Very Preliminary
Comments Most Welcome
Currency Crises and Capital Controls: A Selective Survey
Sweta C. Saxena
and
Kar-yiu Wong
University of Washington
( This version: January 2, 1999)
Abstract: This survey discusses theoretical models of speculative attack and currency
crises, and reviews the empirical evidence. The paper outlines the correspondence of the
models to different cases of crisis (e.g. Latin American crises, the ERM breakdown, and
the recent Asian crisis), and points to gaps in the theoretical literature for explaining the
Asian crisis. The large economic costs resulting from the severe depreciation of Asian
currencies and general problems with macroeconomic management in the presence of
large capital flows has recently led to proposals for limiting capital flows. The paper
reviews the arguments and models for and against capital controls.
JEL Classification: F31, F47
Keywords: Currency Crises, Herding, Twin Crises, Capital Flight, Asian Crisis,
Capital Controls
Authors’ E-mail Address: ssaxena@u.washington.edu, karyiu@u.washington.edu
Table of Contents
1. Introduction ..................................................................................................................... 1
2. Domestic Credit Creation and Currency Crises .............................................................. 2
2.1. A Simple Model of Exchange Rate Determination.......................................... 3
2.2.Domestic Credit Creation and Currency Crises ................................................ 5
3. Speculative Expectations, Multiple Equilibria, and Self-fulfilling Crises ...................... 8
4. Twin Crises: Banking and Exchange Rate Crises......................................................... 11
5. Herding and Capital Flight............................................................................................ 12
6. Moral Hazard and Financial Crises............................................................................... 14
7. Predictability of Crises .................................................................................................. 16
8. Capital Control: A Remedy? ......................................................................................... 18
8.1. Capital Account Liberalization and Currency Crises..................................... 19
8.2. A Historical Look at the Capital Account Liberalization .............................. 20
9. Capital Account Control: Some Conventional Arguments and Counter-Arguments ... 21
10. The Current Debate on Capital Account Liberalization.............................................. 24
11. Sequencing Capital Account Liberalization................................................................ 27
12. Measures to discourage capital inflows ...................................................................... 29
Supplementary Sterilization Measures.................................................................. 32
Causes and Policy Responses to Capital Inflows.................................................. 35
13. Empirical Evidence ..................................................................................................... 37
14. Conclusion................................................................................................................... 40
Figure 1 ............................................................................................................................. 41
Figure 2 ............................................................................................................................. 42
Figure 3 ............................................................................................................................. 43
References ......................................................................................................................... 44
1. Introduction
The recent history of the international financial markets is characterized by numerous
currency crises. Various countries around the world have come under pressure or faced a
crisis at different points in time. The recent counts were the crises in Mexico in 1976 and
Argentina, Brazil, Peru and Mexico in the early and mid-80s, the crises in Chile and
Argentina in 1980s and ERM in 1992, then the one in Mexico in 1995. Now, in 1997 and
1998, a major part of Asia is under a financial crisis.
Economists, who are doing some catching-up work, are trying to provide analysis of
these crises. So far, most of the work focuses on three different but related areas:
(a) Theoretical analysis of the causes and effects of currency crises
Undoubtedly, most of the work on currency crisis focuses on explaining the causes and
effects of currency crisis. Earlier work by Salant and Henderson (1978), Krugman
(1979), and Flood and Garber (1984), which often are dubbed as the first-generation
models, painstakingly points out how persistent government budget deficits may lead to
capital flight and currency crisis. The crises in Chile and Argentina in the 1980s and
ERM in 1992 led to the development of second-generation models, which emphasize the
existence of multiple equilibria in the foreign exchange markets and the possibility of
having crises as self-fulfilling outcomes.
The current crisis in Asia, however, has some features that either were not present or
were not so obvious in previous crises. For example, these countries had responsible
fiscal policies of the governments, and the economies showed solid fundamentals.
Another feature of these economies is that they had been growing with impressive rates
for a long period of time. Prior to the crisis, these countries were regarded by many as the
model of growth for many developing countries. All of a sudden, they faced new
problems in the financial markets that were not expected. It is, therefore, interesting to
investigate any possible links between growth and crisis.
(b) Empirical Studies of Crises
On the empirical side, people have tried to determine whether crises can be predicted. In
particular, there has been interest on finding the relationship between a crisis and certain
variables of the economy, and whether there exist good leading indicators of a crisis.
(c) Policy Recommendation
As the analysis of various crises is being developed, a question that easily pops up in
people’s mind is what the government should do to avoid a crisis. Two approaches can be
suggested. First, one can focus on a particular crisis, determine its causes, and try to see
whether some of these causes can be eliminated through a change in some government
policies. For example, if one looks at the crises in Latin America, one can simply suggest
that lowering the government deficits could avoid a crisis down the road. Second, one can
1
examine the similarities between various crises and determine whether there are some
government policies that could diminish the chances of a crisis in the future.
In terms of the second approach, one can note that while all crises can be distinguished in
terms of their causes and effects, they do share two common features: (i) a fixed
exchange rate regime, and (ii) capital flight and speculative attacks. Corresponding to
these two features, two proposal have been suggested: (i) give up the fixed exchange rate
regime; (ii) capital control, i.e., strict constraints on the inflow and/or outflow of capital
across the borders of a country.
In this paper, we survey some of the more important issues related to currency crises. Our
discussion will be based the three areas described above: the analysis of causes and
effects of crises, empirical studies, and policy recommendation.
In analyzing the causes and effects of crises, we begin with the two main areas
emphasized in earlier work: the existence of persistent fiscal deficits, and existence of
multiple equilibria and self-fulfilling crises. These are discussed respectively in Sections
2 and 3.
We then turn to more recent work that examines other areas: (a) simultaneous existence
of a banking crisis and a currency crisis, so called the twin crises (Section 4); (b) herd
behavior and its relationship to capital flight and speculative attacks (Section 5); and (c)
moral hazard and currency crises (Section 6).
Next, in Section 7, we turn to the work that examines the predictability of crises.
In Sections 8 to 13, we choose to discuss one policy recommendation to avoid a currency
crisis that has been proposed before: capital control. We will not mention about the other
policy suggestion: the floating of a local currency. It is because a fixed exchange rate
versus a flexible exchange rate has long been an important issue in the literature, and we
decided not to cover this area.
In Section 8, we provide some basic material about capital account control, including a
brief history of capital control. In Section 9, we present some traditional arguments for
and against capital control, while Section 10 focuses on more recent arguments. Section
11 explains an alternative recommendation: Instead of liberalizing the capital account in a
single step, as some of Asian countries did prior to the crisis, it has been suggested the
country the account should be liberalized in several steps. We will present some of the
arguments. Section 12 discusses several measures to discourage capital inflow and
outflow, so that an economy may not be so risky under the threat of capital flight. Section
13 presents some empirical studies related to capital control, while the last section
concludes.
2. Domestic Credit Creation and Currency Crises
2
For an economy under a fixed exchange rate regime, a currency crisis usually refers to a
situation in which the economy is under the pressure to give up either the prevailing
exchange rate or the regime. For the former, the economy in crisis in most cases is
required to devalue its currency by a substantial amount,1 and the exchange rate then
moves to a new, but at least temporarily fixed, level. For the latter, the alternative regime
is a flexible exchange rate one.
In the literature, many models and theories have been suggested to explain the causes and
occurrence of a currency crisis. In this section, we focus on the impacts of domestic
credit creation on the exchange rate pegged by the government. Models that use these
impacts to explain the existence of a currency crisis are sometimes called the firstgeneration models.
2.1 A Simple Model of Exchange Rate Determination
To introduce the main features of the first-generation models, let us first lay down a
simple model of exchange rate determination. Consider a one-sector, small, open
economy. To focus on the monetary side of the economy, we assume that its real side is
characterized by full employment, with constant factor endowment and technology. The
following equilibrium conditions are used to describe the monetary side of the economy:
(1)
(2)
(3)
(4)
M t / Pt a bit
M t S t Rt Dt
Pt Pt* S t
i i * S
t
t
t
where M t , Pt , it , are the quantity of (high-powered) money, the general price level, and
the interest rate, respectively. Equation (1) is the money demand equation, with the
output level always at a fixed level. The two coefficients, a and b, are positive numbers.
Equation (2) gives the money supply, which consists of foreign reserves (in foreign
currency) held by the government/central bank, Rt , plus domestic credit, Dt . Variable S t
is the spot exchange rate, defined as the domestic currency price of foreign currency.
Equation (3) is the purchasing power parity, where an asterisk represents a foreign
variable, while equation (4) is the interest parity condition, where a dot above a variable
represents the rate of change of that variable with respect to time. Assuming perfect
foresight, expected rate of depreciation is equal to the actual rate of depreciation. Since
we are considering a small economy, foreign variables are treated as given exogenously.
This allows us to normalize Pt* 1 and i*t 0 .
In this subsection, we assume that the spot exchange rate always adjusts to its equilibrium
level instantaneously and costlessly. With no government intervention, the amount of
1
Devaluation and appreciation of a currency are usually treated asymmetrically. While a forced devaluation is considered as a crisis, a forced appreciation is not.
3
foreign reserve is fixed and is denoted by R0 . The domestic credit is assumed to be
increasing at an exogenously given rate of 0 , i.e., D .
t
The increase in domestic credit is the main feature of most currency crisis models.
Several reasons can be used to explain why it increases, but the most common one is that
the government is running continuous deficits, and that these deficits are financed by
printing money (increase in domestic credit).2
Combining equations (1), (3) and (4) together, we have
(5)
M t aS t bSt .
The solution to equation (5) can be found to be
(6)
S t M t ,
where b / a 2 and 1 / a .3 Recall that the high-powered money consists of
foreign reserves and domestic credit, (2) can be substituted into (6) to give
(7)
S t Dt ,
where 1 /( 1 R0 ) . Equation (7) is represented by line ABCE in Figure 1. The
vertical intercept of the line, A, represents /(1 R0 ) .4 Suppose that initially at time
t t 0 , the quantity of domestic credit is D0 . This is represented by point B. As the
domestic credit increases, the currency is devalued and the exchange rate moves up along
the line BCE. Note that because of the constant rate of increase in Dt , Figure 1 can be
interpreted as a diagram showing the change in S t with respect to time, with t
represented by the horizontal axis.
Because Dt is changing at a rate of , the value of Dt at time t is Dt D0 ( t t 0 ) .
Using this equation, the exchange rate will change according to the following equation:
(8)
S t D0 ( t t0 ) .
2
This is what was observed in many Latin American countries, which experienced currency crises of
various degrees in the seventies and eighties.
3
To derive the solution, we conjecture that the solution of the following form: S t M t .
Differentiating both sides gives S M . Substitute this condition into (5), and comparing this with the
t
t
assumed solution form gives 1 / a and b / a 2 .
4
To have a positive exchange rate in equation (7), we assume that 1 R0 0 .
4
Note that the exchange rate given in (8) depends on the initial value of foreign reserve.
We can consider an alternative rate that corresponds to another reserve level, conveniently chosen to be zero, R0 0 . This implies that 1 . Denote the corresponding rate
~
by S t , which is described by
(9)
~
S t D0 ( t t 0 ) .
The exchange rate in (9) is represented by line GHJ in Figure 1.
Suppose now that at time t t 0 , in an unanticipated move, the government chooses to
raise the exchange rate from the prevailing level to a higher level. In Figure 1, this policy
can be represented by a jump of the exchange rate from point B to F instantaneously.
After the jump, the exchange rate is then fixed, as represented by horizontal line S FC.
