## Appendix 1. Inflows, Fragilities, and Controls—Some Empirics

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---

### Introduction and overview
- Capital flows returning to emerging market economies (EMEs) provide financing for investment, diversify risk, and help develop financial markets; benefits comparable to free trade (IMF Occasional Paper 264, 2008).
- Concerns motivating renewed interest in capital controls:
  - Many inflows perceived as temporary and driven by interest rate differentials that may reverse.
  - Massive inflows can lead to exchange rate overshooting or strong appreciations, complicating management, and can inflate asset price bubbles that amplify financial fragility and crisis risk.
  - Foreign investors may exhibit herd behavior and excessive optimism; even fundamentally sound flows can cause collateral damage (bubbles, booms/busts).
- Key conclusion:
  - If the economy is operating near potential, reserves are adequate, the exchange rate is not undervalued, and inflows are likely transitory, then capital controls—in addition to prudential and macroeconomic policy—are justified.
  - Controls can retain potency if circumvention strategies are more costly than expected returns; the cost of circumvention acts as “sand in the wheels.”
- Empirical assessment:
  - Evidence stronger for controls affecting composition of inflows than aggregate volume (examples: Chile and Colombia).
  - Some items recorded as financial sector FDI may disguise intragroup debt and be akin to debt in riskiness—relevant to emerging Europe during the recent crisis.
  - Multilateral caveat: widespread use of controls by EMEs could exacerbate global imbalances, slow needed global rebalancing, or trigger contagious adoption of controls with longer-term welfare losses.

### Responding to capital inflows — policy toolkit and rationale
- Policy tools available:
  - Fiscal policy
  - Monetary policy
  - Exchange rate policy
  - Foreign exchange market intervention
  - Domestic prudential regulation
  - Capital controls
- Macroeconomic considerations and conditional responses:
  - Exchange rate appreciation:
    - If exchange rate is undervalued from a multilateral perspective, allowing passive appreciation is appropriate.
    - If already overvalued (or roughly in equilibrium), proactive policy response needed to protect competitiveness.
  - Reserve accumulation:
    - If reserves are relatively low or precautionary accumulation desirable, inflows offer an opportunity to augment reserves.
  - Sterilization:
    - Sterilize money supply increase via open-market operations or decrease in domestic credit.
    - Limits: shallow domestic markets, fiscal cost from interest differential, potential perpetuation of inflows if domestic interest rates remain high.
  - If sterilization exhausted or further reserve accumulation not desirable, consider reducing inflows via macro policies or direct methods.
  - Monetary and fiscal policies:
    - Lowering interest rates reduces incentives for inflows; tightening fiscal policy reduces appreciation pressures.
    - If economy at risk of overheating, lowering interest rates is unattractive; fiscal consolidation may be constrained by political/implementation lags.
  - Controls on capital inflows:
    - Particularly useful for transitory surges that cause temporary appreciation but potentially permanent damage to tradable sector.
    - Controls tend to lose effectiveness over time and may need continual strengthening, increasing distortions.
- Financial fragility rationale:
  - Pecking order of capital inflows in decreasing order of riskiness (short-term instruments more risky than long-term within each category):
    - Foreign-currency debt,
    - Consumer-price-indexed local currency debt,
    - Local-currency debt,
    - Portfolio equity investment, and
    - Foreign direct investment.
  - Large inflows may fuel domestic lending booms, foreign-exchange-denominated credit, and asset bubbles; prudential regulation (cyclical capital requirements, limits on FX lending to unhedged borrowers) may suffice in normal times, but large inflows may require controls to buttress prudential measures.
  - Example instruments and effects:
    - Unremunerated reserve requirements on foreign exchange debt reduce external FX borrowing (though may encourage substitution into other external debt).
    - Inflow taxes on short-term debt lengthen maturities by reducing price differential between short- and long-term debt; optimal size depends on liquidity panic risk, fiscal adjustment cost, and elasticity of substitution.
    - Financial transaction taxes deter short-term carry trades.
    - Minimum-stay requirements directly lengthen maturity of liabilities.
  - Risks:
    - Excessive limits on banks can spur disintermediation and growth of nonregulated financial institutions (Wakeman-Linn, 2007).
    - Circumvention (e.g., currency swaps) can undermine effectiveness.

### Other considerations in choosing controls
- Effectiveness depends on:
  - Preexisting administrative/institutional infrastructure to enforce controls. Strengthening controls is easier for countries with substantial existing restrictions.
  - Extent and sophistication of measures adopted; recent measures include restrictions on derivative positions (example: Colombia).
  - Measurement challenges: intensity of controls is hard to measure; empirical identification problems (simultaneity bias) complicate causal inference.
- Controls on outflows:
  - Relaxing outflow controls can affect net inflows ambiguously: it may reduce net inflows by offsetting inflows with outflows, or increase attractiveness by assuring repatriation of capital.
- Multilateral implications:
  - Widespread adoption of controls by EMEs could impede efficient global allocation of investment and hinder addressing global imbalances by preventing necessary appreciation in undervalued currencies.
  - Controls may redirect flows to less able absorbers and provoke generalized financial protectionism.
  - Multilateral considerations do not unambiguously argue against controls; if controls curtail risky forms of inflows, they may reduce precautionary reserve demand and help narrow global imbalances (Ghosh, Ostry, and Tsangarides, 2010).

