## _sdn1106 — Executive Summary

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### Major conclusions
- Four broad conclusions:
  - Capital controls may be useful in addressing both macroeconomic and financial-stability concerns in the face of inflow surges, but countries need first to exhaust macroeconomic-cum-exchange-rate policy options.
  - Prudential regulations and capital controls both reduce buildup of vulnerabilities but create distortions and can be circumvented; no unambiguous welfare ranking of instruments exists (non-discriminatory prudential measures are always appropriate).
  - Measures need to be targeted to the risks: when inflows are intermediated through the regulated financial system, prudential regulation is the main instrument; when inflows bypass regulated markets/institutions, capital controls may be the best option if the regulatory perimeter cannot be widened quickly/effectively.
  - Design of capital controls must be tailored to country circumstances: macro concerns call for broad, price-based, temporary controls; financial-stability concerns permit targeted administrative measures and potentially longer use.

### Context and scope
- Focus: EMEs managing recovery in capital inflows after late-2008/early-2009 sudden stop; emphasis on marginal use of inflow controls.
- Concerns cited:
  - upward pressures on currencies causing erosion in competitiveness and currency risk in balance sheets;
  - inflating credit and asset prices amplifying financial fragilities.
- Prior framing (Ostry et al., 2010) preserved:
  - capital controls defined as measures discriminating by residency of parties to capital transactions;
  - macro policy options (exchange rate adjustment, reserve accumulation, monetary and fiscal policy) should be exhausted first.
- Scope exclusions: structural policies, outflow controls; geared to EMEs with largely open capital accounts.

### How macro and financial-stability considerations fit together
- Benefits of international financial integration emphasized: eases financing constraints, fosters diversification, promotes intertemporal trade, contributes to market development.
- Inflow surge risks distinguished:
  - Macroeconomic risks: exchange rate appreciation, inflation, overheating.
  - Financial-stability risks: generalized credit booms, asset price increases, sectoral balance-sheet vulnerabilities, risky external liability structures, unhedged currency exposure.
- Primary policy taxonomy:
  - Macroeconomic policies for macro risks; prudential policies for financial-stability risks; both typically need adjustment.
- Macroeconomic policy adjustments discussed:
  - allowing the currency to strengthen provided it is not overvalued;
  - accumulating foreign exchange reserves and sterilizing intervention if inflationary concerns emerge;
  - lowering domestic policy rates if the output gap permits;
  - using available scope to tighten fiscal policy.
- Ordering and multilateral consistency:
  - capital controls are last resort because discriminatory; authorities should exhaust macro policy space and non-discriminatory prudential tools first.
- Evidence caveat:
  - mixed evidence on controls' effect on aggregate flows; stronger evidence that controls affect composition of inflows and thus financial-stability risks.

### The policy toolkit — prudential regulations and capital controls
- Two broad classes beyond macro policy:
  - Prudential regulations (strengthen financial-sector resilience; often non-discriminatory by residency or currency).
  - Capital controls (discriminate by residency of parties).
- Prudential measures categories:
  - FX-related prudential measures (discriminate by currency):
    - limits on banks’ open FX position (as a proportion of their capital);
    - limits on banks’ investments in FX assets;
    - measures limiting bank lending in FX to unhedged borrowers, including differential reserve requirements on liabilities in local currency and FX;
    - asymmetric open position limits and exclusion of peg-currency exposures in some currency-board countries.
  - Other prudential measures (non-discriminatory by residency or currency):
    - maximum loan-to-value (LTV) ratios;
    - limits on domestic credit growth;
    - asset classification and provisioning rules;
    - sectoral limits on loan concentration;
    - dynamic loan-loss provisions;
    - counter-cyclical capital requirements.
- Instrument choice principles:
  - Non-discriminatory prudential measures that strengthen resilience are always appropriate.
  - If inflows are intermediated through regulated institutions: prudential regulation is primary; controls can buttress prudential policy.
  - If inflows bypass regulated markets/institutions: capital controls may be necessary.
  - Combining prudential regulation and capital controls can reduce circumvention and distortions.
- Design considerations for capital controls:
  - Macro concerns: broad coverage, price-based, temporary.
  - Financial-stability concerns: targeted on riskiest flows, may include administrative measures, can be used against persistent inflows.
  - Close derivative-market loopholes; consider administrative capacities and legal constraints.

### Box 1 — Prudential Policies: Micro vs Macro (key points)
- Micro-prudential aims: improve individual institutions’ resilience; examples include provisioning, valuation reserves, caps on LTVs, higher risk weights, Basel III measures (minimum capital requirements, leverage ratios, capital conservation buffer, liquid assets buffer, limits on currency and maturity mismatches—Basel III NSFR).
- Macro-prudential aims: target systemic risk via cyclical settings of micro tools; examples include cyclically varying provisioning, cyclically varying LTVs, countercyclical capital buffer (Basel III), SIFI surcharges, tax on volatile funding, caps on credit growth, higher reserve requirements.
- Overlap and distinctions:
  - A regulation raising reserve requirements on banks’ liabilities to nonresidents is a capital control; a rule by currency applied equally to residents and nonresidents is not a capital control.
  - Practical choice tilts on effectiveness of supervision, institutional constraints, and international obligations.

### Matching risks and tools (high-level guidance)
- Exhaust macro policy options first.
- Distinguish bank-intermediated flows from direct nonbank borrowing.
- Bank-intermediated risks and tools examples:
  - Excessive external-liability structure: currency-dependent liquidity requirements, limits on external borrowing, higher reserve requirements.
  - Excessively risky bank assets/FX lending to unhedged borrowers: stricter FX-related regulations, higher capital requirements on FX loans, prohibitions/limits on loans to unhedged borrowers.
  - Lending amplifying macro risks: prudential rules (higher reserve requirements, higher risk weights, tighter classification, countercyclical capital buffer, lower LTVs, higher margins).
- Factors tilting choice: supervision effectiveness, regulatory arbitrage risk, level playing field for SMEs.

### Box 2 — Korea (selected findings)
- Drivers: exporters over-hedged expecting won appreciation; onshore banks hedged via offshore dollar borrowing creating inflows.
- Measures:
  - November 2009: required banks to raise long-term FX borrowing ratio from 80 to 90 percent (later 100 percent) of long-term FX lending — reduced banks’ short-term borrowing.
  - June 2010: package to “prevent excessive foreign exchange leverage” — ceilings on FX derivative positions (relative to bank capital), tighter restrictions on FX-denominated loans, stricter liquidity ratios, prohibition on “excess” hedging of forward contracts with exporters.
  - Reinstatement of non-discriminatory withholding and capital gains taxes on non-resident purchases of government and central bank securities.
- Outcomes:
  - Banks’ external debt did not return to pre-crisis levels, but total capital inflows were not substantially stemmed because measures targeted mainly onshore entities; corporates could hedge offshore and offshore banks could offset via onshore government bond investment.
  - Authorities considered further measures, including a levy on short-term bank borrowing.

### Box 3 — Evidence on effectiveness of macro-prudential measures
- Mixed results overall.
- VAR and case evidence:
  - Tightening macro-prudential measures in Croatia (2003-07), Korea (2008), India (2007), and Peru (2007-08) contributed to a reduction in credit growth in some cases.
  - Romania’s speed limit was circumvented via increases in bank equity through FDI.
  - Macro-prudential measures often lengthened maturity composition of inflows in Croatia, Peru, Romania, Uruguay; combined with capital controls, inflows fell in Colombia.
  - Prudential measures usually did little to restrain asset prices.
  - Prudential measures more effective when combined with supportive macroeconomic policies.
- Country-specific snapshots (selected):
  - Colombia (2007): dynamic provisioning, MRR, limits on gross derivative positions, URR — limited effect on aggregate credit growth, some sectoral containment.
  - Croatia: speed limits and MRR reduced credit growth; MRR had limited impact alone; lending partly replaced by direct foreign borrowing.
  - India (2007): raised cash reserve ratio — reduced credit growth (statistically weak).
  - Peru: loan classification/provisioning and MRR on FX deposits slowed credit expansion and lengthened inflows’ maturity.
  - Romania and Uruguay: mixed effectiveness; shifted composition of inflows and reduced FX lending in some cases.
  - Vietnam: cap on securities-related credit moderated stock market boom.

