## _wp13107

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### Introduction: context and framing
- Global environment after 2008 featured persistently low interest rates and large-scale asset purchase programs in advanced economies, diverting yield-seeking capital to emerging markets.
- Potential challenges from large capital inflows highlighted:
  - impact of real appreciation on competitiveness of the tradables sector;
  - vulnerabilities from exuberance and increased leverage;
  - risk that withdrawal of monetary stimulus triggers sudden capital outflows and financial distress.
- Chile’s recent history and integration indicators:
  - gross foreign assets and gross foreign liabilities are both currently above 100% of GDP.
  - buildup of foreign assets from well below 50% of GDP until late 1990s to over 100% of GDP today.
  - net foreign asset position close to balance since 2006 after prior large net foreign liabilities.
  - de jure indicators show a clear shift towards a more open capital account starting in the late 1990s.
- Key interpretive points:
  - exchange rate rigidity and capital account restrictions determine the scope for countercyclical macro policy during external shocks;
  - domestic institutional investors’ behavior interacts with capital account framework and exchange rate expectations, affecting crisis dynamics;
  - Chile’s shift toward liberalization from the late 1990s was primarily motivated by domestic stability concerns.

### Aiming to secure export-led growth — Background and policy objectives
- Post-1982–83 episode and recovery:
  - Macroeconomic adjustment in 1985-86 restored external sustainability via significant real exchange rate depreciation.
  - Policy mix: initial loose monetary policy, weak real exchange rate, tight fiscal stance; output and employment grew rapidly from 1986 to 1989.
- Early 1990s global environment:
  - Brady Plan in 1989 reduced external debt burdens regionally; U.S. Federal Reserve loose policy after 1990 stimulated capital flows.
  - Chile received large private capital inflows as a percentage of output in 1989 and 1990.
- Domestic policy priorities after 1989:
  - Central Bank of Chile granted formal independence in October 1989 with a mandate for domestic price stability.
  - Authorities prioritized maintaining a competitive exchange rate to support tradable-sector growth.
  - Exchange rate policy: managed band for the peso-dollar rate, adjusted for differences between domestic and foreign inflation.
- Rationale for capital account measures:
  - To avoid breaching the exchange rate band while preserving independent monetary policy and protecting export-led growth.

### The implementation of CFMs in the 1990s — the encaje
- Design and timing:
  - June 1991: introduction of an unremunerated reserve requirement (encaje) on capital inflows.
  - Initial design: 20 percent of certain capital inflows deposited at the central bank in a non-interest-bearing account; deposit term equal to investment horizon or one year, whichever was shortest.
  - May 1992: encaje raised to 30 percent, deposit term fixed at one year irrespective of flow’s horizon, scope extended to wider range of incoming capital.
- Explicit rationale:
  - By effectively taxing foreign credit, the encaje aimed to prevent breaching the exchange rate band while allowing independent monetary policy and preserving the export sector.
- Subsequent adjustments:
  - Encaje was progressively extended to potentially speculative inflows, including secondary market ADR operations and other portfolio flows, resulting in a significant reduction in the liquidity of the domestic equity market.
  - Encaje was progressively lowered first to 10 percent in June 1998, and then eliminated completely in September 1998.

### Real exchange rate dynamics, sterilized interventions, and costs
- Real exchange rate appreciation: appreciated at an annual rate of 5.4% between 1990 and 1997.
- Nominal exchange rate behavior: spent the vast majority of early 1990s against the lower bound (strong side) of the exchange rate band, implying the band was consistently out of line with fundamentals.
- Sterilized interventions: defending the exchange rate required constant sterilized interventions, imposing mounting quasi-fiscal costs on the Central Bank because rates paid on its paper were substantially higher than those earned by its foreign reserves.