### Inflows, fragilities, and controls — stylized facts and empirical evidence
- Objectives for controls:
  - Reduce volume of inflows
  - Limit exchange rate appreciation
  - Alter maturity composition to reduce fragility
  - Increase monetary policy independence
- Empirical evidence (general):
  - Individual country studies often find little or no impact of controls on aggregate volume of inflows; cross-country analyses sometimes find smaller surges among countries with controls.
  - Cardarelli, Elekdag, and Kose (2007): among countries facing surges, those with controls experienced smaller inflows—"2 percent of GDP in episodes with 'high' capital controls compared with 4 percent of GDP in instances where the country had no or low controls."
  - Reasons for mixed evidence on volumes:
    - Recent EME measures tend to be marginal.
    - Controls often introduced as part of packages, making isolation of effect difficult.
    - Measurement of intensity of controls is difficult.
    - Econometric identification problems (countries facing large inflows may be more likely to impose controls).
  - Stronger evidence that controls affect composition, maturity, and monetary policy autonomy:
    - Examples: controls lengthened maturity of inflows in several country studies (Ariyoshi and others, 2000; De Gregorio and others, 2002; Cardoso and Goldfajn, 1998; Cardenas and Barrera, 1997; Goh, 2005).
- Evidence from the global financial crisis (natural experiment):
  - Cross-country stylized facts:
    - Larger stocks of debt liabilities and of FDI in the financial sector ("financial FDI") are associated with worse growth slowdowns.
    - Regression analysis: countries with larger stocks of debt liabilities or financial FDI fared worse; countries with larger stocks of nonfinancial FDI fared better.
      - Interpretation: debt imposes fixed obligations with limited risk sharing; greenfield nonfinancial FDI is more stable and can provide fresh financing.
      - Financial FDI can mask intragroup lending and behave like debt.
  - Channels:
    - Debt and components of financial FDI correlate strongly with credit booms and FX-denominated lending by domestic banks, which in turn associate with greater vulnerability.
    - Vulnerability linked to debt liabilities persists even controlling for credit booms and FX lending—households and firms may borrow directly from abroad or via nonbank intermediaries.
  - Policy implication:
    - Controls that limit debt inflows (and debt-like financial FDI) could usefully supplement prudential regulations targeting domestic credit booms and unhedged FX lending.
  - Empirical association between precrisis controls and crisis outcomes:
    - Negative association between capital controls in place before the global financial crisis and the magnitude of output declines during the crisis (Table A3).
    - Causation not established, but evidence suggests use of controls associated with avoiding some of the worst growth outcomes linked to financial fragility.
    - Supporting evidence: Gupta, Mishra, and Sahay (2007) — in about 200 crisis episodes in about 90 countries over 1970–2007, drops in output during crisis episodes are significantly lower if capital controls existed before the crisis.
- Empirical caveats:
  - Difficulty disentangling effects of controls from accompanying macro/prudential policies.
  - Potential for circumvention and substitution between types of inflows.
  - Heterogeneity across countries in administrative capacity, financial market depth, and severity/nature of inflow surges.

### Box 1. Country Experiences with Controls on Short-Term Capital Inflows — key lessons
- Volume of inflows and exchange-rate pressures:
  - Controls on inflows generally have little impact on the total volume of capital inflows and thus on currency appreciation.
  - Country experiences:
    - Brazil and Chile (1990s): Imposition of inflow restrictions had no significant impact on total capital inflows; the real effective exchange rate appreciated by about 5 and 4 percent annually in Brazil and Chile, respectively.
    - Thailand (December 2006): The real exchange rate started appreciating within a week after controls on short-term flows were imposed.
    - Colombia (2007–08): Controls were ineffective in reducing volume of non-FDI inflows or in moderating currency appreciation.
- Composition and maturity structure:
  - Controls can alter composition and maturity even if volumes are little changed.
  - Quantitative examples:
    - Chile (1991–98): Controls (URR and extensions) coincided with a decline in short-term debt as proportion of total liabilities and an increase in the stock of FDI from about 34 percent in 1991 to 53 percent in 1998.
    - Colombia (post-1993 URR): The share of medium- and long-term debt in the private external debt stock increased to 70 percent of the total external debt stock in 1996, from 40 percent in 1993.
  - Empirical interpretation: Chilean unremunerated reserve requirement (URR) found effective in tilting inflows away from short-term maturities.
- Prudential measures and financial-stability objectives:
  - Prudential measures—either bundled with capital controls or stand-alone—can affect currency mismatches and limit debt inflows.
  - Country experiences:
    - Malaysia (1994): Asymmetric open-position limits of banks introduced with temporary capital controls were effective in influencing volume and composition short term.
    - Chile: Strong prudential framework complemented capital controls in affecting inflow composition.
    - Croatia (2004–08): Prudential measures—including marginal reserve requirement on bank foreign financing—were effective in reducing external bank debt in 2006–08.
- Implementation capacity and durability:
  - Effectiveness critically depends on administrative and enforcement capacity.
  - Typical pattern: Controls’ impact often short lived as markets adjust and circumvent them; strong enforcement (as in Chile) is needed to identify loopholes and prevent circumvention.

