POLICY ISSUES IN

MARKET BASED AND NON MARKET BASED MEASURES

TO CONTROL THE VOLATILITY OF

PORTFOLIO INVESTMENT

E.V.K. FitzGerald

Finance and Trade Policy Research Centre,

University of Oxford

Queen Elizabeth House, Oxford OX1 3LA, U.K.

20 June 1999

[Background paper for the UNCTAD Expert Group meeting on ‘The Relationship between Foreign Portfolio Investment and Foreign Direct Investment’, Geneva June 28-30 1999]

Contents

1. Introduction

2. Causes and Consequences of the Volatility of Foreign Portfolio Investment Flows

3. The Experience of Capital Controls

4. Fiscal and Monetary Policy to Stabilize Capital Flows

5. International Regulatory Issues

6. Conclusions

References

Executive Summary

The wave of financial crises in emerging markets since 1995 has led to increasing concern as to the consequences of the instability of international portfolio capital flows. The leading industrial countries are in the process of constructing a new ‘global financial architecture’. Meanwhile, there is an increasing interest in the regulation of portfolio flows among developing countries.

The causes of the growth and volatility of short term portfolio capital flows towards emerging markets are to be found in systemic characteristics of global financial markets, particularly the way in which investment funds are managed in order to confront uncertainty. Securities markets in developing countries are both narrow and shallow, leading to considerable instability in the face of foreign capital flows. The results can be inconsistent with the levels of domestic savings and real investment required for sustainable economic development.

Developing countries have maintained and adopted measures to control the volatility of portfolio flows. These controls are based on ‘price’ measures, particularly taxes, which act by changing the incentives to market participants. In contrast, ‘quantity’ measures, which are administrative in nature - including exchange controls and borrowing restrictions - have become less common. The use of complex financial instruments and offshore financial centres has made these controls less difficult to evade.

None the less, the empirical evidence shows that marked-based measures are an effective means of balance of payments stabilization when combined with active monetary intervention. The volatility of portfolio flows can be reduced and maturities lengthened despite financial liberalization. Open-market operations have proved quite successful in this regard, and can be complemented by the active use of reserve requirements and public sector deposits. Domestic regulatory systems may also be important supportive factors.

The stabilization of portfolio flows and the lengthening of maturities cannot be achieved by individual developing countries acting in isolation. The existing ‘international financial architecture’ is mainly designed to prevent international bank failures; greater coordination between securities authorities is required due to the systemic instability of global capital markets. This could be supported by appropriate multilateral investment disciplines and cooperation between tax authorities.

Marked based policy measures to control the volatility of foreign portfolio investment in developing countries thus have a significant role to play in underpinning sustainable development, but these should form part of a consistent multilateral framework.

1. INTRODUCTION

1.1 The Increasing Importance of Portfolio Investment

The increasing globalization of capital markets is widely regarded as a unique opportunity for poor economies to accelerate their rate of growth by accessing financial resources. Higher rates of private fixed capital formation are expected to result from financial liberalization, reducing poverty by generating new jobs at good wages and providing fiscal resources for human development (World Bank 1997). Since the mid-1980s developing countries have, in consequence, embarked on an unprecedented unilateral liberalization of their investment regimes - including that for portfolio investment by non-residents.

There are three main categories of private foreign investment flows: foreign direct investment (FDI) which involves investment within a firm where the foreign investor has a permanent interest in the subsidiary; foreign portfolio investment (FPI); and foreign bank lending (FBL) to banks, firms and governments in the recipient country.

Foreign portfolio investment is effected by purchases of bonds and equities issued by companies and governments, on both international and domestic capital markets. Large domestic corporations in developing countries are increasingly issuing international depository receipts or gaining listings on major stock markets; while foreign investors increasingly purchase bonds (particularly government paper) issued on domestic markets. As Table 1 indicates, FPI has accounted for about one half of net private capital flows to ‘emerging markets’ (that is, developing and transition countries) during the 1990s.

Table 1 Emerging Market Economies: Net Capital Flows

(US $ Billion)

	1991	1992	1993	1994	1995	1996	1997	1998
Net private capital flows	123.8	119.3	181.9	152.6	193.3	212.1	149.1	64.3
Net direct investment	31.3	35.5	56.8	82.7	97.0	115.9	142.7	131.0
Net portfolio investment	36.9	51.1	113.6	105.6	41.2	80.8	66.8	36.7
Net bank lending*	55.6	32.7	11.5	-35.8	55.0	15.4	-60.4	-103.4
Net official flows	36.5	22.3	20.1	1.8	26.1	-0.8	24.4	41.7
Change in reserves	-61.5	-51.9	-75.9	-66.7	-120.2	-109.1	-61.2	-34.7
Current account balance	-85.1	-75.6	-116.0	-72.0	-91.0	-91.8	-87.1	-59.2

Source: IMF (1999). * ‘other net investment’ in the source table.

