Capital Spillovers: Towards a New Regime

A look at the externalities from capital controls and potential effects on international finance


The focus of this post is going to be on the arguments in a recent NBER working paper on how capital controls in one country should be evaluated on an international level.

An interesting development in the analysis of capital markets in the past few years has been a changing paradigm on the use of capital controls as macroprudential policy. Through empirical analysis, we've found various channels through which capital controls function. As per the working paper:

Some economists and policymakers have recently become more supportive of controls on capital inflows, particularly if they are aimed at limiting the appreciation of overvalued currencies and reducing financial fragilities resulting from large and volatile capital flows. This support has been bolstered by theoretical work showing that taxes on capital inflows can improve a country’s welfare by reducing negative feedback effects due to capital flow volatility (Korinek, 2010 and Jeanne and Korinek, 2010) or by adjusting the terms-of-trade to shift consumption across periods (Costinot, Lorenzoni, and Werning, 2011). This theoretical work has been supported by empirical work showing that even if capital controls cannot significantly affect the total volume of capital inflows, they can improve the country’s liability structure and increase its resilience to crises (i.e., Ostry et al., 2010).1

Yet the analysis hasn't really focused on external effects of capital controls of country on others. This is an important field of study because, as the study of customs unions or financial contagion has taught us, the effect of controls or restrictions change significantly in a second-best world populated by other states with their own policy regimes. Thus, any possible externalities from one country's capital controls are extremely important in the formulation of policy.

The paper looks at 'moderate, market-based controls on capital inflows in a country which previously had a relatively open capital account." In effect, it shies away from large scale capital controlled regimes like China.  Also, these types of capital controls are unlike the command-and-control regulations that China uses in stopping capital mobility. Instead of a quota, the controls analyzed in the paper make capital harder to move on a per-unit basis. While Chinese capital controls can be represented by a levee, the capital controls analyzed in the paper are the equivalent of making the hill a bit steeper or moving to higher ground. For more rigorous empirical analysis, the paper looks at Brazilian markets, as they are relatively deep and have been subject to multiple changes in capital restrictions over the years. The authors use the Emerging Portfolio Fund Research (EPFR) to analyze changes in mutual and bond funds.  In addition, they interview investors from a variety of backgrounds to learn about how market practitioners respond to capital controls.

An interesting nugget from the empirical analysis is that a large part of the impact from Brazilian capital controls arises from the expectation about future policy. Capital controls in Brazil lower investment in Brazil, but also in other countries that have a higher risk of implementing more capital controls. The specific wording from the paper:

Given these significant portfolio effects of capital controls on investor allocations to Brazil, it is not surprising that there are externalities on portfolio allocations to other countries as well. Confirming comments in some of the investor interviews, we find that these spillovers are heterogeneous and depend on country characteristics and the fund manager’s strategy. When Brazil increases its capital controls, investors increase their portfolio allocations to other countries that are closely linked to growth in China (through commodity or regional exports). There is also mixed evidence that investors may increase their portfolio allocations to other countries in Latin America. At the same time, increased capital controls in Brazil cause investors to reduce their portfolio allocations to countries that are perceived to have a higher risk of following Brazil’s example and implementing new controls (including countries that are traditionally open but recently imposed new controls as well as countries that traditionally have extensive restrictions on capital mobility). These results confirm that much of the effect of controls is from signalling, i.e. changes in investor expectations about government policy, even for countries that are not concurrently adjusting their capital controls (6). 

This shift in expectations then has implications for whether capital controls can be targeted. If controls cause markets to judge an entire government as heterodox, then capital flows as a would reduce all forms of foreign investment. Additionally, Brazilian capital controls may change global expectations about policy for capital controls.  This may change the allocation of funds at a global level as well.


The shift towards Chinese investments in the face of Brazilian capital requirements is quite interesting. This suggests that there's something offered by investments related to China that similar to that of Brazilian investments. This relationship is probably built on the BRICs of emerging markets, but these similar flows weren't recorded as going into Russia or India. Brazil is also unique in its central placement in South America, which is probably the reason Brazilian capital controls pushed a substantial portion of the new flows into other Latin American countries. Although their development has not kept pace with Brazil, they are likely exposed to similar risks with respect to commodity price shocks on the global marketplace. As a result, an investor might decide to shift away from Brazil, which has capital controls, to another Latin American country which would offer a similar type of investment, but with a higher yield due to lower capital controls. The authors use these spillover effects of capital controls to justify more international coordination:

If capital controls shift vulnerabilities from one country to another, this “bubble thy neighbour effect” should be incorporated in any reassessment of the desirability of capital controls. Moreover, if several countries simultaneously adopted controls as part of a standard “policy toolkit”, or if a single large country adopted more stringent controls than Brazil’s small tax analyzed in this paper, the externalities could be substantial. This does not necessarily mean that capital controls will reduce global welfare and should always be avoided. Instead, these results support a role for international coordination or oversight of the use of capital controls to avoid a “bubble thy neighbor” effect which could lead to retaliation across countries and reduce global welfare (6).

