Final Draft

International Capital Flows: Remedy or Curse?

Keith Mellott

Commonwealth Honors College

Isenberg School of Management

May 4, 2015

Abstract

Capital account liberalization has increased the importance and prevalence of

international capital flows. There is much debate over the risks and benefits of

freely moving capital, especially during times of crisis and especially for developing

countries. Capital flow “volatility” is often blamed for worsening the effects of

financial crises in developing countries. In an attempt to control the behavior of

capital flows, countries have implemented different types of capital controls to

varying extents. I argue that capital controls have a relationship with capital inflow

volume both during crises and in general. Specifically, I determine that capital

account restrictiveness is related to lower volumes of capital inflows and vice versa.

1. Literature Review

1.1 The Growth of International Capital Flows International capital flows are movements of money across country borders for the

purpose of investment, business activities, or trade. Gross international capital

flows have increased drastically over the past half-‐century as a result of a globalized

economy, changes in the international political landscape, and advances in

technology. As gross international capital flows have grown in volume, they have

also grown in importance, especially for developing countries. The growth in

international capital flows became markedly more rapid in the mid 1990’s, and

exploded in the mid 2000’s, as indicated in Figure 1. Although the majority of the

increases in capital flows are attributable to advanced countries, Figure 1 indicates

that developing countries are starting to account for a bigger portion of the gross

flows.

The dissipation of the Soviet Union, which occurred in 1991, is one of the

most important political events of the last 50 years. The collapse of the USSR

Figure 1: Global Gross Capital Inflows, Advanced and Developing Countries, 1980-‐2010 This figure shows annual changes in global gross capital inflows and separates the flows that are attributable to developing and advanced countries.

Source: Calculations by Adams-‐Kane & Yueqing Jia (2013), based on data from the IMF International Financial Statistics (IFS) database; annual basis.

subsequently created 15 states, all of which represented new opportunity for

international investors. According to World Bank data, these newly formed

countries experienced a period of economic depression that lasted until the mid

1990’s, with GDP declining and poverty increasing. Domestic financial liberalization

policies allowed these countries to attract outside investors, helping to satisfy

domestic needs for financial capital, savvy management, and advanced technologies.

Levels of foreign direct investment (FDI) to the post-‐Soviet states are shown in

Figure 2. It is obvious that, in the 5 years following the collapse of the USSR, there

was an upward trend of FDI flows to these countries.

1

Communism not only stymied the economic relationship between capitalist

nations and the Soviet Union. The influence of communism had spread to other

parts of the globe, such as Latin America. Once the Soviet regime collapsed, other

countries also abandoned their communist regimes. Countries such as Argentina, 1 Figure 2 depicts the mean net FDI inflow volume as a % of GDP for the 15 post-‐Soviet states: Armenia, Azerbaijan, Belarus, Estonia, Georgia, Kazakhstan, Kyrgyzstan, Latvia, Lithuania, Moldova, Russia, Tajikistan, Turkmenistan, Ukraine & Uzbekistan. There are no country-‐specific weightings for FDI as a % of GDP.

0

0.5

1

1.5

2

2.5

3

3.5

4

1992 1993 1994 1995 1996

FDI Net InHlows (%

GDP)

Year FDI Net Inglows (% of GDP)

Figure 2: Net FDI Inflows to Post-‐Soviet States (% of GDP), 1992-‐19961 This figure measures the average annual net FDI inflow volume to post-‐Soviet States from 1992 to 1996.

Source: Author’s calculations based on World Bank data.

Uruguay, Chile and Brazil all instituted democracy, no longer viewing the

democratic, developed countries of the world as political and ideological enemies.

These countries also liberalized their international trade policies, opening their

borders to foreign investors and capital. Foreign direct investment inflows to

former communist Latin America nations rose quickly throughout the 1990’s, which

is evident in Figure 3.

2

China’s emergence as a global economic power is another political factor that

has contributed to the vast increases in global gross capital flows. During the

1980’s, China became a member of the International Monetary Fund, the World

Bank, the Asian Development Bank, and the General Agreement on Tariffs and 2 Figure 3 depicts the mean net FDI inflow volume as a % of GDP for selected Latin American countries with a history of domestic communist regimes: Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Paraguay, Peru, Uruguay, Venezuela, El Salvador & Guatemala. There are no country-‐specific weightings for FDI as a % of GDP.

Figure 3: Net FDI Inflows to Selected Latin American Countries (% GDP), 1990-‐19982 This figure illustrates the annual changes in Net FDI inflows to Latin American countries with a history of domestic communist regimes from 1990-‐1998.

0 0.5 1

1.5 2

2.5 3

3.5 4

4.5 5

1990 1991 1992 1993 1994 1995 1996 1997 1998

FDI Net InHlows (%

GDP)

Year

FDI Net Inglows (% GDP)

Source: Author’s calculations based on World Bank Data.

Trade. China also retooled their international trade policies, becoming more

receptive to foreign sources of capital and even allowing foreign banks to open

branches within the country. The Chinese government implemented policies that

incentivized foreign investment, a stark contrast from the policies that were in place

prior to the 1980’s, when China was still influenced by the ideologies of Mao

Zedong’s regime. The economic changes instituted in China had their desired effect.

According to data from the World Trade Organization, Chinese trade totaled US

$27.7 billion in 1979, which accounted for 0.7% of worldwide trade. By 1985,

Chinese trade totaled US $70.8 billion, which accounted for 2% of worldwide trade.

Technological advances in the financial industry have also contributed to the

increase in global gross capital flows. New computing capabilities have enabled

financial firms to cost-‐effectively create index funds composed of assets in foreign

countries. These indices have reduced the necessary amount of capital to invest

abroad, making it feasible for individual investors to include foreign assets in their

portfolios. Developing countries have experienced the largest relative increase in

portfolio inflows. Mihaljek (2008) measured changes in portfolio flow volume to

emerging market economies over time. 2005, global portfolio flows to emerging

market economies totaled US $127 billion. By 2007, this number had increased to

US $432 billion.

1.2 Types of International Capital Flows International capital flows can take on a variety of forms, one of which is foreign

direct investment (FDI). FDI is defined as a party buying controlling ownership in a

business enterprise in a country other than their own. The IMF defines “controlling

ownership” as an investment that equates to 10% or more of voting stock. FDI is

differentiated from other types of capital flows because it generally implies that the

investor has long-‐term confidence in both the investment and the economic outlook

of the country where the capital is being invested. FDI sometimes brings benefits to

the host country aside from the capital itself. The foreign investor often provides

technology, infrastructure, and managerial skills in order to operate the business

venture to their liking. A 2002 report from the Organization for Economic

Cooperation and Development addressed the benefits of FDI. “FDI triggers

technology spillovers, assists human capital formation, contributes to international

trade integration, helps create a more competitive business environment and

enhances enterprise development. All of these contribute to higher economic

growth, which is the most potent tool for poverty alleviation.”

