Capital Flow Deflection Paolo Giordani (Luiss), Michele Ruta (IMF), - PowerPoint PPT Presentation

I NTRODUCTION M ODEL E MPIRICAL C ONCLUSION A PPENDIX Capital Flow Deflection Paolo Giordani (Luiss), Michele Ruta (IMF), Hans Weisfeld(IMF), Ling Zhu(UMD) May 12, 2014

I NTRODUCTION M ODEL E MPIRICAL C ONCLUSION A PPENDIX A VERAGE G ROSS I NFLOWS (% GDP) TO D EVELOPING C OUNTRIES BY R EGION 35# La,n#America# 30# Middle#East#and#North# 25# Africa# 20# Asia# 15# Sub!Sahara#Africa# 10# Former#Soviet#Bloc# 5# Central#and#East#Europe# 0# 1995# 1997# 1999# 2001# 2003# 2005# 2007# 2009# !5#

I NTRODUCTION M ODEL E MPIRICAL C ONCLUSION A PPENDIX M OTIVATION ◮ Capital inflows to developing countries are increasingly large and volatile. ◮ Capital controls can be used as prudential policy ◮ Open questions: ◮ what are the spillover effects of capital controls? ◮ what multilateral institutions do countries need to govern capital flows?

I NTRODUCTION M ODEL E MPIRICAL C ONCLUSION A PPENDIX B RAZIL ’ S C ONTROLS AND S OUTH A FRICA ’ S F LOWS 14" 1.2" 12" 1" 10" 0.8" 8" 6" 0.6" 4" 0.4" 2" 0.2" 0" 1990" 1991" 1992" 1993" 1994" 1995" 1996" 1997" 1998" 1999" 2000" 2001" 2002" 2003" 2004" 2005" 2006" 2007" 2008" 2009" 2010" 2011" 2012" )2" 0" South"Africa's"Gross"Inflows"(%"GDP)" South"Africa's"Inflow"Controls" Brazil's"Inflow"Controls" Note: The left vertical axis provides scale for gross capital inflow as percentage of GDP. The vertical right axis provides the scale for Schindler’ measure of inflow controls.

I NTRODUCTION M ODEL E MPIRICAL C ONCLUSION A PPENDIX T HIS P APER ◮ Start from a simple two-period model of optimal capital controls ◮ Capital flow deflection: inflow restrictions in some countries can increase capital inflows to others ◮ Policy response: controls can trigger more controls ◮ Investigate empirical evidence of these multilateral effects ◮ Using panel data for a large sample of LIC/EM, 1995-2009

I NTRODUCTION M ODEL E MPIRICAL C ONCLUSION A PPENDIX C ONTRIBUTION ◮ We formalize capital flow deflection and the subsequent policy response. ◮ We provide the first cross sectional empirical evidence for spillover effects of capital controls. ◮ We find strong evidence of capital flow deflection to countries with similar economic characteristics. ◮ Notwithstanding these strong cross-border spillover effects, we find no evidence of policy response.

I NTRODUCTION M ODEL E MPIRICAL C ONCLUSION A PPENDIX R ELATED L ITERATURE ◮ Theory of optimal capital controls: Korinek (2014), Costinot et al. (2013) ◮ Empirical evidence of spillover effect of capital controls: Forbes et al. (2012), Lambert et al. (2012) ◮ Multilateral rules for capital controls: Jeanne (2012), Ostry et al. (2012) ◮ Determinants of capital flows: Forbes and Warnock (2012), Ghosh et al. (2013) ◮ Determinants of capital controls: Fratzscher (2012), Fernandez et al. (2013)

I NTRODUCTION M ODEL E MPIRICAL C ONCLUSION A PPENDIX R OADMAP ◮ A simple model of optimal capital controls ◮ Empirical evidence of multilateral effects of capital controls ◮ Conclusion

I NTRODUCTION M ODEL E MPIRICAL C ONCLUSION A PPENDIX Model

I NTRODUCTION M ODEL E MPIRICAL C ONCLUSION A PPENDIX A S IMPLE T WO -P ERIOD M ODEL ◮ Multi-country world ( i =1,.. . ,n) lasting for two periods ( t = 1 , 2). ◮ Endowment of tradable goods y i t . ◮ Unit mass of identical consumers in country i maximize U i ( c i 1 , c i 2 ) = u ( c i 1 ) + β i u ( c i 2 ) + e ( C i 1 − Y i 1 ) , s.t. ( c i 1 − y i 1 )( 1 + τ i ) R = y i 2 − c i 2 + T i where τ i is the capital control in country i . ◮ e ( · ) captures the negative externality associated with aggregate capital inflows, e.g. financial fragility

I NTRODUCTION M ODEL E MPIRICAL C ONCLUSION A PPENDIX S OCIAL P LANNER ◮ Social planner in country i chooses { c i 1 , c i 2 } to maximize the social welfare function W i t ( c i 1 , c i 2 ) = u ( c i 1 ) + β i u ( c i 2 ) + e ( c i 1 − y i 1 ) , ◮ Individual consumers do not internalize the negative externality while the social planner does. ◮ The externality provides an efficiency rationale for capital controls.

I NTRODUCTION M ODEL E MPIRICAL C ONCLUSION A PPENDIX O PTIMAL P OLICY ◮ Unilaterally optimal capital controls are: 1 + τ i ∗ = ( 1 + ˆ τ i )( 1 + ˜ τ i ) ◮ Prudential motive: � x ′ ( c i 1 − y i 1 ) when c i 1 − y i 1 > 0 � τ i = u ′ ( c i 1 ) − x ′ ( c i 1 − y i 1 ) when c i 1 − y i 0 1 ≤ 0 . ◮ Terms of trade motive: ˜ τ i = m i ǫ − i , where m i is the size of country i . ǫ − i is the inverse elasticity of global savings faced by i .