When the exchange rate is fixed, St 0 . Equation (4) implies that i = i* = 0, so that
equation (1) reduces to
(9)
M t aS ,
i.e., the equilibrium stock of money is proportional to the given exchange rate. Therefore
when the government pegs the exchange rate, the economy accumulates foreign reserve
and thus money by running a balance of payment surplus.
2.2
Domestic Credit Creation and Currency Crisis
Mexico in 1976, and Argentina, Brazil, Peru and Mexico in the early and mid-80s
experienced various degrees of currency crises. These countries chose to peg their
currencies against foreign ones. At some points they observed capital flight and
speculative attacks on their currencies, which resulted in enormous pressure on the
central bank to devalue their currencies.
Continuous government fiscal deficits had been attributed as one major factor of these
currency crises. These deficits were financed mainly by printing money, i.e., through an
increase in the domestic credit held by the central banks. As Salant and Henderson
(1978), Krugman (1979), and Flood and Garber (1984) pointed out, there is an
inconsistency between deficit financing policy and the policy of a fixed exchange rate. In
the model described above, the money supply that equilibrates the money market is given
exogenously.5 An increase in the central bank’s domestic credit will be matched by a
drop in foreign reserve. Because the amount of foreign reserve held by the central bank is
finite, the government cannot maintain a fixed exchange rate regime indefinitely.
5
This feature is an important one in the Mundell-Fleming models of an small open economy with a fixed
exchange rate and perfect capital mobility.
5
Krugman went on to argue that a crisis occurs when the central bank’s foreign reserve
reaches a minimum level. At this point, the government will have to devalue its currency
or give up its fixed exchange rate policy.
Let us make use of the simple model of exchange rate introduced earlier to explain such
an inconsistency.6 Let us assume that at some point, the economy is represented by point
F in Figure 1, with the exchange rate fixed at S , while domestic credit is increasing at a
rate of . The increase in domestic credit means that point F shifts to the right along the
horizontal line. However, by equation (9), the equilibrium money stock is fixed, meaning
that as the economy is creating domestic credit, it is losing foreign reserve by running
balance of payment deficits. In other words, because M t 0 , we have
(10)
R t D t / S / S 0 .
Equation (10) suggests that the amount of foreign reserve at any time t is given by
(11)
Rt R0 ( t t 0 ) ,
where / S . The change in the foreign reserve over time is illustrated by schedule
ABC in Figure 2.
If this situation continues, the central bank will run out of foreign reserve at time t t x ,
where t x is obtained from (11) by setting Rt 0 :
(12)
t x t 0 R0 / .
At t t x , the value of domestic credit is
(13)
D x D0 ( t x t0 ) D0 S R0 .
As more domestic credit is created, both flexible exchange rates S t (with positive foreign
~
reserve) and S t (with no foreign reserve) are rising. Specifically, S t S when t t y ,
where from (8),
(14)
t y t 0 ( S D0 ) .
~
Similarly, S t S when t t z t y , where (with 1 )
(15)
6
t z t0 ( S D0 ) .
The following model is based on Floor and Garber (1984).
6
It is usually assumed that t y t x .7 The value of domestic credit at t t y is equal to
(15)
D y D0 ( t y t 0 ) ( 1 )D0 ( S ) ,
and that at t t z is equal to
(16)
Dz D0 (t z t0 ) (1 ) D0 ( S ) .
Obviously, because the amount of foreign reserve held by the central bank is limited, the
present situation cannot continue indefinitely. Suppose that the government decides that
this situation terminates when foreign reserve hits a minimum level such as zero, and that
it gives up its fixed exchange rate policy and lets the currency float.8 When the constraint
is removed, the exchange rate becomes the same as the shadow rate.
Such a reversal of the exchange rate policy is a crisis for the economy under
consideration because the government is forced to abandon its originally set exchange
rate policy, after losing a considerable amount of foreign reserve.
Krugman (1979) points out that the fixed exchange rate regime can no longer survive
when the amount of foreign reserve held by the central bank reaches a minimum level.
This implies that the crisis occurs at t t x . So the change in foreign reserve follows
schedule ABC in Figure 2. Flood and Garber (1984), however, argue that if people know
in advance of the devaluation, speculation will occur and could force the devaluation to
happen earlier. For example, shortly before t x , speculators can purchase from the central
bank the remaining foreign reserve, denoted as R' , with an amount of domestic currency
of S R' . When the exchange rate is changed to S' S , where S' is the corresponding
shadow exchange rate, the speculators can sell the foreign reserve back to the central
bank, and get a profit of ( S' S )R' . This profit may not be much if R' is small, but the
profit rate is very high considering the short duration of time. So devaluation will not
occur at t t x , but earlier. However, the same argument can be used to say that
devaluation will not occur just earlier than t x , but even earlier. As a result, at any time
when the shadow exchange rate is higher than the pegged rate, one can argue that
devaluation will occur slightly earlier. This means that the crisis will occur when t t z ,
and the change in central bank’s foreign reserve over time is described by ABE in Figure
2. Furthermore, the above analysis implies that there is no discrete jump in the exchange
rate.
7
This is the case considered in most, if not all, papers analyzing the present issue.
The same analysis applies even if the minimum level is positive, but it is usually assumed that this amount
is less than R y , meaning that the government will not consider giving up the regime before t t z .
8
7
However, the path ABE of foreign reserve requires perfect information, costless
exchange transactions, unlimited resources owned by the speculators, and a clear policy
in terms of when the fixed exchange rate is given up. It should also be pointed out that
between t y and t z , the currency is overvalued (relatively to the existing stock of foreign
reserve held by the central bank). Therefore, if the determination of the government in
defending the pegged exchange rate is unknown to the public and people do not know the
minimum amount of foreign reserve below which the government will give up the
exchange rate regime, then it is possible that some investors may start moving the money
out of the country at or shortly after t y . These may be people who are most pessimistic
about the economy or the resolve of the government. This leads to loss of foreign reserve
of the government, making devaluation more likely. Very soon, more people may take
similar action, and speculative attack occurs. Finally, the capital flight and speculation
become so overwhelming for the government to defend the exchange rate anymore. So a
possible adjustment path of foreign reserve is described by schedule AFG in Figure 2.
3. Speculative Expectations, Multiple Equilibria, and Self-fulfilling
Crises
While the model of currency crisis presented in the previous subsection shows the
inconsistency between continuous creation of domestic credit and a fixed exchange rate,
it has been pointed out that a currency crisis can also occur without the financing of fiscal
deficit through domestic credit creation. The crisis that appeared to be stranger is the
experiences of certain European countries in 1992 – 1993. In this period, while
maintaining fixed exchange rates, these countries faced severe speculative attacks on
their currencies. In August 1993 member countries of the European Monetary System
gave in and allowed more flexibility in their currencies, permitting their currencies to
move within a band of 15 percent instead of 2.25 percent for most Exchange Rate
Mechanism (ERM) rates. However, it is interesting to note that two years later the prices
of some of these currencies were at about the level same as before. This means that these
European countries were not having any obvious macroeconomic troubles and that
currency crises can arise even when economies have sound macroeconomic
fundamentals. In other words, these countries do not have the features that are described
by the first-generation models.
Looking at the breakdown of the ERM, Obstfeld (1994) suggests the following features
of the type of crises experienced by these European countries:
1. There are reasons why the government wants to abandon the peg (to inflate away the
debt burden denominated in domestic currency, and to follow expansionary monetary
policies in case of unemployment, etc)
2. There are reasons why the government wants to defend the peg, hence a conflict
between the two (to facilitate international trade and investment, to gain credibility if
8
has a history of high inflation, and as a source of national pride or commitment to an
international cooperation).
3. The cost of defending the peg rises when people expect the peg would be abandoned,
because people in the past expected that the exchange rate would be depreciated now.
Hence, anticipation of devaluation makes the debt-holders and worker unions in the
past demand higher interest rate and wages, making debt-burden too high and
industries un-competitive at the current exchange rate level.
The important trigger is the expectation of people. If they expect that the currency is
going to be devalued in the near future, they could expect enormous pressure on the
central bank even though the conditions of the economy are solid. Such expectations may
lead them to convert their domestic currency to foreign currency before the devaluation.
If sufficient number of people do that with large sums of domestic currency, the central
bank could run out of foreign reserve and has to devalue the currency. In this case, the
crisis is self-fulfilling. Sometimes the models that emphasize the above characteristics are
called the second-generation models.
However, Krugman (1998a) supposes that a fixed exchange rate could be costly to
defend, if people now expect that it will be depreciated in the future. The usual channel
involves short-term interest rates: to defend the currency in the face of expectations of
future expectations may either worsen the cash flow of the government (or indebted
enterprises) or depress output and employment.
The model introduced earlier can be used to explain the feature of a self-fulfilling
currency crisis. Suppose that the central bank currently owns foreign reserve R0 0 , and
that the government is keeping the domestic credit constant, 0 . From (7), with
0 , the flexible exchange rate corresponding to a foreign reserve of R0 is given by
(17)
S t Dt ,
which is illustrated by line OAB in Figure 3.
Let the current domestic credit be D A , and let the exchange rate be pegged at S . This is
depicted by point A in the diagram. Since the domestic credit is fixed, the economy can
avoid the type of crisis as described above, and can stay at point A indefinitely.
Suppose now that currency speculators believe that there is a positive probability that the
government will devalue the currency in the near future. Specifically, suppose that the
government will let the currency go if the foreign reserve runs down to a minimum level,
such as zero, and that the shadow exchange rate will then be equal to the flexible rate.9
9
When the exchange rate is expected to devalue, the domestic interest rate will rise.
9
In Figure 3, line CEFG shows the shadow flexible rate under the condition that R0 0 ,
and it is described by the following equation (with 1 ):
(18)
~
St Dt .
If the speculators have the resources and choose to purchase all the foreign reserve held
by the central bank, the government will give up its fixed exchange rate policy, and the
exchange rate will jump up to S1 S , as represented by point F in Figure 3. Such
devaluation occurs despite the fact that the economy is fundamentally solid, with no
domestic credit creation due to deficit financing.
In terms of the resources held by the speculators, Obstfeld (1996) distinguishes among
three different cases: (a) when the total resources of the speculators are less than R0 ; (b)
when the resource of each speculator are greater than R0 ; (c) when none of the
speculators has resources greater than R0 , but when two or more of them combined will
have resources greater than R0 . In case (a), devaluation will not occur. In case (b),
devaluation will occur when any one of the speculators purchases R0 from the central
bank, causing devaluation. In fact, all of them will try to be the first to do so. In case (c),
if sufficient number of speculators believe that devaluation will occur and they rush to
purchase foreign reserve, devaluation will definitely occur, even though without
speculation the fixed exchange rate regime could have survived indefinitely. If the
currency is devalued, the total profit of the speculators is ( S1 S ) R0 .
The crisis that occurs in case (c) has two features: (1) there are multiple equilibria. (2) It
is self-fulfilling in the sense that it will not occur if none of the speculators act, but will
occur if a sufficient number of them act.
Figure 3 also shows that a self-fulfilling crisis can occur when domestic credit is in
between D A and DE . As explained before, if the central bank loses all its foreign
reserve, the exchange rate becomes flexible, jumping up to a point in between E and F on
CEFG. If the initial value of domestic credit is equal to DE , the speculators will earn no
profit.
If the initial domestic credit is less than DE , no speculation will occur because if the
fixed exchange rate breaks down, appreciation of the currency will occur and the
speculators lose money. If domestic credit is greater than D A , the currency is overvalued.
The speculators will have a bigger incentive to attack the exchange rate.
There are some models in which the objectives of the government are spelled out, and
multiple equilibria are derived explicitly. See, for example, Obstfeld (1994).
