Capital Inflows: Challenges to Stability
Improved macroeconomic fundamentals in Latin America coupled with high liquidity and uncertainty in the capital markets of developed countries and historically low interest rates have led to large capital flows into several countries in the region. Although capital inflows, depending on their characteristics, may in principle represent greater opportunities for increasing investment rates and economic growth, the region’s experience and emerging markets in general during the 1990s reveals that the volatility of these flows can generate severe macroeconomic problems and financial disruptions. Despite evidence that international investors today differentiate more among the countries of the region based on their fundamentals than they did in the past, the high synchronisation of flows towards emerging markets demonstrates the importance of global factors.18
These capital inflows, as well as the increase in prices for basic products, contributed to the appreciation of nominal and real exchange rates in the region. This appreciation had a particularly marked impact on the currencies of countries with inflation-targeting schemes and flexible exchange rates. As a result, 11 countries recorded nominal currency appreciations during the first 10 months of 2010 in comparison with the same period in 2009, notably the Brazilian real (13.6%), the Colombian peso (13.2%), the Uruguayan peso (13.1%), the Chilean peso (9.4%) and the Costa Rican colon (8%). In contrast, only five countries recorded a nominal depreciation of their currencies, Argentina and the Bolivarian republic of Venezuela standing out in this regard. In real terms the situations are diverse. on the one hand, the currencies of Brazil and Colombia have appreciated with respect to the average exchange rate for the 2000s (38% and 24% respectively), while the currencies of Chile and the Bolivarian republic of Venezuela also seem to have appreciated slightly over the same period (around 10%).19 on the other hand, the currencies of Peru and Mexico seem to be near their historical average, while Argentina’s has slightly depreciated (15% above the average for the 2000s) (Figure 1.6).20
Volatility and excessive appreciations of real exchange rates —above that explained by changes in fundamentals— can reduce competitiveness in the tradable sector of the economy or in tradable activities that do not benefit from increases in export prices. Short-term fluctuations in real exchange rates can have permanent negative effects on economic growth, in particular when firms face credit constraints warranting policy intervention to curb their effects.21 exchange rate appreciations can even nullify the effort in various countries to stimulate innovation, create new productive activities and diversify the economic structure.
Policy makers have adopted a series of measures to try to reduce the volatility of nominal exchange rates and reduce possible exposure to capital flow reversal. Among the measures to reduce capital-flow volatility and the consequent instability of nominal exchange rates are those that discourage short-term capital inflows as well as an increase in foreign exchange assets held by the public sector and certain private financial entities.
Indices of real effective exchange rates for 7 Latin American countries, January 2008-March 2011
Volatility and excessive appreciations of real exchange rates —above that explained by changes in fundamentals— can reduce competitiveness in the tradable sector of the economy or in tradable activities that do not benefit from increases in export prices. Short-term fluctuations in real exchange rates can have permanent negative effects on economic growth, in particular when firms face credit constraints warranting policy intervention to curb their effects.21 exchange rate appreciations can even nullify the effort in various countries to stimulate innovation, create new productive activities and diversify the economic structure. Policy makers have adopted a series of measures to try to reduce the volatility of nominal exchange rates and reduce possible exposure to capital flow reversal. Among the measures to reduce capital-flow volatility and the consequent instability of nominal exchange rates are those that discourage short-term capital inflows as well as an increase in foreign exchange assets held by the public sector and certain private financial entities. Measures to deal with capital inflows can be classified according to whether public authorities try to absorb additional flows or reduce their volume through capital controls.22 Several countries have accumulated significant quantities of international reserves by intervening in foreign exchange markets, including Argentina, Brazil, Colombia, Costa Rica, Guatemala, Mexico and Peru. In addition, countries such as the Plurinational State of Bolivia, Paraguay and Peru has high levels of reserves as a percentage of GDP (near or above 25%) in comparison to other countries in the region. Some countries have adopted a series of measures directly aimed at reducing capital inflows or increasing capital outflows. For example, Chile has gradually increased foreign investment caps for the country’s pension funds, announcing in November 2010 that it would permit up to 80% of these funds to be invested abroad. Peru has adopted similar measures and in September 2010 it announced that it would allow the investment of up to 30% of the funds administered by pension fund managers to be invested abroad. For its part, Brazil increased its financial transactions tax on foreign investment in fixed-rate banking instruments, first to 4% and then, in October 2010, to 6%, while raising the tax on margin deposits in futures markets from 0.38% to 6% and leaving unchanged the 2% tax rate on equity investments. However, other administrative measures were introduced to increase the effectiveness of the tax in terms of curbing speculative capital inflows.
