A Capital Idea? Reconsidering a Financial Quick Fix

Sebastian Edwards

From Foreign Affairs, May/June 1999

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Summary:  Calls for capital controls are growing louder as battered emerging markets try to get back on their feet, but such measures are no substitute for real financial reform.

Sebastian Edwards is Henry Ford II Professor of International Economics at UCLA'S Anderson Graduate School of Management. He was Chief Economist for Latin America at the World Bank from 1993 to 1996.

Massive capital flows have been at the heart of every major currency crisis in the 1990s. Whether Mexico in 1994, Thailand in 1997, Russia in 1998, or Brazil in 1999, the stories are depressingly similar. High domestic interest rates, perceived stability stemming from rigid exchange rates, and apparently rosy economic prospects all attracted foreign funds into these emerging markets, lifting stock prices and helping finance bloated current account deficits. When these funds eventually trickled to a halt or reversed direction, significant corrections in macroeconomic policies became necessary. But governments often watered down or delayed reform, which increased investor uncertainty and nervousness over risk. As a result, more and more capital poured out of the countries and foreign exchange reserves dropped to dangerously low levels. Eventually, the governments had no choice but to abandon their pegged exchange rates and float their currencies. In Brazil and Russia, runaway fiscal deficits made the situation even more explosive.

In the aftermath of these crises, a number of influential academics have argued that the wild capital movements wrought by globalization have gone too far. In the words of Paul Krugman, "sooner or later we will have to turn the clock at least part of the way back" to limit the free mobility of capital. Bolstered by the growing number of capital-controls advocates, proposals for a new international financial architecture have focused on two types of controls: restrictions on short-term capital inflows, similar to those implemented in Chile between 1991 and 1998; and controls on capital outflows, like those Malaysia imposed in 1998. Both schemes try to reduce the "irrational" volatility inherent in capital flows and foster longer-term forms of investment, such as direct foreign investment, including investment in equipment and machinery.

Despite their good intentions, these proposals share a common flaw: they ignore the discouraging empirical record of capital controls in developing countries. The blunt fact is that capital controls are not only ineffective in avoiding crises, but also breed corruption and inflate the costs of managing investment.

DON'T BANK ON IT

Chile, which experimented with short-term capital controls during 1978-82 and 1991-98, has become a favorite test case for proponents of such measures. In both episodes, foreigners wishing to move short-term funds into Chile were required to first deposit their money with Chile's central bank for a specified amount of time -- at no interest. By stemming inflows, the policy aimed to mitigate capital volatility, prevent the currency from rising too quickly (a common result of accelerated capital inflows), and increase the central bank's control over domestic monetary policy. From 1978 to 1982, the controls were particularly stringent; foreign capital was virtually forbidden from entering the country for less than five and a half years. In this way, it was thought, the country would not be vulnerable to short-term speculation.

Proponents of controls cite all the above facts but miss the bigger picture. Indeed, their brand of wishful thinking misreads Chile's history and oversells the effectiveness of this policy. What you do not ...

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