As with the other types of capital flows, the level of global FDI flows has

grown considerably over the past two decades. The levels of net global FDI inflows

from 1980 to 20012 are depicted in Figure 4. Global net FDI inflow volume

increased rapidly starting in the early 1990’s and the upward trend has been

consistent throughout time. The figure shows decreases in global FDI inflow

volume in 2000 and 2007, which are attributable to global crises that had a negative

impact on investor confidence.

Figure 4: Global FDI Net Inflow Volume ($US Millions), 1980-‐2012 This figure shows annual changes in global FDI Net inflow Volume between 1980-‐2012.

-‐$500,000.00

$0.00

$500,000.00

$1,000,000.00

$1,500,000.00

$2,000,000.00

$2,500,000.00

$3,000,000.00

Global FDI Net InHlow Volum

e ($US Millions)

Year

FDI Net Inglows Source: Author’s calculations based on World Bank data. There are no country-‐specific weightings for KAOPEN values.

A 2009 United Nations Conference on Trade and Development report noted

that FDI inflow volume to developing countries has grown at a faster rate than FDI

inflow volume to developed countries. Prior to the 1990’s, global outward FDI from

developing economies was very minimal. Over the past 20 years however, global

outward FDI from developing economies has grown significantly in both nominal

terms and relative to the global outward FDI from developed countries. The most

important determinant of a country’s outward FDI level is economic growth, which

dictates the demand side of investment and the demand for goods and services from

foreign countries. As developing economies continue to grow, their demand for

investment and foreign goods and services will increase and their levels of outward

FDI are expected to do the same.

Foreign portfolio investment (FPI), a financial transaction in which an

individual or institution purchases foreign bonds or equity, is another type of capital

flow. Portfolio flows are more liquid than FDI flows, as they can be transferred to

other parties more easily. Portfolio flows are generally regarded as more volatile

than FDI flows and liquidity is one of the primary reasons for this. Another reason

for this volatility is herding behavior in financial markets, which is the tendency of

asset managers to follow the behavior of other asset managers, causing them to take

action in ways that they independently would not. Hwang & Salmon (2004) find

that herding towards the market is significant, both when the market is falling and

rising. Another reason for portfolio flow volatility is asymmetric information

between financial markets. Portes & Rey (2005) find that inter-‐country differences

in informational wealth, proxied by variables such as telephone traffic and amount

of bank branches, had significant effects on the behavior of cross-‐border equity

flows. Informational advantages incentivize the international movement of capital

as information bearers seize opportunities to profit.

Figure 5 shows how global FDI and portfolio flows have changed in volume

between 1995 and 2009. The figure indicates that, after peaking around 1997,

portfolio flows declined until around 2002. A 2002 UNDP Report attributes this

decrease to the Asian financial crisis, which made asset managers wary of investing

in foreign equities and bonds. Portfolio flows had an even more pronounced

reversal in response to the 2008 financial crisis, dropping precipitously before

rebounding in 2009. The figure indicates that FDI flows reversed one year after

portfolio flows. This reflects the difference in liquidity between the two types of

flows. When the crisis began in 2008, asset managers could immediately sell off

their portfolio investments, whereas investors had to remain committed to their FDI

flows in the short-‐term.

Ananchotikul & Zhang (2014) discovered that portfolio flows to emerging

markets have grown in volume and volatility since 2003. The authors found that

portfolio flows to emerging markets are very responsive to market trends, such as

monetary policies in advanced economies and global aversion to risk. The authors’

calculations indicated that there is statistically significant correlation between the

behavior of portfolio flows to emerging markets and asset prices in those markets,

specifically stock market indices, 10-‐year government bond yields and exchange

Figure 5: Composition of Private Capital Flows, 1995-‐2009 (US$ billions) This figure measures annual changes in global portfolio investment flows and FDI flows between 1995 and 2009.

Source: Calculated for 2002 UNDP Report, based on data from World Bank, Global Finance for Development, and IMF, Balance of Payment Statistics 2009.

rates. During times of portfolio outflows from emerging markets, there also were

drops in the value of stock market indices and increases in 10-‐year government

bond yields. Periods of portfolio outflows from emerging market economies also

were concurrent with depreciation in those markets. The authors concluded that

portfolio flows are generally more volatile than other types of capital flows, but

especially so during times of financial recession. The measured effect of portfolio

flows on asset prices during a recession was 5-‐10 times greater than the magnitude

during non-‐recessionary time periods.

The United Nations Development Programme published a report in 2001 on

Millenial Development Goals, acknowledging the risks that emerging markets face as

a result of portfolio flow volatility. “The consequences of such volatility for growth

are obvious, especially in countries highly reliant on such flows for investment.

When investment sources are unpredictable and volatile, so is growth. This is

especially the case for the smaller, lower-‐income countries where many FDI projects

are huge in relation to the size of the host economy and because these countries

tend to be much less diversified and depend on one or two large projects or sectors.”

Private loans are another type of capital flow. They consist of every type of

bank loan as well as loans from other sectors, such as trade financing loans,

mortgages and repurchase agreements. Private loans are often divided into two

categories: short-‐term and long-‐term. The likelihood of short-‐term debt to expose

countries to risk of crisis is contested in economic literature. Stiglitz (2000) argues

that, by liberalizing the short-‐term capital account, a country opens itself to the risk

of capital flight, which occurs when assets quickly flow out of a country. Capital

flight decreases the level of domestic wealth and is almost always associated with

depreciation of the domestic currency. Diamond & Rajan (2001) assert that

structural flaws are to blame for countries being exposed to such risks. “Short-‐term

debt mirrors the nature of the investment being financed and the institutional

environment that enables investors to enforce repayment. It is no surprise that

illiquid or poor quality investment when a bank or banking system is close to its

debt capacity will result in a buildup of short-‐term debt. The higher likelihood of

crisis stems, not from the short-‐term debt, but from the illiquidity and potentially

low creditworthiness of the investment being financed.” Conventional economic

wisdom dictates that countries, especially those with developing economies, should

be wary of short-‐term loan flows because they are more liquid and volatile than

long-‐term loan flows.

1.3 Benefits of Capital Flows & Recessionary Trends One feature of the globalized economy is an integrated international financial

market. An interconnected financial system facilitates the uninhibited movement of

capital across countries. In theory, international financial integration should allow

for capital to be allocated in the most efficient ways. Fischer (1997) elaborated on

these benefits. “Free capital movements facilitate a more efficient global allocation

of savings, and help channel resources into their most productive uses, thus

increasing economic growth and welfare.” Bailliu (2000) agrees with Fischer’s

assertion that freely moving capital does indeed have the potential to maximize

economic growth and welfare, but argues that, in developing countries, freely

moving capital can only maximize economic benefits if the domestic banking sector

has achieved a minimum level of development and sophistication. Bailliu (2000)

suggested that there are three ways capital flows can foster domestic growth:

increasing domestic investment rates, facilitating investments from foreign agents

with positive spillover effects (such as technology transfers), and increasing

domestic financial intermediation.

