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Change in policies toward capital flows: more of this, less of that

Dilek Aykut's picture

Efforts to contain the surge in hot money flows have been widespread among developing countries (see Global Economic Prospects 2011 for more details).

Brazil, for example, raised its financial operations (IOF) tax on foreign investments in fixed income securities twice so far:  first, from 2 to 4 percent on October 5, and then to 6 percent on October 18.  The impact of these hikes was short-lived and limited, and was therefore followed by further increases in the IOF tax and reintroduction of 15 percent withholding tax on federal securities are being contemplated. Indonesia imposed a 1-month minimum holding period on central bank money market certificates on July 7th and introduced new regulations on the net foreign exchange positions of banks. Meanwhile, Thailand implemented a 15 percent tax on interest income and capital gains by foreign investors.

On the contrary, China, South Africa, and India, which receive high levels of cross-border flows, have not introduced any new measure so far. Rather than new measures, China announced that it will intensify the checks based on existing measures.  Also to ease some of the tension, China and South Africa have started to promote capital outflows. China has boosted its support to outward FDI by its state-owned enterprises, state banks and SWFs through a new round of administrative reforms and lowered the quota for its institutional investors to get a license to invest abroad. Similarly, South Africa will relax any exchange control on residents and is planning to change the prudential framework so that pension funds can invest abroad. 

The effectiveness of the capital controls in reducing the short-term capital flows is still in question. Empirical evidence suggests that effectiveness of capital controls is of limited duration, and best used when the capital surge is temporary (IMF 2010). In fact, the impacts of the two hikes in IOF tax in Brazil and imposition of 1-month minimum holding period in Indonesia were both short-lived. Also, these types of restrictions on a certain type of flow tend to change the composition of capital inflows rather than their levels, hence may do very little in easing the exchange rate pressures. In some cases, shifting the composition (from short-term to long-term) might be the intended result, as countries would like to receive less short-term capital inflows and more FDI inflows—since FDI flows tend to be more stable and have a stronger impact on economic growth.

The differences in policies across different asset groups may have unintended consequences. For example, when Chile restricted short-term hot money inflows (investment with a horizon of less than one year) in the 1990s, some foreign investors created firms in Chile—technically FDI, whose only purpose and investments were short-term fixed-income instruments. Chile later further tightened its capital controls to prevent such avoidance of inflow controls (Roubini 2010). This type of capital control avoidance might be something to watch as most countries, including those that try to curb hot money flows, have also further liberalized their policies to promote FDI inflows since 2009. India, Indonesia and Malaysia raised the cap on foreign–ownership in certain sectors. China lifted the threshold level of investment that requires state approval. Several regulations were relaxed in most developing countries. Recently, in order to limit similar issues, China announced the intensification of audits of fund repatriation by Chinese companies listed abroad and investments by existing foreign-invested Chinese companies.