Losing access to capital markets is a major problem for any market, but a flood of foreign capital creates its own problems as prices go up and EM exporters become less competitive and the prospect of the hot money flowing out just as quickly can destabilize a fragile economy. But countries can defend themselves with capital control rules and, according to new research, they may be able to fine tune their response by targeting different types of capital.

“There is a significant decline in cumulative abnormal returns for Brazilian firms following the imposition of capital controls on foreign portfolio inflows in 2008–2009 consistent with an increase in the cost of capital,” write Laura Alfaro of Harvard Business School, Anusha Chari of the University of North Carolina Chapel Hill, and Fabio Kanczuk of the University of Sao Paulo in their paper The Real Effects of Capital Controls: Financial Constraints, Exporters, and Firm Investment. “Controls on debt flows are associated with less negative returns, suggesting that the market views equity and debt flows as different.”

Quick reversals in Brazil’s capital controls ruling

Brazil provides a particularly good case study because it flicked capital controls on and off multiple times in a relatively short period of time. The combination of a commodities boom and foreign capital inflows drove the Real up from 3.1 R/USD in 2004 to 1.6 R/USD in 2008, and in March 2008 the government put a 1.5% tax on incoming foreign fixed income investments to stem the tide. By October foreign direct investment had plummeted due to the global financial crisis, causing Brazil to eliminate the tax, but in February 2009 foreign investment was already picking back up, and Brazil put capital controls back into place. By October 2009 the tax was up to 2% and was no longer restricted just to fixed income investments.

The researchers looked at market changes in the days immediately following each of these changes to capital control rules to quantify the effects that they had.

bovespa index 1214 Capital Controls

Markets react more to controls on equity flows than debt flows

As you might expect, capital controls cause cumulative abnormal returns (CAR) to drop because it makes the cost of capital go up. The effects of capital controls aren’t uniform. Exporters aren’t as affected because a weaker currency helps their business, large companies are less affected because Western investors invest more in large companies anyways, and of course companies with less dependence on external financing are less effected.

But the effect also depends on the type of investment being targeted. Markets reacted less to capital controls on debt than on equity flows. The researchers point out that capital controls in Brazil increased uncertainty and reduced investment at the firm level, but that’s to be expected (even the IMF has said that limited capital controls have their place) and it’s useful to find ways to better target the rules.

See full study below.