types of capital ?ows and in
countries with existing controls so that the administrative apparatus is already in
place (Ostry et al. 2010). The cost of building necessary administrative support is
not negligible, and it’s often dif?cult to design and implement effective programs
during crises or bubbles, when vested interests are apt to oppose them.
Although more research is needed, our preliminary analysis of different forms
of circumvention seems to indicate that countries are able to dynamically
strengthen regulations over time in ways that enhance stability. In general,
countries that are thought of as having the most successful regimes have all
maintained ?exible regulations, which they adapted to changes in the economic
environments, as well as to opening of loopholes. In both Chile and Colombia in
the 1990s, policymakers reacted strongly to new loopholes in existing regula-
tions by modifying the details of the framework (Stiglitz et al. 2006). In China
and Brazil, policymakers strengthened regulations when various forms of eva-
sion become more signi?cant. In Malaysia, policymakers responded to evasion
through the offshore market by strengthening regulations on domestic banks.
Dynamic management of regulations does not mean that policymakers should be
expected to always respond to changes in markets in a timely manner; markets
82 A Pardee Center Task Force Report | March 2012
move quickly and it usually takes regulators time to adjust to the changes,
even in developed markets. Nonetheless, markets give signals when evasion is
increasing. Monitoring is crucial to this process; when circumventions grow, an
alert regulatory body should
be able to detect them and
adjust regulations accord-
ingly. By monitoring ?nancial
markets—something regula-
tors should already be doing
to maintain the stability of
the ?nancial system in other
areas—they should be better able to dynamically adjust regulations in response to
market developments over time. It is often argued that circumvention is particu-
larly a problem in better-developed markets, such as those with active derivative
markets. While this is true, these markets should give regulators more tools (such
as clearing houses) to monitor ?ows and thus dynamically design interventions.
More broadly, cross-border ?ows represent only one set of risk factors in the
?nancial system, and should not be treated as any less of an issue for surveil-
lance than other ?nancial market transactions. Monitoring open areas of the cur-
rent account, capital account, and derivatives markets where circumvention can
occur, is crucial to being able to identify circumvention as it becomes signi?cant.
Many cross-border ?ows go through the banking system, but other non-bank
institutions, such as the big trading companies, which often have their own capi-
tal ?nancing groups are also part of the market. Regulators need to include all
institutions that act as ?nancial intermediaries under their regulatory umbrella.
Better monitoring of capital account ?ows can have the added bene?t of reduc-
ing tax evasion more broadly, as well as providing information to policymakers
on other risks in the economy.
By monitoring ?nancial markets—some-
thing regulators should already be doing to
maintain the stability of the ?nancial system
in other areas—they should be better able to
dynamically adjust regulations in response
to market developments over time.
Regulating Global Capital Flows for Long-Run Development 83
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versity of Massachusetts–Amherst: Political Economy Research Institute.
The Economist (2008). “Capital In?ows to China; Hot and Bothered,” 26 June. Available
athttp://www.economist.com/node/11639442.
Garber, Peter M. (1998). “Derivatives in international capital ?ow.” NBER Working Paper
No. 6623, June. Cambridge, MA: National Bureau of Economic Research.
Habermeier, Karl, Annamaria Kokenyne, and Chikako Baba (2011). “The Effectiveness
of Capital Controls and Prudential Policies in Managing Large In?ows,” IMF Staff
Position Note SDN 11/14 Washington, D.C.: International Monetary Fund.
Lipscomb, Laura (2005). “An Overview of Non-Deliverable Foreign Exchange Forward
Markets,” 25 May. Federal Reserve Bank of New York. Available athttp://www.bis.
org/publ/cgfs22fedny5.pdf.
Magud, Nicolas, Carmen Reinhart, and Kenneth Rogoff (2006). “Capital Controls: Myth
and Reality: A Portfolio Balance Approach to Capital Controls,” unpublished, Cam-
bridge, Mass.: Harvard University.
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Requirements on Capital In?ows.” CEPAL Review Nº 81: 7–31.
84 A Pardee Center Task Force Report | March 2012
Ocampo, José Antonio, Shari Spiegel, and Joseph E. Stiglitz (2008). “Capital Market Lib-
eralization and Development,” in J. A. Ocampo and J. E. Stiglitz (eds.), Capital Market
Liberalization and Development,” New York: Oxford University Press.
Ostry, Jonathan D., Atish R. Ghosh, Karl Habermeier, Luc Laeven, Marcos Chamon,
Mahvash S. Qureshi, and Annamaria Kokenyne (2011). “Managing Capital In?ows:
What Tools to Use,” IMF Staff Position Note 11/06. Washington, D.C.: International
Monetary Fund.
Ostry, Jonathan D., Atish R. Ghosh, Karl Habermeier, Marcos Chamon, Mahvash S.
Qureshi,and Dennis B. S. Reinhardt (2010). “Capital In?ows: The Role of Controls,”
IMF Staff Position Note 10/04. Washington, D.C.: International Monetary Fund.
Ostry, Jonathan, Ghosh, Atish R. and Chamon, Marcos (2011). “Managing Capital
In?ows: The Role of Capital Controls and Prudential Policies.” NBER Working Paper
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SSRN:http://ssrn.com/abstract=1919437.
Stiglitz, Joseph E., José Antonio Ocampo, Shari Spiegel, Ricardo Ffrench Davis, and
Deepak Nayyar (2006). Stability with Growth: Macroeconomics, Liberalization and
Development. New York: Oxford University Press.
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nomic Stability in China,” TWN Global Economy Series. Penang, Malaysia: Third
World Network.
Regulating Global Capital Flows for Long-Run Development 85
7. China’s Capital Controls:
Stylized Facts and Referential Lessons
Ming Zhang
After the full liberalization of its current account in 1996, China began to liberal-
ize its capital account in a gradual and cautious way. From the capital ?ow cat-
egory perspective, the control on direct investment has already been removed,
but portfolio investment and short-term debt are still regulated tightly. From
the capital ?ow direction perspective, the intention of the Chinese government
on capital control is determined by the real direction of capital ?ow at current
stage. For example, during the 1990s when China had a limited foreign exchange
reserve and faced capital out?ow pressure, the government adopted an “easy in,
dif?cult out” strategy. However, during the 2000s when China had already accu-
mulated a huge foreign exchange reserve and had been facing dramatic capital
in?ow, the government turned to an alternative “easy out, dif?cult in” strategy.
The counter-cyclical style of China’s capital control strategy demonstrates the
government’s effort to avoid vast capital out?ow or in?ows.
China’s capital account has already been partially opened (Table 1). According
to People’s Bank of China (PBC), by the end of 2010, inside the 40 speci?c items
under capital account transactions classi?ed by IMF, 12 percent had been fully
opened, 20 percent had been basically opened, 43 percent had been partially
opened, and the remaining 25 percent had not been opened yet (Ge 2011).
The Chinese government has already removed the major obstacles on inward
and outward direct investment, thinking that direct investment is very stable
and productive. FDI can ?ow in freely as long as the foreign enterprises get
permission from the Ministry of Commerce, and the FDI companies can remit
their legal pro?ts to their home country as they want. By the end of 2010, the
Chinese government had approved the establishment of over 680 thousand FDI
companies and had utilized over $1.1 trillion USD foreign capitals (Sun 2011).
The Chinese government began to allow domestic enterprise to make overseas
direct investment in 2001, whereas China’s outbound direct investment has been
accelerated since 2008. By the end of 2010, Chinese enterprises had established
86 A Pardee Center Task Force Report | March 2012
over 160 thousand ?rms overseas, and the accumulated investment amount
reached $259 billion USD (Sun 2011).
The Chinese government has been very cautious to loosen the control of port-
folio investment, let alone ?nancial derivatives, because portfolio capital ?ow
tends to be more volatile and speculative. The experience of Southeast Asia’s
?nancial crisis had strengthened the above belief. The typical approach has been
to set quotas for inward and outward portfolio investment. On the one hand, a
Quali?ed Foreign Institutional Investor mechanism (QFII) was established in late
2002 to introduce overseas portfolio investment. By the end of 2010, the Chinese
State Administration of Foreign Exchange (SAFE) had approved 97 foreign inves-
tors to enter domestic capital markets and the cumulative investment reached
$19.7 billion USD (Sun 2011). On the other hand, a Quali?ed Domestic Institu-
tional Investor mechanism (QDII) was founded in early 2006 to allow domestic
?nancial institutions to invest in global ?nancial markets. By the end of 2010,
Market
Inflow Outflow
Money Market Residents Prior approval by PBC and
SAFE
No permission except for
authorized entities
Non-Residents No permission No permission
Stock Market Residents List H/N/S shares abroad,
repatriate of QDII
QDII
Non-residents B shares, QFII, RMB QFII Sell B shares, repatriate of
QFII and RMB QFII
Bond and
Other Debts
Residents Prior approval by PBC and
SAFE
No permission except for
authorized entities
Non-residents QFII, RMB QFII Repatriate of QFII and
RMB QFII
Derivatives
and Other
Instruments
Residents Operations by financial
institutions are subject to
review of qualifications
and to limit on foreign
exchange position
Operations by financial
institutions are subject to
review of qualifications
and to limit on foreign
exchange position
Non-residents No permission No permission
Note to typesetting: This table goes in Chapter 7 as Table 1
Table 1: China’s Capital Account Controls (As of September 2011)
Sources: Yu 2007 and we made some revisions.
Note: H/N/S refers to Hong Kong/New York/Singapore stock markets. RMB is the Chinese currency.
See page v for full list of abbreviations.
Regulating Global Capital Flows for Long-Run Development 87
SAFE had approved 88 domestic investors to invest overseas and the accumula-
tive scale reached $68.4 billion USD.
The Chinese government has been employing different treatments to foreign and
domestic enterprises in cross-border debt ?nancing. As for debt in?ows, foreign
enterprises are allowed to borrow freely for many years as long as total foreign
liability does not exceed the gap between the registered capital and the invest-
ment amount, but quali?ed domestic enterprises did not get the permission to
borrow short-term foreign debt under quotas until early 2010. As for debt out-
?ows, Chinese commercial banks have been authorized to lend overseas since
2008, and quali?ed domestic enterprises have been approved to lend money to
their overseas subsidiaries since 2009.
After the global ?nancial crisis, the Chinese government has been promoting
RMB internationalization aggressively. Therefore, the further liberalization of the
Chinese capital account from then on has been overlapping with the measures
to develop an offshore RMB ?nancial center. The existing and potential progress
includes: First, Chinese ?nancial institutions were allowed to issue RMB bonds in
Hong Kong in 2007, and the issuers have gradually expanded to domestic enter-
prises, Chinese Ministry of Finance, Hong Kong’s ?nancial institutions and enter-
prises, and even transnational companies. Second, certain RMB-holding foreign
?nancial investors (including foreign central banks, Hong Kong’s RMB settlement
banks and participation banks) were allowed to invest on China’s domestic bond
market. Third, a RMB QFII mechanism will be established to facilitate foreign
institutional investors to invest on China’s domestic ?nancial markets with RMB.
Fourth, Chinese households will be authorized to invest exchange-traded funds
based on Hong Kong’s stock market.
Why has China taken a gradual and cautious approach to liberalize its capital
account? First, the Chinese government prefers a more independent monetary
policy because China is a large economy and has a different business cycle
compared with United States. Considering the RMB exchange rate is still in?ex-
ible against U.S. dollar, if China’s capital account is fully opened, PBC could do
nothing but import the Fed’s monetary policy. Second, Chinese ?nancial markets
are still underdeveloped and domestic investors are signi?cantly inexperienced.
They could not afford the drastic boom and bust of asset prices resulting from
huge capital in?ow and out?ow. If there is a similar ?nancial crisis in China, the
consequence will be much more serious than in the United States. Third, capital
control has been a key element in Chinese characteristic ?nancial repression,
88 A Pardee Center Task Force Report | March 2012
which underpins the dominating investment-driven growth strategy. By limit-
ing Chinese households and corporations to invest on overseas portfolios, the
Chinese government could maintain very low deposit and loan interest rates,
which boosts the heavy investment of state-owned enterprises and local govern-
ment on manufactures and infrastructures. Fourth, China’s economic reform has
not been completed and the property rights still need to be de?ned more clearly.
Lots of Chinese wealthy people (some of them are corrupted of?cials or entrepre-
neurs with ‘original sin,’ a situation where nations are not able to borrow abroad
in their domestic currency) fear that their properties may be nationalized some
day. Once the capital account is fully opened, there might be a massive capital
out?ow, even accompanied by money laundering and asset stripping (Yu 2007).
Is China’s capital control still effective? The majority voice from the recent
literatures shows that, although there are some leakages, China’s capital account
control is still effective to a large extent. For example, Ma and McCauley (2008)
found the sustained and signi?cant gaps between onshore and offshore RMB
interest rates and persistent USD/RMB interest rate differentials, which re?ected
the ef?cacy of China’s capital account control. In another example, Otani et al.
(2011) discovered that the empirically quanti?ed strength of capital control (by
increasing the transaction costs of cross-border ?nancial transactions) was con-
sistent with the Chinese government’s intention to in?uence capital movements.