The rapid growth of portfolio investment in terms of capital flows across frontiers, is primarily due to the securitization of capital flows and the institutionalization of savings in industrial countries (UNCTAD, 1998c). None the less, new equity issues (as opposed to secondary trading) are not very significant as Table 2 indicates. Between 1996 and 1998, equity issues accounted for only 8 percent of gross private financing to emerging market economies. Rather it is bond issues - by corporations and governments - which account for most of the new market. In consequence, the effect of portfolio flows is felt mainly through their impact on the liquidity of local capital markets rather than directly on the management of local corporations (UNCTAD, 1998d).

Table 2: Gross Private Financing to Emerging Market Economies

	1996	1997	1998
Total gross private financing	218.4	286.1	148.8
Bond issues	101.9	128.1	77.7
Other fixed income	9.4	10.0	0.5
Loan commitments	90.7	123.2	60.7
Equity issues	16.4	24.8	9.9

Source: IMF (1999)

1.2 Concerns about the Volatility of Portfolio Investment

In terms of the relative stability of the three categories of private flows, it is evident from Table 1 that FDI is the more stable flow in the aggregate during the 1990s. FBL is the most volatile of the three - becoming sharply negative when short-term bank credits are not renewed - have been the main source of instability in recent emerging market crises. Aggregate FPI volatility lies between these two. Detailed statistical tests reveal that these patterns are repeated at the individual country level (UNCTAD, 1998d).

Opinions differ widely as to the origins of the evident volatility of exchange rates and capital flows, and the proper means of stabilizing them. None the less, concern is growing that the impact of the volatility in short-term capital flows on developing countries is deleterious due to its effect on real exchange rates, domestic interest rates, asset values and domestic credit levels. National authorities are frequently forced to undertake sudden shifts in fiscal and monetary policy in order to offset such shocks, while international institutions become even further involved in policy conditionality and last-resort lending.[1]

This concern about the impact of short-term capital movements clearly goes beyond the traditional fear of systemic risk in the financial system arising from the differing maturity of assets and liabilities and the consequences of uncertain expectations being transmitted from one institution or market to others (‘contagion’). The ‘real economy’ - that is production, investment, wages, social services and so on - can be negatively affected by capital surges.

Failure to meet the standards required by foreign investors can be penalized by lower investment and growth as capital resources move elsewhere, leading to the danger of marginalization of those groups or nations not able to compete efficiently due to lack of resources, skills or institutions (UNRISD, 1995). Moreover, there are good reasons to believe that financial markets are inherently unstable, and have historically required strong institutions to control them (Kindelberger, 1996). Thus a considerable degree of intervention is probably required in order to ensure an orderly market in portfolio flows and to ensure that these flows support sustainable development. In consequence, it is not surprising that there is increasing interest in the regulation of portfolio flows in developing countries; controls that have only been lifted in recent decades by developed countries themselves (UNCTAD, 1998a).

2. CAUSES AND CONSEQUENCES OF THE VOLATILITY OF FOREIGN PORTFOLIO INVESTMENT FLOWS

2.1 Systemic characteristics of flows towards emerging markets

The theoretical case for liberalising international capital flows is based on four principles. First, free capital movements can facilitate a more efficient allocation of savings, channelling resources to countries where they can be used most productively, and thereby increasing growth and welfare. Second, access to foreign capital markets may enable investors to achieve a higher degree of portfolio diversification, allowing them to obtain higher returns at lower risk. Third, full convertibility for capital account transactions may complement the multilateral trading system, broadening the channels through which countries can obtain trade and investment finance. Fourth, liberalisation may improve macroeconomic performance by subjecting governments to greater market discipline and penalising unsound monetary and fiscal policies.

However, global capital markets are characterized by asymmetric and incomplete information. The increasing international exposure of both equity funds in industrial countries and financial systems in emerging market economies, has not been accompanied by a corresponding depth of information about the true value of the assets and liabilities. The speed and scale of shock transmission between markets has increased enormously due to technological advances in trading and settlement, which forces traders to act without knowledge of wider price movements, exacerbating fluctuations. There are also substantial agency problems for bank lenders and portfolio investors. Unlike multinational corporations involved in direct foreign investment, they can exercise little direct control over the asset acquired and thus cannot protect its market value. Banks can count on the international financial institutions to protect their interests to some extent, but as funds cannot count upon protection of asset value[2], the logical response is to avoid assets which cannot be rapidly sold if things go wrong.

