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Capital Controls: Chile

Nick Rosen

It is somewhat ironic that Chile has become an exemplar for restraining the capital markets. It is better known, after all, as a paragon of radical, free-market economic reform; a Latin paradise for international investors in the 1980s and 1990s. But finding itself flooded with investment inflows, Chilean policymakers discovered that foreign money, like good Maipo Valley wine, can be problematic in excess.

So, at a time when the wave of market liberalization that Chile had once pioneered was sweeping across the developing world, Chile went the other way and imposed precedent-setting capital controls. These controls are often cited as a global model for reducing the volatility of investment flows and protecting the domestic economy against the threat of international financial contagion. They demonstrated their effectiveness during the Mexican crisis of 1995, when numerous countries in the region bled billions of dollars and began to slide into economic disaster, while Chile remained comfortably afloat. But the system – which Chile abolished in 1999 – was not without its detractors; some argue that capital controls robbed Chile of financial liquidity and raised the cost of borrowing for Chilean companies.

The Chilean model is a slightly odd-fitting case-study for the use of capital controls. Unlike most capital-control schemes, which seek to stanch the flow of capital out of the country, Chilean controls were designed to limit the amount of capital coming in to Chile. This seemingly counterintuitive strategy is rooted in the eventful history of the Chilean economy.

In the 1980s and 90s, after General Augusto Pinochet’s military regime toppled socialist president Salvador Allende and brought in American ultra-orthodox economists (the so-called “Chicago boys” named after their Alma mata University of Chicago) to restructure the nation’s economy, Chile embarked on a pioneering free-market strategy: fiscal austerity, far-reaching privatization of state enterprises, tight monetary policy and openness to trade. Chile’s export-led growth, which would come to be known as the “Chilean miracle,” averaged more than 5% a year at a time when other economies in the region were stagnating. Foreign investors, who were just creeping back into Latin America after the debt crisis of the 1980s, found themselves a fertile climate in Chile and brought in their investment capital in droves.

But by the early 1990s, all that investment had become too much of a good thing in Chile—the country became the first victim having to deal with the “challenges of success.” Demand for Chilean assets had driven up the value of the peso so high that it began to threaten the competitiveness of Chilean exports and create undesirable current account deficits.

Furthermore, inflows robbed the Chilean central bank of its ability to use monetary policy. Capital inflows were being exchanged into local currency thus increasing money supply and putting upward pressure on prices. Lowering rates, to discourage inflows, would have only exacerbated the inflation problem. Raising rates, instead—to defend against the inflationary pressures that had so often plagued Chile in the past—was also self defeating since higher interest rates spurred even greater demand for peso-denominated debt instruments, which in turn caused the already lofty peso to move even higher. Put differently, capital flows had robbed the Chilean central bank of its ability to use monetary policy.

Finally, Chilean economists were wary of the fact that a portion of the investment capital inflows was short-term, and thus could quickly leave the country and foment a crisis.

In 1991, Chilean policy makers introduced the “unremunerative reserve requirement” (URR), more commonly known in Chile as the encaje. The measure required financiers to make a non-interest-bearing deposit in the Central Bank valued at 30% of their investment, or pay a one-time 3% fee to recover their deposit. The deposit was required for foreign borrowing (excluding trade credits) and short-term portfolio inflows such as foreign currency deposits in local banks and some forms of foreign direct investment. In essence, the encaje amounted to a tax on investment.

Foreign investors were also prohibited from repatriating their investment for a minimum of three years. This requirement was aimed at changing the composition of Chile’s investment from short-term flows – which are inherently less reliable and prone to “herd behavior” and capital flight – to long-term flows, which are more stable.

Chilean banks and institutional investors faced limits on the size and type of investments they could make abroad. Chile also imposed regulatory requirements for corporate borrowing abroad, and banks were required to report all international capital transactions.

With these controls, Chile sought to relieve the pressure of capital inflows and regain monetary control over interest rates and the value of the peso, while making the composition of investments more stable and long-term.

While capital controls were considered highly taboo among traditional economists, the Chilean model was perceived as a relatively market-friendly approach. In contrast to the ex-post restrictions on outflows imposed by Malaysia years later (considered by some to be like a temporary expropriation), Chile’s controls were viewed as merely preventative “speed bumps” on capital, and less costly to investors and their perception of doing business in Chile.

