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Capital controls in their strictest sense are very unlikely to
be used given historically low interest rates and continued
borrowing by emerging markets and developing economies (EMDEs).
However, the tools available to control capital flows are diverse
in type, application, and implications for the private sector.
Overall, political support for capital controls is rare or
otherwise is gradually reversing (for example, Zimbabwe), with
periodic central bank intervention in foreign exchange (FX) markets
more common (for example, Malawi), except for Argentina, where the
Kirchnerist government continues to support restrictions.
Key drivers of capital controls in the sub-Saharan African
region are the need to protect low foreign reserves, and the need
to respond to persistent structural imbalances that both cause FX
scarcity (for example, Ethiopia) and increased sensitivity to
commodity price fluctuations given dependence on natural resource
revenues (for example, Mozambique and Zambia).
Aside from the potential for another high-impact long-tail
event, there is implicitly a higher risk of a reversal of capital
flows if policy rates rise globally and competing debt instruments
provide greater returns, with capital controls then potentially
being used to stem outflows or, conversely, authorities choosing to
relax restrictions to encourage inflows to meet the shortfall.
Foreign capital is a vital source of investment and growth for
EMDEs. However, dependence on changeable inflows of foreign capital
to finance liquidity gaps is also a vulnerability - as briefly
demonstrated by the coronavirus disease 2019 (COVID-19)
pandemic-induced 'sudden stop'. Strict capital controls generally
are used only as a last resort, with governments instead favoring
more-investor-friendly forms of intervention given historically low
interest rates and continued borrowing by EMDEs. Still, EMDEs are
likely to use a variety of tools to manage volatile capital flows
that imply different consequences for foreign investors.
Mitigating factors
With the onset of the COVID-19 pandemic, pressure on local
currencies and lost export earnings (particularly in natural
resource- and tourism-dependent economies) accelerated across the
Latin America and Caribbean, and sub-Saharan Africa regions.
Capital inflows did recover from April 2020, stemming from the
Organization of Petroleum Exporting Economies plus (OPEC+) agreeing
to oil production quotas that supported commodity prices, the US
Federal Reserve opening temporary repo facilities to improve
liquidity conditions, the rollout of sizeable emergency support
programs and liquidity lines by the International Monetary Fund
(IMF), and the monetary policy responses undertaken by EMDEs'
central banks. Furthermore, the larger economies within Latin
America and sub-Saharan Africa entered the 2019-20 commodities
downturn and COVID-19 pandemic with larger or similar foreign
reserve holdings and more manageable current accounts than previous
crisis episodes.
The imposition of COVID-19 pandemic-related restrictions on
movement and trade also meant that EMDEs' current account deficits
stabilized temporarily or moved into surplus, supporting foreign
reserves and increasing external debt repayment capacity. This was
particularly the case for non-oil exporting countries such as South
Africa and Kenya, whereas oil-dependent economies - for example,
Angola and Nigeria - experienced a widening of their external
balances. Borrowing costs in many EMDEs are now below pre-pandemic
levels, being supported by successful sovereign bond issuance. In
aggregate, there has seemingly been little overall net change in
external liquidity shortfalls for borrowers, with the rapid capital
outflows of March 2020 having been rapidly recovered or plugged by
other means.
Unpacking capital controls
During the COVID-19 pandemic, most EMDEs did not impose outright
restrictions on capital outflows to defend their currencies,
largely because of fears in developing economies that these would
weaken their ability to access international markets or otherwise
result in their being cut off from
Capital control risk: Anticipating the
severity
To assess the severity of policy responses to a potential sudden
stop in net private capital inflows and to identify when such
policy responses are most likely to be adopted, IHS Markit's
economics and country risk team has devised a bespoke capital
controls risk ranking, covering 69 countries in Latin America and
sub-Saharan Africa (where data are available). The risk level
ascends according to a 1-10 linear scale across four risk bands
(Moderate, Elevated, High, Very high), where '10' (Very high)
indicates a greater risk of severe policy responses (that is,
outright restrictions) in addition to early signs of financial
distress. The index comprises three core components:
Financial stress indicators: Early indicators
that a country is experiencing financial distress and will face
foreign currency shortages; for example, a steep rise in short-term
borrowing costs.
Mitigating factors: The capacity to draw down
on foreign reserves and financial support from the IMF, including
in the form of a potential injection of liquidity via a future
general allocation of Special Drawing Rights (see: US Treasury's proposed SDR
allocation).
Political willingness: The level of government
support for resorting to the use of controls on capital flows.
Unfortunately, headline consumer price inflation for April
hinted at sustained weak consumer demand as it held steady at 1.4%
y/y for a third consecutive month according to Statistics Indonesia
and core inflation (which excludes government-controlled and
volatile food prices) hovered for a second consecutive month at the
record-low 1.2% y/y. There was minor upward pressure on food prices
during the month, which may pick up modestly further as Eid al-Fitr
is celebrated in May; otherwise, price increases were relatively
modest across the other major components of the Consumer Price
Index (CPI) indicating limited demand pressures.
Longer-term vulnerabilities
Despite the significant outflows across EMDEs initially caused
by the COVID-19 pandemic, the imposition of strict capital controls
has been rare and such measures have attracted little political
support, other than in selected cases such as Argentina. More
common tools to manage volatile capital flows are foreign exchange
and macro-prudential regulations, which are typically used as part
of a wider toolkit suited to an individual country's needs.
Longer-term vulnerabilities stem primarily from the growth in
foreign-currency-denominated debt burdens and the possibility of a
future persistent rise in dollars rates increasing short-term debt
distress and rollover risks, especially if inflationary fears
materialize in the advanced economies. Aside from the potential for
another high-impact long-tail event (such as a 'third wave' of
COVID-19 virus infections, commodity price crash, or early rise in
advanced economies' interest rates), there is implicitly a higher
risk of a reversal of capital flows as borrowing costs with foreign
creditors rise and, potentially, use of capital controls to stem
outflows.
Posted 24 May 2021 by Chris Suckling, Associate Director, Risk Quantification, S&P Global Market Intelligence