These information and agency problems lead logically to the two main characteristics of short-term investment in emerging markets.[3] First, international portfolio investors and bank lenders seek liquidity and use ‘quick exit’ as a means of containing downside risk. In consequence, indicators such as the ‘quick ratio’ of a country’s short-term foreign liabilities to central bank reserves become critical to market stability, and can easily trigger self-fulfilling runs on a currency. Second, fund managers control risk not by seeking more information or control, but by portfolio diversification based on an assumed lack of covariance between emerging market indices. The competition between funds for clients[4] drives them towards seeking high-yield, high-risk markets, but by the same token leads them to make frequent marginal adjustments to their portfolios.

High-risk emerging market assets with high returns have a positive attraction for global portfolio investors because the riskiness of their overall portfolio is considerably reduced by the low covariance between regional markets; but this does not prevent fund managers from switching frequently between markets in attempt to maximise short-term profitability. Although capital movements towards ‘emerging markets’ should depend upon ‘fundamental valuation efficiency’ on the part of international portfolio managers in assessing future income streams; because this is very difficult in practice and relies to a great extent on observing the behaviour of other investors, so that in practice misallocation is widespread and sudden corrections are frequent (Tobin, 1984).

The volatility of portfolio flows thus cannot be attributed to investor irrationality or even to ‘speculation’ except in the technical sense of international or intertemporal arbitrage (Hirschliefer and Riley, 1992). Rather it is the scale of these flows in relation to the size of the domestic capital market - in terms of both the proportion of the domestic capital stock that is effectively ‘on the market’ and the size of the local market in relation to the international market in which the non-resident investors operate - and the high covariance between asset prices within a given developing economy or even region, which renders them problematic (UNCTAD, 1998d).

Shifts in international portfolio composition usually correspond to changes in perceptions of country solvency by international investors rather than to variations in underlying asset value. Because of the imbalance between borrowers and lenders (emerging market assets form a relatively small part of savers’ portfolios in developed countries, but a large part of firms’ and banks’ liabilities in developing countries) marginal shifts in lenders’ positions tend to destabilize borrowers’ liquidity.[5] These surges are worsened by herding behaviour due to mean variance portfolio optimisation as the market moves in a process of ‘contagion’ (IMF, 1999). As opportunities for diversification increase, the impact of news on the allocation of funds in a single country, relative to initial allocations, grows without bounds resulting in a massive outflows further threatening financial stability.[6] Therefore prudential regulation may be needed of global lenders as much as of global borrowers.

2.2 Capital Market Stability in Open Developing Economies

Financial systems exist in order to facilitate the allocation of resources across space and time, in an environment of uncertainty and transaction costs (Levine, 1997). In general it is expected that the integration of stock markets internationally would reduce their volatility because of the portfolio diversification and increased liquidity and transparency of information this provides (Atje and Jovanovic, 1993; Korajczyck, 1996). It is frequently argued (eg Levine, 1991) that the ability to trade corporate securities should help to fund long-term projects, reducing agents’ productivity risks and increasing their liquidity; and a similar argument is extended to developing countries (Bencivenga, Smith and Starr, 1996). The selection and monitoring functions of financial markets are basically concerned with providing and processing information; but as information is imperfect, financial markets are characterized by market failure and imperfections (Stiglitz, 1994); indeed stock markets can have a negative effect on growth if these markets are subject to excess volatility (De Long et al, 1989).

While resident financial investors evidently behave differently from non-residents, much of this difference arises from their respective portfolio compositions - resident investors have a much greater weighting of local assets (‘home bias’). This home bias in turn results from asymmetric knowledge of local opportunities and control over local agents, plus the currency in which consumption is expressed (Brainard and Tobin, 1992). Access to information and control over investment outcomes also seems to differ between residents and non-residents, although here distinction may well be between large and small investors rather than their location. Moreover, as the result of decades of overseas asset acquisition by domestic wealth-holders in developing countries (‘capital flight’) not only do their portfolios have a large foreign-exchange denominated component, but also much of what appears to be ‘foreign’ portfolio investment inflows is often in fact the reduction of external asset positions by domestic investors (‘repatriation of flight capital’).

