The full report by the Bretton Woods Project and Latindadd is available as a PDF .
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After 30 years of financial liberalisation, developing countries are increasingly relying on techniques to regulate the flows of capital going in and out of their countries. The slow process of acceptance and de-stigmatisation of capital account regulations was triggered by the several financial crises of the 1990s in developing countries, and accelerated after the 2008 global financial crisis, which brought to the fore the risks of unregulated global capital flows.
Financial liberalisation was followed by socially and economically devastating financial crises throughout the world. There is now substantial evidence of the role of financial liberalisation in triggering financial crises, and on how these crises particularly affect the poor. The rationale behind the use of capital account regulations is to reduce the risks associated with volatile capital flows, while contributing to protect and promote economic activity and employment creation.
Latin America is a clear example of a region that in the 1980s and 1990s, under the conditionality and advice of the World Bank and the IMF, embraced financial liberalisation, suffered several financial crises and is now increasingly relying on different forms of regulation of inflows and outflows.
Argentina, Brazil and Costa Rica are among the countries that have recently implemented capital account regulations. This report reviews the evidence available on the impact of the measures implemented in these countries. The case studies provide evidence of the usefulness of capital account regulations not only in achieving financial stability, as already acknowledged by the IMF, but also in preventing unwarranted appreciation of the exchange rate and increasing monetary policy space. In this way, the report highlights the role of capital account regulations in supporting broader development goals like employment creation and poverty reduction.
While in Argentina the capital account regulations implemented since the 2001 crisis are part of a comprehensive policy ‘toolkit’ which represents a U-turn from 1990s financial liberalisation, in Brazil and Costa Rica the measures implemented come as isolated policies responding to a particular context of high capital inflows stimulated by low interest rates in rich countries.
After the 2001 financial crisis that forced half of the population below the national poverty line, Argentina implemented several regulations on capital inflows and outflows, as part of broader prudential macroeconomic policy framework. Since 2005 short-term investments require a deposit of 30% of the value of the investment to be held by the central bank for the period of one year. This regulation has been effective in reducing inflows in boom periods, reducing exchange rate volatility and increasing monetary policy space. Despite regulations on outflows, the level of capital outflows is still high. In general terms, this ‘toolkit’ of regulations helped enable a process of fast economic growth and significant social progress.
In 2009 Brazil implemented taxes on foreign purchases in the stock and bond markets. These taxes aim to prevent speculative inflows appreciating the exchange rate. From 2008, short-term investments, known as carry-trades, flooded the country and artificially inflated the value of the Brazilian currency, posing a threat to the competitiveness of Brazilian industrial exports. The taxes implemented have shown some effectiveness in slowing capital inflows and reducing currency appreciation. By doing this, the tax contributes to protecting employment. However, the incentives and benefits received by short-term investors, like high interest rates and tax exemptions, remain too large to be discouraged by a 2% tax.
Like in Brazil, large speculative inflows were artificially inflating the value of the Costa Rican currency and harming the capacity of local industries to compete internationally. Despite 30 years of liberalisation, in September 2011 Costa Rica decided that short-term foreign loans received by banks and other financial entities would require a non-interest bearing deposit to be made at the central bank. Further research is needed to assess the impact and effectiveness of this policy.
Developing countries and their policy makers should explore pragmatic solutions and learn from the experiences of these Latin American countries. The policy changes in these three case studies are just first steps in the shift towards capital account regulations that benefit people. In order to increase the effectiveness and development impact of capital account management techniques, they have to be implemented early on as part of a comprehensive policy framework and not just as last resort, as advocated by the IMF. Regulations should also be continuously adjusted and fine-tuned in order to stop evasion. Finally, to strengthen this shift, further action is needed at the regional and international level.
Breaking the Mould: How Latin America is coping with volatile capital flows
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Rompiendo el Molde: La regulación de los flujos de capital en América Latina
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