The global financial crisis has re-opened the debate on the place of capital controls in the policy toolkit of emerging-market economies (EMEs). The volatility of capital flows during and after the global financial crisis, and the use of capital controls in major EMEs spawned a vigorous debate among policy-makers on the legitimacy and usefulness of capital controls.
In order to aid the development of best practices in capital controls policy, the literature needs to address four questions:
- Under what circumstances do policy makers utilise capital controls? Do policy-makers use capital controls as macroprudential tools, as envisioned in the recent literature?
- What impact do different capital controls have?
- Do the benefits outweigh the costs?
- How should real world institutional arrangements be constructed, to utilise these tools appropriately?
A rich literature has sprung up in recent years, which has re-engaged with these questions. A number of recent studies examine effectiveness of controls in a single country (Brazil or Chile) or a multi-country setting. See for example, Alfaro et al, 2015; Fernandez et al., 2015; Forbes and Klein, 2015; Pasricha et al., 2015. A full list of references is in our paper. In this literature, several researchers have argued that capital controls may be particularly effective in a country like India with the legal and administrative machinery to implement controls (Habermeier et. al., 2011; Klein, 2012).
Indian policy makers have modified the capital control framework frequently to address concerns about the exchange rate, country risk perception and other issues. For example page 15 of RBI's 2014 Annual Report states that RBI's response to the developments following the US Fed's indication that it would taper its large-scale asset purchase program ``aimed at containing exchange rate volatility, compressing the current account deficit (CAD) and rebuilding buffers.'' This response included use of capital controls, foreign exchange intervention as well as interest rate changes. India is thus a good laboratory for studying the motivations and consequences of capital controls.
Credible research designs in this field require precise measurement of capital controls or capital control actions (CCAs). There are many concerns about the measurement obtained through conventional multi-country databases. We comprehensively analyse primary legal documents from 2004 to 2013, in order to construct a new instrument-level dataset about every capital control action for one asset class (foreign borrowing by firms) for one country (India).
In constructing this database, we differentiate between capital control announcements and capital control instruments (e.g., controls on minimum maturity of loans, controls on eligible borrowers, interest rate ceilings, etc.). In India, several instruments can be changed in the same announcement, and we count each instrument separately. We compare our approach with other recent work that compiles datasets on capital control actions (e.g. : Pasricha et al 2015; Pasricha 2012; Forbes et al. 2015) in our paper.
Q1: Under what circumstances do policy-makers utilise capital controls?
We use event studies to ask whether EME policy-makers use capital controls as macroprudential tools, as envisioned in the recent literature. Specifically, do EME policy-makers use capital controls to pursue macroprudential objectives or to achieve exchange rate objectives? A large literature since 2008 envisions capital controls as prudential tools, that can help mitigate systemic financial sector risk, and therefore views them in a more benign light than controls aimed at managing the exchange rate (See Korinek, 2011; Jeanne and Korinek, 2010; Bianchi, 2011, among others).
Factually assessing the motivations for past EME CCAs can help inform the debate on capital controls, as well as the resulting international consensus on the rules of governance for their use. On the one hand, if it can be discerned in the data that emerging markets have, in fact, been using capital controls to target systemic risk, this bolsters the legitimacy of the EME case for continued use of these instruments. On the other hand, if the data suggest that CCAs have been used for currency manipulation, this bolsters the case of those who argue that further international discussions on the rules of the game are needed to address multilateral concerns.
|Figure 1: Exchange rate change prior to a easing CCA. Positive values denote depreciation.|
|Figure 2: Exchange rate change prior to a tightening CCA. Positive values denote depreciation.|
The key result is in the two figures above. In the five weeks prior to an easing action, USD/INR depreciated by 3% on average. In the five weeks prior to a tightening action, USD/INR appreciated by 5% on average. Not only was the average trend prior to easing of inflow controls that of a depreciation of the currency, this also held true for the broad majority of events in sample: 42 out of the 68 instances of easing in our sample were preceded by exchange rate depreciation.
