Switzerland is a country with a long and proud tradition of neutrality, but given the perilous state of the surrounding eurozone, it may be find itself in a "currency war" as the Swiss franc strengthens in response to capital inflows.
An appreciation has adverse consequences for Swiss exports, and overall national income. The Swiss central bank combated appreciation with intervention in the foreign exchange market in September, and promises to intervene again if the franc appreciates past Sfr1.20. But Swiss authorities are considering deploying a new weapon as well. Last month, Thomas Jordan, the head of the Swiss National Bank, indicated that he was prepared to use capital controls.
The currency war facing Switzerland is reminiscent of the appreciation of the Brazilian real in 2009 and 2010. Mr. Jordan's proposed use of capital controls echoes the Brazilian response. He would be wise to consider that experience, and its lessons about the efficacy of capital controls. Capital controls offer a limited capacity to prevent appreciations in emerging market countries. They are likely to be even less effective for Switzerland.
In 2009, strong Brazilian growth and low interest rates in advanced countries drove international capital to Brazil, causing a 35 percent appreciation of the real that threatened the country's export sector. Brazilian authorities responded by introducing a 2 percent tax on foreigners investing in Brazilian equities, the IOF (Imposto sobre Operações Financeiras). Brazil's real's appreciation halted after this - but, as in so many cases, correlation does not imply causation, since other emerging market currencies also depreciated after October 2009, notably the Korean won and the Indonesian rupiah. The real began to strengthen again after June 2010. This prompted a tripling of the IOF rate in October 2010 and an effort to tighten its bite by closing loopholes. This policy, too, saw only a temporary slowing in the appreciation of the real.
Capital controls fail to stem appreciations because they are leaky. Investors find ways around regulations intended to limit inflows, often by using different financial instruments than those on which controls are directly imposed. This work-around suggests that capital controls are least effective for countries with the most sophisticated financial markets, that is, for countries like Switzerland. Experience also shows that controls are less effective when they are imposed episodically, in response to current conditions, rather than when they are long-standing.
The first round of capital controls are typically followed by subsequent rounds that ratchet up tax rates and widen coverage. This was the experience of Brazil, with the IOF rate tripling in 2010 and the regulations being expanded to new instruments. It also characterizes recent experiences of other countries, such as Colombia, Peru, and Taiwan.
China provides an example of the exception that proves the rule. The government maintains control over capital inflows which allows it to manage the value of the renminbi. It can do this because it has relatively rudimentary capital markets and, more importantly, a long history of unwavering capital controls. In contrast, Brazil has increasingly sophisticated capital markets. Some of the increasing sophistication is precisely because of incentives arising from capital controls -- just as in other countries, financial markets respond to regulation with innovation. The episodic nature of Brazilian capital controls, as well as those of other countries, also makes circumventing them easier.
There may be a role for capital controls, however, for some countries and in some instances. The financial crisis has prompted a re-examination of the range of policies that may be useful for strengthening financial systems. Notably, the IMF recently has shifted its views towards a greater acceptance of capital controls that aim to reduce financial vulnerability. But the efficacy of these policies remains an open question. Most likely, there is not a single answer to the question of the efficacy of capital controls; rather the answer differs across countries and even across time for a particular country. Nevertheless, experience suggests that efficacy of capital controls is especially questionable for advanced economies like Switzerland.
Battling inflows is a difficult challenge. The battle is not helped, however, by the use of ineffective weapons.