The Case for Controlling Capital Outflows

Stephany Griffith-Jones

Emerging countries, and even some low-income ones, are being flooded by short-term capital flows which they do not need; much of this money originates via the carry trade from the second wave of US quantitative easing (QE2). The intent of the US Federal Reserve is to expand the supply of credit in the US, so as to support the recovery and to lower long-term interest rates in the US.

So the impact of the carry trade is negative both for the US (as it undermines the aims of QE2) and for developing countries, which see their exchange rates become overvalued and their asset prices increase excessively.

The response of developing countries has been varied, but increasingly many of them are beginning to impose capital controls, both of the traditional kind, but also more innovative ones, that is those which deal with the new ways in which capital enters developing countries, in particular via derivatives. Indeed, many of these derivatives were initially invented to avoid precisely regulations on capital inflows or other types of financial activity.

Therefore it is positive that developing countries´ economic authorities are beginning to smarten up and have started to regulate these derivatives linked to the carry trade. Examples are the new regulations in Brazil and South Korea, precisely aimed to curb such financial activities, which have no positive development effect (except on profits of some financial institutions) and create a lot of macroeconomic problems. This can lead eventually to increased risk of crises, which as we have learned again in Europe and in the US have terrible economic and social costs.

However, regulation of capital inflows in recipient countries is not enough. A first reason is that the wall of money and of derivatives rushing towards them is so large that by themselves measures in individual recipient countries may not achieve enough cooling effects to avoid their undesirable impacts. Secondly, not all developing countries receiving these excessive inflows will impose such prudential capital controls, and those which do not may suffer even more appreciation and asset price bubbles. This would be harmful not only to them, but also to other developing countries, which could suffer if in the future the former country had a crisis and they were hit by financial contagion.

For this reason, and particularly in this conjuncture, it seems desirable or the source countries to impose measures to discourage the carry trade originating in them, as we have argued recently with Kevin Gallagher, for example, in our letter published recently in the Financial Times. (In the past I have written in favour of such measures jointly with Jane D´Ärista).

The key point today is that such measures would not just favour developing countries, but would also be in the interest of the source countries, and particularly the US, keen that the liquidity being produced by the Fed results in increased credit creation within its own economy – the US-which precisely will support its recovery and is not channeled towards speculative bubbles in developing countries. This could lead to future crises in those countries, where again the developed countries’ governments (and taxpayers) would have to provide new bail-outs, something  they can scarcely afford.

Therefore measures to discourage the carry trade and other short term outflows from the US seem to be more feasible politically, as they make clear economic sense from the perspective of the US economic authorities who would take them to meet their own aims. The only opposition would come from those who make short-term speculative profits. But we cannot let them continue dictating economic policy that leads to perverse results even for them, as well as for the rest of the society!

Implementing such measures may have some technical difficulties, but they would build on broader regulatory measures on derivatives being taken in the US and Europe as a result of the financial crisis; furthermore, the Brazilian and Korean measures show such regulatory policies can be successfully implemented in this field.