The argument about "retaliation across countries" exposes an important weakness of capital controls. If capital controls function primarily by pushing hot money flows onto other countries, a global regime of capital controls is likely to have the same effect that capital controls have on a country-by-country basis. In effect, the fallacy of composition strikes again, as if every country imposed capital controls, capital controls would no longer address vulnerabilities in finance. Rather, they would just lower the global return on capital.


Section 2 of the paper moved on to investor surveys of attitudes towards capital controls. They reveal a wide diversity of views on capital flows.  While some investors were neutral (“cost of doing business”), quite a few of them interpreted capital controls as signalling something more fundamental about the country (“anti-investor bias of the country,”  “an increase in policy uncertainty in the future,” “a government that does not know what to do,” or a “lack of stability in economic policy”) that constituted "a draconian policy".  Other investors had positive views, as "controls showed the country was addressing potential vulnerabilities due to a rapid expansion of credit related to capital inflows".  If capital flows substantively affect future expectations of capital stability, these yield expectations should be integrated into the design of policy.  Yields could be used as a tool to look at market expectations of the future path of policy.

Capital controls also have heterogenous effects on different investors.  Equity investors face higher levels of volatility, so taxes on the order of a few percentage points of return were not very worrisome. On the other hand, for those who were dealing with fixed income assets or had absolute thresholds to reach, the tax on incoming capital had a major effect.

The surveys also reveal that capital controls, as currently implemented, affect the economy with long and variable lags.  This would take place in spite of advanced knowledge of when the controls would be implemented.  There were four key reasons for this:

1. Expectation lag - even though capital controls changed the expectations of future policy, any given change could only be part of a "broad assessment" of investments in a country.  As a result, one capital control would not immediately affect a change in investment strategy.
2. Institutional lag - in many institutions, fund allocations depend upon decisions of large committees that go through a "lengthy process of meetings, documentation and approvals" (10).  As a result of the internal transaction costs of making the decision, capital controls don't have immediate effects.
3. Coordination lag - the effect of capital controls extends beyond one firm.  Rather, investors require information about the actions of other agents to make a decision; they can't ex-ante coordinate to figure out how much each firm will invest.  As a result, responses to capital controls take time.

All of this shows that investors respond in very different ways to capital controls; the image of a representative investor investing symmetrically with the market is an illusion.  Policy then needs to be designed carefully to take into account these different types of investments.

Overall, this paper has notable implications for a global shift away from financial fragility through capital controls. The signalling argument means there's room for rule based policy when it comes to macroprudential regulation.  To clarify what the government wants to do with capital flows, they can create a "macroprudential regime" to try and anchor investor expectations, thereby creating an environment more conducive to growth. 

Also, the international spillovers of capital flows make the dynamics of adjustment to an international landscape dotted with capital controls unpredictable. As more and more large economies move towards capital controls, two scenarios could evolve. One is that the states without capital controls would be seen as freer to capital flows. This would create strong incentives for the remaining states to implement controls so as to prevent the new flows of hot money from coming into their polities. Even without international coordination, there would be a snowballing effect towards a new regime on capital controls. On the other hand, if the expectations channel was strong enough, the remaining states could go without controls as investors already expect them to be willing to take measures to moderate capital flows. In effect, the actions of the first movers would immunize the rest. Under this scenario, the first movers would be providing a public good with their decision to move first. As a result, there would be an inefficient level of capital controls. I'm not sure which one is more correct, but either way they make the study of international finance very exciting as development marches forward.

A Look Back Through the Lens of Complexity: "Bigger is Better"

When fears about the Euro were not always so well developed

Recent developments in Europe have created fears that Greece will soon exit the Euro. The spectacular way that the Euro has failed has led some to wonder why the Euro came together in the first place. Interestingly, the concern about a systemic Eurozone crisis did not really register when the Greek crisis started. Perhaps there were some musing that the crisis could spread, but it seemed that people believed that there would be a rescue package and that the crisis would pass. Size would come to the rescue, and an economy larger than that of the United States, the EU would end the threat of financial contagion.

