Thursday, April 8, 2010

De jure vs. de facto capital mobility in South America (gratuitously wonky)

I know a lot of you have been waking up in the middle of the night with a cold sweat, anxiously wondering about the state of financial liberalization in South America. What's more, you've got that dreaded feeling of anguish in your stomach, that creeping suspicion that de facto and de jure measures of capital mobility might show different results. Oh the horror! Well, despair no more because maladjusted knows these feelings all too well and is here to put an end to your sleepless nights.

Remember back in the day when the IMF and other international organizations were telling developing countries that they should open up their financial markets? You know, since financial liberalization is basically the same as trade liberalization, it followed that if free trade is super awesome for development so is the free movement of money across borders. I mean, borrowing money is the same as trading goods, only across time, right? Moreover, rich countries have a lot of money and poor countries don't, so letting the rich countries invest all they want in poor countries kinda makes a lot of sense. What could possibly go wrong? It's not like capital flows can suddenly stop, create dangerous asset bubbles, exacerbate the business cycle or lead to financial crises.

Whatever. The point is that developing countries have sought to open up their financial markets to foreign capital and South America is no exception. The graph below takes a first look at capital mobility. We'll call it the "de jure" approach.

[De jure capital mobility, 2008]

This shows how freely money can move in and out of each country in principle. The index was put together using the IMF's Annual Report on Exchange Arrangements and Restrictions (AREAR), which catalogs every member country's regulations and restrictions on international transactions. AREAR distinguishes between 13 different types of regulations on capital flows, ranging from restrictions on financial derivatives to foreign direct investment. In any case, if a country has regulations in all 13 categories it gets a score of zero, meaning that capital is not very mobile. At the other extreme, if a country gets a score of 100 it means it doesn't have any regulations and capital is perfectly mobile.

Chile, Peru and Uruguay have the least restrictions on capital mobility, with equal scores of 84.6, while Argentina, Brazil and Venezuela are on the other end of the spectrum with relatively high restrictions. Now, the outlier here is Colombia, which has by far the most restrictions and a low score of 7.7.

Yes indeed, the US' BFF actually has labyrinth-like restrictions and regulations on international financial transactions. If a type of transaction exists, chances are Colombia regulates it. Colombia pretty much regulates everything from personal capital movements to foreign direct investment (curiously, the only type of transactions it doesn't restrict in some way are those pertaining to real estate).

But what's the problem with the de jure index? Well, it is based on restrictions in principle, which is to say that it only tells us about the laws governing capital flows in each country but doesn't tell us anything about how they are enforced or how restrictive they each are. For example, two countries could both have restrictions on financial derivatives. Say country A has a 2% tax rate on each derivative while country B has a 30% tax rate. Obviously country B is much more restrictive but under the de jure index both regulations are given equal weight. Similarly, A country could have restrictions on almost every type of transaction but in practice might not have the institutional capacity (read: is too corrupt) to enforce them.

This takes me to our second measure of capital mobility. While the de jure measure can be loosely interpreted as the "intention" to regulate or restrict capital flows, the de facto measure below shows capital flows in practice.

[De facto capital mobility, 2003-2006]
This one measures capital mobility in terms of actual flows. It basically takes the absolute value of the capital and financial account of each country's balance of payments (courtesy of the IMF's international financial statistics) and divides it by GDP. In other words, it sums the amount of money entering and leaving a country and shows it relative to the economy's size. Also, in order to avoid the effect of yearly fluctuations and the contraction of flows during the global financial crisis, all the values are taken as an average of 2003 through 2006.

So now that we have both measures of financial liberalization, what can they tell us? The first thing to notice is that there's a bit of a reshuffling in the order of countries, meaning that the countries with the most laws and regulations on capital flows do not necessarily have the least capital mobility. Chile and Uruguay still lead the pack but now Chile dwarfs every other country. Peru goes from the top bracket down to sixth place. Also, Colombia jumps up a few spots.

Another insight is that while Venezuela comes in as the second to last place in the de jure index, it is third according to the de facto measure. The emerging market darling Brazil comes in pretty low in this case, but this is mostly because of the sheer size of its economy (has a much, much larger denominator than any of the other countries).

Well, there we have it folks. It seems that feeling of dread in your gut was justified afterall: de jure and de facto measures of capital mobility paint different pictures about the state of financial liberalization in South America. I hope maladjusted was able to put your mind at ease and help you get some sleep.

1 comment:

  1. Not bad. But you're going to have a big hole regarding remittance profits in your de facto numbers.