Capital controls have been largely criticized in the literature, both for their ineffectiveness and for creating market distortions. Some governments in the 1990’s commonly used them, as an instrument to control short-term investment flows, in order to reduce the vulnerability of the economy, and to prevent financial crisis. More recently, countries like Colombia have imposed capital controls to limit excessive short-term inflows that will cause high currency appreciation. These controls, which require foreigners to make a deposit of 40% of their portfolio investment for six months at the Central Bank without earning interests, have been ineffective in stopping the strengthening of the peso, and have had a negative impact in the equity market.
After experiencing a very important growth between 2002 and 2006, when daily trading volume went up from US$2 million to US$50 million, and market capitalization increased six-fold, last year the Colombian stock market had a very poor performance, and in 2008, the IGBC index is down by 12%, the worst one in Latin America. This can be partially explained by the fact that the market is highly concentrated in local participants, accounting for 97% of daily transactions, 50% of which are retail investors. On the other hand, no more than 20 stocks are considered to be liquid and traded on a daily basis with volumes higher than US$1 million. Last year was a historic one for the Country’s stock market in terms of IPO’s. More than US$5 billion were raised by Colombian companies through equities and the biggest IPO ever took place, when Ecopetrol, the state-owned oil company issued 10% of its shares, for US$2.5 billion. This amount was absorbed entirely by local investors, and close to 500.000 Colombians are now new shareholders of Ecopetrol. Retail investors bought 62% of the stocks and Pension funds acquired 37% of this issuance. Immediately after the stock began trading in November 2007, market capitalization increased by 50%. But contrary to what was expected, liquidity did not increased proportionally, and the rest of the stocks prices decreased by the end of the year, as a lot of retail investors reduced their positions in those equities to buy Ecopetrol.
In 2008, the market is down by 12% and retail investors have been net sellers in the market, reducing the portion of their portfolios invested in equities by US$D187 million. On the other hand, institutional investors (including pension funds and insurance companies) have been net buyers, acquiring more than US$200 million in stocks between January and March. Only Ecopetrol and some energy and mining stocks have had a positive year-to-date return, while the rest of the stocks are still in negative terrain, and volatility in the market has been very high.
What this situation shows is that the Colombian market needs to diversify its participants in order to reduce volatility, since relying only in local buyers and sellers is very risky. In fact, countries like Brazil, where 35% of daily transactions are made by foreign investors, and who bought on average 70% of the IPO´s in that country last year, have recovered more rapidly from the recent crisis. The Bovespa Index is up by 1% in 2008, after falling by 11% at the beginning of this year.
But more importantly, we should mention that the Colombian peso has appreciated by 10.5% against the dollar since January, and by 16% in the last 12 months. The main cause of the revaluation of the peso is the big inflow of Foreign Direct Investment, which reached more than US$9 billion in 2007. Last year, foreign portfolio investment was close to US$1.5 billion and less than USD100 million in the last quarter, while during the same period FDI reached US$2.5 billion.
Therefore, capital controls in Colombia have been ineffective in stopping the appreciation of the currency, and have created distortions in the equity market, increasing its volatility. At the end of last year, the government announced some relaxations for the controls, including the elimination of the restriction for IPOs´. While this is a first step in the right direction, it is far from sufficient. An elimination of all restrictions, at least as far as equities are concerned, is necessary to promote the liquidity, transparency and proper operation of the stock market in Colombia.