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The 2000s: The Global Financial Crisis and the Rebirth of Capital Controls

Although the optimism about free capital flows was severely dented by the experience of the emerging market crises of the late 1990s and early 2000s, and dissenting voices even from the establishment started to question the benefits of unfettered capital flows,11 the first part of the 2000s was characterized by another boom in capital flows to DECs. Partly as a result of adjustment programs in the aftermath of the crises, and partly as a result of further changes in domestic economic models, large parts of DECs experienced further financial liberalization, including those previously more careful such as India and China. To make this liberalization possible and supposedly avoid future instabilities and crises, in many countries, these liberalization programs were accompanied with fundamental changes in the macroeconomic framework. To avoid unsustainable exchange rate pegs, which were identified as the root cause of the crises of the 1990s, many of these countries switched to at least officially floating exchange rates.[1] [2] The new nominal anchor was provided by the overriding importance of inflation and the institutionalization of inflation-targeting regimes. Finally, stability was to be provided by inde?pendent central banks and, as will be seen below, the massive accumulation of foreign exchange reserves.

As a result of these changes, and the return of liquidity to international financial markets after the dot-com bubble, there was an unprecedented surge in international capital flows. Private financial flows to DECs swelled from an average of US$487 billion in 2003-2005 to more than US$1.5 trillion in 2007. In terms of stocks, Akyuz (2015) shows that for the entire period of 2000-13 gross international assets and liabilities of DECs grew by about 15 and 12.5 percent per annum, respectively, and their gross balance sheets expanded by more than fivefold. In addition, the nature of these capital flows changed. Rather than bank lending or foreign currency sovereign debt flows as in previous episodes, capital flows were increasingly directed towards (short-term) domestic currency assets, such as domestic public bonds, equities and even more complex assets such as derivatives and the currency per se as in the notorious carry trade phenomenon (Akyuz 2015; Kaltenbrunner and Painceira 2015). According to the World Bank (2013), at the end of 2012 the share of non-resident holdings in $9.1 trillion local debt markets of DECs reached an unprecedented 26.6 percent, exceeding 40 percent in some economies (Akyuz 2015). On the investor side, traditional DEC investors (such as banks and dedicated funds) were complemented with a wide range of other actors, including institutional investors (pension and insurance funds) and new types of mutual fund investors such as exchange-traded funds and macro hedge funds (Aron et al. 2010; Bonizzi 2013; Ffrench- Davis and Griffith-Jones 2011; Jones 2012; Yuk 2012). Given the large size of their balance sheets, any reallocation of these investors can have large repercussions on developing country asset markets.

The results of these strong capital inflows were sustained exchange rate appreciations, domestic asset price bubbles and credit booms. To deal with these pressures, DECs initially largely followed the standard market- based macroeconomic toolkit recommended by neoclassical economists and international financial institutions (IFIs). As indicated above, this consisted of inflation-targeting regimes, central bank independence and fiscal prudence to provide credibility and macroeconomic discipline. To deal with the strong exchange rate pressures, countries were recommended to engage in sterilized foreign exchange intervention. This was permissible as long as the exchange rate goal did not become inconsistent with the inflation target, and inflation remained the one and overriding objective of monetary policy. Whereas foreign exchange purchase were aimed at dampening the worse impact on the exchange rate (and accumulate a war chest of foreign exchange reserves in the case of future outflows), sterilization operations should mop the excess liquidity from the market to avoid any negative impact on inflation. As a result, given the combination of strong capital inflows and all-time high of commodity prices, foreign exchange reserves in DECs swelled from US$0.5 trillion in 2000 to US$8.1 trillion in 2014.

As capital flows experienced their final surge from the beginning of 2006 some countries, in particular those which received the largest amounts of capital, started to impose restrictions on international capital flows. Colombia, for instance, imposed an URR on foreign borrowing and portfolio inflows in 2007 (while also limiting the currency derivative positions of banks). Similarly, Thailand imposed a 30 percent URR (with a 10 percent penalty if the funds were withdrawn in less than one year) (Gosh and Qureshi 2016). Brazil tightened its tax on foreign purchases of bond and equities in the run-up to the crisis in January 2008 (Baumann and Gallagher 2012 ; Fritz and Prates 2013). However, these attempts remained timid, limited and, despite the increasingly obvious negative impact of the strong capital flows, the attitude towards capital controls remained generally negative. As Gosh and Qureshi (2016) show, in some situations the controls even backfired. For example, evoking memories of the currency crisis nearly a decade earlier, the introduction of Thailand’s URR resulted in strong market reactions, which plunged by 15 percent in less than one day. Financial markets sent “a clear signal that they did not approve of the capital controls, whether on outflows or on inflows, to the point of not even bothering to distinguish between them” (Gosh and Qureshi 2016, p. 28).