For the easing events which were preceded by an appreciation, the extent of the appreciation was small compared with that seen with events preceded by depreciation: the largest 5-week appreciation prior to an easing was 1.3%, compared to 9.2% for depreciation. The average appreciation prior to an easing was only 0.5%, compared to an average depreciation prior to easings of 5%.
None of the variables that measure the build-up of systemic risk show a similar strong pattern in the 6 months prior to the event date (see Figures 5-8 and Table 5 in the paper). The prime motivation for CCAs in India appears to be exchange rate policy and not macroprudential policy. This shows a certain gap between capital controls in the ideal world and capital controls as they operate in the field.
Q2: What impact do different capital controls have?
Next, we measure the impact of capital control actions. In order to obtain a credible estimation strategy, we utilise propensity score matching to identify time points which are counterfactual. This yields a quasi-experimental design where the treatment effect can be measured. Specifically, for each week in which a capital control action was taken, we identify a week in which macro / financial stress was similar, but no capital control action was taken.
|Impact upon||Coefficient||Std. Error||t-statistic|
|Net foreign inflow||-0.04||0.03||-1.33|
Our results suggest that there was no significant impact of the capital control actions, either on the exchange rate or on measures connected with systemic risk (Table 1). Table 1 above shows the coefficient for the period 4 weeks after the capital control action. Similar values are found for all other time horizons. There is no statistically significant impact upon any of the outcomes at horizons from 1 to 4 weeks.
Broader implications of our results
These results have many implications for the global debate about capital controls. In many countries, the capital controls system was fully dismantled. In such an environment, it may be particularly easy to evade capital controls, for example through financial engineering. The best opportunity to obtain effectiveness of capital controls may be in countries like China or India, where large bureaucracies implement capital controls, and the detailed system of specifying rules about every asset class and every type of economic agent was never dismantled. For this reason, India is an ideal laboratory to study capital controls. If capital controls are found to be useful in India, the case could potentially be made that other EMEs, which dismantled the overall capital controls system, should reverse these reforms.
Our results show that Indian authorities seem to be using capital controls as a tool for exchange rate policy and not for systemic risk mitigation, and their actions seem to be ineffective. These results are also consistent with many papers in the recent literature which are skeptical about the usefulness of capital controls (Chamon and Garcia, 2015; Fernandez et. al, 2015; Forbes and Klein, 2015; Forbes et. al., 2015; Hutchison et. al, 2012; Klein, 2012; Patnaik and Shah, 2012; Pasricha et.al, 2015; Warnock, 2011).
The strength of the research presented here is that it provides credible estimates about one locale, India. A fruitful line of inquiry would be to apply such strategies to multiple countries, and build up a literature with careful assessment of country experience, one country at a time, about the ways in which capital controls are used, in the field, and about their treatment effects. A much more expansive strategy would seek to undertake such thorough instrument-level analysis on a multi-country scale in order to construct a consistent database about capital control actions on the scale of all EMEs or the whole world.
Even when capital controls do yield a desired treatment effect, the important question of cost-benefit analysis remains. A body of research is required which would assess the costs and the benefits of utilising these tools. On the cost-assessment side, a wide body of research on capital controls focuses on microeconomic distortions from capital controls (Alfaro et al, 2015; Forbes, 2007). On the benefits side, the evidence is mixed regarding the extent to which capital controls are able to deliver on the objectives of macroeconomic policy. While capital controls seem to be able to change the composition of flows toward more long-term debt, it is not clear to what extent this represents a mislabelling of flows (Magud et al., 2011; Carvalho and Garcia, 2008). Pasricha et al. (2015) find that capital control actions were not useful in allowing major emerging markets to change their trilemma configurations and Patnaik and Shah (2012) find that the Indian capital controls are not an effective tool for macroeconomic policy.
