Capital Controls in Emerging Markets: A good idea?

Today’s post is from Adrian Blundell-Wignall, Special Advisor to the OECD Secretary-General on Financial Markets. The view expressed here is his own and does not necessarily reflect that of any OECD government.

A couple of years ago the IMF produced some (cautious) comments and studies arguing that currency management and capital controls were OK in some circumstances. Many emerging market countries took this as an endorsement of their approach to policy which has not been limited to temporary crisis measures.  The Figure below shows the national investment-saving correlations for the OECD countries over 1982-2010 and for a group of emerging countries (China, Brazil, India, South Africa, Mexico and South Korea) in the manner of Martin Feldstein and Charles Horioka.

In a 1980 paper, Feldstein and Horioka looked at two views of the relation between domestic saving and the degree of mobility of world capital. If capital is perfectly mobile, you would expect there to be little or no relation between the domestic investment in a country and the amount of savings generated in that country, since capital would flow freely to wherever the returns were highest. On the other hand, if the flow of long-term capital among countries is impeded by regulations or for other reasons, investors will be more likely to keep their money in their own country and increases in domestic saving will be reflected primarily in additional domestic investment. Feldstein and Horioka’s analysis supported the second view more than the first.

Three decades later, the OECD economies have more-or-less achieved an open economy without capital controls (led in large part by Europe). But the emerging markets have a high correlation of national savings to investment (0.7), indicating a prolonged lack of openness.

National Investment-Savings Correlations: OECD versus Emerging Economies

S-I correlations

Source: OECD

The growing gap between the correlations for the OECD (highly open) and the emerging economies (impeded) is pointing to a fundamental imbalance in the world economy. Does it matter? The IMF study mentioned above showed that countries with stronger capital controls had a lesser fall in GDP in the post-crisis period. While the original authors were cautious in interpreting their results, this was not so for the users of those findings. This is all the more worrying given that the OECD exactly reproduced the IMF study and found that the results were not robust to a simple stability test. In other words, the OECD tests show that these results certainly should not be used as a basis for claiming some form of general support for long-term use of capital controls.

The OECD also ran a simpler study using the IMF’s own measures of capital controls, with both the IMF’s original sample period and updating it. The OECD study found significant and contradictory results, which were much more consistent with an exchange rate targeting and “impossible trinity” interpretation of outcomes:

  1. In the good years prior to the crisis, capital controls are indeed good supporters of growth. This is likely because combined with exchange rate management there is a foreign trade benefit, companies are not constrained for finance, and containing inflows reduces the build-up of money and credit following from exchange market intervention (and associated asset bubbles).
  2. However, in the post-crisis period the exact opposite is found and the results are highly significant. Capital controls are negatively correlated with growth. The pressure on the exchange rate is down, not up, as foreign capital retreats, and international reserves are used up defending against a currency crisis (contracting money and credit). Companies are more constrained by cash flow and external finance considerations.  Just at the time when foreign capital is needed, countries with the most controls suffer the greatest retreat of foreign funding. Investment and GDP growth suffer.
  3. The full sample period (data from both before and after the crisis) shows significant negative effects of capital controls. That is, the overall net benefit appears negative compared to less capital controls.

These results have an intuitive appeal, consistent with economic theory. While it is early days, and some caution is required, the findings suggest that in the long-run dealing with the global investment-savings imbalances could be of benefit not only to developed countries, but also to the developing world itself.

Useful links
Capital Controls on Inflows, the Global Financial Crisis and Economic Growth: Evidence for Emerging Economies by Adrian Blundell-Wignall and Caroline Roulet of the OECD Directorate for Financial and Enterprise Affairs
This paper discusses the issues mentioned above in detail. It investigates whether countries that had controls on inflows in place prior to the crisis were less vulnerable during the global financial crisis. More generally, it examines economic growth effects of such controls over the entire economic cycle, finding that capital restrictions on inflows (particularly debt liabilities) may be useful in good times but may have adverse effects in a crisis.
Macro-prudential Policy, Bank Systemic Risk and Capital Controls by Adrian Blundell-Wignall and Caroline Roulet of the OECD Directorate for Financial and Enterprise Affairs
This paper looks at macro-prudential policies in the light of empirical evidence on the determinants of bank systemic risk, and the effectiveness of capital controls. It concludes that complexity and interdependence is such that care should be taken in implementing macro-prudential policies until much more is understood about these issues.