### Appendix: Empirics on inflows, fragilities, and controls — sample and key regression results
- Sample and measurement:
  - Usable sample: up to 37 EMEs (full sample 50 EMEs but data limitations restrict usable sample to a maximum of 37 countries).
  - Performance metric: average growth in 2008 and 2009 relative to the country’s historical average (real GDP growth, 2003–07).
- Main empirical findings (selected coefficients and statistics as reported):
  - Foreign-liability composition and crisis performance (Table A1, selected coefficients):
    - Non-Financial FDI (% of GDP, 2007): -0.071**  -0.086*** -0.087***  -0.090*** -0.087***.
    - Financial FDI (% of GDP, 2007): 0.195** 0.134 0.002 0.021 -0.045.
    - Debt Liabilities (% of GDP, 2007): 0.116*** 0.116*** 0.102** 0.091*** 0.084*.
    - FX Credit (% of GDP, 2007): 0.153*** 0.043 0.008.
    - Change in Credit/GDP from 2003 to 2007: 0.151*** 0.101* 0.100.
    - Observations and fit: Observations 35 34 30 33 30 33 29; R-squared 0.43 0.60 0.41 0.47 0.61 0.717 0.727 (as reported).
  - Channels of risk (Table A2):
    - Financial FDI (% of GDP, 2007) coefficient on FX Credit: 1.305*** (standard error 0.346); coefficient on Change in Credit/GDP: 0.914** (standard error 0.398).
    - Debt Liabilities (% of GDP, 2007) coefficient on FX Credit: 0.389*** (standard error 0.071); coefficient on Change in Credit/GDP: 0.258** (standard error 0.104).
    - Observations 31 and 34; R-squared 0.75 and 0.31 (as reported).
  - Capital controls and crisis outcomes (Table A3 probit results; controls based on Schindler (2009) index averaged over 2000–05):
    - Controls on Overall Inflows: -2.026* and -2.644** (standard errors 1.043 and 1.329 in two specifications).
    - Controls on Bond Inflows: -4.054* and -8.548** (standard errors 2.294 and 3.708 in two specifications).
    - Controls on Equity Inflows: 2.057 and 3.443** (standard errors 1.376 and 1.722).
    - Observations 37 in each reported specification; Pseudo R-squared 0.117 0.240 0.168 0.368 (as reported).
  - Interpretive summary: Correlations suggest controls on debt flows are significantly associated with avoiding crises; these controls are not associated with lower average precrisis growth in the evidence presented.
- Synthesis:
  - Debt liabilities, including debt recorded as financial FDI, are linked to greater vulnerability—partly because they help fuel credit booms and FX lending.
  - Controls on certain types of inflows can complement prudential regulation to limit financial fragility; empirical evidence presented is suggestive rather than definitive.

### Policy implications and conclusions (from the source)
- No one-size-fits-all response; standard toolkit includes currency appreciation, reserve accumulation, fiscal and monetary adjustments, and strengthened prudential frameworks.
- Capital controls can be a legitimate component of the policy response in certain circumstances (e.g., when macro policy adjustments are constrained or prudential frameworks cannot quickly address fragility).
- Multilateral risks from widespread use of controls:
  - Could harm global allocation of investment, prospects for global recovery and growth, and lead to contagion or crowding out of less-distortionary policies.
  - Could contribute to widening global imbalances if used by countries with undervalued currencies to resist appreciation.
  - Conversely, controls that curtail “hot money” might reduce precautionary reserve accumulation and thus reduce global imbalances.
- Recommendation:
  - Decisions on use of controls should weigh distortions and implementation costs against benefits of regaining macro policy control and reducing financial fragility.
  - Regular reassessment is needed; any use should internalize systemic dangers from widespread adoption.

*Source: Appendix 1. Inflows, Fragilities, and Controls—Some Empirics (IMF, content unit _spn1004).*

### References .............................................................................................................

### References

### Listed Boxes
- Box 1. Country Experiences with Controls on Short-Term Capital Inflows .........................................14

### Listed Figures
- Figure 1. Coping with Surges in Capital Inflows: Macroeconomic and Prudential Considerations ...........7

### Listed Tables
- Table 1. Selected Cases of Control Measures on Capital Inflows ...........................................................16

*Source: _spn1004 - References .............................................................................................................*

### Appendix 1. Inflows, Fragilities, and Controls—Some Empirics ................................................ 18

### Appendix 1. Inflows, Fragilities, and Controls—Some Empirics

### Introduction and overview
- Capital flows returning to emerging market economies (EMEs) provide financing for investment, diversify risk, and help develop financial markets, with benefits comparable to free trade (see Reaping the Benefits of Financial Globalization, IMF Occasional Paper 264, 2008).
- Concerns motivating renewed interest in capital controls:
  - Many inflows perceived as temporary and driven by interest rate differentials that may reverse.
  - Massive inflows can lead to exchange rate overshooting or strong appreciations complicating management, and can inflate asset price bubbles that amplify financial fragility and crisis risk.
  - Foreign investors may exhibit herd behavior and excessive optimism; even fundamentally sound flows can cause collateral damage (bubbles, booms/busts).
- Key conclusion: if the economy is operating near potential, if reserves are adequate, if the exchange rate is not undervalued, and if inflows are likely transitory, then capital controls—in addition to prudential and macroeconomic policy—are justified. Controls can retain potency if circumvention strategies are more costly than expected returns—the cost of circumvention acts as “sand in the wheels.”
- Empirical assessment is challenging; evidence stronger for controls affecting composition of inflows than aggregate volume. Examples: Chile and Colombia showed some success in tilting composition toward less vulnerable liability structures (De Gregorio and others, 2000; Cardenas and Barrera, 1997).
- Some items recorded as financial sector FDI may disguise intragroup debt and be akin to debt in riskiness—relevant to emerging Europe during the recent crisis.
- Multilateral caveat: widespread use of controls by EMEs could exacerbate global imbalances, slow needed global rebalancing, or trigger contagious adoption of controls with longer-term welfare losses.

