Capital Controls or Macroprudential Regulation?

IMF Working Papers, October 1, 2015

Source details

International capital flows can create significant financial instability in emerging economies because of pecuniary externalities associated with exchange rate movements.
It is desirable to employ both capital controls and domestic macroprudential regulation:
- Macroprudential regulation reduces overborrowing.
- Capital controls increase the aggregate net worth of the economy as a whole by also stimulating savings.
The two policy measures should be set higher the greater an economy's debt burden and the higher domestic inequality.
In the baseline calibration based on the East Asian crisis countries, the authors find optimal capital controls and macroprudential regulation in the magnitude of 2 percent.
In advanced countries where the risk of sharp exchange rate depreciations is more limited, the role for capital controls subsides.
Macroprudential regulation remains essential in advanced countries to mitigate booms and busts in asset prices.

The paper presents a tractable model highlighting pecuniary externalities tied to exchange rate movements that cause excessive borrowing in emerging economies.
Key mechanisms emphasized:
- Exchange rate depreciations create pecuniary externalities that amplify financial instability.
- Macroprudential tools act to restrain domestic leverage and reduce overborrowing.
- Capital controls can raise aggregate net worth by encouraging savings in addition to limiting external borrowing.

Use a mix of capital controls and macroprudential regulation rather than relying solely on one instrument.
Increase the stringency of both instruments when:
- An economy's debt burden is higher.
- Domestic inequality is higher.
In emerging markets (as in the East Asian crisis calibration), consider capital controls and macroprudential regulation of about 2 percent.
In advanced economies, prioritize macroprudential regulation even if capital controls play a smaller role.

Baseline calibration is based on the East Asian crisis countries.
Numerical finding from calibration: optimal capital controls and macroprudential regulation in the magnitude of 2 percent.
Page length: 35.
Issue: 218.
Volume: 2015.
DOI: https://doi.org/10.5089/9781513506463.001
Series: Working Paper No. 2015/218
Stock No: WPIEA2015218
ISBN: 9781513506463
ISSN: 1018-5941

Subject: Asset prices, Balance of payments, Capital controls, Consumption, Exchange rates, Foreign exchange, National accounts, Prices, Real exchange rates
Keywords: asset price externality, Asset prices, asset purchase, capital controls, Consumption, covariance term, East Asia, exchange rate, exchange rate depreciation, exchange rate effect, exchange rate fluctuation, Exchange rates, Financial stability, inequality, macroprudential regulation, marginal utility, pecuniary externalities, price change, Real exchange rates, resource constraint, simplifying terms, wedge terms, WP

IMF Working Paper by Anton Korinek and Damiano Sandri (October 1, 2015), Working Paper No. 2015/218.