Chilean-style capital controls

A floating, yet stable, market-determined exchange rate, that reflects the long-term balance of a country’s current account is the only sustainable currency regime. Heavy-handed interventions in forex markets will always result in domestic imbalances eventually.

Artificially undervalued currencies come with their own set of problems; in particular, overreliance on exports and a severe misallocation of resources as seen in countries such as China, as well as tensions with trading partners. The beauty of a floating currency is that it acts as an automatic stabilizer to the domestic economy. If net exports are reduced, a floating currency weakens, automatically rebalancing the balance of trade. It stimulates or dampens the domestic economy as needed, and helps to manage inflation.

The exception to this rule is when large speculative inflows come into the picture. In certain global financial conditions, short-term, speculative capital can flood economies with funds to reap quick rewards; this is referred to as hot money. It can quickly strengthen the currency of the country it enters, rendering the country’s exports uncompetitive. It can also leave just as quickly as it entered, causing tremendous destabilization to the country’s domestic market and currency valuation. Taking emergency measures to stem the outflow of capital is rarely effective in these crises; the capital controls are always evaded, and tend to create opportunities for corruption. This was the story of the Asian Financial Crisis of the 1990s, as well as the Russian and Argentine financial crises, among others.

The remedy to this issue lies in a method Chile has experimented with in the 1990s. Speculative inflows were limited through a tax on short-term inflows (mainly through a non-remunerated reserve requirement on foreign liabilities). This effectively changed the composition of inflows (to be tilted toward longer-term investment) without reducing inflows overall, and protected Chile from the effects of hot money. The Chilean peso maintained its stability, and the domestic economy was insulated from the financial shocks that affected many other emerging markets during this decade. The New Physiocrats strongly endorse this policy of a floating currency combined with taxing short-term inflows. To mitigate the potential effects of making capital more expensive, under our platform, the revenues raised would be split between ASP accounts and Sectoral Banks, balancing incentives for equity and debt financing.