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From: Brookings Papers on Economic Activity
Fall 2012
pp. 356-367 | 10.1353/eca.2012.0025

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Comment by Kristin J. Forbes

The desirability of capital controls has been debated for decades. My discussion begins by placing this paper by Michael Klein in the context of this important debate. I then consider some details of Klein's analysis, highlighting the important contribution made by the data and several econometric issues that need to be addressed in order for the results to shift views on the desirability of episodic capital controls. I conclude by raising a key question that will, I hope, be addressed in future work in order to clarify exactly what determines the efficacy of capital controls.

The Context

My figure 1 shows that net capital flows to emerging markets have increased dramatically since the early 2000s, and that these flows can be extremely volatile. These large and volatile flows can present substantial challenges for many countries—especially those with weaker and less developed financial markets. For example, large net inflows of capital can cause sharp currency appreciations, reducing competitiveness, increasing trade deficits, and causing Dutch disease. They can increase the money supply and liquidity, generating inflation, overheating of the economy, inefficient lending, and bubbles in housing and other markets. Research has shown that such surges are correlated with real estate booms, banking crises, debt defaults, inflation, and currency crises. Just as challenging can be the "sudden stops," when the capital inflows dry up, which research shows are correlated with currency depreciations, slower growth, and higher interest rates.

Policymakers faced with these dangers from large and volatile capital inflows are constantly challenged as to how best to respond. There are a number of standard policy responses—such as lowering interest rates, tightening fiscal policy, allowing the currency to appreciate, accumulating reserves, and encouraging capital outflows. But each of these has significant limitations or costs, as my table 1 shows. These extremely limited options have forced a fundamental rethinking of other strategies. Two that have received substantial attention are macroprudential regulation and temporary controls on capital inflows (what Klein calls "episodic" controls).

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Figure 1. 

Net Private Capital Flows to Emerging Markets, 1990-2012a

There is by now fairly widespread agreement that macroprudential regulations should have a role in managing large and volatile capital inflows, as well as in strengthening the overall financial system. Constructing the appropriate regulations, however, is extremely difficult for technical reasons. Even if it were possible to design the optimal regulations, garnering political support for them has been challenging in many countries with strong financial lobbies.

Given the limitations of other policies, the use of episodic controls on capital inflows has garnered recent support from a number of sources. Several emerging markets viewed as market friendly and supportive of foreign investment have recently used these controls. (A prominent example is Brazil's use of the Imposto sobre Operacões Financieras, or IOF, in 2010 and 2011.) Even the International Monetary Fund (IMF), formerly a bastion of capital market liberalization, has supported capital controls in certain circumstances as part of the "policy toolkit" (Ostry and others 2011). Several empirical papers have shown that taxes on capital inflows can reduce financial vulnerabilities by changing the composition (albeit not the volume) of inflows. The argument for controls has also been bolstered by a series of theoretical papers modeling the various ways in which taxes on capital inflows can be optimal in the presence of other distortions.

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Table 1. 

Options for Managing Surges of Capital Inflows

Klein's paper, however, presents a serious challenge to this sea change in support of episodic controls on capital inflows. His results show that capital controls do not work if they are episodic. He argues that long-term and widespread capital controls ("walls") may have some effect, but any controls that are viewed as temporary ("gates") will not reduce financial vulnerabilities. This directly undermines the key arguments made in support of episodic controls by institutions such as the IMF. His results also show that episodic controls do not significantly moderate currency appreciation. This directly undermines the key arguments made in support of episodic controls by most policymakers who have used these controls. Therefore, if the results of Klein's analysis withstand the test...

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