### Responding to capital inflows — policy toolkit and rationale
- Policy tools available:
  - Fiscal policy
  - Monetary policy
  - Exchange rate policy
  - Foreign exchange market intervention
  - Domestic prudential regulation
  - Capital controls

- Macroeconomic considerations and conditional responses:
  - Exchange rate appreciation:
    - If exchange rate is undervalued from a multilateral perspective, allowing passive appreciation is appropriate.
    - If already overvalued (or roughly in equilibrium), proactive policy response needed to protect competitiveness.
  - Reserve accumulation:
    - If reserves are relatively low or precautionary accumulation desirable, inflows offer an opportunity to augment reserves.
  - Sterilization:
    - Sterilize money supply increase via open-market operations or decrease in domestic credit.
    - Limits to sterilization: shallow domestic markets, fiscal cost from interest differential, and potential perpetuation of inflows if domestic interest rates remain high.
  - If sterilization exhausted or further reserve accumulation not desirable, consider reducing inflows via macro policies or direct methods.
  - Monetary and fiscal policies:
    - Lowering interest rates reduces incentives for inflows; tightening fiscal policy reduces appreciation pressures.
    - If economy at risk of overheating, lowering interest rates is unattractive; fiscal consolidation may be constrained by political/implementation lags.
  - Controls on capital inflows:
    - Particularly useful for transitory surges that cause temporary appreciation but potentially permanent damage to tradable sector.
    - Controls tend to lose effectiveness over time and may need continual strengthening, increasing distortions.

- Financial fragility rationale:
  - Pecking order of capital inflows in decreasing order of riskiness (short-term instruments more risky than long-term within each category):
    - Foreign-currency debt,
    - Consumer-price-indexed local currency debt,
    - Local-currency debt,
    - Portfolio equity investment, and
    - Foreign direct investment.
  - Large inflows may fuel domestic lending booms, foreign-exchange-denominated credit, and asset bubbles; prudential regulation (cyclical capital requirements, limits on FX lending to unhedged borrowers) may suffice in normal times, but large inflows may require controls to buttress prudential measures.
  - Example instruments and their effects:
    - Unremunerated reserve requirements on foreign exchange debt reduce external FX borrowing (though may encourage substitution into other external debt).
    - Inflow taxes on short-term debt lengthen maturities by reducing price differential between short- and long-term debt; optimal size depends on liquidity panic risk, fiscal adjustment cost, and elasticity of substitution.
    - Financial transaction taxes deter short-term carry trades.
    - Minimum-stay requirements directly lengthen maturity of liabilities.
  - Excessive limits on banks can spur disintermediation and growth of nonregulated financial institutions (Wakeman-Linn, 2007).
  - Circumvention (e.g., currency swaps) can undermine effectiveness of such measures.

### Other considerations in choosing controls
- Effectiveness depends on:
  - Preexisting administrative/institutional infrastructure to enforce controls. Strengthening controls is easier for countries with substantial existing restrictions.
  - Extent and sophistication of measures adopted; recent measures include restrictions on derivative positions (e.g., Colombia).
  - Measurement challenges: intensity of controls is hard to measure; empirical identification problems (simultaneity bias) complicate causal inference.
- Controls on outflows:
  - Relaxing outflow controls can affect net inflows ambiguously: it may reduce net inflows by offsetting inflows with outflows, or increase attractiveness by assuring repatriation of capital.
- Multilateral implications:
  - Widespread adoption of controls by EMEs could impede efficient global allocation of investment and hinder addressing global imbalances by preventing necessary appreciation in undervalued currencies.
  - Controls may redirect flows to less able absorbers and provoke generalized financial protectionism.
  - Multilateral considerations do not unambiguously argue against controls; if controls curtail risky forms of inflows, they may reduce precautionary reserve demand and help narrow global imbalances (Ghosh, Ostry, and Tsangarides, 2010).

- Summary policy logic:
  - Two main reasons to impose controls: limit exchange rate appreciation and limit crisis vulnerability from risky foreign borrowing.
  - Controls are typically temporary to counter surges; persistent inflows require fundamental economic adjustment.
  - Rule of thumb: flows pushing real exchange rate toward equilibrium more likely persistent than those contributing to overshooting.

### Inflows, fragilities, and controls — stylized facts and empirical evidence
- Objectives for controls: reduce volume of inflows, limit exchange rate appreciation, alter maturity composition to reduce fragility, increase monetary policy independence.
- Existing empirical evidence:
  - Individual country studies often find little or no impact of controls on aggregate volume of inflows; cross-country analyses sometimes find smaller surges among countries with controls.
  - Cardarelli, Elekdag, and Kose (2007): among countries facing surges, those with controls experienced smaller inflows—"2 percent of GDP in episodes with 'high' capital controls compared with 4 percent of GDP in instances where the country had no or low controls."
  - Reasons for mixed evidence on volumes:
    - Recent EME measures tend to be marginal.
    - Controls often introduced as part of packages, making isolation of effect difficult.
    - Measurement of intensity of controls is difficult.
    - Econometric identification problems (countries facing large inflows may be more likely to impose controls).
  - Most studies find stronger evidence for controls affecting composition and maturity of inflows and for enhancing monetary policy autonomy.
    - Example: controls found to lengthen maturity of inflows in several country studies (Ariyoshi and others, 2000; De Gregorio and others, 2002; Cardoso and Goldfajn, 1998; Cardenas and Barrera, 1997; Goh, 2005).

