As the developed economies struggle to revive growth and create jobs, the debate about currency wars has come to forefront, with generalised quantitative easing, an EU Tobin tax, and confusing comments from G7 official regarding the effects of Abenomics on the yen.
Emerging markets have been experimenting with capital controls with the aim of combating real exchange-rate appreciation. Among financially open emerging markets, no country has gone to a greater length than Brazil. It thus serves us well to to analyse the recent Brazilian experience with capital controls.
Brazilian capital controls
On October 2009, the Brazilian government began to introduce what would become an extensive set of controls on inflows of foreign capital (Jinjarak, Noy Zheng 2012). It started with a 2% tax on financial transactions on foreign investments in portfolio debt and equity, collected at the initial currency conversion, similar to a Tobin tax. Several other measures followed. But since 2012, many of the controls have been relaxed or eliminated, suggesting that one more cycle of capital controls may be coming to an end, as occurred between 1993 and 1998. It is therefore an opportune time to assess the success of these measures.
It's important to keep in mind the basic differences between the two control cycles. In 1993-98, foreign flows were mainly attracted by the high domestic interest rate and predetermined exchange rate (crawling peg). Most capital inflows were directed to carry-trade operations, which involved borrowing in strong currencies with low interest rates and investing those funds in Brazil’s much higher interest rates. On the other hand, the capital flows that resumed after the recovery from the 2008 crisis were much more diversified, because Brazilian interest rates were not as high as in the past, the Brazilian economy was more developed and had investment-grade status, and the exchange rate was floating.
Brazil's recent experience with capital controls has attracted much attention in the wake of a remarkable change of position by the IMF, which now recommends, under specific circumstances, the use of capital controls to prevent the creation of bubbles and financial crises1. Part of the interest derives from the fact that never before has a fairly open economy experimented so actively with capital controls. There is also great interest among academic economists (for instance, at the American Economic Association meetings, last January, there were at least four papers analysing various aspects of Brazil’s experience with capital controls).
Brazil’s recent experience
In a paper co-authored with Marcos Chamon (2013) we analyse the recent Brazilian experience. The literature on capital controls shows mixed results2 but, in general, there is stronger evidence that capital controls alter the composition of flows (e.g. less carry-trade and more direct foreign investment), with more mixed results on the volume of total capital inflows, and the exchange rate. A common criticism of the results on composition is that investors may have managed to disguise taxed flows (eg carry trade) as non-taxed flows (eg FDI).
Our article follows an alternative approach, and instead of focusing on volumes we compare prices for similar financial assets available in Brazil and in the US. We compare shares traded in Brazil with their respective American depositary receipts (ADRs), which are based on the same underlying shares but are traded in the US market. If the controls have been effective, a premium as large as the magnitude of the tax on financial transactions (2%) should have risen. We find such a premium, but only at times of excess foreign demand for Brazilian shares. We also show that the size of the premium between the underlying share and the ADRs induces the issue of new ADRs. In the fixed-income market, the spread between the interest rate in dollars in Brazil (Cupom Cambial) and in the US is lower than the tax rate on financial transactions (6%), and temporary spikes following some of the controls tend to be short lived. Overall, we document that capital controls did produce a wedge between the Brazilian and international financial market.
The Brazilian authorities were, as a rule, candid about the main motivation for the imposition of controls: combating the appreciation of the real. Thus, it is natural to use the developments in the exchange rate as the main criteria to evaluate the effectiveness of the controls. We do not find a statistically significant impact on the exchange rate in the immediate aftermath of the different measures. We constructed counterfactuals for the exchange rate, based on econometric models without capital controls, and compared the results with those that actually occurred. We also compared the real exchange rate with other currencies of similar countries. Both exercises suggest an ineffectiveness of controls in affecting the exchange rate. What seems to have strongly affected the exchange rate was the unexpected easing of monetary policy in the second half of 2011.
