The Multiple Effects of Capital Controls
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Zehri, Chokri Article The Multiple Effects of Capital Controls Comparative Economic Research. Central and Eastern Europe Provided in Cooperation with: Institute of Economics, University of Łódź Suggested Citation: Zehri, Chokri (2020) : The Multiple Effects of Capital Controls, Comparative Economic Research. Central and Eastern Europe, ISSN 2082-6737, Łodz University Press, Łodz, Vol. 23, Iss. 4, pp. 169-185, https://doi.org/10.18778/1508-2008.23.33 This Version is available at: https://hdl.handle.net/10419/259254 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may be saved and copied for your personal and scholarly purposes. You are not to copy documents for public or commercial purposes, to exhibit the documents publicly, to make them publicly available on the internet, or to distribute or otherwise use the documents in public. If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by-nc-nd/4.0
Comparative Economic Research. Central and Eastern Europe Volume 23, Number 4, 2020 http://dx.doi.org/10.18778/1508-2008.23.33 Chokri Zehri The Multiple Effects of Capital Controls Chokri Zehri Assistant professor of economics, Prince Sattam Bin Abdulaziz University, College of Sciences and Humanities in Al-Sulail, Department of Business Administration, Al-Sulail, Saudi Arabia, e-mail: [email protected] Abstract Capital controls are seen as a means to promote financial stability or improve macro‑ economic adjustment in economies with nominal rigidities and suboptimal monetary policy. Such controls may take various forms, including explicit or implicit taxation of cross‑border financial flows and dual or multiple exchange rate systems. Using a quarter dataset on capital controls actions in 27 emerging economies from 2010 to 2018, the study analyzes the effectiveness of capital controls (CCs) along different angles. Since the 2008 financial crisis, strengthening capital controls has allowed more monetary policy autonomy and exchange rate stability, verifying the Mundell‑Flem‑ ing trilemma model. Following CCs, the results show that accumulating international reserves may compensate for the loss of inflows and lead to more effective policies. Tighter CCs on inflows cause significant spillovers, specifically in the conditions of li‑ quidity abundance. These spillovers originate from the problem of policy coordination of emerging economies and are mainly caused by capital controls being used as an instrument to manage capital flows. For governments that have to manage the risks associated with inflow surges or disruptive outflows, capital controls need to play a key role. Keywords: capital, controls, flows, impacts JEL: F21, F32, F41, F42 Introduction Itis important tounderstand international capital flows toenhance macroeconom‑ ic stability and design effective economic policies. Effective capital controls (CCs) re‑ duce the volume ofcapital flows, alter the composition from short‑term tolong‑term capital flows, make exchange rates more stable, and allow monetary policy autonomy
170 Chokri Zehri (Magud etal.2018, p.114). Previous studies highlighted various problems concerning CCs, but itis unclear whether these controls achieve their objective ornot (Korinek 2011, p.76; Bianchi and Mendoza 2011, p.45; Benigno etal.2013, p.73). The identified problems include the absence ofatheoretical framework todefine the macroeconomic consequences ofthese controls, the heterogeneity between countries that apply CCs, and the success ofthese restrictions. Several studies have also identified the difficulties that occur due toisolating the direct effect ofCCs, which limits the success ofcapital flows and their objectives (Fernandez etal.2015, p.82; Forbes etal.2015, p.32; Alfa‑ ro etal.2017, p.112). CCs are used incountries all around the globe, but their effectiveness isstill not clear. Itcomplicates the development ofastandard ofbest practices toaccomplish the influential regulation ofinternational capital flows due tothe specific character‑ istics ofeconomies and different market responses (Forbes etal.2015, p.41). There are two aspects ofstudying the effectiveness ofCCs: (a) actions oncapital control and (b)achieving macroeconomic objectives (autonomy ofmonetary policy, reduction ofexchange rate pressures, etc.). The present study discusses the impact ofcontrols onemerging markets. After the Great Recession of2008, several economies used restrictions, especially onshort term capital inflows, while others increased restrictions (Fernandez etal.2015, p.61). This study isassociated with the studies ofmonetary policy and exchange policy ininflu‑ encing the nature ofthe financial crisis. Recently, monetary policy has been restricted bythe global financial cycle under aflexible exchange