- Evidence from the current global financial crisis (natural experiment):
  - Cross-country stylized facts:
    - Larger stocks of debt liabilities and of FDI in the financial sector ("financial FDI") are associated with worse growth slowdowns.
    - Regression analysis: countries with larger stocks of debt liabilities or financial FDI fared worse; countries with larger stocks of nonfinancial FDI fared better.
      - Interpretation: debt imposes fixed obligations with limited risk sharing; greenfield nonfinancial FDI is more stable and can provide fresh financing.
      - Financial FDI can mask intragroup lending and behave like debt.
  - Channels:
    - Debt and components of financial FDI correlate strongly with credit booms and FX-denominated lending by domestic banks, which in turn associate with greater vulnerability.
    - The vulnerability linked to debt liabilities persists even controlling for credit booms and FX lending—households and firms may borrow directly from abroad or via nonbank intermediaries.
  - Policy implication: controls that limit debt inflows (and debt-like financial FDI) could usefully supplement prudential regulations targeting domestic credit booms and unhedged FX lending.
  - Empirical association between precrisis controls and crisis outcomes:
    - There appears to be a negative association between capital controls in place before the global financial crisis and the magnitude of output declines during the crisis (Table A3).
    - Causation not established, but evidence suggests use of controls associated with avoiding some of the worst growth outcomes linked to financial fragility.
    - Supporting evidence from other samples: Gupta, Mishra, and Sahay (2007) — in about 200 crisis episodes in about 90 countries over 1970–2007, drops in output during crisis episodes are significantly lower if capital controls existed before the crisis.

- Empirical caveats:
  - Difficulty disentangling effects of controls from accompanying macro/prudential policies.
  - Potential for circumvention and substitution between types of inflows.
  - Heterogeneity across countries in administrative capacity, financial market depth, and severity/nature of inflow surges.

*Source: Appendix 1. Inflows, Fragilities, and Controls—Some Empirics (IMF).*

### Box 1. Country Experiences with Controls on Short-Term Capital Inflows

### Box 1. Country Experiences with Controls on Short-Term Capital Inflows

### Volume of inflows and exchange-rate pressures
- Controls on inflows generally have little impact on the total volume of capital inflows and thus on currency appreciation.
- Country experiences and specific findings:
  - Brazil and Chile (1990s): Imposition of inflow restrictions had no significant impact on total capital inflows, nor were exchange-rate pressures alleviated; the real effective exchange rate appreciated by about 5 and 4 percent annually in Brazil and Chile, respectively.
  - Thailand (December 2006): The real exchange rate started appreciating within a week after controls on short-term flows were imposed.
  - Colombia (2007–08): The episode of controls was ineffective in reducing the volume of non-FDI inflows or in moderating currency appreciation.

### Composition and maturity structure of inflows
- Controls can alter the composition and maturity of inflows even if volumes are little changed.
- Notable examples and quantitative changes:
  - Chile (1991–98): Controls (URR and extensions) coincided with a decline in short-term debt as a proportion of total liabilities and an increase in the stock of FDI from about 34 percent in 1991 to 53 percent in 1998.
  - Colombia (post-1993 URR): The share of medium- and long-term debt in the private external debt stock increased to 70 percent of the total external debt stock in 1996, from 40 percent in 1993.
- Empirical interpretation:
  - Studies find the Chilean unremunerated reserve requirement (URR) effective in tilting inflows away from short-term maturities.
  - Controls appear able to shift composition toward longer maturities and higher FDI shares.

### Prudential measures and financial-stability objectives
- Prudential measures—either bundled with capital controls or as stand-alone tools—can affect currency mismatches and limit debt inflows.
- Country experiences:
  - Malaysia (1994): Introduced prudential requirements (asymmetric open-position limits of banks) along with temporary capital controls; these measures were effective in influencing the volume and composition of inflows in the short term.
  - Chile: A strong prudential framework complemented capital controls in affecting inflow composition.
  - Croatia (2004–08): Imposition of prudential measures—including marginal reserve requirement on bank foreign financing—was effective in reducing external bank debt in 2006–08.
- Practical point: Prudential tools can be effective in limiting foreign-exchange exposure and debt inflows that contribute to financial fragility.

### Implementation capacity and durability of effects
- The effectiveness of controls and prudential measures critically depends on administrative and enforcement capacity.
- Typical pattern: Controls’ impact is often short lived as markets adjust and circumvent them; strong enforcement (as in Chile) is needed to identify loopholes and prevent circumvention.