10
4. Twin Crises: Banking and Exchange Rate Crises
The new generation models emphasize the importance of financial sector and capital
flows in currency crises. Hence, the term “twin crises”. The frequent occurrence of twin
crises (Nordic countries in 1990s, Turkey in 1994, Venezuela, Argentina and Mexico in
1994, Bulgaria in 1996, and Asian countries in 1997) has been a result of banking crisis
precipitating a currency crisis, either by an increase in money supply, or by a large scale
withdrawal leading to a decrease in money demand. The causation between the balance
of payments and banking crises is, however, debatable. Stoker (1995) and Mishkin
(1996) argue that balance of payments crisis leads to banking crisis. According to
Stoker, an external shock, coupled with commitment to fixed exchange rate, leads to loss
of reserves. If this loss of reserves is not sterilized, then a speculative attack is followed
by a period of abnormally high interest rates leading to credit crunch, increased
bankruptcies and financial crisis. Mishkin argues that devaluation could weaken the
position of the banks if they have a large share of their liabilities denominated in foreign
currency. However, Diaz-Alejandro (1985), Velasco (1987), Calvo (1995) and Miller
(1995) argue that banking crises lead to balance of payments crises. The argument is
that central banks bailout financial institutions by printing money, and this erodes their
ability to maintain the prevailing exchange rate commitment. But Reinhart and Vegh
(1996) suggest that the two crises have some common causes—an example of “perverse”
dynamics of an exchange rate based inflation stabilization plan. Since prices are slow to
converge to international levels, exchange rate appreciates markedly. Initially, there is a
boom in imports and economic activity, which is financed by borrowing abroad. This
leads to a widening of current account deficits and financial markets infer that
stabilization program is unsustainable, hence the currency is attacked. The increase in
bank credit during the boom is financed by foreign borrowings, when capital flows out
and asset market crashes, it leads to the collapse of the banking system as well.
McKinnon and Pill (1996) show that financial liberalization along with some
microeconomic distortions—like implicit insurance deposits—can make boom-bust
cycles more pronounced as they lead to lending boom that leads to the eventual collapse
of banking system. Goldfajn and Valdes (1997) show that changes in international
interest rates and capital inflows are amplified by the intermediating role of banks and
how these swings may produce business cycles that ends in bank runs and financial and
currency crashes.
However, the stylized facts that these models tend to explain are: (Goldfajn and Valdes,
1997 and Kaminsky and Reinhart, 1996)
1. Banking crises are highly correlated to currency crises.
2. Capital inflows increase steadily before the crisis and fall sharply during the crisis.
3. Banking activity (intermediation) increases some time before the collapse.
Goldfajn and Valdes (1997) model the interaction of liquidity creation by financial
intermediaries with capital flows and exchange rate collapses in a two time-period
11
framework, hence focussing on the role of the financial intermediaries in the currency
crises. These intermediaries provide liquidity, which is attractive to foreign investors with
short-term incentives for investment, hence helping in capital inflows. However, due to
any exogenous shocks, when the foreign investors want to withdraw their deposits, these
intermediaries, being locked in illiquid assets, face the risk of failure. Hence, a bank run
leads to capital outflows and currency collapse. Their model provides role for the banking
system in magnifying the shocks to fundamentals (productivity and interest rates), but
does not assume any kind of inconsistency in policy making, like the first and second
generation models.
Some of the important results from their model are:
1. Under intermediation, the probability of a run will be positive and non-decreasing
with respect to international interest rate.
2. There are proportionally more capital outflows with intermediaries in period 1.
3. There is a trade-off in the sense that intermediation may generate larger inflows, but,
at the same time, a higher probability of a run against the country.
4. If devaluations are expected, runs against the intermediary are more likely.
5. The intermediation process generates a transmission and amplification mechanism in
which small shocks translate into larger effects.
5. Herding and Capital Flight
In this section, we turn to another explanation of the existence of currency crisis: herd
behavior. Herding, which is an example of information cascade, is said to exist when
individuals tend to choose actions similar to previous actions chosen by other individuals.
In other words, with herding effects, individuals tend to move in conformity, and a small
shock to society could lead to a mass shift in the actions of people. In some special cases,
people can choose to give up the private information or signals they possess and follow
the actions of others, even though the private information or signals they have would
suggest them to act otherwise.
A famous example is Keynes' beauty contest example.10 Earlier work includes the papers
by Leibenstein (1950) on the bandwagon effects. Recently, more rigorous models have
been suggested to explain herd behavior.11 Several models that have been introduced to
explain investment behavior are mentioned here.
10
In a beauty pageant, a judge picks up the girl who he thinks others would pick, rather than who he
considers to be the most beautiful.
11
See, for example, Banerjee (1992), Bikhchandani, et al (1992), and Froot, et al (1992).
12
Froot, et al (1992) show that speculators with short horizons may herd on the same
information, trying to learn what the other informed traders know. These could lead to
multiple equilibria, and herding speculators may even choose to study information that is
completely unrelated to fundamentals. So, the large perceived penalty for missing a bull
market leads managers to follow the pack even if fundamentals do not warrant it;
conversely, the penalty of losses during the bear market are lower as all other managers
are losing money as well.12
Krugman (1998a) suggests similar reasons why herding might occur. First, there is a
bandwagon effect, which is driven by the awareness that investors have private
information—where investors ignore their own information and thrive on the information
of other investors. It has been argued that bandwagon effects in markets with private
information create a sort of “hot money” that at least sometimes causes foreign exchange
markets to overreact to news about national economic prospects. Second, much of the
money invested in crisis-prone countries is managed by agents rather than directly by
principals—where the principal-agent problems arise.
The above models usually assume sequential actions by individuals, so that those who
take actions later will observe what actions others have taken previously. Calvo and
Mendoza (1998) introduce a model in which herding can exist even when individuals
have simultaneous decision making. They find that with informational frictions, herding
behavior may become more prevalent as the world capital market grows. With
globalization, the cost of collecting country-specific information to discredit rumors
increases and managers, facing reputational costs, choose to mimic the market portfolio. 13
Hence, small rumors can induce herding behavior and move the economy from a no
attack to an attack equilibrium.
Herding is a type of distortion in the economy in the sense that the actions of some
individuals can produce externality. This has two implications, both are important in
explaining the occurrence of a crisis. First, the actions of a limited number of individuals
may produce at best some limiting adverse effect on an economy. The same action of a
large number of individuals can make a possible damage unbearable. For example,
Obstfeld (1996) argues that in some cases, the attacks by a limited number of speculators
on the local currency will not do much harm, as the central bank has enough foreign
reserves to defend. However, if a large number of speculators launch similar attacks, the
central bank could run out of reserve and the country could face a crisis. Another
example is the current crisis in Asia. For countries like Thailand or South Korea, failure
of firms in the economy is nothing strange, and as long as the number of failures during
any period of time is limited, the economy usually has capacity to absorb these losses.
However, if widespread failures exist at about the same time, huge bad loans can be
12
As Krugman (1998a) puts it: “I feel worse if I lose money in a Thai devaluation when others don’t, than I
will if I lose the same in the general rout.”
13
The details in country credit ratings (CCRs) is assumed to be costly; They find an empirical regularity
about the CCRs that new information changes the perceptions of investment conditions significantly in
emerging markets than in developed and least developed countries. Also, information gathering requires
larger adjustments in mean and variance of the returns on assets in emerging markets than in OECD
countries.
13
created, and financial institutions could face repayment problems if the money originally
comes from abroad.14 Furthermore, if the values of bad loans were not high, these
financial institutions can borrow more to ease the cash flow problem, but if the bad loans
are high, it is difficult to borrow such large amounts in a short time.
Another externality created by herding is that while certain massive actions may hurt the
economy, these actions could be entirely rational from individuals' point of view.15 Such
rational behaviors occur when there are payoff externalities (payoffs to an agent adopting
an action increases as the number of agents adopting that action increases) or principalagent problems (managers have an incentive to hide in the herd so that their actions
cannot be evaluated).
Of course, as Flood and Marion (1998) argue, in many cases, herding could explain some
part of the currency crises in Asia, but not the whole. First, individuals are less likely to
ignore their own or new information in a world where they can adjust their strategies
continuously to new information. Second, in case strategic interactions are important,
then the cascade story is unsatisfactory, because the potential capital gains arising from
the action of one agent does not depend on actions chosen by others.
Wong (1998) applies herding behavior to provide a theory of the formation of bubbles in
the housing market in case of Thailand, and explains how the bubbles had caused some of
the troubles in the economy. When the growth of the economy creates rising demand of
housing, investors respond with more supply. Consecutive periods of high growth
reward the more optimistic and aggressive investors with huge profits. These profits and
successes prompt pessimistic investors to revise upward their beliefs of the future and
become more aggressive. More firms enter the market and ride the bandwagon. Bubbles
are then formed when (a) investors get too optimistic; or (b) a widespread failure and
bankruptcy of firms in the housing market creates big losses to financial institutions,
which in turn could not repay their foreign debts; or (c) a widespread failure and
bankruptcy of firms in the housing market creates pessimism and panics in the economy,
prompting capital flight and speculative attacks on the domestic currency.
6. Moral Hazard and Financial Crises
14
For example, Thailand passed the Bangkok International Banking Facility in 1992, allowing domestic
banks and financial institutions to borrow from abroad to finance local investment projects. As capital was
available in other countries at very low interest rates, the new policy of Thailand led to huge inflow of
foreign capital. Much of this money went to the housing/real estate sector, creating big jumps in supply.
When these investments went sour, bad loans were created and these banks and financial institutions did
not have the money to repay the loans they borrowed from aboard. The worst part was that most of these
foreign loans were denominated in foreign currency such as the yen or the dollar, and usually no hedging
against currency depreciation had been made. When the Thai baht was devalued, these financial institutions
suffered double hits.
15
Interested readers are referred to Devenow and Welch (1996) for a summary on rational herding
literature.
14
Moral hazard can occur under asymmetric information because borrowers can alter their
behavior after the transaction has taken place in ways that the lender regards as
undesirable. In financial markets, however, moral hazard could occur in the absence of
asymmetric information; i.e., moral hazard arises from the possibility that investor
behavior will be altered by the extension of government guaranteed that relieve investors
of some of the consequences of risk taking.
Krugman (1998b) and Corsetti, et al (1998) have proposed moral hazard as a possible
explanation for currency crises, especially the Asian crisis of 1997. Krugman considers a
case of over-guaranteed and under-regulated financial intermediaries. Since these
institutions do not have to put any capital up-front, and have the liberty to walk away at
no personal cost in case of bankruptcy, the economy engages in excessive investment.
This economy is made worse off by globalization. If it did not have access to world
capital market, then excessive investment demand by these intermediaries would show up
as high rates of interest, and not as excessive investment. But access to world market
allows the moral hazard in the financial sector to translate into real excess capital
accumulation.
Corsetti, et al (1998) also recognize moral hazard as a source of over-investment,
excessive external borrowing and current account deficits. Unprofitable projects and cash
shortfalls are re-financed through external borrowing as long as foreign creditors lend to
domestic agents against future bail-out revenue from the government. The government
deficits need not be high before the crisis, but refusal of foreign creditors to re-finance the
debt forces the government to step in and guarantee the outstanding stock of external
liabilities. The government might recourse to seigniorage revenues. Expectations of
inflationary financing thus cause a collapse of the currency and anticipate the event of a
financial crisis.
In fact, the argument of moral hazard is not only applicable to the intermediaries, but also
to the governments. Proponents of moral hazard argue that IMF creates bailout for the
governments or investors in the event of a crisis.