If only they were right.

We now see massive capital outflows from the periphery and a frighteningly fast flight to quality within the Eurozone. But wasn't size supposed to blunt these impacts? While this narrative of "strength through fragility" seems hopelessly naive now, it's interesting to note that even in May/June of 2010 Foreign Affairs published an article by Richard Rosecrance extolling the benefits of size and larger currency arrangements in an era of turbulent capital flows. Rereading the essay, many of the key passages remind us how hindsight is 20-20, and that the narrative of the day can often push policy in the wrong direction.

The essay starts with a description of the Asian financial crises that roiled markets in the late 1990's as a justification for larger economic zones and currency areas;

But eventually the trading-state model ran into unexpected problems. Japanese growth stalled during the 1990s as U.S. growth and productivity surged. Many trading states were rocked by the Asian financial crisis of 1997-98, during which international investors took their money and went home. Because Indonesia, Malaysia, Thailand, and other relatively small countries did not have enough foreign capital to withstand the shock, they had to go into receivership. As Alan Greenspan, then the U.S. Federal Reserve chair, put it in 1999, "East Asia had no spare tires." Governments there devalued their currencies and adopted high interest rates to survive, and they did not regain their former glory afterward.

Russia, meanwhile, fell afoul of its creditors. And when Moscow could not pay back its loans, Russian government bonds went down the drain. Russia's problem was that although its territory was vast, its economy was small. China, India, and even Japan, on the other hand, had plenty of access to cash and so their economies remained steady. The U.S. market scarcely rippled. 

Small trading states failed because the assumptions on which they operated did not hold. To succeed, they needed an open international economy into which they could sell easily and from which they could borrow easily. But when trouble hit, the large markets of the developed world were not sufficiently open to absorb the trading states' goods. The beleaguered victims in 1998 could not redeem their positions by quick sales abroad, nor could they borrow on easy terms. Rather, they had to kneel at the altar of international finance and accept dictation from the International Monetary Fund, which imposed onerous conditions on its help. In the aftermath of the crisis, the small trading states vowed never to put themselves in a similar position again, and so they increased their access to foreign exchange through exports. Lately, they have proposed forming regional trade groups to get larger economically, by negotiating a preferential tariff zone in which to sell their goods and perhaps a currency zone in which to borrow cash.

The story of the Eurozone has shown us that increasing lending through large currency zones is a fool's errand. Private capital flows to the periphery destroyed the PIGS' competitiveness even though they were being quite fiscally conservative. The ability to borrow easily in good times has actually worsened situations, as at the first sign of debt troubles capital can quickly move out of the periphery states, again forcing them to "kneel at the altar of international finance and accept dictation from the International Monetary Fund."  Comically, Greece has been forced to accept "onerous conditions" from Germany for their help in the bailouts. While larger currency areas may secure cheaper funding in the short run, long run capital prospects don't improve.  In a sense, the larger currency area is a form of manufactured stability. It allows volatility to be restrained in good times, only to become fearsome in times of crisis. It's a blowup strategy, with all of the risk in the far left tail.

Moreover, a common currency area actually prevents a country from pursuing the other solution to sudden financial shocks: higher trade in goods. While the Asian economies faced the problem that "the large markets of the developed world were not sufficiently open to absorb the trading states' goods", Greece is facing the exact opposite problem. Past capital flows have left the economy severely overvalued and other markets may be willing to buy Greek goods, if only Greece could devalue its currency!  To worsen the problem, fears about Greece's debt situation lowers global equity values, further reducing global demand for Greek goods! A common currency area takes away from the external devaluation adjustment mechanism and therefore only aggravates the problems that small countries face in financial crises.

The fact that there is no adjustment mechanism makes the larger market available to each state less useful.  According to Rosencrance:

The 27 states that now compose the European Union will soon be accompanied by almost ten others, making Europe stretch from the Atlantic to the Caucasus. Member states have benefited from participating in an enlarged market extending beyond their national borders. The absence of tariffs in the EU allows greater cross- border commercial cooperation, which promotes specialization and efficiency and provides consumers in the member states with cheaper goods for purchase. Over time, as economists such as Andrew Rose and Jeffrey Frankel have shown, such trade zones increase their members' trade volume and GDP growth. There are also administrative advantages: southern and eastern European states with less advanced economies have found help and tutelage from veteran EU members and have not been allowed to fail (even if their fiscal policies have been reined in). 