### Box 4 — Croatia case (key chronology, measures, outcomes)
- 2003: speed limit on bank lending and minimum retained earnings rule — banks circumvented via sales to affiliated leasing companies and transferring risk to foreign parents.
- July 2004: speed limit replaced by MRR — additional non-interest bearing deposits required when foreign liabilities increased above end-June 2004 level; MRR rate increased and regulation refined to close loopholes (applied to affiliated leasing companies, off-balance-sheet items, debt securities).
- By 2008: banks required to place 72% of increase in foreign liabilities with the CNB (or in liquid foreign assets); 28% disposable for lending. Despite high reserve requirements, domestic lending continued to increase.
- Mid-2006 and 2008: capital adequacy and risk-weight tightening; differentiated minimum capital requirements in 2008 — banks with credit growth below 12% per annum: minimum capital adequacy rate of 12%.
- Outcomes and lessons:
  - Prudential measures reduced bank credit growth at times but credit was replaced by direct foreign borrowing — altering inflow structure toward channels outside prudential coverage.
  - Case underscores difficulty of curtailing credit growth without economy-wide capital controls when flows bypass regulated institutions and exchange rate policy is constrained.

### Appendix I — Empirical analysis (key findings and methodology)
- Sample and coverage:
  - Full sample: 50 EMEs; usable sample restricted to 41 countries.
  - Panel data period: 1995–2008.
  - For full pre-crisis policy coverage: 34 countries with full information in 2007; only Ecuador lacked any type of regulation in 2007 among those 34.
- Policy indices constructed as simple averages of binary components:
  - Fincont: capital controls on the financial sector.
  - Fxreg: FX-related prudential regulations.
  - Domreg: other prudential measures on the financial sector.
- Composition of external liabilities (Table A1):
  - Cross-sectional and panel results: both economy-wide capital controls (Kai) and FX-related prudential regulations (Fxreg) are statistically associated with a smaller share of debt liabilities in total external liabilities.
  - Individual components most associated: controls on bond inflows, banks’ borrowing abroad, and lending locally in FX.
- Foreign-currency lending and credit booms (Tables A2, A3):
  - FX-related prudential measures strongly associated with lower reliance on FX-denominated lending; effect on general lending booms is weaker.
  - Other prudential measures (sectoral limits, reserve requirements) associated with reduced frequency of general lending booms.
  - Both capital controls and Fxreg retain significance in panel evidence for FX credit, indicating complementarity.
  - Sample limitations when Domreg included (Domreg data available for 2005 and 2007 only).
- Crisis resilience (Table A4):
  - Countries with capital controls (especially on debt liabilities) or prudential measures in place prior to 2008–09 crisis exhibited greater growth resilience.
  - Individual regressions: positive and statistically significant coefficients for (i) capital controls (especially economy-wide controls on debt liabilities), (ii) FX-related prudential regulations, and (iii) other prudential measures (reserve requirements, restrictions on concentration).
  - When capital controls and FX-related prudential measures included together, capital controls retain statistical significance; capital controls and macro-prudential measures can both be individually significant when included together.
- Methodological notes (preserved exactly):
  - Private credit boom: residual from regressing change in private credit to GDP over 2003-07 on private credit to GDP in 2003; policy indices averages over 2000-02 except macroprudential index pertains to 2005. ** indicates significance at 5 percent.
  - Forex credit residual: obtained from regressing forex credit to GDP in 2007 on private credit to GDP in 2005 and de facto exchange rate regime dummy; policy indices averages over 2003-05 except macroprudential index pertains to 2005. ** and *** indicate significance at 5 and 1 percent.
  - Crisis resilience residual: obtained after regressing difference between real GDP growth averaged over 2008-09 and 2003-07 on trading partner growth and terms of trade change. Policy indices averages over 2000-02 except macroprudential index pertains to 2005. * and ** indicate significance at 10 and 5 percent.
- Key quantitative points preserved:
  - By 2008, CNB required banks to place 72% of the increase in foreign liabilities with the CNB (or in liquid foreign assets); 28% disposable for lending.
  - 2008 differentiated minimum capital requirements: banks with credit growth below 12% per annum: minimum capital adequacy rate of 12%.
  - Regression examples reported in the text: PC = -10.57 + 2.06***PKF + Control var; FX = -1.55 + 1.03***PKF + Control Var.
  - In a sample of 41 emerging market countries over 2003–07:
    - Defining booms and surges as the top decile, half of credit booms are associated with a capital inflow surge, and these same booms are also those that ended in bust.
    - If booms and surges are defined as the top quartile, 90 percent of booms are associated with a surge in inflows, and of the 60 percent that ended in a bust, all were associated with a capital inflow surge.

### Designing capital control instruments — objectives and operational guidance
- Design goals: effective (achieve intended aim; hard to circumvent) and efficient (minimize distortions; transparent enforcement).
- Price-based measures (taxes, URRs) vs administrative (quantity-based) measures:
  - Price-based measures generally preferable: less opaque, easier to adjust cyclically.
  - Administrative measures may be more appropriate for financial-sector prudential objectives if transparent and rules-based.
  - Calibrating price-based measures can be difficult under information asymmetries and uncertainty (Weitzman, 1974).
- Temporary vs persistent flows:
  - For macro reasons, controls appropriate for temporary inflows; exchange rate should adjust to permanent shocks.
  - For prudential reasons, distinction less pertinent; persistent flows may be more dangerous for asset price booms.
  - Operational option: keep administrative apparatus permanently to implement a tax or URR when needed, possibly setting the rate to zero when not required.
- Targeting:
  - Macro objective: broad controls across inflow types.
  - Financial-stability objective: targeted controls on short-term, FX-denominated debt and some portfolio flows.
  - Tradeoff: targeted controls easier to circumvent (exemptions, relabeling, derivatives).
- Circumvention risks and policies to limit them:
  - Common channels: relabeling, tax-exempt vehicles, derivatives exposure, intra-bank transactions between domestic and foreign operations.
  - Derivatives can enable circumvention unless covered/taxed at same rate as original inflow.
  - Closing loopholes often requires complementary prudential measures (e.g., limits on banks’ gross currency positions).
  - Administrative capacity and bank implementation costs matter.

### Box 6 / Table 1 — Colombia net private capital flows (weekly averages, US$ mln.)
- Before (6 Jul 2006–6 May 2007) and After (7 May 2007–4 Jul 2008):
  - Total: Before 99.6; After 104.9; Change (after-before) 5.3
  - Total non-FDI: Before 3.7; After -32.8; Change -36.4
    - Borrowing: Before -10.8; After -17.1; Change -6.3
    - Portfolio (non-residents): Before 25.2; After -3.6; Change -28.8
    - Portfolio (residents): Before -4.7; After -18.1; Change -13.3
  - FDI: Before 95.9; After 137.7; Change 41.8
- Notes: Before and After periods defined as above; source cited in text.

### Box 7 — Taxes vs URRs (key operational comparisons and country examples)
- Mechanism:
  - URRs require part of inflow to be deposited unremunerated for a period; effect similar to taxes by reducing net returns; larger burden on short-term flows.
  - URRs create liquidity costs and deadweight loss relative to pure taxes; URR deposits in FX immediately reduce exchange rate pressure by deposit amount; taxes paid in local currency require FX conversion.
- Administrative and institutional notes:
  - Central bank usually can impose URRs; taxing authority required for inflow taxes — administrative roles determine choice.
  - URRs removable/set to zero more easily than taxes but may be more complex administratively (returning deposits, differing periods).
  - Tax administration easier (levied at FX conversion); tax agents can be brokers, depositaries, fund managers.
  - Institutional capacity and governance quality are critical.
- Country parameters (selected exact figures preserved):
  - Chile: URR set in 1991 at 20 percent; later increased to 30 percent; deposit period set at one year; rate reduced to zero in 1998.
  - Colombia: 40 percent-six month URR in 2007; URR increased to 50 percent in May 2008; two-year minimum-stay requirement on inward FDI to prevent circumvention.
  - Thailand: 30 percent-one year URR late 2006; early withdrawals penalized by withholding one-third of the deposit (i.e., a 10 percent tax on transaction value); URR eliminated March 2008.
  - Russia: multiple URRs in 2004 including 3 percent, 365 days URR on foreign borrowing; 20 percent, 365 days URR on transactions with government bonds; 50 percent, 15 days URR for ruble denominated loans from residents for certain transactions; URRs lifted in 2006.
  - Brazil: IOF tax on certain capital inflows in March 2008 at 1.5 percent; re-introduced October 2009 with 2 percent on foreign equity and fixed-income inflows and 1.5 percent on ADR conversions; subsequently increased to 6 percent for fixed-income inflows and extended to derivatives.