### Crisis episodes and policy responses
- Tequila crisis (1994–1995):
  - Very limited impact on overall macro-financial stability in Chile; effects mainly reflected in equity valuations.
- Russian-LTCM crisis (1997–1998):
  - Spreads on Latin American sovereign debt increased by around 1,000 basis points in a few weeks.
  - Copper price fell from $1.19 per pound in mid 1997 to 67 cents at the end of 1998.
  - Central Bank defended the exchange rate band and raised policy rates; liquidity evaporated and interbank rates reached levels well over 100% during the worst of the crisis.
  - Policy response was significantly pro-cyclical; unemployment rose sharply to almost 12 percent in 1999, and the economy experienced its first year of negative growth since 1983.
  - Estimates suggest the structural level of unemployment (NAIRU) increased by 1.3 to 3.3 percentage points between 1998 and 2004 (Restrepo, 2008).
- 2007–2009 global financial crisis:
  - Between August 2007 and August 2008, external demand and financial conditions deteriorated; inflation ran up to 9% by mid 2008.
  - Central Bank intervened in April 2008; the peso depreciated approximately 15% between April and July 2008.
  - After Lehman (September 2008), the peso lost an additional 25% of its value against the U.S. dollar by the end of the year.
  - From early 2009 the monetary policy rate was aggressively cut, rapidly reaching the zero lower bound.
  - Non-conventional stimulus: Central Bank offered fixed rate, six-month repos (Facilidad de Liquidez a Plazo, FLAP).
  - Fiscal stimulus: government repatriated a substantial amount of foreign assets to finance a large fiscal stimulus package totaling approximately 2% of GDP.
  - Outcomes: very quick economic recovery; no significant banking solvency failures.

### Transition to inflation targeting and further liberalization (1999–2004)
- Policy regime change:
  - September 1999: Central Bank abandoned the exchange rate band and announced a move to full inflation targeting beginning in May 2000.
  - Interventions since the 1999 float occurred four times: in August 2001, October 2002, April 2008 and January 2011; interventions announced quantities and duration ex ante.
- Liberalization steps in 2000–01:
  - Unremunerated reserve requirement for inflows, the one-year holding period, and restrictions on channeling flows through the banking system suspended in 2000-01; only statistical reporting retained.
  - Full integration of the domestic stock exchange to non-residents.
  - Investment regime for institutional investors liberalized to allow significant foreign portfolio allocation.
  - Market risk regulation for banks revamped, allowing development of a domestic market for foreign exchange hedging instruments.
  - Some restrictions remained on mandatory settlement of certain operations through the formal foreign exchange market.
- Fiscal framework changes:
  - Adoption of a fiscal spending rule to maintain a structural surplus.
  - Independent committee set long-term export prices (including copper) to insulate fiscal spending from commodity cycles.
  - A-cyclical spending policy aimed to save during booms and dissave during slumps to generate counter-cyclical fiscal stance while ensuring medium-term fiscal balance.

### Financial market development, institutional investors, and hedging
- Yield curve and encaje effects:
  - Over the 1990s the yield curve had been persistently inverted due to the encaje, allowing short-term interest rates to deviate from international parity conditions.
  - Following suspension of the encaje, the slope of the yield curve shifted appreciably.
- Hedging and intermediation:
  - Reform of market-risk regulation helped develop a liquid market for hedging instruments.
  - Pension funds and institutional investors broadened foreign asset portfolios and created demand for currency hedging, generating a liquid currency derivatives market.
  - Banks acted as intermediaries in providing hedging and spot dollar liquidity, financing themselves through lines of credit with foreign bank counterparties and using non-delivery forward contracts cleared abroad to manage positions.

### Empirical evidence on the effectiveness of capital controls (encaje)
- Theoretical estimates:
  - Herrera and Valdés (2001): a 1-year 30% URR generates a spread on 3-month rates of approximately 310 basis points.
- Empirical findings (mixed):
  - Valdés-Prieto and Soto (1998): URR led to substitution between taxed and exempt short-term flows; total net short-term inflows 1991–1996 remained unaffected.
  - Labán and Larraín (1994): introduction in 1991 coincided with substantial reduction in short-term flows.
  - Larraín, Labán and Chumacero (2000): increasing reserve requirement reduced total short-term inflows and shifted composition.
  - Gallego, Hernandez and Schmidt-Hebbel (1999): encaje contributed an increase in spreads of 100 to 200 basis points and reduced cumulative inflows from 29 to 27 percent of GDP over 1991–1997.
  - De Gregorio, Edwards & Valdés (2000): limited impact on magnitude of inflows and exchange rate at longer horizons; significant composition effect reducing short-term debt by between 0.5 and 1 percent of GDP.
  - Edwards and Rigobón (2009): using higher frequency data, find controls more effective than earlier studies suggest, with tighter controls associated with depreciation and reduced vulnerability to external shocks.
- Synthesis:
  - Measures contributed to decoupling domestic and foreign interest rates and to shifting inflows toward longer maturities, but overall impact on aggregate inflow volumes was relatively small.
  - Prior to the 1997–98 crisis, controls constrained monetary policy and contributed to pro-cyclical responses when large external shocks hit.