rate regime when capital flow management ispreferable tomaintain monetary autonomy, and there isfree capital mobility (Rey 2015, p.83; Passari and Rey 2015, p.22). Optimal CCs and monetary pol‑ icy were explored with small, open countries, considering risk premium shocks (Farhi and Werning 2014, p.15). Those studies reported that CCs retain monetary autonomy inafixed exchange rate and work astrade manipulation inaflexible exchange rate regime. Exchange rate policies are beneficial tolower the severity ofafinancial crisis beyond CCs (Benigno etal.2016, p.31; Chamon and Garcia 2016, p.152). Likewise, Devereux, Young, and Yu(2017) showed that CCs can beconsidered state‑improving tools when optimally merged with monetary policy inthe presence ofpolicy commit‑ ment. Many older studies onCCs focused onthe incompatibility triangle, soCCs were usually related tothe hope ofkeeping adegree ofautonomy ofthe monetary policy while applying fixed exchange regimes. Inthe last several years, some emerging econ‑ omies (EEs) have tended touse amore flexible exchange rate. The fear offloating will cause these countries tointervene massively onthe exchange markets orto vary their director rate toprevent huge fluctuations inthe exchange rate. Wecontribute toprevious empirical studies intwo ways. First, weuse arecent, large dataset oncapital control acts, which allow usto more exactly detect the policy whose efficiency isevaluated. Most ofthe previous studies onthe effectiveness ofCCs used infrequent data, usually annual.Capital control measures thus used are less precise, and they suffer from two essential shortcomings: they donot reflect the fair intensi‑
171 The Multiple Effects of Capital Controls ty oftheir application among countries, and they are often confused with other pol‑ icies simultaneously applied with CCs. The use ofquarterly data inthis study allows for alarger time interval and allows for amore correct analysis ofthe actions taken bypolicymakers. Second, the effectiveness ofCCs isexamined using amodel that regroups the com‑ ponents ofthe monetary policy trilemma, which indicates that itis difficult touse afixed exchange rate, together with anindependent monetary policy and anopen capital account. These components are usually studied independently. Amajor con‑ tribution ofthe paper isto regroup the three elements ofthe incompatibility triangle into one model. The incompatibility triangle framework also shows that the dejure and defacto changes inthe opening ofacapital account are related (Rebucci and Ma2019, p.35). This ishow wecan examine whether the applied controls are effective from this incompatibility triangle. Thus, using apanel VAR model, wetest whether capital markets affect both monetary policy autonomy and changes inthe exchange rate. Aspresented inseveral studies, CCs are endogenous, which highlights the re‑ current changes inthese controls among countries, and, therefore, wewill know their repercussions onother macroeconomic policies. Tothe best ofour knowledge, there isno previous study that used apanel VAR approach tostudy the repercussions ofCC changes onmonetary and exchange policies. Asregards CC effects, weanalyze domestic and multilateral impacts. Domestical‑ ly, our main finding isthat byreducing capital inflows, CCs make itpossible tobet‑ ter stabilize the economy. Itallows more independence tomonetary policy and allows less pressure onthe exchange policy atwhich the exchange rate manifests slight fluc‑ tuations. Empirical evidence shows that EEs accumulated excessive international reserves after the 2008 crisis. Our study has shown that despite the strict capital controls ap‑ plied byseveral emerging countries after the crisis, itdid not prevent the accumula‑ tion ofreserves. The latter supported the decisions ofmonetary policy and exchange rate policy. Tothe best ofour knowledge, few previous studies have highlighted the association between capital control actions with the accumulation ofinternational re‑ serves (Jeanne 2016, p.52; Korinek 2018, p.86). For the multilateral effects, the study presents anunderstanding ofthe spillovers that may happen following restrictions applied byacountry. Other countries will beaf‑ fected after the migration ofcapital flows totheir frontiers. Little empirical evidence exists onthis spillover effect (Forbes etal.2017, p.112; Lambert etal.2011, p.165). Weare among the first todemonstrate empirically these policy changes towards cap‑ ital controls asareaction tothe early policy ofanother country which has already ap‑ plied similar controls. Our paper isorganized asfollows. After presenting the literature review ofthe ef‑ fectiveness ofCCs inSection 2, wepresent the data and methodology inSection 3. The results ofthe model regressions are presented inSection 4. The last section gives conclusions.
