CEPR Paper: Capital Controls Can Help Governments Pursue More Stable, Higher Growth

In response to the
International Monetary Fund's (IMF's) recent recognition of the
positive potential for capital controls, the Center for Economic and
Policy Research released a paper
today that indicates that capital controls can play an important role
in developing countries by helping to insulate them from some of the
harmful effects of volatile and short-term capital flows.

"Many developing countries have suffered serious contagion effects from
the reversal of capital flows in the wake of the recent world economic
downturn," said Mark
Weisbrot, Co-Director of The Center for Economic and Policy
Research. "It is clear that capital controls can play a part in
reducing some of this harm."

In a February
paper [PDF], the IMF concluded that "there may be circumstances in
which capital controls are a legitimate component of the policy
response to surges in capital inflows." The Fund's Global
Financial Stability Report [PDF] released last week was less
sanguine about capital controls, but the net result is that the IMF
appears more open to supporting capital controls than in the past.

The CEPR
paper, "Capital Controls and Monetary Policy in Developing
Countries," written by CEPR economist Jose Antonio Cordero and Juan
Antonio Montecino, looks at both the theoretical and empirical
literature on capital controls.

Short-term capital flows may be very volatile; they react quickly to
sudden changes in investors' moods, external events, and to perceptions
of governments' macroeconomic policy decisions. In 2007 net debt flows
to the developing world were more than 6.5 times as large as they were
in 2003; yet, in 2008 these flows were at less than half their 2007
level. Short-term debt flows, which almost quadrupled between 2003 and
2007, turned negative in 2008.

A surge of capital inflows, especially short-term and/or speculative
inflows, can cause the domestic currency to appreciate. This can reduce
competitiveness in the country's tradable goods sector, slow economic
growth, and harm economic development by increasing the volatility and
hence uncertainty of international prices.

Capital flows can also cause enormous damage when they are reversed,
with large capital outflows leading to a financial crisis. This was a
major cause of the Asian financial crisis of 1997-1999, and also harmed
many countries in 2008-2009.

The paper concludes that capital controls can provide an alternative to
an inflation-targeting with floating exchange rate regime, or a "hard
peg" fixed exchange rate regime (which has been shown to have other
severe disadvantages, as in Argentina, Brazil, and Russia in the
1990s). With capital controls, it may be possible for the government to
maintain a more stable and competitive exchange rate while keeping
inflation in check.

The authors look at controls on capital inflows in Malaysia
(1989-1995), Colombia (1993-1998), Chile (1989-1998), and Brazil
(1992-1998). They also consider the case of Malaysia's controls on
outflows in 1998-2001.

They conclude that there is sufficient backing in both economic theory
and empirical evidence to consider more widespread adoption of capital
controls in order to address some of the macroeconomic problems
associated with short-term capital flows, to enable certain development
strategies, and to allow policy makers more flexibility with regard to
crucial monetary and exchange rate policies.