However, Radelet and Sachs (1998) do not see the current Asian crisis as a result of
carelessness on the part of the investors because they were sure to be bailed out in a
crisis. First of all, only state-owned enterprises can be bailed out in a crisis. According to
Radelet and Sachs, if the creditors feared a risk of a crisis in Asia, then spread on Asian
bonds should have increased, but it did not. If the creditors felt an increasing risk of
government-led bailout, then ratings of long term government bonds should have gone
down, but they did not either. A large part of the investment went into the risky equity
market, and bank loans went to non-financial corporate sector, where the direct
government bailout was least possible. Creditors have been aware of weak bankruptcy
laws and ineffective judicial systems in Asia. Hence, the foreign investors lent because
they anticipated these economies to perform well, and not because they believed that they
would be bailed out.
15
7. Predictability of Crises16
There are different definitions of crisis that have been used in empirical literature. Some
papers use a narrow definition of crisis as a devaluation of exchange rate.17 Other papers
use the term crisis in a broader sense, i.e., as an increase in Market Pressure Index
(MPI)18. It is constructed as follows:
MPI i ,t =
(% ei ,t )
+
ei , t
( i i,t )
-
(% ri,t )
ii , t
ri , t
where e is the bilateral exchange rate of country “i” with US or Germany; i is the interest
rate in country “i” and r is the non-gold international reserves that the central bank has;
the changes in exchange rate, interest rate and reserves are weighted by their respective
standard deviations. This index is high when there is pressure on the currency and low
otherwise. The intuition is that if there is an attack on the currency, either the exchange
rate would depreciate, or interest rate would be raised to ward off the attack, or the
central bank would sell foreign currency to support the exchange rate. Most papers use
probit or logit analysis, where the dependent variable is a discrete measure of crisis,
which is also the probability of a crisis. For example, Eichengreen, Rose and Wyplosz
(1996a) define the dependent variable as:
DUMMPIx = 1 if MPIx > MPIx + 1.5*MPIx, , 0 otherwise;
where is the mean of the MPI in country x, and is the standard deviation of MPI.
Kaminsky and Reinhart (1996) construct the MPI as a weighted average of exchange rate
changes and reserve changes, and define crisis as:
DUMMPIx 1 if MPIx MPIx 3 * MPIx , 0 otherwise
The exclusion of incidents of speculative pressure on the exchange rate below the
arbitrary threshold value has the disadvantage of introducing sample bias into the
estimation procedure. Flood and Marion (1998) argue that many models of speculative
attack indicate that unanticipated devaluations produce the largest jump in the MPI. The
size of jumps in the MPI at the time of attack is reduced by the extent to which the attack
is anticipated. Thus, selection of only extreme values of the MPI (as in construction of
the dependent variable for probit models) may reduce the share of predictable crises in
the sample and reduce the number of crises that are likely to be correlated with
fundamental economic determinants. Cerra and Saxena (1998) use Markov Switching
Models (MSMs), which make the probability of a crisis continuous and endogenous.
16
For a comprehensive review on empirical literature, see Kaminsky, Lizondo and Reinhart (1997).
Edwards (1989), Edwards and Montiel (1989), Edwards and Santaella (1993) and Frankel and Rose
(1996)
18
See Eichengree, Rose and Wyplosz (1996), Sachs, Tornell and Velasco (1996), Kaminsky, Lizondo and
Reinhart (1997) and Cerra and Saxena (1998) for construction of this variable.
17
16
Radelet and Sachs(1998b) define a financial crisis as a sharp shift from capital inflow to
capital outflow between year t-1 and year t.
A banking crisis could be defined in either of the two ways: financial distress meaning a
situation of insolvency of banks, or financial panic referring to illiquidity in the banking
sector. A run on the bank occurs when individual depositors withdraw money from the
bank because they fear that “other depositors” are withdrawing money, and not because
banks have made bad investments. This immediate withdrawal of funds by all depositors
makes the banks illiquid, and the bank run a success.
Kaminsky, Lizondo and Reinhart (1997), Kaminsky and Reinhart (1996) and Kaminsky
(1998) use the signals approach, where the idea is that economy behaves differently
during crisis and tranquil times. The events that start a crisis will be present in “the
leading indicators” before the actual crises and thus will help currency crises. This
approach involves monitoring the evolution of a number of economic variables to find
whether the variables are behaving in an anomalous way and thus are “signaling” a future
crisis. This approach involves specifying a “threshold”, beyond which the variable sends
a “signal” of future crisis—the signal could be an accurate one or give a “false alarm”.
The 24-month before the crisis erupts is defined as “crisis” times, while the rest of the
months are defined as “tranquil” times. The choice of threshold determination involves
striking a balance between Type I (Rejecting H0 when H0 is true) and Type II (Accepting
H0 when H0 is false) errors. The sizes of the errors are and , respectively. If is 0 (the
threshold is too lax), then the indicator will catch all the crises, but will give lots of false
signals (noise). If is 0 (the threshold is too tight), the indicator will never issue a false
signal, but it will miss all the crises. Hence, for each variable, the critical region is
selected so as to minimize the noise-to-signal ratio:
Noise-to-signal ratio =
where (1 )
1
number of months with good signals
number of months in the crisis window
number of months with bad signals
number of months outside the crisis window
where goods signals are the signals inside the crisis window and bad signals are the
signals that are outside the crisis window, and the crisis window is the 24-months
preceding the crises.
The most common leading indicators used in the literature are:
1. Over-borrowing cycles: M2 multiplier, domestic credit/GDP, financial liberalization;
2. Bank runs: Bank deposits;
3. Monetary Policy: “excess” M1 balances;
17
4. Balance of Payments problems: exports, imports, terms of trade, real exchange rate,
reserves, M2/reserves, real interest rate differential, world real interest rate, foreign
debt, capital flight (deposits of domestic residents in BIS banks) and short-term
foreign debt/total foreign debt;
5. Growth slowdown: output, domestic real interest rate, lending /deposit rate ratio,
stock prices.
The following shocks signal vulnerability to a crisis:
1. Since crises are preceded by over-lending cycles, signals are associated with large
positive shocks to the M2 multiplier, the domestic credit /GDP ratio, excess real M1
balances, and M2/reserves, and high levels of foreign debt.
2. Problems in the capital account can worsen if foreign debt is concentrated at short
maturities and there is capital flight. So large positive shocks to these indicators are
associated with possible future crises.
3. Large positive shocks to the lending/deposit interest rate ratio and to real interest rates
are taken as signals of crises.
4. Large negative shocks to deposits warn of future financial fragility.
5. The weak external sector is captured by large negative shocks to exports, the terms of
trade, the real exchange rate and reserves and large positive shocks to imports, the
real interest rate differential, and the world real interest rate.
6. The recessions are captured by large negative shocks to output and to the stock
market.
8. Capital Control: A Remedy?
The current crisis in Asia has renewed an old debate on whether a country, especially the
emerging economies like Thailand, Malaysia, and Indonesia, should limit the inflow and
outflow of capital as its economy is growing. People are alarmed by the size of the
speculative attacks on local currencies of these countries and the possible damages
caused by a sudden outflow of capital on the central bank's foreign reserve stock and the
financial and real sides of the economy. All these countries, after months of attacks on
their currencies and massive depletion of the reserve stocks, eventually gave up their
fixed exchange rate regimes. In the nineties, while these countries were growing
impressively, they attracted large amounts of capital from investors all over the world. In
1997, as the prospect of devaluation became more and more likely, everyone tried to
move his/her capital out of these countries as soon as possible. That created a huge swing
in the direction of movement of capital. While in 1996, the 5-Asian economies (South
18
Korea, Indonesia, Malaysia, Thailand and the Philippines) received net private capital
inflows amounting to $93billion, in 1997, they experienced an estimated outflow of
$12.1billion, a turnaround in a single year of $105billion, amounting to more than 10%
combined GDP of these economies (Rodrik 1998).
The ease of capital movement across the borders of the countries, which was at a time
regarded as the main reason for attracting capital which is used for domestic investment
and growth, allowed foreign investors to move their capital out in 1997, and facilitated
speculative attacks. It was therefore straightforward to blame these currency speculators
and question the wisdom of allowing capital movement in the first place. In fact,
Malaysia was the first country in the current crisis (and the only one so far) to turn to a
strict control on inflow and outflow of capital.19
In the following sections, we will present several issues about capital control and
arguments for and against capital control. Before we do that, let us present some
background material.
8.1 Capital Account Liberalization and Currency Crises20
As mentioned above, in the Mundell-Fleming model for a small open economy with a
fixed exchange rate and perfect capital mobility, the money supply that equilibrates the
money market is given exogenously. This means that such an economy has no
independent monetary policy. Any attempt by the central bank to raise the domestic
interest rate above the world rate (plus a risk premium) will invite foreign capital inflow
while any attempt to lower the domestic rate below the world rate will lead to capital
outflow. On the other hand, if there is a change in the world interest rate, the domestic
rate has to change accordingly. As a result, it is argued that there is inconsistency
between the policy of simultaneous currency pegging and capital account liberalization
for small open economies.
As a matter of fact, all the Asian and Latin American countries that experienced currency
crises had various degree of capital account liberalization prior to the crises. A good
example is Thailand. The passage of the Bangkok International Banking Facility in 1992
had resulted in a surge in foreign debts, a significant percentage of which went to the
housing market. The eventual collapse of the housing market has contributed to the crisis
in 1997.21
In trying to apply the Mundell-Fleming model to explain the link between capital account
liberalization and currency crises for these Asian and Latin American countries, three
related points can be noted. First, for most countries, capital mobility is far from perfect:
There are transactions costs, information asymmetry, heterogeneity between domestic
19
Malaysia adopted this new policy on September 1, 1998.
IMF (1998) provides further discussion of the theoretical links between capital account liberalization and
financial crises.
21
See Wong (1998) for a theoretical model.
20
19
and foreign assets, and administrative requirements. Because of the friction caused by
these factors, domestic monetary policy cannot be effective, and domestic interest rates
can deviate from foreign interest rates.
Second, not all currency crises reflect inconsistent domestic policies. As the secondgeneration models emphasis, crises can be self-fulfilling. This seems to be what the ERM
breakdown of 1992 suggests.
Self-fulfilling currency crises can be due solely to the actions of speculators, but the
existence of domestic difficulties and huge external debts can also trigger self-fulfilling
crises. In particular, when an economy is showing signs of difficulties, investors would
want to move their capital out of the country and foreign lenders would refuse to provide
more loans.
Third, most of these countries experienced not only a currency crisis but also a bank
crisis. With the imperfection of and lack of sufficient supervision in the domestic banking
system, the ability of domestic banks and financial institutions to borrow from abroad
makes the economy vulnerable. Both overborrowing (from abroad) and overlending (to
domestic investors) could occur, and any widespread failure of some important sectors
could trigger loss of investors' confidence, bank run, and financial crisis. On the other
hand, if the problems of the domestic financial institutions are confined to the domestic
economy so that foreign lenders regard these problems as short term, domestic financial
institutions could raise new capital from abroad to help them solve the illiquidity
problems.
8.2 A Historical Look at the Capital Account Liberalization
Exchange rate restrictions were unheard of in the period before World War I. Even
during the war, pressures on exchange rate were easily avoided by official reserve
holdings and credit operations. The stabilization of exchange rate was relatively easier as
there were no historical memories of wars leading to severe realignments. The most
memorable war was Franco-German war of 1870, which did not affect the currency of
victorious nation, while leaving the currency of the defeated country depreciated by a
mere 3½ %.
The failure to establish international monetary stability during the inter-war period led to
trade restrictions and capital controls. The sentiments did not change even after World
War II. Controls in the post World War II were generally targeted to achieve balance of
payments objectives or as a part of broader economic development strategies (in addition,
there were restrictions on current international transactions). The exchange controls in the
UK were designed to protect sterling in the face of a weak balance of payments problem.