172 Chokri Zehri Literature review Multiple effects on monetary and exchange policies The theoretical and empirical literature onthe effectiveness ofCC onmonetary and exchange policies has several methodological shortcomings. There are several criti‑ cisms ofthe indexes used toreflect the intensity ofCC. Itis often difficult toseparate the effects caused bythe controls from the effects caused byother macroeconomic policies, such asthe effectiveness ofprudential supervision. CCs have been successful indifferent countries; however, the degree ofsuccess isnot equal for all countries. The empirical literature shows multiple impacts ofCCs onproxy variables ofmon‑ etary and exchange policies. Some recent studies have shown evidence that these con‑ trols can effectively affect the monetary and exchange policies under some macroeco‑ nomic conditions, and they also can protect economies from external shocks (Pasricha etal.2018, p.176; Magud etal.2018, p.51). Some studies focused onthe macroeco‑ nomic framework inwhich CCs are instituted. Among these studies, Bayoumi etal. (2015) studied 37 countries that introduced outflow restrictions from 1995–2010. They found evidence that capital outflow restrictions reduce the pressure onboth policies under certain conditions. These conditions include strong macroeconomic funda‑ mentals (growth rate, inflation, and fiscal and current account balances), good institu‑ tions (World Bank Governance Effectiveness Index), and existing restrictions (intensi‑ ty ofCCs orcomprehensiveness). When none ofthe three conditions are met, controls will fail tosupport these policies. Furthermore, some studies suggest that controls are more effective inadvanced countries than inothers, perhaps because ofthe better quality ofinstitutions and regulations (Binici etal.2010). Some recent studies (Pasricha etal.2018; Magud etal.2018) analyzed the condi‑ tions ofsuccess ofcapital controls and especially their impacts onthe country that applies these controls compared tocountries that did not apply these restrictions. Pasricha etal. (2018) used arecent frequency dataset oncapital control instruments in16emerging market economies from 2001 to2012. They give novel evidence onthe domestic and multilateral impacts ofthese instruments. Increases infinancial liber‑ alization constrain monetary policy autonomy and decrease exchange rate instability, confirming the incompatibility trilemma. Magud etal. (2018) presented ameta‑anal‑ ysis ofthe literature onCCs, seeking tostandardize the results ofnearly 40 empirical studies. They build two indices ofcapital controls: the Capital Controls Effectiveness Index and the Weighted Capital Controls Effectiveness Index. Their results show that CCs oninflows seem tomake monetary policy more independent, and they alter the composition ofcapital flows (Zehri 2020, a); there isless evidence that they reduce real exchange rate pressures. Kim and Yang (2012) determined that afixed exchange rate allows CCs tosupport the independence ofthe monetary policy. This impact isclear‑ er with wide and long term CCs.
