Aurora Borealis
1 January 2015 CFA Institute Journal Review

Capital Controls in the 21st Century (Digest Summary)

  1. Paul Lebo

The authors examine the recent studies that illustrate that capital controls can be strategically used on a short-term basis as an instrument of macroeconomic and macroprudential management. They find that capital controls, according to multiple empirical studies, are highly durable. Loosening and tightening capital controls as a short-term policy measure can be challenging because it is based primarily on theory rather than experience.

What’s Inside?

The authors examine recent academic findings that suggest that capital controls can be used on a temporary basis as a second-best alternative to solving macroeconomic issues. Using empirical research, they reject the academic findings, noting that there are very few historical examples when capital controls have been used on a temporary basis. In fact, they are typically sticky instruments of economic policy that persist for decades. The authors conclude with a discussion on the signals that countries may send to markets and other countries when they adjust capital controls.

How Is This Research Useful to Practitioners?

In recent publications, academics have shown a growing receptivity to the use of capital controls. Such academics have studied three areas in which capital controls can be used to temporarily combat a range of economic and financial challenges. In many of these cases, monetary policy, fiscal policy, and other regulatory action would be the preferred tool to resolve the problem, but when they are unavailable, capital controls may be used as the next-best alternative.

Some of the recent literature cites the attractiveness of using capital controls to influence the international terms of trade. Specifically, capital controls can be used to alter domestic purchasing power to either favor the domestic consumer via stronger terms of trade or favor the domestic exporter via weaker terms of trade. Other literature suggests that capital controls can be used to support financial stability. For example, when capital inflows are creating financial risks, a country can tighten the capital controls. Brazil, Indonesia, Thailand, and South Korea are examples of countries that have successfully adjusted the intensity of their capital controls. They are exceptions rather than the rule. These developing countries have fully established systems for the implementation of their capital control adjustments.

The authors cite numerous examples and provide compelling evidence to suggest that capital controls are not used on a temporary basis but instead are sticky economic instruments that last for decades. Evidence indicates that capital controls are loosened or removed as financial and political systems become more deeply developed.

How Did the Authors Conduct This Research?

Using the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions for 169 countries and territories, the authors illustrate the duration of different types of capital controls. They break down the different types of capital controls into histograms for the period of 1996–2012 and demonstrate two extremes. First, from this sample, 21 countries had no capital market security controls during this time period. Second, for those countries that did have these types of capital controls during 1996–2012, 98 countries had the controls in place for the entire period. The authors provide similar empirical evidence with regard to other measures of controlling capital.

They demonstrate that capital controls have been persistent over time regardless of such macroeconomic factors as exchange rates, inflation, GDP growth, and the financial crisis.

Abstractor’s Viewpoint

The authors provide a lengthy review of the arguments for and against capital controls. The numerous figures all point to the same conclusion, providing comprehensive support for the authors’ argument.

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