In this paper, we provide empirical evidence on the factors that motivated emerging economies to change their capital outflow controls in the recent decades. Liberalization of capital outflow controls can allow emerging market economies (EMEs) to reduce net capital inflow (NKI) pressures, but may cost their governments the fiscal revenues that external financial repression generates. Our results indicate that external repression revenues in EMEs declined substantially in the 2000's compared with the 1980's. In line with this decline in external repression revenues and their growth accelerations in 2000's, concerns related to net capital inflows took predominance over fiscal concerns in the decisions to liberalize capital outflow controls. Emerging markets facing high volatility in net capital inflows and higher short-term balance sheet exposures liberalized outflows less. Countries eased outflows more in response to higher stock price appreciation, higher appreciation pressures in the exchange market and higher real exchange rate volatility. Non-IT monetary policy regimes also liberalized outflows more in response to greater reserves accumulation and higher NKI.
Recent years have seen a re-emergence of the policy debate on the appropriateness of capital controls. Opponents argue that capital controls can lead to local and global misallocation of resources, perpetuate global imbalances (by allowing countries to maintain undervalued real exchange rates) and encourage corruption. Further they, argue that in the empirical literature these controls have been found to be of limited effectiveness in stemming net capital inflows (NKI). Proponents argue that capital controls are macro-prudential measures and an optimal response to distortions in financial markets (for example herd behavior, too-big-to-fail). These controls are deemed to be an important tool to prevent the build-up of financial sector risks and to reduce the damage associated with sudden stops.1 Adding fuel to the debate, the International Monetary fund (IMF) has softened its longstanding opposition, and now suggests that capital controls may be a valid tool of macroeconomic and macroprudential management when other tools have been exhausted (IMF, 2011a).
The debate on what emerging market economies (EMEs) should or should not do has two key missing elements. The first is a fact-based analysis of the macroeconomic and financial pressures that EME policymakers most often respond to when imposing capital controls. The empirical literature assessing emerging market motivations for capital controls is scant.2 The second key missing element is a discussion of the use of capital outflow controls as a potential response to NKI pressures. Most of the recent policy debate has focused on tightening of capital inflow controls in response to surges in net capital inflows. 3 However, because NKI are the difference between capital inflows and outflows, countries that have existing outflow controls have another potential tool to reduce NKI – the liberalization of outflows. 4 This tool was discussed in the literature on managing capital flows of the 1990's (see Laban and Larrain, 1997), but it has been missing from the recent debate. Recent research in Pasricha (2012) documents that in 22 EMEs between 2004 and the onset of the 2008 financial crisis, outflow controls were liberalized more frequently than inflow controls were tightened. The pre-2008 crisis period saw a surge in net capital inflows to EMEs of a magnitude comparable to the post-2008 crisis surge, yet inflow tightening measures became a primary tool of restricting NKI only after the crisis.
The use of outflow liberalization in NKI management policy can be constrained by the fact that outflow controls exist not only to manage capital flows but also to allow government to lower the cost of borrowing by keeping domestic savings at home. Sustained outflow controls often form part of a web of regulations on the domestic financial sector (for example, interest rate ceilings, high reserve requirements, directed lending) that constitute “financial repression”. These regulations seek to further reduce the cost of government borrowing and to allocate savings to preferred sectors. Capital outflow controls help prevent capital flight in response to domestic regulations, and therefore are a key ingredient of financial repression. The revenues from financial repression can be substantial. Giovannini and Melo (1993) show that for some 24 emerging and developing economies over the period 1972–87, revenues from external repression averaged 1.4% of GDP. These considerations suggest that the decision to liberalize outflow controls in response to surging inflows could involve weighing the benefits of reduced NKI against the loss of revenues from financial repression.
In this paper, we provide evidence on EME motivations for capital outflow policy by examining fiscal and macroeconomic factors at the time when outflow controls were liberalized. We address the two gaps in literature identified above by focusing on capital outflow controls and by providing a positive analysis of outflow policy changes. To accomplish this, we build two novel datasets. First, we extend the dataset provided in Pasricha (2012) to cover the period 2001–2010. This dataset comprises all changes in capital account regulations in 22 large EMEs and therefore provides a de-jure assessment of capital controls. 5 Second, we estimate the revenue from external financial repression which, following Giovannini and Melo (1993), is defined as the fiscal revenue obtained by preventing residents from freely investing abroad. It is measured as the difference between the (effective or ex-post) external and domestic interest rate on government debt, times the government's domestic debt.
Our updated Giovannini and de Melo measure of external repression revenues is available for 15 countries.6 We find that in contrast to the 1980's, when many EMEs were found to be earning significant revenues from external repression, EMEs in the most recent decade earned negative (and statically insignificant) revenues from external repression on average. The negative revenues mean that EME governments faced lower borrowing costs in foreign markets (even after accounting for costs imposed by exchange rate fluctuations) than in the domestic market. The decline in external repression revenues has occurred despite the fact that emerging economies continue to maintain significant restrictions on capital outflows (notwithstanding the liberalizations over time).
There are several interpretations of the negative external repression revenues found in our study. An EME government with positive revenues from repression may be reluctant to liberalize outflows to manage the concerns posed by surging NKI for fear of losing these revenues, but may find it easier to liberalize when there are no revenues to be lost. In fact, EMEs did liberalize outflow policy substantially in the 2000's. Most of the outflow liberalizations took place in the years of surging NKI (putting downward pressure on domestic interest rates) and rapid economic growth (leading to increasing fiscal revenues from other sources), which suggests that fiscal concerns did not pose a binding constraint for EMEs in this period. Another interpretation of the negative external repression revenues is that, while many of these EMEs could have borrowed even more in markets abroad in the last decade, they refrained from doing so. That they chose not to borrow more abroad even at favorable interest rates may reflect concerns about greater balance sheet exposure (as most can borrow only in hard currencies) and the fear of a sudden stop. Finally, emerging markets may be willing to temporarily accept negative repression revenues to preserve the future repression tax base.
The result that concerns related to net capital inflows took predominance over fiscal concerns in the decision to liberalize capital outflow controls in the 2000's finds further support in our empirical exercise. EMEs liberalized outflow controls less when facing greater NKI volatility and higher short term balance sheet exposure, while they eased more when stock price appreciation, exchange market appreciation pressure and (for non-freely floating and non-IT monetary policy regimes) NKI and reserves accumulation were high– all pointing to concerns about foreign exchange valuation and domestic overheating concerns. Unlike in the 1980's, we find very limited importance of fiscal variables in explaining liberalization of capital outflow controls – only in the samples of relatively closed and non-inflation targeting countries, do we see a negative association of greater external repression revenues with easing of outflows. This lack of association is consistent with the decline in repression revenues for EMEs in the 2000's. This decade saw the growth accelerations of emerging markets, which led to a decline in their risk premia. The 2000's were also a decade of few adverse external shocks, real exchange rate appreciation pressures in EMEs and overall improved stances of their fiscal policies. Revenues from repression therefore became less important in the decision to liberalize outflows.
The paper is organized as follows: in the next section, we elaborate on the potential motivations for imposing capital outflow controls. Section 3 describes the construction of and trends in one of the main data series compiled in the paper – the changes in capital outflow controls. We devote section 4 to describing the measures used to capture fiscal concerns, including the second main data series compiled in the paper – revenues from external repression. Section 5 identifies testable hypotheses and outlines the econometric methodology. Section 6 presents the results and section 7 concludes.
