Prudential capital controls are ways of financial regulation that aim to mitigate risk to the financial system as a whole, usually taking the form of residency-based measures such as transaction taxes, other limits, or outright prohibitions that a nation's government can use to regulate flows from capital markets into and out of the country's capital account. Prudential capital controls aim to mitigate systemic risk, reduce business cycle volatility, increase macroeconomic stability, and enhance social welfare.Jeanne, O., A. Subramanian, and J. Williamson, 2012, Who Needs to Open the Capital Account? Washington, DC: Peterson Institute for International Economics.
Distinctions from capital controls in general
The term “prudential” distinguishes such typical capital control measures from other general capital controls by emphasizing both the motive of “prudence” and the ex-ante timing. Firstly, the prudence motivation requirement says that such regulation should curb and manage the excessive risk accumulation process with cautious forethoughts for the purpose of preventing an emerging financial crisis and economic collapse. Secondly, the ex-ante timing means that such regulation should be taken effectively before the realization of any unfettered crisis as opposed to taking policy interventions after a severe crisis already hits the economy.Korinek, Anton 2011, "The New Economics of Prudential Capital Controls: A Research Agenda", IMF Economic Review 59, 523-561. In addition, prudential capital controls only apply to capital inflows because the excessive risk accumulation process that intrinsically creates the domestic financial vulnerability is usually associated with capital inflow rather than outflow. Neely (1999) summarized some other nonprudential ways of exercising capital controls.Neely, C.J., 1999, “An Introduction to Capital Controls,” Federal Reserve Bank of St. Louis Review, November/December, pp. 13–30. For example, restrictions on the volume and price for domestic currency and financial asset transactions, requirements for administrative approval of capital outflow, or limits on the amount of money that a citizen is allowed to take out of the country.
History
The history of capital free flows and controls unfolds with the history of financial globalization. At the onset, capital moved freely across borders during the Gold Standard period before World War I. After World War II, owing to the suspicion that a country's macroeconomic instability could be due to the volatile capital flows, capital flows were deliberately managed under a variety of administrative controls as part of the governance in the international monetary Bretton Woods system.Michael W. Klein, 2012. "Capital Controls: Gates versus Walls," NBER Working Papers 18526, National Bureau of Economic Research, Inc.
Starting from early 1970s, increasingly relaxed capital controls along with the adoptions of floating exchange rate regime worldwide, though in the midst of concerns, announced the collapse of the Bretton Woods. Roughly from 1990s to 2009 known as the Washington Consensus period, it was widely accepted that the economic prosperity in the emerging market economies was attributed to the liberalization of their capital accounts and the increasing capital inflow. Then the policy prescriptions for these countries were that capital controls should be loosened and eventually abandoned.
The pro-capital flow arguments were not reviewed and critiqued until the Great Recession in the late 2000s. Emerging markets experienced strong capital inflows in the boom stage of a business cycle whereas they witnessed huge flow reverse and financial collapse in the bust period. This boom and bust cycles in international capital flows imposed significant welfare costs. Then the theoretical underpinnings of the Great Recession crisis mechanism give a role for the prudential capital controls as an intervention to adjust the market imperfections in order to mitigate the systemic boom-bust cycle effects brought by the international capital flows
Theoretical paradigms for prudential regulations
To justify the necessity of the external regulation, market imperfections of a free market economy must be identified as socially inefficient and adjustable in the sense of pareto improving. Three different theoretical paradigms can be used to illustrate the market imperfections and to introduce the role of prudential regulations: 1. The Agency Paradigm; 2. The Mood Swing Paradigm. 3. The Externality Paradigm.De la Torre, A. and Lze, A. (2009). Regulatory reform: Integrating paradigms. The World Bank. Policy Research Working Paper 4842. The Prudential Capital Controls, as a particular form of prudential regulations, builds its theory foundation heavily on the paradigm of externalities.
The Agency paradigm highlights various forms of principal-agent problems. An example is a moral hazard problem: considered as lender of last resort and provider of deposit insurance, government induces the under-regulated banks to take excessive risks which creates the financial vulnerability.Farhi, Emmanuel and Jean Tirole. 2012. “Collective Moral Hazard, Maturity Mismatch, and Systemic Bailouts”. American Economic Review, 102(1): 60-93. The moral hazard problem occurs in both the individual level and in a collective fashion, which justifies the prudential regulations.
In the Mood Swing paradigm, investors’ and consumers’ animal spirit induces an overly optimistic mood in good times of tracing the mispriced asset price signals, which accumulates excessive risk that runs down the financial system and the economy when there is a bad shock. Then ex-ante macroprudential regulations can play a role to manage overall mood and alert the risks.Akerlof, George A. and Shiller, Robert J. (2009). Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism. Princeton University Press.