The changes in the short-term asset holdings of non-residents are to a considerable extent exogenous to fluctuations in the real economy - output, investment, employment and wages. It is widely agreed that the larger part of the fluctuations in short-term capital flows to any one developing country are caused by changes in global capital markets (Calvo, Leiderman and Reinhart, 1993;IMF, 1997). Moreover financial markets - particularly in developing countries - are supply-constrained (Stiglitz & Weiss, 1992) so that they are in stable disequilibrium with adjustments determined by creditors rather than debtors because demand is in effect infinitely elastic at the equilibrium interest rate. In consequence, changes in the asset demand pattern (reflecting international portfolio composition) of non-resident investors, rather than the supply of liabilities by residents, can be taken as the immediate cause of short term capital flows.

Apart from the longer-term effects on saving and investment, portfolio capital inflows are generally regarded as being expansive in the sense of increasing domestic adsorption, unless they are fully sterilized by increasing reserves. However, this expansive process is not the same as an autonomous rise in government expenditure (or even an export-led boom) because to create a flow the portfolio investment asset must have been acquired from (or sold to) a domestic agent and much depends upon that domestic agent’s consequent response - to consume, invest or acquire external assets in the case of private agents, or to spend, invest or reduce debt in the case of government.

Short-term capital inflows often lead to an unsustainable appreciation of the exchange rate, which prevents export promotion and generates an import boom, while the expansion of domestic credit consequent upon asset sales to non-residents being deposited in the domestic banking system tends to result in unsafe loans at low rates of interest. The subsequent outflow usually forces cutbacks in domestic adsorption to restore external balance, which lead in turn to a fall in current output levels. Fragile financial institutions then often collapse under the pressure of bad debts and the fall of asset prices as interest rates rise and domestic activity declines (Rojas-Suarez and Weisbrod, 1994).

In sum, portfolio flows mainly affect domestic capital market liquidity and (through foreign demand for domestic currency in order to make asset purchases) the exchange rate. The direct impact on private fixed capital formation is not great, for two reasons: on the one hand, government bond sales and corporate commercial paper issues dominate the market, while on the other hand, most equity purchases are on the secondary market or initial offerings of privatised state enterprises.

2.3 Savings, Investment, Macroeconomic Volatility and Capital Surges

The impact of portfolio flows on economic development depends upon their net effect on savings and investment, and thus the key issue in evaluating the initial impact of these (and other) short term capital flows is the way in which the savings-investment balances of the public and private sectors react to an exogenous change in short term external liabilities.[7] A ‘virtuous’ debt cycle, requires, of course, that in the longer term the subsequent fixed capital formation is sustainable.[8]

It had been expected that financial liberalization would raise savings in developing countries (World Bank, 1997), but in fact this has not been the case. There is in fact a strong substitution observed between external and domestic savings - with an elasticity of about 0.5 (Edwards 1995; Masson, Bayoumi & Samiei, 1995). Turner (1996) shows that in the first half of the 1990s, private portfolio capital flows made the link between external savings and domestic investment more indirect, which has enhanced the likelihood of external savings being used to finance consumption rather than investment because consumers and financial markets react more rapidly than real investment to the relaxation of liquidity constraints. Short capital inflows appear to foster consumption through two channels. First, the positive wealth effect generated by the increase in asset prices and real exchange rate appreciation leads wealth holders.[9] Second through credit boom they bring about as portfolio asset purchases from residents increase bank liquidity and thus consumer credit in the wake of financial liberalization.

This outcome is reinforced by the orthodox policy response to short-term capital flows. In the IMF ‘monetary programming model’ (Khan and Huq, 1990), an autonomous inflow of capital will permit the government to relax monetary policy and increase growth; a subsequent outflow would lead to the opposite policy. In other words, policy becomes pro-cyclical rather than stabilizing. Moreover, bond yields (and thus interest rates) in small open economies exposed to the international capital market do not act so as to balance savings and investment. Broadly speaking, the domestic interest rate (i) is determined by the international interest rate (i_$), the expected depreciation of the exchange rate (E_e - E) and the country risk proper (ρ):

Of these three terms, the first is clearly exogenous and fluctuates considerably in the short term; the second depends not only on the current macroeconomic policy of the government but also on expected policy in the future and fluctuations in other currencies; and above all, the third term depends on foreign investors’ perceptions of the country in the context of changing circumstances in the region and the world as a whole - and is the factor which determines the lack of substitutability between asset classes. The domestic interest rate is thus a consequence of much the same domestic and external factors that determine short-term capital flows, rather than acting as a domestic capital market clearing mechanism.

