from BBH’s Win Thin on capital controls in Brazil
Finance Minister Mantega said that Brazil is considering a tax on short-term fixed income investments but not on long-term. No further details were given, but he noted that the central bank has increased its daily intervention volumes and that authorities are considering other measures to stem the real’s rally. It was almost one year ago that Brazil re-introduced the IOF tax of 2% on all incoming FX transactions on October 19 2009. Then, USD/BRL was trading around 1.71 and that is where we find the market currently. Recall that the IOF tax did not discriminate between equity and fixed income investment, and instead was levied on incoming FX transactions. Mantega’s comments suggest a more targeted approach that differentiates between short- and long-term inflows that sounds a lot like Chile’s encaje (one of the first to try and limit hot money inflows).
Prior to the Chilean encaje, most EM policy-makers were focused on how to prevent foreign capital outflows in times of crisis, not on limiting inflows. Chile’s encaje (“strongbox” in Spanish) was an unremunerated reserve requirement (URR) that became necessary when Chile’s success in liberalizing and modernizing its economy led to a surge in foreign investment that put strong upward pressure on the peso. The goals of the encaje were to 1) moderate peso appreciation, 2) limit short-term capital inflows in order to minimize disruptions from speculative hot money, and 3) allow greater independence for monetary policy, as rate hikes to dampen inflation would be overwhelmed by the expansionary effects of greater foreign capital attracted by the higher interest rates. Starting in June 1991, the Chilean government subjected foreign capital inflows to a one-year, non-interest paying deposit with the central bank. The encaje was initially set at 20% and was first applied only to fixed income and foreign loans. What’s interesting is that the encaje was continually modified, as policy-makers sought to find the right balance and cut off potential loopholes. The deposit requirement varied from 10-30% and the penalty for early withdrawal ranged from 1-3%. The encaje was eventually eliminated in 1998.
Was the Chilean encaje successful in meeting the three goals? Evidence on the experience has been mixed. Many studies suggest that the measures did change the maturity of inflows. An IMF research review concluded that the encaje, combined with other financial sector reforms, allowed the government more monetary policy autonomy and shifted the composition of foreign investment from “hot money” towards the longer term. After entering into discussions of a possible trade agreement with the United States, the Chilean government eliminated the encaje in 1998. But given the wall of money going into EM right now, we think more and more countries will start to consider and possibly enact encaje-type programs in the coming months. The fundamental drivers of these inflows (growth and interest rate differentials between developed world and EM) are likely to persist through 2011.
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