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DEVELOPING COUNTRIES’ EXPERIENCE WITH CAPITAL ACCOUNT REGULATIONS Presentation in the Technical Group Meeting of the Group of 24, Colombo, Sri Lanka, February 28, 2018 José Antonio Ocampo Member of the Board Banco de la República, Colombia

The major policy issues (1) Capital flows towards emerging and developing countries are highly pro-cyclical, in terms of availability and cost. This generates two types of risks:  Financial-stability risks : boom-bust cycles in the domestic financial system that may lead to a financial crisis.  Macroeconomic-policy risks : pressure to adopt pro-cyclical macroeconomic management, with large destabilizing effects.

The major policy issues (2) However, not all booms end up in crises: The critical issues are current account deficits and associated currency appreciation.  Reduction of external debts and accumulation of reserves serve as additional buffers against capital flow volatility.  The domestic counterpart of the current account deficit is important: the long-term effects are very different if they reflect increases in investment rather than reductions in domestic savings.

Some features of capital flows  There is a “volatility hierarchy: FDI is less volatile than financial flows (portfolio and debt flows).  LICs more limited access to private capital flows.  Flows towards EMEs are sensitive to monetary policy in AEs, and to risk perception.  Since EMEs markets are relatively small, a small portfolio decision in AEs has major effects on EMEs  Sensitivity has declined due to: reserve accumulation, development of domestic bond markets, and stronger growth of EMEs.  There was a major surge after the 2007-09 North- Atlantic financial crisis, which has eased, but there have been no “sudden stop” in financing  Major disturbance focused on China in 2015-16.

10,0 12,0 14,0 16,0 18,0 20,0 22,0 0,0 2,0 4,0 6,0 8,0 1/01/1998 Pro-cyclical pattern of capital flows (1) 1/04/1998 1/07/1998 1/10/1998 1/01/1999 1/04/1999 1/07/1999 1/10/1999 1/01/2000 1/04/2000 1/07/2000 1/10/2000 1/01/2001 1/04/2001 Emerging Economies: Spreads and Yields of Sovereign Bonds, 1998-2017 1/07/2001 1/10/2001 1/01/2002 1/04/2002 1/07/2002 1/10/2002 1/01/2003 1/04/2003 1/07/2003 1/10/2003 1/01/2004 1/04/2004 1/07/2004 1/10/2004 1/01/2005 1/04/2005 1/07/2005 1/10/2005 1/01/2006 1/04/2006 1/07/2006 1/10/2006 1/01/2007 1/04/2007 1/07/2007 1/10/2007 1/01/2008 1/04/2008 1/07/2008 1/10/2008 1/01/2009 1/04/2009 1/07/2009 1/10/2009 1/01/2010 Spreads 1/04/2010 1/07/2010 1/10/2010 1/01/2011 1/04/2011 1/07/2011 1/10/2011 1/01/2012 1/04/2012 Yields 1/07/2012 1/10/2012 1/01/2013 1/04/2013 1/07/2013 1/10/2013 1/01/2014 1/04/2014 1/07/2014 1/10/2014 1/01/2015 1/04/2015 1/07/2015 1/10/2015 1/01/2016 1/04/2016 1/07/2016 1/10/2016 1/01/2017

Pro-cyclical pattern of capital flows (2) Net Private Capital Flows to Emerging Markets, 1990-2016 A. Total (billions of current dollars) 800 600 400 200 0 -200 -400 -600 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 FDI Net flows Portfolio Net Flows Other Net Flows Total

Pro-cyclical pattern of capital flows (3) B. Excluding China 1990-2016 600 500 400 300 200 100 0 -100 -200 -300 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 FDI Net flows Portfolio Net Flows Other Net Flows Total

Pro-cyclical pattern of capital flows (4) Net Private Capital Flows to Low Income Economies 2003-2016 (billion current dollars) 40 30 20 10 0 -10 -20 -30 -40 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 FDI Net flows Portfolio Net flows Other Net flows Total

The liberalization process has been uneven in the emerging and developing world Chinn-Ito Index of Capital Account Openness -1.000 -0.500 0.000 0.500 1.000 1.500 2.000 2.500 Developed OECD 1997 Asia 2007 Latin America and 2014 Caribbean Middle East and North Africa Sub-Saharan Africa

Types of capital account regulations (1)  Capital inflow regulations (generally on financial flows, rarely on FDI)  Capital outflow regulations  Foreign-exchange related regulations: on lending holding deposits in foreign currency, or limits on open foreign- exchange positions of financial institutions.  Financial sector restrictions: differential treatment of domestic financial transactions for residents vs. non- residents; restrictions on residents’ accounts abroad. Capital inflow and outflow regulations can be price-based (reserve requirements or taxes), but they can also be administrative/quantity-based. Other regulations are administrative-based.

