When one thinks about capital controls in Latin America, Chile is the country that usually comes up to mind. Colombia has also been a “champion” in these types of distortions. Since 1998 Colombia has had three rounds of bureaucratic creativity on capital controls. From 1998 to 2000 and from May 2007 until today, controls have been oriented to unremunerated reserve requirements on capital inflows. During the first round the reserve requirement was of 25% of the inflow (portfolio investment or short term foreign debt) and lasted for 12 months. This was later reduced to 10% during a 6 month period. Since May 2007 the reserve requirement was on 40% of the portfolio or short term debt inflow during a 6 month period. Between these two there was a restriction of no inflows for investments with a lower than 12 month duration. This policy lasted from December 2004 to June 2006.
Recently both the Central Bank who regulates debt flows and their controls as well as the Ministry of Finance in charge of regulating portfolio flows have eased the controls slightly. Nonetheless they are still there. Why? Difficult to answer.
Last week Fedesarrollo, a local think tank, organized a debate on the impact of recent capital control policies in Colombia. Several analysts were invited as well as public sector officials. Unfortunately, Central Bank officials did not attend. I had the privilege of being one of the panelists, and presented preliminary results of a paper that hopefully will be released in January 2008 on the impact of capital controls on capital flows, the real exchange rate and financial volatility. The results of this paper are not much different from what has been found elsewhere, and are very much in line with the perception of the other panelists that included market participants, the director of the Public Debt Department of the Ministry of Finance, and the head of Fedesarrollo.
The results of our paper suggest that capital controls have not had any significant impact on the level of the real exchange rate or on capital inflows, especially when controlling for external factors such as the global EMBI spread or the VIX. Capital controls have had a very small transitory effect on short term capital inflows that vanishes pretty fast. These results are found using a structural VEC (vector error correction) model that includes industrial production, the real exchange rate, capital flows (total in some specifications and disaggregated in others), external financial conditions, and different proxies for capital controls. Using GARCH models we find that capital controls have had some impact on the volatility of the nominal exchange rate, but again, not on its level. As stated, this evidence supports findings for other countries, most notably Chile.
One might think that if they do not reach their goals, which in Colombia were reducing short term inflows and containing currency appreciation, it is costless to maintain them. Well, not necessarily. One at least has to wonder if they might have harmed the development of private capital markets. In Colombia both private bond markets and the stock market are particularly tiny. A study presented by Valores Bancolombia, a local market participant, in the same panel, shows that capital controls have in fact limited the possibility of their development, in the context of a very strong development in other countries of the region, such as Brazil.
So why do capital controls remain despite the evidence against them? Unfortunately the main Central Bank officials who could give us some answers did not to attend the debate. Nonetheless a highly ranked staff member of one of the technical departments of the Central Bank did attend, and provided a realistic, but very sad reason for monetary authorities to keep them. According to this person removing capital controls would increase President Uribe’s pressure on the Central Bank to intervene in the foreign exchange market to reduce the exchange rate’s appreciation, and this could interfere with the inflation targeting policy. In other words, Colombia has to live with capital markets distortions because the Central Bank feels unable to manage its independence properly. Somehow, this does not sound as the best possible justification for adopting policies, and I guess it suggests a strong need to revise Colombia’s monetary arrangements.