### Interaction with the IMF and external influences
- Fund relations and debates:
  - IMF missions and Executive Directors consistently urged further liberalization to deepen domestic capital markets; authorities argued controls supported monetary stability and export-led growth.
  - 1995: IMF staff argued against strengthening inflow controls and recommended tighter fiscal policy, sterilized intervention, and liberalization of outflows; authorities nonetheless increased controls.
  - February 1998: Executive Directors considered Chile’s one-year unremunerated deposit requirement had “played a useful role in reducing the volatility of capital inflows and in lengthening the maturity of external obligations.”
  - IMF never expressed full support for the measures; institutional stance evolved and officially changed in 2012 to include capital controls among acceptable tools for limited circumstances.
- External agreements:
  - Accession to the OECD in 2009.
  - Free trade agreements: United States in 2002 and European Union in 2003.
  - Legal attributions: none of these agreements changed the Central Bank’s exclusive legal attributions to regulate the foreign exchange market under its Constitutional charter.
  - US FTA appendix limited claims on capital account restrictions to reduction in transfers after one year.

### Conclusions and policy-relevant lessons
- Three key observations:
  1. Chilean authorities refrained from re-adopting capital controls two decades after being strong supporters, despite renewed global debate.
  2. A hands-off approach to capital account regulation, combined with a flexible exchange rate and a fully-fledged inflation targeting regime, was motivated by domestic stability concerns and allowed significant policy activism that limited real costs in output and jobs during the Great Recession.
  3. External drivers (OECD accession, FTAs, IMF consultations) played a limited role in the evolving stance on capital account policies.
- Two caveats on generalizing Chile’s experience:
  - In larger, more diversified emerging markets with important manufacturing bases, exchange rate fluctuations can have greater real effects on activity; in resource-intensive economies like Chile exchange rate movements mainly shift nominal income between sectors with limited impact on overall activity.
  - Existence of a large domestic capital market with well regulated institutional investors enabled broader financial integration and helped prevent vulnerabilities associated with bank-based financial integration (term and liquidity mismatches correlated with commodity prices).

*Prepared by Yan Carrière-Swallow and Pablo García-Silva; May 2013 — WP/13/107 (Sections 1–4).*

### Section 1

### Capital Account Policies in Chile — Macro-financial considerations along the path to liberalization

### Introduction: context and framing
- Global environment after 2008: advanced economies implemented unprecedented monetary stimulus featuring persistently low interest rates and large-scale asset purchase programs; this diverted yield-seeking capital to emerging markets.
- Potential challenges from large capital inflows highlighted:
  - impact of real appreciation on competitiveness of the tradables sector;
  - vulnerabilities from exuberance and increased leverage;
  - risk that withdrawal of monetary stimulus triggers sudden capital outflows and financial distress.
- Chile’s recent history: during the 1990s Chile used Capital Flow Measures (CFMs) to stem appreciation and current account pressures; since the early 2000s Chile underwent a process of significant capital account liberalization.
- De facto international financial integration indicators (Figure 1 summary):
  - gross foreign assets and gross foreign liabilities are both currently above 100% of GDP;
  - buildup of foreign assets from well below 50% of GDP until late 1990s to over 100% of GDP today;
  - net foreign asset position close to balance since 2006 after prior large net foreign liabilities.
- De jure liberalization indicators (Figure 2 summary):
  - multiple normalized indexes based on AREAER show a clear shift towards a more open capital account starting in the late 1990s.
- Comparative lens:
  - 1997-98 Asian-LTCM-Russia crisis occurred under a closed capital account and relatively rigid exchange rate which constrained monetary policy and aggravated the fall in domestic demand.
  - 2008-09 Global Financial Crisis occurred under inflation targeting and a more open capital account, allowing significant countercyclical policy response.
- Key interpretive points emphasized by the authors:
  - exchange rate rigidity and capital account restrictions determine the scope for countercyclical macro policy during external shocks;
  - domestic institutional investors’ behavior interacts with capital account framework and exchange rate expectations, affecting crisis dynamics;
  - Chile’s shift toward liberalization from the late 1990s was primarily motivated by domestic stability concerns (resilient growth and job creation), with IMF consultations and trade liberalization exerting external influence but not appearing to be the immediate drivers of policy change.