There is other evidence about the ef?cacy of China’s capital control. In the ?rst
half of 2008, China faced a dramatic short-term capital in?ow (Figure 1). To
mitigate the capital in?ow, the Chinese government has adopted three measures:
?rst, a data exchange program was established between the Customs, the Minis-
try of Commerce, and SAFE to screen the capital in?ow through transfer pricing
in foreign trade, namely high export-invoicing and low import-invoicing; second,
anther data exchange program was founded between the Ministry of Commerce,
SAFE, and commercial banks to check whether the registered capitals or loans
of foreign enterprises ?ow into domestic asset markets; third, the government
began to investigate and punish cross-border underground banking businesses
extensively and severely. These measures achieved an instant and signi?cant
effect. From June of 2008, the short-term capital in?ow declined dramatically.
After the bankruptcy of Lehman Brothers, China began to face short-term capital
out?ows, and therefore the government loosened them. However, under the global
excess liquidity exacerbated by collective quantitative easing, China has been fac-
Regulating Global Capital Flows for Long-Run Development 89
ing a new wave of short-term capital in?ow since late 2009. Therefore the focus of
Chinese capital control turned to dealing with massive capital in?ow again.
Are there any referential lessons that could be drawn from China’s experience
of capital control for other developing countries? First, in comparison with other
emerging market economies such as Chile or Brazil that prefer price measures
in capital control, China prefers quantitative measures instead, especially on
quotas and administrative approvals. On the one hand, this demonstrated that
China’s liberalization of capital accounts still lags behind the above economies
signi?cantly. On the other hand, because the quantitative measures tend to make
more distortions than price measures, China is suffering a much higher welfare
cost than Chile or Brazil in executing capital controls. Therefore, in the future
China may turn to more price-oriented capital control tools such as unremuner-
ated reserve requirements and withholding taxes.
Second, it seems that the Chinese government does not follow the prescriptions
made by the IMF about how to deal with capital in?ow. The IMF suggested that
the countries should take a three-tool approach to handle capital in?ow: the
macroeconomic policies, the macroprudential regulations, and the capital con-
trols. Capital control should not be a replacement but a complement to proper
macroeconomic and macroprudential policies (IMF 2011). However, China does
Figure 1: China’s Short-term International Capital Flow
Notes: The monthly short-term international capital ?ow is calculated by the monthly foreign ex-
change purchase by PBC minus the sum of monthly trade surplus and FDI utilized, which is a very
rough estimation of high frequency short-term capital in?ow.
Sources: CEIC and the author’s calculation.
90 A Pardee Center Task Force Report | March 2012
not satisfy the criteria of using capital control tools directly. On the one hand, the
Chinese government hasn’t utilized all the necessary macroeconomic tools to
manage capital in?ow, especially the exchange rate appreciation. According to
the IMF, the systematic macroeconomic policy responses toward capital in?ow
include: tight ?scal policy, interest rate cut, exchange rate appreciation and
sterilized intervention. As for China, in order to mitigate the negative impacts of
the global ?nancial crisis and promote domestic structural adjustment, the ?scal
policy should be properly expansionary. To ?ght in?ation pressure, PBC has to
raise interest rates. PBC has been doing sterilized intervention heavily in the past
several years.
The only available tool for PBC to adopt now is a faster appreciation of the RMB
exchange rate. However, the concerns that a fast RMB appreciation might hurt
export and employment, and a fast RMB appreciation may result in an even
higher appreciation expectation thus leading to exchange rate overshooting,
dominated the debate among policymakers. The probability for a signi?cantly
faster appreciation of RMB remains low. On the other hand, China has a long
way to go in operating appropriate macroprudential regulations. Although the
Chinese major commercial banks got a good overhaul in the early 2000s, after
the burst of global ?nancial crises, the banks lent heavily to local government to
make infrastructure investments, which might bury the seed of a new wave of
non-performing loans after several years. Besides that, there are still lots of ?nan-
cial fragilities in domestic ?nancial sectors, and this may be why the Chinese
government could not afford faster capital account liberalization.
Third, China still faces the challenge of sequencing capital account openness
and the liberalization of the interest rates and exchange rates. Some economists
argue that, due to the resistance of interest groups, it is very dif?cult to complete
the liberalization of interest rates and exchange rates in the short-term, there-
fore the Chinese government should speed up the opening of its capital account
?rst. Ideally and theoretically, the fast liberalization of the capital account will
exert external pressure on the government to further liberalize interest rates and
exchange rates. However, if the capital account is fully opened before the liber-
alization of interest rates and exchange rates, there will be a signi?cant interest
rate spread between domestic and overseas markets and a strong RMB apprecia-
tion expectation, which will no doubt arouse more dramatic short-term capital
in?ow. The volatile and speculative capital in?ow will exacerbate the domestic
excess liquidity, thus leading to asset price bubbles and in?ation pressure ?rst. If
the capital in?ow suddenly stops or even reverses in the future, there will prob-
Regulating Global Capital Flows for Long-Run Development 91
ably be a devastating ?nancial crisis. Therefore, the liberalization of interest rates
and exchange rates should be a prerequisite for fully opening the Chinese capital
account. Moreover, the liberalization of interest rates and exchange rates could
improve resource allocation and promote the transition of growth model. The
Chinese government should try to overcome the resistance of interest groups,
and liberalize interest rates and exchange rates as soon as possible.
REFERENCES
Ge, Huayong (2011). “The Prerequisites and Strategies to Promote the Basically Convert-
ibility of Capital Account,” China Finance, No. 14, July.
International Monetary Fund (IMF) (2011). “Recent Experiences in Managing Capital
In?ows: Cross-Cutting Themes and Possible Policy Framework,” IMF Policy Paper,
February. Washington, D.C.: International Monetary Fund.
Ma, Guonan and McCauley, Robert N. (2008). “Ef?cacy of China’s Capital Control: Evi-
dence from Price and Flow Data,” Paci?c Economic Review, 13(1): 104–123.
Otani, Ichiro, Fukumoto, Tomoyuki and Tsuyuguchi, Yosuke (2011). “China’s Capital
Controls and Interest Rate Parity: Experience during 1999–2010 and Future Agenda
for Reforms,” Bank of Japan Working Paper Series, No.11-E-8, August. Tokyo: Bank of
Japan.
Sun, Lujun (2011). “The Openness of China’s Capital Account and Its Future Trajectory,”
China Finance, No. 14, July.
Yu, Yongding (2007). “Managing Capital Flows: The Case of the People’s Republic of
China.” Paper prepared for the Asian Development Bank Institute (ADBI) Project on
Capital Controls, December 12.
92 A Pardee Center Task Force Report | March 2012
Regulating Global Capital Flows for Long-Run Development 93
Section III: The Global Cooperation of Capital
Account Regulations?
8. The IMF, Capital Account Regulation, and
Emerging Market Economies
Paulo Nogueira Batista, Jr.
1
The international ?nancial crisis has led to a major revision of economic policy
recommendations since 2008. This revision, albeit un?nished, has affected a
large number of policy issues, including of course regulation and supervision.
The previous preference for light touch regulation and the faith in the self-
correcting virtues of free markets have been replaced by a renewed emphasis
on the role of governments and central banks in preventing speculative excesses
and the build-up of risks.
An important part of this debate is, or should be, the regulation of international
capital ?ows. Prior to the crisis, capital account liberalization was almost an
article of faith in some circles. The bene?ts of free capital ?ows were accepted
with no major reservations by many policymakers and international organiza-
tions. Capital controls were stigmatized.
This has changed to some extent. However, as José Antonio Ocampo pointed
out, there is a curious dichotomy in what is now mainstream thinking. The need
for strong regulation and supervision is generally recognized—and how could
it not be after what happened in the ?nancial systems of the United States and
Europe? But, curiously, this recognition does not extend in the same degree to
the regulation of international ?nancial ?ows. As Ocampo observed, cross-border
?nance has received much less attention, as if it did not require regulation—or
indeed as if it was not part of ?nance. I will come back to this point when I
1 Executive Director at the International Monetary Fund for Brazil, Colombia, Dominican Republic, Ecuador, Guy-
ana, Haiti, Panama, Suriname and Trinidad and Tobago. The views expressed in this paper should not be attributed
to the IMF or to the governments the author represents at the IMF’s Executive Board.
94 A Pardee Center Task Force Report | March 2012
address the hesitant nature of the International Monetary Fund’s recent shift
toward the acceptance of capital account regulations.
THE STANDARD APPROACH
Before the crisis broke out in 2007–2008, the standard approach recommended
to countries facing large-scale capital in?ows involved basically two aspects:
?scal adjustment and exchange rate appreciation. In addition, it was suggested
that restrictions on out?ows of capital be relaxed. That was the message that
countries received from the IMF, for example, but little else. Even international
reserve accumulation was frowned upon.
For example, Brazil had begun to accumulate reserves in earnest in 2006. This
would serve us well during the crisis. However, staff of the Fund in annual Article
IV consultations warned Brazil against excessive reserve growth.
Even at that time, the insuf?ciency of the standard approach—let the currency
rise and adjust ?scal policy—was relatively clear. Emerging market countries had
ample experience of the dangers of exchange rate overvaluation. A persistently
strong currency undermined the economy’s international competitiveness and
could lead to dangerously high current account de?cits. A sudden reversal of
capital ?ows—as often happened—forced economies to undergo painful adjust-
ment. In Latin America, perhaps more than in most other regions, boom-bust
cycles driven by international capital movements were an often-recurring
phenomenon.
Fiscal policy was not well placed to respond to large and volatile capital move-
ments. In theory, ?scal adjustment could allow looser monetary policy, lowering
the attractiveness of domestic ?nancial assets for foreign investors. In practice,
?scal policy is a slow, heavy, and clumsy instrument to deploy against fast-
moving and ?ckle capital ?ows. It is always subject to political constraints and
largely dependent on legislative approval. Also, one must bear in mind that
?scal policy has other objectives; it seems to make little sense to tie it to the
?uctuating moods of international investors.
Moreover, as has been noted by several analysts, there is what we could call “the
paradox of good fundamentals.” Fiscal adjustment, leading to an improvement in
public accounts and ?scal fundamentals, may strengthen con?dence and attract
further ?ows of capital from abroad.
Regulating Global Capital Flows for Long-Run Development 95
Removing restrictions on out?ows can help to somewhat alleviate upward pres-
sure on the exchange rate, if residents do take the opportunity to invest outside
the country. But this can also increase external vulnerability at a later stage,
facilitating capital ?ight in times of uncertainty and crisis.
OUTBREAK OF THE CRISIS
The weakness of the standard approach became glaring with the outbreak of
the crisis. The wall of liquidity produced by the expansionary monetary poli-
cies of the reserve currency issuing central banks—the Federal Reserve ?rst and
foremost, but also the European Central Bank, the Bank of Japan and the Bank
of England—contributed to create formidable problems for emerging market
countries. Emerging markets suffered less and recovered faster from the crisis—a
factor that reinforced their attractiveness for international investors. Growth and
interest rate differentials between emerging markets and advanced economies
combined to generate large ?ows of capital from the latter to the former.
Beyond these cyclical factors, there seems to be occurring a fundamental reas-
sessment of international risks in favor of emerging markets, i.e., a reallocation
of portfolios that may be leading to a longer-lasting increase in the supply of
capital to emerging markets. This has its positive sides of course, but many
emerging market countries will be dealing with an “embarras de richesses.”
One has spoken of the “curse of natural resources.” One could equally speak of
the “curse of the overabundance of capital ?ows.” One of the worst things that can
happen to a country is to fall into the good graces of international capital markets.
Since mid-2011, the worsening of the economic and ?nancial situation in the
advanced economies, notably in the euro area, highlights yet again that capital
in?ows can be a very mixed blessing. Changes in the availability of external
loans and investments can
happen quickly and unex-
pectedly. If the country receiv-
ing in?ows is unprepared,
these sudden reversals can
cause great damage to the economy and the ?nancial system. The euro area cri-
sis has not hit emerging markets with full force so far, but it led to an increase in
risk aversion and to a ?ight to so-called safe havens, generating some turbulence
and exchange rate depreciation.
One of the worst things that can happen to
a country is to fall into the good graces of
international capital markets.
96 A Pardee Center Task Force Report | March 2012
Now, there is still a widespread view that capital ?ows are of bene?t to recipient
countries. This view is not entirely wrong; one may well be able to construct a
plausible case in its favor. But the least one can say is that it often ?ies in the face
of experience. Quite a number of economies have been severely hurt, sometimes
literally destroyed, by imprudent capital account liberalization and surges in
capital ?ows. One has only to look to emerging countries in Eastern Europe for
recent examples. Iceland is another shocking case.
I would like to mention, in passing, that an often-unnoticed aspect of the euro
area crisis is the role played by the boom-bust cycle associated to free capital
movements. Abundant capital in?ows allowed pro-cyclical ?scal policies, rapid
credit growth, and high current account de?cits in the periphery of the euro
zone, as well as in Iceland and several emerging market countries in Eastern
Europe. The sharp reversal of ?ows after the 2008 crisis forced these economies
to undergo a wrenching adjustment process. As time goes by, we will probably
come to realize that capital account management policies may be necessary not
only in emerging markets but also in advanced economies.
THE NEED FOR CAPITAL ACCOUNT MANAGEMENT
Policymakers in emerging markets seem to be aware of the risks associated to
capital movements. Painful experiences have made them acutely conscious of
the dangers of external indebtedness and foreign capital. On the other hand, the
temptation remains to enjoy the good times, in the hope that “this time it will
be different.” In any case, many countries have been adopting measures to curb
in?ows or to safeguard against risks brought by them. The task, as we know, is
far from easy.
