beyondbrics

This post by Guillermo Calvo of Columbia University is the second of three that beyondbrics is publishing on Wednesday on capital controls. All will be available here. Join the debate by posting your comments.

The resilience of capital flows towards emerging market economies is a sign that the world economy may be moving towards resolving global imbalances and allocating capital more effectively.

However, many EM policymakers fear that it could be “too much of a good thing.” Portfolio flows could turn out to be highly speculative and exit en masse, as they have done during several EM financial crises in the last two decades.

Supporters of controls on capital inflows say they can help to attenuate the negative effects of large capital inflows and potential outflows. I disagree.

Capital controls cannot achieve their ultimate goals because, on the whole, they have little effect on total inflows, and do not prevent a “Sudden Stop” in capital inflows, or outright capital outflows.

There is, however, a major role for government intervention in mitigating the economic risks created by substantial capital inflows in emerging markets.

Capital inflows tend to strengthen EM currencies, lowering exports’ profitability. This provokes a loud outcry from politically influential export groups, who quickly push the overvaluation argument into the headlines.

If social welfare is the major objective, however, this is not a strong argument for interfering with capital inflows. Current exports are important but should not prevent the development of other activities with greater growth potential given EMs’ increasing appeal.

The outcry, however, may still be justified if sharp changes in relative prices that usually accompany disruptions in capital flows cause serious financial distress.

A sharp fall in real estate prices, for example, can cause a contraction in borrowers’ wealth and provoke bankruptcies that do not necessarily lead to better resource allocation – as illustrated by the subprime crisis.

Moreover, if a large sector of the economy is unable or unwilling to serve its debt obligations, this can cause further damage to the credit channel through contagion effects.

Such bankruptcies are more likely if either inflows or outflows are large and largely unexpected (a salient characteristic in past Sudden Stop episodes), because even sophisticated borrowers are not likely to take necessary precautions against wild but low-probability fluctuations in relative prices.

Therefore, there is a strong case in favor of either putting sand in the wheels of finance to slow down the absorption of capital inflows – as opposed to slowing down the flows themselves – or for the government to prevent massive bankruptcies by fiscal means.

Turning to the problems with capital controls, the main weakness of those on inflows is that they appear to be highly ineffective in lowering total capital inflows, making them an unlikely way of putting a dampener on aggregate demand and avoiding a spike in relative prices.

Experience in China and India, however, suggests that capital inflows may be better managed if coupled with controls on capital outflows. But, to ensure effectiveness, the latter should apply to all items in the capital account, including foreign direct investment and medium-term loans.

Otherwise, investors might find ways to circumvent them. This would be an easy trick in economies such as Brazil, where there is a sophisticated financial sector.

The above does not imply that authorities should sit back, relax and watch the drama unfold. In the short run, the government may shield the export sector by, for example, extending cheap credit. This is a propitious time for government’s largesse because credit is plentiful for the public sector and, moreover, taxes can be raised without causing major shock to the non-financial sector. However, an important caveat is that these types of policies must have a clear sunset clause to stop them from becoming permanent.

Another concern is related to fear of a Sudden Stop of capital inflows. Empirical research suggests that controls on capital inflows may help to deter hot capital. Some observers conclude from this evidence that capital inflow controls will diminish the incidence of potential capital outflows. However, capital outflows could be large even after imposing controls on capital inflows for an extended period of time, as Chile illustrates in the context of the 1998 Russian/LTCM crisis. Lengthening the maturity of inflows does not prevent capital flight by domestic residents.

But again in this case there is a role for government. A surge in capital inflows is accompanied by a sharp rise in domestic banks’ liabilities (such as deposits and foreign-exchange denominated credit lines with foreign banks) and credit. Bankruptcies and financial turmoil almost always involve domestic bank complications. Thus, it is advisable to enact pro-cyclical prudential regulations by, for example, increasing banks’ reserve or liquidity requirements, or putting limits on banks’ short-term, foreign-exchange-denominated debt obligations (a policy South Korea has recently implemented).

In conclusion, controls on capital inflows are unlikely to be helpful in slowing down those inflows, unless they apply to all types of flows, and are coupled with effective controls on capital outflows. But this runs the risk of stopping the necessary “good” flows that help to redress global imbalances.

However, policy makers can make a difference through temporary fiscal and credit measures to prevent major credit market spillovers, and through prudential controls in order to improve banks’ resilience in case of Sudden Stops and other financial disruptions.

Guillermo Calvo is professor of international and public affairs at Columbia University in New York