beyondbrics

This post by Kevin Gallagher of Boston University is the first of three that beyondbrics is posting on Wednesday on capital controls in emerging markets. Join the debate by posting your comments below.

Emerging markets have their hands full trying to stem currency appreciation and asset bubbles due to their higher interest rates and formidable economic recoveries relative to the west. The situation will only worsen as world leaders continue to fail to reform global finance and the US moves to another round of quantitative easing.

In times like this, capital controls have regained their legitimacy as a tool emerging markets can resort to. One could make the argument that many emerging markets eventually need to let their currencies appreciate, in real terms. But flows of speculative capital that stop and start suddenly are a destabilising way to that end.

For John Maynard Keynes, Harry Dexter White, and the other architects of the international financial institutions, capital controls were seen as a core component of global financial stability.

Indeed, Keynes said the “control of capital movements, both inward and outward, should be a permanent feature of the post-war system.”

From the Reagan-Thatcher era to the height of the Washington Consensus, capital controls fell out of favor. The argument was that by lifting capital controls emerging markets would have more access to credit and investment and thus enable stability and growth.

The pendulum has now swung in the other direction. A parade of studies have showed that capital account liberalisation was not associated with growth in emerging markets, and that capital controls have been fairly effective.

Countries such as Brazil, Venezuela, Indonesia, South Korea, Taiwan, and now Thailand have deployed some form of capital or currency controls in the wake of the crisis. It is prudent for other emerging markets to follow suit, but with care.

Capital controls range from deterrent measures such as taxes on short-term debt to outright bans on certain kinds of speculative capital. The goal of capital controls – which are often turned on when capital flows overheat then get turned off when stability is restored – is to prevent massive inflows of hot money that can drive the appreciation of local currencies and threaten financial stability.

In a 2006 report by the National Bureau of Economic Research (NBER), Carmen Reinhart and Nicholas Magud examine the most rigorous studies on the use of capital controls before the crisis and conclude “capital controls on inflows seem to make monetary policy more independent, alter the composition of capital flows and reduce real exchange rate pressures.”

A February 2010 IMF staff position note came to the same conclusions about past studies. In addition, the IMF conducted its own econometric analysis and found that capital controls “were associated with avoiding some of the worst growth outcomes” of the current economic crisis. The IMF concludes that the “use of capital controls – in addition to both prudential and macroeconomic policy – is justified as part of the policy toolkit.”

Other 2010 studies by the Asian Development Bank and the United Nations confirmed these findings and echoed similar policy recommendations.

This month Dominique Strauss-Kahn, IMF managing director, said “I understand that many economies contemplating huge capital inflows have to take action to avoid those capital inflows to create bubbles and problems in their own economy” and “We can understand that some element of capital controls can be put in place.”

Getting the economics right on capital controls is only half the battle. The implementation of effective controls needs to be taken very seriously. Two of the biggest barriers to effective capital controls are investor evasion and US trade agreements.

According to another NBER report, by Bernardo Carvalho and Marcio Garcia, investors have circumvented capital controls in the past by disguising short-term capital as foreign direct investment, through currency swaps and other derivatives, and by purchasing American depositary receipts.

Since 2003, US trade and investment treaties have outlawed capital controls by developing-country trading partners by mandating the free flow of capital to and from a country, regardless of its level of development — for instance, in trade deals with Chile, Peru, and Singapore. Pending deals with Colombia and South Korea would also ban capital controls.

Interestingly, the trade treaties of other higher-income countries — such as Canada, Japan, and the European Union — grant countries the right to use capital controls, or at least grant exemptions during times of crises.

In times like this developing countries need every tool at their disposal to prevent and mitigate financial crises. Capital controls are a legitimate part of the toolkit. Critics who say capital controls are not legitimate tools are ignoring the near consensus in the economics literature that controls have some merit. Attention now needs to turn to putting in place the proper regulations to penalise capital control evaders and to reform outdated trade treaties that can accentuate instability among emerging markets.

Kevin P. Gallagher is associate professor of international relations at Boston University and the author of a UN study on capital controls titled “Policy Space to Prevent and Mitigate Financial Crises” and a new book “The Dragon in the Room: China and the Future of Latin American Industrialization“.