Reserve accumulation is an alternative. For many emerging market economies, it
has been extremely important as a mechanism of self-insurance against external
shocks. It has drawbacks, however. First, costs may be substantial, especially
when interest rate differentials are persistently high. With low interest rates in
the reserve currency issuing countries, the remuneration of reserves has fallen
substantially. Interest rates in developing countries tend to be higher. When ster-
ilized interventions fail to avoid appreciation of the national currency, losses for
the central banks tend to be high. This is particularly the case for Brazil, where
interest rates have been chronically very high.
Regulating Global Capital Flows for Long-Run Development 97
Moreover, reserve accumulation is yet another example of the paradox of strong
fundamentals: high reserves increase the perception that the country is safe and
this attracts further in?ows.
The conclusion seems inescapable: macroeconomic policies—?scal, monetary,
exchange rate, reserve accumulation—alone do not suf?ce. There is increasing
recognition that countries blessed or cursed with an overly abundant supply
of international capital will be well advised to resort to macroprudential mea-
sures and capital controls. To avoid the stigma attached to capital controls, the
IMF staff has recently used the expression “capital ?ow measures” (CFMs) that
encompass both macroprudential measures and capital controls.
IMF AND G-20 DISCUSSIONS OF CAPITAL ACCOUNT REGULATION
In 2010, the IMF belatedly recognized that capital controls and macroprudential
measures are “part of the toolkit” available to policymakers. This was a welcome
step. The Brazilian chair in the IMF had repeatedly called for a reconsideration
of the institution´s reluctance to accept that ?scal adjustment plus exchange rate
?exibility would not take care of the problems faced by countries overwhelmed
by surges in capital in?ows.
That said, the IMF´s recognition is still somewhat hesitant. In March 2011, the
Executive Board of the Fund discussed a “possible framework” for capital ?ow
management that was broadly endorsed by a majority of the Board, as a ?rst
round articulation of the institution´s views. This tentative framework leaves
much to be desired. For instance, capital account regulations are seen as a last
resort to be used after everything else has been tried. They are presented as
a possible complement and not a substitute for “sound macroeconomic poli-
cies.” They are recommended as temporary instruments, given that they can be
evaded as times go by. At the same time, and in contradiction to the previous
point, a big deal is made of possible externalities or spillovers of capital controls.
None of these quali?cations seem persuasive. For instance, macroprudential
measures and capital account regulations, adopted at a relatively early stage,
preferably in combination with other measures such as reserve accumulation,
may avoid the build-up of problems that become increasingly dif?cult to deal
with. Tools that can be used quickly, such as prudential measures and controls,
are instrumental in avoiding the development of such situations.
98 A Pardee Center Task Force Report | March 2012
Even amongst Fund staff, there is no consensus on these points. As the Fund’s
chief economist, Olivier Blanchard, observed in May, when he summarized a Rio
de Janeiro conference on capital ?ows, “we should move away from strict policy
orderings toward a more ?uid approach of using ‘many or most of the tools most
of the time’ instead of ‘this now, that later.’” This observation contradicts ?atly
one of the features of the “possible framework” endorsed by the Executive Board
in March. Blanchard also observed that evidence presented at the Rio conference
suggested that spillovers across recipient countries were not very large. “Theo-
retical and further empirical work is badly needed here,” he added.
In so far as effectiveness is concerned, the experiences of Brazil and other coun-
tries seem to show that prudential measures and capital account regulations can
at the very least moderate appreciation, lengthen the pro?le of external liabili-
ties, and improve the composition of capital in?ows. IMF staff has tended to
support this sort of preliminary conclusion in its studies of country experiences.
Despite the lack of ?rm knowledge in the staff of the IMF about many issues and
the lack of consensus in the Executive Board, Fund Management, supported by
most advanced countries, jumped the gun in March and had the Board endorse
the “possible framework” that I have alluded to. Does this help the membership
in any way? Not much I would say. It may even be counterproductive in the
end. Under the pretext of allowing capital account regulations in some limited
circumstances, the Fund may be seeking to extend its jurisdiction to the capital
account.
Under the Articles of Agreement of the IMF, member countries have no obliga-
tion whatsoever to liberalize capital account transactions. Legally speaking, they
enjoy full freedom to regulate capital movements. This does not apply to coun-
tries that have given up this freedom, in part or in total, by their membership of
the OECD, of the euro area, or that have signed bilateral investment agreements
or free trade agreements with the United States. Those cases apart, member
countries are entirely free, under Article VI of the Articles of Agreement, to
adopt capital controls. This Article states that “members may exercise such
controls as are necessary to regulate international capital movements.” Under
some circumstances, the Fund may even require them to adopt controls to avoid
the use of the institution´s resources to ?nance capital ?ight. This is exactly what
happened in the case of Iceland, a country hard hit by the severe impact of the
international crisis on its overblown ?nancial sector. Iceland requested ?nancial
Regulating Global Capital Flows for Long-Run Development 99
assistance from the Fund and controls on out?ows of capital became an impor-
tant part of the IMF’s program for Iceland.
Some advanced countries have been calling on the Fund to establish codes of
conduct or guidelines for the management of capital ?ows. President Nicolas
Sarkozy of France was particularly blunt about this when he launched the
agenda for the French presidency of the G-20 and the G-8 in January 2011. He
called for the establishment by the G-20 of a code of conduct and criticized
the “recent multiplication of unilateral measures” affecting capital movements.
President Sarkozy came back to the subject in even more forceful terms at the
opening of a G-20 Seminar in China, last March:
A code of good conduct, strong guidelines and a common framework gov-
erning the possibility of implementing capital controls where necessary
must de?ne the conditions under which restrictions on capital movements
are legitimate, effective and appropriate to a given situation. If we agree on
these rules, ladies and gentlemen, it will be a major evolution in the doc-
trine of the IMF, to the bene?t of the emerging countries, which suffer from
excessive volatility of capital movements. Is it reasonable, today, given the
increasing impact of capital movements, that the IMF can issue recom-
mendations to a country only as concerns its current account balance of
payments and not concerning its capital account? I would like someone to
explain to me why a recommendation about one is legitimate and a rec-
ommendation concerning the other is illegitimate. Expanding the super-
vision of the IMF to include theses aspects strikes me as crucial. In the
longer term, France—and I’m saying this now—is favorable to a modi?ca-
tion of the IMF’s Articles of Agreement to broaden its supervision mandate.
Yet if we decide on more coordination, more rules and more supervision,
we then need to decide which organization is in charge of enforcing such
rules and conducting such supervision. For France, it’s clear. It’s the IMF.
The Brazilian chair at the Fund and in the G-20 has been very critical of these
attempts to establish a framework or a “code of conduct” for capital account
management. The debate is still ongoing, but has lost some of its steam since
the beginning of the year. Time has shown that the focus of the IMF and some
advanced countries on guidelines or even a “code of conduct” for capital ?ow
measures was ill-timed and unnecessary. In that discussion, among many other
problems, insuf?cient consideration was given to “push” factors or to the poli-
cies in major advanced economies that produced large and often disruptive
100 A Pardee Center Task Force Report | March 2012
?nancial ?ows. As the IMF and the G-20 wasted precious time on this, the crisis
reemerged in the advanced countries, especially in the euro area, due to unsus-
tainable debt levels, fragile banking systems and, ironically, the after-effects of
the collapse of a credit boom driven by free capital ?ows.
The Brazilian chair in the IMF has argued that it would be highly inappropriate
and politically unsustainable to attempt to use the Fund´s skewed voting power,
which gives undue weight to advanced countries, to impose their agenda on
developing countries that are not willing to face any restrictions on the liberty to
manage the capital account.
There is a further irony here. Some of the countries that are at the epicentre of
the worst crisis since the Depression of the 1930s, and are still far from having
solved their own problems, seem very eager to promote the establishment of
codes of conduct for the rest
of the world, including for
emerging market countries
that are currently dealing
with overabundant liquidity
generated by the monetary
policies of these very same
countries. One is tempted to
say: put your own house in order before you start preaching to others again. It is
too early to forget that the previous round of preaching by developed countries—
deregulate, liberalize, trust markets, etc.—ended in tears for them and for those
developing countries that followed that preaching all too eagerly.
KEYNES AND WHITE
Free capital movements were not part of the IMF´s original mandate. Article
VI of the Articles of Agreement was there from the very beginning. Misguided
attempts to amend or suppress this Article in the late 1990s came to nothing.
At the time, the Brazilian chair at the IMF was among those who opposed the
attempt to impose capital account liberalization as an obligation.
Those who know the history of the IMF are aware that the founding fathers of
the institution, John Maynard Keynes and Harry Dexter White, had learned from
the acute instability caused by laissez-faire with respect to international capital
movements in the period between the World Wars. Keynes explained at the time
of the creation of the Fund that members would have “full liberty to control such
It is too early to forget that the previous
round of preaching by developed coun-
tries—deregulate, liberalize, trust markets,
etc.—ended in tears for them and for those
developing countries that followed that
preaching all too eagerly.
Regulating Global Capital Flows for Long-Run Development 101
movements.” Each country was given the choice to leave all transactions free or
to enforce controls. If it chose the latter, Keynes was of the view that it should be
left “to discover its own technique.”
Keynes and White were right, I believe. Since the global crisis, the pendulum has
swung again away from laissez-faire and towards recognition that strong regula-
tion and supervision of ?nancial activities are indispensable to the smooth and
ef?cient functioning of a market economy. Capital movements are no exception.
REFERENCES
Blanchard, Olivier (2011). “What I Learnt in Rio: Discussing Ways to Manage Capital
Flows,” summary of the conference on Managing Capital In?ows in Emerging Mar-
kets, organized by the Ministry of Finance of Brazil and the International Monetary
Fund, Rio de Janeiro, May.
Eyzaguirre, Nicolás, Martin Kaufman, Steven Phillips, and Rodrigo Valdés (2011).
“Managing Abundance to Avoid a Bust in Latin America,” IMF Staff Discussion Note,
SDN/11/07, April. Washington, D.C.: IMF.
Gallagher, Kevin P. (2011). “The IMF, Capital Controls and Developing Countries,” Eco-
nomic & Political Weekly, Vol. XLVI, No 19. May.
Habermeier, Karl, Annamaria Kokelyne, Chikako Baba (2011). “The Effectiveness of
Capital Controls and Prudential Policies in Managing Large In?ows,” IMF Staff Dis-
cussion Note, SDN/11/14, August. Washington, D.C.: IMF.
International Monetary Fund (1969). The International Monetary Fund 1945–1965,
Twenty Years of International Monetary Cooperation, Volume III: Documents, edited
by J. Keith Horse?eld, Washington, D.C.: IMF.
International Monetary Fund (2011). “Recent Experiences in Managing Capital In?ows:
Cross-Cutting Themes and Possible Policy Framework,” IMF Policy Paper, February.
Washington D.C.: IMF.
Keynes, John Maynard (1980). The Collected Writings of John Maynard Keynes, Volume
XXV, Activities, 1940–1944, Shaping the Post-War World: The Clearing Union, pub-
lished for The Royal Economic Society.
Keynes, John Maynard (1980). The Collected Writings of John Maynard Keynes, Volume
XXVI, Activities, 1941–1946. Shaping the Post-War World: Bretton Woods and Repara-
tions, published for The Royal Economic Society.
102 A Pardee Center Task Force Report | March 2012
Ocampo, José Antonio (2011). “Reforming the International Monetary System,” Wider
Annual Lecture 14, United Nations University, World Institute for Development
Economics Research (UNU-WIDER).
Ostry, Jonathan D., Atish R. Ghosh, Karl Habermeier, Marcos Chamon, Mahvash S.
Qureshi, and Dennis B. S. Reinhardt (2010). “Capital In?ows: The Role of Controls.”
IMF Staff Position Note, SPE/10/04, February. Washington, D.C.: International Mon-
etary Fund.
Pradhan, Mahmood, Ravi Balakrishnan, Reza Baqir, Geoffrey Heenan, Sylwia Novak,
Ceyda Oner, and Sanjaya Panth (2011). “Policy Responses to Capital Flows in
Emerging Markets,” IMF Staff Discussion Note, SDN/11/10, April. Washington, D.C.:
International Monetary Fund.
Sarkozy, Nicolas (2011). “Lancement de la présidence française du G-20 e du G-8,” Palais
de l’Elysée, January.
Sarkozy, Nicolas (2011). “Address by the President of the French Republic.” Opening of
the G20 Seminar on Reform of the International Monetary System, Nanking (China),
March.
Uribe E., José Darío (2011). “Managing Capital In?ows in Emerging Markets: the Case
of Colombia,” paper presented in the conference on Managing Capital In?ows in
Emerging Markets, organized by the Ministry of Finance of Brazil and the Interna-
tional Monetary Fund, Rio de Janeiro, May.
Regulating Global Capital Flows for Long-Run Development 103
9. The Need for North-South Coordination
Stephany Grif?th-Jones and Kevin P. Gallagher
Developing countries have in recent years become again the destination for
speculative capital ?ows, with in?ows reaching pre-crisis levels. Many of these
nations are deploying prudential capital regulations to stem these ?ows. Such
measures could be coupled with action by developed countries in order to dis-
courage capital out?ows and risk taking from their economies, so as to encour-
age capital to productive use within their own economies; such measures would
simultaneously avoid excessive exchange rate strengthening in developing
economies, both supporting their own growth and helping avoid possible future
crises within these developing economies.