### Appendix: Empirics on inflows, fragilities, and controls
- Sample and measurement:
  - Sample: usable sample of up to 37 EMEs (full sample 50 EMEs but data limitations restrict usable sample to a maximum of 37 countries).
  - Performance metric: average growth in 2008 and 2009 relative to the country’s historical average (real GDP growth, 2003–07).
- Main empirical findings:
  - Foreign-liability composition and crisis performance:
    - Countries with larger stocks of debt liabilities fared worse in the crisis on average; countries with larger nonfinancial FDI fared better.
    - Table A1 coefficients (selected):
      - Non-Financial FDI (% of GDP, 2007): -0.071**  -0.086*** -0.087***  -0.090*** -0.087*** (standard errors shown in source).
      - Financial FDI (% of GDP, 2007): 0.195** 0.134 0.002 0.021 -0.045.
      - Debt Liabilities (% of GDP, 2007): 0.116*** 0.116*** 0.102** 0.091*** 0.084*.
      - FX Credit (% of GDP, 2007): 0.153*** 0.043 0.008.
      - Change in Credit/GDP from 2003 to 2007: 0.151*** 0.101* 0.100.
    - Observations and fit in reported regressions: Observations 35 34 30 33 30 33 29; R-squared 0.43 0.60 0.41 0.47 0.61 0.717 0.727 (as reported).
  - Channels of risk:
    - Debt and some debt-like components of financial FDI are associated with fueling domestic credit booms and greater foreign-exchange-denominated lending by domestic banks.
    - Table A2 links foreign liabilities to banking system FX-credit and credit booms:
      - Financial FDI (% of GDP, 2007) coefficient on FX Credit: 1.305*** (standard error 0.346); coefficient on Change in Credit/GDP: 0.914** (standard error 0.398).
      - Debt Liabilities (% of GDP, 2007) coefficient on FX Credit: 0.389*** (standard error 0.071); coefficient on Change in Credit/GDP: 0.258** (standard error 0.104).
      - Observations 31 and 34; R-squared 0.75 and 0.31 (as reported).
  - Capital controls and crisis outcomes:
    - Countries that had controls on inflows in place in the years leading up to the crisis appear to have fared better in avoiding the worst growth outcomes (crises defined as declines in real GDP growth in the sample’s lowest decile).
    - Table A3 probit results (controls based on Schindler (2009) index averaged over 2000–05):
      - Controls on Overall Inflows: -2.026* and -2.644** (standard errors 1.043 and 1.329 in two specifications).
      - Controls on Bond Inflows: -4.054* and -8.548** (standard errors 2.294 and 3.708 in two specifications).
      - Controls on Equity Inflows: 2.057 and 3.443** (standard errors 1.376 and 1.722).
      - Observations 37 in each reported specification; Pseudo R-squared 0.117 0.240 0.168 0.368 (as reported).
    - Interpretive note from source: Although causation is not established, these correlations suggest controls on debt flows are significantly associated with avoiding crises; these controls are not associated with lower average precrisis growth in the evidence presented.
- Synthesis of empirical section:
  - Debt liabilities, including debt recorded as financial FDI, are linked to greater vulnerability—partly because they help fuel credit booms and FX lending.
  - Controls on certain types of inflows can complement prudential regulation to limit financial fragility; empirical evidence presented is suggestive rather than definitive.

### Policy implications and conclusions (from the source)
- No one-size-fits-all response; standard toolkit includes currency appreciation, reserve accumulation, fiscal and monetary adjustments, and strengthened prudential frameworks.
- Capital controls can be a legitimate component of the policy response in certain circumstances (e.g., when macro policy adjustments are constrained or prudential frameworks cannot quickly address fragility).
- Widespread use of controls carries multilateral risks:
  - Could harm global allocation of investment, prospects for global recovery and growth, and lead to contagion or crowding out of less-distortionary policies.
  - Could contribute to widening global imbalances if used by countries with undervalued currencies to resist appreciation.
  - Conversely, controls that curtail “hot money” might reduce precautionary reserve accumulation and thus reduce global imbalances.
- Recommendation: Decisions on use of controls should weigh distortions and implementation costs against benefits of regaining macro policy control and reducing financial fragility; regular reassessment is needed; any use should internalize systemic dangers from widespread adoption.

*Source: Box 1, “Country Experiences with Controls on Short-Term Capital Inflows” (excerpted from the supplied IMF content unit).*