### Practical guidance — concluding operational points
- Multiple tools are likely needed; perfecting one tool is counterproductive.
- Price-based measures preferable for macro objectives; administrative measures suitable for financial-stability objectives on the financial sector if transparent and rules-based.
- Controls may require broader coverage than desirable to reduce circumvention; some circumvention is inevitable when incentives exceed costs.
- Complement prudential measures with controls to close loopholes; weigh tradeoffs between hedging costs and loophole closure.
- Administrative capacity, institutional arrangements, and international obligations shape feasible policy design.

*Source: _sdn1106 — Executive Summary, IMF PDF (excerpts and figures as provided).*

### Executive Summary ......................................................................................................

### Executive Summary

### Major sections
- I. Introduction — page 5
- II. How Do Macro and Financial-Stability Considerations Fit Together? — page 7
- III. The Policy Toolkit — page 10
- IV. Managing Capital Inflows: Matching Risks and Tools — page 12
- V. Some Evidence on Effectiveness of Instruments in Managing Inflows — page 20
- VI. Designing Capital Control Instruments — page 23
- VII. Conclusions — page 29

### Boxes (by title and page context)
- Box 1. Prudential Policies—Micro versus Macro
- Box 2. Korea—Macroprudential Rules in Relation to Capital Inflows
- Box 3. Macroprudential Policies, Credit Growth, and Asset Prices: Some Recent Experiences
- Box 4. Dealing with Capital Inflows and Excessive FX Lending: The Case of Croatia
- Box 5. International Arrangements Restricting the Scope for Capital Controls
- Box 6. Effectiveness of Capital Controls: Brazil and Colombia
- Box 7. Taxes vs. URRs

### Figures (by title and page context)
- Figure 1. Using Capital Controls for Macroeconomic and Financial-Stability Risks — page 7
- Figure 2. Frequency Distribution of Pre-Crisis Policy Measures — page 12
- Figure 3a. Choice of Instruments to Mitigate Risks Associated with Flows through the Banking System — page 14
- Figure 3b. Choice of Instruments to Mitigate Risks Associated with Flows through the Unregulated Financial Sector — page 18
- Figure 4. Domestic Credit and Net Capital Flows to GDP — page 21
- Figure 5. Debt Liabilities and Policy Measures — page 22
- Figure 6. Domestic Private Credit and Policy Measures — page 22
- Figure 7. Crisis Resilience and Policy Measures — page 23
- Figure 8. Capital Controls: Design Considerations — page 27
- Figure A1. Correlation Between Policy Measures — page 34
- Figure A2. Pre-Crisis Country Coverage of Policy Measures, 2007 — page 37

### Tables (appendix)
- Table A1. Policy Measures and Debt Liabilities — page 38
- Table A2. Policy Measures and Foreign-Currency Lending — page 39
- Table A3. Policy Measures and Domestic Credit Booms — page 40
- Table A4. Policy Measures and Crisis Resilience — page 41

### Appendix and Empirical Analysis components
- Appendix 1. Empirical Analysis — page 33
  - A. Measuring Capital Controls and Prudential Policies — page 33
  - B. Estimation Results — page 34

*Source: _sdn1106 - Executive Summary, IMF PDF (pages and contents as listed in the provided document).*

### EXECUTIVE SUMMARY

### _sdn1106 - EXECUTIVE SUMMARY

### Executive summary — main conclusions
- Four broad conclusions:
  - First, capital controls may be useful in addressing both macroeconomic and financial-stability concerns in the face of inflow surges, but before imposing capital controls, countries need first to exhaust their macroeconomic-cum-exchange-rate policy options. The macro policy response needs to have primacy both because of its importance in helping to abate the inflow surge, and because it ensures that countries act in a multilaterally-consistent manner and do not impose controls merely to avoid necessary external and macro-policy adjustment.
  - Second, while prudential regulations and capital controls can help reduce the buildup of vulnerabilities on domestic balance sheets, they both inevitably create distortions—reducing some “good” financial flows alongside “bad” ones—and may be circumvented. Thus, there is no unambiguous welfare ranking of policy instruments (though non-discriminatory prudential measures are always appropriate), and a pragmatic approach taking account of the economy’s most pertinent risks and distortions needs to be adopted.
  - Third, measures need to be targeted to the risks at hand. When inflows are intermediated through the regulated financial system, prudential regulation will be the main instrument. When inflows bypass regulated markets and institutions, capital controls may be the best option if the perimeter of regulation cannot be widened sufficiently quickly or effectively.
  - Fourth, the design of capital controls needs to be tailored to country circumstances. Where inflows raise macro concerns, controls will need to be broad, usually price-based, and temporary (though institutional arrangements to implement controls could be maintained). To address financial-stability concerns, controls could be targeted on the riskiest flows, might include administrative measures, and could be used even against more persistent inflows.

### Context and scope (Introduction)
- Emerging market economies (EMEs) face increasing challenges managing the recovery in capital inflows since the sudden stop of late-2008 and early-2009; the recovery has been uneven across countries and types of flows.
- Concerns cited:
  - upward pressures on currencies that, if not sustained, create dislocations through erosion in competitiveness and currency risk in some balance sheets;
  - inflating credit and asset prices that may not be sustainable and could amplify financial fragilities.
- Prior framing (Ostry et al., 2010):
  - capital controls defined as restrictive measures that discriminate on the basis of the residency of the parties to a capital transaction;
  - role demarcated to support macroeconomic goals and financial-stability goals.
  - counseled exhausting macro policy options first: allow exchange rate to reach a multilaterally-consistent medium-run level; build reserves consistent with country-insurance metrics; ensure domestic policy mix (monetary and fiscal) consistent with internal balance and sustainable public debt.
- This note elaborates how macro and financial-stability rationales fit together; what combination of prudential measures and controls should be deployed; and how controls should be designed for efficiency and effectiveness.
- Scope exclusions: structural policies (left aside because they take time), outflow controls (discussion focused on inflow controls), generally geared to EMEs with largely open capital accounts contemplating marginal controls in face of sudden inflow surge.