Indeed, one important aim of regulating cross-border capital ?ows in both recipi-
ent and source countries is the reduction of systemic risk build up in both of
them, thus reducing risk of future crises.
We will argue therefore that such measures of managing excessive capital
out?ows from developed countries, and especially from the U.S., could be a rare
“win-win” opportunity, as they would bene?t both the U.S. and the developing
economies. The only ones to lose would possibly be ?nancial institutions, mak-
ing short-term pro?ts; however, we have seen the disastrous results of de?ning
economic policies only to maximize pro?ts for the ?nancial industry, while
neglecting their impact on systemic ?nancial and macroeconomic stability and
on the real economy.
CAPITAL FLOWS IN THE WAKE OF THE CRISIS
As nations across Asia and Latin America still have a long way to go in terms
of income growth, foreign investment is quite welcome. The problem is, the
sheer volume and composition of these ?ows implies that a large part of them
are short-term, volatile, and do not go into productive investment. Indeed, mass
in?ows of short-term capital have been causing asset bubbles and currency
appreciation in developing countries, making macroeconomic policy dif?cult
and increasing the risk of future crises.
104 A Pardee Center Task Force Report | March 2012
Short in?ows have been ?ocking to the developing world largely through the
mechanism of the carry trade and other mechanisms, usually using derivatives.
Since the crisis began, interest rates have been very low in the U.S. and other
industrialized nations. As Mohan in this volume shows, there is clear evidence
over the last 30 years that there is broad correspondence between periods of
accommodative monetary policy in advanced economies and capital ?ows to
emerging market economies, as well as the reverse; each monetary tightening
produces capital ?ows reversals and often crises in emerging countries.
In the recent period, increased U.S. liquidity and low interest rates have trig-
gered U.S. ?nancial institutions to decrease their risk-taking in the U.S., thus
leading to little or no credit creation, which is the main transmission channel of
monetary expansion to domestic economic activity; it has, however, increased
risk taking abroad, channelling it to nations with higher interest rates for rapid
return, as well as better growth prospects in the medium term. Speculative short-
term ?ows push up the value of emerging market currencies and create asset
bubbles. For this reason, the U.S. was criticized at the G-20 meeting in Seoul in
late 2010. For example, Brazil, with high interest rates, had seen an appreciation
of over 40 percent due in part to the carry trade, and was most vocal in Seoul.
But this is a problem in many emerging and even low-income developing coun-
tries, like Uganda, with excessive short-term in?ows.
PRUDENTIAL REGULATIONS IN DEVELOPING COUNTRIES
Emerging and developing economies have a “new” set of options to stem the
tide. One of them, which several are now pursuing, is to engage in prudential
capital account management, by taxing, putting unremunerated reserve require-
ments or discouraging by other means, excessive capital in?ows. This is not a
panacea on its own, but does help provide greater monetary policy autonomy
to those countries; this is essential, as their growth rates are at present high, and
it is essential for them not only to avoid in?ation in goods and services, but also
asset price bubbles and overvalued exchange rates.
Many nations such as Brazil, China, Argentina, Taiwan, Thailand, South Korea,
Peru, and Indonesia have put in place various forms of capital account regula-
tions to limit excessive in?ows. Such controls have been recently sanctioned
by the IMF—a very signi?cant shift. However, the support by the IMF for capital
account regulations has some limitations (as discussed by Nogueira Batista and
Ocampo in this volume).
Regulating Global Capital Flows for Long-Run Development 105
Indeed, capital account management measures follow a mountain of economic
evidence in academia and by the international ?nancial institutions—most
notably the National Bureau of Economic Research in the U.S., the International
Monetary Fund, the United Nations, and the Asian Development Bank—that
capital account management
by developing countries
is a useful tool of policy, if
accompanied by broadly
prudent macro-economic poli-
cies. In February 2010, IMF
economists published a staff
position note titled, “Capital
In?ows: The Role of Controls,”
empirically showing that
capital controls not only work
but “were associated with
avoiding some of the worst growth outcomes” of the current economic crisis. The
paper concludes that the “use of capital controls—in addition to both prudential
and macroeconomic policy—is justi?ed as part of the policy toolkit.”
That IMF report singles out measures such as taxes on short-term debt (like Bra-
zil’s) or requirements whereby in?ows of short-term debt need to be accompa-
nied by an unremunerated deposit to be placed in the central bank for a certain
period of time (as practiced in the past by nations such as Chile, Colombia, and
Thailand). The goal of these measures—which are often turned on when capital
?ows start to overheat and turned off when such ?ows cool—is to prevent mas-
sive in?ows of hot money that can appreciate the exchange rate and threaten the
macroeconomic stability of a nation.
The IMF’s ?ndings came at an appropriate time. In the wake of the U.S. Federal
Reserve’s quantitative easing and other measures to loosen monetary policy, the
carry trade again started bringing speculative capital to developing countries
that could disrupt their recovery from the crisis (even though there have been
episodes in autumn 2011 of brief reversals of such ?ows).
To make the proper deployment of capital account management effective how-
ever, at least four obstacles need to be overcome:
Capital account management measures
follow a mountain of economic evidence in
academia and by the international ?nancial
institutions—most notably the National Bureau
of Economic Research in the U.S., the Inter-
national Monetary Fund, the United Nations,
and the Asian Development Bank—that capital
account management by developing countries
is a useful tool of policy, if accompanied by
broadly prudent macro-economic policies.
106 A Pardee Center Task Force Report | March 2012
First, after a while investors creatively evade prudential capital management
through derivatives and other instruments. Second, U.S. trade and investment
agreements make capital controls dif?cult to implement. Third, speculative capital
can still wreak havoc because hot money bypasses countries that successfully
deploy controls and goes instead to nations that do not. Fourth, the massive scale of
capital ?owing from source countries may overwhelm even those countries using
capital account management of their in?ows, given their relatively small size.
Brazil started imposing a tax on hot money in?ows in 2009, and has been ?ne-
tuning it ever since, in part because of the volume of ?ows but also because the
regulation was being evaded. Some investors have bypassed controls by disguis-
ing short-term capital as foreign direct investment, through currency swaps and
other derivatives, and by purchasing American Depositary Receipts (ADRs).
ADRs are issued by U.S. banks and allow investors to buy shares of ?rms outside
the U.S.—enabling investors to purchase Brazilian shares but in New York and
thereby skirt controls in Brazil. In a step in the right direction, Brazil moved to
put a 1.5 percent tax on ADRs to stem speculating around the controls. Thus,
a Brazilian bank or investor that deposits shares with foreign banks will be
charged the tax. Most recently (mid-2011), Brazil has started taxing net foreign
exchange derivative positions above a certain level, which is an interesting
measure as it may help curb excessive pressure on the national currency to
become too strong, and help avoid evasion of other capital account management
measures. It would be helpful for emerging economies to exchange experiences
on regulating capital ?ows to see to it that controls are not evaded.
Since 2003, U.S. trade and investment treaties have made prudential manage-
ment of the capital account by developing-country trading partners dif?cult if not
impossible by mandating the free ?ow of capital to and from a country, regard-
less of its level of development—for instance, in trade deals with Chile, Peru,
and Singapore. (In Singapore’s and Chile’s cases, the countries resisted these
measures, but ultimately agreed to the treaties.) Recently rati?ed deals with
Colombia and South Korea would also ban prudential capital controls. Other
higher-income countries and trade partners—such as Canada and Japan—grant
countries the right to use the macroeconomic tool, or at least grant exemptions
to prevent or mitigate crises.
The third and perhaps most dif?cult problem is that capital will simply ?ow by
those nations that successfully deploy controls to nations that do not, (imply-
Regulating Global Capital Flows for Long-Run Development 107
ing negative externalities for the latter). Some economists, such as former
IMF economist Arvind Subramanian propose full-?edged coordinated capital
controls among all emerging market economies to circumvent the problem. This
idea has merit, but of course not all emerging markets will agree to coordinate.
We propose attacking the problem at its source.
The fourth, and also serious, problem is that if interest differentials are impor-
tant, the incentive for investors to come into emerging economies is very large,
and thus the scale of capital account management effort by the emerging
country would have to be very large; this is particularly the case because global
capital markets are so large and so mobile, and can thus overwhelm relatively
small emerging and developing economies and ?nancial markets. Again comple-
mentary measures in the source countries would help tackle the issue. Though
we propose below measures to be taken in the U.S. currently the main source
of carry trade, such measures would be more effective if they were coordinated
with other countries that are sources of short-term capital out?ows or risk taking.
REGULATE THE CARRY TRADE IN THE UNITED STATES
As pointed out, actions taken by developing countries on their capital accounts
may not be enough, as the wall of money at times coming towards them is so
large. Therefore, it may be desirable to complement these measures with action
by the countries where the capital is coming from, especially the U.S. Given that
the majority of the carry trade effect will in the near future come from the U.S.,
the United States could start regulating the out?ow of capital due to the carry
trade. As pointed out, though the scale may be greater now, there have been
several previous episodes where very loose U.S. monetary policy contributed
to surges in capital ?ows to developing economies, episodes that have mostly
ended in tears. Already in 1998, one of the authors of this essay, writing with
Jane D’Arista (D’Arista and Grif?th-Jones 2008) argued for measures to discourage
excessively large portfolio out?ows from source countries, such as unremuner-
ated reserve requirements on such out?ows.
At present, the U.S. could introduce measures to discourage the carry trade
?ows going from that country to the rest of the world, and especially developing
countries, when these are excessive; this could be done for example by taxing
such ?ows (on the spot market) and excessive risk taking abroad. Thus, foreign
exchange derivatives that mimic spot transactions could have higher margin
requirements, to discourage them. Alternatively, such foreign exchange deriva-
tives could also be taxed at a level equivalent to the tax on foreign exchange spot
108 A Pardee Center Task Force Report | March 2012
transactions, on the notional value of that derivative, such as non-deliverable
forwards. Interesting lessons could be drawn, for example, from the recent expe-
rience of Brazil in taxing foreign exchange derivatives, which also seems to show
the feasibility of such taxes. There are two routes through which U.S. monetary
easing is transmitted abroad:
(a) the money and credit supply channel, which implies higher capital out?ows
and less credit creation in the U.S., and
(b) the derivatives channel, whereby the ?xed risk budget of U.S. banks or hedge
funds is allocated more towards emerging economies risk and therefore less to
risk taking in the U.S.
The above sketched proposal would attempt to curb both routes, when and if
desirable, that is if excessive capital and risk taking was going abroad.
Such a measure would bene?t the U.S. economy, as the purpose of monetary
easing is precisely to encourage increased lending and risk-taking in the U.S.,
and not for funds to be channeled abroad; it would bene?t emerging countries,
whose economies are being harmed by excessive short-term in?ows that could
cause future crises. It would thus be a big win-win for the world economy.
The results of the most recent U.S. Congressional elections unfortunately make
it dif?cult in the near future for the U.S. to pursue the best policy to keep its
economy recovering: further ?scal expansion. As Keynes taught us—and as we
have seen during numerous crises—private investment and consumption will
not recover on their own (due both to over-leveraging and lack of con?dence),
without the stimulus of aggregate demand, which only governments can give in
these particular circumstances. Once the recovery is on track, ?scal policy needs
to contract, to avoid both overheating and excessive public debt.
On its own, loose U.S. monetary policy seems, indeed, not to be enough to restore
the U.S. economy to growth; supportive ?scal policy would be highly desirable, as
would other measures to stimulate aggregate demand. Furthermore, easy mon-
etary policy may contribute to further overheating of asset prices and exchange
rates in the emerging economies, which could not just complicate macroeco-
nomic management for them now, but also increase the risk of future crises.
To ensure loose monetary policy helps the U.S. economy to grow, institutional
mechanisms and a broader framework need to be found to channel the addi-
tional liquidity created by the Fed as credit to the real economy. The key is to
Regulating Global Capital Flows for Long-Run Development 109
expand credit to small and medium-sized enterprises, starved of funds at pres-
ent, and to ?nance large investments in infrastructure, including that required to
generate clean energy and energy conservation. Institutional innovations may be
necessary to achieve this, such as the creation of an Infrastructure Fund, as well
as possibly special institutions dedicated to lending to small and medium enter-
prises. Indeed, in the U.S., the Federal Reserve could, for example, possibly use
some of the liquidity it creates to purchase bonds of a U.S. Infrastructure Fund or
Bank; this would both provide credit to a sector key for future development, as
well as lead to an increase in aggregate investment and demand.
Internationally, if the U.S. dug into the emergency toolbox again, it could place
prudent capital regulations or taxation on the out?ow of speculative capital from
the U.S. via mechanisms such as the carry trade; this might help avoid future
crises in those countries, which would harm not only them, but also the U.S.
and the world economy. Taxation may have some important advantages. First,
taxes are more dif?cult to avoid or evade, as they involve not just authorities
like the Federal Reserve, but also the Internal Revenue Service, with the latter
having possibly stronger enforcement mechanisms. Second, such taxation could
generate some additional revenue for a U.S. government with a large budget
de?cit, surely an attractive feature. However, the tax would need some ex-ante
?exibility on rates, so it could be modi?ed according to the level of out?ows and
derivatives positions. Complementary to introducing measures like new taxes to
discourage out?ows of capital or increased risk taking abroad, it seems clearly
desirable—in the U.S. and elsewhere—to reduce existing tax biases in favor of
such ?ows, like tax loopholes; indeed, this could be a ?rst step to discourage
excessive short-term out?ows.