### Aiming to secure export-led growth — Background and policy objectives
- Post-1982-83 episode:
  - Chile lost access to global financial markets after the 1982-83 recession and financial crisis.
  - Macroeconomic adjustment in 1985-86 restored external sustainability via significant real exchange rate depreciation.
  - Policy mix: initial loose monetary policy, weak real exchange rate, tight fiscal stance; output and employment grew rapidly from 1986 to 1989 with major improvement in external balances.
- Early 1990s global environment:
  - Successful Brady Plan in 1989 reduced external debt burdens in the region.
  - Sustained recovery in global growth and commodity prices and U.S. Federal Reserve loose policy after 1990 stimulated capital flows into Latin America and declining spreads between 1990 and 1997.
  - Chile received large private capital inflows as a percentage of output in 1989 and 1990.
- Domestic policy priorities after 1989:
  - Central Bank of Chile granted formal independence in October 1989 with a mandate for domestic price stability amid double-digit inflation.
  - Authorities prioritized maintaining a competitive exchange rate to support tradable-sector growth and to limit vulnerability to financial turmoil reminiscent of 1982.
  - Exchange rate policy: managed band for the peso-dollar rate with band adjusted for differences between domestic and foreign inflation and repeated width modifications (Figure 4 referenced).
- Rationale for capital account measures:
  - To avoid breaching the exchange rate band while preserving independent monetary policy and protecting export-led growth, authorities implemented capital account measures in the early 1990s.

### The implementation of CFMs in the nineties — the encaje
- Policy instrument introduced:
  - June 1991: Central Bank of Chile introduced an unremunerated reserve requirement on capital inflows known as the encaje.
  - Initial design: 20 percent of certain capital inflows had to be deposited at the central bank in a non-interest-bearing account; deposit term equal to investment horizon or one year, whichever was shortest — effectively penalized shorter-horizon flows more heavily.
  - May 1992: encaje raised to 30 percent, deposit term fixed at one year irrespective of the flow’s horizon, and scope extended to a wider range of incoming capital.
- Explicit stated rationale by Central Bank:
  - By effectively taxing foreign credit, the encaje aimed to prevent breaching the exchange rate band while allowing an independent monetary policy.
  - Exchange rate and capital account policies were explicitly aimed at preserving the export sector as a cornerstone of Chile’s development strategy.

*Prepared by Yan Carrière-Swallow and Pablo García-Silva; May 2013 — Section 1 of WP/13/107*

### Section 2

### _wp13107 - Section 2

### Policy objectives and exchange rate framework
- By 1993, the authorities made explicit their objective of using the exchange rate policy to keep the real exchange rate aligned with a sustainable external balance, understood as a current account deficit of between 3 and 4 percent.
- The authorities aimed to limit volatility of the exchange rate (Banco Central de Chile, 1993).
- Domestic stability was understood as requiring a significant gap between domestic and foreign interest rates, which made it impractical and unadvisable to fully integrate fixed income markets (Banco Central de Chile, 1995).

### Capital account restrictions, encaje, and market effects
- Capital account restrictions (encaje) were used to limit inflows and to influence portfolio allocation toward domestic fixed income.
- Encaje was progressively extended to potentially speculative inflows, including secondary market ADR operations and other portfolio flows (Banco Central de Chile, 1996), resulting in a significant reduction in the liquidity of the domestic equity market.
- The encaje was progressively lowered first to 10 percent in June 1998, and then eliminated completely in September 1998.
- The encaje and related capital controls biased institutional investor portfolios toward domestic fixed income during periods of large capital inflows.

### Real exchange rate and sterilized interventions
- Despite efforts, the real exchange rate appreciated at an annual rate of 5.4% between 1990 and 1997.
- The nominal exchange rate spent the vast majority of the early part of the decade against the lower bound (e.g. strong side) of the central bank’s exchange rate band, implying the band was consistently out of line with economic fundamentals (Magendzo, Rojas and Vergara, 1996).
- Defending the exchange rate required constant sterilized interventions, imposing mounting quasi-fiscal costs on the Central Bank since rates paid on its paper were substantially higher than those earned by its foreign reserves.

### Impact of the Tequila crisis (1994–1995)
- The Tequila crisis had a very limited impact on overall macro-financial stability in Chile.
- Effects were mainly reflected in equity valuations, with muted consequences on interest rates and the exchange rate.
- Capital inflows decreased somewhat, but the balance of payments was buttressed by a significant increase in the terms of trade.