### How macro and financial-stability considerations fit together
- Policymakers should recognize that international financial integration is fundamentally beneficial (eases financing constraints, fosters diversification of investment risk, promotes intertemporal trade, contributes to financial market development).
- Inflow surges can produce:
  - economic overheating;
  - excessive appreciation;
  - pressures in particular sectors (sectoral credit booms, asset price bubbles).
- Risks distinguished:
  - Macroeconomic risks: exchange rate appreciation, inflation, overheating.
  - Financial-stability risks: generalized credit booms, asset price increases across classes (macro booms), sectoral balance-sheet vulnerabilities (e.g., housing), risky external liability structures, unhedged currency exposure, credit risk from foreign-currency lending to unhedged borrowers.
- Policy taxonomy:
  - Primary policy responses are macroeconomic policies (for macro risks) and prudential policies (for financial-stability risks). Both sets generally need adjustment in response to inflow surges.
- Macroeconomic policy adjustments discussed:
  - allowing the currency to strengthen provided it is not overvalued;
  - accumulating foreign exchange reserves to counter appreciation if the currency is on the strong side, and sterilizing intervention if inflationary concerns emerge;
  - lowering domestic policy rates if the output gap permits;
  - using available scope to tighten fiscal policy.
- Analytical guidance references preserved:
  - Exchange Rate Assessments: CGER Methodologies, IMF Occasional Paper 261, 2008;
  - Country Insurance, IMF Occasional Paper 254, 2007.
- Interaction and cross-effects:
  - macro measures can affect financial-stability risks (e.g., appreciation may abate inflows that fuel housing bubbles);
  - prudential measures can affect macro outcomes (e.g., lower maximum loan-to-value ratios can ease overheating pressures).
- Ordering and multilaterally-consistent approach:
  - capital controls are presented as a last resort because of their discriminatory nature and higher bar given multilateral concerns;
  - national authorities should first exhaust macro policy space, allow the exchange rate to strengthen to an appropriate multilaterally-consistent degree, and strengthen non-discriminatory prudential tools before resorting to capital controls;
  - direct regulation of foreign currency borrowing by non-financial entities is an alternative when administratively feasible, but should not replace necessary macro adjustment.
- Effectiveness caveat:
  - evidence on effectiveness of capital controls in influencing aggregate flows is mixed; evidence that controls affect composition of inflows (and thus financial-stability risks) is stronger.

### The policy toolkit — prudential regulations and capital controls
- Two broad classes of measures beyond macro policy:
  - Prudential regulations: intended to strengthen financial-sector resilience or limit excessive risk; often applied at individual-institution level even when serving macro-prudential aims.
  - Capital controls: restrictive measures discriminating on residency of parties to a capital transaction (discussed in detail elsewhere in the note).
- Prudential measures categorized for analytical purposes:
  - FX-related prudential measures (discriminate by currency, not residency):
    - limits on banks’ open FX position (as a proportion of their capital) are common;
    - limits on banks’ investments in FX assets;
    - measures to limit bank lending in FX to unhedged borrowers, including differential reserve requirements on liabilities in local currency and FX.
    - note: in some currency-board countries, exposures in the peg currency are excluded in the open position calculation; asymmetric open position limits (different limits on short and long positions) are categorized as FX-related measures even if they could act to discourage inflows.
  - Other prudential measures (non-discriminatory by residency or currency):
    - maximum loan-to-value (LTV) ratios;
    - limits on domestic credit growth;
    - asset classification and provisioning rules;
    - sectoral limits on loan concentration;
    - dynamic loan-loss provisions;
    - counter-cyclical capital requirements.
- Instrument choice principles:
  - Non-discriminatory prudential measures that strengthen financial resilience are always appropriate.
  - When inflows are intermediated through regulated financial system, prudential regulation is primary; controls on relatively risky banking inflows may buttress prudential policy.
  - When inflows bypass regulated markets/institutions (e.g., domestic entities borrowing directly abroad) and the regulatory perimeter cannot be widened quickly/effectively, capital controls may be the only option.
  - A combination of prudential regulation and capital controls can reduce circumvention and distortions.
- Design considerations for capital controls:
  - Where inflows mainly raise macro concerns: controls should have broad coverage, usually be price-based, and be temporary (though administrative capacity to implement controls may be maintained).
  - Where inflows mainly raise financial-stability concerns: controls can be narrowly targeted on the riskiest inflows, include administrative measures, and can be used against more persistent inflow surges.
  - Targeted controls should be designed to close loopholes, including those arising from derivative markets.
  - Administrative capacities of different agencies, institutional and legal constraints, and other country-specific factors influence design and implementation.

*Source: EXECUTIVE SUMMARY, _sdn1106*

### Box 1. Prudential Policies—Micro versus Macro

### Box 1. Prudential Policies—Micro versus Macro

### Micro-prudential policies
- Aim: improve individual institutions’ resilience to risks (including those arising from international capital flows); may also reduce systemic risk by mitigating externalities from individual institutions’ behavior.
- Examples:
  - Forward-looking provisioning of expected losses
  - Valuation reserves to cover the risk of mean reversal in prices of marked-to-market assets
  - Caps on LTVs/minimum collateral haircuts
  - Higher risk weights on specific types of exposures (such as real estate lending)
  - Minimum capital requirements, including better quality of capital (as in Basel III)
  - Leverage ratios
  - Capital conservation buffer (Basel III)
  - Liquid assets buffer (Basel III)
  - Limits on currency and maturity mismatches (Basel III NSFR)

### Macro-prudential policies
- Aim: explicitly target systemic risk; often adapt micro-prudential tools with settings conditioned on macro-financial developments or indicators of systemic risk in rule-based or discretionary ways.
- Examples:
  - Cyclically varying provisioning requirements
  - Cyclically varying LTVs
  - Countercyclical capital buffer (Basel III)
  - Capital/liquidity surcharge/levies on SIFIs
  - Tax on volatile funding (Shin, 2010)
  - Caps on credit growth
  - Higher reserve requirements

### Capital controls and overlap with prudential and FX measures
- Definition: Capital controls limit the rights of residents or non-residents to enter into capital transactions or effect transfers/payments associated with these transactions.
- Typical measures: taxes on flows from non-residents, unremunerated reserve requirements (URR) on such flows, special licensing requirements, outright limits or bans; may be economy-wide, sector-specific, or industry-specific; may differentiate by type or duration of flow (debt, equity, direct investment; short-term vs. medium- and long-term).
- Key distinctions and practical overlaps:
  - A regulation setting higher reserve requirements on banks’ liabilities to nonresidents constitutes a capital control; a regulation drawing boundaries by currency of denomination and applying equally to residents and nonresidents would not be a capital control, despite practical overlap.
  - Higher marginal reserve requirements on nonresident local-currency bank deposits than on residents’ deposits is generally viewed as prudential but would have much the same effect as a capital control.
  - A prudential tax on non-core liabilities (Shin, 2010) could operate like a capital control if most funding comes from nonresidents.
  - LTV ratios are normally prudential, but differing LTVs by currency of denomination would be FX-related measures.
- Practical design considerations: when prudential frameworks are underdeveloped or financial markets unsophisticated, capital controls may be more effective; when markets work well and international obligations constrain controls, prudential rules may be used. Intent may be similar (e.g., slowing aggregate or specific inflows).

### Policy guidance for managing capital inflows: matching risks and tools
- Initial step: exhaust macroeconomic policy options before contemplating capital controls or discriminatory prudential measures.
- Distinguish flows intermediated through domestic regulated financial institutions (RFIs) from direct borrowing not intermediated through RFIs.
- When inflows are intermediated through banks, key risk areas and tools:
  - Excessively risky external liability structure (e.g., reliance on short-term funding to finance longer-term loans):
    - Tools: prudential measures (currency-dependent liquidity requirements) or capital controls (limits on external borrowing, higher reserve requirements on liabilities to non-residents), or combination.
  - Excessively risky bank assets:
    - Credit risk from FX lending to unhedged borrowers: consider stricter FX-related regulations on banks (higher capital requirements on FX loans), or prohibitions/limits on loans to borrowers without a natural hedge.
    - Currency risk from open FX positions (banks borrow in FX but lend in local currency): consider tightening FX open position limits (in relation to bank capital) and increasing FX liquidity requirements.
  - Bank lending amplifying macroeconomic risks (lending or asset price boom):
    - Monetary tightening in a closed economy could attract more capital here; prudential rules to reduce lending booms may be appropriate—examples include increasing reserve requirements (equally or differentiated across local-currency and FX liabilities), raising risk weights for certain types of lending, tightening loan classification rules, countercyclical capital requirements, lower loan-to-value ratios (especially for real estate loans), and higher margin requirements for equity-related lending.
- Bottom line when flows are bank-intermediated: prudential measures targeted to external liability structure, currency and credit risk, and lending/asset price boom risks may be appropriate. Capital controls may be useful if prudential measures cannot timely address targeted risks or if flows might migrate to the unregulated financial sector.
- Factors tilting choice between measures:
  - Effectiveness of supervision: strong supervision favors prudential measures.
  - Institutional constraints and regulatory arbitrage: may favor a customized mix of capital controls and prudential measures.
  - Level playing field concerns for SMEs: capital controls on direct borrowing abroad may create a more level playing field for SMEs compared with prudential measures that raise bank borrowing costs, although both can disproportionately affect SMEs.