Measures to discourage short-term out?ows would facilitate the liquidity created
by the Fed to stay in the U.S. and have a better chance of going toward produc-
tive investment.
THE ROAD AHEAD
Re-orienting capital ?ows for productive development, leading to growth, should
be a key priority. Prudential capital account regulations, deployed in both the
industrialized and developing world, should be examined as one instrument to
achieve this aim. Coordination between developed and developing countries
on this issue would be desirable; this should be eased by the fact that often the
aims of both developed and developing countries may coincide. However, it
does not seem desirable for such coordination to be imposed multilaterally, as
110 A Pardee Center Task Force Report | March 2012
no institution at present seems to have the appropriate, well-trusted governance
ability to represent the collective interests of all countries. Nevertheless, the IMF
could continue to be a useful forum to exchange experiences on capital account
management (by both developed and developing countries) and possibly provide
a useful voluntary forum for informal coordination, in cases where all countries
involved desire such a role to be played.
To rectify some of the problems related to capital ?ows, industrialized nations
(especially the U.S.) should consider regulating the carry trade and providing
safeguards in their trade treaties to allow developing nations to deploy pruden-
tial regulation. Developing countries should also put in place prudential regula-
tions. The Financial Stability Board, or another relevant body, as well as national
regulatory authorities, should watchdog those who evade these regulations.
REFERENCES
D’Arista, J. and Grif?th-Jones, S. (1998). “The boom of portfolio ?ows to emerging mar-
kets and its regulatory implications,” in: A. Montes, A. Nasution, and S. Grif?th-Jones
(eds,) Short Term Capital Flows and Economic Crises, pp. 52–69. Helsinki: World
Institute for Development Economics Research.
Regulating Global Capital Flows for Long-Run Development 111
10. International Regulation of the Capital Account
Arvind Subramanian
This short essay, which is based on Jeanne, Subramanian, and Williamson (forth-
coming), argues that there is a growing need for an international regime to regu-
late capital account transactions. Such a regime should allow nations to deploy
capital controls that are deemed ‘corrective’ but should also provide mechanisms
for disciplining capital controls where they have spillover effects via facilitating
undervalued exchange rates and hence beggar-thy-neighbor trade effects on
partner countries. Cooperation between the International Monetary Fund (IMF)
and the World Trade Organization (WTO) might be necessary to implement such
a regime.
CORRECTIVE VERSUS STRUCTURAL CAPITAL CONTROLS
A new wave of theoretical research shows that capital controls, in certain situ-
ations, can be seen as correcting for market failure, rather than being seen as
distortionary in the market (Korinek 2009; Jeanne and Korinek 2010; Bianchi
2010; etc.). This new work provides a rigorous, welfare-based basis for public
intervention. The rationale is essentially the same as for “macroprudential”
regulation to deal with booms and busts in credit and asset prices in a domes-
tic context (Brunnermeier 2009; Adrian and Shin 2009). In a new book I have
authored with Olivier Jeanne and John Williamson, we argue that there should
be a global regime that allows for corrective capital controls. A current example
of a corrective capital control might be Brazil’s tax on foreign currency purchases
of equities that was put in place in 2010.
However, capital controls can also be used to sustain undervalued exchange
rates as an instrument of mercantilism, with beggar-thy-neighbor effects on trad-
ing. The obvious present-day example of a nation that deploys structural controls
is that of China, where capital controls play a part in an elaborate regime to keep
the nation’s currency undervalued in order to support an export-led growth strat-
egy. Our view is that there is a need to regulate these structural controls, not least
because the freedoms of smaller countries are affected by spillovers from these
112 A Pardee Center Task Force Report | March 2012
distortive controls. We must also consider multilateral rules on capital ?ows even
within the IMF.
AN ALTERNATIVE APPROACH FOR AN INTERNATIONAL REGULATORY
REGIME
Although some nations may currently bene?t from the status quo, a global
regulatory regime for the use of capital controls would make more nations better
off than under current circumstances. Why so, if non-regulation is appealing
for some states because the status quo provides policy space and freedom? But
the current debate seems to suggest that non-regulation might mean less policy
space for some. This is especially evident in the pre-2008, intellectual zeitgeist
which created stigma from national and uncoordinated action. For example,
Brazil in 2009 suffered from the worst of both possible worlds: out of fear of the
stigma, it imposed weak controls, which ended up being ineffective in restricting
in?ows but that incurred the stigma anyway.
In addition, non-regulation has led to abuse of structural controls, and these,
in turn, create negative global externalities. We need to regulate capital in?ows
nationally, especially from
a cyclical/prudential per-
spective (Ostry et al. 2010),
but there is no consensus
regarding multilateral rules on
permissible curbs on ?ows.
A starting point for a new
regime would be the recogni-
tion of the need for corrective controls while at the same time seeing that capital
controls/undervalued exchange rates are potentially as big a problem as capital
in?ows and overly ambitious capital ?ows.
Thus, the case for an international regime is:
• Because there can be circumstances in which unconstrained national actions
are collectively damaging;
• Because a lack of rules stigmatizes countries for not abiding by whatever hap-
pens to be the conventional wisdom, which in recent years has favored free
capital mobility, and countries that impose capital controls therefore often do
so apologetically and with less-than-optimal vigor;
A starting point for a new regime would be
the recognition of the need for corrective
controls while at the same time seeing that
capital controls/undervalued exchange rates
are potentially as big a problem as capital
in?ows and overly ambitious capital ?ows.
Regulating Global Capital Flows for Long-Run Development 113
• Because the lack of a rule fails to give countries a pointer of what they should
be aiming for; and
• To try in a different way to persuade China to revalue its exchange rate.
PROPOSAL: SYMMETRY WITH TRADE
Of course the full details would need attention, but for the sake of argument
a regime for capital account regulations could be set up that is analogous to
the global trade regime. In trade, as in the WTO, nations are permitted to have
contingent protections for a variety of reasons, with a long-run commitment
to phase those out and replace them with safeguards for extraordinary events.
When a nation’s measures adversely affect another nation however, the affected
nation can dispute the measure and convene a tribunal whereby the party found
to be in violation with stated codes of conduct has to change that measure or
face economic retaliation.
In our book we ?nd no evidence that capital account liberalization is good for
growth: hence rules on structural capital regulations should in principle be more
permissive than those, say, on goods. But, as was the case in the WTO, we sug-
gest that all quantitative restrictions on capital ?ows be converted to price-based
measures and that there be a “binding” of the amount of controls that can be
deployed.
The main features of course would be “optimal” or corrective controls that tax on
in?ows independent of duration of investment. This tax ought to be:
• differentiated according to the type of ?ow (debt versus equity, versus foreign
exchange, etc.).
• the tax rate ought to be set at a level which is countercyclical: from 0 to 15
percent in a calibrated model.
To summarize, corrective controls should be price-based, countercyclical, with
a maximum effective tax rate of 15 percent, and, crucially, with a “structural
exemption” that would be negotiated down or disciplined. Such a new regime
would be housed at the IMF and should institute cooperation between IMF and
WTO (Mattoo and Subramanian 2008).
The IMF has been able to in?uence member countries that have borrowed from
it, but it has not been successful in affecting economic policy in countries that do
not need IMF money. Moreover, the IMF lacks an effective enforcement mecha-
114 A Pardee Center Task Force Report | March 2012
nism. Compounding these problems is the IMF’s eroding legitimacy. It lost its
status as a trusted interlocutor in emerging markets, particularly in Asia, after
the Asian ?nancial crisis of 1997–1998. There, the IMF was seen as having failed
to provide enough money to countries in need and as having attached unneces-
sarily tough conditions to its loans, which many believe aggravated the effects of
the crisis. The IMF’s governance structure is also outdated; it re?ects the receding
realities of the Atlantic-centered world of 1945 rather than the rise of Asia in the
21st century.
One possibility going forward would be for the IMF and the WTO to cooperate
on exchange-rate issues. The IMF would continue to provide technical expertise
to assess the valuation of currencies. But because undervalued currencies have
serious consequences for global trade, it would make sense to take advantage of
the WTO’s enforcement mechanism, which is credible and effective. The WTO
would not displace the IMF; rather, this arrangement would harness the com-
parative advantages of each institution.
OBJECTIONS
A few objections to controls are commonly raised. I will address each of these
objections, in turn, and argue why they are not good arguments against the type
of global governance system that we are proposing.
The ?rst argument against controls is that controls are always distortive. Here,
we must draw a distinction between controls which might create a distortion,
and ones that correct for a current distortion. Another common objection is that
controls are easily evaded. Evidence for this is mixed, and evasion depends
largely on the types of controls enacted. Nonetheless, destigmatizing the use of
capital controls, and therefore giving their use legitimacy, may go a long way
towards cutting down some forms of evasion. Another objection is that controls
have costly unintended consequences. Here too the evidence is mixed. On bal-
ance, capital controls can be a legitimate tool and not just the last option as was
previously suggested by the IMF.
One of the few good arguments for allowing blunt instruments, such as quantita-
tive controls, is related to implementation capacity. Where regulatory regimes
are weak, blunt instruments might often have to take precedence over more
?nely tuned ones.
Regulating Global Capital Flows for Long-Run Development 115
One current problem with introducing a regulatory regime that phases out
structural capital controls would be inducing cooperation from China. We have
already some analogues from the WTO for how to approach this issue. These
analogues involve invoking carrots and sticks, both in trade in goods and in
capital.
Carrots in the trade arena could take the form of eventually granting China the
status of a market economy, which would make it less vulnerable to arbitrary
unilateral action—especially antidumping duties—by its trading partners (Messer-
lin 2004). At the moment, the disciplines on such actions are less stringent when
the target is a non-market economy.
In trade in assets, carrots could take the form of securing investment opportu-
nities for its sovereign wealth funds (SWF) in an environment where Chinese
investments could increasingly be subject to national regulations with a protec-
tionist slant. Clear rules on SWF-related investments could thus be one of the
inducements for China to cooperate (see Mattoo and Subramanian 2008). It is
worth noting here that China’s huge stockpile of reserves (which is not likely to
be eliminated any time soon) will mean that the Chinese state will be a foreign
investor for some considerable time, so guaranteeing an outlet for these invest-
ments could be important for China (and also for the oil-exporting countries).
The nature of the carrots in this area is spelled out in Mattoo and Subramanian
(2008).
Sticks in trade in goods could of course take the form of imposing tariffs on
countries that do not agree to bring their capital account restrictions in line with
new rules. Sticks in trade in assets could take the form of a broad reciprocity
requirement whereby capital importing countries declare that they will limit
sales of their public debt henceforth to only include of?cial institutions from
countries in which they themselves are allowed to buy and hold public debt.
CONCLUSION
Intellectually, the ground has shifted in favor of cyclical, prudentially based
measures to restrict surges in capital in?ows. But that is now a given. The issues
going forward are ?rst, whether this shift to allow corrective controls should be
codi?ed in an international regime for capital account regulation; and second,
whether there should also be regulation of structural controls which facilitate
beggar-thy-neighbor practices.
116 A Pardee Center Task Force Report | March 2012
Some American economists and lawmakers have called for imposing a duty on
imports from countries with undervalued exchange rates. But any such unilat-
eral action would be, by de?nition, partial and hence ineffective. Undervalued
currencies affect more than just one country: China’s cheap yuan, for example,
has an impact not only on the United States and the European Union but also
on emerging economies and African countries, whose products compete with
China’s on the world market.
A multilateral approach to such distortions may prove more fruitful. Under the
historical division of labor between the International Monetary Fund and the
WTO, the IMF has jurisdiction over questions relating to exchange rates. But its
oversight has been weak at best. Surely a better approach would be to imple-
ment a comprehensive regulatory regime that addresses the problem of excess
capital ?ows in addition to distortive controls, such as structural exchange rate
regimes which lead to broad spillovers in the global economy. An analogue to
the WTO, but administered by the IMF, would be one possible mechanism for
such regulation.
Regulating Global Capital Flows for Long-Run Development 117
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Regulatory Responses.” Working Paper, University of Maryland.
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Funds: A New Role for the World Trade Organization.” Working Paper 08-2. Washing-
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“Capital In?ows: The Role of Controls.” IMF Staff Position Note, February. Washing-
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pubs/ft/spn/2010/spn1004.pdf.
118 A Pardee Center Task Force Report | March 2012
Regulating Global Capital Flows for Long-Run Development 119
11. Capital Account Regulations
and the Trading System
Kevin P. Gallagher
The global community has not made a conscious effort to coordinate measures
to regulate global capital ?ows. In the absence of such an effort, a patchwork
de-facto regime has arisen—including global, regional, and bilateral trade and
investment treaties—that may complicate efforts to coordinate capital account
regulations in the 21st century. This short essay discusses how capital ?ows are
treated in the trading system and outlines practical measures that nations may
take to create the policy space for CARs in new and existing treaties.
Table 1 summarizes the extent to which capital account regulations are permit-
ted under various trade and investment arrangements.
