NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Do Controls On Capital Inflows Work?

"The increase in the domestic cost of capital associated with higher interest rates is an important cost of these capital controls."

To prevent currency crises such as those that have rocked Asia, Russia, and Brazil, an increasing number of analysts, including experts at the World Bank and International Monetary Fund, have spoken out in favor of restricting capital mobility in emerging markets. In Controls on Capital Inflow: Do They Work? (NBER Working Paper 7645), Jose De Gregorio, Sebastian Edwards, and Rodrigo Valdes examine the efficacy of such controls. They focus their study on Chile, which maintained policies aimed at restricting capital mobility during most of the 1990s and which many analysts point to as the model for other emerging economies.

Between 1987 and 1997 Chile's gross domestic product grew in excess of 7.5 percent, inflation was reduced, and the real exchange rate for the peso appreciated on average between 4 and 5 percent. High domestic interest rates, however, attracted foreign funds that put pressure on money creation. In an environment of appreciating real exchange rates and a loss of monetary control, the Chilean authorities in 1991 introduced controls on capital inflow. These controls took the form of unremunerated reserve requirements (URR), essentially a tax or forced loan to Chile's Central Bank.

This meant that anyone borrowing money from abroad had to deposit a percentage of the loan in the bank in a non-interest bearing account. At first the deposits were fixed for 90 days, then for a full year. Over the decade the percentage of the loans was adjusted as high as 30 percent before it was reduced and eventually phased out. Other measures to control capital inflows were also attempted, but in their study De Gregorio, Edwards, and Valdes restrict themselves to the impact of the URR.

In the course of their analysis the authors employ a variety of methods, and also consider the interest rate-equivalent cost of the URR for both short-and long-run investment, the currency in which the loans are denominated, and the impact of loopholes that periodically required adjustment of the URR policy. Bearing in mind that one of the main objectives of the URR was the reduction of the volume of capital coming into the country, the authors initially conclude from their analysis that the Chilean measures had an important effect on short-term capital inflows, but a much less significant effect on long-term capital inflows. Considering short-and long-term capital inflows together, the authors maintain that the URR had a significant impact on the composition of capital inflows, without affecting overall volume.

The authors then turn to other objectives of the URR, namely independent control of interest rates and of real exchange rates. By examining the data, De Gregorio, Edwards, and Valdes conclude that the URR policy did result in a temporary if rather small increase in real (indexed) interest rates. This in turn had two consequences: the URR allowed the monetary authorities, at least in the short term, to target interest rates without generating a vicious circle of higher rates, increased inflows, sterilization, even higher rates, and even larger inflows. However, as a result of the URR, there was an increase in the cost of capital in the country.

Maintaining a stable real exchange rate was central to Chile's imposition of the URR, especially since the rate began appreciating substantially in the early 1990s. A reduction in the volume of capital inflows was expected to prevent further appreciation. The authors declare their analysis of the data in this regard is inconclusive. Their study indicates a slight and temporary depreciation in the real exchange rate, but an earlier study they conducted indicated a small appreciation in the rate. More conclusive results, they say, will have to wait for longer time series, although they note that it is unknown at this time if Chile will reimpose capital controls.

Finally, the authors stress that the increase in the domestic cost of capital associated with higher interest rates is an important cost of the URR. Why, they ask, must firms borrow with a tax if the world is willing to lend cheaper? Additionally, since the URR penalizes more short-term credit, the yield curve tends to be inverted. Small firms, which cannot issue long-term bonds in international capital markets, have to borrow at interest rates higher than similar firms can do in other countries. This constitutes a bias, the authors say, against firms that cannot borrow long, which usually means small businesses or start-up operations.

-- Matt Nesvisky


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