Fischer (1997) points out that free capital movement benefits capital-‐seeking

agents because institutions, firms and individual investors have access to ever-‐

increasing sources of capital. The author notes that foreign capital markets have

grown substantially in terms of the volume of funds being distributed on an annual

basis. Enhanced capital access can also reduce the cost of capital. International

sources of capital are oftentimes cheaper than those available in the domestic

market. Stulz (2005) discovered that the largest reductions in capital cost are

enjoyed by developing countries that are gaining access to international capital

markets for the first time. He determined that developed countries with a

longstanding presence in the international financial market can also reduce their

capital costs, but to a lesser extent.

International capital account liberalization has not only benefitted recipients

of capital, but also distributors of capital. The interconnected financial system has

created new opportunities for investors to diversify their portfolios and achieve

higher returns. Levey and Sarnat (1970) found that investment portfolios can

achieve “material improvements” in risk reduction by diversifying their holdings,

specifically by purchasing equities in developing countries to complement holdings

in developed countries.

As Bailliu (2000) noted, another benefit of international capital flow

liberalization is the transfer of technology, infrastructure, and intellectual capital

that often comes with FDI. Acknowledging that multinational corporations account

for a large portion of global research and development investment, Borensztein,

Gregorio & Lee (1998) found that FDI is important for the international transfer of

technology and, in developing countries, leads to more growth than domestic

investment as long as the host country’s infrastructure is advanced enough to

absorb the technology spillovers.

Despite their benefits, freely moving international capital flows have not

always created positive outcomes for emerging market economies. One of the most

important drawbacks of capital flows is the pattern of reversals in periods of crises.

Capital flight occurs when a large volume of capital flows out of a country. Capital

flight is almost always a symptom, rather than a cause, of a financial crisis. Capital

flight was present in the global recession of 2008. Total net private capital flows

had reached a historic high of US $1.2 trillion in 2007, only to fall to US $649 billion

in 2008. According to Suchanek & Vasishtha (2009), they fell even further in 2009,

to US $435 billion. This affirms the findings of Kaminsky, Reinhart, & Vegh (2005).

The authors calculated that, for all groups of countries, capital flows are pro-‐cyclical,

with higher inflows during periods of growth and lower inflows during periods of

crisis.

Capital flow reversals during a recession can worsen a crisis, especially in

emerging market economies. Calvo & Reinhart (1999) discovered that during a

crisis, developing countries often experience decreased access to sources of

international capital, which makes recovery more difficult. They point out that a

country hoping to enact expansionary policies to recover from recession will find

this increasingly difficult as their sources of international capital disappear. Not

only does capital decrease in availability, but it also increases in cost.

Bernanke (2000) discovered that reduced access and increased cost of

capital discourages investment, contributing to reduced aggregate demand and

decreased output during a crisis. During recessions, there is heightened uncertainty

in the domestic economy and, from the perspective of a foreign loaner, risk. Banks

become reluctant to lend as liberally as they did during the pre-‐crisis period.

Bernanke (2000) discovered that banks’ unwillingness to lend during crises has

gotten more severe over time. Cyclical decreases in bank loans contribute to

decreases in private loan flows during a recession. Countries cannot expect private

loan flows to be as abundant during a crisis as they are in a stabile economic

environment. Decreased loan flows indicate that firms are not undertaking as many

investment projects during a recession, which makes it difficult to recover via

economic growth and expansion.

Capital flight is not always caused by a financial crisis within the domestic

economy. Capital flow reversals can also be triggered by exogenous factors. If

investment opportunities with higher returns and less risk are available in foreign

entities, investors have an incentive to remove their money from the domestic

economy and reallocate it to the more attractive investment. When this occurs,

investors demand repayment and the domestic country will face high volumes of

capital outflows, which it can respond to in two ways. First, the country can raise

the domestic interest rate, which reduces or eliminates the opportunity cost that the

investor incurs by keeping his or her money in the domestic country. This will be

effective in reducing capital outflows, but it also discourages investment because

interest rate hikes increase the cost of borrowing. Decreased investment

contributes to a growth stall, exasperating the effects of a recession. If the country

does not wish to raise the domestic interest rate, it can opt to repay the investors.

Since many foreign investments are denominated in foreign currency, the domestic

country has to deplete their foreign reserves to meet their repayment obligations.

In extreme cases, depleted foreign reserves can lead a country to insolvency.

According to World Bank data, in 2008, when the global financial crisis was starting

to reach its apex, Brazil had foreign exchange reserves of $205.5 billion, which was

12.9% of their GDP. According to The Economist3, these foreign reserves gave Brazil

the ability to intervene in foreign exchange markets and stabilize the Brazilian real.

They also were able to provide foreign exchange swaps for Brazilian corporations

that were struggling to pay back US dollar-‐denominated debt. If Brazil hadn’t

possessed substantial pre-‐crisis amounts of foreign reserves, they would have been

less able to pay back their short-‐term debts, which could have led them towards

insolvency.

Capital flow reversals can also be caused by the exogenous factor of

quantitative easing (QE). QE is the process of a central bank buying securities from

the market to lower global interest rates and increase the money supply, with the

goals of promoting more lending and increasing liquidity. QE is most effective when

it is conducted by an economy of large scale, such as that of the US. During

quantitative easing, countries ideally use the money they receive from selling

domestic securities in ways that stimulate growth in the domestic economy. This

theoretically increases investor confidence in the domestic economy, promoting a

resurgence of international trade and investment.

In response to the 2008 financial crisis, the Federal Reserve instituted

aggressive QE policies, eventually purchasing trillions of dollars of securities. QE

creates a risk of capital flow reversals when the policies are eventually phased out,

or tapered. In May 2013, Ben Bernanke, the former Chairman of the Federal

Reserve, provided a glimpse of the chaos that can ensue when quantitative easing

policies are tapered. According an article published by Forbes4, Bernanke sparked

3 The article Just in Case was authored by multiple writers for The Economist and was electronically published on October 12, 2013. 4 The article Bernanke’s QE Dance: Fed Could Taper in Next Two Meetings, Tightening Would Collapse the Market was electronically published on May 22, 2013. The article was authored by Agustino Fontevecchia.

wild swings in the market when he hinted at the possibility of tapering QE in the

near future. The Dow Jones Industrial Average, a stock market index composed of

30 large publically owned American companies, increased and decreased by over

100 points at various points throughout Bernanke’s speech. It is inevitable that

quantitative easing will eventually be phased out and, to some extent, investors will

probably respond by withdrawing their capital from developing countries. The

degree to which investors respond to QE tapering by withdrawing their capital from

developing countries will determine how severely economic growth in emerging

markets will be hindered.

1.4 Capital Controls: History & Types

Most, if not all, of countries institute at least some capital controls, which are

domestic policies that regulate flows to and from capital markets. Throughout

history, capital controls have been used for varying purposes and to different

extents. Eichengreen (2008) explains that capital controls initially gained

popularity in mainstream economics during the time period between World War I

and World War II. The purpose of capital controls at this point in time was to allow

countries to rebuild their economy during the post-‐World War I period without the

fear of capital flight. Eichengreen (2008) mentions that during the three decades

after World War II, capital controls became less prevalent and international capital

flows reached record highs. Industrial nations led the way in liberalizing

international capital flow policies, while encouraging developing countries to do the

same.