Under the World Trade Organization, if a nation has committed to granting
market access in cross-border trade in ?nancial services or committed to allow-
ing foreign investment in ?nancial services, it must liberalize its capital account
in order to honor those speci?c commitments. The WTO does have a prudential
exception and a balance of payments exception, but it is not clear that such
WTO US BITS/FTAs Other BITS/FTAs
Permissible Capital Controls
Current no no no
Capital
inflows no* no sometimes
outflows no* no sometimes
Safeguard Provisions
Current yes** no yes**
Capital
inflows no no yes
outflows yes no yes
Number of Countries Covered 69 58
Dispute Resolution format State-to-State Investor-State Investor-State
Enforcement instrument Retaliation Investor compensation Investor compensation
*Capital controls fully permissible for nations that have not committed to liberalize cross-border trade in financial services
**Permitted only under IMF approval
Policy Space for Capital Controls: A Comparison
Table 1: Policy Space for Capital Controls: A Comparison
Source: Gallagher 2011
120 A Pardee Center Task Force Report | March 2012
safeguards will apply to all types of capital controls. In any event, at this writing
most developing countries have not yet agreed to grant market access in the
?nancial services sectors that would require open capital accounts. However,
developed countries see the liberalization of ?nancial services in developing
countries as the cornerstone of a new WTO agreement under the Doha Round.
Some, but not all, Free Trade Agreements (FTAs) and Bilateral Investment Trea-
ties (BITs) also restrict the ability of developing nations to deploy capital controls.
Virtually all U.S. agreements require the free ?ow of capital to and from the U.S.
and its trading partner, without exception. In contrast to the WTO where when a
dispute arises, such a dispute has to be brought by a state (and can thus be diplo-
matically “screened”), FTAs allow the foreign ?rm to directly ?le a claim against
a host state for such measures. If a claim is lost the host state has to change its
policy and pay damages to the private ?rm. Such a claim was rendered under
the U.S.-Argentina BIT when, in the aftermath of Argentina’s ?nancial crisis
Argentina sought to impose a tax on out?ows that was deemed to be tantamount
to an “expropriation” (Salacuse 2010).
However, while U.S. FTAs and BITs strictly forbid the use of capital account
regulations, the agreements of other major capital exporting nations allow for
more ?exibility. Most BITs and FTAs conducted by Japan, the European Union,
and Canada either have a safeguard measure whereby a nation is able to pursue
its domestic regulations related to capital account regulations, or a safeguard
measure to prevent and mitigate ?nancial crises. For instance, the EU-Chile and
Canada-Chile agreements have annexes that allow Chile to deploy its infamous
unremunerated reserve requirements (URRs), whereas the U.S.-Chile agreement
does not.
These examples of ?exibility among many of the world’s larger capital exports
can provide the basis and example for global reform.
THE WORLD TRADE ORGANIZATION
The General Agreement on Trade in Services (GATS) is currently the only bind-
ing multilateral pact that disciplines capital account regulations, though speci?c
countries may have certain freedoms if the governments in place in the 1990s
did not make widespread commitments in the ?nancial services sector. More
speci?cally:
Regulating Global Capital Flows for Long-Run Development 121
• A member is most protected from a WTO challenge over capital account
regulations if it committed no ?nancial services sectors to GATS coverage in
any mode.
• However, even nations that have made widespread commitments in ?nancial
services may have—if challenged—recourse to various exceptions, although
these have not been tested and the record of WTO exceptions in other con-
texts is not reassuring.
• The policy space for controls on current account transactions defers to the IMF.
The GATS is part of the Marrakesh Treaty that serves as an umbrella for the vari-
ous agreements reached at the end of the Uruguay Round of GATT negotiations
that established the WTO. The GATS provides a general framework disciplining
policies “affecting trade in services” and establishes a commitment for periodic
future negotiations. The GATS is divided on the one hand into a part on “General
Obligations,” which binds all members. These include the obligation to pro-
vide most favored nation treatment to all WTO members (Article II), and some
disciplines on non-discriminatory domestic regulations that are still being fully
developed (Article VI).
On the other hand, the GATS also includes a part dealing with “Speci?c Com-
mitments,” which apply only to the extent that countries choose to adopt them
by listing them in their country-speci?c schedules. These cover primarily the
disciplines of Market Access (Article XVI) and National Treatment (Article XVII)
(Raghavan 2009).
Numerous annexes cover rules for speci?c sectors: the Annexes on Financial Ser-
vices are of particular relevance for capital account regulations. Trade in services
occurs across the four services ‘modes’ discussed in the GATS in general: Mode 1
(Cross-border supply), Mode 2 (Consumption abroad), Mode 3 (Commercial Pres-
ence) and Mode 4 (Presence of natural persons). With respect to capital account
regulations, Modes 1 and 3 are most important:
122 A Pardee Center Task Force Report | March 2012
IMF analysts have found that about 16 countries have signi?cant Mode 1 com-
mitments in ?nancial services, while around 50 each have signi?cant Mode 2
and 3 commitments for the sector—this includes most OECD countries. (Valckx
2002, Kireyev 2002.)
The IMF has articulated how commitments in Modes 1 and 3 can impact the
capital account and related regulations:
Of course, if a nation has not made commitments then it is free to pursue any
and all capital account regulations that it sees ?t. If a nation has made com-
mitments, a distinction needs to be made with respect to ?nancial services
and capital ?ows. Under the GATS nations liberalize speci?c types of ?nancial
services, such as banking, securities, insurance, and so forth. That said, if a
nation has made a commitment in a particular sector and capital account regula-
tions restrict the ability of WTO members to make capital movements linked to
Box 1: Relevant De?nitions in GATS
Mode 1: Cross-border supply is defned to cover services fows from the territory of one
Member into the territory of another Member (e.g., banking or architectural services transmit-
ted via telecommunications or mail).
Mode 3: Commercial presence occurs when the user of a fnancial service is immobile and
the provider is mobile, implying that the fnancial service supplier of one WTO Member estab-
lishes a territorial presence, possibly through ownership or lease, in another Member’s territory
to provide a fnancial service (e.g., subsidiaries of foreign banks in a domestic territory).
Box 2: Capital Account Liberalization and GATS Commitments
WTO members must allow cross-border (inward and outward) movements of capital if these
are an essential part of a service for which they have made liberalization commitments regard-
ing its cross-border supply (without establishment). For example, international capital transac-
tions are an integral part of accepting deposits from or making loans to nonresidents (mode
1). International capital transactions are also usually associated with fnancial services such as
securities trading on behalf of a customer residing in another country. The establishment of a
commercial presence (mode 3) in a host country by a foreign services supplier involves both
trade in services and international capital transactions. In permitting the establishment of a
commercial presence, WTO members must allow inward (but not outward) capital transfers
related to the supply of the service committed.
Source: IMF 2010
Regulating Global Capital Flows for Long-Run Development 123
the particular ?nancial service, then those nations may be brought to the WTO
under its dispute resolution mechanism (WTO 2010).
WTO members have recourse to binding dispute settlement procedures, where
perceived violations of GATS commitments can be challenged and retaliatory
sanctions or payments authorized as compensation. The process for disputes
is “state-to-state” dispute resolution where a party has to demonstrate damage
from a particular policy to that party’s government and the government decides
whether or not to enter into a dispute on behalf of the affected party. Such a
dispute is carried out at the WTO with the “defending” government representing
the party from which the dispute originated.
If a nation’s capital account regulations were found in violation of its GATS com-
mitments, it could invoke one or more exceptions in the GATS text. A ?rst option
would be to claim that the measure was taken for prudential reasons under
Article 2(a) of the Annex on Financial Services. This exception reads:
In?ows controls such as unremunerated reserve requirements or in?ows taxes
could be argued to be of a prudential nature, especially given the new IMF report
discussed earlier. However, the sentence stating that prudential measures “shall
not be used as a means of avoiding the Member’s commitments or obligations
under the Agreement” is regarded by some as self-cancelling and thus of limited
utility (Tucker and Wallach 2009; Raghavan 2009). Others however do not see
the measure to be second-guessing but rather “as a means of catching hidden
opportunistic and protectionist measures masquerading as prudential” (Van
Aaken and Kurtz 2009). Still others point out that, in contrast with other parts
of the GATS that require a host nation to defend the “necessity” of the measure,
there is no necessity test for the prudential exception in the GATS. This arguably
gives nations more room to deploy controls. Indeed, Argentina lost cases related
Box 3: Prudential Exception in GATS
Notwithstanding any other provisions of the Agreement, a Member shall not be prevented
from taking measures for prudential reasons, including for the protection of investors, deposi-
tors, policy holders or persons to whom a fduciary duty is owed by a fnancial service supplier,
or to ensure the integrity and stability of the fnancial system. Where such measures do not
conform with the provisions of the Agreement, they shall not be used as a means of avoiding
the Member’s commitments or obligations under the Agreement.
124 A Pardee Center Task Force Report | March 2012
to controls under BITs because they failed such a “necessity test.” Nations have
requested that the WTO elaborate on what is and is not covered in the prudential
exception, but such requests have fallen on deaf ears (Cornford 2004). And as of
this writing, the prudential exception has not been tested.
If a country’s capital account regulations were found in violation of its GATS
commitments in ?nancial services, it could also invoke Article XII “Restrictions
to Safeguard the Balance of Payments.” Paragraph 1 of Article XII states:
The next paragraph speci?es that such measures can be deployed as long as
they do not discriminate among other WTO members, are consistent with the
IMF Articles (thus pertain only to capital account controls), “avoid unnecessary
damage” to other members, do “not exceed those necessary” to deal with the bal-
ance of payments problem, and are temporary and phased out progressively.
It may be extremely dif?cult for a capital control to meet all of these conditions,
especially the hurdles dealing with the notion of “necessity,” a slippery concept
in trade law that countries have had dif?culty proving. Moreover, concern has
been expressed about the extent to which the Balance of Payments exception
provides nations with the policy place for restrictions on capital in?ows that are
more preventative in nature and may occur before “serious” balance of payments
dif?culties exist (Hagan 2000). If a nation does choose to use this derogation, the
nation is required to notify the WTO’s Balance of Payments Committee.
FTAs AND BITs
U.S. BITs and FTAs do not permit restrictions on in?ows or out?ows. If a nation
does restrict either type of capital ?ow they can be subject to investor-state
arbitration whereby the government of the host state would pay for the “dam-
Box 4: Balance of Payments Exception in GATS
In the event of serious balance-of-payments and external fnancial diffculties or threat thereof,
a Member may adopt or maintain restrictions on trade in services on which it has undertaken
specifc commitments, including on payments or transfers for transactions related to such com-
mitments. It is recognized that particular pressures on the balance of payments of a Member
in the process of economic development or economic transition may necessitate the use of
restrictions to ensure, inter alia, the maintenance of a level of fnancial reserves adequate for the
implementation of its programme of economic development or economic transition.
Regulating Global Capital Flows for Long-Run Development 125
ages” accrued to the foreign investor. The BITs and FTAs of other major capital
exporters such as those negotiated by the EU, Japan, China, and Canada, either
completely “carve out” host country legislation on capital account regulations
(therefore permitting them) or allow for a temporary safeguard on in?ows and
out?ows to prevent or mitigate a ?nancial crisis. The U.S. does not have either
measure. However, a handful of FTAs have recently allowed for a grace period
whereby foreign investors are not allowed to ?le claims against a host state until
after the crisis period has subsided.
Capital Controls and U.S. Treaties
In contrast with the treaties of many other industrialized nations, the template
for United States trade and investment treaties does not leave adequate ?exibil-
ity for nations to use capital account regulations to prevent and mitigate ?nancial
crises (Gallagher 2011). At their core, U.S. treaties see restrictions on the move-
ment of speculative capital as a violation of their terms. The safeguards in U.S.
treaties were not intended to cover capital account regulations.
U.S. trade and investment treaties explicitly deem capital account regulations as
actionable measures that can trigger investor-state claims. The Transfers provi-
sions in the investment chapters of trade treaties, or in stand alone BITs, require
that capital be allowed to ?ow between trading partners “freely and without
delay.” This is reinforced in trade treaties’ chapters on ?nancial services that
often state that nations are not permitted to pose “limitations on the total value
of transactions or assets in the form of numerical quotas” across borders.
In the ?nancial services chapters of U.S. trade treaties, and in U.S. BITs, there is
usually a section on “exceptions.” One exception, informally referred to as the
“prudential exception,” usually has language similar to the following from the
U.S.-Peru trade treaty:
126 A Pardee Center Task Force Report | March 2012
Capital account regulations are not seen as permissible under this exception.
This has been communicated by the United States Trade Representative and
in 2003 testimony by the Under Secretary of Treasury for International Affairs
to the U.S. Congress and reiterated in a recent letter by U.S. Treasury Secretary
Timothy Geithner in response to a letter signed by more than 250 economists
requesting that the U.S. reform its treaties (see Taylor 2003; Geithner, 2011). In
general this is because the term “prudential reasons” is usually interpreted in a
much narrower fashion, pertaining to individual ?nancial institutions. Concern
has also been expressed that the last sentence is “self-canceling,” making many
measures not permissible.
The prudential exception in services chapters or BITs is usually followed by an
exception for monetary policy that often reads like (again to use the U.S.-Peru
Trade treaty):
Box 5: Prudential Exception for U.S.
