Friday, July 13, 2007

Regulating Short-Term Capital Flows (A Policy Brief)

Ronald C. Molmisa

This policy brief was prepared as part of the United Nations Research Institute for Social Development's (UNRISD) study entitled "Global Civil Society Movements: Dynamics in International Campaigns and National Implementation." The Philippine country study examined five contemporary civil society movements that deals with debt, international trade rules and barriers, global taxation, corruption, and fair trade.


The series of capital account crises in 1990s (i.e. ASEAN, Brazil, Mexico) highlighted the need for emerging economies to reduce their dependence on foreign capital. There has been a heightened interest, among economic managers, in mechanisms and institutions to effectively manage short-term capital flows, which can threaten and undermine countries’ socio-economic well-being. Capital controls, if effectively used by the state, can be beneficial to the economy in several ways (Singh 2000, 136-1139). They can protect and insulate the domestic economy from volatile capital flows and other negative externalities. Capital account regulation is critical for the enhancement of domestic savings and investment. Imposition of capital controls increases the bargaining power of countries to negotiate with the private sector and multilateral institutions wherein a country asserts its ability to shape economic policy. By influencing the exchange rate, governments can maneuver the terms of trade in order to protect domestic products from external competition (i.e. devaluing exchange rate to boost exports). Capital controls can also help in saving foreign exchange for debt servicing, imports and capital goods. Governments can also generate much-needed revenues through tax-based investment controls, custom duties, and controlled exchange rates, among others. The type of capital controls to be implemented, however, depends on the nature of financial flows and the institution through which the capital is flowing. For instance, capital controls on the banking sector will be different from the non-banking sector (e.g. capital markets) because of their peculiar characteristics and distinct regulatory agencies (Singh 200, 125).

The Philippine government’s liberalization of capital accounts requires reexamination given the unpredictable character of the global financial market. One serious policy error the Philippines Central Bank (BSP) committed before and during the early years of the 1997 Asian financial crisis was the protection of peso to project a strong economy. In parallel to the uncontrolled surge of portfolio investments, BSP purchased large amount of dollars which overvalued the country’s currency. It exacerbated the worsening trade deficit during the period. Thereafter, there was a widespread realization that depreciating the peso was imperative to reveal the real exchange rate. This can be pursued by discouraging short-term capital flows.

Prudent regulations and strong financial institutions are considered the best protection against currency and banking crises. But since these measures may take time to realize, short-term capital controls must be properly established (WBGDF 2000). These controls can accomplish two goals: 1) reduce (but not eliminate) the volatility of flows and 2) reduce (but not eliminate) the discrepancy between private and social returns (Reyes-Cantos 1999). They are appropriate “where financial markets are thin, the private sector’s risk-management practices are underdeveloped, and the regulators’ capacity to supervise the financial sector is limited – in other words, where the conventional defences against systemic risk are not enough” (Eichengreen 1998). The following section is a cursory look at current policies of the government relating to capital controls. Succeeding part discusses the different strategies that the government can adopt in managing capital inflows and outflows. These models throw “sand in the wheels” of global finance which can protect the country from any financial market reversals.

Current Policies on Capital Controls

The government maintains a liberalized policy on external current and capital account transactions. The Arroyo government’s Medium-Term Development Plan (MTPDP) for the period 1999-2004 and 2004-2010 recognize that reliance on volatile capital flows---short term debt and investment--can destabilize the foreign exchange market and the financial system. They, however, have failed to institute policies on capital controls pertaining to the external sector. The documents reveal that country will continue to liberalize and deregulate many of its industries in the future. Government financial reforms focus more on strengthening the regulatory framework and promotion of a market-determined exchange rate. Nine years after the crisis, no significant capital control mechanisms are instituted (e.g. mandatory deposits, taxes on significant foreign exchange transactions) to protect the country from massive capital flight.

In January 2004, BSP eased the rules on dollar investments by allowing foreign investors to recover their dollar investments in the stock market with certain conditions (Ferriols 2004). Learning from the Asian crisis, BSP allows investors to convert the peso proceeds of their stock investments into dollars provided the original stocks were bought with dollars. The dismantling of restrictions on the outflow of dollars from the stock market is envisioned to manage speculative capitals which can cause instability in the peso-dollar exchange rates. Following are the existing government policies relating to foreign exchange transactions and foreign investments (BSP 2005, 2006).