Post-‐World War II financial crises started to highlight the risks of freely

moving capital, especially in developing countries. Economists and governments

have tried to better their understanding of capital flow behavior and how capital

controls can be instituted to mitigate the risks of capital volatility during crises.

(Chamon & Garcia, 2014) examine the ways that Brazil used capital controls to

respond to the 2008 crisis. Brazil was the one of the most aggressive emerging

markets in terms of their reactionary capital control policies. Beginning in 2009, the

Brazilian government imposed controls such as portfolio flow taxes, loan flows

taxes, currency exchange taxes, and increased reserve requirements for domestic

banks. The authors discovered that capital controls increased the price of Brazilian

assets and, to a certain extent, isolated the Brazilian financial market from the

international financial market. The authors also concluded that the capital controls

as a whole successfully contained the appreciation of the real (the domestic

Brazilian currency). The Brazilian government began relaxing their capital controls

in 2011. The authors infer that the controls allowed Brazil to avoid a bubble and

out-‐of-‐control domestic credit levels. The downside of the capital controls was the

reduced access to foreign financing, possibly contributing to the low investment and

growth performance during the post-‐crisis period. Brazil is but one example of a

country that has had success with capital control policies during a crisis. These

success stories have caused many economists believe that capital controls are a

legitimate way to shield countries from some of the effects of recessions.

There are a wide variety of capital controls that can be instituted by a

country. Capital controls can target short-‐term investments, long-‐term investments,

or both. Wary of the risks that come with the volatility of short-‐term capital flows,

some countries impose capital controls with the goal of attracting investment

projects that necessitate long-‐term commitment from investors. In Vietnam, the

government requires as a precondition that foreign investors set up a Vietnamese

capital bank account, which enables the tracking of flows in and out of the country.

Also, the Vietnamese government requires that foreign investors fulfill all financial

obligations to the State of Vietnam before distributing any profits (KPMG). Ostry,

Ghosh, Habermeier, Chamon, Qureshi & Reinhardt (2010) provide another example

of capital controls that target short-‐term flows. From 2006-‐2008, Thailand imposed

an unremunerated reserve requirement on any foreign currencies sold or

exchanged against the domestic baht. The requirement was 30% and was effective

in reducing the volume of net flows as well as altering the composition of inflows

(there was a greater percentage of foreign direct investment inflows and a lower

percentage of short-‐term flows).

Some capital controls that target long-‐term capital flows are due to domestic

aversion to foreign ownership of domestic assets. In Mexico, for example, Article 27

of the constitution limits foreign investment in domestic real estate and natural

resources. Neely (1999) explains that this is a protective measure Mexico has taken

to prevent foreign companies from exploiting Mexican resources for short-‐term

profits, which is has frequently occurred in the history of Mexico. Another reason a

country might impose capital controls specific to long-‐term flows is because of a

general aversion to the risks of taking part in international financial markets. South

Korea, for example, restricted long-‐term foreign investment inflows before they

radically reformed their capital account starting in the late 1990s. Noland (2007)

attributes South Korea’s restrictions on FDI inflows to the country’s unwillingness

to have the foundation of their economy be contingent on foreign capital and

uncontrollable macroeconomic factors. South Korea is exemplary of an economy

that rapidly developed without relying on FDI inflows. The country instead relied

on technology licensing and international loans to spur growth.

Capital controls can also be categorized by whether or not they restrict

capital account transactions via price mechanisms or quantity controls. Price

controls usually manifest themselves in the form of taxes. A popular price

mechanism is the “Tobin” tax, which was first introduced in 1972. Tobin taxes

impose a small percentage tax on all foreign exchange transactions. Frankel (1996)

explains that the purpose of the Tobin tax was to reduce the incentive to switch

investment positions in the short-‐term in the foreign exchange market, which would

mitigate market volatility. Another price-‐based capital control is the mandatory

reserve requirement, which requires foreign investors to deposit a percentage of

their investment with the central bank (earning no interest). Mandatory reserve

requirements are meant to build the foreign reserves of the central bank. Chile

implemented such a policy from 1991 to 1998, specifically targeting short-‐term

inflows. In the context of Chile, their mandatory reserve requirement essentially

functioned as a tax on short-‐term inflows. Stiglitz (2000) praised Chile’s mandatory

reserve requirement because it reduced the volatility of short-‐term inflows without

compromising long-‐term, growth-‐fostering inflows such as FDI.

Quantity-‐based capital controls can take the form of policies that set a ceiling

for borrowing from foreign residents. According to Athukoralge (2001), Malaysia

set such ceilings in response to the 1998 Asian crisis, limiting foreign currency

borrowings by residents and domestic borrowing by non-‐residents. Malaysia

implemented another quantity-‐based control by setting a ceiling on banks/ external

liabilities not related to trade or investment. Other times, countries may require

that governmental approval be granted before transactions are made on certain

types of assets. The case of South Korea prohibiting nearly all long-‐term flows is

one example of this type of quantity-‐based control.

2. Data

2.1 Quantifying Capital Account Restrictiveness Due to the variety and complexity of capital controls, quantifying capital account

openness is a burdensome task. Different countries at different points in time

decide to impose different mixes of capital controls. Given the variety of available

capital controls, each mix tends to be unique. It is therefore important to have a

standard measure of capital control restrictiveness.

Many capital account openness indices have been constructed using the

IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions

(AREAER). The AREAER is a database of binary variables that contains information

about the types of capital controls are employed by the 187 IMF member countries.

The variables in the AREAER include a wide variety of capital controls, such

as restrictions on international payments and transfers, arrangements for payments

and receipts, regulations on residents’ and nonresidents’ accounts, exchange rate

systems, financial sector policies, and foreign exchange market operations. A binary

variable with the value of 1 indicates that a country has instituted the particular

capital control and 0 otherwise.

The AREAR is effective in distinguishing between de jure and de facto capital

controls. De jure capital controls are legally instituted policies. De facto capital

controls relate to how robustly the controls are implemented, and how effective

they are in serving their purpose. De facto capital controls are harder to quantify

than de jure capital controls, but they depict reality more accurately, which makes

them more valuable for practical perspective.

There are various issues that arise when measuring capital account openness

with the binary variables contained in the AREAER. Binary measurements indicate

whether or not a country has instituted a given capital control, but provide no

information on the degree to which it has been implemented. Therefore, there is no

way to measure differences in intensity of a given capital control between countries.

Another issue with the variables in the AREAER is that they are broadly defined,

preventing them from capturing certain details and distinguishing features of

capital controls. Some of the problems associated with a lack of capital control

specificity were addressed in 1997, when the IMF revised the classification of the

variables in the AREAER. The new variable categorizations now account for

distinctions between restrictions on inflows and outflows as well as the differences

between different types of capital transactions. However, it is doubtful that any

categorization of the variables in the AREAR, no matter how specific, could ever

perfectly encapsulate the complexity and variety of capital controls.