### Chapter 3, World Economic Outlook, October (Washington: International Monetary

### Chapter 3, World Economic Outlook, October (Washington: International Monetary Fund)

### References on Capital Controls and Capital Flows
- Cardenas, Mauricio, 2007, “Controle de Capitales en Colombia ¿Funcionan o No?” Debate de Coyuntura Económica, December (Bogotá, Colombia, Fedesarollo).
- Cardenas, Mauricio, and Felipe Barrera, 1997, “On the Effectiveness of Capital Controls: The Experience of Colombia During the 1990s” Journal of Development Economics, October 1997, Vol. 54(1), pp. 27-57.
- Cardoso, Eliana, and I. Goldfajn, 1998, “Capital Flows to Brazil: The Endogeneity of Capital Controls,” IMF Staff Papers, Vol. 45(1), pp. 161–202.
- Cardoso, Jaime, and Bernard Laurens, 1998, “Managing Capital Flows-Lessons from the Experience of Chile,” IMF Working Papers No. 98/168 (Washington: International Monetary Fund).
- Carvalho, Bernardo S. de M., and Márcio G. P. Garcia, 2008, “Ineffective Controls on Capital Inflows under Sophisticated Financial Markets: Brazil in the Nineties,” in S. Edwards and M. Garcia, eds., Financial Markets Volatility and Performance in Emerging Markets (Cambridge, Massachusetts: National Bureau of Economic Research).
- Clements, Benedict J., and Herman Kamil, 2009, “Are Capital Controls Effective in the 21st Century? The Recent Experience of Colombia,” IMF Working Paper No. 09/30 (Washington: International Monetary Fund).
- Concha, Alvaro, and Arturo J. Galindo, 2008, “An Assessment of Another Decade of Capital Controls in Colombia: 1998–2008,” Paper for XIII LACEA Meeting (Rio de Janeiro, Brazil).
- De Gregorio, José, Sebastian Edwards and Rodrigo Valdes, 2000, “Controls on Capital Inflows: Do They Work?” Journal of Development Economics, October, Vol. 63(1), pp. 59-83.
- Dell’Ariccia, Giovanni, Julian di Giovanni, André Faria, Ayhan Kose, Paulo Mauro, Jonathan D. Ostry, Martin Schindler, and Marco Terrones, 2008, Reaping the Benefits of Financial Globalization, IMF Occasional Paper No. 264 (Washington: International Monetary Fund).
- Edison, Hali, and Carmen Reinhart, 2001, “Stopping Hot Money” Journal of Development Economics, December 2001, Vol. 66(2), pp. 533–53.
- Edwards, Sebastian, 1999, “How Effective Are Capital Controls?” Journal of Economic Perspectives, Fall 1999, Vol. 13(4), pp. 65–84.
- Edwards, Sebastian, and Jonathan D. Ostry, 1992, “Terms of Trade Disturbances, Real Exchange Rates, and Welfare: the Role of Capital Controls and Labor Market Distortions,” Oxford Economic Papers, Vol. 44, pp. 20–34.
- Edwards, Sebastian, and Roberto Rigobon, 2009, “Capital Controls on Inflows, Exchange Rate Volatility and External Vulnerability” Journal of International Economics, July, Vol. 78(2), pp. 256-67.
- Forbes, Kristin, 2007, “The Microeconomic Evidence on Capital Controls: No Free Lunch,” in Sebastian Edwards, ed., Capital Controls and Capital Flows in Emerging Economies: Policies, Practices and Consequences (Cambridge, Massachusetts, National Bureau of Economic Research).
- Gallego, Francisco, and Leonardo Hernández, 2003, “Microeconomic Effects of Capital Controls: The Chilean Experience During the 1990s,” International Journal of Finance and Economics, Vol. 8(3), pp. 225–53.
- Gallego, Francisco, and K. Schmidt-Hebbel, 1999, “Capital Controls in Chile: Effective? Efficient?” Central Bank of Chile Working Paper No. 59 (Santiago: Banco Central de Chile).
- Ghosh, Atish, Manuela Goretti, Bikas Joshi, Uma Ramakrishnan, Alun Thomas, and Juan Zalduendo, 2008, “Capital Inflows and Balance of Payments Pressures—Tailoring Policy Responses in Emerging Market Economies” IMF Policy Discussion Paper 08/2 (Washington: International Monetary Fund).
- Goh, Soo Khoon, 2005, “New Empirical Evidence on the Effects of Capital Controls on Composition of Capital Flows in Malaysia,” Applied Economics, Vol. 37(13), pp. 1491–1503.
- Hutchison, Michael, Jake Kendall, Gurnain Pasricha, and Nirvikar Singh, 2009, “Indian Capital Control Liberalization: Evidence from NDF Markets,” NIPFP Working Paper No. 2009-60 (New Delhi: National Institute of Public Finance and Policy).
- Kim, Jun, Mahvash.S. Qureshi, and Juan Zalduendo, 2010, “Surges in Capital Inflows,” mimeo (Washington: International Monetary Fund).
- Korinek, Anton, 2008, “Regulating Capital Flows to Emerging Markets: An Externality View” (unpublished; College Park, Maryland: University of Maryland).
- Korinek, Anton, 2009, “Excessive Dollar Borrowing in Emerging Markets: Balance Sheet Effects and Macroeconomic Externalities” (unpublished; College Park, Maryland: University of Maryland).
- Kose, Ayhan, Eswar Prasad, Kenneth Rogoff, and Shang-jin Wei, 2006, Financial Globalization: A Reappraisal, IMF Working Paper 06/189 (Washington: International Monetary Fund).
- Magud, Nicolas, Carmen Reinhart, and Kenneth Rogoff, 2007, “Capital Controls: Myth and Reality, A Portfolio Balance Approach to Capital Controls (San Francisco: Federal Reserve Bank of San Francisco).
- Miles, William, 2004, “Effectiveness of Capital Controls: the Case of Brazil,” Review of Development Economics, Vol. 8(1), pp. 68–80.
- Montiel, Peter, and Carmen Reinhart, 1999, “Do Capital Controls and Macroeconomic Policies Influence the Volume and Composition of Capital Flows? Evidence from the 1990’s,” Journal of International Money and Finance, Vol. 18(4), pp. 619–35.
- Reinhardt, Dennis B.S., 2009, “Into the Allocation Puzzle - A Sectoral Analysis,” mimeo.
- Reinhart, Carmen, and Todd Smith, 1998, “Too Much of a Good Thing: The Macroeconomic Effects of Taxing Capital Inflows,” in Reuven Glick, ed., Managing Capital Flows and Exchange Rates: Perspectives from the Pacific Basin (Cambridge, United Kingdom: Cambridge University Press).
- Schindler, Martin, 2009, “Measuring Financial Integration: A New Data Set,” IMF Staff Papers, Vol. 56(1), pp. 222–38.
- Tamirisa, Natalia, 2004, “Do Macroeconomic Effects of Capital Controls Vary by Their Type? Evidence from Malaysia,” IMF Working Paper No. 04/3 (Washington: International Monetary Fund).
- Valdes-Prieto, Salvador, and Marcelo Soto, 1998, “The Effectiveness of Capital Controls: Theory and Evidence from Chile,” Empirica, Vol. 25(2), pp. 133–64.
- Wakeman-Linn, John, 2007, “Managing Large Scale Foreign Exchange Inflows: International Experiences” (unpublished; Washington: International Monetary Fund).