Justification Based on the Externality Paradigm, prudential capital controls, as one of the prudential regulations, are called to deal with the typical market imperfection known as the pecuniary externality in an open economy in order to curb the destabilizing effects of capital flows on domestic financial market.
Pecuniary externality and market incompleteness
The key market imperfection, the pecuniary externality, is defined as a particular form of externality that a private agent's optimal decision affects the welfare of another agent through prices. Other market distortions, such as the incomplete markets in which private agents cannot fully insure their idiosyncratic risks, the information asymmetry and limited commitment by which lenders do not know whether or not the borrowers will default and thus have collateral requirements on the borrowers, could aggravate the role of pecuniary externality.Greenwald, B. and Stiglitz, J., 1986. “Externalities in economies with imperfect information and incomplete markets”, Quarterly Journal of Economics, 101(4): 229-264. When applied to the open economy context with incomplete markets that involves external borrowing and collateral constraint, the pecuniary externality can be used to explain the stylized fact of an open economy's excessive borrowing from outside the country as seen by overly large amount of capital inflow: small, rational and individual domestic private agents take as given the exchange rates and asset prices that determine the external borrowing limit, but they do not internalize the price effects of their individual actions that their joint behavior could determine the level of exchange rates and asset prices and hence the degree of financial fragility in the economy. In other words, private agents take too much risk.Jeanne, O., and A. Korinek, 2010, “Excessive Volatility in Capital Flows: A Pigouvian Taxation Approach,” American Economic Review, Vol. 100, No. 2, pp. 403–7. Then their aggregate borrowing exceeds the socially efficient level so that the risk of a financial systemic collapse is created and it could potentially lead to a financial crisis and economic downturn.Bianchi, Javier. 2011. "Overborrowing and Systemic Externalities in the Business Cycle." American Economic Review, 101(7): 3400-3426.
Financial amplification effects
Such a problem of excessive borrowing rooted on the pecuniary externality and market incompleteness can be much more severe when some financial amplification mechanism is present:Paul Krugman, 1999. "Balance Sheets, the Transfer Problem, and Financial Crises," International Tax and Public Finance, Springer, vol. 6(4), pages 459-472, November.Aghion, Philippe & Bacchetta, Philippe & Banerjee, Abhijit, 2000. "A simple model of monetary policy and currency crises," European Economic Review, Elsevier, vol. 44(4-6), pages 728-738, May.Mendoza, E.G., 2002, “Credit, Prices, and Crashes: Business Cycles with a Sudden Stop,” in Preventing Currency Crises in Emerging Markets, ed. by S. Edwards and J.A. Frankel (Chicago: University of Chicago Press). For example, some negative shocks on the aggregate demand could lead to the real depreciation and the fall of domestic asset prices, which brings about the incipient adverse balance sheet effects that decrease the firm net worth and value of collateral. Consequently, the shrink of collateral value further constrains the private agents’ accesses to external borrowing through the binding borrowing constraint, which in turn results in the economy-wise spending cut and initial aggregate demand contraction is thus amplified. As shown in the graph depicting such a loop of effects, it is even striking that adverse shock on any step of this feedback loop could trigger this amplification of initial negative effects. Hence the overly large inflow of capital would potentially create a systemic risk and activate the amplification mechanism, which ultimately would generate large business cycle volatility, sudden collapse of the financial system and the economic recessions only given such a small incipient adverse shock on the feedback loop.
Policy interventions
To curb the amplification mechanism, mitigating the pecuniary externality that results in the excessive risk-taking and excessive capital inflow for an open economy is the key,Jeanne, O., and A. Korinek, 2010, “Managing Credit Booms and Busts: A Pigouvian Taxation Approach,” NBER Working Paper, w16377. As proved by Greenwald and Stiglitz (1986), in the presence of pecuniary externality and market incompleteness, some policy intervention that aims to reduce the pecuniary externality problem could achieve larger social benefits while incur only small social cost. This justifies the role for external intervention. In the case of excessive external borrowing problem in the open economy, the prudential capital controls are the desired regulations that kick in to induce private agents to internalize the externality and to reduce the excessive risk-taking exposures.
Optimal policy exercises
Classic textbook policy recommendation that deals with externalities includes variations of Pigouvian Tax.Varian, Hal R., 1992. "Microeconomic Analysis", Third Edition, W. W. Norton & Company.
Pigouvian taxation