(See Box 1.1). Argentina, Colombia and Peru have maintained or introduced similar measures, while another instrument has been to increase unremunerated reserve requirements (Argentina, Brazil, Colombia and Peru).23 The accumulation of international reserves strengthens the future capacity to cope with sharp drops in terms of trade or a “sudden stop” in capital flows and reduces exchange rate volatility. However, it also increases the challenges for monetary policy in the region. If the region’s central banks intervene in the market without sterilising the injections of national currency, they increase the risk of affecting the inflationary expectations of the public. But if they intervene in the market sterilising these interventions (totally or partially), there is the resulting quasi-fiscal cost and risk of damage to their own balance sheet. For many countries in the region, a major challenge for current economic policy is to maintain financial stability if the increased availability of funds feeds a boom in bank lending or potential bubbles in certain asset markets. In this regard, stock prices in several local exchanges have shown a strong performance since early 2009.
Capital Controls as Part of the Macroeconomic Tool Kit
“Not only are capital controls ineffective, but in addition they raise domestic
This type of internally inconsistent comments is not unusual when discussing capital controls —a subject marked with strong beliefs and weak data. To gain some perspective we must organise our analysis around two basic questions: i) Are they effective (i.e. do they affect the market in the desired direction)?, and if so, ii) are they efficient instruments (in other words, do the benefits outweigh the costs)? This box begins with the basics, analysing the first question in light of experience with controls on capital inflows through taxation.
These controls, traditionally associated with unremunerated reserve requirements (URRs) on capital inflows imposed in Chile and Colombia during the 1990s, are basically a variation of the Tobin tax on international capital flows. In fact, Chilean authorities at the time offered the option of a tax equivalent to the URRs to those investors who preferred to pay upfront and maintain their liquidity.
The standard argument of the sceptics was that these controls failed to stop capital inflows and currency appreciation. However, this appreciation seems to be biased, since we do not know what the inflows and appreciation would have been if there were no controls. Yet, there are ways to quantify what capital controls aim to introduce in the first place.
The simplest and most natural way to measure the effect of capital controls is through deviations from covered interest parity, in other words, the differential between the difference in interest rates and the forward discount (or the “carry” in local currency that international investors receive).a A study for the Chilean case shows that this difference oscillated between 2% and 3% during the period of controls, close to the value of the equivalent Tobin tax.b A similar exercise for the most recent case of the Brazilian financial transactions tax (Imposto sobre Operações Financeiras, IO F) leads to the same conclusions: a 6% tax on capital inflows creates a 6% gap between the differential in interest rates (the difference between the Selic rate [the Brazilian reference rate] and the short-term rate on US treasuries that are near zero) and the carry of the Brazilian currency, the real (Figure 1.7, left panel). Similar behaviour is also found in the cases of the Turkish lira (Figure 1.7, right panel) and the Israeli shek
Effects of Capital Controls in Brazil and Turkey
Capital controls are also effective, as they impose a toll on traffic in and out of domestic markets. Their effectiveness depends on the cost of the toll (and the volume of traffic). For example, a 2% tax will not obtain much more than a 2% cut in the value of local assets (including the local currency); a 10% tax will obtain a proportionally (but probably not linearly) stronger effect; meanwhile, a 2% tax opened to future adjustments (as recently seen in Brazil) should have an effect somewhere in between, as it affects the expectations of short-term speculative investors. Summing up, capital controls are not irrelevant, as their opponents argue, nor are they as influential as their defenders say. Rather, they are an additional element in the toolkit of macroeconomic counter-cyclical policies that should complement monetary, fiscal and exchange-rate policy and prudential regulation.
Source: Produced by Eduardo Levy Yeyati.
a From a technical perspective, the covered parity implies that the carry for currencies (alternatively, the future discount) must be equal to the rate differential plus transaction costs, which include taxes on international capital flows.
b De Gregorio et al. (2000).
Christian Daude and Angel Melguizo on Channel 10 in Peru discussing the launch of the 2012 Latin American Outlook
Christian Daude on Channel N in Peru discussing the launch of the 2012 Latin American Outlook