This attitude arguably changed with the international financial crisis and its aftermath. Despite strong fundamentals, record foreign exchange reserves and a successful reduction in their ‘original sin’ (the inability to borrow in domestic currencies), DECs’ currencies plunged in the wake of the failure of Lehman Brothers. For example, the Brazilian Real depreciated by more than 60 percent during August and October 2008. In a similar vein, the Colombian Peso and Korean Won both lost 13 percent in a month largely independent of domestic economic fundamentals (Arduini et al. 2012).

Kaltenbrunner and Painceira (2015) argue that these large exchange rate movements were the result of the structural changes in DECs’ financial integration in the years preceding the crisis. On the one hand, the large exposure of foreign investors to domestic currency assets had made the prices of these assets increasingly sensitive to international market conditions. On the other hand, foreign investors’ holding of domestic currency assets had converted currency movements into a crucial part of returns (often surpassing those made by the interest differential). This, in turn, had two implications for the exchange rate. First, the attempt to take advantage of favourable exchange rate movements in thin financial markets created the risk of destabilizing bubble dynamics, where foreign investors’ expectations created self-fulfilling exchange rate swings (Kaltenbrunner 2015a). Second, foreign investors’ exposure to domestic currency assets, funded on international financial markets, shifted the currency mismatch from the domestic to the foreign actors, thereby making them very sensitive to expected exchange rate changes. In this vein, Akyuz (2015) shows that the Lehman Brothers collapse had a much stronger impact on local currency issues than dollar-denominated issues. At the same time, local currency issues recovered much faster as expectations of exchange rate appreciation returned. Finally, it is interesting to note that long-term investors, in particular pension funds, contributed strongly to this adjustment. Although later to act, once pension funds adjusted their portfolios, the size of these positions was much larger exerting substantial pressures on DEC exchange rates (IMF 2014).

Some developed countries, such as Iceland and Cyprus, had to impose controls to deal with the effects of the crisis and its aftermath. DECs, in turn, initially recovered relatively quickly. In 2010, growth in DECs reached a strong 7 percent (compared with 2.8 percent in developed ones) (World Bank 2011). In addition, the reduction of currency mismatches meant that the private sector was less affected and central banks could, for the first time, conduct counter-cyclical policy.[3] Nevertheless, the crisis experience left important scars, which played an important role in the subsequent decision to implement capital controls.

The moment for more widespread capital controls in DECs came in the years following the global financial crisis of2008. Low, if not negative, real interest rates in developed countries meant that these countries experienced a fourth, and even more violent, surge of capital flows. According to Akyuz (2015), it is estimated that non-residents held $1 trillion government debt of DECs at the end of 2012 (not counting official loans). About half of this debt was incurred during 2010-12. Again, this surge resulted in appreciating exchange rates, overheating asset and credit markets, and balance of payments pressures. This time round, the situation was met with a more confident approach by DECs trying to stem the tide.

For example, to name just some of the more prominent cases, in October 2010 Brazil increased its tax on portfolio inflows to 4 percent and 6 percent for the case of equity funds and fixed income investments (IOF), respectively. At the same time, it increased the IOF on margin requirements on derivatives transactions from 0.38 percent to 6 percent. Confronted with further strong capital inflows, it implemented non-interest-bearing reserve requirements for the FX short positions of banks,[4] increased the IOF on new foreign loans to 6 percent, and implemented several restrictions on the local derivatives market in the first half of 2011 (Prates and Fritz 2012). The Brazilian finance minister at that time, Guido Mantega, went so far as to speak of a currency war.

