Matt Nesvisky wrote (in the December 2007 NBER Reporter) about an NBER paper: Exchange controls and international trade by Shang-Jin Wei and Zhiwei Zhang. This fits into the Indian debate on the costs and benefits of capital controls. This paper figured in this `Capital controls' slideshow done at MOF in July 2007. The quick summary of this paper is: "The experience of the emerging market economies during the late 1990s suggests that controls on capital transactions that are intended to regulate capital flows also tend to harm trade substantially." Nesvisky's text says:
Some years ago, NBER Research Associate and Columbia University Professor Shang-Jin Wei and IMF economist Zhiwei Zhang learned from a top finance official of a certain country that it was common for both companies and individuals to try to circumvent that country's capital account restrictions. A common practice, the source allowed, was mis-invoicing imports, exports, or both. The government naturally reacted by stepping up inspections of goods passing through the customs to make sure that they are not mis-reported to evade capital controls. From this, the economists concluded that attempts to enforce exchange controls most likely raised the cost to firms of engaging in importing and exporting. Just how costly this might be is reported in their study, Collateral Damage: Exchange Controls and International Trade (NBER Working Paper No. 13020).
For their study, Wei and Zhang use data on capital account restrictions collected by the International Monetary Fund (IMF) since 1996 on 184 countries. The IMF's Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER) uses up to 192 indicators to track exchange controls for individual member countries. From this database, Wei and Zhang are able to construct three broad categories of indicators for 1) controls on proceeds from exports and payments for imports, 2) controls on capital transactions, and 3) controls on foreign exchange (FX) transactions and other items not specific to trade or capital transactions.
Wei and Zhang find that countries tend to have more controls on capital transactions and foreign exchange transactions than on trade payments. At the same time, countries with more controls in one category are also likely to have more controls in the other categories. Broadly speaking, the researchers observe that all three indices showed a moderate decline during the years 1996-2005 for countries instituting multiple controls.
There are substantial differences across countries as well as variation over time for many countries. Wei and Zhang illustrate this point with a close examination of the patterns for three developing countries -- Brazil, Chile, and Malaysia -- and one OECD country, Greece. Each of these countries experienced substantial changes in its controls during the sample period.
The researchers conclude that economically and statistically significant evidence exists to confirm their suspicions about the "collateral damage" to international trade brought on by exchange controls. They report that an increase by a single standard deviation in the controls on foreign exchange transactions reduces trade by the same amount as an increase in the tariff rate of 11 percentage points. A comparable increase in the controls on trade payments has the same negative effect on trade as an increase in the tariff rate of 14 percentage points. The experience of the emerging market economies during the late 1990s suggests that controls on capital transactions that are intended to regulate capital flows also tend to harm trade substantially. According to these researchers, the collateral damage of exchange controls should therefore be part of any assessment of the desirability of capital account liberalization.
Wei and Zhang caution that their study is only a first step towards understanding the effects of exchange controls on trade. It is possible, they note, that the effects are non-linear; that is, the same measure in an already restrictive exchange control regime may do more harm than in a less restrictive regime. Moreover, the effects may vary by sectors: exchange controls may raise the cost of trading in more differentiated products more than the cost of trading in homogeneous products; as differentiated products have a greater variance in their unit values over different varieties, it may be more difficult for traders to convince bureaucrats that a particular transaction is not mis-invoiced to evade exchange controls. In such a case, exchange controls imply one more distortion by affecting a country's pattern of specialization.
The effects may also interact with other features of the economy; the same exchange controls may do either more or less damage in a governance-challenged economy, depending on whether corruption primarily weakens the exchange controls or exacerbates the burden of complying with the controls. Such questions, Wei and Zhang suggest, are worthy of further research.