Capital Control in Fashion Again?

This year, we have seen strong currency appreciation in emerging markets both because of external conditions, including high liquidity, a weak US dollar and strong risk appetite as well as domestic factors such as relatively strong fundamentals and wider interest rates differentials. As portfolio investments to emerging markets also rising, policymakers are in dilemma how to avoid losing international competitiveness while also containing asset inflation and the emergence of asset bubbles.

So far, reaction was pretty limited to either verbal intervention or reserve accumulation. Others have kept or chosen more aggressive administrative measures, including capital controls mostly targeting portfolio investments rather than FDI.

The imposition of capital controls on capital inflows as well as currency intervention tends to be ineffective in reversing the appreciating trend of the local currencies, especially if the latter are primarily driven by external factors. However, capital controls may be helpful in easing volatility and the pace of the trend itself. The risk is that capital controls are seen as punitive measures against capital markets, raise uncertainty about future policy actions, hurt the credibility of the central banks and increase the cost of external funding for local businesses.

Ultimately, the decision will be guided on how fast capital is flowing in, sterilization costs and monetary policy flexibility. Those countries where currencies and equity markets that experienced surge over the course of the year are the most likely to impose some sort of limitations on capital inflows.

On October 20, Brazil surprised investors with a 2% tax on capital inflows to both equity and bond markets. Likewise, in March 2008, Brazil used a 1.5% tax on fixed income inflows only to contain the Brazilian real’s appreciation then, which was lifted in October 2008 shortly after the Lehman collapse.

Chile is no stranger to capital controls, having imposed a 20% unremunerated reserve requirement on foreign loans from 1991-98. Chile’s foreign exchange regime is free floating and it tends to let the markets know of its intentions well in advance and their mechanisms are very transparent in length and quantity.

And in Asia-Pacific, despite a flood of portfolio investments, it still needs foreign capital to simulate investment and finance its current accounts. Most have opted to contain the currency appreciation via verbal and actual interventions, which has led to reserve growth of over US$70 billion in Q3 alone, ex-China. Based on the pace of reserve growth, and flow of hot money, this has led to an appreciation of domestic real assets, especially property. It is even clearer in the case of China, given its quasi dollar peg, which suggests inflows will persist. Tolerance for greater currency movement will be more visible for countries like South Korea, India and Indonesia with low export dependence, reliance on energy imports, and inflation risks.