In their first years, despite the predictions of Chile’s critics in the financial community and Washington, these controls appeared successful – Chile managed to regain monetary controls while suppressing inflation—which declined from 22% to 6% between 1991 and 1997 – and depreciating the peso to make Chilean exports more attractive. And despite the controls, money continued to flow in; Chile received an estimated $6.5 billion in total capital inflows in 1994. And the credits that came into Chile had longer maturities, indicating that the composition of investment was more stable. This would serve Chile well during the “Tequila Crisis” of 1994 and 1995, when countries like Mexico and Argentina, which had thrown open their doors to foreign money, faced massive capital flight. Keeping a firm hand on the quantity and quality of international capital moving across its borders, Chile managed to dodge the financial stampede out of the region. The country would continue to enjoy such a high level of growth and healthy investment that in 1997, as inflows topped $8 billion, the government further strengthened controls, lowering the threshold for investments subject to controls to $100,000 from $200,000. This clamp-down was also a response to the prevalent evasion of controls, as companies sought to access long-term foreign bonds and American Depositary Receipts in the U.S. that faced less or no taxes.

The following year brought a much bigger economic crisis, which ignited in Russia and Asia and soon swept into the Americas. The contagion resulted from panicked flight of short-term capital, causing many – even skeptics at the IMF – to concede that moderate, Chilean-style limits on short-term capital inflows could be helpful to defend against speculation and capital flight.

But just as many were advocating the Chilean recipe, Chile itself was beginning to phase out its capital controls. Despite the country’s strong economic fundamentals, Chile suffered from investors’ apparent inability to discriminate between good and bad credits amidst the tumult and confusion in the emerging markets. Chile’s trade balance was also becoming a concern, as the price of copper and other key export commodities began a sharp descent. Government officials announced reductions in import spending and more strategic devaluations of the peso, which further bothered investors. A speculative attack against the peso ensued and the central bank quickly lost billions in foreign reserves defending the currency, causing some to question just how effective were Chile’s capital controls.

Another problem, say Chile’s critics, arose from Chile’s $30 billion private pension system, which relied heavily on the local stock market for investment. Some believe capital controls had contributed to the dramatic reduction in stock trades in Chile, as buyers and sellers migrated to New York and other stock exchanges to avoid costly regulations. The Santiago bourse could no longer serve the needs of Chilean pensioners, who now faced diminished investment opportunities and higher transaction costs.

Most importantly, though, Chilean companies—once the darling of international investors—were being punished. What had once been a problem of too much capital had now reversed; Chile, like all other Latin American countries, was bleeding foreign money. Even before the crisis of outflows, Chilean firms were facing an estimated 20% higher foreign funding costs as a result of the capital controls. Local businessmen complained that capital controls favored large conglomerates and multinational companies, who could more easily access capital overseas where costs were lower.
In June 1998, Chilean authorities, facing an external financing challenge, finally relented to the pressure. The encaje was reduced to 10% of investment and then further lowered to 0% later in the year (while no deposit was then required, the requirement was kept in place as an emergency measure). In 2001, the encaje was abolished altogether. “You can’t fall in love with these instruments,” claimed Chilean Central Bank head Carlos Massad, explaining that, in the post-Russia/Brazil crises era when foreign capital had become highly skittish, Chile could no longer afford to discourage investment or push up borrowing costs. The “lock-in” requirement of one year was maintained until May of 2000, when it, too, was terminated. By then Chile had begun to phase out the remaining “red tape” requirements that obligated investors to seek authorization for capital flows linked to investments, and restricted companies from seeking foreign currency-denominated debt and American Depositary Receipts (Chilean stocks listed on the New York Stock Exchange).

But after Chile abandoned the last of its capital controls, there was no great surge in investment and growth; economic crisis in Argentina, global downturn and low copper prices have left the country’s growth figures slouching around 3% in 2001, a figure expected to decline to 2% in 2002. With or without capital controls, it seems Chile could not escape the recent decline that has spared no country in Latin America. This ambiguous result has left the reputation of Chilean-style capital controls an open debate. Prominent economists like Sebastian Edwards of UCLA claim that Chile’s controls were ineffective at best, and at worst costly – as the controls sapped investment and dessicated the local stock market. Others, like Columbia University’s Joseph Stiglitz, stand by the model as a prudent strategy to protect developing countries from the increasingly capricious and volatile shifts of global capital beyond a country’s control. The question may linger until other countries venture to buck the trend of capital market liberalization and follow the path blazed by Chile.

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