In a similar vein, South Korea implemented a series of measures to reduce the strong pressures on the won. Like Brazil, it deployed more traditional controls, such as limits on bank loans and levies, but also devised innovative regulations on derivatives in order to stem inflows (Gallagher 2015). For example, starting in July of 2010, South Korean banks had

Average capital controls (Source

Fig. 7.1 Average capital controls (Source: Fernandez et al. (2015b); Notes: The strength of capital controls is approximated with an index between 0 (no controls) and 1 (complete controls); indices are based on the IMF AREAER data)

to limit their currency forward and derivative positions at 50 percent of their equity capital. For foreign banks, the ceilings were set at 250 percent of their equity capital. Furthermore, South Korea tightened the ceilings on companies’ currency derivatives trades to 100 percent of underlying transactions from the current 125 percent. Finally, Taiwan introduced controls on numerous occasions and even urged other nations to do the same. In November, 2009, it introduced bans on foreign funds from investing in time deposits and limited the percentage of currency that could be held by banks (Gallagher 2011).

Figure 7.1 shows the average inflow and outflow restrictions of a large range of DECs.

One can observe the continuous decline of capital controls measures for the decade after 1995 (including the years of the DECs’ crises), the slight increase around 2006 and the further surge in 2008 in the wake of the global financial crisis. Figure 7.1 also shows that until 2013 controls had remained relatively high and even increased further in the wake of the 2013 US tapering announcements.[5]

At the same time, the IMF seemed to make a U-turn and for the first time endorsed some restrictions on capital flows. Confronted with the challenges posed by the large swings in capital flows, it produced a series of research and policy papers, which gave legitimacy to a certain degree of capital account management (IMF 2011b; see, also, Ostry et al. 2010a, b). These culminated in the IMF’s Institutional View on the Liberalization and Management of Capital Flows, which explicitly acknowledged that capital controls could form a legitimate part of the policy toolkit (IMF 2012). An in-depth engagement with this apparent change of mind is beyond the remit of this chapter, and some issues will be taken up again in Sect. 7.7, but critiques have questioned the extent of the IMF’s changing position.[6] [7] The conditions under which capital controls are legitimate remain relatively stringent. Only if the exchange rate is not undervalued, all other options are exhausted, and capital controls are not used to stray from orthodox fundamentals, these represent legitimate policy tool.1 7 Thus, in practice the space for capital controls remains rather limited.

What interests us more at this point is: (a) why we have we seen this more positive stance towards capital controls from the side of the implementing countries; (b) what exactly has changed; and (c) whether we have indeed observed such a rupture in international governance. The first of these issues will be briefly addressed below, the second and third shall be discussed in more detail in Sect. 7.7.

Grabel (2015) has pointed to five reasons, which could explain DECs’ more active use of capital controls. These are: the rise of increasingly autonomous developing states, which take advantage of the policy autonomy granted by the accumulation of foreign exchange reserves; the increased assertiveness of their policymakers due to their success in responding to the current crisis; a pragmatic adjustment by the IMF to an altered global political economy and its attempt to maintain legitimacy; the need for capital controls by countries at the extreme; and, finally, the evolution in the ideas of academic economists and IMF staff. Thus, for Grabel (2015) , the crisis of 2008 marks a radical departure from the past, where the increased economic success and confidence of many DECs allowed them not only to break the rules but to “tear up the rule book altogether” (Grabel 2015) p. 18). The increased international power and influence of DECs, and the IMF’s attempt to maintain legitimacy through showing a kinder face is also mentioned by Gallagher (2011). Moreover, he shows, with regard to the examples of Brazil and South Korea, how a combination of memories of the devastating impacts of the emerging market crises of the 1990s and political parties, which had the institutional structure and political backing to intervene in global capital markets and relatively autonomous finance ministry technocrats with some influence over the central bank, created space for measures of what he calls “countervailing monetary power” (Gallagher 2015).

Although I agree with Grabel (2015) and Gallagher (2015) that the global crisis of 2008 marked a turning point with regards to capital controls in many DECs, I am slightly less optimistic about the new policy space and autonomy gained by these countries. I would argue that rather than a sign of increased policy autonomy, many DECs had no other choice than to resort to capital controls in the presence of the extraordinarily strong capital flows and the exhaustion of the conventional, market-based framework, which had become victim of its ‘own success’. In the new era of international financialized capitalism, capital flows to DECs have reached unprecedented dimensions, which these countries were simply unable to absorb in their domestic economies. DECs found themselves in a dilemma and unable to employ other policy measures, as strong, yield-driven capital flows caused domestic overheating, asset price bubbles and inflationary pressures. Institutionally bound by an inflation?targeting regime, they had to raise interest rates to slow down the economy and reduce the inflationary pressures. Higher interest rates, however, further attracted yield-driven capital flows, undermining the central bank’s initial attempt to cool the economy and thereby further appreciating the exchange rate. At the same time, the sterilized foreign exchange interventions also maintained high interest rates and substantially increased the public debt burden and fiscal cost. Moreover, Kaltenbrunner and Painceira (2012) show that rather than reducing the pressures on the exchange rate, the sterilized interventions plus reserve accumulation acted at times in a counterproductive manner, further attracting capital flows and appreciating the exchange rate.) [8] Thus, on this account, rather than a reflection of more autonomous, independent policymaking, recent controls were the ultimate (temporary) resort of DECs to escape the contradictions of the conventional, neoclassical model.

