Capital control policies in emerging market (EM) economies have fluctuated for the past two decades as markets have responded to changing global dynamics. This continues to be the case in 2013.
The term capital controls refers to a wide array of tools policymakers use to limit the flow of capital in and out of their economies. They typically target short-term portfolio flows—such as the purchase of domestic bonds and stocks by foreigners—that can generate undesired currency volatility. Long-term flows such as foreign direct investment tend to be allowed to move more freely.
During the 1990s, EM economies generally liberalized capital accounts and allowed currencies to reflect the swings in economic conditions. In recent years, however, many countries introduced control measures to prevent excessive capital inflows from creating credit bubbles and to contain currency appreciation to a level that could render exports uncompetitive and curb growth. This happened at a time when developed countries’ central banks brought their interest rates to near zero and embarked on so-called quantitative easing, which weakened their currencies with respect to those of the emerging world.
This trend is now changing again.
In an environment of ample global liquidity, EM fixed-income markets attracted a whopping $220 billion of capital inflows between 2010 and 2012, while another $100 billion went into EM equity markets. While inflows continued early this year, these dynamics changed dramatically in May, when the U.S. Federal Reserve hinted it might wind down its asset purchase program later this year.
Since then, two-thirds of the cumulative inflows of $45 billion to the EM fixed-income markets registered through May have exited amid a sharp increase in U.S. Treasury bond yields, while the outflows from EM equities have brought cumulative net inflows down from a positive $33 billion in February to a negative $15 billion as of September 2013. This reversal has forced EM policymakers to de-activate many of the control measures adopted in recent years to contain capital inflows. Some countries in Asia are even considering or enacting new measures to limit capital outflows. Latin America has not been the exception, with various control measures adopted in recent years.
Among the countries that experienced large capital inflows, there are examples of relatively mild measures—like the special reserve requirement of short-term bank deposits held by foreigners in Peru, introduced in August 2010—to harsher ones—like the 6 percent financial operations (IOF) tax on portfolio inflows to Brazil unveiled in October 2010.
In addition to capital inflows, the currencies of many Latin American countries were also lifted by the Chinese demand-induced commodities boom. That pushed their balance of payments into surplus and forced central banks to accumulate significant foreign- exchange (FX) reserves, which have nearly doubled over the past five years.
But the tide has turned. Foreigners are exiting local markets, the Chinese economy has decelerated and commodity prices have declined. With domestic demand still resilient, current account deficits have widened across the region. In Brazil, unlike in previous years, an external gap is no longer being financed by foreign direct investment. As a result, in June 2013, Brazilian Finance Minister Guido Mantega announced the elimination of the infamous IOF tax so that the country could instead focus on attracting portfolio inflows to help cover the current account deficit.
While most economies in Latin America have faced the challenge of implementing strategies to manage the avalanche of capital inflows in recent years, the opposite phenomenon occurred in Argentina and Venezuela—which have been grappling with persistent private sector capital outflows. As a result, FX policy in these economies has gravitated toward institutionalizing strict capital outflow controls.
With the root causes of capital flight (preservation of capital from the threat of inflation and/or expropriation) left unaddressed in both Argentina and Venezuela, authorities have been trying to limit the sale of central bank reserves that would be required to fund the abnormal outflow of capital. This has led to prioritizing trade and debt service–related transactions at the official rate over FX demand for portfolio rebalancing. And both governments have been hoping—elusively—that the currencies may anchor domestic goods inflation amid loose monetary policy. Capital outflow controls have been evolving in Argentina and Venezuela since 2002 and 2003, but were meaningfully tightened with a variety of new restrictive measures in mid-2010 in Venezuela, and at the end of 2011 in Argentina.
In turn, controls have produced de facto parallel FX markets. These shadow exchange rates have diverged significantly from official exchange rates, even when the latter are managed with various degrees of flexibility—a discretionary crawling peg in Argentina and a fixed peg in Venezuela that is complemented by an official alternative FX platform.
Since monetary imbalances are the key drivers of the shadow FX and have been influenced by political cycles, it is unlikely that these strict capital outflow controls will be lifted soon. In 2013, Argentina is in a pre-election phase. Venezuela is in a post-election climate, but the politically weak government of President Nicolás Maduro, in advance of the expected municipal elections in December 2013 that are likely to prove a litmus test of his administration, has so far been reluctant to deliver a very strong fiscal adjustment.
As the U.S. Federal Reserve unveils the parameters of its tapering of asset purchases in coming months, the hope is that capital outflows from EM economies will eventually abate. Together with the recent signs of growth stabilization in China and the recovery in the U.S. and Europe, Latin American currencies—and policymakers—should feel some relief, although a return of massive capital inflows is unlikely anytime soon.