The controls in the US in the 1960s were aimed at improving a weak balance of payments
by preventing capital transfers abroad. The controls in Japan and France ensured that
savings were invested at home than abroad, while those in Germany and Switzerland
were aimed at restricting capital inflows to prevent the exchange rate from appreciating.
20
These restrictions were consistent with members’ obligations under the IMF’s Articles of
Agreement. For example, Article IV, Section 3, states that “Members may exercise such
controls as necessary to regulate international capital movement.” The rationale was to
prevent short-term equilibrating capital movements rather than long-term ones.
However, by 1958, the current account restrictions were removed in Western Europe and
industrial countries waited until the end of 1970s to remove the capital controls. The UK
suspended all exchange controls in 1979, while Japan dismantled restrictions on capital
movements in 1980, Australia and New Zealand in 1983, the Netherlands in 1985, France
Sweden and Denmark in 1989, Norway, Belgium and Luxembourg in 1990, Finland and
Austria in 1991, Portugal and Ireland in 1993 and Iceland in 1994.
Some of the developing nations have been liberal on capital account, like the Middle East
oil exporting countries, Singapore, Hong Kong, Panama and Liberia. Indonesia opened
its capital account in 1970, while Uruguay maintained a liberal capital account for a
number of years.
9. Capital Account Control: Some Conventional Arguments and
Counter-arguments
Capital account control or liberalization is an old issue. Many arguments have been
suggested to support capital account control, but many have also been made to argue for
capital account liberalization.22 We present some of the more traditional ones here. In the
next sections, we will focus on those that are more relevant to the current Asian crisis.
9.1 Volatility of Short-Term Capital
Proponents of capital controls argue that controls help limit volatile short-term capital
flows (avoiding balance of payments crises, exchange rate volatility, etc) and provide
greater independence of interest rate policy. Financial markets are very liquid and react
quickly to shocks, while the real economy is slow to react due to price and wage rigidities
and investment irreversibility. Tobin (1978) and Dornbusch (1986) argue that this
differential speed of adjustment, together with exogenous excess volatility in financial
markets, may induce excess exchange rate volatility (over shooting, bubbles, etc) with
negative effects on real economic activity. While Tobin proposes “throwing sand in the
wheels” of short-run capital flows by imposing a uniform tax on all foreign exchange
transactions, which would discourage very short-term capital flows, but with negligible
effects on long run ones, Dornbusch suggests adoption of measures such as dual
exchange rate systems, which would partially protect the real economy from fluctuations
in the financial markets.
22
Some more discussions can be found in Mathieson and Rojas-Suarez (1992), Johnston and Ryan (1994),
and Grilli and Milesi-Ferretti (1995).
21
Opponents of capital controls argue that controls are particularly ineffective in preventing
short-term movements, and the degree of insulation of monetary policy is therefore very
limited. Large capital movements tend to occur when interest rates and exchange rates are
out of line with fundamentals and therefore indicate the need for more timely adjustments
in exchange rates and interest rates. Since it is difficult to distinguish between short-term
and long-term investment and also between direct and portfolio investment, hence
imposing controls on short-term inflows could crowd out the long-term foreign
investment.
9.2 Protection of Foreign Reserves
Proponents of capital controls argue that controls support the balance of payments by
protecting the foreign exchange reserves by preventing outflows of domestic savings
and capital flight. Unstable macroeconomic and political environment in many
developing economies can reduce the expected private returns from holding domestic
financial instruments, and hence risk averse savers may prefer to hold a significant
portion of their wealth in foreign assets that are perceived to yield higher or more certain
real returns. Controls help retain domestic savings by reducing the return on foreign
assets through interest equalization tax or by raising the costs of moving funds abroad)
and by limiting access to foreign funds.
Opponents of capital controls argue that because of the scope for avoidance through trade
and other channels, capital controls are ineffective in preventing outflows, but can
discourage inflows and may not necessarily protect the balance of payments. In addition,
even if capital controls limit the acquisition of foreign assets, they may still be ineffective
in increasing and sustaining the availability of savings for domestic capital formation. If
domestic financial instruments carry relatively uncertain and low real rates of return and
residents cannot acquire foreign assets, they often respond by reducing their overall
savings or by holding their savings in inflation hedges such as real estate or inventories.
9.3 Limitations on Foreign Ownership of Domestic Assets
Proponents of capital controls argue that controls limit foreign ownership of domestic
factors of production. These controls prevent either unwarranted depletion of a country’s
natural resources or the emergence of a monopoly in a particular industry. Equity and
income distribution considerations are often cited as justifications for limiting ownership
of domestic factors of production and real estate.
Opponents of capital controls view controls as discouraging foreign direct investment.
FDI may be an important source of external finance and the acquisition of new
technologies.
9.4 Taxation of Domestic Financial Activities, Income and Wealth
Proponents of capital controls argue that controls are needed to maintain the
authorities’ ability to tax financial activities, income and wealth. Since domestic
22
residents have an incentive to shift some portion of their financial activities and portfolio
holdings abroad to avoid taxes on income from interest and dividends, controls are
viewed as limiting holdings of foreign assets or to gaining information on the scale of
residents’ external asset holdings so that these holdings can be taxed.
Opponents of capital controls argue that governments can impose measures such as high
reserve requirements that raise the demand for money and, hence, the inflation tax base.
But this is detrimental in the long run as it raises rates of interest and hence discourage
capital accumulation. Also, restricting foreign investment could slow market
development, domestic investment and growth. Controls often breed bribery and rent
seeking activities; this mentality could spill over to tax system and provide avenues for
expansion of underground economies23.
9.5 Insulation of Domestic Structural Reform Programs from Foreign Shocks
Proponents of capital controls argue that controls help in stabilization and structural
reform programs. An early opening of capital account can cause a real appreciation,
because of high interest rates typically associated with a stabilization plan and increased
real exchange rate volatility. These would make trade liberalization more problematic.
The credibility of the stabilization program plays a key role in determining the
consequences of free capital mobility. For e.g., if a stabilization program lacks
credibility, the liberalization of the capital account could lead to currency substitution and
capital flight, which could trigger a balance of payments crisis, devaluation and inflation.
If the plan is credible, the high interest rates associated with a stabilization program may
cause temporary large capital inflows. Sterilization of capital flows makes the interest
rates remain high, encouraging further inflows and hence imposing a quasi-fiscal cost on
the central bank. In the absence of sterilization, increase in money supply could
jeopardize control of inflation. If nominal exchange rate is allowed to appreciate, it may
deter trade reforms aiming at lower barriers to imports. Even if there was uncertainty
about the likely success of the reform program, a capital inflow could occur if residents
temporarily repatriate funds abroad to take advantage of the high real rates of interest.
Opponents of capital controls feel that there are advantages in liberalizing the capital
account simultaneously with domestic financial sector reforms. Capital account
liberalization will reinforce policies to liberalize domestic interest rates and the domestic
economy more generally and to help create a competitive and efficient financial system.
The increase in net private capital inflows, which tend to accompany the capital account
liberalization, will help to support balance of payments during the period of domestic
financial sector liberalization. In addition, capital controls reduce the credibility of
government promises that international investors will be able to repatriate their funds.
23
There is a huge body of literature (e.g. Calvo, Leiderman and Reinhart, 1995, and Johnston and Ryan,
1994) that provides support for the argument that controls breed corruption and that they are easy to get
around with, e.g. Tax on short term borrowing is effective only in the short run, as private sector quickly
finds ways to dodge those taxes through over- and under-invoicing of imports and exports and increasing
reliance on parallel financial and foreign exchange markets.
23
An open capital account, with a threat for capital outflows, and of short-term capital
flows in either direction, could have a disciplining effect, making the authorities careful
in their macroeconomic management.
9.6 Short-term Relief from Speculative Attacks
While proponents of capital controls argue that control program may help government
buy time to move the fundamentals to a region where self-fulfilling speculative attacks
are less likely, the opponents hold the view that the possibility that controls might be
introduced in the future can generate attacks where none would be observed otherwise.
9.7 Lowering Local Interest Rates
Proponents of capital controls argue that controls help reduce the local interest rates
without allowing capital outflows, so that investment could be encouraged. The
opponents feel that capital controls are perceived as an additional risk factor by the
investors. Hence, instead of reducing interest rates and limiting outflows, controls would
require higher risk premia, and so would lead to higher interest rates to compensate for
higher risk.
10. The Current Debate on Capital Account Liberalization
Some argue that controls have played an important role in virtually all systems of pegged
exchange rates since WW II24. The controls give authorities some autonomy to preserve
the peg, some space to organize orderly realignments and make it easier to ward off the
speculative attacks. Others argue that capital controls were always easy to evade and
never played an important role in limiting exchange rate flexibility25. Dooley (1995)
argues that controls have influenced yield differentials across countries, but there is no
evidence that controls have helped governments achieve policy objectives, such as
avoiding real appreciation, or that controls have enhanced welfare as the theory suggests.
In addition, Johnston and Ryan (1994) and Grilli and Milesti-Ferretti (1995) find
empirically that controls do not affect economic variables, like volume and composition
of private flows, changes in foreign reserves or level of exchange rate. In fact, controls
are associated with higher inflation and lower real interest rates.
Eichengreen et al (1996b) show that capital controls make a difference. Using data for 20
countries26 over the period 1962-92, they show that capital controls have been associated
with significant differences in the behavior of macroeconomic variables such as budget
deficits and money growth rates, but not in case of interest rates and foreign exchange
24
See Wyplosz (1986) and Giovannini (1989)
See Gros (1987), Gros and Thygesen (1992). However, Johnston and Ryan (1994) argue that they have
been effective in developed nations, vis-à-vis developing countries.
26
The countries included are: US, UK, Austria, Belgium, Denmark, France, Germany, Italy, the
Netherlands, Norway, Sweden, Switzerland, Canada, Japan, Finland, Greece, Ireland, Portugal, Spain,
Australia, South Africa, India and South Korea. However, their study is concentrated on EMU.
25
24
reserves. However, Vinals (1996) argues that this is an evidence of controls being
ineffective. In fact, Eichengreen, et al (1996b) find that periods when capital controls are
effective are associated with inflation and high trade deficits. This leads Vinals (1996) to
argue that capital controls help authorities follow expansionary polices. Since such
polices are associated with fundamental imbalances, capital controls eventually lead to
exchange market turbulence and to unavoidable devaluations. Hence, controls make
“self-fulfilling” attacks justified.
In short, Vinals (1996) believes that “capital controls do not seem to facilitate the defense
of exchange rate stability in the short-run but continue to undermine it in the medium
term through relaxation of policy discipline and coordination.”
Reinhart and Smith (1997) argue that capital controls of the 1990s are asymmetric (they
are imposed to discourage inflows) and are temporary. The temporariness is either preannounced or the market rightly perceives them to be temporary as they are countercyclical. Even if they are intended to be permanent, they end up being temporary as
investors find ways to circumvent the controls, making them ineffective. They study the
welfare consequences of taxes on capital inflows, and study the shock to the world
interest rate that generates a surge in capital inflows. They find that if countries let the
controls in effect for longer time period than the world interest rate is in effect, then it
becomes costly because it causes the domestic real interest rate to rise once the temporary
shock disappears, offsetting the benefits associated with smoothing the shock.
Stiglitz (1998) argues that increase in capital flows to developing countries increased the
vulnerability of these economies to crises. He suggests some necessary, but not sufficient,
conditions to deal with the capital flow problems. First, there should be more information
and greater disclosure, which would avoid triggering and exacerbation of crises. But the
caveat is that markets don’t fully incorporate all the information as the world is
dominated by private-to-private capital flows. Second, emerging markets could create
more robust financial markets, more transparent systems of corporate governance, and
less error-prone macroeconomic policy. But again, developing countries have less
capacity for financial regulation and greater vulnerability to shocks. Third, intervention in
case of short term flows, which bring no ancillary benefits, besides trade credits, in an
economy where saving rates are already high, but increase the vulnerability of an
economy.
