Central Banks’ Recent Experiments with Capital Controls Not Very Effective

Distinction between episodic and long-standing restrictions is important; recession caused shift in exchange rate policies

SEPTEMBER 13, 2012 -
The recent use of short-term capital controls has not helped governments stop exchange rate appreciations, prevent asset price booms and busts, nor avoid general economic volatility post-Great Recession, according to a new paper presented today at the Fall 2012 Conference on the Brookings Papers on Economic Activity (BPEA). 

In “Capital Controls: Gates and Walls”(pdf), author Michael Klein of the Fletcher School of Tufts University, and former Chief Economist for the Department of the Treasury’s Office of International Affairs, performs an analysis of the use of capitol controls in 44 countries over a 15-year period, looking at the pattern of capital inflows and their effects on financial variables, GDP, and exchange rates.  Given that controls on capital inflows have been receiving increasing support in policy circles, among researchers, and in the general economic debate, especially since the onset of the Great Recession, he looks specifically at the differences between long-standing controls on a broad range of assets (walls) and episodic controls that are imposed and removed, and tend to be on a narrower set of assets (gates).  Klein finds that longstanding controls help reduce both financial vulnerability and increase GDP growth while episodic controls are far less effective, but that in fact neither long-standing nor episodic controls significantly affect exchange rates, which may be one of the central banks’ key goals in pursuing these policies.

Klein writes that  some theories support the use of episodic controls against surging capital inflows, or to guard against a boom/bust cycle, but there is little or no theoretical support for long-standing capital controls.  “Long-standing capital controls are like walls that protect against the vicissitudes of international capital markets… [they] tend to be wide as well as high, limiting all manner of capital flows, including those that could provide cheap capital, financial development, and opportunities to diversify risk. An alternative, episodic capital controls could open like gates during tranquil times to enable an economy to benefit from international capital, but swing shut in the face of capital inflows that threaten to cause an unwanted appreciation or a destabilizing asset market boom. The transitory nature of these controls, as well as having them targeted towards particular categories of assets, would make them less distortionary and inefficient than broad, long-standing controls.”  But he notes that there are problems with the gates: they might not latch shut tightly, they may shut too late or there may be impediments to their closing.

Klein points out that the differences in the effects between long-standing and episodic controls may have been less apparent 15 years ago than today because there was a trend towards the liberalization of long-standing controls up through the mid-1990s. He finds that China’s long-standing controls are important for the government’s ability to manage the value of the Renminbi whereas Brazils’ recent attempts to use episodic controls were ineffective.  

Download the paper (PDF) »