Are Capital Controls Effective?

The global crisis has reignited debate on the desirability of capital controls. This column examines evidence from Argentina and Chile and argues that capital controls can be effective, but that their effectiveness and efficiency varies. It adds that controls need to be considered as part of a macro-prudential toolkit to prevent asset inflation and overvaluation that is costly to revert in the down cycle.

“Not only are they ineffective but, in addition, they raise domestic interest rates.” This type of internally inconsistent commentary is not unusual when discussing capital controls – a subject marked with strong beliefs and weak data. Now that the G20 has sanctioned capital controls in Seoul under the umbrella of macro-prudential policies, it is a good time to revisit the subject of controls in a dispassionate way. [1]

The capital control debate can be broken into two basic questions:

  • How effective are they? and,
  • Are they efficient instruments (and if so, when)?

This column addresses the first of these two questions. The debate about the effectiveness of capital controls – namely, whether or not they influence cross-border flows– has received considerable attention in the economic literature. One area of focus has been the controls on inflows imposed by the Chilean government in the mid 1990s, which has generated a series of empirical works, sometimes with contrasting results (see for example, Edwards 1999, De Gregorio et al. 2000. Edwards and Valdes 2000, and Gallego and Hermández 2003).

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[1] In the G20´s own terms:“…in circumstances where countries are facing undue burden of adjustment, policy responses in emerging market economies with adequate reserves and increasingly overvalued flexible exchange rates may also include carefully designed macro-prudential measures.” (G20 2010).