Krugman (1998c) also suggests that temporary capital controls could bring a respite for
the suffering Asian countries27. However, Friedman (1998) thinks that this is the worst
possible choice, as the emerging countries need external capital (and the discipline and
knowledge that comes with it) to make the best use of their capacities. He suggests either
a currency board arrangement or a floating exchange rate. Under the former, a balance of
payments deficit automatically shows up in a decrease in high-powered money, and
hence the discipline of external transactions is maintained, which is not possible under a
pegged exchange rate system. Under the latter, changes in exchange rate absorb the
27
Krugman (1998d) became defensive about the capital controls when Prime Minister of Malaysia,
Mahathir, imposed controls in Malaysia shortly after his article emphasizing their importance.
25
pressures that would otherwise lead to a crisis in a pegged exchange rate while
maintaining domestic monetary independence. According to Friedman, the present crisis
is not a result of market failure, but that of governments intervening in or seeking to
supercede the market both internally via loans, subsidies or taxes and other handicaps,
and externally via the IMF, the World Bank and other international agencies.
While Rodrik (1998) advocates capital controls because governments otherwise have to
carry out policy based on “what 20 or 30 foreign exchange dealers in London, New York
and Frankfurt” think, Henderson (1998) is of the opinion that “foreign exchange markets
are a continuing, minute-by-minute election in which everyone with wealth at stake,
including residents of the country, gets to vote, an election in which the winners are those
countries whose governments have the most pro-growth policies”. In his opinion, capital
controls allow governments to hide the damage their policies do, which leads them to
even-more-damaging policies.
Rodrik (1998) and Bhagwati (1998b) argue that free trade is not the same thing as free
capital flows. Rodrik thinks that financial markets are different from goods and services
markets in that the former are prone to market failures arising from asymmetric
information, incompleteness of contingent markets and bounded rationality. In fact,
Bhagwati suggests that countries like India and China, which still haven’t shed their
controls on capital should not do that until they have attained political stability, sustained
prosperity and substantial macroeconomic expertise. They should instead concentrate on
internal reforms like privatization and external reforms like freer trade. They should
allow targeted convertibility for dividends, profits and invested capital for direct foreign
investment, as this brings in capital and skill and is more stable than short-term capital
flows.
Unlike Stiglitz and Krugman, Bhagwati feels that the free capital economies, which are
currently afflicted by panic-driven outflows, should not jump into capital controls. These
countries need to restore the confidence. Capital controls, such as in Malaysia, can help
lower interest rates to boost the economy, but if diffidence increases, who will borrow to
invest?
Like Rodrik, Bhagwati (1998a) feels that the pro-capital free movement has dominated
because of the self-interest of Wall Street financial firms, which see the free capital
mobility world as an arena to make money. “Wall Street has an exceptional clout with
Washington because of networking of like-minded luminaries among the powerful
institutions—Wall Street (Altman went from Wall Street to Treasury and bank), the
Treasury Department (Secretary Rubin is from Wall Street), the State Department, the
IMF and the World Bank (James Wolfensohn, President of the World Bank, was as
investment banker; Ernest Stern, managing director of J.P. Morgan, served as an acting
president of the World Bank) most prominent among them”.
26
11. Sequencing Capital Account Liberalization28
It is widely accepted that capital account liberalization benefits economic growth: by
improving the ability to tap savings globally at lower costs; enhancing the domestic
agents’ portfolio choices; improving resource allocation through increased competition
for financial resources; and increasing the availability of resources to support investment,
and to finance trade and other activities. Michel Camdessus, Managing Director of the
IMF, believes that “the trend towards capital account convertibility is “irreversible”, and
all countries have an important stake in seeing that the process takes place in an orderly
way.” Since the benefits from free capital markets are undeniable, then the costs and risks
need to be minimized. Stanley Fisher, IMF First Deputy Managing Director, feels that
there is a consensus that “liberalization without a necessary set of preconditions in place
may be extremely risky.” These preconditions are (IMF Survey 1998):
a sound macroeconomic policy framework; in particular, monetary and fiscal policies
that are consistent with the choice of exchange rate regime;
a strong domestic financial system, including improved supervision and prudential
regulations covering capital adequacy, lending standards, asset valuation, effective
loan recovery mechanisms, transparency, disclosure, and accountability standards,
and provisions ensuring that insolvent institutions are dealt with promptly;
a strong and autonomous central bank; and
timely, accurate and comprehensive data disclosure, including information on central
bank reserves and forward operations.
The optimal sequencing of capital account liberalization is complicated. Since all
countries are different—in their levels of economic and financial development, in their
existing institutional structures, in their legal systems and business practices, and in their
capacity to manage the liberalization process—there is no single rule for sequence of
steps to undertake in financial and capital account liberalization and no guideline for how
the process should take. There have been differing views, however, about the sequencing
issue. While some believe that capital account should be liberalized following the
liberalization of the current account and the domestic financial system, others hold the
opinion that there should be simultaneous liberalization of the current and capital
accounts. Liberalization of direct investment is seen as a significant part of the real sector
reforms, while liberalization of portfolio investment flows is coordinated with financial
sector reforms and the development of financial markets and instruments. However, there
are certain advantages in coordinating the liberalization in the financial sector and capital
accounts:
28
This section draws mainly from Johnston (1998), Johnston, et al (1997), IMF (1998), Johnston and Ryan
(1994).
27
The freedom of international capital flows reinforces the policies to liberalize
domestic interest rates and helps create a competitive and efficient domestic financial
system. The institutional reforms required could be mutually beneficial to both; e.g.,
creation of efficient money and foreign exchange markets.
Since capital account liberalization encourages the return of flight capital and
eliminates impediments to inflows of foreign investment, it could support the balance
of payments during periods of financial sector liberalization, when lifting of
domestic credit controls initially leads to rapid increase in bank credit than deposits,
increasing domestic resource pressures as banks run down holdings of excess
liquidity, and weaken the balance of payments.
Many developing and transition economies already have a de facto high degree of
currency convertibility, and openness of these economies means that even small
changes in the invoicing or timing of exports and imports can result in movements of
foreign exchange relative to GDP. Maintaining controls under these circumstances
results in pronounced balance of payments statistical discrepancies, which
complicate the interpretation of underlying economic trends, and obscures the
interrelationships between the domestic and external financial conditions.
Since the preconditions for capital account liberalization do not seem more onerous
than those for domestic financial liberalization, hence the two should take place
simultaneously. The direct controls on interest rates and credits need to be replaced
by indirect controls, as there is scope for avoidance of direct controls through capital
movements. Hence, the adoption of indirect monetary controls should either precede
or occur simultaneously with liberalization of capital account. In fact, these reforms
should take place early in domestic financial liberalization, as interest rates need to
be market determined, and opening of capital account may have little impact on
interest rate policy.
If the sequencing is not followed appropriately, then there are potential risks from
opening the capital account. Continued reliance on credit controls or high non-interest
bearing reserve requirements for monetary controls, and failure to address properly
inefficiencies in domestic financial markets resulting in wide spreads between deposit
and lending rates, may encourage borrowing abroad rather than domestically.
Inappropriate incentives for foreign borrowing may also be provided by the tax system,
leading to an overvalued exchange rate and excessive external debt burden.
Even if domestic financial and capital account liberalization do not proceed
simultaneously, one should clearly recognize that there is a danger of removing most
restrictions on capital account transactions before major problems have been addressed in
domestic financial system. The problems include: inadequate accounting, auditing and
disclosure practices in the financial and corporate sectors, which weaken market
discipline; implicit government guarantees, which encourage excessive, unsustainable
capital inflows; and inadequate prudential supervision and regulation of domestic
financial institutions and markets, which create scope for corruption, connected lending
28
and gambling for redemption. If these problems are severe, and still countries open their
capital accounts, they run the risk of a crisis. Hence, countries should work towards
removing these distortions, when they open their capital accounts. Reliance on temporary
selective controls is recommended as a part of the financial regulatory framework. Given
the destabilizing effects of short term flows, there may be a case for liberalizing longer
term flows, particularly, foreign direct investment, ahead of short term capital inflows.
Foreign direct investment has its own economic benefits, including transfer of technology
and of efficient business practices.
Hence, capital account liberalization is not an “all or nothing” affair. A comprehensive
liberalization of capital transactions and transfers does not mean an abandonment of all
rules and regulations connected to foreign exchange transactions. In fact, the individual
components of the capital account can be, and usually are, liberalized selectively. Certain
areas need to be regulated and strengthened:
1. Prudential regulations related to nonresidents and foreign exchange transactions and
transfers.
2. Measures designed to prevent tax evasion and money laundering
3. Reporting by market participants ensuring the timely and accurate compilation of
monetary, external debt and balance of payments data.
4. Strengthening the banking sector: Banks are the major intermediaries and channel for
capital flows in many developing countries. Their interest rates and credit policies
may influence the structure of domestic interest rates and financial markets, and
hence the composition of capital flows. For example, wide bank deposit/lending
spreads may promote foreign corporate borrowing; or the underpricing by banks of
credit and maturity transformation risks may distort the yield curve, and thus the
composition of flows. As a result, banking systems may not only be faced with
problems of insolvency and illiquidity, but the underpricing of credit and maturity
risks can hinder the development of longer term markets due to an underpricing of
longer term risks in the economy. Allowing weak banks to expand their balance
sheets will lead to banking crises. The reforms for weak banks should focus on capital
adequacy, loan loss provisioning, credit assessment, liquidity management, and
increasing foreign participation.
12. Measures to discourage capital inflows
Latin America and the Asian countries have been the biggest recipients of capital flows in
the 1990s. This does not mean that these countries had an open capital account. They all
had some kind of intervention at some point or the other. All the monetary authorities met
these inflows by intervening in the foreign exchange market. This would be evident from
the following table (table 1 from Calvo, Leiderman and Reinhart, 1995)
29
Year
Balance of Goods
Services, and
Private Transfers1/
$ billion
1985
1986
1987
1988
1989
1990
1991
1992
-5.5
-19.8
-11.8
-13.4
-10.2
-8.5
-20.5
-34.6
Balance on Capital
Account plus Net
Errors & Omissions2/
$ billion
Changes in
Reserves3/
$ billion
Latin America
6.5
13.2
15.0
5.7
12.7
23.6
38.9
53.4
-1.0
6.6
-3.2
7.7
-2.6
-15.1
-18.4
-18.8
Asia
1985
-18.7
22.7
-4.0
1986
-1.1
25.5
-24.4
1987
14.8
24.7
-39.5
1988
2.6
8.7
-11.3
1989
-8.1
17.1
-9.0
1990
-10.0
31.7
-21.7
1991
-10.2
48.9
-38.7
1992
-25.2
46.3
-21.1
1/ Data for Western Hemisphere and Asia from IMF’s World Economic Outlook
2/ A minus sign indicates a deficit in the pertinent account. Balance on goods, services and private transfers is equal to the current
account balance less official transfers. The latter are treated in this table as external financing and are included in the capital account.
3/ A minus sign indicates an increase.
This table clearly shows that in response to the capital flows, the monetary authorities
intervened in the foreign exchange markets to sterilize the inflows. This sterilization
process has been discusses below.
