Analysis of the Effectiveness of Existing Capital Controls and Alternative Policies for Mitigating Volatility of Capital Flows

This paper consists of two parts. In the first part, we evaluate the effectiveness of capital controls adopted by 16 emerging economies. The results show that among direct controls, indirect controls, capital controls(either direct or indirect), and prudential-type measures, none of them proved to have a significant effect on reducing inflows of investments prior to the global financial crisis. After the financial crisis, however, capital controls showed significant effects. Direct controls and capital controls(either direct or indirect), as well as prudential measures were found to have noticeably reduced foreign inflows through debt securities, and portfolio and combined(portfolio plus other investments) investments. In the second part, we propose a Conditional Financial Transaction Tax(hereafter “CFTT”) which can help resolve issues with current capital control measures. CFTT works by imposing taxes at a predetermined rate on foreign capital inflows that exceed a certain level. In the case of Korea, we propose that foreign portfolio investors be subject to taxation(pursuant to a “CFTT Act”) for any net foreign capital inflows that exceed the historical monthly average plus ∝ (e.g. 1.5×the standard deviation) for two consecutive months, provided that if foreign capital flows become net outflows for a certain period, CFTT is automatically suspended. By imposing taxes equivalent to the arbitrage opportunities that arise from interest arbitrage trading(i.e. exploitation by traders of the disparities between swap rates and between domestic and foreign interest rates, etc.), unwanted inflows of “hot money”(funds from overseas that induces excess volatilities of capital movements) can be controlled and restricted.