CEPR Paper: Capital Controls Can Help Governments Pursue More Stable, Higher Growth

April 19, 2010

April 19, 2010

For Immediate Release:April 19, 2010
Contact: Dan Beeton, 202-239-1460

Washington, D.C. – In response to the International Monetary Fund’s (IMF’s) recent recognition of the positive potential for capital controls, the Center for Economic and Policy Research released a paper today that indicates that capital controls can play an important role in developing countries by helping to insulate them from some of the harmful effects of volatile and short-term capital flows.

“Many developing countries have suffered serious contagion effects from the reversal of capital flows in the wake of the recent world economic downturn,” said Mark Weisbrot, Co-Director of The Center for Economic and Policy Research. “It is clear that capital controls can play a part in reducing some of this harm.”

In a February paper [PDF], the IMF concluded that “there may be circumstances in which capital controls are a legitimate component of the policy response to surges in capital inflows.” The Fund’s Global Financial Stability Report [PDF] released last week was less sanguine about capital controls, but the net result is that the IMF appears more open to supporting capital controls than in the past.

The CEPR paper, “Capital Controls and Monetary Policy in Developing Countries,” written by CEPR economist Jose Antonio Cordero and Juan Antonio Montecino, looks at both the theoretical and empirical literature on capital controls.

Short-term capital flows may be very volatile; they react quickly to sudden changes in investors’ moods, external events, and to perceptions of governments’ macroeconomic policy decisions. In 2007 net debt flows to the developing world were more than 6.5 times as large as they were in 2003; yet, in 2008 these flows were at less than half their 2007 level. Short-term debt flows, which almost quadrupled between 2003 and 2007, turned negative in 2008.

A surge of capital inflows, especially short-term and/or speculative inflows, can cause the domestic currency to appreciate. This can reduce competitiveness in the country’s tradable goods sector, slow economic growth, and harm economic development by increasing the volatility and hence uncertainty of international prices.

Capital flows can also cause enormous damage when they are reversed, with large capital outflows leading to a financial crisis. This was a major cause of the Asian financial crisis of 1997-1999, and also harmed many countries in 2008-2009.

The paper concludes that capital controls can provide an alternative to an inflation-targeting with floating exchange rate regime, or a “hard peg” fixed exchange rate regime (which has been shown to have other severe disadvantages, as in Argentina, Brazil, and Russia in the 1990s). With capital controls, it may be possible for the government to maintain a more stable and competitive exchange rate while keeping inflation in check.

The authors look at controls on capital inflows in Malaysia (1989-1995), Colombia (1993-1998), Chile (1989-1998), and Brazil (1992-1998). They also consider the case of Malaysia’s controls on outflows in 1998-2001.

They conclude that there is sufficient backing in both economic theory and empirical evidence to consider more widespread adoption of capital controls in order to address some of the macroeconomic problems associated with short-term capital flows, to enable certain development strategies, and to allow policy makers more flexibility with regard to crucial monetary and exchange rate policies.


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