### Russian-LTCM crisis, 1997–1998: shock and policy response
- The forced depreciation of the baht in July 1997 had limited effects in Latin America, but Russia’s announcement that it would default was a major shock to capital markets.
- Spreads on Latin American sovereign debt shot up by around 1,000 basis points in the space of a few weeks, with quick transmission to commercial debt markets.
- The terms of trade deteriorated markedly; the price of copper fell from a high of $1.19 per pound in mid 1997 to 67 cents at the end of 1998.
- Rather than loosen monetary policy, the central bank mounted a defence of the exchange rate band and raised policy rates to support the peso.
- Liquidity evaporated in the domestic financial system; interest rates in the interbank market reached levels well over 100% during the worst of the crisis.
- The policy response was significantly pro-cyclical; unemployment rose sharply to almost 12 percent in 1999, and the economy experienced its first year of negative growth since 1983.
- Estimates suggest the structural level of unemployment (NAIRU) increased by 1.3 to 3.3 percentage points between 1998 and 2004 (Restrepo, 2008).

### Behaviour of banks, AFPs, and sudden outflows
- Pension funds (AFPs) had gradual liberalization of overseas investment limits through the 1990s, but as late as 1998 AFPs had largely refrained from investing abroad, so that the regulated upper limit was not binding.
- Capital controls combined with higher domestic returns biased institutional portfolios toward domestic fixed income, increasing vulnerability to shifts in sentiment and expected exchange depreciation.
- The crisis manifested more as a sudden start of capital outflows than as a sudden stop of inflows, placing additional pressure on the currency.

### Transition to inflation targeting and foreign exchange intervention policy
- In September 1999 the central bank abandoned the exchange rate band and announced a move to a fully fledged inflation targeting regime beginning in May 2000.
- The Central Bank argued that exchange rate flexibility would allow more flexible monetary responses to external shocks and that short-term exchange rate movements would largely cancel out over the inflation-targeting policy horizon.
- Interventions in the foreign exchange market were restricted to cases where the real exchange rate had deviated substantially from equilibrium and where such deviation was damaging to the economy.
- Interventions since the 1999 float occurred four times: in August 2001, October 2002, April 2008 and January 2011. Interventions were carried out by explicitly announcing quantities and duration, without announcing any particular level for the exchange rate.

### Further capital account liberalization (2000–2004)
- The unremunerated reserve requirement for inflows, the holding period of one year for foreign investments and capital contributions, and restrictions on channeling flows through the regulated banking system were all suspended in 2000-01; only the statistical requirement for balance of payments compilation was retained.
- Full integration of the domestic stock exchange was achieved by opening market participation to non-residents.
- The investment regime for institutional investors was liberalized, allowing pension funds and insurance companies to allocate a significant share of their portfolio abroad.
- Market risk regulation for banks was revamped, allowing development of a domestic market for foreign exchange hedging instruments.
- Some restrictions remained on mandatory settlement of certain operations through the formal foreign exchange market.

### Fiscal framework changes
- A fiscal spending rule was adopted to maintain a structural surplus and ensure long-term fiscal sustainability.
- An independent committee was tasked with determining the long-term price of Chile’s most important exported products, including copper, to insulate fiscal spending from commodity price cycles.
- The a-cyclical spending policy aimed to save excess revenues during booms and dissaving during slumps to generate a counter-cyclical fiscal stance while ensuring fiscal balance over the medium-term.

### Domestic financial developments and yield curve
- Over the nineties, the yield curve had been persistently inverted due to the operation of the encaje, allowing short-term interest rates to deviate from international parity conditions.
- Following the suspension of the encaje, the slope of the yield curve shifted appreciably.

*Source: _wp13107 - Section 2*

### Section 3

### _wp13107 - Section 3

### Development of currency hedging and institutional investors
- Flexibilizing the capital market and exchange rate regime was coupled with a reform of the regulatory framework for market risk by the central bank, which helped develop the market for hedging instruments significantly.
- The regulatory expansion of investment opportunities for pension funds and other institutional investors allowed them to broaden their portfolios of foreign assets significantly.
- Pension fund demand for hedging currency risk:
  - Generated development of an increasingly liquid currency derivatives market.
  - Acted as counterpart to hedging needs implicit in liability management of large non-financial corporate issuers of long-term external debt.
- Intermediation and market flows:
  - Banks, until a few years ago the only entities allowed to offer foreign currency hedging to institutional investors, played the role of intermediaries.
  - Demand for spot market dollar liquidity by institutional investors is satisfied by the domestic banking system, which finances itself through lines of credit with foreign bank counterparties.
  - Institutional investors sell part of their spot dollar exposure in the forward market, with domestic banks again acting as intermediaries.
  - Major imbalances between institutional investors and non-financial corporate actors are covered by banks with forward positions with non-residents, implemented using non-delivery forward contracts cleared abroad, due to market risk regulations imposing a significant capital charge to banks for un-hedged currency risk.

