Magnitude of externalities
Our theory of externalities based on financial vulnerabilities provides a clear framework to determine the optimal magnitude of policy measures. The reason why capital inflows expose an economy to financial fragility is that they may reverse precisely when the economy is experiencing financial difficulty and trigger the described feedback loops.
Different forms of capital inflows result in different probabilities of future capital outflows with different payoff characteristics in the event of a crisis, which in turn leads to different externalities. Optimal macro prudential policy should aim to precisely offset these externalities.
If an emerging economy takes on dollar debts and subsequently experiences a financial crisis, the exchange rate depreciates and the domestic value of the debt increases sharply, implying that dollar debt imposes a large negative externality. CPI-indexed debt protects borrowers against the risk of exchange rate fluctuations, imposing smaller externalities. Local currency debts and portfolio investments play an insurance role, since the value of the local currency and equity markets tend to go down during crises. Finally, non-financial foreign direct investment often stays in the country when a financial crisis hits; in those instances it does not impose any externalities.
In Figure 2, we report a sample estimation of the annual magnitude of externalities created by various types of capital inflows to Indonesia (see Korinek 2010b for a detailed description of the analytical method employed). For each type of capital flows, the blue bar to the left represents the average magnitude of externalities over the past two decades, whereas the red bar on the right captures the externalities imposed during the 1997/98 financial crisis.
Figure 2. Externalities of different types of capital inflows
Dollar debt, for example, imposed a long-run average externality of 1.54% annually on the Indonesian economy over the past two decades. However, during the East Asian crisis of 1997/98, the externality reached 30.70%, justifying a tax of equal magnitude on the eve of the crisis.
More generally, optimal policy measures on capital inflows should be regularly adjusted for changes in the financial vulnerability of the economy (see Jeanne and Korinek 2010). The externalities of foreign capital rise during booms when leverage increases and financial imbalances build up. After a crisis has occurred and economies have de-levered, new capital inflows create smaller externalities, justifying a zero tax in bad times when a country seeks to attract more capital. Optimal capital flow regulation should therefore be strongly procyclical. For dollar debt, a tax of between 0 and 30%, with an average of 1.5%, can be justified for the case of Indonesia.
The maturity structure of debt flows also plays a crucial role. International creditors often refuse to roll over short-term debt when financial conditions in an emerging economy deteriorate, creating a large risk of instability. On the other hand, long-term loans cannot be recalled before their maturity date.
Design and implementation issues
While the theoretical case for capital controls is compelling, the practical implementation poses a number of challenges in today’s globalised financial markets where multinational companies and armies of traders seek to arbitrage around any hurdle that policymakers throw in the way of free capital flows. An essential aspect in designing capital controls is therefore to think about how to minimise possibilities for evasion or corruption.