    • Any person or firm can purchase foreign exchange (FX) with pesos from banks in the Philippines for outward remittances to pay for FX obligations to payees abroad provided supporting documents required under Bangko Sentral ng Pilpinas’ (BSP) rules are presented to the FX selling bank. Such obligations may include payment of importations and non-trade FX obligations such as medical expenses incurred abroad, or servicing foreign loans or investments. BSP registration is required for foreign loans or investments before these can be paid/serviced using FX purchased from banks.
    • The minimum documentary requirements for the sale of FX by banks, non-bank BSP-supervised entities and their affiliate/subsidiary forex corporations are contained in Circular-Letter dated 24 January 2002 (for payment of import obligations) and Circular No. 388 dated 26 May 2003 (for non-trade transactions).
    • Imports of gold in any form is allowed without restriction except for coin blanks, essentially of gold, which require prior BSP approval, and for any article manufactured in whole or in part of gold, the stamps, brand or marks of which do not indicate the actual fineness of gold quality, which is prohibited. Exports of gold in any form is likewise allowed except for gold from smallscale mining or panned gold, which is required to be sold to the BSP pursuant to Republic Act No. 7076 dated 27 June 1991.
    • Registration of imports under Documents against Acceptance (D/A) and Open Account (O/A) to be paid with foreign exchange purchased from a Philippine commercial bank is no longer required. Instead, such imports need only to be reported to BSP through banks prior to payment, in accordance with BSP existing rules.
    • A person may, without prior BSP approval, import or export, or bring in or out of the country, or electronically transfer legal tender, Philippine notes and coins, checks, money orders or other bills of exchange drawn in pesos against banks operating in the Philippines in amounts not exceeding P10,000.00. Prior authorization from the BSP is required for larger amounts.
    • Regarding the amount of foreign currency that a person may bring in or out of the Philippines, there is no such restriction or limit on the amount but a person bringing foreign currency in or out of the country in excess of US$10,000.00 or its equivalent must declare this in writing by accomplishing a BSP Foreign Currency Declaration Form available at the Bureau of Customs desk in the arrival/departure areas of all international airports/seaports. Traveler’s checks in any amount are exempted from such declaration requirement.
    • The registration of foreign/non-resident investments with the BSP is not mandatory. It is required only if the FX to pay for future repatriation of the capital and outward remittance of dividends/profits thereon will be purchased from banks in the Philippines. BSP had delegated to commercial banks the registration of foreign investments in shares of stock listed in the Philippine Stock Exchange (PSE) purchased thru the PSE trading floor.
    • Registration will authorize the investor to purchase FX from the Philippine banking system to service repatriation of capital and/or remittance of dividends/profits/earnings from registered investments. The BSP registration document is part of the prescribed documents to support an application to buy FX from banks.
    • Basic requirements for registration
      • First, as a general rule, there must be an inward remittance of FX, which should be converted to pesos thru a bank in the Philippines as evidenced by a duly accomplished BSP-prescribed Certificate of Inward Remittance (for cash investments) or, proof of transfer of assets to the investee/beneficiary firm in the Philippines (for investments in kind).
      • Second, there must be evidence of receipt of the funds/assets by the local investee/beneficiary/seller such as Sworn Certification of such receipt and issuance of shares in consideration thereof (for investment in stock corporations); stockbroker’s purchase invoice or subscription agreement (for PSE-listed shares acquired through the PSE trading floor); accredited dealer’s Confirmation of Sale (for government securities); Certificate of Time Deposit (peso time deposits with tenor of 90 days or longer); and contract (for money market instruments).
    • Foreign investments in peso time deposits with banks can be registered with the BSP provided that the deposits were funded by an inward remittance of foreign exchange, which was converted into pesos thru the Philippine banking system. In addition, the time deposit has to have a maturity of 90 days or longer.