Financial Services chapter: Article 12.10: Exceptions
1. Notwithstanding any other provision of this Chapter or Chapter Ten (Investment), Four-
teen (Telecommunications), or Fifteen (Electronic Commerce), including specifcally Articles
14.16 (Relationship to Other Chapters) and 11.1 (Scope and Coverage) with respect to the
supply of fnancial services in the territory of a Party by a covered investment, a Party shall not
be prevented from adopting or maintaining measures for prudential reasons, including for the
protection of investors, depositors, policy holders, or persons to whom a fduciary duty is owed
by a fnancial institution or cross-border fnancial service supplier, or to ensure the integrity
and stability of the fnancial system. Where such measures do not conform with the provisions
of this Agreement referred to in this paragraph, they shall not be used as a means of avoiding
the Party’s commitments or obligations under such provisions.
Box 6: More Exceptions in U.S. FTAs?
Nothing in this Chapter or Chapter Ten (Investment), Fourteen (Telecommunications), or
Fifteen (Electronic-Commerce), including specifcally Articles 14.16 (Relationship to Other
Chapters) and 11.1 (Scope and Coverage) with respect to the supply of fnancial services in the
territory of a Party by a covered investment, applies to non-discriminatory measures of general
application taken by any public entity in pursuit of monetary and related credit or exchange
rate policies. This paragraph shall not affect a Party’s obligations under Article 10.9 (Perfor-
mance Requirements) with respect to measures covered by Chapter Ten (Investment) or under
Article 10.8 (Transfers) or 11.10 (Transfers and Payments).
Regulating Global Capital Flows for Long-Run Development 127
This second exception could be seen as granting nations the ?exibility to pursue
necessary monetary and exchange rate policy (of which capital account regu-
lations are part). Yet the last sentence in that paragraph speci?cally excludes
transfers.
These provisions were very controversial with the U.S.-Chile and U.S.-Singapore
trade treaties in the early 2000s. U.S. trading partners repeatedly asked for a
safeguard that would include capital account regulations but the United States
has denied that request (Vandevelde 2008). In a few instances, U.S. negotia-
tors granted special annexes that allowed U.S. trading partners to receive an
extended grace period before investor-state claims can be ?led with respect to
capital account regulations, as well as limits on damages related to certain types
of controls.
These annexes are still inadequate in the wake of the ?nancial crisis for at least
four reasons. First, the annexes still allow for investor-state claims related to
capital account regulations—they just require investors to delay the claims for
compensation. An investor has to wait one year to ?le a claim related to capital
account regulations to prevent and mitigate crises, but that claim can be for a
measure taken during the cooling-off year. The prospect of such investor-state
cases could discourage the use of controls that may be bene?cial to ?nancial
stability.
Second, many other nations’ treaties allow for capital account regulations.
Indeed, the Canada-Chile FTA, the EU-Korea FTA, the Japan-Peru BIT, and the
Japan-Korea BIT (just to name a few) all grant greater ?exibility for capital account
regulations. This gives incentives for nations to apply controls in a discriminatory
manner (applying controls on EU investors but not on U.S. investors).
Third, the IMF has expressed concerns that restrictions on capital controls in
U.S. agreements, even those with the special annexes, may con?ict with the
IMF’s authority to recommend capital controls in certain country programs, as
they have done in Iceland and several other countries. Finally, the special dis-
pute settlement procedure included in the U.S.-Chile and Singapore FTAs did not
become a standard feature of U.S. agreements. It is not in CAFTA, any U.S. BIT,
or the recently rati?ed U.S.-Korea FTA.
128 A Pardee Center Task Force Report | March 2012
Capital Account Regulations and BITs and FTAs for Major Capital Exporters
The EU, Japan, Canada, and increasingly China are major capital exporters. Each of
these capital exporters has numerous BITs and FTAs with nations across the world.
And loosely, the BITs of these nations have the same general characteristics found in
U.S. BITs. However, in the case of the use of capital account regulations to prevent
and mitigate ?nancial crises, the BITs and investment provisions of all BITs and
FTAs by these exporters either contain a broad “balance of payments” temporary
safeguard exception or a “controlled entry” exception that allows a nation to deploy
its domestic laws pertaining to capital account regulations.
Examples of the balance-of-payments approach can be found in the EU-South
Africa and Mexico FTAs (remember Mexico negotiated such a provision in
NAFTA), the Japan-South Korea BIT, and the ASEAN agreements. The Korea-
Japan BIT has language that clearly allows for restrictions on both in?ows and
out?ows, presumably inspired by the 1997 crisis. The BIT states:
Another way capital account regulations are treated by capital exporters in
FTAs and BITs is referred to as ‘controlled entry’ whereby a nation’s domestic
laws regarding capital account regulations are deferred to. Canada and the EU’s
FTAs with Chile and Colombia each have a balance-of-payments safeguard and
a controlled entry deferment. As an example of controlled entry, the invest-
ment chapter of the FTA between Canada and Colombia has an Annex, which
states “Colombia reserves the right to maintain or adopt measures to maintain
or preserve the stability of its currency, in accordance with Colombian domestic
legislation,” and lists speci?c laws and resolutions in Colombia that pertain to
capital account regulations.
Controlled entry provisions are to be found in BITs as well. The EU does not
sign many BITs as a union, but individual countries do. The China-Germany BIT
Box 7: Exception in Korea-Japan BIT
a. in the event of serious balance-of-payments and external fnancial diffculties or threat
thereof; or
b. in cases where, in exceptional circumstances, movements of capital cause or threaten to cause
serious diffculties for macroeconomic management, in particular, monetary or exchange
rate policies
Source: Salacuse 2010, 268.
Regulating Global Capital Flows for Long-Run Development 129
states that transfers must comply with China’s laws on exchange controls (Ander-
son 2009). In the case of China, that nation has to approve all foreign in?ows and
out?ows of short-term capital (see Zhang in this group of essays).
Interestingly, EU member BITs vary a great deal. Some, like the China-Germany
BIT and the UK-Bangladesh BIT, allow for a nation to defer to its own laws
governing capital account regulations. On the other hand, Sweden and Austria
had U.S.-style BITs with no exceptions whatsoever. However, the European Court
of Justice ruled in 2009 that Sweden’s and Austria’s BITs with several developing
countries were in violation to their obligations under the EU treaty. While the EU
treaty requires EU members to allow for free transfers, it also allows members
to have exceptions. The court found that Sweden’s and Austria’s treaties were
incompatible with the EU treaty and that such treaties would need to be renego-
tiated to include exceptions to the transfer provisions (Salacuse 2010). In 2011,
the EU ordered its members to re-negotiate their bilateral investment treaties
with developing countries. The predominant reason for their wish to re-negotiate
was due to a recent decision of the European Court of Justice (ECJ) regarding the
free transfer of capital clauses included in many EU member state BITs. Indeed,
the ECJ concluded that these clauses are in contradiction with EU law and need
to be re-negotiated. The decision is based on the fact that the EU treaty, while
demanding the free transfer of capital, also provides for the possibility to regu-
late and restrict the free transfer of capital if the economic situation so requires.
OPTIONS FOR REFORM
Reforming treaties in order to grant individual nations and the global community
the policy space to deploy capital account regulations to prevent and mitigate
?nancial crises is fairly simple
at the technical level but quite
dif?cult at the political level.
Box 8 outlines the technical
measures that could be made
to future or existing treaties in
order for such treaties to allow
nations and the global com-
munity to deploy and coordinate capital account regulations to manage global
capital ?ows in such a manner that enhances ?nancial stability and economic
development.
Reforming treaties in order to grant indi-
vidual nations and the global community
the policy space to deploy capital account
regulations to prevent and mitigate ?nancial
crises is fairly simple at the technical level
but quite dif?cult at the political level.
130 A Pardee Center Task Force Report | March 2012
Box 8: Reforming Trade and Investment Treaties
for Capital Account Regulation
National-level
• Draft and pass a law or resolution that allows the nation’s fnancial authorities to put capital
account regulations in place during periods of anticipated or actual fnancial instability.
WTO
• Critically assess the benefts of “listing” cross border trade in fnancial services (Mode 1) or
commercial presence of foreign services (Mode 3) under GATS commitments.
• If a nation chooses to make Mode 1 and Mode 3 commitments, opt for “limiting” such
liberalization with exception to national laws regarding capital account regulations.
• If a nation has existing commitments to liberalize their fnancial sector through Mode 1 or
Mode 3, seek clarifying language under the exceptions in the GATS.
FTAs/BITs
• Remove short-term debt obligations and portfolio investments from the list of investments
covered in treaties.
• Create ‘controlled entry’ Annexes in BITs and FTAs that provide full exception for when a
nation deploys a national law pertaining to capital account regulations.
• Design a balance-of-payments exception that covers both infows and outfows such as the
provisions found in the Japan-South Korea BIT.
• Clarify that the Essential Security exceptions cover fnancial crises, and that measures taken
by host nations are self-judging.
• Resort to a State-to-State dispute resolution process for claims related to fnancial crises,
analogous to the WTO and the other chapters in most FTAs.
• If a nation has an existing FTA or BIT that does not permit capital account regulations, seek
to negotiate interpretive notes that clarify existing exceptions in the treaties.
Regulating Global Capital Flows for Long-Run Development 131
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Regulating Global Capital Flows for Long-Run Development 133
Task Force Members
Amar Bhattacharya
Director, The Intergovernmental Group of Twenty-Four on International
Monetary Affairs and Development (G-24)
Amar Bhattacharya is Director of the Group of 24. The Intergovernmental Group
of Twenty-Four on International Monetary Affairs and Development (G-24) was
established in 1971 with the objective of helping to articulate and support the
position of developing countries in the discussions of the International Monetary
Fund, the World Bank, and other relevant fora. Prior to his current position, Mr.
Bhattacharya had a long-standing career at the World Bank. His last position was
as Senior Advisor and Head of the International Policy and Partnership Group
in the Poverty Reduction and Economic Management Network of the World
Bank. In this capacity, he was the focal point for the Bank’s engagement with key
international groupings and institutions such as the G-7/G-8, G-20, International
Monetary Fund, Organisation for Economic Co-operation and Development,
and the Commonwealth Secretariat. Mr. Bhattacharya has had a long-standing
engagement on issues of global governance and reform of the international
?nancial system as well as aid architecture.
Mark Blyth
Professor of International Political Economy, Brown University
Mark Blyth researches how uncertainty and randomness impact economic
systems, and how the ideas we have about how such systems work are them-
selves causally important within them. He was a member of the Anglo-German
Warwick Commission on International Financial Reform that made a case
for post-crisis macroprudential regulation. He is the author of several books
including Great Transformations: Economic Ideas and Institutional Change in
the Twentieth Century (Cambridge University Press, 2002), and most recently,
Austerity: The History of a Dangerous Idea (Oxford University Press, 2012) that
interrogates the return to prominence of ?nancial orthodoxy following the global
?nancial crisis.
134 A Pardee Center Task Force Report | March 2012
Leonardo Burlamaqui
Program Of?cer, Ford Foundation and Associate Professor of Economics,
State University of Rio de Janeiro
Leonardo Burlamaqui has written and published widely on innovation and com-
petition, knowledge governance, development economics, intellectual property
rights, globalization and institutional change, and the political economy of global
trade and ?nance. Recent publications include “Intellectual Property, Innova-
tion and Development” published in the Brazilian Journal of Political Economy
(Fall 2010), and the essay “Governing Finance and Knowledge,” published in the
special issue of the Journal Homo Oeconomicos, “Schumpeter for Our Time”
(Spring 2010). His forthcoming publications include the chapter “From Intellec-
tual Property to Knowledge Governance” (with Mario Cimoli) in J. Stiglitz et al.
(eds): Intellectual Property Rights: Legal and Economic Challenges for Develop-
ment (Oxford University Press, 2011), and “Knowledge Governance: An Analyti-
cal Perspective and Its Policy Implications,” to be published in Burlamaqui, L.,
Castro, A.C. and Kattel, R. (eds): Knowledge Governance: Reasserting the Public
Interest (Anthem Press, 2012).
Gerald Epstein
Professor of Economics and Founding Co-Director of the Political Economy
Research Institute (PERI) at the University of Massachusetts, Amherst
Gerald Epstein has written articles on numerous topics including ?nancial
regulation, alternative approaches to central banking for employment genera-
tion and poverty reduction, and capital account management and capital ?ows.
He also has worked with several UN organizations. Some of his recent work
includes “Avoiding Group Think and Con?icts of Interest: Widening the Circle of
Central Bank Advice” with Jessica Carrick-Hagenbarth, in Central Banking, May
2011 and Beyond In?ation Targeting: Assessing the Impacts and Policy Alterna-
tives (Elgar Press, 2009), co-edited with Erinc Yeldan. Professor Epstein is also
co-coordinator of SAFER, a group of economists and other analysts working for
?nancial restructuring and reform.
Regulating Global Capital Flows for Long-Run Development 135
Kevin P. Gallagher
Associate Professor of International Relations, and Faculty Fellow, Frederick
S. Pardee Center for the Study of the Longer-Range Future, Boston University
Kevin Gallagher is the author of The Dragon in the Room: China and the Future of
Latin American Industrialization (with Roberto Porzecanski), The Enclave Economy:
Foreign Investment and Sustainable Development in Mexico’s Silicon Valley (with
Lyuba Zarsky), and Free Trade and the Environment: Mexico, NAFTA, and Beyond.
He has been the editor or co-editor for a number of books, including Putting Devel-
opment First: the Importance of Policy Space in the WTO and IFIs, and Rethink-
ing Foreign Investment for Development: Lessons from Latin America. Professor
Gallagher is also a research associate at the Global Development and Environment
Institute at Tufts University. In 2009 he served on the U.S. Department of State
Advisory Committee on International Economic Policy.
