Academic journal article Contemporary Economic Policy

Capital Control and Domestic Interest Rates: A Generalized Model

Academic journal article Contemporary Economic Policy

Capital Control and Domestic Interest Rates: A Generalized Model

Article excerpt

I. INTRODUCTION

Traditional capital control theory maintains that capital control definitely raises interest rates. Based on that consensus, capital control is studied as it affects a country's welfare and output. If we examine historical data of interest rate behavior in different countries during capital control, we see varied results. Interest rates increased in some countries and decreased in others. The most glaring example of an anomaly in capital control theory is Malaysia, which experienced successful capital control in 1994. In this case, Malaysia's interest rate continued to go down as its output grew. This article examines the effect capital control might have on interest rates and real-side economies.

Generally speaking, we can divide capital control into two categories: (1) administrative or direct controls and (2) market-based or indirect. Administrative controls usually control the volume of capital flow by outright prohibitions, explicit quantitative limits, or an approval procedure. These can be done by imposing administrative obligations on the banking system to control capital flow. Market-based controls usually discourage capital flow by making capital flow transactions more costly, as in affecting the price of a given transaction. Explicit taxation of cross-border capital flow, unremunerated reserve requirement (URR), and a dual exchange rate system are some examples commonly used around the world.

To manage heavy capital inflow, traditional theories tell us that government must face a dilemma between the need to keep interest rates high due to capital control on the one hand, and the need to discourage short-term capital inflows on the other. Reinhart and Smith (2001) developed a market-based framework to assess the rise in interest rates (and welfare implications) after capital control is established. The interest rates rise because of the transaction cost after capital control is instituted.

Must capital control (inflow) lead to high interest rates and low output? Malaysia is one of the most successful examples of controls on capital inflow in the 1990s. Yet its interest rate and output response to capital control are quite different from what capital control theory predicts. After Malaysia instituted capital controls in 1994, interest rates dropped and output continued to grow. This article seeks to unravel this mystery by examining the effect capital control might have on interest rates and real-side economies. With old debt retired and no (or little) capital inflow, the economy's external debt decreases; this decreases the moral hazard problem and leads to lower interest rates. This debt shrinkage might outweigh the effect of costly capital transactions by capital control, decreasing interest rates and increasing output. Otherwise interests rates go up and output decreases.

The article focuses on capital inflow and is organized as follows: Section II contains stylized facts about capital control in Malaysia. Section III offers a literature review. Section IV presents the model. Section V provides a dynamic system and its results. Section VI summarizes and concludes.

II. STYLIZED FACTS

In 1994 Malaysia experienced a very successful example of government control of capital inflow. After capital controls were put in place, net private capital flows in Malaysia dropped from about 16% to only 4%. Malaysian authorities prohibited nonresident purchase of money market securities and placed asymmetric limits on reserve requirements on ringgit funds of foreign banks. The additional reserve requirements, which work as an ultimately recoverable resource (URR), make capital transactions more costly, hence investors ask for a high rate of return. Because of this, we should expect to see an increase in interest rates, as the theory of capital controls predicts.

However, the interest rates in Malaysia did not behave as expected. Figure 1 shows that the Treasury-bill rate dropped after capital controls were instituted. …

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