### Korea—Box 2 summary (selected findings)
- Context: strong exporter demand (notably shipbuilders) to hedge future dollar receipts; exporters over-hedged ahead of the crisis expecting won appreciation; onshore banks (mostly foreign bank branches) acted as counterparties and hedged via offshore dollar borrowing and spot FX, creating onshore hedged positions and capital inflows.
- Measures and chronology:
  - November 2009: required banks to gradually raise their long-term FX borrowing from 80 to 90 percent (later raised to 100 percent) of their long-term FX lending; succeeded in reducing banks’ short-term borrowing.
  - June 2010: package to “prevent excessive foreign exchange leverage,” strengthening earlier measures—included ceilings on FX derivative positions of banks (in relation to bank capital), tighter restrictions on provision of FX-denominated loans, stricter liquidity ratios for domestic banks, and prohibition on banks providing “excess” hedging of forward contracts with exporters.
  - Authorities reinstated non-discriminatory withholding and capital gains taxes on non-resident purchases of government and central bank securities (residents already subject to these).
- Outcomes:
  - Measures appear to have prevented banks’ external debt from returning to pre-crisis levels but did not substantially stem total capital inflows because measures targeted mainly onshore entities; corporates could hedge offshore and offshore banks could offset short-KRW positions via onshore government bond investment.
  - Authorities remain concerned with destabilizing inflows and are considering further measures, including a levy on short-term bank borrowing.

### Evidence on effectiveness of macro-prudential measures (Box 3 summary)
- General findings:
  - Macro-prudential measures to stem capital inflows and reduce excessive credit growth have had mixed results.
  - VAR analysis of EMEs indicates tightening macro-prudential measures in Croatia (2003-07), Korea (2008), India (2007), and Peru (2007-08) contributed to a reduction in credit growth; other cases were less effective.
  - Romania’s speed limits on credit growth (2003-08), expressed as a percentage of bank capital, were circumvented by increases in bank equity through FDI in the banking sector.
  - Macro-prudential measures often lengthened the maturity composition of capital inflows in Croatia, Peru, Romania, and Uruguay, though effects on total net flows were limited; combined with capital controls, inflows fell in Colombia.
  - Prudential measures contributed to financial sector resilience (e.g., lengthened maturity of inflows in Croatia, Korea, Peru; Uruguay shifted composition from external borrowing to FDI over 2003-08).
  - Macro-prudential measures usually did little to restrain asset prices; some moderation of stock market booms (Vietnam) with small estimated impact.
  - On balance, prudential measures are more effective when accompanied by supportive macroeconomic policies that rein in domestic demand, particularly under an open capital account.
- Country examples (measures, aims, observed effectiveness):
  - Colombia: Dynamic provisioning, marginal reserve requirement (MRR), limits on banks' gross derivative positions, URR (all 2007) — Aim: reduce credit growth — Effect: No strong effect on credit growth (but evidence of sectoral containment in consumer credit).
  - Croatia: Speed limit (2003, 2007); liquidity ratio (2006-08); MRR (2004-07) — Aim: reduce credit growth and unhedged foreign borrowing — Effect: Speed limit and reserve ratio reduced credit growth; MRR had no strong impact; decreased FX lending and lengthened maturity of inflows but no effect on asset prices.
  - India: Raised cash reserve ratio (2007) — Aim: reduce credit growth and asset price increases — Effect: Reduced credit growth (statistically weak), no effect on asset prices.
  - Korea: Strict liquidity ratios and limits on foreign currency lending to residents (2008); cap on banks' FX forward positions (2010) — Aim: reduce credit growth, unhedged foreign borrowing, and banks' external borrowing — Effect: Insignificant effect on FX lending to households but reduced credit growth; banks' foreign borrowing dropped after the cap.
  - Peru: Tighter loan classification and provisioning (2007-08); MRR on FX deposits (2008) — Aim: reduce credit growth — Effect: Slowed credit expansion and lengthened maturity of inflows.
  - Romania: Speed limit on credit growth (2005-07); raised reserve requirements on FX deposits (2002-06); tightened prudential rules on real estate lending — Aim: reduce credit growth and unhedged foreign borrowing — Effect: Reduced bank-intermediated foreign flows, but strong credit growth continued via increased financial FDI funding lending.
  - Uruguay: Prudential measures on loan classification and provisioning (2003-08) — Aim: address financial fragilities and dedollarize economy — Effect: Insignificant effect on credit expansion that started in 2006, but reduced credit risk and FX lending to residents, and shifted inflows from foreign borrowing to FDI.
  - Vietnam: Cap on securities-related credit (2007) — Aim: curb speculative investment in securities — Effect: Moderated the stock market boom.

*Source: Content from "Box 1. Prudential Policies—Micro versus Macro" in the supplied IMF PDF content.*

### Box 4. Dealing with Capital Inflows and Excessive FX Lending: The Case of Croatia

### Box 4. Dealing with Capital Inflows and Excessive FX Lending: The Case of Croatia

### Background and constraints
- Foreign-owned banks have dominated the Croatian banking system since 2000 and played a key role in moving foreign capital into Croatia.
- The surge in capital inflows raised macroeconomic and financial-stability concerns, especially because household consumer borrowing was an important component.
- Constraints faced by the Croatian National Bank (CNB):
  - The inflexible exchange rate regime limited the use of monetary policy.
  - Fiscal policy was constrained due to large structural budget problems.
- In response, the CNB primarily adopted prudential measures on the financial sector, some of which included an element of capital control.

### Timeline of CNB measures and banks' responses
- 2003
  - CNB introduced a speed limit to bank lending and a rule on minimum retained earnings if bank lending exceeded a certain threshold.
  - Banks sidestepped the limit by:
    - Selling part of their loan portfolio to affiliated leasing companies.
    - Transferring credit risk to the books of their foreign parents via an accounting loophole.
- July 2004
  - The speed limit was replaced by a capital control on domestic banks—the marginal reserve requirement (MRR).
  - MRR required banks to make additional non-interest bearing deposits with the CNB if their foreign liabilities increased above their value recorded at end-June 2004.
  - Over time the MRR rate was increased and the CNB refined the regulation to close loopholes (e.g., applied MRR to affiliated leasing companies, off-balance-sheet items related to selling credit risk, and to debt securities issued).
- By 2008
  - Banks were required to place 72% of the increase in foreign liabilities with the CNB, or in liquid foreign assets.
  - The remaining 28% was disposable for lending to clients.
  - Despite extremely high reserve requirements, banks’ domestic lending continued to increase.
- Mid-2006
  - Capital adequacy rules were tightened: risk weights applied to bank loans in foreign exchange and to loans in kuna indexed to foreign currency but granted to unhedged clients were set above the minimum Basel II standards.
  - Combination of higher reserve requirements and capital adequacy failed to curtail capital inflows or domestic lending.
- 2007
  - CNB reintroduced a speed limit to bank lending, this time covering the selling of credit portfolios and credit risk.
  - Limiting bank lending caused a significant decline in household credit growth.
  - Credit availability to enterprises remained high as borrowing from local banks was replaced by direct foreign borrowing.
- 2008
  - CNB introduced minimum capital requirements differentiated by credit growth rates:
    - Banks with credit growth below 12% per annum had to satisfy a minimum capital adequacy rate of 12%.
    - Banks growing faster faced higher capital adequacy requirements.
  - Risk weights and minimum retained earnings ratios were increased for fast-growing banks.
  - Higher risk weights applied to bank loans in FX and to those in kuna indexed to FX and granted to unhedged clients.