Further research is required on the institutional arrangements for capital controls. As an analogy, monetary policy was long viewed as being effective, but it was only in the 1980s that clarity was obtained around the institutional structure of independent central banks with inflation targets and monetary policy committees. In similar fashion, if capital controls have to graduate into the macroprudential policy toolkit, normative research is required in designing the optimal institutional arrangements for systemic risk regulation with mechanism design, akin to a monetary policy committee, and accountability, similar to an inflation target.
Laura Alfaro, Anusha Chari and Fabio Kanczuk. The real effects of capital controls: Financial constraints, exporters and firm investment NBER Working Paper 20726, Dec 2014.
Marcos Chamon and Marcio Garcia. Capital controls in Brazil: Effective? Journal of International Money and Finance, 2016 (Forthcoming).
Bernardo S. de M. Carvalho and Marcio G. P. Garcia. Ineffective controls on capital inflows under sophisticated financial markets: Brazil in the nineties In Sebastian Edwards and Marco G. P. Garcia (Eds.), Financial markets volatility and performance in emerging markets, pp. 29-96. University of Chicago Press.
Andres Fernandez, Alessandro Rebucci, and Martin Uribe. Are capital controls countercyclical? Journal of Monetary Economics, 76:1--14, 2015.
Anton Korinek. The new economics of capital controls imposed for prudential reasons. IMF Working Paper, Dec 2011.
Javier Bianchi. Overborrowing and systemic externalities in the business cycle. American Economic Review: Vol. 101 No. 7, Dec 2011.
Kristin J. Forbes. One cost of the Chilean capital controls: Increased financial constraints for smaller traded firms. Journal of International Economics 71(2): 294-323, Apr 2007.
Kristin J. Forbes and Michael W. Klein. Pick your poison: The choices and consequences of policy responses to crises. IMF Economic Review, 63(1):197--237, Apr 2015. ISSN 2041-4161.
Kristin J. Forbes, Marcel Fratzscher, and Roland Straub. Capital-flow management measures: What are they good for? Journal of International Economics, 96, Supplement 1:S76 -- S97, 2015. ISSN 0022-1996. 37th Annual NBER International Seminar on Macroeconomics.
K. F. Habermeier, C. Baba, and A. Kokenyne. The effectiveness of capital controls and prudential policies in managing large inflows. IMF Staff Discussion Note SDN/11/14, International Monetary Fund, 2011.
Nicolas E. Magud, Carmen M. Reinhart and Kenneth S. Rogoff. Capital controls: Myth and reality - A portfolio balance approach. NBER Working Paper No. 16805, Feb, 2011
Michael M. Hutchison, Gurnain Kaur Pasricha, and Nirvikar Singh. Effectiveness of capital controls in India: Evidence from the offshore NDF market. IMF Economic Review, 60(3): 395--438, 2012.
Michael W. Klein. Capital controls: Gates versus walls. Brookings Papers on Economic Activity, 45(2 (Fall)):317--367, 2012.
Olivier Jeanne and Anton Korinek. Excessive Volatility in Capital Flows: A Pigouvian Taxation Approach. American Economic Review, 100(2), May 2010.
Radhika Pandey, Gurnain Kaur Pasricha, Ila Patnaik, Ajay Shah. Motivations for capital controls and their effectiveness. Working paper, 2016.
Gurnain Kaur Pasricha. Recent trends in measures to manage capital flows in emerging economies. The North American Journal of Economics and Finance 23 (3), 286-309.
Gurnain Kaur Pasricha, Matteo Falagiarda, Martin Bijsterbosch and Joshua Aizenman. Domestic and multilateral effects of capital controls in emerging markets. NBER Working Paper No. 20822.
Ila Patnaik and Ajay Shah. Did the Indian capital controls work as a tool of macroeconomic policy. IMF Economic Review, 60(3):439--464, 2012.
Frank E. Warnock. Doubts about capital controls. Working Paper 14, Council on Foreign Relations, 2011.
Gurnain Pasricha is at the Bank of Canada, and the other three authors are at the National Institute for Public Finance and Policy, New Delhi. The views expressed in this post are those of the authors. No responsibility for them should be attributed to the Bank of Canada or NIPFP.