The Real Effects of Capital Controls: Evidence from Brazil

The market value of Brazilian companies, especially smaller and purely domestic firms, declined in response to the imposition of capital controls.

The massive surge of foreign capital to emerging markets following the global financial crisis of 2008-09 has led to renewed debate about the merits and consequences of international capital mobility. While the free flow of international capital can reduce the cost of capital, increase investment and growth, and boost international diversification for foreign investors, it also can pose significant risks for the recipient economies if subject to sudden stops or reversals. To manage the risks associated with the recent capital inflow boom, several emerging markets have imposed taxes or capital controls to curb the flow of foreign capital into their economies.

In The Real Effects of Capital Controls: Financial Constraints, Exporters, and Firm Investment (NBER Working Paper No. 20726), Laura Alfaro, Anusha Chari, and Fabio Kanczuk consider the booming economy of Brazil. They analyze firm-level data that make it possible to study how capital controls affected the stock market performance of Brazilian firms and the competitiveness of exporters.

In March 2008, Brazil imposed a 1.5 percent tax on foreign capital inflows that were used to purchase fixed-income securities. This tax was removed in October 2008, after a sharp decline in foreign investment that was attributable primarily to the global economic downturn. The tax was reinstated in October 2009 as the Brazilian economy rapidly recovered, and expanded to a 2 percent tax on fixed-income, portfolio, and equity investments. After a series of further increases, in October 2010 the tax on fixed-income investments was raised to 6 percent.

The researchers find a significant decline in stock market returns of Brazilian firms coincident with the imposition or tightening of capital controls. The average firm declined in market value by 3.4 percentage points in a two-day period corresponding to announcement of more-stringent capital controls when the authors allow the effect to vary by firm size. They also find that the decline in value was smaller for large firms, suggesting that these businesses were partially shielded from the impact of controls. When the authors distinguish between controls on debt and on equity flows they find that the negative stock market returns associated with new controls on equity flows were larger than those for controls on fixed-income investments.

Another key finding is that firms engaged in exporting experienced smaller negative returns than firms that sold only to the domestic market. The authors observe that exporters "may have access to foreign currency proceeds, and therefore not be affected by the capital controls to the same extent as purely domestic firms." Exporting firms may also be affected positively by capital controls if the controls lead to a depreciation of the Brazilian real, which in turn would make Brazilian exports more competitive.

Finally, the market value and investment of external finance-dependent firms was negatively impacted by the controls. Because the study uses firm-level data, it is possible to compare the investment effects on firms of different sizes. For firms below the median firm size, investment fell to an average of 1.7 percent between 2009 and 2011, from an average annual rate of 8.9 percent in the prior two years. Firms that do not produce for export markets saw an even sharper decline in investment, while exporters actually increased their investment during this period.

-- Matt Nesvisky