173 The Multiple Effects of Capital Controls Klein and Shambaugh (2015) found that economies with large CCs are more cov‑ ered concerning external monetary shocks. Meanwhile, Liu and Spiegel (2015) showed that the wide use ofCCs allows countries tomaintain adesired interest rate differen‑ tial between domestic and foreign markets. However, these strict controls did not have any link with the currency appreciation detected insome countries intheir sample. Ito, McCauley, and Chan (2015) studied asmall open economy and focused onsimple policy rules, while Devereux etal. (2019) investigated the optimal monetary policy and optimal CC. Amodel with fixed exchange rates, downward nominal wage rigidities, and free capital mobility was presented byBayoumi etal. (2015), where anoptimal devaluation eliminates the effects ofthe wage rigidity. Table 1 summarizes the results ofmost studies onthis issue and shows that the “Unclear” effect dominates the findings. Table 1. Summary of studies’ results Study Reducing Real Exchange Rate Pressure Autonomy of Monetary Policy Control on Inflows Brazil Unclear Unclear Chile Unclear Unclear Colombia Unclear Unclear Malaysia (1989) Yes Yes Malaysia (1994) Unclear Yes Thailand Unclear Unclear Malaysia (1998) Yes Yes Control on Outflows Brazil Yes Unclear Chile Unclear Yes Colombia Yes Unclear Thailand Unclear Unclear Multi‑country studies Unclear Unclear Source: author’s own elaboration. Indexes of capital controls Itis difficult togive anexact measure ofCC. The pre–2008 crisis literature utilizes in‑ dexes that measure the degree ofcapital restrictions. These indexes usually serve toset the extent ofrestrictions (the kind oftransactions controlled) and then define what isthe most appropriate when evaluating the effectiveness ofcontrols. Many improve‑ ments inmeasuring CCs have been made inthe recent literature. The relevant novelties ofthese studies gather data onvariations ininstitutional arrangements (Edison and Warnock 2003, p.63; Ocampo, Spiegel and Stiglitz 2008, p.23; Qureshi, Ostry, Ghosh, and Chamon 2011, p.91). The advantage ofthis method isthat itprecisely determines
174 Chokri Zehri the type ofpolicy action that isconsistent with the time ofthe action. Asdiscussed inthe introduction, the puzzle ofthe similarities ofpolicy effects over time and across EEs continues toappear with this approach. Older studies utilized diverse approaches toimprove the distinction ofcapital con‑ trol impacts. These approaches can bearranged into two classes: the first, called “split‑ ting‑the‑announcements” method, aims todefine similar and homogeneous macroe‑ conomic policies. Quantitatively, these policies must have relatively identical impacts, especially oncapital inflows. This needs torearrange the controls established inmore homogeneous subgroups ofcontrols. The second aims tocompute the opportunity cost ofcertain variations inregulation. This can beachieved bycomputing atax rate ofthe control actions (Benigno etal.2016, p.31; Forbes etal.2016, p.162; Baba and Kokenyne 2011, p.151). Unfortunately, this effective tax isonly applied for acertain type ofpolicy tool (e.g., unremunerated reserve requirements), which form aminori‑ ty ofthe actions made byEEs. Inthis study, wecombine the advantages ofboth approaches byemploying indexes constructed recently insome empirical studies (Fernández etal.2016; Chinn and Ito 2008). Fernández etal. (2016) presented anew data set ofCCs divided into ten asset categories along with the structure ofinflows and outflows. These indexes were applied to100 economies over the period 1995–2013. Our study uses the first three indexes among the ten asset categories ofCC: ka, kai, and kao (controls applied respectively togross flows, inflows, and outflows). Chinn and Ito (2008) create anew index that measures the extent ofopenness incapital account transactions, this index istermed kaopen, and itwas regularly updated (the last update isthere of2017). Table2 sum‑ marizes these indexes. Table 2. Capital Control Indexes Index Definition Source ka Overall restrictions index (all asset cate‑ gories) Fernández, Klein, Rebucci, Schindler, and Uribe (2016) “Capital Control Measures: A New Dataset” kai Overall inflow restrictions index (all asset categories) kao Overall outflow restrictions index (all asset categories) kaopen The extent of openness in capital account transactions Chinn, M. D., and H. Ito, The Chinn‑Ito Index, http://web.pdx.edu/~ito/Chinn‑Ito _website.htm, last updated July 2017 Source: author’s own elaboration. The principal distinction between both indexes isthat the kaopen index isalarg‑ er measure ofcapital account liberalization, including regulations tothe current ac‑ count ofthe balance ofpayments and the foreign exchange market, while the dataset ofFernández etal. (2016) issmaller, focusing especially oncapital flows. However, ithas further details onthe intensity ofcontrols, with distribution data onten asset
175 The Multiple Effects of Capital Controls categories. The indexes ofFernández etal. (2016) make itpossible todetect more time change when countries set regulations than the Chinn‑Ito index. These indexes ofChinn and Ito (2008) and Fernández etal. (2016) capture the cross‑country changes inthe level ofcapital account liberalization; unfortunately, how‑ ever, they are smaller inthe time scope due tothe way they are built and their annual frequency. Toovercome these shortcomings, wepropose duplicating the annual value ofeach ofthese indexes in4 equal sub‑values, asif they were quarterly data. This does nothing todiminish the robustness ofthis analysis since CCs are often long‑term po‑ litical instruments. This change will allow consistency with the frequency ofthe other variables inthe model, which are quarterly. Data and methodology Capital control instruments may affect aset ofvariables, but atthe same time, they can beaffected bythese variables. Thus, weuse apanel VAR model. This model includes asystem ofequations inwhich the dependent variables will berepresentative ofCCs, capital flows, monetary policy, and exchange rate policy. Our sample includes 27 EEs that used CCs over the period 2010Q1 to2018Q4. Weuse the interest rate differential asaproxy for monetary policy independence (rate variable). Acountry that maintains adifferential ofthe domestic and external interest rate makes itpossible toact onthe volume ofcapital inflows and, consequent‑ ly, tofreely define adomestic interest rate without having aconstraint with the exter‑ nal rate. The standard deviation ofthe bilateral exchange rate (tothe US $) isaproxy used for the volatility ofthe exchange rate (the xchge variable). Toseparate the effect ofthe capital flows variables, wedistribute them between inflows (the infl variable) and outflows (the outf variable), and for the global flows, weuse the “gross” variable. Also, weinclude aset ofexogenous variables tocontrol for drivers that can influence the endogenous variables (the short‑term interest rate inthe United States (us_rate), the price ofoil (oil), real gross domestic product growth inthe United States (gdp) and international reserves (ir). The impact ofCCs used bythe country can affect the inflows toother countries, and these spillover effects are presented bythe variable (spill). Apanel VAR isthe baseline model. The independent variables ofthis model are all considered endogenous and are explained bythe set ofexogenous variables previous‑ ly cited. The model iswritten asfollow: Yi,t = α0 + Z1yi,t−1 +…+ Znyi,t−n + W1xi,t−1 +…+ Wmxi,t−m + FEi + £i,t (1) Our model isdescribed byasystem ofequations, where Ytis the vector ofendog‑ enous variables for country i, x t is the vector ofexogenous variables common toall countries, £ i,t isthe vector ofresiduals, and “Z” and “W” represent the coefficients for the endogenous and exogenous variables, respectively. Factors that have omitted