But it is possible that the cumulative effect of the controls, especially the tax on financial transactions on foreign-exchange derivatives (which can hit investors not only upon entry but also when they close their position), has amplified the effect of the cuts in the interest rate on the exchange rate, even though many of the capital controls have been relaxed since March 2012. The exchange rate has fluctuated within a narrow band since mid-2012, with sterilised interventions by the Central Bank of Brazil in both directions, suggesting they are reasonably happy with the current level.
In principle, capital controls can be desirable and welfare-improving, if they help avoid excessive debt and asset price bubbles3 which was indeed a risk, given the appetite of foreign investors towards Brazilian assets. But Brazil has a very low domestic saving rate (only 16% of GDP), and needs to complement it with foreign savings in order to enable an investment rate compatible with the aim of sustaining GDP growth. There is a risk that the capital controls may have a lasting impact on the capital inflows that could leverage the growth potential of the Brazilian economy.
Cardenas, Mauricio, and Felipe Barrera (1997), “On the Effectiviness of Capital Controls: The Experience of Colombia during the 1990s,” Journal of Development Economics, 54(1), 27-57.
Cardoso, Eliana and Ilan Goldfajn (1998), “Capital Flows to Brazil: The Endogeneity of Capital Controls,” IMF Staff Papers, 45(1), 161–202.
Carvalho, Bernardo S de M, and Márcio G P Garcia (2008), “Ineffective Controls on Capital Inflows under Sophisticated Financial Markets: Brazil in the Nineties”, in S Edwards and M Garcia (eds.) Financial Markets Volatility and Performance in Emerging Markets, Cambridge, Massachusetts, National Bureau of Economic Research.
De Gregório, José, Sebastian Edwards, and Rodrigo Valdés (2000), “Controls on Capital Inflows: Do They Work?”, Journal of Development Economics, 63(1), 59-83.
Edwards, Sebastian, and Roberto Rigobon (2009), “Capital Controls on Inflows, Exchange Rate Volatility and External Vulnerability,” Journal of International Economics, 78(2), 256-67.
Forbes, Kristin (2007), “One cost of the Chilean capital controls: increased financial constraints for smaller traded firms,” Journal of International Economics, 71(2), 294-323.
Garcia, Márcio G P and Chamon, Marcos (2013), “Capital controls in Brazil: Effective?” Economia.
Jinjarak, Yothin, Noy, Ilan and Zheng, Huanhuan (2012), “How effective were the 2008-2011 capital controls in Brazil?”, VoxEU.org, 22 November.
Korinek, Anton (2011), “The Economics of Prudential Capital Controls: A Research Agenda”, IMF Economic Review, 59, 3, 523-561.
Magud, Nicolas, Carmen Reinhart and Kenneth Rogoff (2011), “Capital Controls: Myth and Reality – A Portfolio Balance Approach”, NBER Working Paper 16805.
Ostry, Jonathan D, Atish Ghosh, Karl Habermeier, Marcos Chamon, Mahvash Qureshi, and Dennis Reinhart (2010), “Capital Inflows: The Role of Controls”, IMF Staff Position Note 2010/04.
Ostry, Jonathan D, Atish Ghosh, Marcos Chamon, and Mahvash Qureshi (2012), “Tools for managing financial-stability risks from capital inflows,” Journal of International Economics, 88(2), 407-421.
1 See Ostry et al. (2010 and 2012), and IMF (2012)
2 Magud, Reinhart and Rogoff (2011) provide an excellent survey and meta-analysis of that literature. Case studies for Latin American countries’ experience with the previous cycle of capital inflows in the nineties include Cardenas and Barrera (1997) for Colombia, de Gregorio, Edwards and Valdes (2000), Forbes (2007) and Edwards and Rigobon (2009) for Chile, and Cardoso and Goldfajn (1998) and Carvalho and Garcia (2005) for Brazil.
3 See Korinek (2011).