Macroprudential Regulation of International Finance
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Macroprudential Regulation of International Finance

Managing Capital Flows and Exchange Rates

Edited by Dongsoo Kang and Andrew Mason

Recent events, such as capital flow reversals and banking sector crises, have shaken faith in the widely held belief in the benefits of greater financial integration and financial deepening, which are typical in advanced economies. This book shows that emerging economies have often weathered the storm best despite the supposed burden of ‘weak institutions’. It demonstrates that a better policy framework requires reliable indicators of vulnerability to financial instability, as well as improved policy tools and automatic stabilizers that anticipate and limit the vulnerabilities to financial crises.
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Chapter 4: Capital controls: a pragmatic proposal

Maria Socorro Gochoco- Bautista and Changyong Rhee


The use of capital controls has been a controversial issue, but prior to the global financial crisis of 2008–09, it is fair to say that capital controls were not generally viewed favorably. Standard theory regards capital controls as barriers to free capital mobility that prevent capital-scarce countries from borrowing at lower rates to finance investment and current consumption. This intertemporal consumption smoothing is welfare enhancing and efficient, since it allows countries with insufficient capital to use the excess capital of other countries. Similarly, capital-abundant countries are able to realize higher returns in the future by forgoing present consumption and lending their savings internationally. Indeed, openness to cross-border flows in the past decades enabled many countries to prosper, join the ranks of emerging markets and become suppliers of capital to the rest of the world. The International Monetary Fund (IMF) itself was on the verge of amending Article VIII of its Articles of Agreement to include capital account convertibility, but decided not to when the Asian financial crisis occurred in 1997. However, new perspectives on the role of capital controls are now emerging in the aftermath of the global financial crisis of 2008–09 (Ostry et al., 2010, 2011; Group of Twenty, 2011; Ostry, 2012). Indeed, past aversion to capital controls has seemingly been replaced with a new appreciation of its contribution to economic policy as a tool for financial stability (Gallagher et al., 2011; Jeanne et al., 2012). The global financial crisis provided another convincing case of the well-known critique that openness to crossborder mobility of capital can give rise to macroeconomic concerns as well as increased risk of financial crisis despite the many benefits it brings. It also shows that these risks are not necessarily confined to emerging and underdeveloped economies. Many developed countries with a sufficient level of financial market and institutional infrastructure development also suffered from financial crises. Large capital inflows occurred—fueling conspicuous and ultimately unsustainable consumption, through the wealth effects of asset bubbles—as exemplified by the irrational lending behavior of mortgage originators and credit-driven consumption in the run-up to the US mortgage crisis of 2007 (Stiglitz, 2010).

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