At the same time, I would argue, the global crisis of 2008 had shown that even following this conventional, neoclassical model would not protect DECs from the vagaries of the international markets. As seen above, despite sound fundamentals, a reduction in balance sheet weaknesses, floating exchange rates, and record levels of foreign exchange reserves, these countries faced masses of capital outflows and large exchange rate adjustments when the subprime crisis struck in the USA. More than that, it was those countries which had adhered most diligently to the conventional model, and thus attracted most capital flows, which suffered most. Not even the presence of long-term, institutional investors, generally considered to be less destabilizing and more beneficial types of capital flows, reduced this impact. To the contrary, the large size of these investors’ balance sheets had tremendous implications for domestic asset markets when they adjusted their positions. Thus, I would argue that it was the increased awareness among DECs that even playing according to the rules would not save them from the volatility of capital flows which emboldened these countries to resort to capital control measures. In other words, it became clear that DECs had nothing to lose by break?ing the rules and that, once again, following neoclassical policy advice would not allow for beneficial international integration.

Finally, this became particularly acute after the international financial crisis. Whereas before the crisis high commodity prices and external demand compensated for an appreciation in exchange rates, flagging external demand and falling commodity prices put pressures on external balances after the global crisis. This made any measures to dampen appreciation pressures even more important. As capital flows began to weaken and became negative in the wake of tapering (announcements), many of these controls were dismantled again in an effort to support weakening currencies and respond to a growing need for external financing in view of their widening current account deficits (Akyuz 2015).

  • [1] As early as 2002, the IMF had begun to soften its preference for unfettered international capitalflows. In that year, Kenneth Rogoff, then serving as Chief Economist and Director of Research ofthe IMF, wrote in the December issue of the IMF’s publication Finance and Development: “Thesedays, everyone agrees that a more eclectic approach to capital account liberalization is required”(Rogoff2002, p. 1).
  • [2] In practice, many of them have been managing their exchange rates, a phenomenon known as‘fear of floating’.
  • [3] It is important to note, however, that in several countries, including Brazil, Mexico and Poland,the large exchange rate movements had a severe impact on several companies, which had assumedspeculative derivatives positions. In other words, whereas the vulnerabilities related to the originalsin had been mitigated, others had emerged.
  • [4] Banks are important counterparties to the positions of foreign investors. Reducing the open FXposition banks could take, was aimed at impacting this counterparty function and hence new capital inflows.
  • [5] It is important to note, however, that not all countries resorted to capital controls during thattime. Several countries, including Turkey, Chile, Mexico and Colombia, publicly rejected controlsand continued to purchase dollars and conduct expansionary monetary policy. According to Grabel(2015) these divergent responses reflect several factors including different political economies, thecontinued say of neo-liberal ideas, and perhaps also the pride of struggling with a too strong currency in countries which traditionally faced the opposite problem. Moreover, it is important tonote that many countries are legally barred from introducing controls on capital flows as a result oftheir membership of bilateral or multilateral trade and investment treaties (Gallagher 2010).
  • [6] For a more in-depth engagement with the IMF’s changing position see, for example, Chwieroth(2014), Dierckx (2011), Fritz and Prates (2013), Gabor (2012), Gallagher (2014), Grabel (2015).
  • [7] For example, the IMF itself shows in a staffnote that all examined countries (10 countries in Asia,Turkey, Brazil and South Africa) would have to pursue more orthodox macroeconomic policiesbefore they could legitimately use capital controls (Pradhan et al. 2011).
  • [8] 18This result is also confirmed by Montiel and Reinhart (1999), who show that monetary sterilization is associated with an increase in capital flows, in particular short-term portfolio flows.
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