The response of Central Banks to swings in capital flows is an area within international finance that has received a lot of attention because of the impact such swings may have on macroeconomic performance. The imposition of capital controls is one way to deal with capital flow volatility.
The discussion of their effectiveness has sparked an ongoing debate (Edison, Klein, Ricci and Sloek, 2002) in academia and in policy circles.
This chapter looks at a special case of capital controls: multiple exchange rate systems. Their imposition has been a policy instrument used to stop capital outflows and to avoid BOP crises. Recently Argentina (2002) and Venezuela (2003) have implemented multiple exchange rates in an effort to stop capital °ight and to prevent financial crises, in situations where a unified devaluation is not a viable policy option, because high pass-through and liability dollarization imply that a unitary devaluation would lead to high inflation, deteriorating balance sheets and bankruptcies; and where defending the currency is also not an attractive option due to lack of reserves or concerns that rising interest rates will depress economic activityand also hurt firms' profitability as debt service increases.
These side effects make multiple exchange rate systems attractive, because they preserve the stabilization role of monetary policy and they also might stop capital flight without having an in°ation spike. Multiple exchange rates segment the foreign currency market so that different exchange rates apply to di®erent types of transactions. When multiple exchange rates are in place, the government sets an offcial or preferential exchange rate for some -or all- current account transactions, and creates a parallel exchange rate at a higher value1 for capital account transactions. So, if there is a run against the local currency or if there is a shock to the capital account, the parallel rate depreciates automatically, without a®ecting the domestic price of imports, and without forcing the Central Bank to lose reserves or increase interest rates.
Nevertheless, the impact of multiple exchange rates on macroeconomic performance has not received full attention in the literature. Most existing studies look at macroeconomic performance and capital controls without paying attention to their simultaneous determination3. Moreover, not all capital controls are created equal. Some policies target capital in°ows while others restrict capital out°ows.
The benefit of free capital mobility is one of the most controversial and unsettled issues within the international finance literature. Theory mentions many benefits from having an open capital account. For example, Prasad, Rogo,Wei and Kose
(2004) distinguish between direct and indirect benefits from inancial integration. By direct benefits they list \the augmentation of domestic savings, reduction in the cost of capital through better global allocation of risk, transfer of technological and managerial know-how and stimulation of domestic financial sector development". By indirect benefits they consider the promotion of specialization, commitment to better economic policies and signaling".
However, the authors also remark that is has not been possible so far to establish an empirical robust relationship between financial integration and economic performance. But all that glitters is not gold. Second generation models of currency crisis predict that it is possible that countries may suffer capital out°ows or currency crises, even if they have strong fundamentals, raising the issue of potential threats from not having some kind of capital controls. Because of capital market imperfections (like asymmetric information), foreign investors may pull their investments out rom a country, triggering a crisis, even if macroeconomic fundamentals are sound. The literature also shows that herd behavior can make things even worse (Gale (1996)). For example, the contagion literature shows that the financial channel may become important in spreading shocks from one country to another
Author: Leopoldo Avellan, Doctor of Philosophy, 2005,Department of Economics, University of Maryland
Source: http://drum.lib.umd.edu/bitstream/1903/3054/1/umi-umd-2858.pdf