There are four macroeconomic consequences of exogenous changes in short-term capital flows (FitzGerald, 1999c).[10] First the main direct transmission effects on the real economy are through variations in funds available to firms and in the demand for government bonds; while the main indirect effects are through variations in the real exchange rate and the level of economic activity. Second, the impact on the fiscal sector is mainly seen in sudden shifts in the perceived solvency of the public sector, and thus upon the level of debt believed by foreign investors to be sustainable; the effect of these fluctuations is felt in volatile levels of public investment, which reduce the efficiency of public provision of infrastructure and social services. Third, the impact on the firms sector is mainly through the supply of working capital, which generates asymmetric responses in terms of investment and output due to the impact on firms’ balance sheets; the volatility of expected profits resulting from this has a strong depressive effect on private investment. Fourth, the impact on the household sector is the result of the employment and wage effects; these occur both directly through firms’ response to short term capital flows, and as a result of the consequences of fiscal instability; and also indirectly through the effects of real exchange rate variations on real wages and aggregate employment levels.

The most damaging effect of volatile short-term capital flows is on private fixed investment, and thus on the growth of employment and productivity in the longer run. This is derived from the effect of this volatility on the expectations of firms about the profitability of investment through the impact of macroeconomic variables such as the real exchange rate and interest rates. Most investment expenditures are largely irreversible - sunk costs that cannot be recovered if market conditions turn out to be worse than expected. As firms[11] can delay investments until more information arrives, there exists an opportunity cost of investing now rather than waiting. In consequence, the value of a unit of investment must exceed the purchase and installation cost, by an amount equal to the value of keeping the investment option alive - which will increase exponentially with the level of uncertainty (Dixit and Pindyck , 1994). In consequence, if the goal of macroeconomic policy is to stimulate investment (and thus growth), macroeconomic stability and credibility may be much more important than particular levels of taxes or profit rates (Pindyck and Solimano, 1993). These findings apply a fortiori to the situation where short-term capital surges require abrupt compensatory movements in fiscal and monetary stances.

3. THE EXPERIENCE OF CAPITAL CONTROLS

3.1 The Motivation for Capital Controls

Recent financial market turmoil has prompted new interest in capital controls because emerging markets are adopting a more sceptical attitude towards short‑term external finance in the wake of the crisis in East Asia. The IMF Articles of Agreement only require member countries to avoid imposing restrictions on current account transactions, such as those related to trade in goods and services and the remittance of profits and dividends. Specifically, Article VI.3 states that: “Members may exercise such controls as are necessary to regulate international capital movements, but no member may exercise these controls in a manner which will restrict payments for current transactions or which will unduly delay transfers of funds in settlement of commitments, except as provided in Article VII, Section 3(b) and in Article XIV, Section 2.”

Several developed countries (including France, Spain and Italy) have in the comparatively recent past resorted to controls on the inflow or outflow of capital as a temporary expedient to stabilise domestic financial markets even though such controls have deliberately distortionary consequences and may increase the risk of a relaxation of macroeconomic discipline as well as discriminating against foreign investors. In developing countries, where domestic capital markets are imperfect and systems for financial supervision are not robust, there is a strong case for not liberalising capital account transactions fully until these problems have been addressed (Eichengreen and Mussa, 1998). None the less, the IMF Interim Committee agreed in 1997 that full convertibility for capital account transactions should be the ultimate objective for all Fund members.[12]

Johnston and Tamirisa (1998) examine the determinants of capital controls in 45 developing and transition countries. Their econometric evidence indicates that balance of payments and macroeconomic management, market and institutional evolution, and prudential factors are important in explaining recourse to capital controls. However, macroeconomic variables appear primarily to motive controls on capital inflows, while institutional and market structures appear to motivate financial regulations related to the operations of banks and institutional investors. Their findings indicate that capital controls in fact reflect in fact the overall framework of economic regulation and the degree of financial market development, rather than just balance of payments management objectives.

3.2 The Design of Capital Controls

The focus of this paper is on preventive controls - that is, on capital inflows; and specifically those with a temporary horizon. The controls may be in the form of a tax on capital inflows (Brazil, Chile, Colombia and Thailand) or quantitative restrictions on capital inflows (Czech Republic and Malaysia) including prudential measures directed at the domestic banking sector.