But when Germany is running a massive current account surplus vis-a-vis virtually every other member of the Eurozone, the cross-border commercial cooperation is a joke. The cheaper German goods for purpose are only that way because of past capital flows that rendered periphery states uncompetitive. Given the horrendous costs of internal devaluation and the low likelihood that it would restore problems with capital structure, any possible microeconomic efficiency from trade is being swamped by disastrous levels of youth unemployment and civil unrest. When there's no transfer union, these asymmetric effects of trade flows on the different countries become incredibly important. We can no longer say "Europe is benefiting", we instead see the periphery on the verge of a full-fledged financial contagion.

It is also interesting to note that Rosencrance also makes an institutional argument here. Through the interaction of the "responsible" core states with the "irresponsible" periphery states, the periphery states will be brought up to the core states' level of institutional maturity. However, large capital flows promoted by a common currency rendered these kinds of supply side reforms unnecessary, and this institutional shift never happened. And as the Eurozone drama is unfolding, it is quite possible that some periphery states will be allowed to fail as the "help and tutelage from veteran EU members" abandons them.

In addition to these new harsh economic realities, the political realities of the situation don't seem to match up with Rosencrance's arguments either. According to the essay:

The peaceful expansion of trade blocs today, moreover, is likely to bring outsiders in rather than keep them out. It has done so in Europe and to some degree in North America and Asia as well. Self-sufficient trade blocs are impossible and will not be sought after. The key to a successful trade group, in fact, is that as it grows, it attracts sellers from the outside. 

What would China, India, and Japan do if the United States and the EU formed a trade partnership? They would not find an Asian pact a satisfactory rejoinder to the transatlantic combination. Since the major markets of the world are located in Europe and North America, Asian exporting nations would have to continue to sell to them. And if Japan eventually joined the partnership, the stakes for China and India would rise. China and India might not be significantly challenged if they could substitute domestic sales for exports. But even they, as big as they are, could not do so entirely. However important Chinese consumption becomes, it will not be able to sop up all the goods that China currently exports to technologically advanced and luxury markets in Europe, the United States, and Japan. To avoid falling behind, Beijing and New Delhi would need a continuing association with markets elsewhere.

What all this means is that the patterns of global politics and economics that have prevailed for the last half millennium are increasingly outmoded. During that period, eight out of the 11 instances of a new great power's rise led to a "hegemonic war." With a potential Chinese challenge looming in the 2020s, the odds would seem stacked in favor of conflict once again, and in other eras it would have made sense to bet on it. 

Yet military conflict is not likely to occur this time around, because even if political power sometimes repels, today economic power attracts. The United States does not need to fight rising challengers such as China or India or even to balance one off against another. It can use its own market capacity, combined with that of Europe, to draw surging protocapitalist states into its web. 

During the Cold War, the economic force of the West eventually surpassed and subverted even the heavy industrial growth of the Soviet economy. In the 1980s, the attractions of North Atlantic, Japanese, and even South Korean capitalism were a critical factor in Soviet leader Mikhail Gorbachev's decision to renew his country's economic and political system -- and end the Cold War. They also helped stimulate Deng Xiaoping's reforms in China after 1978.
Now that the formula for capitalist economic success has become widely understood and been replicated, Western economic magnetism will stem not just from the triumphs of individual economies but from their development as an increasingly integrated group. The expansion and agglomeration of economies in Europe -- and perhaps also across the Atlantic -- will serve as a beacon for isolated successes such as those in Asia.

The argument here seems to be that larger scale economic integration would be a virtuous cycle and therefore serve to moderate international conflict. As a result of integration in certain regions, other states will be forced to integrate with them, creating a unified global trade and financial regime. However, if large economic regime are important to this process, doesn't this just heighten the fragility embedded in the international system? This is especially vivid for the Euro now as, if anything, the collapse of the Eurozone would severely discredit the argument that open, integrated, western economies are the correct way forward. The failure of agglomeration would serve as a deterrent to the "isolated successes such as those in Asia."

A look back on such essays about the Euro serves as a reminder on how limited our capacity for prediction really is, and how the common narrative at any given time can hide the fragilities that persist in complex systems. The reasons behind large scale political developments such as the EMU are often opaque and create economic regimes whose faults are only revealed to us later. It is for this reason that our awareness of fundamental fragilities within economies is incredibly important. We do not know what we are truly doing, so we must strive towards a system that is robust to our errors.