Using the information from the AREAER, Chinn and Ito (2008) created a

capital account openness index called KAOPEN. The authors reversed the values of

the binary variables in the AREAER in order to construct KAOPEN in a way that has

higher index values corresponding to less restrictive current account policies.

Selected binary variables in the AREAER are weighted and aggregated into

individual index values for each IMF member country. The aggregated index

measurements assume values between 0 to 1, with 0 representing complete

restriction and 1 representing complete openness. KAOPEN values are measured

annually, with 1970 being the earliest year that data is available for.

KAOPEN is the most appropriate capital account openness index to use in this

study for two reasons. KAOPEN is constructed so as to focus on de jure capital

controls, making it effective in measuring the extent of regulatory restrictions on

capital account transactions. Since the purpose of this study is to evaluate the

effectiveness of a country’s legally imposed capital controls in mitigating the

negative effects of a financial crisis, KAOPEN’s focus on de jure capital controls

makes it a logical choice of index.

The second reason KAOPEN is an ideal index of capital account

restrictiveness is that it is a holistic, robust measure of capital account openness.

Countries oftentimes impose capital controls in a variety of ways to increase their

collective effectiveness. As Edwards (1999) points out, the private sector frequently

circumvents capital controls. Countries can make this more difficult by adopting an

all-‐inclusive approach to their capital control policies. A country with a closed

capital account can reinforce these policies by imposing controls on the current

account or by changing the requirements for surrendering export proceeds.

Malaysia adopted this strategy in response to the Asian Crisis of 1998. KAOPEN

incorporates variables from a variety of categories in the AREAR, accounting for a

wide range of capital controls. Therefore, KAOPEN values are strong measures of

the entirety of countries’ approaches to capital account restrictiveness.

Here, I first examine KAOPEN values from 1970 to 2012 across the entirety of

the IMF member countries to investigate if there is a global trend towards capital

openness or restrictiveness. I then focus on the regions of Latin America and

Southeast Asia, to investigate if there are region-‐specific capital account openness

trends. I evaluate KAOPEN for these regions across the entirety of the time series

(1970 to 2012) as well as specifically for time periods leading up to, during, and

after a crisis. For Latin America, my analysis focuses on the five years preceding and

following the 2002 South American recession. For Southeast Asia, my analysis

focuses on the five years preceding and following the 1998 Asian financial crisis.

2.2 KAOPEN Values Figure 6 presents the average of annual KAOPEN values for the 187 IMF

member countries as a group from 1970 to 2012. The change in global KAOPEN

values over time indicates that, in general, capital account openness has increased

since 1970. However, Figure 6 shows that the trend toward global capital account

openness slowed and even reversed in the late 1970’s and early 1980’s. The mean

global KAOPEN value did not begin to increase again until the late 1980’s. The

reduction in KAOPEN values during the late 1970’s and early 1980’s is attributable

to the global recession that occurred during the same time period. The recession

negatively impacted both developed economies and emerging market economies.

The trend is particularly evident in the Latin American debt crisis during that

period. In the 1960’s and 1970’s, Latin American countries built up vast quantities

of foreign debt by borrowing from international creditors to fund economic

development projects. Investors were initially eager to finance projects in

developing Latin America because GDP in the region was rapidly growing. By the

late 1970’s, however, Latin American countries were struggling to repay their debts,

partly due to rising oil prices and increasing interest rates in the United States and

Europe. Investors became wary of Latin America’s ability to repay their debts. They

withdrew their funds from the region, causing a large outflow of capital flight.

According to Pastor (1989), capital flight in Latin America totaled $151 billion

between 1973 and 1987. This equates to 43% of their total external debt during

that time period. The rapid outflow of capital from Latin America deprived the

region of important funding that was expected to be used for developing projects

and servicing their foreign debt. Latin American countries came to identify capital

flight as one of the primary causes for their economic woes. As a result, countries in

the region became more restrictive on capital account transactions and even the

IMF made stricter capital controls a precondition for Latin American countries to

receive debt-‐relief assistance packages.

Figure 7 depicts the KAOPEN value for Latin American countries from 1970

to 1990. The figure shows a strong trend towards capital account restrictiveness

during the late 1970’s and early 1980’s in Latin America. The figure shows that

0.3

0.35

0.4

0.45

0.5

0.55

0.6

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

KAO

PEN

Year

Figure 6: Mean KAOPEN Value for all IMF Member Countries, 1970-‐2012 The figure presents the mean KAOPEN value for all IMF member countries from 1970-‐2012.

Source: Author’s calculations based on World Bank data. There are no country-‐specific weightings for KAOPEN values.

0

0.1

0.2

0.3

0.4

0.5

0.6

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

KAO

PEN

Year

Latin American countries did not begin liberalizing their capital accounts until the

late 1980’s.

In contrast, this trend is absent for developing countries during the same

period. Figure 8 shows the KAOPEN value for a selected group of countries that had

some of the largest economies (in terms of nominal GDP) in the world in 1980. The

figure makes it evident that the overall trend towards capital account

restrictiveness was not present in developed countries with prominent economies.

Thus, the overall trend towards stricter capital controls in the late 1970’s and early

1980’s, apparent in Figure 6, did not apply globally, but had important regional

distinctions.

5

5 Figure 7 depicts the mean KAOPEN value from 1970 to 1990 for selected Latin American countries: Argentina, Bolivia, Chile, Colombia, Ecuador, Guatemala, Mexico, Paraguay, Peru, Uruguay & Venezuela. There are no country-‐specific weightings applied to KAOPEN values.

Figure 7: Mean KAOPEN Value for Latin American Countries, 1970-‐19905 The figure presents the mean KAOPEN value for selected Latin American countries for 1970-‐1990.


6

Excluding the reversal in the late 1970’s and early 1980’s, there is clearly an

overall trend towards global capital account openness. This has made international

capital reallocation and international trade easier, prominent features of the

present-‐day integrated global economy.

Figures 9 graphs the KAOPEN values in Latin America and Southeast Asia

from 1970 to 2012, illustrated the regional differences in capital account openness.

In general, Latin American countries have liberalized their capital accounts more so

than Southeast Asian countries. The next section of this paper relates KAOPEN

values to FDI inflow volume on a regional basis, which should indicate whether or

not the dichotomy of the approaches taken by Southeast Asian countries and Latin

6 Figure 8 depicts the mean KAOPEN value from 1970 to 1990 for a selected group of developed countries that were global leaders in terms of GDP in 1980: Canada, France, Germany, Italy, Japan, Spain, the United Kingdom & the United States. There are no country-‐specific weightings applied to KAOPEN values.

0.4

0.45

0.5

0.55

0.6

0.65

0.7

0.75

0.8

0.85

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

KAO

PEN

Year

Figure 8: Mean KAOPEN Values for Developed Countries, 1970-‐19906 The figure shows the mean KAOPEN values for a selected group of developed countries from 1970-‐1990.


American countries towards capital account restrictiveness has yielded different

outcomes for the countries in those regions.

