Collateral Damage: Exchange Restrictions and Trade Flows

1. Collateral Damage: Exchange Restrictions and Trade Flows Shang-Jin Wei Zhiwei Zhang

2. Introduction • Are exchange restrictions (capital controls) good for developing countries? • Adverse effects of liberalization – Rodrik, Stiglitz, survey by Kose, Prasad, Rogoff, and Wei • Costs of not liberalizing – Forbes’ study on cost of borrowing in Chile • This paper: Effects on international trade

3. Can exchange restrictions damage trade? • Examples • Repatriation requirements for exporters. • Anecdote with the chief of a foreign exchange control administration • Empirical research is scarce • Tamirisa (1999) • Data limitation • Specification issue

4. Notable features of this paper: • Three unique databases • AREAER database for exchange controls. • Country-pair specific tariff data from WITS – allowing for calculation of tariff equivalent. • Non-tariff barriers index from IMF/PDR/TRI. • Theory-consistent gravity model that incorporates recent theoretical advances • Anderson – Van Wincoop (2003) • Helpman – Melitz – Rubinstein (2006)

5. Exchange Restrictions • 192 indicators in AREAER • Three groups of restrictions on: • Trade payments. • Capital transactions. • FX transactions (exchange taxes and subsidies …) and others.

6. Main findings: Exchange restrictions have large negative effect on trade • Increasing restrictions on trade payments by 1 S.D. is equivalent to increasing tariff rate by 9 to14 percentage points. • Increasing restrictions on FX transactions and others by 1 S.D. is equivalent to raising tariff rate by 11 to 15 percentage points.

7. Controls on Trade Payments or Proceeds • Imports and Import Payments: • 1. Foreign exchange budget • 2. Financing requirements for imports • 3. Documentation requirements for release of foreign exchange for imports • Exports and export proceeds: • 1. Repatriation requirement • 2. Financing requirements • 3. Documentation requirements • 4. Export licenses • 5. Export taxes

8. Restrictions on Following Capital Transactions: • 1. Capital and money market instruments • 2. Derivatives and other instruments • 3. Credit operations • 4. Direct investment • 5. Liquidation of direct investment • 6. Real estate transactions • 7. Personal capital transactions • 8. Provisions specific to commercial banks and other credit institutions • 9. Provisions specific to institutional investors • 10. Other controls imposed by securities laws

9. Restrictions on FX Transactions and others • 1. Exchange tax • 2. Exchange subsidy • 3. Absence of forward exchange market • 4. Currency requirements for pricing & settlement • 5. Payments arrears • 6. Controls on trade in gold (coins and/or bullions) • 7. Controls on exports and imports of banknotes • 8. Controls on transfers • 9. Proceeds from invisible transactions • 10. Resident Accounts • 11. Nonresident Accounts

10. Almost all exchange restrictions can be used as capital controls. • Malaysia. (Johnson, Kochhar, Mitton & Tamirisa 2006) • Currency requirements for settlement. • Export proceeds. • China • Residents holding FX bank accounts.

11. Restriction Indices • For each group of the restrictions, an index is constructed as the weighted sum of all restrictions in place. • Weights are chosen to ensure each category within the group receives equal weight.

14. Augmented gravity model: Y: Bilateral trade flows. X: Importer’s and exporter’s GDP, distance, Mills ratio and predicted probability of trade (Helpman-Melitz-Rubinstein), colonial ties, common language… RI: Vector of restriction indices. Tariff: Bilateral tariff rates. NTB: Non-trade barrier index from TRI. IMP, EXP, Year: fixed effects for importer, exporter, year.

16. Tariff Equivalent Calculations • A 10 percent increase in tariff rate is associated with a 7 percent reduction in trade volume • Increasing restrictions on trade payments by 1 standard deviation (0.18) is associated with:0.18*(-0.537)/(-0.717)*100 = 13.9 percentage points increase in tariff.

17. Alternative Specifications • Country pair fixed effects – to incorporate trade costs more generally. • Separate import price indices for two trading partners • to proxy for time varying trade costs.

18. Model with country-pair fixed effects:

19. Model with time-varying import price indices

21. Refined categories of restrictions: • Both imports and exports restrictions seem to matter. • Capital transactions show different signs. • Negative estimates for restrictions on cap & money market instruments, derivatives. • Positive estimates for FDI, personal capital transactions, and provisions to institutional investors. • Restrictions on FX transactions and others are predominantly trade-reducing. • Currency requirements, exchange taxes and subsidies, and arrears.

22. Case Study: • The financial crises in emerging markets during 1996 – 1999 period led governments to set more controls. • Sample includes11 emerging markets in the MSCI index that strengthened their controls on either FX transactions or capital transactions during 1996 – 1999 period. • Did increase in exchange controls led to less trade, after controlling for changes in tariff, NTB index, GDP, and exchange rates?

23. Dependent variable: change in bilateral trade, 1996 to 1999

24. Tentative Conclusion: • Some exchange restrictions have large adverse effects on trade • Increasing restrictions on trade payments by 1 S.D. is equivalent to raising tariff by 9 to 14 percentage points. • Increasing restrictions on FX transactions and others by 1 S.D. is equivalent to raising tariff by 11 to 15 percentage points.

25. Further Research Needed: • Non-linear effects. • Interactive effects (e.g. with governance) • Suggestions?