Controls on Risky Capital Inflows Likely to Expand

The implementation of capital controls on short-term and especially risky capital inflows is rising and likely to continue to do so as the current recovery gathers pace.

Guest Post byOxford Analytica

Prior to the 2008-09 financial crisis, it had become widely accepted among international financial institutions and many leading national policymakers that the benefits of liberalizing capital flows outweighed those of capital controls, which anyway might prove ineffective in achieving their objectives. Yet the crisis jolted this consensus:

• Bubble caution. The crisis created a step change in awareness among policymakers about the need to try to avoid the formation of asset price bubbles and ensuing financial market instability. As a result, increased regulation of financial activity and capital markets has become more widely sought, and capital controls are a potential element of this.
• Perception check. At the height of the financial crisis, sudden flight of short-term capital away from emerging markets illustrated lingering risk perception associated with developing countries. The financial instability in some emerging markets generated by these sudden outflows raised the attractiveness of capital controls as a way to mitigate future volatility.
• Recovery pressures. Perhaps most important of all, the rapid return of capital to emerging markets in the current recovery has generated pressure in favour of capital controls.

The dynamics of the global recovery are generating interrelated reasons for developing country governments to consider implementing capital controls:

• Exchange rate. Many floating developing country currencies have risen dramatically since March 2009, undermining export competitiveness.
• Liquidity. The large amount of liquidity in the global economy as a result of monetary and fiscal stimulus efforts worldwide aggravates the risk of economic dislocation through sudden inflows or outflows of short-term capital.
• Inflation. Inflationary pressures so far are only of major concern in some asset classes within certain countries. Some countries, such as China, are attempting to stem inflationary pressure by taking further domestic measures, including constraining bank credit growth.

As a result of these pressures, several countries over the last year have moved to constrain foreign capital inflows, including Brazil, Taiwan, Indonesia and South Korea.

There are three main categories of capital controls:

Price-based. These include taxes on investments; taxes on interest paid in local currency; and taxes on foreign debt issuance by domestic residents. A key benefit of price-based controls is that they can be variable according to maturity, which means they can be used to promote longer-term investment.

Quantitative. These usually consist of limits on the amount of foreign funds that can be invested in local currency. Such limits are often used in countries that do not have floating exchange rates, such as China.

Regulatory. These require the depositing of part of the value of an investment in a specified local currency instrument, indirectly reducing the investor’s total yield.

While controls may only be effective temporarily, they can still be useful in constraining local currency appreciation and diminishing financial market volatility.

While the choice of capital control depends on each country’s specific circumstances, there are general reasons why most controls have limited impact:

• Evasion. The effectiveness of capital controls on short-term capital inflows is usually temporary, as investors tend to find ways to evade them. However, this does not mean that they are not useful as a temporary and/or partial brake on inflows.
• FDI strength. Debt and portfolio capital inflows may be dwarfed by foreign direct investment (FDI) inflows, particularly if a recipient country enjoys political stability and a supportive business environment. Governments are usually far more reluctant to deter FDI than short-term debt, as FDI is directly associated with increasing productive capacity.
• Foreign dependence. Countries that are particularly reliant on foreign capital remain unlikely to impose capital controls despite the changing global sentiment towards their adoption.