7

2.3 KAOPEN & FDI Inflows; Time-‐Series Data Selection I examine the relationship between KAOPEN values and net FDI inflow volume for

my focus countries over an eleven-‐year period centered around the year of the

financial crisis: 1998 for Southeast Asia and 2002 for Latin America. Figures 10 and

11 show the % GDP change for my countries of focus in each region over an 11-‐year

period. In Latin America, the crisis was deepest in 2002 as evidenced by the GDP

7 Figure 9 depicts the mean KAOPEN value from 1970 to 1990 for a selected group of Latin American and Southeast Asian countries. The Latin American countries included are Argentina, Bolivia, Chile, Colombia, Ecuador, Guatemala, Mexico, Paraguay, Peru, Uruguay & Venezuela. The Southeast Asian countries included are Cambodia, Indonesia, South Korea, Lao PDR, Malaysia, Myanmar, Philippines, Singapore, Thailand & Vietnam. There are no country-‐specific weightings applied to KAOPEN values.

Figure 9: Mean KAOPEN Values for Latin American and Southeast Asian Countries, 1970-‐20127 This figure shows the mean KAOPEN value for Latin American and Southeast Asian Countries between 1970 and 2012.

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

KAO

PEN

Year LA KAOPEN values SE Asia KAOPEN Values


contraction seen in figure 10. In Southeast Asia, the crisis was deepest in 1998 as

evidenced by the GDP contraction seen in Figure 11. Thus, I recognize 2002 as the

start of the financial crisis in Latin America and 1998 as the start of the financial

crisis in Southeast Asia.

8

9

8 Figure 10 shows the mean annual % GDP change from 1997 to 2007 for my focus countries in Latin America: Argentina, Chile & Venezuela. There are no country-‐specific weightings applied to GDP change values.

Figure 11: Mean Annual % GDP Change for Southeast Asian Countries, 1993-‐20039 This figure shows the annual % GDP Change for my focus Southeast Asian Countries from 1993-‐2003.

-‐8 -‐6 -‐4 -‐2 0 2 4 6 8 10 12

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 % GDP Change

Year % GDP

Figure 10: Mean Annual % GDP Change for Latin American Countries, 1997-‐20078 This figure shows the annual % GDP Change for my focus Southeast Asian Countries from 1991-‐2001.

-‐6

-‐4

-‐2

0

2

4

6

8

10

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 % GDP Change

Year % GDP



The KAOPEN values for the five years preceding the crisis indicate the

intensity of a given country’s capital controls before the beginning of the recession.

The KAOPEN values in the years after the start of the crisis reveal if a given country

responds by opening or closing their capital account and to what extent. The FDI

inflow levels during the five years after the start of the crisis are of particular

interest, because they show how effective a given country’s reactionary capital

control alterations relate to actual capital flow volume. I find that FDI inflows are

sensitive to capital controls imposed in response to a crisis.

Figures 12 and 13 show how the mean KAOPEN value in Latin America and

Southeast Asia changed during the 11-‐year periods centered around the year in

which their respective crises began. Figure 12 indicates that in general, Latin

American countries responded to the 2002 crisis by loosening capital controls.

Figure 13 shows that countries in Southeast Asia also opened their capital accounts,

but less drastically than Latin American countries. In 2001, one year before the

start of 2002 crisis, the average KAOPEN value in Latin America was .655. The

average KAOPEN value in Southeast Asia in 1997, one year before the start of the

1998 crisis, was .371. Before the start of the crisis, Southeast Asian countries had

much less open capital accounts than countries in Latin America. This is consistent

with the broader trend of Southeast Asian countries being more averse to capital

account liberalization than Latin American countries, which is shown in Figure 9.

9 Figure 11 shows the mean annual % GDP change from 1992 to 2002 for my focus countries in Southeast Asia: Vietnam, Singapore, Indonesia & Malaysia. There are no country-‐specific weightings applied to GDP change values.

10 11

2.4 KAOPEN & FDI Inflows; Latin America The Latin American crisis of 2002 was sparked by the devaluation of the Brazilian

real. After the devaluation of the real, Argentine export competitive was damaged

because the Argentine peso was pegged to the US dollar, preventing the country

from devaluing in order to restore their export competitiveness. What started out

as a currency crisis in Argentina turned into a sovereign debt crisis when the

country’s economy started contracting because decreased tax receipts could no

longer finance the country’s outstanding interest payments. Despite assistance from

the IMF, the market’s confidence in Argentina and the peso continued to deteriorate.

10 Figure 12 shows the mean annual KAOPEN value from 1997 to 2007 for selected countries in Latin America: Argentina, Bolivia, Chile, Colombia, Ecuador, Guatemala, Mexico, Paraguay, Peru, Uruguay & Venezuela. There are no country-‐specific weightings applied to KAOPEN values. 11 Figure 13 shows the mean annual KAOPEN value from 1993 to 2003 for selected countries in Southeast Asia: Cambodia, Indonesia, South Korea, Lao PDR, Malaysia, Myanmar, Philippines, Singapore, Thailand & Vietnam. There are no country-‐specific weightings applied to KAOPEN values.

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

KAO

PEN

Year

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

KAO

PEN

Year

Figure 12: Mean Annual KAOPEN value for Latin American Countries, 1997-‐200710 This figure shows the average annual KAOPEN value in Latin America from 1997-‐2007.

Figure 13: Mean Annual KAOPEN value for Southeast Asian Countries, 1993-‐200311 This figure shows the average annual KAOPEN value in Latin America from 1993-‐2003.

Source: Author’s calculations based on World Bank data. Source: Author’s calculations based on World Bank data.

Argentina gradually phased out the peso’s peg to the dollar, but action did not come

swiftly enough. The crisis reached an apex near the end of 2001, when confidence in

the peso was so compromised that Argentina experienced a bank run. Arellano

(2008) notes that Argentina eventually decided to default on over $100 billion of

their debt in December of 2001. This should have worsened the situation in

Argentina because a default would theoretically block Argentina’s access to

international capital markets. Towards the end of 2002, however, World Bank data

shows that the global price of soy, which is one of the most prominent Argentine

exports, soared to their highest level since mid-‐2000. Argentina enjoyed an export-‐

driven recovery; GDP contracted by 10.89% in 2002 then grew by 8.84% in 2003.

Argentina’s economy began to slow down in 1998 when the Brazilian Real

was devalued. The recession was by no means mild; World Bank data indicates that,

from 1998 to 2002, the Argentine economy shrank by over 25%. Figure 14

indicates that Argentina responded to the crisis by increasing capital account

restrictiveness. Net FDI inflow volume in Argentina follows a trend similar to

KAOPEN values in Argentina. Similar year-‐to-‐year relative changes in KAOPEN and

FDI inflows indicate that the extent of Argentina’s capital controls have a

relationship with capital flow volume. Although Argentina’s economy began to

recover in 2003, net FDI inflows did not begin to increase until 2004, one year after

Argentina began to reopen their capital account. This indicates that FDI inflows are

more responsive to capital controls than macroeconomic trends.