Financial Market Trends – OECD Journal

OECD work on Institutional investors and long-term investment

Growth ahead, but risks are many

Click to read the reoprt
Click to read the report

The latest economic forecasts from the OECD could be summed up in four words: More growth, more risks. The “more growth” part is perhaps the easiest to explain. According to OECD economists, the world economy should continue to strengthen its recovery over the next couple of years, albeit at a slower pace than in previous recoveries. The OECD is forecasting global growth of 2.7% for this year, rising to 3.6% for 2014 and 3.9% in 2015.

These numbers might look encouraging, but they’re down – by about half a percentage point – since the OECD’s last forecasts in May. That downward revision is due in large part to the slowing performance of the emerging economies, other than China.

Digging a little deeper, the OECD is forecasting a strengthening performance in both the United States and the euro zone, with the U.S. economy forecast to grow by 2.9% in 2014 (click on the map below for detailed data). The euro zone won’t be able to match that pace, but next year’s forecast expansion of 1% would certainly be welcome after several years of sluggish performance. By contrast, after racking up forecast growth of 1.8% this year, Japan’s pace of expansion is tipped to slow to 1.5% in 2014.

Disappointingly, the upturn in OECD economies may not do much to bring down unemployment. The jobless rate in OECD countries is projected to fall by only half a percentage point, to 7.4%, by the end of 2015, a slower decline than had been expected.


Of course, all these forecasts will only pan out if the world economy manages to avoid those risks we mentioned. Some of these will be all too familiar to regular readers of the blog, such as continued concerns over Europe’s banks. Others have emerged more recently – indeed, they’re responsible in large part for the OECD’s lowering of its growth forecasts.

The most notable, perhaps, is the increasing uncertainty over the emerging economies, other than China. Even though the emerging economies have stronger growth prospects than developed countries, they face a growing list of challenges, including less favourable demographics and diminishing opportunities for “catch-up” growth. Their vulnerability was highlighted over the summer when investors pulled out of emerging economies in expectation that the Federal Reserve, or U.S. central bank, would begin returning to the sort of “normal” monetary policies that were suspended in response to the financial crisis. In the event, that didn’t happen, but, as the latest OECD Economic Outlook points out, the turmoil that followed even discussion of it “revealed how sensitive some EMEs [emerging market economies] are to U.S. monetary policy.” For now, the situation in the emerging economies appears to have stabilised, but there must be concerns over what will happen when the U.S. does eventually change course on its monetary policy.

On a long list, two other risks are also worth noting briefly. The first concerns the political situation in the U.S., which has led to a series of showdowns between legislators and the executive. “The episode of budget brinkmanship in October 2013 has once again shaken global markets and harmed consumer confidence,” notes the Economic Outlook. To avoid a repeat, it says, “The debt ceiling needs to be scrapped and replaced by a credible long-term budgetary consolidation plan with solid political support.”

And then there’s the concern over the potential for deflation in the euro zone. To explain, prices tend to rise most of the time in developed countries – a process called inflation. By contrast, falling prices – or deflation – are much less common. If deflation kicks in, it can be very hard to turn it around – consumers may put off purchases in expectation of lower prices next month or next year, so reducing demand and creating a self-sustaining spiral. To reduce the risk of deflation taking hold, the European Central Bank cut interest rates earlier this month, which should boost demand. But, says the Economic Outlook, it should be prepared to take further measures if deflation risks intensify.

Useful links

OECD Economic Outlook (2013, Vol. 2)

OECD economic analysis and forecasting

OECD data on GDP growth in 3rd quarter 2013

ABCDE: Combine our knowledge and best practices

Click to go to the conference website

This week, we’ll be reporting on the Annual Bank Conference on Development Economics (ABCDE) taking place here at the OECD, in co-operation with the World Bank and France. Our first post is from OECD Secretary-general Angel Gurría.