Notwithstanding the desire to have capital inflows into the country, they have been a
source of concern for most countries that have experienced huge inflows. They have
some destabilizing side effects, like appreciation of local currency may lead to a loss of
competitiveness for exports, hence giving rise to inflation; lack of proper intermediation
of capital flows could lead to resource misallocation; short-term “hot money” flows could
lead to reversal at short notice causing a financial crisis. The usual step taken by the
central banks to avoid currency appreciation and inflation is to “sterilize” the capital
inflows. To look at the sterilization process, let’s look at the balance sheet of the central
bank.
Assets
Domestic Credit (DC)
Foreign Currency (FC)
Liabilities
Monetary Base (MB)
In the event of capital inflows, there would be a high demand for domestic currency,
which would lead to appreciation of domestic currency and loss of competitiveness of
exports. To prevent this appreciation, the central bank buys foreign currency (FC),
increasing the monetary base (MB) in the economy. Higher money supply in the
economy would lead to higher inflation. To prevent this, the central bank wants to
sterilize these inflows by keeping the MB constant. This is done by decreasing the
domestic credit (DC) through the classical form of open market operation (OMO), i.e.,
selling treasury securities. But the problem is that this leads to an increase in rate of
30
interest, which leads to further increase in capital inflows29. Unfortunately, most
developing countries lack the tools to run this OMO or find it too costly, since the
financial system is not fully liberalized and issuing securities to mop up the inflowing
liquidity places a heavy debt-service burden on the government or central bank. The
central bank loses when it raises its funds by investing in foreign assets, which has lower
interest rates compared to what it has to pay on the bills that it sells. This could require
re-capitalization of the central bank. The risks increase when much of the capital inflows
are in the form of short-term portfolio investment, which is more likely to reverse in case
of change of sentiments compared to foreign direct investment.
The impact of freedom of capital movements on monetary and exchange rate policy can
be seen through the covered interest parity, which is the consequence of arbitrage
between short-term domestic and foreign interest rates, and the discount on the currency
in the forward exchange market. The covered interest parity is:
i d i f Fd
e f es
100 , id is the domestic interest, if the foreign interest rate of the
es
same maturity and Fd the forward discount for that maturity, es is the rate of exchange
(units of domestic currency in terms of foreign currency) in the spot exchange market,
and ef the forward exchange rate on the date of maturity of the interest rate contracts.
Hence, where the foreign interest rate and forward exchange rate are predetermined, a
country could determine the domestic interest rate or the spot exchange rate, but not both.
where Fd
With greater capital mobility, short-term interest rates will be determined by the covered
interest rate parity condition. If both interest rates and exchange rates are inconsistent
with this condition, then there would be incentives for significant short-term capital
flows. Hence, monetary and exchange policies are constrained to achieve different
macroeconomic targets, when the capital account is open. On the one hand, if monetary
policy targets inflation, then exchange rate is not free to be used as an expenditureswitching instrument to achieve current account balance objectives; fiscal policy could be
used to achieve savings/investment balance. On the other hand, if exchange rate is
targeted to achieve current account balance, or if exchange rate is fixed, monetary policy
would have little autonomy to achieve domestic stabilization objectives or to manage the
consequences of short-term capital inflows.
Hence countries turn to less conventional measures, like widening the exchange rate
bands, intervening in forward exchange markets, or imposing capital controls like
variable deposit requirements and interest equalization taxes on foreign borrowings.
Then, there are “belt-and-braces” strategy, where indirect monetary policy instruments
are combined with some capital controls, and “sand-in-the-wheel” policies, where
29
This assumes that capital is perfectly mobile and that domestic and foreign bonds are perfectly
substitutable. But OMO is often considered a temporary means of sterilization, which often fails in the
presence of persistent inflows.
31
controls have targeted short-term capital flows, which have often been perceived by
authorities as volatile and destabilizing.
Supplementary Sterilization Measures30: There are several measures that could be used
instead of the OMO to control the money supply. Each has its own advantage and
disadvantage, as discussed below.
Discount Policy and Directed Lending: This is used to increase the cost or restrict the
use of central bank credit. But this policy tool loses its flexibility when rediscounts
and loans granted by the central bank are often automatic tools for priority lending in
the developing nations. The rediscount ratio cannot be adjusted often, as it would be
counterproductive to the goal of providing cheap credit to targeted sectors. So for this
to be an effective tool, subsidies through the discount windows will need to be
eliminated. Even if that is not the case, still central bank would not like to change the
rediscount ratio as the elasticity of the demand for credit is low (i.e. demand for credit
would not fall in response to higher rates of interests)
The advantage of changes in discount rate over the OMO is that they would entail a
smaller fiscal cost, since discount rates are lower than the market rates. These
changes don’t impact the local money markets, since they are used as rediscount
facilities. This weak link between the discount rate and bank lending rate helps make
the sterilization process a success, as the market rates are not raised, which prevents
further inflows of capital.
Reserve Requirements: The other way of limiting the credit is through an increase in
the statutory reserve requirement, e.g., Columbia followed in 1991.These reserves are
either remunerated (where the central bank pays interest on the deposits) or nonremunerated (where commercial banks don’t get any return). If the interest paid is
close to the market rates, then the cost is similar to open market sales of interestbearing instruments.
However, this tool has its own limitations. Sometimes banks already hold excess
reserves. Then, in the presence of weak banks (which are plenty in developing
countries), it would be difficult to implement. Some countries find it hard to raise it
further, as it could be already at a high level (in response to sterilizing the flows
previously as in Korea and Columbia). Frequent changes could disrupt the efficient
management of bank portfolios and send a wrong signal about the banking system.
They are considered a tax on banks, and hence could lead to disintermediation
(financial activity going outside of the banking sector), which could weaken the
control of central bank.
Government Deposits: The public sector deposits could be shifted from commercial
banks to the central bank, especially when they form a large part of banks’ deposits as
in Malaysia and Thailand. As long as the interest paid on government’s deposits is
30
This section draws from Lee (1997)
32
lower at the central bank, this measure has an advantage of not imposing fiscal or
quasi-fiscal costs31.
This tool has a disadvantage though, similar to changes in reserve requirement. If
these transfers are frequent, then it would be difficult for banks to manage their
portfolios efficiently. This tool is limited by the availability of government deposits,
as the government deposits may be held at the central bank by law or some types of
public sector deposits may not be within the government’s control.
Foreign Exchange Swaps: In the foreign exchange swap, the central bank agrees to
sell the foreign exchange against the domestic currency and simultaneously agrees to
buy it back at a specified date in the future, using forward exchange rate. Banks that
buy the foreign currency could lend it to domestic residents or invest abroad, but the
domestic monetary base gets reduced. It gives the banks an incentive to “export” the
funds, hence leading to capital outflow to offset the inflow. This is done by pricing
the swap in such a way that the difference between the spot and the forward rate is
bigger than the interest rate differential between foreign and domestic markets.
The advantage of using swaps over the OMO is that they are highly flexible, and can
be varied in length reflecting expectations about duration of capital inflows and the
time period for which they need to be offset. Although swaps have a short maturity
period, but they could be “rolled over” easily. Unlike the OMO, which require shortterm government securities, they can be executed with out them, which is helpful in
case of countries not running budget deficits.
The swaps have their downside too. They can cause losses for the central bank when
it gives favorable margins on interest rate differentials. The effect could be nullified if
the foreign exchange sold by central bank is sold back against the local currency. This
could become popular with commercial banks, but could be avoided if monitoring
and supervision is strengthened, or there are restrictions on how banks can trade the
swap proceeds.
Wider Exchange Rate Bands: Widening exchange rate bands in response to capital
inflows allows the exchange rate to appreciate, and import prices to fall. Hence, there
is a downward pressure on inflation, which reduces the need to sterilize all the capital
inflows. This band also increases the risk of devaluation and help reduce the inflow.
A wider band gives central bank some flexibility for intervention, especially when
there is a reverse in market sentiments.
On the downside, a wider exchange rate band could wrongly signal that the central
bank wants to devalue the currency to make exports competitive instead of
controlling inflation. Also, if wide changes in exchange rate are well anticipated, then
they could provoke large inflows and outflows of capital.
31
When the central bank sterilizes, it issues high yielding government securities and acquires low yielding
international reserves (e.g. U.S. Treasury Bills). This operation imposes a cost, which is often termed as
quasi-fiscal cost.
33
Intervention in Forward Exchange Market: The central banks could give the domestic
investors the opportunity to “hedge” the value of their foreign investments by locking
in a forward exchange rate through a forward exchange facility. This could
encourage capital outflows. But this may be difficult to use in the absence of a welldeveloped forward markets.
However, this could be risky and might entail fiscal costs if the central bank incurs
financial losses. The central banks have to be careful in not offering excessively
favorable premiums above the existing interest differentials.
This tool could be made more effective by encouraging private sector’s demand for
forward transactions, enhancing the liquidity and efficiency of the forward market.
This was done in Korea by relaxing the documentation criteria for eligibility to make
forward transactions.
Easing Restrictions of Capital Outflows: The restrictions on capital outflows could
be eased by easing surrender requirement on foreign exchange earnings, allowing
local institutions to make investments abroad, or letting non domestic entities to issue
local currency bonds in the domestic market. These measures would work if the
restrictions had been effective to begin with. This could increase the overall
efficiency of the investments made by local institutions, who diversify their
portfolios internationally. Exporters can manage their foreign assets efficiently by
being able to retain their foreign earnings. The local financial market would be
developed if international organizations issue bonds. Remittance of profits and
income is simplified, which is a positive signal, meaning that capital can be moved in
and out easily, thereby lowering the risk premium on financial assets.
However, easing of capital outflows in practice has encouraged inflows as it
increases the confidence in the exchange system.
Variable Deposit Requirements: This measure requires that a certain percentage of
foreign currency borrowed by the domestic residents has to be kept with the central
bank in interest free, non assignable deposits for a fixed period. This is like a tax on
foreign borrowing. It is like the non-remunerated requirement, but it is paid in foreign
currency. It does not affect the rate of interest like the OMO, hence does not lead to
further inflows.
The advantage is that it penalizes the short-term borrowings more severely, which are
mostly perceived as destabilizing. The requirement could be higher on short-term
borrowings, hence targeting the “hot money inflows” that are seeking short-term
gains. Since the deposits are non-remunerated, hence there is no fiscal cost involved.
This measure has its own disadvantages. Borrowers find ways to circumvent these
controls. There is resource misallocation. Borrowers can’t take advantage of lower
interest rates in international markets, because the deposit requirement is like a cost,
34
and hence firms engaged in international trade are penalized. It not only hurts
“speculative” investment, but also “genuine” investment.
Interest Equalization Taxes: Unlike variable deposit requirements, this measure could
have a direct impact on both inflows and outflows of capital. This is used to level the
yields between foreign and domestic securities, discouraging domestic investors to
buy foreign assets. Hence, it is tax on capital outflows. But, if it is imposed on capital
inflows, then it could be referred to as “capital import tax”. It decreases the return on
local assets for the foreign investors, while increases the cost of borrowing for
domestic companies.
Its biggest advantage is that it can influence the exchange rate without changing
interest rates or intervention in the currency markets. There is a debate about what the
tax should be, i.e. should it be higher for short-term transactions than for long-term
transfers, or whether public debts should be exempt. This measure has been used by a
lot of countries, including the U.S.. However, it should only be used as a temporary
measure, otherwise investors find ways to circumvent it.
The disadvantages are that it raises administrative costs of implementation, raises cost
of capital and has the tendency to distort allocation of resources.
Causes and Policy Responses to Capital Inflows32: The threat of overheating in the wake
of large capital inflows leads the policymakers to make difficult decisions on the
magnitude, sequencing and timing of policy actions. These decisions need to be tailored
to recipient country’s economic objectives, exchange rate regime, institutional
constraints, and, especially, the causes and composition of the inflows. Since it is difficult
to distinguish between temporary and sustainable inflows, judgements must be based on
limited information.