### Regional and domestic financial environment since 2003
- From 1999 to 2004:
  - Deleveraging following the Asian/Russian/LTCM crises and an unfavorable external environment led to subdued economic performance, allowing the Central Bank to pursue a loose monetary policy.
- From 2004 on:
  - Chilean peso and Brazilian real floated fairly freely and with a high correlation.
  - Large difference between yields in short-term interest rates in Brazil and Chile provided incentives for regional carry trade, resulting in accumulation of a significant short position in pesos by non-residents.
  - This non-resident short position in pesos put pressure on the peso to depreciate, in part counteracting the full appreciation that might otherwise have occurred.
- Fiscal developments:
  - A large surge in the price of copper generated substantial fiscal income.
  - Authorities adhered to the fiscal rule, channeling large fiscal surpluses into a sovereign wealth fund held abroad.
  - By 2006 the Chilean government had become a net external creditor.
- Interaction of forces:
  - Broader investment opportunities for pension funds, access to external finance by the banking sector, and active positioning by non-residents in the NDF market for pesos posed challenges for smooth operation of domestic money markets when global financial conditions worsened later in the decade.
- By 2007:
  - FDI came to represent over 60% of external liabilities by 2007.

### Facing the global financial crisis and the Great Recession (2007–2009)
- Pre-crisis and early crisis dynamics:
  - Between August 2007 and August 2008, external demand and financial conditions deteriorated markedly.
  - International inflation accelerated substantially due to high global food and energy prices, causing inflation to run up to 9% by mid 2008.
  - The Central Bank kept monetary stance tight in response to rising inflation.
  - Appreciating pressure on the peso during 2008 led the central bank to undertake a currency intervention in April; the peso depreciated approximately 15% between April and July.
  - The intervention followed precedent: announcement of exceptional circumstances by the Board and an explicit mechanism announced ex ante, including disclosure of amounts to be purchased.
- After Lehman Brothers (September 2008):
  - Measures of uncertainty such as the VIX index reached record levels; counterparty risk and macro risk surged.
  - Latin America faced reduced global demand and lower commodity prices, implying the need for further real exchange rate depreciation.
  - The peso lost an additional 25% of its value against the U.S. dollar by the end of the year.
  - The Central Bank did not conduct outright sales of foreign exchange in the spot market but undertook measures to address lack of dollar and peso liquidity in domestic financial markets.
- Amplification through institutional investor positions:
  - Sharp correction in equity prices reduced the market value of equity investments held abroad by institutional investors, shrinking their long dollar positions while forward dollar sales in the domestic market retained dollar valuations.
  - Pension funds faced a choice: quickly unwind forward positions or increase purchases of spot dollar liquidity to comply with regulatory limits; both actions added to depreciating pressures at a time when dollar liquidity providers were retrenching.
- Monetary and fiscal policy response:
  - From early 2009 the monetary policy rate was aggressively cut, rapidly reaching the zero lower bound.
  - Non-conventional stimulus: Central Bank offered fixed rate, six-month repos (the Facilidad de Liquidez a Plazo, or FLAP).
  - Fiscal response: government repatriated a substantial amount of foreign assets to finance a large fiscal stimulus package totaling approximately 2% of GDP.
- Outcomes:
  - Economic recovery was very quick, initiating withdrawal of monetary and fiscal stimulus by 2010.
  - No significant financial fragilities were exposed; all banks remained solvent throughout the crisis.
  - The inflation-targeting framework, open capital account, flexible exchange rate regime, and sound fiscal framework were flexible enough to face 2008–09 tensions, aided by prior credibility in operation of a floating exchange rate regime.

