ANTON KORINEK: Stemming the tide
University of Maryland associate professor Anton Korinek outines policy approaches that can break the boom and bust cycle of capital flows to emerging markets
Two years after the most severe global financial crisis in decades, financial markets are flush with liquidity, aided by ample monetary stimulus from central banks around the world. Emerging market economies are experiencing large inflows of capital that are driving up their exchange rates and inflating asset prices.
Policymakers in the affected economies are justifiably worried about the consequences: surges in capital flows have historically been followed by severe crashes that have resulted in social, economic and political catastrophe. In recent months, Brazil, Indonesia, Korea, Peru, Taiwan, and Thailand, among others, have imposed or tightened capital controls in an attempt to avoid this fate.
Capital flows, by their nature, can trigger large economic costs, typically outside the control of recipient countries. Just as environmental pollution exacts a large toll on society, capital can leak into unwanted jurisdictions. Policymakers then can take some steps in insulating their economies from this threat by regulating and discouraging risky external financial flows, in particular dollar-denominated debts.
The most toxic asset class for emerging markets has historically been foreign currency debt.
If an emerging economy takes on dollar debts and subsequently experiences a financial crisis, the exchange rate depreciates and the domestic value of the debt increases sharply. By contrast, debt indexed to consumer price inflation, protects borrowers against exchange rate depreciations, imposing a smaller cost.
While the theoretical case for capital controls is compelling, the practical implementation poses a number of challenges in today’s globalized financial markets where armies of traders seek to surmount any hurdle that policymakers throw in the way of free capital flows.
HOW TO TAX CAPITAL INFLOWS
The following characteristics of capital controls are desirable.
First, taxes are likely to be more effective than unremunerated reserve requirements – which force foreign portfolio investors to park a portion of their investments in local bank accounts earning no interest and often for more than a year – in the current economic environment.
Both forms of capital controls have been used in practice. Economic theory suggests that the two measures are equivalent since the opportunity cost of not receiving interest on reserves amounts to a tax.
However, in today’s world of ample liquidity, the cost of holding reserves in bank accounts is extremely low. This implies that reserve requirements would have to be set at very substantial levels to affect investor behaviour.
Furthermore, the opportunity cost of holding reserves changes whenever global interest rates fluctuate. For example, a given reserve requirement is eight times as onerous when interest rates are 2% than when they are 0.25%. Taxes then are the most effective instrument to penalize foreign portfolio investors.
Second, controls on the stock of foreign capital in the country are also more desirable than controls that solely affect inflows. This is a workable plan. Foreign investors should be forced to hold their investments in designated so-called “non-resident investment accounts” and face taxes on these accounts on a daily basis. That’s because solely taxing inflows could prove ineffective. Global investors typically seek to increase capital inflows in a country before capital controls are imposed or increased. This phenomenon undermined the effectiveness of Brazil’s move in October to further hike taxes on investments in government bonds.
An effective way of ensuring compliance with the rules is by restricting creditor claims – in the event of bankruptcy or other legal proceedings – to only those foreign investors that have their investments in properly documented non-resident investment accounts.
Third, capital controls must distinguish between the type and maturity of capital flows. Regulation should tax risky forms of flows, such as short-term dollar debt, rather than safe forms such as non-financial FDI. This move will shift the liabilities of companies, households and governments of emerging economies towards safer forms of finance.
This in itself would make the economy more robust to shocks. However, the very fact of having different forms of capital taxes will trigger regulatory arbitrage with market players rushing to circumvent capital controls – possibly under the cover from regulators. It is, therefore, necessary for emerging market policymakers to consider a ban against derivatives contracts in all foreign exchange regulations.
Last, controls must also adapt to macroeconomic circumstances. The vulnerability of emerging economies created by capital inflows fluctuates with the domestic business cycle as well as with global liquidity conditions. Just as central bankers adjust interest rates in response to inflationary pressure, regulators in emerging markets have to calibrate their regulations to the prevailing macroeconomic environment.
Anton Korinek is assistant economics professor at the University of Maryland