There are three categories of causes of capital inflows:
1. autonomous increase in the domestic money demand function
2. increases in the domestic productivity of capital
3. external factors, such as falling international interest rates.
The first two domestic factors are referred to as “pull” factors and the third as “push”
factors. The economic impact and the policy response to capital inflows depend on the
forces driving them, as well as the recipient country’s exchange rate regime. Under a
fully flexible exchange rate, capital inflows (irrespective of the driving force) would lead
to appreciation of currency, a drop in the relative price of imported goods, and a shift in
consumption away from nontradables—all of which tend to alleviate inflationary
pressures. Ceteris paribus, the more flexible the exchange rate, the less likely it is that
capital inflows would lead to inflationary pressures. However, under a managed float or a
fixed exchange rate, the cause of capital inflows determines whether or not there would
be inflationary pressure. If the inflows have been due to increase in money demand
function, then they will not be inflationary. But if they increase due to other reasons, then
32
This sub-section draws from Haque, Mathieson and Sharma (1997)
35
foreign reserves will accumulate, which, in the absence of sterilization, would expand the
monetary base, increase inflationary pressures and deteriorate external position.
The policymakers could get a rough idea for the cause of inflows from the financial
indicators listed in the table below (table 1 from Haque, Mathieson & Sharma, 1997)
How financial indicators could shed light on capital inflows
External factors;e.g.
falling international
interest rates
(temporary inflows)
Indicator
Asset Prices
Interest rates
Yield Curve
Exchange rate
Equity prices
Real estate prices
Upward shift of money
Demand curve
Increase in productivity
of domestic capital
(sustained inflows)
Increase
Flattens
Appreciates
Decrease
Decrease
Increase
?
Appreciates
Increase
Increase
Decrease
Becomes steeper
Appreciates
Increase
Increase
Inflation
Decreases
Increases
Increases
Likely to decrease
Increases
Increase
Increases
?
Increase
Increases
Increase
Likely to increase
May decrease
Increases
Increases, in both
short and long term flows
?
Increases, especially
in short term flows
Monetary and credit aggregates
Real money balances
Increase
Base money
Increases
International reserves
Increase
Bank credit
Likely to increase
Foreign currency deposits
Decrease
Balance of payments
FDI
Portfolio investment
?
Increases, especially in
Short term flows
? indicates that the effect is uncertain.
The appropriate policy responses depend on the causes of inflows, as well as degree of
flexibility allowed by the domestic institutional structure and the existing policy stance. It
is easier to deal with disruptions caused by the inflows when countries follow relatively
balanced macroeconomic policies. The upward pressure on exchange rate can be party
offset by accelerating the pace of trade and exchange liberalization, including easing
controls on capital outflows. There are three other ways of dealing with the possible
effects of large capital inflows: sterilized intervention, fiscal tightening and exchange rate
appreciation. The optimal mix of instruments depends on the country’s institutional
structure and past policies. For e.g. non-availability of suitable instruments or insufficient
development of financial markets could limit sterilized intervention. Fiscal policy is
unwieldy for short-term demand management because of the associated formulation and
implementation lags. Temporary capital controls could be another way to deal with huge
capital inflows.
The appropriate use of each instrument for countries with balanced macroeconomic
policies is shown in the table below (table 2 in Haque, Mathieson & Sharma, 1997).
36
Instruments for managing capital inflows
A matrix for countries with balanced macroeconomic policies
Upward shift of domestic
Money demand curve
Increase in productivity
of domestic capital
(sustained flows)
External factors-e.g. falling
international interest rates
(temporary inflows)
Sterilization
May be needed to smooth
Fluctuations.
May be needed to smooth
Fluctuations
Is appropriate
Exchange rate
Appreciation
Equilibrium real effective
exchange rate does not change
The warranted appreciation
of the equilibrium real effective
exchange rate can be achieved
partly through nominal
appreciation and partly though
increases in the prices of nontraded goods.
Equilibrium real exchange rate
need not change. Temporary
nominal appreciation of the
exchange rate may be warranted
if there are constraints on
sterilization.
Fiscal policy
No policy response is required
Fiscal policy tightening is
required, especially if the
absorptive capacity of the
economy is limited relative to
the size of the inflows.
If the constraints on sterilization
are too severe and the external
competitive position is weak,
then some fiscal tightening may
have to be considered.
When inflows are induced by increase in money demand function (say, due to financial
deregulation), no policy response is required, as expansion of monetary base will not be
inflationary. However, sterilization may be required to smooth fluctuations in exchange
rate and interest rates. Measures might be needed to restrict bank intermediation because
increase in money balances is likely to expand bank credit, which could lead to excessive
risky lending if the banking system is weak and poorly supervised.
If there is a sustained increase in inflows, say, due to increased productivity of domestic
capital, then appreciation of the equilibrium real effective exchange rate (REER) should
be achieved through adjustments in goods, factor and asset prices. Over the medium run,
a tight fiscal policy may be needed to control increases in domestic absorption, to prevent
an excessive appreciation of the REER and to contain the external deficit.
Sterilization is the most recommended response to temporary inflows, say, due to falling
international interest rates. However, the ability to sterilize inflows is likely to be limited
and short lived if the substitutability between domestic and international assets is high or
exchange rate is pegged. Fiscal adjustment is not recommended unless sterilization is
severely constrained, as it involves frequent changes in tax and government spending
structure, which could lead to additional adjustment costs.
In countries with unbalanced financial policies, short term inflows are likely to be
influenced by domestic interest rates and expected changes in exchange rate movements,
due to loose fiscal and tight monetary polices. Hence, appropriate mix of fiscal and
monetary policies is the best response. But reducing interest rates to decrease speculative
inflows could stimulate domestic demand and lead to overheating.
13. Empirical evidence
37
Empirical work links capital account liberalization and performance of macroeconomic
variables. However, the work has been limited by the absence of a clear measure of the
degree of liberalization and the intensity of controls. The usual measure is to construct a
dummy variable from the IMF’s Annual Report on Exchange Arrangements and
Exchange Restrictions. However, this variable doesn’t measure the intensity of controls,
and captures restrictions on capital outflows (since it refers to resident-owned funds
only). To account for intensity, some studies have used information on multiple currency
practices and/or surrender of export proceeds to form a single index. Then others have
used country-by-country descriptions of foreign exchange restrictions. Still others, who
use high frequency data, have used onshore-offshore interest differentials, the size of the
black market premium and deviations from covered interest rate parity to infer the
effectiveness and intensity of controls.
Using a dummy variable for controls from Annual Report on Exchange Arrangements
and Exchange Restrictions for OECD countries, Epstein and Schor (1992) find that
countries with strong left-wing parties and non-independent central banks tend to impose
restrictions on capital account transactions. Grilli and Milesi-Ferretti (1995) use a panel
of 61 countries and three different measures of controls (restrictions on payments of
capital transactions, multiple currency practices, and restrictions on payments for current
transactions). They find that countries with low per capita income, a large government,
fixed or managed exchange rate, unbalanced current accounts and a central bank with
limited independence are more likely to impose capital controls.33 Using the onshoreoffshore interest differentials for 11 OECD countries, Lemman and Eijffinger (1996)
show that controls are positively related to domestic inflation, degree of political stability
and the level of investment (as controls keep domestic rates of interest low, boosting
domestic investment).
Using data for 20 countries34 over the period 1962-92, Eichengreen, et al (1996b) show
that capital controls have been associated with significant differences in the behavior of
macroeconomic variables such as budget deficits, trade deficits and money growth rates,
but not in case of interest rates and foreign exchange reserves. These differences are more
noticeable for the observations from tranquil periods.
Johnston and Ryan (1994) study the impact of controls on capital movements on the
private capital accounts of countries’ balance of payments using data from 52 countries
for the period 1985-92. They find that exchange controls significantly alter the structure
of industrial countries’ capital accounts, especially by restricting outflows of recorded
direct and portfolio investment. However, for developing countries, capital controls do
33
Similar results are found by Alesina and Milesi-Ferretti (1995) and Quinn and Inclan (1997), where the
former use a broader measure of restrictions, including multiple exchange rates, surrender of export
proceeds and current account restrictions, and the latter construct measures of financial openness that
combine proxies for current and capital account restrictions.
34
The countries included are: US, UK, Austria, Belgium, Denmark, France, Germany, Italy, the
Netherlands, Norway, Sweden, Switzerland, Canada, Japan, Finland, Greece, Ireland, Portugal, Spain,
Australia, South Africa, India and South Korea. However, their study is concentrated on EMU.
38
not effectively prevent the outflows, and misinvoicing35 may be used to circumvent the
exchange controls.
Bartolini and Drazen (1997) construct an index of capital controls similar to Epstein and
Schor (1992) and Grilli and Milesi-Ferretti (1995) for 74 developing countries from 1970
to 1994. The policies of free capital mobility signal governments’ future policies. They
find that the industrial countries’ rates of interest are the main determinants of developing
countries’ liberalization decisions. When world interest rates are low, emerging markets
experience an inflow and engage in a widespread policy of free capital mobility; when
interest rates are high, only sufficiently committed countries allow free capital mobility,
whereas others impose controls to trap capital onshore, thus signaling future policies
affecting capital mobility.
Grilli and Milesi-Ferretti (1995) find that capital controls are associated with higher
inflation and lower real interest rates, while there is no correlation between controls and
economic growth. In a sample of 23 countries over a period 1975-89 and after controlling
for initial per capita GDP, initial secondary enrollment rate, an index of quality of
governmental institutions and regional dummies for East Asia, Latin America and subSaharan Africa, Rodrik (1998) finds that capital account liberalization does not lead to
higher per capita GDP growth, higher investment as a share of GDP or lower inflation.
Quinn (1997) constructs an index of financial and capital account openness for 64
countries to capture the intensity of controls. Controlling for initial income, education and
political instability, he finds a positive correlation between capital account liberalization
and economic growth. Tamarisa (1998) finds that for 1996, capital controls have acted as
a deterrent to trade in developing and transition economies.
Dooley (1996) reviews theoretical and empirical work on controls over international
capital movements. The empirical literature suggests that controls have been “effective”
in the narrow sense of influencing yield differentials. There is little evidence that controls
have helped the governments meet policy objectives, except reducing governments’ debtservice costs, and controls don’t even enhance economic welfare.
Mathieson and Rojas-Suarez (1992) test the relationship between programs to control
capital flight and other fundamental determinants of capital flight. They find that, during
episodes of capital outflows in response to increased risk from inflation and default risk,
countries with capital controls did not prevent capital flight; at the same time, the private
sector’s reaction to a deterioration of the fundamentals was delayed.
Cardoso and Goldfjan (1998) study the case of Brazil, by accounting for the endogeniety
of capital controls by considering a government that sets controls in response to capital
flows. They find that the government reacts strongly to capital flows by increasing
35
Misinvoicing of trade transactions measures the extent to which the imports and exports recorded in the
balance of payments misrepresent the value of goods shipped. Such mis-invoicing can be an important
channel for the circumvention of controls on capital movements; e.g., a company seeking to export capital
outside the exchange control regulations might over-invoice its imports and under-invoice its exports.
39
controls on inflows during booms and relaxing them during times of distress. They also
find that controls temporarily alter levels and composition of capital flows, but have no
sustained effects in the long run.
14. Conclusion
In this paper, we survey some of the more important issues related to currency crises and
capital control. It is hoped that this paper will help the reader get a good idea of the
features of various financial crises.
The literature on currency crises and capital control, however, is huge, and this survey is
not meant to be exhaustive. There are some issues not covered here because of space
constraint, and more issues are constantly arising. The survey is to provide a snap shot of
what is currently available.
40
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