Figure 14: FDI Net Inflows & KAOPEN Values in Argentina, 1997-‐2007 This figure shows the KAOPEN values and FDI net inflow volumes for Argentina from 1997 to 2007. FDI Net Inflows are measured in $US Millions.

Figure 15: FDI Net Inflows & KAOPEN Values in Chile, 1997-‐2007 This figure shows annual FDI Net Inflows and KAOPEN Values in Chile from 1997-‐2007. FDI Net Inflows are measured in $US Millions.

0

0.2

0.4

0.6

0.8

1

1.2

$0.00

$2,000.00

$4,000.00

$6,000.00

$8,000.00

$10,000.00

$12,000.00

$14,000.00

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

KAO

PEN

FDI Net InHlows, $US MIllions

Year FDI Net Inglows KAOPEN

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

$0.00

$5,000.00

$10,000.00

$15,000.00

$20,000.00

$25,000.00

$30,000.00

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

KAO

PEN

FDI Net InHlows, $US Millions




The 2002 crisis did not affect Chile as much as it did Argentina. According to

the World Bank, Chile only had GDP contraction in 1999, while Argentina’s economy

shrank for four consecutive years. Calvo (2005) attributes Chile’s relatively strong

performance during the recession to the fact that Chile did not have as severe of a

pre-‐crisis currency-‐denomination mismatch. Figure 15 indicates that Chile

responded to the crisis by opening their capital account, which is the opposite of

what Argentina did. Chile experienced a drop in FDI inflows from 1999 to 2002, but

had a strong resurgence afterwards. Again the relationship between capital account

restrictiveness and net FDI inflows appears to be significant, even in the case of a

country that was not affected by the crisis to the same degree as Argentina. This

enforces the argument that net FDI inflows are more sensitive to towards short-‐

term variations in capital controls than macroeconomic trends.

Venezuela also experienced adverse effects from the crisis of 2002; their

economy shrank by 9% in 2002 and by 8% in 2003 according to the World Bank.

Adding to the economic problems the country was facing, political instability led to a

strike in December 2002. The strike caused a crisis in the Venezuelan oil industry,

greatly reducing the country’s crude oil output for much of 2003. Venezuela started

experiencing capital flight as confidence in their economy deteriorated. In order to

curb the capital flight and prevent further depletion of foreign reserves, Venezuela

increased the intensity of their capital controls as indicated in Figure 16. FDI inflow

volume rose during 2000 and then steeply declined, coinciding with the time that

Venezuela’s KAOPEN value decreased. Even in the case of a country that

experienced a crisis due to internal rather than exogenous factors, there appears to

be a significant relationship between capital account restrictiveness and capital flow

volume. It is difficult to ascertain causality; some of the FDI inflow reductions are

likely due to a general lack of investor confidence in the region. It seems probable,

however, that the heightened capital account restrictions also played a part in the

reduction of FDI inflow volume during and after the crisis.

2.5 KAOPEN & FDI Inflows; Southeast Asia The 1998 Asian financial crisis began in Thailand, when the country was forced to

float the Thai baht after large-‐scale currency speculation attacks and a shortage of

foreign reserves led to the failure of their fixed exchange rate system. Thailand’s

outstanding debt payments, which they had already struggled to honor, became

even more difficult to pay back after the decision to float the baht led to devaluation.

Similar to how Brazil’s devaluation impacted Argentina’s export competitiveness,

Thailand’s devaluation reduced the export competitiveness of other Southeast Asian

countries. Trade links were the channel for financial contagion and caused the Thai

crisis spread to most other countries in Southeast Asia.

Figure 16: FDI Net Inflows & KAOPEN Values in Venezuela, 1997-‐2007 This figure shows annual FDI Net Inflows and KAOPEN Values in Venezuela from 1997-‐2007. FDI Net Inflows are measured in $US Millions.

0

0.2

0.4

0.6

0.8

1

1.2

$0.00

$1,000.00

$2,000.00

$3,000.00

$4,000.00

$5,000.00

$6,000.00

$7,000.00

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

KAO

PEN


Year

FDI Net Inglows KAOPEN


Vietnam has historically taken a conservative approach towards capital flows by

implementing a wide variety of capital controls. Vietnam was not as adversely

affected by the 1998 Asian financial crisis as other countries in the region. Table 1

shows the average annual % change in GDP for selected Southeast Asian countries

between 1998 and 2002, as well as the standard deviation for the yearly

fluctuations in % GDP change. Vietnam averaged the highest annual GDP in the

region over the five-‐year period. Vietnam’s propensity to shield itself from the

international financial system reduced the country’s interconnectedness with the

rest of the market, which is likely one explanatory factor for their relatively strong

performance during the crisis of 1998. Vietnam also had the smallest standard

deviation of their annual % GDP changes, indicating that Vietnam has less year-‐to-‐

year variability in their economic performance. This is also likely attributable to

severity of their capital control policies.

Vietnam’s FDI inflow volume between 1992 and 2002 follows closely with

the country’s KAOPEN values over the same time period, as seen in Figure 17. The

figure indicates that Vietnam’s capital controls were gradually loosened between

1992 and 1996, which facilitated higher FDI inflow volume. After 1996, however,

Vietnam stopped liberalizing their capital account and even tightened restrictions a

bit in 2001. This coincides with a reduction in FDI inflow volume. Although there

appears to be some relationship between KAOPEN and FDI inflows, it is likely the

small variation in FDI inflow volume during the crisis period is due to a general lack

of confidence in the outlook of the regional economy.

Country Average Annual % GDP Change

Standard Deviation of Annual % GDP Changes

Vietnam 5.97% 0.76 Philippines 2.69% 1.92 Malaysia 2.71% 6.38 South Korea 5.16% 6.49 Thailand 1.23% 6.67

Table 1: Average Annual % GDP Change & Standard Deviation in Selected Southeast Asian Countries, 1998-‐2002


Malaysia and Indonesia had similar pre-‐crisis KAOPEN values, as indicated in

Figures 18 and 19. Both countries reduced their capital account openness in

response to the crisis, with Malaysia implementing capital controls a bit more

severely than Indonesia. Overall, FDI inflow volume decreased in both countries

over the ten-‐year period, as depicted by the trend lines in the figures. Although

there is an overall downward trend in FDI inflow volume, there are drastic year-‐to-‐

year FDI variations. One reason for this could be that Malaysia and Indonesia had

liberalized capital accounts prior to the recession (both countries have the

maximum KAOPEN values in the early 1990’s). Year-‐to-‐year variations in FDI inflow

volumes to Malaysia and Indonesia’s are much greater than those of Vietnam. Less

variation in Vietnam is likely due to the country’s capital account restrictiveness.

Liberalized pre-‐crisis capital accounts in Malaysia and Indonesia and the resulting

Figure 17: FDI Net Inflows & KAOPEN Values in Vietnam, 1992-‐2002 This figure shows annual FDI Net Inflows and KAOPEN Values in Vietnam from 1992-‐2002. FDI Net Inflows are measured in $US Millions.

