The embrace of ad hoc capital controls to address temporary market inefficiencies on a case-by-case basis, while pragmatic, perpetuates the view that each capital crisis is an isolated example of failed financial institutions.Capital market

Brett W. Fawley

Luciana Juvenal

English

Research Papers in Economics

Economic SYNOPSES
short essays and reports on the economic issues of the day
2011 ■ Number 27
F
inancial globalization over the past 40 years has
been driven in part by the idea that what is optimal
for international trade in goods—the absence of
regulation—is optimal for international trade in assets in
the form of free capital flows. Since the recent financial
crisis, however, many emerging markets have responded
to large inflows of investment by imposing controls on
them.1 The financial press has claimed that the International
Monetary Fund (IMF), previously a strong advocate of
complete capital account liberalization (i.e., uninhibited
international capital flows), has reversed its position by
supporting such controls and even detailing a policy frame-
work for their use (Talley and Reddy, 2011).2 To the con-
trary, the IMF’s proposal retains the fundamental doctrine
of free capital flows without addressing the most important
question: Is free trade in dollars really no different from
free trade in widgets?
Advocates of free capital flows argue that they promote
efficient resource allocation: Global savings flows to its most
productive uses, maximizing economic growth. Critics
argue that the herding tendency of investors creates large,
highly disruptive booms and busts in the domestic credit
of individual countries, compromising their monetary
policy independence. The Asian financial crisis of 1997-98,
for example, is commonly attributed to herding behavior:
Unprecedented large inflows of capital to Indonesia,
Malaysia, Korea, Thailand, and the Philippines in 1996
suddenly reversed in 1997, with $12 billion flowing out of
these countries.
After the Asian financial crisis, many economists asked
whether capital crises could ever be eliminated in a world
of free capital flows (e.g., Rodrik, 1998). The response of
the IMF was “[We] recognize that without both sound
macroeconomic policies…and strong, transparent, and
properly supervised banks…opening up capital flows is
dangerous and inadvisable. The opening-up must occur in
the proper sequence; this is the moral of the Asian story”
(Anjaria, 1998).
In the wake of the recent financial crisis, the IMF’s pro-
posed policy framework for capital controls only reiterates
this lesson learned: Controls are defined as a last-resort
policy tool to handle transitory capital inflows when
exchange rate appreciation is against fundamentals, foreign
exchange buildups are inadvisable, and reforming the finan-
cial system would take too long (IMF, 2011). The implica-
tion remains that a properly regulated and supervised
banking system can fully mitigate any risks posed by free
capital movements: Capital controls represent a temporary
stopgap when the “proper sequencing” fails. The counter-
argument remains that no amount of domestic banking
regulation can prevent the capital crises inherent to unfet-
tered capital flows.
One commonly cited factor in capital crises is that coun-
tries borrow too much during good times (Magud and
Reinhart, 2007). For example, Korea was again subject to
large outflows in 2008 following the collapse of Lehman
Brothers. After this episode, Korea introduced and strength-
ened limits on the buildup of short-term external debt in
its banking system that had facilitated the abrupt reversals
of capital flows in 1997 and 2008. For its part, the IMF
labeled Korea’s reaction “macroprudential” and targeted at
financial stability risks, which the new IMF guideline on
capital controls permits “at any time…provided they are
not assessed to have been designed to influence inflows”
(IMF, 2011). But clearly the measures are both designed to
address systemic risk and targeted at capital inflows.
The embrace of ad hoc capital controls to address tem-
porary market inefficiencies on a case-by-case basis, while
pragmatic, perpetuates the view that each capital crisis is
Capital Controls by Any Other Name
Brett Fawley, Senior Research Associate
Luciana Juvenal, Economist
The embrace of ad hoc capital controls
to address temporary market 
inefficiencies on a case-by-case basis,
while pragmatic, perpetuates the view
that each capital crisis is an isolated
example of failed financial institutions.an isolated example of failed financial institutions. The
question that should be debated is whether a strict distinc-
tion between macroprudential measures and measures
targeted at international capital movements is justified.
Surely free capital flows, like free trade in goods, carry large
benefits. Yet the proposition that trade in dollars carries no
more risk than trade in goods remains controversial. If reg-
ulating internal debt accumulation is important for limiting
systemic risks, then regulating external debt accumulation
should be similarly important. Moreover, measures targeted
at specific capital flows, such as short-term external debt,
do not exclude the benefits of capital flows in the form of
foreign direct investment and other equity flows. ■
Anjaria, Shailendra F. “The Capital Truth: What Works for Commodities Should
Work for Cash.” Foreign Affairs, November/December 1998, 77(6), pp. 142-43;
www.foreignaffairs.com/articles/54606/shailendra-j-anjaria/the-capital-truth-
what-works-for-commodities-should-work-for-cas.
International Monetary Fund Strategy, Policy, and Review Department. “Recent
Experiences in Managing Capital Inflows—Cross-Cutting Themes and Possible
Policy Framework.” February 14, 2011;
www.imf.org/external/np/pp/eng/2011/031111.pdf.
Magud, Nicolas and Reinhart, Carmen M. “Capital Controls: An Evaluation,” 
in Sebastian Edwards, ed., Capital Controls and Capital Flows in Emerging
Economies: Policies, Practices, and Consequences. Chicago: University of Chicago
Press, 2007; pp. 645-74.
Rodrik, Dani. “Who Needs Capital-Account Convertibility?” in Should the IMF
Pursue Capital-Account Convertibility? (Essays in International Finance).
Princeton University, May 1998, No. 207, pp. 55-65;
http://people.umass.edu/econ721/rodrik.98.princetonessay.PDF.
Talley, Ian and Reddy, Sudeep. “IMF Reverses Position on Capital Controls.”
Wall Street Journal, April 6, 2011; http://online.wsj.com/article/SB100014240
52748703712504576245004198979930.html.
1 Examples include Brazil, Colombia, Indonesia, Korea, Taiwan, Thailand, and
Turkey, among others.
2 While the IMF Articles of Agreement signed in 1944 explicitly allowed for cap-
ital controls, the IMF pushed to amend its charter in the 1980s and 1990s to
mandate capital account liberalization. 
Economic SYNOPSES Federal Reserve Bank of St. Louis      2
research.stlouisfed.org
Posted on August 31, 2011
Views expressed do not necessarily reflect official positions of the Federal Reserve System.

Capital controls by any other name

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Capital controls by any other name

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