The Prometheus Institute Factbook | Capital Flows

Capital flows

- In 1997 Indonesia, Korea, Malaysia, Philippines, and Thailand experienced net financial outflows of $13 billion (IMF 2004), 2 an average currency depreciation of 77 percent, and severe economic contractions. In sharp contrast, China and India had maintained more stringent capital controls and appeared to be relatively immune to the crises in their neighbors. This comparison used to support capital controls, however, misses several important points. Although the capital controls may have reduced China's and India's vulnerability during the 1997 Asian crisis, capital controls provide no security against financial crises in general. Many countries with capital controls have experienced devastating crises. For example, India experienced a major currency crisis in 1991 and China experienced a major currency crisis in 1994--despite the existence of capital controls in both countries that were even more stringent than in 1997. Several Latin American countries experienced severe debt crises in the 1980s--despite the existence of capital controls.

- This evidence only complicates the story. Studies generally find a positive--instead of negative--correlation between capital controls and the occurrence of currency crises in both bivariate and multivariate analyses (Glick and Hutchinson 2000; Eichengreen 2003: chap. 3). Taken at face value, these results could be interpreted as suggesting that crises may actually be more likely-- instead of less likely--to occur in countries with capital controls.

- Since accurately measuring capital account liberalization and its interactions with other key macroeconomic variables may be even more difficult than for trade liberalization, it is not surprising that the initial work in this area has generated mixed results to date.

- In one such study, Johnson and Mitton (2002) examine how the Malaysian controls on capital outflows affected stock returns for individual Malaysian companies. The authors' results suggest that the Asian crisis initially increased financial pressures on Malaysian firms, improving market discipline and reducing the ability of governments to provide subsidies for politically connected firms. When the capital controls were put into place in September 1998, however, investors believed the Malaysian government would have more freedom to help favored firms. In other words, the article suggests that capital controls reduced market discipline and provided a shelter for government cronyism. The estimates suggest that this cost of the capital controls was substantial. In the initial phase of the crisis (from July 1997 to August 1998), politically connected firms lost about $5.7 billion in market value due to the fall in the expected value of their political connections. When the controls were enacted in September 1998 (and market values were substantially lower), politically connected firms gained about $1.3 billion in market value due to the increased value of their connections. In September 1998, after the capital controls had reduced market discipline, political connections were worth about 17 percent of the total market value of connected firms.

- Research by Desai, Foley, and Hines (2004) shows that multinationals distort their trade patterns, profits, and dividend repatriation in order to evade capital controls. They estimate that multinational affiliates are about 10 percent more likely to remit dividends to parent companies in the presence of capital controls, and that the distortions to profitability from capital controls are comparable to a 24 percent increase in the corporate tax rate. They also show that the cost of borrowing is higher in countries with capital controls, and when this effect is combined with the other steps multinationals take to evade the controls, this reduces the size of foreign investment by 13 percent to 16 percent. to 16 percent

- Courtesy of the Cato Institute

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