Types of capital account regulations (2) Capital Account Regulations, 1995-2015 (Erten-Ocampo) 0.800 FX-related 0.700 regulations Capital-outflow 0.600 regulations Capital-inflow 0.500 regulations 0.400 Financial sector restrictions 0.300 0.200

Types of capital account regulations (3) Capital Account Regulations in Emerging and Developing Countries by Income Level, 2015 (Erten-Ocampo) Capital-inflow Capital-outflow Financial sector FX-related retrictions retrictions regulations regulations Upper Middle Income 0.509 0.574 0.278 0.694 Lower Middle Income 0.458 0.521 0.403 0.656 Low Income 0.722 0.778 0.611 0.833

Managing financial-stability risks  Large empirical literature that indicates that capital inflow restrictions improve the liability structure of borrowing countries and reduce financial fragilities (Ostry et al, several others)  Preventive capital account regulations reduce the risk of financial crises, acting as “circuit breakers” against contagion effects (Ocampo/Palma and Stiglitz).  Capital inflow takes can enhance social welfare by diminishing the negative effects of capital account volatility (Korinek and Jeanne).

Macroeconomic-stability risks (1)  Capital regulations on inflows taxes and active reserve management can moderate appreciation during booms (Jeanne, Korinek, Farhi/Werning).  Evidence that they reduce capital inflows and moderate appreciation (Ocampo/Tovar, Edwards/Rigobon)...  … but there is broader debate on this issue (De Gregorio et al., Magud et al, Klein). In cross-country analyses, it is critical whether or not the sample includes developed countries.  When exchange rate evolution and reserve accumulation are included in a variable of “foreign exchange pressure”, positive effects of CARs (Erten/Ocampo).

Macroeconomic-stability risks (2)  Broader evidence that they increase domestic/interest rate spreads, giving some space for contractionary monetary policies during booms (De Gregorio et al., Villar/Rincon).  Imposition of CARs during booms reduces the growth decline during crises and facilitates the recovery (Ostry et al., Erten/Ocampo).  Controls on capital outflows can help moderate restrictive macroeconomic policies during crises (Ariyoshi et al., but also several programs in recent years, such as that of Iceland).  They may be the only way to solve coordination failures in debt restructuring processes.

The IMF’s 2012 “institutional view”  Capital account interventions recommended as a policy of “last resort”, once all other macro policy options are exhausted.  Preference for capital inflow over outflow measures.  Preference for price-based measures over quantity-based.  “Institutional view” still embraces liberalization but warns about the costs of pre-mature capital account and financial liberalization.

Conclusion: CARs can play an important role as part of the family of “macroprudential policies”  Strong evidence that they promote financial stability…  … and increase the margins for counter -cyclical macroeconomic policies.  To promote financial stablity, they must be accompanied by strong domestic prudential regulation and supervision.  They must be used as a complement, not as a substitute for counter-cyclical macroeconomic policies. Their use as a substitute may make crises unavoidable and more severe.

Conclusion (cont.)  No reason why they should be temporary. They should rather be permanent but managed in a counter-cyclical way.  Inflow regulations may have advantages over outflow regulations, and price-based regulations over quantity/administrative-based regulations, but the arguments are not compelling.  Targeting transactions rather than agents may be better, but the effects on domestic vs. foreign agents will always be different.  Institutional structure and capacity building is essential. It may require maintaining some foreign exchange controls.

DEVELOPING COUNTRIES’ EXPERIENCE WITH CAPITAL ACCOUNT REGULATIONS Presentation in the Technical Group Meeting of the Group of 24, Colombo, Sri Lanka, February 28, 2018 José Antonio Ocampo Member of the Board Banco de la República, Colombia