### Outcomes and lessons from the Croatian experience
- Prudential measures had some success in reducing the growth of bank credit and reduced capital inflows for a short time.
- However, credit availability remained high as domestic bank credit was partially replaced by direct lending from abroad.
  - This replacement altered the structure of capital inflows toward channels not covered by prudential policies or capital controls on banks.
- Key conclusion: It can be very difficult to curtail credit growth associated with a surge in capital flows without economy-wide capital controls, particularly when flows can bypass regulated financial institutions and when exchange rate policy cannot be used to stem inflows.

### Broader implications in the discussion (excerpted adjacent analysis)
- When flows bypass regulated financial institutions, two main risks arise:
  - Nonfinancial entities take on an excessively risky external liability structure (FX-denominated debt, especially short duration), which may create externalities and amplified fragilities.
    - Limiting such risky flows and maturity risk may call for capital controls because prudential rules targeted to RFIs will have little effect.
    - Regulating borrowing of the nonfinancial sector without discriminating between resident and non-resident sources is possible in principle but may be slow or costly to implement.
  - Private non-financial balance sheets acquire excessive currency risk even without aggregate excessive borrowing; unhedged borrowers can be tempted into excessive FX risk.
    - Capital controls may be appropriate for riskier liabilities; an alternative is FX-related measures (e.g., prohibiting borrowing in FX for mortgages by domestic nonfinancial entities).
  - Direct borrowing from abroad by non-financial entities can fuel asset price inflation and bubbles; since such borrowing bypasses the domestic banking system, monetary policy and prudential regulation will have limited traction, and capital controls on foreign borrowing (and complementary instruments) could be needed.
- Key takeaway: For flows bypassing the regulated financial system, the case for using capital controls is much stronger because the flows are outside the usual perimeter of prudential policies.
  - Extending the perimeter of regulation to avoid capital controls may be impractical given legal arrangements and administrative capacity.
  - Exceptions may arise from international obligations that prohibit or constrain capital controls (e.g., EU treaty, GATS, OECD, bilateral investment treaties).

### Quantitative and empirical notes (selected figures and findings from adjacent analysis)
- By 2008, CNB required banks to place 72% of the increase in foreign liabilities with the CNB (or in liquid foreign assets); 28% was disposable for lending.
- 2008 differentiated minimum capital requirements:
  - Banks with credit growth below 12% per annum: minimum capital adequacy rate of 12%.
- Empirical relationships reported in the broader analysis (panel/sample descriptions retained as presented):
  - PC = -10.57 + 2.06***PKF + Control var
  - FX = -1.55 + 1.03***PKF + Control Var
  - In a sample of 41 emerging market countries over 2003–07:
    - Defining booms and surges as the top decile, half of credit booms are associated with a capital inflow surge, and these same booms are also those that ended in bust.
    - If booms and surges are defined as the top quartile, 90 percent of booms are associated with a surge in inflows, and of the 60 percent that ended in a bust, all were associated with a capital inflow surge.

*Source: _sdn1106 - Box 4. Dealing with Capital Inflows and Excessive FX Lending: The Case of Croatia*

### Appendix 1). FX-related prudential measures—especially limits on banks’ open FX

### Appendix 1). FX-related prudential measures—especially limits on banks’ open FX positions and regulations regarding domestic lending in FX—are strongly associated with a lower reliance on FX-denominated lending, but the effect of such measures on general lending booms is weak.

### Effects of FX-related prudential measures and other policy indices
- FX-related prudential measures (especially limits on banks’ open FX positions and regulations regarding domestic lending in FX) are strongly associated with a lower reliance on FX-denominated lending.
- The effect of FX-related prudential measures on general lending booms is weak.
- Prudential measures—especially sectoral limits on banks’ lending and reserve requirements—are associated with a reduced frequency of general lending booms.
- Prudential measures are not significantly associated with the extent of FX lending.

Key methodological notes (as used in figures and regressions)
- Private credit boom is the residual (including constant) obtained after regressing change in private credit to GDP over 2003-07 on private credit to GDP in 2003. Policy indices are averages over 2000-02 except for the macroprudential measures index, which pertains to 2005. ** indicates significance at 5 percent level.
- Forex credit is the residual (including constant) obtained after regressing forex credit to GDP in 2007 on private credit to GDP in 2005 and a binary variable indicating the de facto exchange rate regime in 2007 (equal to one if fixed and zero otherwise). Policy indices are averages over 2003-05 except for the macroprudential measures index which pertains to 2005. ** and *** indicate significance at 5 and 1 percent levels, respectively.
- Crisis resilience is the residual (including constant) obtained after regressing the difference between real GDP growth rates averaged over 2008-09 and 2003-07 on trading partner growth and terms of trade change. Policy indices are averages over 2000-02 except for the macroprudential measures index, which pertains to 2005. * and ** indicate significance at 10 and 5 percent levels, respectively.

### Policy measures and crisis resilience
- The 2008–09 global financial crisis provides a “natural experiment” suggesting greater growth resilience in countries that had either capital controls (especially on debt liabilities) or prudential measures in place prior to the crisis.
- Individual regressions of the change in real GDP growth during 2008–09 (relative to 2003–07) yield positive and statistically significant coefficients for:
  - (i) capital controls (especially economy-wide controls on debt liabilities);
  - (ii) FX-related prudential regulations; and
  - (iii) other prudential measures (especially reserve requirements and restrictions on concentration of lending to individual sectors).
- When capital controls and FX-related prudential measures are included simultaneously in regressions, capital controls retain statistical significance.
- When capital controls and macro-prudential measures are included together, both remain individually significant.
- Interpretation: some substitutability exists across capital controls and FX-related prudential measures, and complementarity exists between capital controls and prudential tools in enhancing growth resilience during capital inflow boom-bust cycles.

### Designing capital control instruments — objectives and general guidance
- Goals: design controls that are effective (achieve intended aim and are not easily circumvented) and efficient (minimize distortions and scope for non-transparent or arbitrary enforcement).
- In many circumstances, capital controls will not be needed because judicious use of macroeconomic policies and prudential tools may suffice.
- Multiple tools are likely to be needed; focusing on the perfect design of only one tool may be counterproductive.
- Price-based measures (e.g., a tax or URR) versus administrative (quantity-based) measures (e.g., ceilings/limits, authorization requirements, prohibitions):
  - Price-based measures are generally preferable because they are less opaque and/or subject to arbitrary enforcement, and may be easier to adjust cyclically.
  - Administrative measures may be more appropriate for prudential purposes, particularly when applied to the financial sector, provided they are transparent and rules-based.
  - When authorities face information asymmetries and uncertainty about private-sector responses, calibrating price-based measures can be difficult (Weitzman, 1974).
  - A rule of thumb: price-based measures preferable in general; administrative measures may be better for financial-sector prudential objectives (e.g., limits on open FX positions).

### Temporary vs. persistent flows and operational considerations
- For macroeconomic reasons, controls should be used in the face of capital inflows expected to be temporary, because the exchange rate should adjust to permanent shocks.
- For prudential concerns, the transitory vs. persistent distinction is less pertinent—both can pose financial stability risks; persistent flows may be more dangerous for asset price booms.
- Controls and prudential measures can be strengthened or imposed to counter the credit cycle and remain until flows abate or reverse.
- One operational possibility: keep administrative apparatus permanently in place to implement a tax or URR when appropriate, reducing the rate (possibly to zero) when no longer required. But adjusting the URR or tax should not be automatic and policy prerequisites must be met.

### Targeting of controls
- If objective is macroeconomic (exchange rate/competitiveness), controls should be applied broadly across inflow types because aggregate inflow matters.
- If objective is financial stability, controls can be targeted more narrowly at riskier inflows (generally, short-term, foreign-currency denominated debt, some portfolio flows).
- Tradeoff: targeted controls can be more easily circumvented through exempt transactions, relabeling, or derivative markets.