176 Chokri Zehri and that can affect the dynamics ofthe model (e.g., administration efficiency) are re‑ grouped inthe term FEi, which represents the country fixed effects (FE variable). Toexamine ifthe cross‑sectional changes inCC can bewell used, weregress the model with the use ofthe Chinn‑Ito (Chinn and Ito 2008) and Fernández etal., (2016) indexes. All ofthe explicative variables are introduced with one lag difference. Addi‑ tionally, wepropose aregression with the levels ofthese indexes and analyze the ef‑ fect ofashock tothem. Results Inthis section, wepresent the evidence from the estimation ofthe PVAR model for the period 2010:1–2018:4. Weanalyze ifvariations inCCs affect monetary and exchange rate policies and are under the forecasts ofthe incompatibility triangle. Wealso inves‑ tigate the impact oninternational reserves and the multilateral effects. Weexamine the effect ofashock onCC, considered itas aninside policy instrument, and ondifferent national policy variables, including differential interest rate, exchange rate volatility, capital movements, international reserves accumulation, and spillover effect. The results ofthe PVAR analysis are displayed inTable 3. They show apositive and significant coefficient ofthe changes in“ka” and “kaopen” inthe equation inwhich the differential interest rate isthe independent variable. These findings show that chang‑ es incapital controls raise the differential ofthe interest rate and subsequently allow more autonomy ofthe monetary policy. The two other indexes ofcapital controls (kai and kao) donot affect the monetary policy. The results present negative and signifi‑ cant coefficients ofthe changes in“ka” and “kaopen” inthe equation ofexchange rate volatility (compared tothe US dollar) suggesting that capital controls support the sta‑ bility ofthe exchange rate policy, i.e., more liberalization isconducive tohigher ex‑ change rate instability. Table 3. PVAR Analysis Coefficient Std. Err. ZP>|z| [95% Conf. Interval] rate ka 0.019 0.055 2.17 0.006 –0.998 0.118 kai 0.049 0.767 0.58 0.365 0.915 3.157 kao 0.035 0.858 0.15 0.247 0.758 2.549 kaopen 0.541 0.467 3.58 0.000 1.625 4.457 xchge –0.227 –0.569 –4.00 0.000 –0.339 –0.116 gross 0.041 0.467 0.58 0.365 1.625 4.457 spill 0.045 0.658 1.15 0.247 0.958 3.549 ir 0.7195 0.085 2.44 0.000 –0.738 0.218
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185 The Multiple Effects of Capital Controls Rudebusch, G.D., Williams, J.C.(2016), Awedge inthe dual mandate: Monetary poli‑ cy and long‑term unemployment, “Journal ofMacroeconomics”,47, 5–18. http://dx .doi.org/10.1016/j.jmacro.2015.05.001 Zehri, C.(2020a), Capital Restrictions Policies, Currency Appreciation and Foreign Debts.“Montenegrin Journal ofEconomics”,16(3), 149–159. https://doi.org/10.142 54/1800‑5845/2020.16‑3.12 Zehri, C.(2020b), Conditions for the success ofcapital controls: The elasticity ap‑ proach.“International Journal ofFinance & Economics”. Articles inpress. https:// doi.org/10.1002/ijfe.2182 Streszczenie Wielorakie skutki kontroli przepływu kapitału Kontrola kapitału jest postrzegana jako metoda zapewnienia stabilności finansowej lub poprawy programu dostosowań makroekonomicznych w gospodarkach, w któ‑ rych występują sztywności nominalne i nieoptymalna polityka pieniężna. Taka kon‑ trola może przybierać różne formy, w tym jawnego lub ukrytego opodatkowania transgranicznych przepływów finansowych oraz wprowadzenia systemu podwójnych lub wielokrotnych kursów walutowych. Wykorzystując kwartalne dane dotyczące kontroli kapitału w 27 gospodarkach wschodzących w latach 2010–2018, przeanali‑ zowano skuteczność kontroli kapitału pod różnymi kątami. Od kryzysu finansowego w 2008 r. wzmocnienie kontroli kapitału umożliwiło zwiększenie autonomii polityki pieniężnej i stabilności kursu walutowego, zgodnie z założeniami modelu Mundella‑ ‑Fleminga. Wyniki analizy pokazują, że gromadzenie rezerw międzynarodowych może rekompensować utratę wpływów i prowadzić do realizacji bardziej skutecznej polityki. Silniejsza kontrola napływu kapitału powoduje znaczne skutki uboczne, szczególnie w warunkach nadmiernej płynności. Te zewnętrzne efekty wynikają z problemu koor‑ dynacji polityki gospodarek wschodzących i są głównie spowodowane przez kontrolę kapitału stosowaną jako instrument zarządzania przepływami kapitału. W działaniach rządów, które muszą zarządzać ryzykiem związanym z gwałtownym napływem lub odpływem kapitału, kontrola kapitału powinna odgrywać kluczową rolę. Słowa kluczowe: kapitał, kontrola, przepływy, skutki JEL: F21, F32, F41, F42