### References on Exchange Rates, Financial Fragility, and Balance Sheets
- Chang, Roberto, and Andrés Velasco, 2000, “Banks, Debt Maturity and Financial Crises,” Journal of International Economics, Vol. 51, pp. 169–19.
- Danielsson, Jon, and Asgeir Jonsson, 2005, “Countercyclical Capital Charges and Currency Dependent Economies,” Financial Markets, Institutions & Instruments, Vol. 14(5), pp. 329–48.
- Eichengreen, Barry, and Ricardo Hausmann, 1999, “Exchange Rates and Financial Fragility,” in New Challenges for Monetary Policy, Federal Reserve Bank of Kansas City, pp. 329–368.
- Kim, Jun, Mahvash.S. Qureshi, and Juan Zalduendo, 2010, “Surges in Capital Inflows,” mimeo (Washington: International Monetary Fund).
- Korinek, Anton, 2009, “Excessive Dollar Borrowing in Emerging Markets: Balance Sheet Effects and Macroeconomic Externalities” (unpublished; College Park, Maryland: University of Maryland).
- Krugman, Paul, 1987, “The Narrow Moving Band, the Dutch Disease and the Competitive Consequences of Mrs. Thatcher,” Journal of Development Economics, Vol. 27, pp 41–55.
- Krugman, Paul, 1998, “What Happened to Asia?” (unpublished; Cambridge, Massachusetts: Massachusetts Institute of Technology).
- Lane, Phillip, and Gian Maria Milesi-Ferretti, 2007, “The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities, 1970-2004.” Journal of International Economics, Vol 73(2), pp. 223-50.
- Lee, Jaewoo, Gian Maria Milesi-Ferretti, Jonathan D. Ostry, Alessandro Prati, and Luca Ricci, 2008, Exchange Rate Assessments: CGER Methodologies, IMF Occasional Paper No. 261 (Washington: International Monetary Fund).
- Lipschitz, Leslie J, Timothy Lane, and Alex Mourmouras, Alex, 2005, “Real Convergence, Capital Flows, and Monetary Policy: Notes on the European Transition Countries,” in Euro Adoption in Central and Eastern Europe: Opportunities and challenges (Susan Schadler, ed.)
- Lipschitz, Leslie J, Timothy Lane, and Alex Mourmouras, Alex, 2006, “Capital Flows to Transition Economies: Master or Servant?” Czech Journal of Economics and Finance, pp 56, 5-6.
- Ma, Guonan, and Robert N. McCauley, 2008, “Efficacy of China’s Capital Controls: Evidence from Price and Flow Data,” Pacific Economic Review, Vol. 13(1), pp. 104–23.
- Schneider, Martin, and Aaron Tornell, 2004, “Balance Sheet Effects, Bailout Guarantees and Financial Crises,” Review of Economic Studies, Vol. 71, pp. 883–913.
- Ghosh, Atish, Jonathan D. Ostry, and Charalambos Tsangarides, 2010, “Exchange Rate Regimes and the Stability of the International Monetary System” IMF Occasional Paper 270 (Washington: International Monetary Fund).

### Other relevant works cited
- Gupta, Poonam, Deepak Mishra, and Ratna Sahay, 2007, “Behavior of Output During Currency Crises,” Journal of International Economics, Vol. 72, No. 2, pp. 428–50.
- Jankov, Ljubinko, 2009, “Spillovers of the Crisis: How Different Is Croatia?” Paper presented at “Recent Developments in the Baltic Countries—What Are the Lessons for Southeastern Europe?” March 23, Oesterreichische Nationalbank, Vienna.
- Korinek, Anton, 2008, “Regulating Capital Flows to Emerging Markets: An Externality View” (unpublished; College Park, Maryland: University of Maryland).
- Magud, Nicolas, Carmen Reinhart, and Kenneth Rogoff, 2007, “Capital Controls: Myth and Reality, A Portfolio Balance Approach to Capital Controls (San Francisco: Federal Reserve Bank of San Francisco).
- Montiel, Peter, and Carmen Reinhart, 1999, “Do Capital Controls and Macroeconomic Policies Influence the Volume and Composition of Capital Flows? Evidence from the 1990’s,” Journal of International Money and Finance, Vol. 18(4), pp. 619–35.
- Reinhart, Dennis B.S., 2009, “Into the Allocation Puzzle - A Sectoral Analysis,” mimeo.
- Schindler, Martin, 2009, “Measuring Financial Integration: A New Data Set,” IMF Staff Papers, Vol. 56(1), pp. 222–38.

*Chapter 3 references, World Economic Outlook, October (Washington: International Monetary Fund).*

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