Capital restrictions can be tamed, but not timed

By Vikram Barhat | October 26, 2011 | Last updated on October 26, 2011
3 min read

Awareness of capital control tools and a road map for when they’ll likely be implemented can reduce uncertainty and help investors anticipate some of the structural changes that can impact cross border fixed-income portfolios.

Uncertainties abound and things are changing pretty quickly, said Tina Vandersteel, fixed-income portfolio manager at Grantham, Mayo, Van Otterloo & Company, at the recent CFA Institute Conference in Boston, Mass.

Using the Mundell-Fleming’s Impossible Trinity model—a framework to describe policy choices of global central banks—as a reference point, Vandersteel said countries can use a combination of fixed-exchange rates, free capital movement and independent monetary policy to enforce capital controls.

“In the first group [of countries] we have the open capital account inflation targeters—countries whose monetary policy frameworks are designed around domestic inflation targets,” she said.

For the most part they have pretty open capital accounts and include the G10 countries. “Inflation targeters have some numerical objective for inflation; they have some intermediate objective, [and their] policy tool is generally a short-term interest rate.”

In the second group are the open capital account exchange rate targeters. “Their monetary policy frameworks are a by-product of their exchange rate targets, not the other way around,” said Vandersteel. “In this group we have Hong Kong and Singapore; I’d also like to throw the euro constituents, and possibly Switzerland, in this camp.”

The final group consists of the closed capital account multiple price targeters. “Closing your capital account is about maintaining control,” she said. “In the last crisis they felt like the whole thing was out of control; they like having control.”

After the 2008 crisis, policymakers got wise to the cross-border spill-over effects, and have now added a new goal: domestic financial stability.

“There’s absolutely nobody who would question policymakers’ desire to have domestic financial stability,” she said. “Folks may quibble with the country’s exchange rate target, others may feel its exchange rate target is too high, or maybe even too low, but it’s hard to fault them for wanting domestic financial security.”

The countries that have open capital accounts are enforcing financial stability oriented rules, generally framed as macro-credential measures. “These macro-credential measures in many cases have the same effect as capital controls, but they’re not called capital controls,” said Vandersteel.

On the other hand, the closed capital account countries have pretty much everything at their disposal. “When a country’s capital accounts are hard- or soft-closed, all of the tools, including fiscal policy, become fair game.”

The aim of the game, she said, is to have two interest rates—one for foreigners and another for locals.

“They can do this through price restrictions [or] through quantity restrictions,” she said. “We’re all offshore investors [and] face difficulties when trying to access these markets. The interest rate that we achieve is not the same one that domestics achieve.”

Vandersteel likens policy frameworks to fashion, given the cyclical nature of their occurrences best reflected in the IMF’s views on capital controls.

“In the 1997 Asian financial crisis, they were lambasting all of the countries for using capital controls; now they say there are circumstances in which you should use capital controls,” said Vandersteel. “That’s not new; they’ve supported them in the past, they didn’t support them for a while, they support them again now.”

These structural changes, and changes of heart, create uncertainty and “wreak havoc on the standard models.”

Anticipating the type and timing of these restrictions is hard and leads to high turnover in the index.

“If a country introduces a restriction, they get slashed from the index [such as GBI-EM indices, comprehensive emerging market debt benchmarks that track local currency bonds issued by Emerging Market governments], and as they take away the restriction they go back in the index.”

Active managers, she said, need a broad toolkit, which includes onshore bonds, offshore bonds and a whole host of derivatives, to deal with these complications.

Vikram Barhat