### Evidence for the effectiveness of capital controls
- Theoretical context:
  - Some models treat unremunerated reserve requirements (URR) as fixed proportional taxes on capital inflows, generating bands of sustainable interest rate differentials under uncertainty.
  - Herrera and Valdés (2001) parameterized a model for Chile predicting that a 1-year 30% URR generates a spread on 3-month rates of approximately 310 basis points.
  - Recent theory explores capital controls as macro-prudential tools under nominal rigidities or fixed exchange rate regimes, and to internalize pecuniary externalities from external borrowing.
- Empirical evidence (mixed results, several strands):
  - Valdés-Prieto and Soto (1998):
    - Estimate that the URR led to substitution between taxed and exempt short-term flows.
    - Conclude total net short-term inflows during 1991 to 1996 remained unaffected; controls unsuccessful at delivering monetary independence.
  - Labán and Larraín (1994):
    - Earlier finding that introduction of capital controls in 1991 coincided with substantial reduction in short-term flows and reduction in degree of capital mobility.
  - Larraín, Labán and Chumacero (2000):
    - Using a threshold approach, identify a regime switch in 1990; find increasing the reserve requirement reduced total short-term inflows and permanently shifted their composition.
  - Gallego, Hernandez and Schmidt-Hebbel (1999):
    - Find significant impact of the encaje on decoupling domestic and foreign interest rates, contributing an increase in spreads of 100 to 200 basis points, and shifting composition of flows towards longer maturities.
    - Conclude measures effectively reduced aggregate volume of capital inflows.
    - Note reduction in cumulative inflows from 29 to 27 percent of GDP over 1991–1997, a relatively small magnitude compared to total stock of debt.
  - De Gregorio, Edwards & Valdés (2000):
    - Find controls had limited impact on magnitude of capital inflows, interest rate differentials, and real exchange rate, particularly at longer horizons.
    - Find significant effect on composition: encaje shifted inflows towards longer maturities, reducing short-term debt by between 0.5 and 1 percent of GDP.
    - Through composition effect, encaje allowed short-term interest rates to deviate from international parity, producing an inverted yield curve for much of the decade and allowing higher real policy rates relative to foreign central banks.
  - Edwards and Rigobón (2009):
    - Using higher frequency data and more sophisticated approach, find controls more effective than earlier studies suggest: tighter controls associated with depreciation of the exchange rate and reduction in its vulnerability to external shocks.
- Overall synthesis from empirical literature:
  - Measures contributed to decoupling domestic and foreign interest rates, facilitating gradual reduction of domestic inflation without abandoning the depreciated exchange rate policy.
  - Evidence indicates some impact on reducing net short-term inflows and shifting debt profile toward longer maturities, but impact was relatively small in magnitude.
  - Capital controls prior to the crisis constrained monetary policy during the Asian crisis, requiring a pro-cyclical response; controls were ineffective at delivering desired monetary policy independence without compromising exchange rate stability in the face of large external shocks.

### External influence on the shifting stance of Chilean capital account policies
- Given the evolution since the early 1990s and the narrative in preceding sections, the most important determinant of the shift in stance regarding capital account policies (first imposition of strict CFMs, then gradual liberalization) was domestic stability concerns.

*Source: _wp13107 - Section 3*

### Section 4

### _wp13107 - Section 4

### Historical macroeconomic stance and labor market outcomes
- The overall macroeconomic stance in the late eighties achieved a very quick exit from the debt crisis and the extremely high unemployment rate that accompanied it.
- A weak real exchange rate boosted jobs in the tradables sector (mainly in agriculture) and started a successful experience of export-led growth.
- Figure 6 shows the share of total employment in the agricultural sector from 1980 through 2010.
- The unemployment rate fell rapidly from a high of over 30% during the crisis to mid-single digits by the transition to democracy in 1990; these rates were substantially lower than those that prevailed during the pre-1982 boom.
- The Central Bank, under its Organic Charter, was charged with implementing monetary policy and regulating foreign exchange transactions.

### Exchange rate regime, capital account liberalization, and external agreements
- The exchange rate regime was made more flexible, and capital account regulations were relaxed, as the costs of excessive rigidity in the monetary framework was brought to the fore in 1998-1999.
- A liberalization of the exchange rate regime accommodated a gradual depreciation of the exchange rate in early 2000.
- External agreements and memberships noted:
  - Accession to the OECD in 2009.
  - Free trade agreement with the United States in 2002.
  - Free trade agreement with the European Union in 2003.
- Legal attributions: None of these agreements changed the Central Bank’s exclusive and broad legal attributions to regulate the foreign exchange market under its Constitutional charter.
- Limited constraint in the FTA with the United States: appendix 10-C establishes that claims arising from capital account restrictions be submitted only after one year has passed following their imposition, and that such claims be limited to the reduction in transfers and not include incidental damages or loss of profits.

