Are Capital Controls Countercyclical? Fernandez-Rebucci-Uribe Discussion by Anusha Chari (UNC-Chapel Hill & NBER) AEA Annual Meeting January 2015

Capital Controls: A swing in the academic pendulum  While international trade in financial assets brings many potential welfare gains, it also entails significant risks.  The extent to which policy-makers should allow foreign capital to flow into their economies remains a controversial issue.  Following the advice of academics, many emerging market policy makers opened up their capital markets to foreign capital in the late 1980s and early 1990s.  In the aftermath of a spate of financial crises in the late 1990s however, a heated debate over capital account liberalization has consumed the profession.  The swing in the academic pendulum has not been lost on policy makers who have increasingly taken to imposing a variety of capital controls.

IMF December 2012  “For countries that have to manage the risks associated with inflow surges or disruptive outflows, a key role needs to be played by macroeconomic policies, as well as by sound financial supervision and regulation, and strong institutions. In certain circumstances, capital flow management measures can be useful. They should not, however, substitute for warranted macroeconomic adjustment.”

This paper focuses on prudential controls  Theoretical models use two rationales to advocate the use of capital controls: (i) to promote financial stability in the presence of collateralized lending. (ii) to improve macroeconomic adjustment in economies with, for example, downward nominal wage rigidity and fixed exchange rates.  In both classes of models capital controls serve to internalize a systemic externality generated by decentralized individual behavior.  Also, it is optimal to impose controls during booms to mitigate inefficiencies generated by the externality.  In sum, moderate the amplitude of expansions & contractions through capital controls.

Are capital controls counter-cyclical?  Answer: No  Capital controls do not seem counter-cyclical or prudential in nature. If anything they are acyclical.

Three main findings that call into question the predictions of recent theoretical models  Unconditional standard deviation of cyclical component of controls is small.  Cyclical components of controls on inflows & outflows are positively correlated.  On average, controls on capital inflows & outflows are virtually unchanged during macroeconomic booms & busts.  Findings robust to income levels, exchange rate regime, level of external indebtedness, asset category, crisis period, intensity of controls, alternative indices.

Comprehensive dataset extends Schindler (2009)  New data covers for 91 countries  Capital inflows & outflows separately  Six categories of assets  Residence of transacting agent  Vast improvement on the IMF’s AREAR measure.  Compiling index is a service to the profession.

Important question and contribution  Sets up challenge for models advocating a rationale for prudential capital controls by confronting theory with the data.  Points to administrative costs of controls & governmental inertia or political economy explanations for why the cyclical component of controls does not vary much.  Do governments simply adopt a capital account policy stance that does not change much with the business cycle? Gates versus Walls?  Findings could help (a) refine theory & (b) inform policy.

Some questions & suggestions  Are we losing information through aggregation? Level I (asset-level index) 4 asset categories  domestic, foreign (0, 1) 2 asset categories  (0,1) Level II (country-level index) A tabulation of the frequency distribution of the controls used may shed light on whether certain components of the index are more variable than others or give clues about whether certain types of controls are more favored by governments. Parsing the data in this way might also help identify the cyclical component (if any) of the controls more precisely. Might also permit an event-study type analysis by asset category.

Some questions & suggestions  Country heterogeneity seems to matter. What is the benefit of having developed countries in the sample?  Can the Great Contraction exercise be repeated for other crisis periods focusing on the countries most affected by the crisis?  Since the counter-cyclical & prudential rational for controls does not appear to be borne out by the data, is there a role for a protectionist rationale in the theoretical models? Would this be more consistent with the data?  Theoretical models almost exclusively focus on debt as the financial instrument. In reality governments can use controls on a variety of capital flows. How can theoretical models be refined to evaluate the welfare impact of other types of instruments?

Conclusion  I very much enjoyed reading this paper.  Performs a very useful exercise of directly confronting the theoretical predictions from models of capital controls with what governments actually do.  Has implications for going forward how we model capital controls and also illustrates that the rationale for capital controls from a policy-maker’s perspective may be very different from that of the academician.  Again, something theory and empirical work can explore further perhaps in a political economy setting.  Bottom line: the paper gives a lot of food for thought.