Leaving aside[13] direct investment and real estate transactions on the one hand, and credit operations and provisions specific to commercial banks on the other; the types of portfolio investment transactions possibly subject to controls are: shares or other securities of a participating nature; bonds or other debt securities; money market instruments; collective investment securities; derivatives and other instruments. In all five categories there are possible inflows (purchase locally by nonresidents or sale or issue abroad by residents) and outflows (sale or issue by nonresidents, or purchase abroad by residents) to be considered. In addition there may be provisions specific to institutional investors, typically restricting their ability to invest abroad.[14]

Capital control measures on these transactions can be divided into three broad categories: price-based, quantity based and regulatory. Price-based measures reduce the interest rate differential between domestic and foreign assets by lowering the rate of return on an asset for any level of risk. This would induce investors to reallocate their portfolios away from that asset on the familiar mean-variance criterion. On capital inflows this would include a tax rate on interest payments in the local currency, and entry tax (or stamp duty) on the investment in local currency or a tax on foreign debt issuance by domestic residents. All these taxes can be structured to depend on the maturity of the investment.[15] Keynes’ original argument for a transaction tax to lengthen horizons; and may be relevant for emerging markets (Dornbusch, 1996, 1997).[16]

Quantity based capital control measures on portfolio capital inflows usually take the form

of limits on the amount of foreign funds that can be invested in local currency.[17] In contrast to price-based (ie tax) measures, the objective of quantitative capital controls is not to alter the return properties of local assets but rather to regulate the amount of foreign funds that can access these assets. In other words, non-residents’ portfolios are altered by asset rationing rather than by altering the mean-variance characteristics.

Quantitative restrictions have typically involved limitations on external asset and liability positions of domestic financial institutions (especially banks); on the domestic operations of foreign financial institutions; on the external portfolios, real estate holdings or direct investment of nonbank residents. Measures implemented have included prudential limits or prohibitions on non-traded related swap activities, off-shore borrowing, banks’ net foreign exchange positions (Czech Republic, Indonesia, Malaysia, Philippines, Thailand), caps on banks’ foreign currency liabilities (Mexico) and even broad measures to prohibit residents from selling short term money market instruments to foreigners (Malaysia). Often the type of instrument to be used is controlled rather than the volume - such as restricting the ability of domestic borrowers to issue bonds on international markets.

The advantage of price-based controls is that they can be built into the investors’ risk-return calculations and are credible insofar as they are backed by a sound legislative and legal framework. Their disadvantage is that they represent a relatively weak brake on large capital surges in response sudden changes in expected returns - where the tax payable on short stays may be very small compared to the gains (or losses) to nonresident investors from changing their portfolio composition rapidly.

The difficulty with quantitative restrictions is that they are subject to administrative discretion and thus investors cannot build their costs into their portfolio calculation. Their scope and application will be uncertain, introducing an unknown element of investor risk, and amplifying the opportunities for corruption. In addition, the ability of even honest administrators to keep up with new forms of derivatives is limited.

Regulatory capital control measures attempt to combine the effects of price-based and quantity-based measures.[18] They involve the obligatory deposit of a proportion of portfolio purchases in local cash or government paper, and thus reduce the liquidity of the investor during the time period of the measure and cost her the yield difference. In consequence, they are more ‘market-friendly’ than quantitative restrictions. Although they do not generate explicit tax revenues, these measures can discriminate effectively between potential foreign investors according to their attitude to risk and thus encourage longer-term equity or bond holdings.

3.3 Circumvention of Capital Controls

In principle, the adoption of any measures aimed at preventing capital flows from enforcing the interest parity condition immediately introduces an incentive for circumvention (Dooley et al, 1996). Whether this occurs depends upon the fixed, variable and penalty components of circumvention. The fixed cost refers to finding loopholes in the legislation and constructing appropriate financial instruments to take advantage of them, which becomes easier with financial market sophistication (if only off-shore) and in any case is a one-off cost which can become in effect a public good. The variable cost refers to the administrative expenses and yield losses involved in continued circumvention and varies with the volume of transactions; it is particularly high in the case of prudential measures. The penalty component reflects not only the respective fine but also the risk of punishment and the reputational consequences of conviction.

Insofar as all these costs can be reduced to an equivalent tax, and that tax can be administered transparently with considerable welfare benefits in terms of public revenues, this would seem to be an argument for price-based controls.[19] In practice, private operators will inevitably find ways to evade controls if there is sufficient incentive, if only by traditional methods such as the over- (or under-) invoicing of current account transactions, which are usually left uncontrolled due to international trade commitment