### Circumvention risks and limiting circumvention
- Common circumvention channels:
  - Unrestricted current transactions and liberalized capital transactions (e.g., nonresidents receiving local-currency payments and investing locally).
  - Relabeling of flows (e.g., treating portfolio flows as FDI) and use of tax-exempt vehicles (e.g., ADRs).
  - Use of derivatives to obtain exposure while only posting margin (reducing the taxable/taxed inflow footprint).
  - Transactions between a bank’s domestic and foreign operations not covered by controls (allowing banks to hedge and create equivalent inflows).
- Derivatives markets can enable circumvention unless derivatives transactions are taxed/covered at the same rate as the original inflow would have been.
- Design features can create loopholes (Brazil’s IOF experience noted as instructive).
- Closing loopholes often requires prudential measures complementing controls (e.g., limits on banks’ gross currency positions).
- Administrative capacity and costs: considerable administration is usually required to ensure effectiveness, and banks often bear implementation costs.

### Case study evidence: Brazil and Colombia (Box 6 and Table 1)
- Both countries used inflow controls to address external competitiveness and increase monetary policy independence. Measures varied (tax vs. URR) and evolved to target portfolio flows (fixed income and equity).
- ADR issuance initially exempted in both countries; Brazil later imposed a tax on ADR issuance to close circumvention via ADR conversion.
- On-shore and off-shore derivatives markets in both countries provided circumvention avenues.
- Colombia curtailed some circumvention via a prudential measure that limited banks’ overall gross position in currency derivatives, though off-shore derivative trading by pension funds increased.
- Transactions costs for derivative-based circumvention are non-negligible but typically smaller than the tax/URR; they generate fees rather than government revenue.
- Limits on gross currency positions can reduce hedging and close loopholes, but restrict legitimate hedging—tradeoffs must be weighed.

Table 1. Colombia: Net private capital flows before and after capital controls (weekly avg flows in US$ mln.)
- Category  Before  After  Change (after-before)
- Total  99.6  104.9  5.3
- Total non-FDI  3.7  -32.8  -36.4
  - Borrowing  -10.8  -17.1  -6.3
  - Portfolio (non-residents)  25.2  -3.6  -28.8
  - Portfolio (residents)  -4.7  -18.1  -13.3
- FDI  95.9  137.7  41.8

Notes on Table 1
- Before represents average flow for the period 6th July 2006 to 6th May 2007; After represents average flow for the period 7th May, 2007 to 4th July, 2008.
- Source: Clement and Kamil (2009).

### Practical guidance and final considerations
- Controls may need broader coverage than desirable to reduce circumvention; some circumvention is inevitable when incentives exceed costs.
- In countries with sophisticated financial markets, design must account for loopholes via derivatives.
- Weigh benefits of limiting circumvention against administrative and compliance costs borne by authorities and banks.
- Policy design should consider the country’s institutional setup and administrative ease of imposing particular measures.
- Prudential tools (e.g., limits on open FX positions, reserve requirements, sectoral lending limits) can complement capital controls and, in many cases, may be sufficient without discriminatory capital controls.

*Source: IMF staff estimates and text from the referenced IMF chapter.*

### Box 7. Taxes vs. URRs

### Box 7. Taxes vs. URRs

### Mechanism and economic effects
- URRs (unremunerated reserve requirements) require that part of an inflow be deposited in an unremunerated account for a period of time; they have a similar effect to taxes on inflows by reducing net returns.
- Both taxes on inflows and URRs place a larger burden on short-term flows (example: an entry tax has a larger impact on the net return on a one-year flow than on a ten-year investment).
- A tax-equivalent rate for a URR can be computed as a function of the level of the URR as a proportion of the investment and the opportunity cost of those funds.
- In a low-interest rate environment, a substantial deposit may be required for a URR to be effective, possibly raising liquidity concerns.
- URRs create liquidity costs because part of the funds are not available immediately to the investor, and the URR deposit is not useful as collateral to a counterparty other than the central bank, producing a deadweight loss relative to a pure tax.
- URR deposits made in foreign exchange immediately reduce exchange rate pressure by the amount of the deposit; a tax generally paid in local currency requires conversion of FX into local currency, with the resulting exchange rate pressure.

### Country examples and specific parameters
- Chile:
  - URR set up in 1991 at a 20 percent rate (with varying length depending on the maturity of the credit).
  - Rate subsequently increased to 30 percent and the deposit period set at one year, regardless of the credit’s maturity.
  - Coverage of the URR was expanded.
  - Rate reduced to zero in 1998.
- Colombia:
  - Applied a 40 percent-six month URR in 2007.
  - Withdrawals before the six-month period were subject to substantial penalties.
  - In June 2007, equities issued abroad were exempted; in December, the URR on IPOs was eliminated and early-withdrawal penalties were reduced.
  - Persistent appreciation pressures led to an increase in the URR to 50 percent in May 2008.
  - To prevent circumvention, a two-year minimum-stay requirement was implemented on inward FDI.
- Thailand:
  - Implemented a 30 percent-one year URR in late 2006.
  - Early withdrawals were subject to approval by the Bank of Thailand and were penalized by withholding one-third of the deposit, i.e., a 10 percent tax on the transaction value.
  - Later, debt flows that were fully hedged became exempt from the URR.
  - URR eliminated in March 2008.
- Russia:
  - Introduced multiple URRs in 2004:
    - a 3 percent, 365 days URR on foreign borrowing;
    - a 20 percent, 365 days URR on transactions with government bonds;
    - a 3 percent, 365 days URR for transactions with other securities;
    - a 50 percent, 15 days URR for ruble denominated loans from residents and certain securities transactions;
    - a 3 percent, 365 days URR for ruble loans to residents and specified domestic securities transactions.
  - The URR was lifted in 2006.
- Brazil:
  - Implemented a tax (IOF) on certain capital inflows in March 2008, at a 1.5 percent rate.
  - Tax eliminated at the onset of the global crisis, but re-introduced in October 2009, with a 2 percent tax on foreign equity and fixed-income inflows and a 1.5 percent tax applied when foreign investors convert ADRs into receipts for shares issued locally.
  - Subsequently, the tax rate was increased in two steps to 6 percent for fixed-income inflows and extended to derivatives.

### Administrative considerations and implementation
- Choice between URRs and taxes is often driven by administrative considerations:
  - Typically, the central bank can impose a URR but does not have authority to levy taxes; most countries have adopted URRs for this reason.
  - In Brazil’s case, the inflow tax had been created in the past and the Ministry of Finance has authority to adjust its rate.
- Removal and adjustment:
  - Unlike a tax, a URR can usually be removed (or set to zero) more easily because the budget is not directly reliant on its revenues, but a URR may be more burdensome to administer than a tax.
- Administrative complexity:
  - URR administration is relatively complex because the deposited amount must be returned to the investor after the expiry of the reserve period; complexity increases with differing reserve periods and URR rates, and when banks must maintain reserves based on previous conditions until their expiry.
  - Tax administration appears easier: the tax can be levied at the time when FX is converted to local currency for taxable purposes; no additional follow up is needed, though documentation should be maintained to monitor compliance.
  - Tax agents can be brokers in the stock exchange, securities depositaries, or fund managers.
- Institutional capacity and governance:
  - Controls consistent with existing practices can be inserted more quickly and seamlessly, reducing circumvention.
  - Administrative capacity is critical; countries should opt for measures that play to their relative administrative strengths.
  - Consideration must be given to the character and quality of governance, since measures may be subject to dilution through lobbying or arbitrary/corrupt administration.
- Supervision and enforcement:
  - Financial institutions are often the cornerstone of controls implementation, requiring careful supervision to ensure compliance.
  - This supervision is distinct from, and in addition to, normal prudential supervision, and can be performed by the supervisory authority, the central bank, and possibly the tax authority.
- International obligations:
  - International obligations (bilateral, regional, or multilateral agreements) may restrict the use of controls.

### Role of price-based vs. administrative measures within policy mix
- Given their similarity, the choice between URRs and inflow taxes often depends on administrative authority and capacity.
- Price-based controls (taxes, URRs) may be preferable when applied for macroeconomic reasons; administrative measures (including prohibition of certain flows) may be appropriate when controls are used for financial-stability purposes, especially on the financial sector.
- Administrative measures need to be transparent and rules-based to avoid potential rent-seeking behavior.