Ilene Grabel
Professor, Josef Korbel School of International Studies, University of Denver
Ilene Grabel has been a research scholar at the Political Economy Research
Institute of the University of Massachusetts since 2007, and was a lecturer at
the Cambridge University Advanced Programme on Rethinking Development
Economics since its founding. She has worked as a consultant to United Nations
Development Programme/International Poverty Centre, United Nations Con-
ference on Trade and Development/G-24, United Nations University—World
Institute for Development Economics Research (UNU WIDER), and with Action-
Aid and the NGO coalition, “New Rules for Global Finance.” She has published
widely on ?nancial policy and crises, the political economy of international capi-
tal ?ows to the developing world, the relationship between ?nancial liberaliza-
tion and macroeconomic performance in developing countries, central banking,
exchange rate regimes, the political economy of remittances and, most recently
on the normalization of capital controls and the effect of the global ?nancial cri-
sis on policy space for development. Professor Grabel is co-author (with Ha-Joon
Chang) of Reclaiming Development: An Alternative Policy Manual (Zed Books,
2004). Grabel also blogs for the TripleCrisis (www.triplecrisis.com).
136 A Pardee Center Task Force Report | March 2012
Stephany Grif?th-Jones
Financial Markets Program Director at the Initiative for Policy Dialogue,
Columbia University
Stephany Grif?th-Jones is a member of the Warwick Commission on Financial
Regulation and was a Professorial Fellow, Institute of Development Studies. She
has published widely on the international ?nancial system and its reform. Her
research interests include global capital ?ows, with special reference to ?ows
to emerging markets; macro-economic management of capital ?ows in Latin
America, Eastern Europe and sub-Saharan Africa; proposals for international
measures to diminish volatility of capital ?ows and reduce likelihood of currency
crises; analysis of national and international capital markets; and proposals for
international ?nancial reform.
Rakesh Mohan
Professor of the Practice of International Economics and Finance at the
School of Management and Senior Fellow, Jackson Institute for Global
Affairs, Yale University
Rakesh Mohan serves as chairman of the National Transport Development Policy
Committee of the Government of India, with rank of Minister of State, (non exec-
utive) Vice Chairman of the Indian Institute of Human Settlements; and Senior
Adviser, McKinsey Global Institute, McKinsey and Company. He is also a non
resident Senior Research Fellow of Stanford University. He has researched exten-
sively in the areas of economic reforms and liberalisation, industrial economics,
urban economics, infrastructure studies, economic regulation, monetary policy
and the ?nancial sector. He was secretary of the Indian Ministry of Finance, and
also Deputy Governor of the Reserve Bank of India between 2002 and 2009. In
this capacity he co-chaired the G-20 Working Group “Enhancing Sound Regula-
tion and Strengthening Transparency” (2009), and the Committee on the Global
Financial System (CGFS) Working Group on Capital Flows (2008–2009). He is
the author of Monetary Policy in a Globalized Economy: A Practitioner’s View
(Oxford University Press, 2009), which focuses on the issues relating to the evolu-
tion of banking and ?nance, the conduct of monetary policy, the management
of the ?nancial sector, and the role of central banking. His latest book is Growth
with Financial Stability: Central Banking in an Emerging Market (Oxford Uni-
versity Press, 2011).
Regulating Global Capital Flows for Long-Run Development 137
José Antonio Ocampo
Professor, Director of the Economic and Political Development Program in
the School of International and Public Affairs, and Fellow of the Committee
on Global Thought, Columbia University
José Antonio Ocampo has held numerous positions at the United Nations and in
his native Colombia, including UN Under-Secretary-General for Economic and
Social Affairs, Executive Secretary of the UN Economic Commission for Latin
America and the Caribbean (ECLAC), and Minister of Finance of Colombia. He
has received many distinguished awards, including the 2008 Leontief Prize for
Advancing the Frontiers of Economic Thought and the 1988 Alejandro Angel
Escobar National Science Award of Colombia. He has published extensively, and
his latest books include Growth and Policy in Developing Countries: A Structur-
alist Approach, with Lance Taylor and Codrina Rada (2009), and Time for a Vis-
ible Hand: Lessons from the 2008 World Financial Crisis, edited with Stephany
Grif?th-Jones and Joseph E. Stiglitz (2010).
Dani Rodrik
Ra?q Hariri Professor of International Political Economy, John F. Kennedy
School of Government, Harvard University
Dani Rodrik has published widely in the areas of international economics, eco-
nomic development, and political economy. He is the recipient of the inaugural
Albert O. Hirschman Prize of the Social Science Research Council in 2007. He
has also received the Leontief Award for Advancing the Frontiers of Economic
Thought, and honorary doctorates from the University of Antwerp and the
Catholic University of Peru. He is af?liated with the National Bureau of Economic
Research (Cambridge, Mass.), Centre for Economic Policy Research (London),
Center for Global Development, and Council on Foreign Relations, among others.
138 A Pardee Center Task Force Report | March 2012
Shari Spiegel
Senior Economic Affairs Of?cer, World Economic and Social Survey (WESS)
team at the United Nations Department of Social and Economic Affairs,
Development Policy and Analysis Division
Shari Spiegel is co-author and co-editor of several of books and articles on capi-
tal and ?nancial markets, debt, and macroeconomics. She served as Executive
Director of the Initiative for Policy Dialogue (IPD), a think-tank presided over
by Joseph Stiglitz at Columbia University. She has extensive experience in the
private sector, most recently as a principal at New Holland Capital and as head
of ?xed-income emerging markets at Lazard Asset Management. She also served
as an advisor to the Hungarian Central Bank in the early 1990s.
Arvind Subramanian
Senior Fellow jointly at the Peterson Institute for International Economics
and the Center for Global Development
Arvind Subramanian previously served as Assistant Director in the Research
Department of the International Monetary Fund. During his career at the Fund,
he worked on trade, development, Africa, India, and the Middle East. He served
at the GATT (1988–1992) during the Uruguay Round of trade negotiations, and
taught at Harvard University’s Kennedy School of Government (1999–2000) and
at Johns Hopkins’ School for Advanced International Studies (2008–2010).
He has written on growth, trade, development, institutions, aid, oil, India,
Africa, the WTO, and intellectual property. He has published widely in academic
and other journals and has also published or been cited in leading magazines
and newspapers. He is currently a columnist for India’s leading ?nancial daily,
Business Standard. He advises the Indian government in different capacities,
including as a member of the Finance Minister’s Expert Group on the G-20. He is
the author of India’s Turn: Understanding the Economic Transformation (Oxford
University Press, 2008) and the forthcoming book Eclipse: Living in the Shadow
of China’s Economic Dominance. He is co-editor of Ef?ciency, Equity, and Legiti-
macy: The Multilateral Trading System at the Millennium with Roger Porter and
Pierre Sauvé (Brookings/Harvard University Press, 2002).
Regulating Global Capital Flows for Long-Run Development 139
Shinji Takagi
Professor of Economics, Osaka University
Shinji Takagi has taught at Osaka University since 1990. He has held numerous pro-
fessional appointments, including: Economist at the International Monetary Fund
(1983–1990); Senior Economist, Japanese Ministry of Finance (1992–1994); Visiting
Professor of Economics, Yale University (2000–2001); advisor in the IMF Inde-
pendent Evaluation Of?ce (IEO, 2002–2006); Macro-Financial Expert at the Asian
Development Bank (2007–2008; 2009–2010); Visiting Fellow at the ADB Institute
(2007–2009); and consultant for ASEAN central banks (2010–2011). He is a special-
ist in international monetary economics and has authored or co-authored more
than 100 publications, including books, articles in international journals, and book
chapters. While at the IEO, he managed a project to evaluate the IMF’s approach to
capital account liberalization; while at the ABD Institute, he collaborated with Mario
Lamberte and Masahiro Kawai on a project on managing capital ?ows in Asia.
Ming Zhang
Senior Research Fellow and Deputy Director of Department of Interna-
tional Finance, Institute of World Economics and Politics (IWEP), Chinese
Academy of Social Science (CASS)
Ming Zhang is also the Deputy Director of the Research Center for International
Finance (RCIF) of CASS. His research covers international ?nance and Chinese
macro-economy. In the past several years his ?elds of interest have included the
global ?nancial crisis, management of China’s foreign exchange reserves, cross-
border capital ?ow, and RMB internationalization. He is the author of six books
and more than 60 papers in academic journals. He also writes columns for news-
papers and magazines. Before joining in IWEP, he worked as an auditor in KPMG,
and a PE fund manager in Asset Managers Group, a Japanese listed company.
140 A Pardee Center Task Force Report | March 2012
Regulating Global Capital Flows for Long-Run Development 141
OTHER PARDEE CENTER PUBLICATIONS
Pardee Center Task Force Reports
Latin America 2060: Consolidation or Crisis?
September 2011
Beyond Rio+20: Governance for a Green Economy
March 2011
The Future of North American Trade Policy: Lessons from NAFTA
November 2009
The Pardee Papers series
The Future of Agriculture in Africa
Julius Gutane Kariuki (No. 15), August 2011
Africa’s Technology Futures: Three Scenarios
Dirk Swart (No. 14), July 2011
The Global Land Rush: Implications for Food, Fuel, and the Future of Development
Rachel Nalepa (No. 13), May 2011
Energy Transitions
Peter A. O’Connor (No. 12), November 2010
Issues in Brief series
Capital Account Regulation for Stability and Development: A New Approach
Kevin P. Gallagher, José Antonio Ocampo and Stephany Grif?th-Jones (No. 22),
November 2011
Adulthood Denied: Youth Dissatisfaction and the Arab Spring
M. Chloe Mulderig (No. 21), October 2011
Perceptions of Climate Change: The Role of Art and the Media
Miquel Muñoz and Bernd Sommer (No. 20), February 2011
The Future of Corporate Social Responsibility Reporting
(No. 19), January 2011
142 A Pardee Center Task Force Report | March 2012
Pardee Center Conference Reports
Africa 2060: Good News from Africa
April 2010
Sustainable Development Insights
Rio+20: Accountability and Implementation as Key Goals
Adil Najam and Miquel Muñoz (No. 8), August 2011
Global Environment Governance: The Role of Local Governments
Konrad Otto-Zimmerman (No. 7), March 2011
Green Revolution 2.0: A Sustainable Energy Path
Nalin Kulatilaka (No. 6), October 2010
Global Environment Governance: The Challenge of Accountability
Adil Najam and Mark Halle (No. 5), May 2010
The Role of Cities in Sustainable Development
David Satterthewaite (No. 4), May 2010
All publications are available for download as PDF ?les at www.bu.edu/pardee/publications.
Hard copies are available by email request to [email protected].
Pardee House
67 Bay State Road
Boston, Massachusetts 02215
www.bu.edu/pardee
ISBN 978-1-936727-04-9
The Frederick S. Pardee Center for the Study of the Longer-Range Future at Boston University
serves as a catalyst for studying the improvement of the human condition through an increased
understanding of complex trends, including uncertainty, in global interactions of politics, econom-
ics, technological innovation, and human ecology. The Pardee Center’s perspectives include the
social sciences, natural science, and the humanities’ vision of the natural world. The Center’s focus
is de?ned by its longer-range vision. Our work seeks to identify, anticipate, and enhance the long-
term potential for human progress—with recognition of its complexity and uncertainties.
Occasionally, the Pardee Center convenes groups of experts on speci?c policy questions to identify
viable policy options for the longer-range future. The Pardee Center Task Force Reports present the
?ndings of these deliberations as a contribution of expert knowledge to discussions about impor-
tant issues for which decisions made today will in?uence longer-range human development.
Pardee Center Task Force on Regulating Global Capital Flows for Long-Run Development
The Pardee Center Task Force on Regulating Global Capital Flows for Long-Run Development
was convened on behalf of the Pardee Center’s Global Economic Governance Initiative by Kevin
P. Gallagher, Associate Professor of International Relations at Boston University, along with
Stephany Grif?th-Jones and José Antonio Ocampo of the Initiative for Policy Dialogue (IPD) at
Columbia University. The Task Force is co-sponsored by IPD and the Global Development and
Environment Institute at Tufts University. The Task Force, which includes leading scholars and
practitioners from across the globe, ?rst met at Boston University in September 2011. The goal
of the Task Force and this report is to contribute expert knowledge to the debate among national
and global policymakers and other economists concerning whether and how nations can use
what have been traditionally referred to as capital controls (which we classify as ‘capital account
regulations’ or CARs) to prevent and mitigate ?nancial crises caused by short-term speculative
capital ?ows in developing countries.
Based on discussions among members, this report posits that there is a clear rationale for capital
account regulations in the wake of the ?nancial crisis, that the design and monitoring of such reg-
ulations is essential for their effectiveness, and that a limited amount of global and regional co-
operation would be useful to ensure that CARs can form an effective part of the macroeconomic
policy toolkit. The protocol for deploying capital account regulations in developing countries that
is put forth in this report stands in stark contrast to a set of guidelines for the use of capital con-
trols endorsed by the board of the International Monetary Fund (IMF) in March 2011. However,
the Task Force’s recommendations are more in sync with the set of “coherent conclusions” on
capital account regulations endorsed by the G-20 in November 2011. Our hope is that this Pardee
Center Task Force Report will help inform the discussions and decisions of policymakers and the
IMF as they move forward on this issue under the rubric of the G-20 recommendations.
Task Force Co-Sponsors
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