0

0.05

0.1

0.15

0.2

0.25

$0.00

$500.00

$1,000.00

$1,500.00

$2,000.00

$2,500.00

$3,000.00

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

KAO

PEN


Year

FDI Net Inglows KAOPEN Source: Author’s calculations based on World Bank data.

interconnectedness with the international financial system could have made their

economies more susceptible to market trends. The economies’ responsiveness to

market dynamics could be a primary cause in the year-‐to-‐year FDI inflow variations

seen in Figures 18 and 19.

Figure 18: FDI Net Inflows & KAOPEN Values in Malaysia, 1992-‐2002 This figure shows annual FDI Net Inflows and KAOPEN Values in Malaysia from 1993-‐2003. FDI Net Inflows are measured in $US Millions.

Figure 19: FDI Net Inflows & KAOPEN Values in Indonesia, 1992-‐2002 This figure shows annual FDI Net Inflows and KAOPEN Values in Indonesia from 1992-‐2002. FDI Net Inflows are measured in $US Millions.

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

$0.00

$1,000.00

$2,000.00

$3,000.00

$4,000.00

$5,000.00

$6,000.00

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

KAO

PEN


FDI Net Inglows KAOPEN

0

0.2

0.4

0.6

0.8

1

1.2

-‐$6,000.00

-‐$4,000.00

-‐$2,000.00

$0.00

$2,000.00

$4,000.00

$6,000.00

$8,000.00

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

KAO

PEN




Singapore is a unique case in Southeast Asia due to its interconnectivity with

the global economy as well as the sophistication of their domestic economy. Figure

20 compares annual GDP per capita from 1994 to 1997 in my Southeast Asian

countries of focus. Singapore’s GDP per capita in every year dwarfs those of its

regional counterparts. Strong GDP per capita in Singapore is a byproduct of their

industrialized economy and a stable political environment that actively promotes

domestic business.

Before the 1998 Asian financial crisis, Singapore had the maximum possible

KAOPEN value, as seen in Figure 21. Singapore was not immune to contagion effects

from neighboring countries; according to the World Bank, Singapore experienced a

$0.00

$5,000.00

$10,000.00

$15,000.00

$20,000.00

$25,000.00

1994 1995 1996 1997

GDP per Capita (Constant 2005 $US)

Year Singapore Vietnam Indonesia Malaysia

Figure 20: Annual GDP per Capita in Southeast Asian Countries of Focus, 1994-‐1997 (Constant 2005 $US) This figure shows how annual GDP per Capita changed between 1994-‐1997 in Singapore, Vietnam, Indonesia & Malaysia.



GDP contraction of over 2% in 1998. Singapore responded quickly and decisively,

allowing their currency to depreciate against the US dollar, which reduced the

potential gains of would-‐be currency speculators.

Singapore’s strategy of slightly increasing capital control restrictiveness can

be observed in Figure 21. FDI inflows to Singapore increased at a steady rate prior

to the 1998 crisis, but similar to the other countries in the region, decreased after

1996. Figure 21 shows that Singapore’s FDI inflow volume recovered very quickly

after the crisis, reaching an all-‐time high in 1999. This type of FDI inflow resurgence

did not occur in Malaysia, Indonesia, or Vietnam. It is likely that Singapore’s post-‐

crisis FDI inflow increases are partly due to the timeliness and effectiveness of the

mild capital controls they imposed after 1996.

Another probable cause of Singapore’s post-‐crisis FDI inflow resurgence is

the sophistication and liberalization of their pre-‐crisis economy. Singapore was

already an industrialized, trade-‐centric nation that had proved itself as a viable

investment opportunity. Past performance was likely the primary reason that the

market’s confidence in Singapore, and FDI inflow volume, was restored so quickly

after the crisis. The case of Singapore seems to indicate that a country with an open

capital account and a strong presence in international financial markets can respond

to crises by implementing mild capital controls. After initially experiencing a drop

in capital flows, a country with an open capital account will likely enjoy a swift

capital inflow recovery.

2.6 Formalizing the Relationship Between KAOPEN & FDI Inflows In order to ascertain the strength of the relationship between KAOPEN and net FDI

inflow volume for my focus countries, I measure the correlation between the two

variables. The correlation is measured during an eleven-‐year period centered on

the year that the respective crises began. It inevitably takes some time for changes

in capital account restrictiveness to reflect in capital flow volume. I lagged the FDI

variable by one year to account for this time delay. If KAOPEN is a robust measure

of capital account openness and an effective determinant of flow volume, there

should be a positive correlation between the index value and FDI inflow volume.

The correlations are displayed in Table 2.

Figure 21: FDI Net Inflows & KAOPEN Values in Singapore, 1992-‐2002 This figure shows annual FDI Net Inflows and KAOPEN Values in Venezuela from 1997-‐2007. FDI Net Inflows are measured in $US Millions.

0

0.2

0.4

0.6

0.8

1

1.2

$0.00

$2,000.00

$4,000.00

$6,000.00

$8,000.00

$10,000.00

$12,000.00

$14,000.00

$16,000.00

$18,000.00

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

KAO

PEN

FDI InHlow Volum

e ($US Millions)



The correlation values indicate a strong positive relationship between

KAOPEN values and net FDI inflow volume in each of my focus countries except for

Vietnam and Singapore. Vietnam and Singapore are unique cases because over the

11-‐year crisis period centered around 1998, both countries made smaller

alterations in their capital controls than the five countries. It is difficult to derive

meaningful correlation values for Vietnam and Singapore given the limited number

of years in the sample and the minimal changes made to each country’s capital

account during that time period. The correlation values are encouraging because

they strengthen the argument that there is an association between the two

variables. It is crucial, however, to acknowledge that the correlation values in no

way imply causation.

Country Correlation

Argentina 0.526 Chile 0.420

Venezuela 0.476

Vietnam -‐0.257

Malaysia 0.556

Indonesia 0.745 Singapore 0.069

Table 2: Correlations Between KAOPEN Values & FDI Inflow Volume for Focus Countries, 11-‐

Year Period Centered on Start of Crisis


3. Conclusion This paper evaluates the impact of capital controls on capital flow volume during a

financial crisis. In general, I find that capital account restrictiveness has a negative

relationship with capital flow volume, specifically net FDI inflows. This relationship

was present for both Latin American and East Asian countries. This relationship

held whether or not a country increased or decreased their capital account

restrictiveness. The relationship also held regardless of a country’s pre-‐crisis

economic vulnerability. I observed that countries with open pre-‐crisis capital

accounts can effectively respond to a regional crisis by imposing mild capital

controls, and then eliminating them after the worst phase of the crisis passes.

My findings suggest that capital account restrictiveness is a more robust

predictor of FDI inflow volume than macroeconomic variables such as GDP growth.

Lessening capital controls during a crisis is more effective at increasing capital

inflow volume than domestic macroeconomic recovery. I find that changes in

capital account restrictiveness do not immediately impact net FDI inflow volume. It

generally takes about one year to observe measureable effects of imposing or

eliminating capital controls on FDI net inflow volume.

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