*Source: Box 7. Taxes vs. URRs, IMF Staff Discussion Note (excerpt).*

### APPENDIX I. EMPIRICAL ANALYSIS

### APPENDIX I. EMPIRICAL ANALYSIS

### A. Measuring Capital Controls and Prudential Policies
- Sample and data coverage:
  - Sample consists of 41 EMEs (full sample 50 EMEs, usable sample restricted to 41 countries).
  - Cross-sectional data covers the most recent financial crisis; panel data covers 1995–2008.
- Constructed policy indices (each index is a simple average of included binary components where 1 indicates existence of a regulation and 0 otherwise):
  - Fincont: capital controls on the financial sector (controls specific to financial institutions on borrowing abroad, maintenance of accounts abroad, and differential treatment of deposit accounts held by nonresidents).
  - Fxreg: FX-related prudential regulations (lending locally in foreign exchange, purchase of locally issued securities denominated in foreign exchange, differential treatment of deposit accounts in foreign exchange, and limits on open foreign exchange positions).
  - Domreg: other prudential measures on the financial sector (loan-to-value ratio, reserve requirements, limits on credit concentration in specific sectors).
- Data sources and construction notes:
  - De jure measures constructed using IMF’s AREAER and an in-house country desk survey.
  - Economy-wide capital account controls measured using Schindler (2009).
  - Data on debt liabilities (sum of portfolio debt and other investment) as a share of total external liabilities obtained from an updated and extended version of the Lane and Milesi-Ferretti (2007) dataset.
  - For Domreg measures, available data pertains to 2005 and 2007 only.
  - For analytical purposes, only cases where the reserve requirement exceeds 10 percent are counted as having reserve requirements.
- Cross-index relationships and country coverage:
  - The constructed measures tend to be positively correlated with each other and with Schindler (2009)’s measure of economy-wide capital account controls.
  - Correlation is higher between capital controls (economy-wide and financial sector) and FX-related prudential regulations than between those measures and the domestic prudential index.
  - Pre-crisis cross-sectional snapshot (2007) for 34 EMEs with full information: about one-third of countries had measures in all categories (economy-wide capital controls, FX-related prudential regulations, and other prudential measures).
  - All countries except Bulgaria and Ecuador had some form of FX-related prudential regulations in place in 2007.

### B. Estimation Results
- General estimation approach:
  - Cross-sectional regressions for pre-crisis snapshots and panel regressions (1995–2008).
  - In panel regressions, rather than country fixed effects (policy measures are slow-moving), pooled models control for region and income-group specific effects and include year effects; some specifications include country fixed effects depending on the dependent variable and sample.
  - Policy indices (Kai, Fincont, Fxreg, Domreg) are typically lagged by one year in panel specifications.
  - Domreg indices materially reduce sample size because they are available for 2005 and 2007 only.

- Composition of external liabilities (Table A1):
  - Dependent variable: share of debt liabilities in total external liabilities (in percent).
  - Cross-sectional (pre-crisis) results (columns 1–13):
    - Estimated coefficients for both economy-wide capital controls (Kai) and FX-related prudential regulations (Fxreg) are individually and jointly statistically significant.
    - Higher restrictions are associated with a smaller share of debt liabilities.
    - Individual components with strongest association: controls on bond inflows, banks’ borrowing abroad, and lending locally in FX.
  - Panel results (columns 14–26):
    - Findings reinforced: countries with capital controls (both economy-wide and financial sector specific) tend to have the composition of external liabilities tilted away from debt.
  - Notes:
    - Robust standard errors reported; significance indicated at 10, 5, and 1 percent levels.
    - Domreg1 is the average of reserve requirements and restrictions on concentration in sectors; Domreg2 also includes LTV ratios.

- Credit booms (Tables A2 and A3):
  - Foreign-currency lending (Table A2):
    - Cross-sectional evidence (recent crisis): countries with both economy-wide capital controls and FX-related prudential regulations have lower domestic borrowing in foreign currency (ratio to GDP).
    - Fxreg effect dominates when both included together using Fxreg2 (comprehensive Fxreg).
    - Within Fxreg2, restrictions on lending locally in foreign exchange and limits on open FX positions show the strongest association with reduced forex lending.
    - Panel evidence (1995–2008): indices for both capital controls and FX-related prudential regulations retain significance when included together, providing evidence of complementarity.
    - Dependent variable examples and controls:
      - Recent crisis dependent variable: FX credit to GDP in 2007; Kai, Fincontrol, Fxreg averaged over 2003–05; Domreg pertains to 2005 measures; de facto fixed exchange rate dummy and private credit to GDP in 2005 included as initial conditions.
  - Domestic credit booms (Table A3):
    - Dependent variable: change in private credit to GDP (recent crisis: change over 2003–07; panel: annual change).
    - Recent crisis cross-sectional evidence (columns 1–13):
      - Both FX-related prudential regulations (Fxreg) and other prudential measures (Domreg) are strongly related with smaller credit booms.
    - Panel data analysis:
      - Strong association found for other prudential policy measures (Domreg) in reducing domestic credit booms.
    - Sample limitations:
      - Sample size drops drastically when Domreg indices are included because Domreg data are available for 2005 and 2007 only.

- Crisis resilience (Table A4):
  - Dependent variable definitions:
    - Recent crisis: difference between real GDP growth averaged over 2008–09 and 2003–07 (columns 1–13).
    - Past crises (1995–2008): difference between real GDP growth rate in the crisis year and the average past 5-year growth rate.
  - Key findings:
    - Economy-wide capital controls (Kai) appear associated with improved growth resilience in crises.
      - Columns (1)–(13): countries with capital controls on inflows (particularly bond inflows) fared better in terms of lower output decline during the recent financial crisis.
    - FX-related prudential regulations show some effect when included alone, but the effect of capital controls tends to dominate when both are included together (see column 11).
    - Other prudential measures (Domreg), particularly limits on sectoral lending and reserve requirements, seem to complement capital account restrictions; both measures retain significance when included together.
    - Evidence from past crises (VEE database, 1995–2008) supports the association of economy-wide capital controls with growth resilience.
  - Additional notes and robustness:
    - Excluding Baltic countries weakens statistical significance of the association between overall controls on inflows and growth decline, but the association between growth decline and capital controls on debt liabilities remains statistically significant.
    - Robust standard errors and control variables (growth in trading partners and terms of trade improvement) included in regressions; significance indicated at standard levels.

### Key quantitative and data points (preserved exactly as in source)
- Sample sizes and coverage:
  - Full sample consists of 50 EMEs; usable sample restricted to 41 countries.
  - Panel data period: 1995–2008.
  - For analytical pre-crisis coverage of all policy measures: universe comprises 34 countries for which data on all measures is available.
  - Only one country (Ecuador) out of the 34 EMEs for which full information was available had no type of regulation in place in 2007.
- Measurement and timing:
  - Kai, Fincontrol, Fxreg are averaged over 2000–05 for some cross-sectional regressions; over 2003–05 for FX credit regressions, and over 2000–02 for credit boom regressions as specified in table notes.
  - Domreg measures pertain to the measures in place in 2005 (available for 2005 and 2007 only).
  - Reserve requirement threshold for counting as a reserve requirement in Figure A2: exceeds 10 percent.
- Data sources explicitly cited in the source:
  - IMF’s AREAER, Schindler (2009), Lane and Milesi-Ferretti (2007), and IMF staff country desk survey.
- Tables and figures referenced:
  - Figure A1 (correlations among indices), Figure A2 (pre-crisis country coverage of policy measures, 2007).
  - Tables: Table A1 (Policy Measures and Debt Liabilities), Table A2 (Policy Measures and Foreign-Currency Lending), Table A3 (Policy Measures and Domestic Credit Booms), Table A4 (Policy Measures and Crisis Resilience).
  - Specific index definitions: Fincont1, Fincont2, Fxreg1, Fxreg2, Domreg1, Domreg2 as defined in table notes.

*Source: APPENDIX I. EMPIRICAL ANALYSIS (IMF staff estimates based on AREAER, Schindler (2009), Lane and Milesi-Ferretti (2007), and country desk survey).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/sdn/2011/_sdn1106.pdf_