Policy Options and Recommendations

Control on Inflows

Controls on inflows must be implemented to maintain the country’s autonomy in monetary policy. This can be accomplished by imposing ceilings on investments and loans, implementing capital gains tax, setting minimum period of stay or applying reserve requirements for incoming investments. By practice, controls on inflows are easier to implement than controls on outflows. Nonetheless, they have been proven effective only if applied in the short-run as preemptive and corrective measures. Otherwise, they can become distortionary and be subject to the arbitrary behavior of market players.

Chilean Unremunerated Reserve Requirement (URR)

The Chilean capital controls strategy is instructive. In June 1991, the country introduced what became known as an unremunerated reserve requirement (URR) or encaje on new capital inflows. These restrictions aimed to reduce inflation brought by the surge of capital in 1980s and maintain export competitiveness. A rate of 20 percent was applied to all portfolio capital to be held in a non-interest bearing account with the central bank for up to one year. A year after, the rate was raised to 30 percent for foreign currency borrowing except by corporations. By August 1992, the rate was applied to all transactions. The rate was lowered to 10 percent in June 1998 before being zeroed out in September 1998 (Ariyoshi et al. 2000). The government also imposed a stamp tax of 1.2 percent for short-term foreign lending with a maturity of one year or less. The country experienced an impressive 8.5 percent average annual growth during the period encaje is in place.

The Fabella Proposal

UP School of Economics Professor Dr. Raul Fabella’s proposed a “time-graduated capital gains tax” to target foreign and local speculators in stock and real estate market (Fabella 1998). It aims to minimize, if not totally prevent asset bubble formation. The proposal can be summarized as follows:

1. A capital gains tax of 100 percent of all capital gains in excess of the 91-day T-bill rate if the stock or real property is sold in less than a year after purchase

2. 70 percent of capital gains in excess of the 91-day T-Bill rate compounded two years if the sale is done between the first and second year of purchase

3. 50 percent of capital gains in excess of compounded 91-day T-Bill rate r(1+r)(1+r) if the sale is done after the 2nd and 3rd year of purchase.

4. a flat 15 percent capital gains tax thereafter

Stiglitz Proposal

World Bank Chief Economist and Nobel Prize Laureate, Joseph Stiglitz, suggested a limit on the extent of tax deductibility for interest in debt-denominated or foreign-linked currencies. This is to discourage too much dependence on foreign borrowings and resolve the country’s problem on short-term indebtedness. It must be noted that Chapter 7 section 34B of the National Internal Revenue Code of the Philippines provides for the deduction of interest expense from one’s gross income. As explained by Reyes-Cantos (1999:22), “the amount deductible shall be reduced by an amount equal to a declining percentage of interest income subjected to final tax. The rate is 41% starting 1998, 39% for 1999, and 38% for 2000. A further downward adjustment of the rate can therefore be put into effect for the interest expense on foreign currency-denominated loans” (Reyes-Cantos 1999,22).

International Tobin Tax

The Tobin tax (inspired by a proposal by former Yale University professor and Nobel Laureate James Tobin) is essentially a permanent, uniform, ad valorem Global civil society organizations have used the tax to achieve two fundamental goals: 1) curb speculative short-term capital flows in the foreign-exchange market which produce volatile exchange rates, and 2) increase the national macroeconomic and monetary policy autonomy of global economies. It is important that the tax be implemented in the regional level (i.e. ASEAN or EU) to prevent capital from going to tax-free territories. Tobin tax was first promoted by the United Nations Development Program (UNDP) during the preparations for the 1995 World Summit on Social Development, held in Copenhagen, Denmark. But the unfavorable response of Washington to the proposition stalled any UN plan to seriously scrutinize the proposal. Several studies have proven the feasibility of the tax (Kaul and Langmore 1996, Patomaaki 1999, OXFAM GB 2001, Griesgaber 2003) transactions tax on international foreign exchange (forex) transactions. The percentage of tax being imposed is inversely proportional to the length of the transaction (i.e., the shorter the holding period, the heavier the burden of tax). For instance, a tax of 0.25 percent implies that a twice daily round trip carries an annualized rate of 365 percent; while a round trip made twice a year, carries a rate of 1 percent. Hence, for a tax rate of 0.1 percent or $1,000 per million dollars sold, it could cost a daily or weekly speculators tax of 10 to 50 percent on their investment.

