CAPITAL CONTROLS IN EMERGING MARKET ECONOMIES: Ineffective for macroeconomic management and with potentially damaging side-effects

18 Mar 2016

Capital controls imposed by emerging market economies are ineffective for macroeconomic management and may have stronger international spillovers than previously thought. That is the key conclusion of research by Gurnain Pasricha, Matteo Falagiarda, Martin Bijsterbosch and Joshua Aizenman, to be presented at the Royal Economic Society''s annual conference in Brighton in March 2016.

Their study analyses data from 17 large emerging market economies for the period 2001-11. They find that although capital controls helped emerging market economies before the global financial crisis because inflows from non-residents were balanced out by falling outflows from residents, afterwards the sheer ease of sending capital around the globe meant that they became less useful. This also meant that spillovers became more important, where some countries were affected by another country''s decision to impose capital controls. The authors comment:

''Our results suggest that caution should be exercised when using capital controls as an instrument for macroeconomic management. Their impact seems to be situation-specific and they may have unintended consequences for other countries.''

''Our results also underline the growing prominence of outward investment flows from emerging market economies. As these resident flows grow in importance, policy-makers will increasingly need to take into account the impact of their capital control policies on those flows.''

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Capital controls imposed by emerging-market economies (EMEs) are not effective for macroeconomic management and may have stronger international spillovers than previously thought

That is the key conclusion of new research by Gurnain Pasricha, Matteo Falagiarda, Martin Bijsterbosch and Joshua Aizenman on the effects of capital controls, a topic that has received increasing attention in the policy debate. Using a novel data set of policy actions on capital controls and currency-based prudential measures in 17 large EMEs for the period 2001Q1 to 2011Q4, the researchers provide new insights into the macroeconomic effects of capital controls.

Capital control actions do not allow countries to avoid the trade-offs of the monetary policy trilemma

Where they have a desired impact on the trilemma variables – net capital inflows, monetary policy autonomy and the exchange rate – the size of that impact is small. While the researchers find some evidence of effectiveness before the global financial crisis, the usefulness of these measures weakened in the post-crisis environment of abundant global liquidity and relatively strong economic growth in EMEs.

The increasing role of resident flows in EMEs and the macroeconomic context are crucial for understanding the effects of capital flow management

A key reason for the lack of effectiveness of controls is that these policies may have unintended consequences for capital flows they do not target. Before the global financial crisis, efforts to curb gross inflows were effective, but the impact on these (mainly non-resident) inflows was offset by a reduction in gross outflows (driven by residents in EMEs). After the financial crisis, these effects weakened in the presence of abundant global liquidity and strong economic growth in EMEs.

This is the first study that provides evidence of multilateral or spillover effects of capital controls for a large number of countries, including Brazil, Russia, India, China and South Africa

During the 2000s, capital control policies in large EMEs had significant implications for other EMEs. Capital control changes had an impact on other countries both via exchange rates and net capital flows (especially cross-border bank lending). Spillovers of capital controls were more important in the aftermath of the global financial crisis than before the crisis. Moreover, they seem to have been more prevalent in Latin America than in Asia, reflecting the greater role of cross-border banking and more open capital accounts in the former countries.

These findings have important implications for the policy debate on the effectiveness of capital controls

First, caution should be exercised when using capital controls as an instrument for macroeconomic management: their impact seems to be situation-specific, they may have unintended consequences for other flows and they generate spillovers to other countries.

Second, these results underline the growing prominence of outward investment flows from EMEs. As these resident flows gain further in importance, policy-makers in EMEs will increasingly need to take into account the impact of their capital control policies on those flows.

''Domestic and Multilateral Effects of Capital Controls in Emerging Markets'', by Gurnain Pasricha, Matteo Falagiarda, Martin Bijsterbosch and Joshua Aizenman has been published as National Bureau of Economic Research Working Paper No. 20822, European Central Bank Working Paper No. 1844 and Bank of Canada Staff Working Paper No. 2015-37.

Gurnain Pasricha is at the Bank of Canada, Matteo Falagiarda and Martin Bijsterbosch are at the European Central Bank, and Joshua Aizenman is at the University of Southern California and the National Bureau of Economic Research.

The views expressed are those of the authors and do not necessarily reflect those of the institutions they are associated with.

Gurnain Pasricha

gpasricha@bank-banque-canada.ca

Martin Bijsterbosch

martin.bijsterbosch@ecb.europa.eu