These are momentous days for the OECD and its work on development. Last week, US Secretary of State Hillary Clinton chaired our 50th Anniversary Ministerial Council Meeting, at which Ministers urged the OECD to adopt a comprehensive new approach to development. They gave us a strong mandate to launch a development strategy in line with our member countries’ aim of promoting development worldwide, and of achieving higher, more inclusive, sustainable growth for the widest number of countries. This effort will entail greater collaboration and knowledge sharing, mutual learning, and deeper partnerships with developing countries and other international organisations.

This week, we are co-hosting the ABCDE, joining forces with the World Bank and France in bringing together some of the best and brightest thinkers on development economics. We’re putting into practice our desire to deepen our understanding of the diverse realities and challenges that developing countries are facing in today´s rapidly changing economic landscape.

It is only natural that we sharpen our focus on development. The epicenter of economic activity is shifting from industrialised countries to the large developing countries and, more than ever, their future growth prospects are closely intertwined. Over the past decade, a group of emerging and developing countries has achieved remarkable advances in terms of growth and development. They have lifted millions of people out of extreme poverty, becoming a vital development source of trade, investment and aid. If current trends continue, we anticipate that developing countries will account for nearly 60% of global GDP by 2030.

These dynamic new poles of growth have useful experiences and knowledge to share. Working closely with them, we can combine our knowledge and best practices in the service of all countries, and particularly the poorest. We will develop new perspectives on how to achieve inclusive growth, identify new ways to address inequality and poverty, and find new pathways towards social and economic well-being.

Here at the OECD, we have begun broadening our sources of knowledge, building on 50 years of gathering evidence, sharing experience and promoting good practice. Four new member countries are enriching our work: Chile, Estonia, Israel and Slovenia. Russia is moving closer to accession, and we are engaging closely with Brazil, China, India, Indonesia and South Africa on a wide range of policies. We are also working hard to support G20 discussions, which represent a major step towards more inclusive and innovative global decision-making.

Looking at the ABCDE conference theme of Broadening Opportunities for Development, I note that emerging economies are both highly familiar with the challenges and highly innovative in finding solutions.

Broadening opportunities is about tackling inequality, about not leaving people behind in our ever-changing world economy. Across OECD countries, the richest 10% of people earn 9 times more than the poorest 10 per cent. In Mexico and Chile, the rich have incomes more than 25 times higher than the poorest. Beyond the OECD, our figures for Brazil suggest a ratio of 50 to 1, and our figures for South Africa suggest a ratio of 147 to 1! This reminds us that despite formidable progress in emerging economies, the battle against poverty is not yet won.

The good news is that many emerging economy governments now have the resources to make smart social investments. Mexico and Brazil, with their successful cash transfer programmes and other innovations, have shown the way.

What can we learn from them? How can we understand better the diverse realities of developing countries and the particular challenges they face?

What is clear is that, in OECD countries and elsewhere, high levels of inequality are economically, politically and ethically untenable. Inequality prevents the most vulnerable from breaking through the vicious cycle of poverty. We need to identify policies that can boost access to education, skills, jobs and social services, promoting upward mobility for talented and hard-working women, men and youths. We need to ensure that growth is participative and inclusive, fostering social cohesion. We need to close gender gaps in education and employment, empowering women to gain entrepreneurial skills and use them to their fullest. And, finally, I think we need to understand that development is not all about income, but about a more general notion of societal progress.

I am looking forward to reading your views and following ABCDE discussions!

Useful links:

Live conference webcast from the World Bank

OECD Forum 2011. Shifting wealth

Two panels in this session – emerging economies, and trade and investment. With an 8:30 start, most of us are looking more like early worms than early birds.

The first panel is far more dynamic, given the consensus in favour of more trade and investment. The emerging economy discussion takes an interesting turn when moderator Liam Halligan asks participants where the next IMF director should come from.

Indian finance minister Anand Sharma gives a diplomatic reply, saying global institutions should reflect global realities.

Anatoly Moskalenko from Russia’s Lukoil avoids answering a question concerning Russia’s acceptance by these institutions, saying simply that Russia would like to join the OECD and other bodies.

And then it’s back to the politicians. Brazilian Under-Secretary for Economic Affairs Valdemar Carneiro Leao describes the quantitative easing decided by the EU and US as “how can I put it: unorthodox”. He is less diplomatic later, reminding us how Brazil was preached at by the IMF and other institutions to be more liberal, but the regulations they kept in place saved their financial markets from the tsunami that hit the deregulators.