Control on Outflows (Malaysian strategy)

Controls on outflows should be implemented whenever the country has to contend with dwindling foreign exchange reserves and speculative attacks on currency. This should only be utilized during the height of a financial crisis. The classic example of this strategy was made by the Malaysian government. Malaysia’s controls on capital outflows were implemented to safeguard the gains of the country prior to the 1997 financial crisis. The surge of capital between 1990 to 1993 forced Malaysian authorities to put temporary restrictions on speculative inflows in 1994 which, unexpectedly, led to the rise in dollar interest rates and decline in capital inflows. To safeguard the economy from further financial instability, capital outflows controls were installed by tightening monetary policies, slashing government expenditures and postponing the implementation of mega-projects. Several measures allowed a progressive reduction in interest rates without affecting the exchange rate or inducing capital flight. The strategy includes fixing of the ringgit to 3.8 to a dollar, repatriation of ringgit held abroad, ending of offshore trading in ringgit instruments, retention of the proceeds of sales of Malaysian securities in the country for a year, payment in foreign currency for imports and exports, among others (Lamberte 1998). Capital controls in Malaysia introduced two benefits. First, it ensured greater policy autonomy in lowering interest rates. Second, capital controls provided the economy elbow room to pursue economic adjustments and accelerate structural reforms necessary for sustained economic recovery (Masahiro and Takagi 2003,13).

Simultaneous Controls on Inflow and Outflow (Chinese strategy)

China managed to shield its economy from the 1997 Asian financial crisis because of its strict capital controls (Singh 2000, 144-145). These mechanisms provided the country a foreign exchange reserves totaling $150 billion, $40 billion trade surplus and a $40 billion capital account surplus at the end of 1998. Interest rates in the country were significantly reduced during the crisis period. The Chinese government maintained a fixed exchange rate and independent monetary policy. Emphasis was made on attracting long-term investments (i.e. FDIs) and curbing portfolio and other short-term speculative inflows. Key elements of controls on inflows include the universal requirement for registration and strict criteria of approval. All inward FDIs must seek approval from relevant state agencies. Investors can only open foreign exchange capital accounts in designated banks sanctioned by the government to engage in foreign exchange activities. As for the outflows, there was a tight control over the use of foreign exchange. All outward FDIs must be registered. All their incomes need to be repatriated back to China within six (6) months of the end of fiscal year of the host country. Foreign exchange required for offshore business operations can be kept after obtaining approval of Chinese authorities. Chinese residents were not also allowed to borrow from foreign banks and other financial institutions. They are not also allowed to open personal foreign exchange accounts abroad.


The above-cited measures are not necessarily mutually exclusive. The challenge is to come up with a policy design that incorporates their paramount strengths in different contexts. It must be emphasized that they should only “complement and not supplant” other reform measures like sound prudential regulation and consistent monetary and fiscal policies (Reyes-Cantos 1999,25) . The government must “reduce it dependence on foreign capital, rapidly enlarge domestic savings and use its domestic resources judiciously” (Sta. Ana 1998, 110). Admittedly, there is challenge of striking a balance between reducing the inflow of portfolio investments and encouraging the entry of foreign direct investments (FDIs), which are more permanent and more beneficial to the economy.

Sequencing and timing are important in short-term capital regulation. It is recommended that the Philippine government follow the footsteps of China in managing the entry and exit of foreign capital. At present, the Philippine government can pursue the above-cited capital controls on inflows. It is imperative that they are instituted before a financial crisis. Implementing the mechanisms otherwise may be detrimental to future investments. Controls on outflows, however, must be applied only in times of speculative attacks on the country’s currency. Similarly, they must be “time-bound” since they should only act as corrective measures.

Overall, the implementability of the proposed measures hinges on the administrative capacity of the government. It must be noted that Malaysia’s capital controls proved to be successful because of the presence of strong regulatory institutions. In similar vein, the Chilean strategy could not have been effective without the earlier reforms implemented by the government such as the restructuring of banking system, enacting fiscal policies for budget surpluses and reduction of public debt.


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