I NTRODUCTION M ODEL E MPIRICAL C ONCLUSION A PPENDIX D EFINITION OF W ORLD M ARKET E QUILIBRIUM ◮ A world market equilibrium is defined as the gross real world interest rate R ∗ and each country’s consumption plan and capital controls { c i 1 , c i 2 , τ i ∗ } n i = 1 that satisfy u ′ ( c i 1 ) = β i R ∗ u ′ ( c i 2 )( 1 + τ i ∗ ) , 1 ) = ( y i 2 − c i 2 ) ( c i 1 − y i , R ∗ � n m i ( y i 1 − c i 1 ) = 0 , i = 1 1 + τ i ∗ = ( 1 + � τ i )( 1 + � τ i ) .

I NTRODUCTION M ODEL E MPIRICAL C ONCLUSION A PPENDIX C APITAL F LOW D EFLECTION ◮ Let Ω denote the set of borrowing countries, and group S ⊆ Ω with i belonging to group S . ◮ A rise in the capital controls in the group S − i = S \ { i } causes an increase in capital inflows to country i : � c i 1 ( R , τ i ) − y i d 1 ] > 0 d τ S − i ◮ Intuition: capital controls create a spillover effect on other borrowers

I NTRODUCTION M ODEL E MPIRICAL C ONCLUSION A PPENDIX C APITAL F LOW D EFLECTION Borrowing"country"i" Borrowing"countries"S 6i" World"market" R" R" R" CFS" τ S6i" R*" R*’" CFD" CFD S6i" CFD’" CFD i" A" B’" B" C" D" D’" E" F’" F" DD’ is the capital flows deflected to country i .

I NTRODUCTION M ODEL E MPIRICAL C ONCLUSION A PPENDIX P OLICY R ESPONSE ◮ A rise in capital controls in the set of countries S − i induces policy response in country i such that: d � τ i ) + d � d τ i ∗ τ i τ i d τ S − i ( 1 + � d τ S − i ( 1 + � τ i ) , d τ S − i = where m i d ε − i d τ S − i = d � d � d � τ i τ i τ i dR ∗ d τ S − i d τ S − i = − (i) d τ S − i > 0 and (ii) ≶ 0 . m i d ε − i dR τ i − 1 d � ◮ Intuition: capital flow deflection induces more prudential capital controls.

I NTRODUCTION M ODEL E MPIRICAL C ONCLUSION A PPENDIX M ULTIPLIER E FFECT ◮ A shock to the set of countries S ⊆ Ω causes a prudential policy response of each country i ∈ S such that | d � d ρ | = | ∂ � ∂ρ + d � d τ S · d � d ρ | > | ∂ � τ i τ i τ i τ S τ i dR ∗ ∂ρ | dR τ and R ∗ creates a ◮ Intuition: the complementarity between � chain reaction amplifying the policy response to the shock.

I NTRODUCTION M ODEL E MPIRICAL C ONCLUSION A PPENDIX M ULTIPLIER E FFECT R E E’ E’’’ E’’ F R D › b fi b › R , _ fi b › R , _ v fi b

I NTRODUCTION M ODEL E MPIRICAL C ONCLUSION A PPENDIX Do Capital Controls Deflect Capital Flows and Lead to a Policy Response?

I NTRODUCTION M ODEL E MPIRICAL C ONCLUSION A PPENDIX D ATA ◮ Sample countries: ◮ Focus on LIC/EM where capital controls are used as a policy tool ◮ 78 countries − select those with at least 10 years of observations for all variables ◮ Country sample is larger (131) when computing τ S − i . ◮ Sample period: ◮ Annual data from 1995-2009 ◮ Constrained by the inflow control data (Schindler, 2009)

I NTRODUCTION M ODEL E MPIRICAL C ONCLUSION A PPENDIX E MPIRICAL S TRATEGY : C APITAL F LOW D EFLECTION ◮ Pull-push model with spillover variable: t − 1 + β 3 τ S − i ω i t = β 0 + β 1 R t + β 2 τ i + β 4 x i t + u i t t ω i t denotes country i ’s gross inflows as a share of GDP. τ S − i denotes the spillover variable–inflow controls in the t set of countries S − i ; it is computed as � j ∈ S − i y j t τ j t τ S − i = � t j ∈ S − i y j t y i t is real GDP, x i t is a vector of the rest pull-push factors, and u i t is the error term.

I NTRODUCTION M ODEL E MPIRICAL C ONCLUSION A PPENDIX C APITAL F LOW D EFLECTION ( S − i IS THE ENTIRE SAMPLE EXCLUDING i ) (1) (2) Expected Signs Global Push Factors Real US interest rate -0.337** - (0.152) VIX -0.132*** - (0.0490) Domestic Pull Factors (all lagged) Real GDP growth rate 0.595*** 0.504** + (0.188) (0.194) Real GDP growth rate shock -0.434** -0.406* - (0.209) (0.207) Real GDP per capita (logged) 0.652 0.481 + (0.571) (0.565) De jure Capital inflow control -2.468* -2.455* - (1.341) (1.440) Composite risk index 0.150** 0.143** + (0.0647) (0.0646) Spillovers ROG's inflow control 23.00*** 8.013 + (5.807) (27.50) Year fixed effects No Yes Observations 1,007 1,007 R-squared 0.135 0.167