By Adugna Olani, Queen’s University PhD student

Government capital controls are typically viewed with skepticism because they impede capital movement across countries. Recently, the financial crisis has brought crisis transmission through capital flows to the forefront.

In recent research, I show how imposing capital controls on a short term, volatile, and potentially speculative capital flows to developing countries can improve the wellbeing of residents in those countries.

Capital flows are useful for developing countries. Specially, in lower income countries, savings tends to be small, and investment tends to be lower. Capital flows can help with this shortage in investment, and during crisis, capital flows are an important for consumption smoothing.

However, not all types of capital flow are alike. “Foreign portfolio liability” is a capital flow type that is usually short term, as such investors are interested in the short term interest gains from this type of investment. In contrast, “foreign direct liability,” such as building subsidiaries and having control of all or part of a firm in the developing countries by a foreign investor is a longer term type of investment. This type of investment increases the transfer of technology, management skills, and production methods to developing countries.

My analysis of the large data set of developing countries shows that output volatility within a developing country is strongly associated with increased foreign portfolio liability. Since foreign portfolio liability can be invested or reversed by a few clicks on computer keyboards, and these in turn increase crisis transmission and exchange rate volatility in the developing countries, output volatility increases. However, the increase in foreign portfolio liability is not associated with output growth. In contrast, foreign direct liability is strongly associated with increased output growth.

These results are extremely important because increased output volatility leads to decreased growth in developing countries. Increased volatility is also associated with uncertainty and risk to the foreign and domestic investors.

The literature in capital flows also shows that there is some substitutability between foreign direct and foreign portfolio liability. This is because firms in the developing countries use any financing mechanism that is profitable. Therefore, if it is cheaper to finance their investments through foreign portfolio debt, their financing decision renders too little foreign direct liability and excessive foreign portfolio liability. Since the developing countries’ firms do not take into account the aggregate benefit from foreign direct debt, there is a room for government’s action to improve on the market outcome.

Particularly, there is a room for capital control of foreign portfolio liability. If government increases the capital control tax on foreign portfolio liability interest income of the foreign lender, then the lender requires an increased interest payment on her lending. Because of this, it becomes expensive to issue debt in the form of foreign portfolio liability while it becomes relatively cheaper for the domestic firm to finance its debt in terms of foreign direct liability.

Therefore, the capital control tax can accomplish two purposes. First, it increases domestic financing using foreign direct liability and this in turn increases the domestic output, technology, and employment. Second, output volatility, which is partly explained by increased foreign portfolio liability is controlled. Through both channels the wellbeing of the developing economies residents is improved.

I quantify these effects using a theoretical model and data simulation. The analysis shows that an increase in capital control tax on foreign portfolio liability from zero to ten percent is equivalent to increasing the developing countries household consumption by five percent, a remarkable improvement.