How big is the risk of capital controls in Emerging Markets?:: HSBC

Visit http://indiaer.blogspot.com/ for complete details �� ��

How big is the risk of capital controls?

But, with such big flows into emerging markets,

and central banks hesitant to raise rates as this

would probably cause their currencies to

appreciate, won’t more countries impose capital

controls? Brazil, for example, levied a 2% IOF tax

on portfolio inflows in October 2009, and raised

the rate to 4% and then 6% this October (although

not for equities). News reports this week – denied

by the Finance Ministry – suggest that Korea may

be thinking of an income tax on securities (at

least, bonds) held by foreigners.

Our view is that, while some countries might

impose capital controls, they will be more

reluctant to impose them on equities than on other

asset classes. The IMF’s report Capital Inflows:

The Role of Controls, February 19, 2010, argues

that there is a pecking order of capital inflows in

order of riskiness, with portfolio equity

investment ranking behind only foreign direct

investment in terms of desirability. Equity

investments allow for “greater risk sharing

between creditor and borrower”.

If a country were to impose controls on bonds but

not equities, this could even increase the attraction

of the latter. And, since the expected return from

equities (because of the equity risk premium) is

higher, a small entry tax, such as Brazil imposed,

may have less impact on equities than on other

assets.

But, when in the past countries have imposed

controls on equities, the stock market did

generally react negatively. Table 9 shows five

examples of countries which restricted inflows.

Brazil’s stock market, for example, fell by 3%

after the IOF was announced last year, and

underperformed global equities by 4% over the

following three months.

But the example of Thailand in 2006 – which

announced a unremunerated reserve requirement

of 30% on all portfolio inflows – is clearly

causing governments to think hard before

introducing controls on equity inflows. The Thai

market fell by 17% the day after the rule was

announced; within 24 hours, the authorities

reversed it for equities.