US Under-Secretary for Economic, Energy and Agricultural Affairs defends US economic policy, saying it was needed to restore the health of the US economy.

WTO chief Pascal Lamy anticipates the next panel by talking about the Doha round. He says there’s agreement or near-agreement on most points, but tariffs on industrial products are a sticking point, and he’s worried by the increase in the share of world trade affected by protectionist measures.

Norway’s Finance Minister Sigbjorn Johnsen speaks with the compassion and peace of mind of a chancellery managing a budget surplus. He explains that human capital is a more important asset than oil. He’d rather discuss DSK’s succession at the IMF at the IMF, not the OECD.

Brazil puts the cat among the pigeons again by asking why the OECD is represented at the G20 given that it’s not a global institution. No reply, but there’s no OECD panellist.

Going South: What’s in it for development?

This post comes to us from Annalisa Prizzon of the OECD Development Centre

The rapid growth of emerging economies has led to a shift in economic power from West to East and South. According to Perspectives on Global Development, a new annual thematic publication by the OECD Development Centre, developing and emerging countries now account for nearly half of world GDP in purchasing power parity (PPP) terms. This is expected to rise to nearly 60 percent of global GDP by 2030.

The growing dynamism of economic activity between developing and emerging countries is one of the factors underpinning this new economic and power landscape for the global economy.

Not so long ago, few people would have expected China to become the leading trade partner of Brazil, India and South Africa. In 2009 that became a reality. Likewise, the Indian multinational Tata is now the second most active investor in sub-Saharan Africa.

But what is the development potential arising from these South-South flows?  South-South trade – which represented 19% of global trade in 2008, compared to around 8% in 1990 –  could be one of the main engines of growth over the coming decade, especially if the right policies are pursued.

Trade between southern partners can provide opportunities for learning-by-doing in less competitive market environments. It can also give access to cheaper intermediate inputs and facilitate integration into value chains supplying southern markets, which are often much less standards-intensive than comparable northern markets.

OECD Development Centre simulations suggest that there is a large potential for welfare improvements through  the reduction of trade barriers and trade costs on South-South trade. Were developing countries to reduce their tariffs on South-South trade to the levels applied on trade between northern countries, they would secure  static welfare gains of  $59 billion (gains that do not take into account cumulative benefits over time).

This is worth almost twice as much as a similar reduction in tariffs on their trade with the North. The dynamic gains, in terms of greater competition and technology acquisition are likely to be much larger.

Moreover, these results are not contingent on the outcome of ongoing multilateral negotiations – they are measures which developing countries themselves can implement. Some are already acting to realise these gains. In December 2009, 22 developing countries (including Egypt, Morocco and Nigeria) participating in the São Paulo round agreed to cuts of at least 20% on tariffs that apply to some 70% of the goods exported within this group of nations. A timeline was set for intensive negotiations to conclude the agreement by the end of September 2010.

South-South foreign direct investment (FDI) also has enormous untapped potential for low-income countries. Southern multinationals, for example, may be more likely to invest in countries with a similar or lower level of development since they often have technology and business practices tailored to developing country. Technology acquisition and up-grading is thus potentially easier.

Another dimension is the emergence of new aid donors.  Emerging economies – aid recipients themselves – contributed the equivalent of about 15 percent of the aid flows of OECD DAC donors in 2009. Official development assistance from donors who are not members of the OECD Development Assistance Committee (DAC) but who report to the DAC amounted to almost $9.1 billion in 2008. The real figure is likely to be much higher. What is crucial at this stage is to leverage the resources and experience of these new development actors to maximise aid effectiveness.

The impact on development of trade, foreign direct investment and aid flows between developing and emerging economies has only recently started to be monitored and analysed in a systematic way. The picture is still rather incomplete. Yet one thing is clear: emerging and developing countries are currently driving global growth while the high-income countries struggle to shake off the impact of the global financial and economic crisis. In the future, we will need to  capitalise on these trends if the global economy is to be successfully rebalanced.  

Useful links

OECD work on development issues