Capital controls: mud in the wheels of market efficiency.

• Author: Forbes, Kristin J.

In the early and mid-1990s, most economists and policymakers supported rapid capital account liberalization for emerging markets. Liberalization was expected to have widespread benefits. It was predicted to increase capital inflows, thereby financing investment and raising growth. Capital inflows--especially in the form of direct investment--would provide improved technology and management techniques, as well as access to international networks, all of which would further increase productivity and growth. Liberalization could facilitate the diversification of risk, thereby reducing volatility in consumption and income. It could also increase market discipline, thereby leading to a more efficient allocation of capital and higher productivity growth. Many countries followed this advice and removed their capital account restrictions.

The initial results were generally positive--increased capital inflows, investment booms, and impressive growth performance. But then a series of financial crises affected several emerging markets that had recently removed capital account restrictions, such as Mexico, Thailand, Korea, Russia, and Argentina. In contrast, several Asian countries that had maintained more stringent capital controls--such as China and India--emerged from the Asian crisis relatively unscathed. These experiences caused many people to reassess their previous support for capital account liberalization in emerging markets.

Many leading economists and policymakers now support the use of capital controls in some circumstances, especially taxes on capital inflows. For example, former U.S. Treasury Secretary Robert Rubin expressed sympathy for controls on capital inflows, such as those adopted by Chile in the 1990s (see Rubin and Weisberg 2003: 257). In 1998 a series of reports by the G-22 raised concerns about capital account liberalization and cautiously endorsed taxes on capital inflows. (1) The Economist (1998: 24) concluded a survey on global finance with the statement: "Some kinds of restriction on inflows (not outflows) of capital will make sense for many developing countries." Even the IMF, formerly the bastion of capital market liberalization, has expressed support for certain capital controls. Stanley Fischer, former first deputy managing director of the IMF, writes: "The IMF has cautiously supported the use of market-based capital inflow controls, Chilean style" (Fischer 2002).

Just as surprising as this sea-change in views on the benefits of capital controls is the lack of rigorous economic analysis supporting this reversal. One of the most basic concepts underlying economics is that any policy measure should be assessed based on whether its benefits outweigh its costs. People may disagree on how to value or weigh the different costs and benefits, but there is little disagreement about the merits of this framework. Given this basic principle of economic analysis, it is surprising that the debate on capital controls has virtually ignored this framework and downplayed the evidence of substantial and pervasive costs.

Granted, doing a full cost-benefit analysis of the impact of capital controls is not easy. And granted, finding robust empirical evidence on the benefits of capital account liberalization is complex and has yielded mixed results to date. But simply focusing on one possible benefit of restricting capital flows--reducing country vulnerability to crises--could ignore substantial costs that overwhelm this possible benefit. Closing capital accounts can lead to a series of pervasive economic distortions that significantly reduce productivity, market efficiency, and aggregate growth. Even a small reduction in growth rates, when compounded over time, can have a much more deleterious effect on a country's standard of living than a short-lived currency crisis.

Therefore, in this article, I attempt to pull together the various pieces of evidence on the costs and benefits of capital controls. Although my comments are not, in any way, the full cost-benefit analysis that is long overdue on this topic, I hope to demonstrate that economists and policymakers may have been too quick to support capital controls. In particular, I argue that the benefits of capital controls are dubious and disputable, while the costs are substantial and pervasive. Capital controls create numerous microeconomic distortions that significantly reduce market efficiency. Most important, I hope to show that the free movement of capital should be an important goal for emerging markets, although exactly how they attain this goal may be more nuanced than some of the earlier recommendations for immediate and comprehensive liberalization.

The Benefits of Capital Controls: Dubious

The most frequently cited benefit of capital controls is that they can reduce country vulnerability to crises. This claim is supported by events during the Asian crisis. Several countries in the region that had recently opened their capital accounts experienced large capital outflows, forcing them to abandon their pegged exchange rates. For example, in 1997 Indonesia, Korea, Malaysia, Philippines, and Thailand experienced net financial outflows of $13 billion (IMF 2004), (2) an average currency depreciation of 77 percent, and severe economic contractions. In sharp contrast, China and India had maintained more stringent capital controls and appeared to be relatively immune to the crises in their neighbors.

This comparison used to support capital controls, however, misses several important points. Although the capital controls may have reduced China's and India's vulnerability during the 1997 Asian crisis, capital controls provide no security against financial crises in general. Many countries with capital controls have experienced devastating crises. For example, India experienced a major currency crisis in 1991 and China experienced a major currency crisis in 1994--despite the existence of capital controls in both countries that were even more stringent than in 1997. Several Latin American countries experienced severe debt crises in the 1980s--despite the existence of capital controls.

Moreover, even if capital controls can insulate a country for some period, they tend to lose their effectiveness over time. By the early 1970s, the capital controls included in the Bretton Woods system had become increasingly porous, allowing imbalances to accumulate that eventually led to the breakdown of the system. Since then, capital mobility has only increased and financial market instruments have become increasingly complex and sophisticated. As a result, even if capital controls were able to reduce country vulnerability to crises in the past, they are even less likely to be effective in the future.

Rather than focusing on anecdotal evidence based on examples of countries with and without capital controls that have and have not experienced crises, several economists have attempted more formal empirical analysis of whether capital controls can reduce the probability of crises. This evidence only complicates the story. Studies generally find a positive--instead of negative--correlation between capital controls and the occurrence of currency crises in both bivariate and multivariate analyses (Glick and Hutchinson 2000; Eichengreen 2003: chap. 3). Taken at face value, these results could be interpreted as suggesting that crises may actually be more likely--instead of less likely--to occur in countries with capital...