### Interaction with the IMF and the evolution of capital account policies
- The authorities maintained a constructive and collaborative relationship with the Fund throughout the transition to democracy; IMF officials consistently applauded their guidance of the economy.
- The central bank’s official policy framework in the early nineties was to maintain a real interest rate target “believed to be consistent with broad objectives as regards economic growth, inflation, and the balance of payments”.
- As of 1991, the exchange rate policy was viewed by the authorities and by the IMF as having “served to safeguard an adequate level of competitiveness that was essential to the achievement of export-led growth”.
- Use of capital controls was a point of contention during Article IV consultations:
  - IMF missions and Executive Directors consistently urged further liberalization of the capital account to deepen domestic capital markets and integrate them to international finance.
  - Authorities argued controls on inflows were outweighed by benefits of increased monetary stability and strong export-led growth.
- In 1995, when authorities considered strengthening controls on inflows, IMF staff argued against these measures on grounds they would increase the cost of capital, distort resource allocation, and be unlikely to deliver desired results.
  - IMF recommended tighter fiscal policy, sterilized intervention in the foreign exchange market, and further liberalization of capital outflows instead.
  - Authorities proceeded with increased controls on inflows in 1995, extending the scope of the URR to include Chilean stocks traded on the New York Stock Exchange using ADRs, foreign direct investment and bond issues.
- Following the Asian financial crisis:
  - At a meeting in February 1998, Executive Directors considered that Chile’s one-year unremunerated deposit requirement had “played a useful role in reducing the volatility of capital inflows and in lengthening the maturity of external obligations.”
  - An in-depth 1998 Article IV study concluded it was difficult to establish the effectiveness of the URR in Chile; the IMF never expressed full support for the measures.
- As Chile began dismantling controls on inflows in 1998, the IMF gradually became more tolerant of such measures over time; the IMF officially changed its institutional stance in 2012 to include capital controls among acceptable policy tools, and only for use under limited circumstances (IMF, 2012).

### Performance during the 2008 financial crisis and policy toolkit
- The monetary policy framework in place in Chile—characterized by a flexible inflation targeting regime with an open capital account—was well equipped to handle the 2008 financial crisis.
- Chile performed favorably relative to the 1997-1998 Asian-LTCM-Russian crisis, when maintaining an exchange rate band forced the Central Bank to raise rates aggressively and exacerbated a liquidity crunch.
- Evidence on whether Chile’s capital controls were effective in shielding the exchange rate from external shocks is mixed.
- Development of local capital markets under a liberalized capital framework helped the economy adjust to the transitory shock:
  - The absence of capital controls and a more developed futures market for trading currency contracts allowed rapid repatriation of pension fund assets at the onset of the crisis without generating a large uncovered mismatch.
  - The central bank responded by cutting rates and extending long-term liquidity facilities to stimulate domestic absorption.
  - A substantial depreciation of the currency supported exports amid very weak external demand.

### Conclusions and policy-relevant lessons
- Three key observations from Chile’s policy shifts:
  1. As global conditions rekindled debate on capital account policies, Chilean authorities refrained from re-adopting measures even though they had been strong supporters two decades earlier.
  2. A hands-off approach to capital account regulation, combined with a flexible exchange rate and a fully-fledged inflation targeting regime, was motivated by domestic stability concerns and allowed significant policy activism that limited real costs in terms of output and jobs during the Great Recession.
  3. External drivers (accession to the OECD, free trade agreements, IMF Article IV consultations) played a limited role in the Chilean authorities’ evolving stance on capital account policies.
- Two caveats on generalizing Chile’s experience:
  - First, in larger and more diversified emerging market economies with a more important manufacturing base, exchange rate fluctuations can have real effects on economic activity; by contrast, in Chile and other resource-intensive economies, exchange rate movements mainly shift nominal income between sectors with limited impact on overall economic activity.
  - Second, the existence of a large domestic capital market with well regulated institutional investors enabled broader financial integration and helped prevent vulnerabilities associated with bank-based financial integration (term and liquidity mismatches correlated with commodity prices) that could introduce dangerous financial fragilities.

*Source: _wp13107 - Section 4*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2013/_wp13107.pdf_