Monetary stability, exchange rate regimes, and capital controls: what have we learned?

• Author: Xafa, Miranda
• Position: Report

Few topics in macroeconomics are as contentious as capital account liberalization and exchange rate regimes. This article attempts to briefly summarize what we have learned through the turbulent 1990s and the relatively benign 2000s. It is obviously not intended to review the massive literature on these topics, only to distill the main policy conclusions--or at least what I think are the main policy conclusions.

In contrast to current account liberalization, which is enshrined in the Articles of Agreement, the International Monetary Fund has no explicit mandate to promote capital account liberalization. Even so, the IMF seeks to be a "center of excellence" in analyzing capital account issues, in light of the growing financial globalization and its implications for macro management in member countries. To deal with surges in capital inflows, the IMF has generally advocated tightening fiscal policy to prevent overheating and limit real appreciation (IMF 2007a). Such a policy response helps reduce the economy's vulnerability to a "hard landing" after the inflows abate. However, counter-cyclical fiscal policy is no panacea, because governments may be unable to change the fiscal stance to the extent and at the speed required to offset the impact of shifts in capital inflows.

Are capital controls the answer? Controls have been occasionally imposed to discourage capital inflows and reduce appreciation pressures (Chile in 1991, Thailand in 2006, Colombia in 2007) or to discourage outflows (Malaysia in 1998). In the process, they may entail substantial microeconomic costs, inter alia by raising the cost of capital (Forbes 2007). There is little empirical evidence that controls are effective in stemming capital flows, especially over the longer term, as markets find ways around them. With the possible exception of market-based prudential measures, controls have a negative signaling effect and markets tend to view them as a country risk factor.

Removal of controls on outflows is another policy countries have adopted to deal with recent surges in capital inflows. However, empirical evidence from the 1980s and 1990s suggests that eliminating controls on outflows can attract inflows by sending a positive market signal (Bartolini and Drazen 1997).

The Case for Free Capital Mobility: Theory and Evidence

There is an analogy between trade in goods and trade in capital, since cross-border investment is a form of intertemporal trade: The lender/investor delivers present goods on the expectation that the user of the funds will deliver future goods. It is therefore natural to presume that capital mobility promotes growth just as trade promotes growth. The theoretical justification for this presumption is based on allocative efficiency considerations. However, while there is much empirical evidence that trade is good for growth, the evidence on capital mobility is mixed at best. Why is that? Various explanations have been put forth.

First, the theoretical presumption that capital account liberalization is good for growth applies only in a first-best world. When other distortions exist, liberalization may in fact reduce growth, by shifting resources to less productive sectors. It has been argued that a second-best outcome is more likely in the case of capital account liberalization, because information asymmetries are intrinsic to financial markets. (1) Some economists, therefore, consider capital account liberalization as a threat to economic and financial stability (Rodrik 1998, Stiglitz 2000).

Second, capital account liberalization is a continuum that extends over time and across different types of capital flows. Early empirical studies based on "on-off" liberalization--as if it were a binary choice--oversimplify reality. More recent studies that distinguish between different types of flows and different degrees of liberalization have found evidence of positive growth effects. Disaggregating the data also sheds light on the link between liberalization and crises. Research points to substantial benefits from liberalizing equity flows, while debt flows denominated in foreign exchange can be problematic (see Henry 2007).

Third, a strand of the literature suggests that, besides the neoclassical allocative efficiency channel, the benefits of financial globalization are also realized through "collateral benefits" (Kose et al. 2006). These benefits are hard to uncover in cross-country regressions that try to explain growth, because their impact works through other...