Time-Varying Financial Integration: Capital Controls

The imposition of controls on cross-border capital movements increases transaction costs and tends to break down LOOP. For this reason, capital controls provide a natural test of the cross-market premium as a measure of the intensity of financial integration. This section centers on how the behavior of the cross-market premium differs when controls are introduced, and how this behavior depends on the nature of the control.³¹

6.1. Capital Controls and the Cross-Market Premium

In the presence of controls on capital outflows, an international investor seeking to buy the DR to sell the underlying stock would need to repatriate the proceeds from this sale and incur a cost κ. Conversely, when controls on inflows are in effect, purchasing the underlying stock to sell the DR would require paying an inflow cost λ .

Thus, as quantitative controls on outflows increase in effective intensity ( κ → ∞ ), the potential deviation of local stock prices relative to DRs increases proportionally: binding controls on outflows would elicit a large cross-market premium. Similarly, controls on inflows would introduce a negative cross-market premium, as they inhibit international investors to profit from relatively low domestic prices. In sum, controls on outflows (inflows) increase the upper (lower) boundary of the no-arbitrage band, keeping the other boundary unchanged, and causing the premium to be, on average, positive (negative).

6.2. Capital Controls: What and When?

First, it is important to define what we understand by capital controls and how we identify the periods when they are in place. Capital control periods are relatively easy to detect. Governments impose them through regulation.³² Moreover, a number of public institutions document them. Appendix Table 3 describes the capital controls imposed in each of the countries we study. One salient feature from this table is that capital controls differ by intensity, across countries and over time. Another relevant aspect is the difference in the type of control, the most notorious one being between controls on inflows (typically used to discourage short-term inflows) and those on outflows (to prevent the capital flight in the midst of a crisis). We focus our attention solely on controls that may affect the cross-market premium.³³

Six countries in our sample experienced a period when capital restrictions affected the behavior of stock markets: Argentina, Chile, Indonesia, Korea, South Africa, and Venezuela. Argentina introduced controls on capital outflows in December 2001 together with restrictions on cash withdrawals from commercial banks (the so called “corralito”) as an attempt to stop capital flight. The majority of these controls stayed in place until December 2002, when the corralito was lifted and the bulk of the restrictions were eliminated. However, in the first months after the corralito was abandoned, some minor controls were still in place that could potentially have affected the premium. During the first half of 2003, virtually all controls on outflows were eliminated. Chile introduced controls on inflows in the form of an Unremunerated Reserve Requirement (URR) already in 1992, but these controls only affected the DR market from July 1995 onwards. In August 1998, with the markets in turmoil and the Chilean peso under attack, the controls were finally lifted.³⁴

Controls in South East Asia took a different form, typically involving quantitative limits on foreign ownership. Indonesia had a 50 percent limit on foreign investments in place when the first DR started trading; this restriction was lifted in September 1997. However, a ceiling on foreign investment would not affect arbitrage by foreign investors as long as foreign participation is below the 50 percent limit. There is some casual evidence on this: foreign ownership of publicly listed companies in Indonesia was 30 percent in 1993 and 25 percent in 1997 (Asian Development Bank, 2000). Also in Korea, a ceiling on the share of foreign investor ownership was in effect. For most stocks, this ceiling was lifted in May 1998; however, for a number of stocks it has continued to be in place. Cross-listed stocks using DRs faced an additional restriction: until January 1999, the conversion of underlying shares into DRs was severely restricted (e.g. approval was needed by the issuing company’s board). In November 2000, Korea changed its regulations so that underlying shares could be converted into DRs without board approval, as long as “the number of underlying shares that can be converted into DRs” is less than “the number of underlying shares that have been converted from DRs.”³⁵ For four of the stocks in our country portfolio (SK Telecom, Kepco, Posco, and KT Corp) this rule has often prevented arbitrage to take place: in effect, these stocks still face controls on capital inflows. The other two stocks in our portfolio (Kookmin Bank and Hanaro Telecom), however, were unaffected by the rule during the period covered by our sample, so that controls were effectively not in place. To accommodate for this difference in the incidence of controls, we divide Korean stocks into two groups: restricted and unrestricted. Furthermore, we divide the control period of Korea into three distinct subperiods. The first one, referred to as very restrictive, lasts until January 1999. The second period, called restrictive, lasts from January 1999 until November 2000, when free conversion was allowed but conditioned by the rule. The third period, less restrictive, goes from November 2000 to the end of the sample period.

In South Africa, the dual exchange rate system adopted in 1979, and temporarily abandoned in 1983, effectively worked as a control on capital outflows. This system was abolished in March 1995. Venezuela experienced two episodes of controls on capital outflows. The first one started in June 1994 and lasted until May 1996. A new set of controls on outflows was introduced in January 2003, and was still in place at the end of the sample period.

6.3. Summary Statistics

Figure 5 [ PDF 107.2KB | 1 page ] displays the evolution of the simple average of the cross-market premium of all stocks selected for each country. For the particular case of Korea, we include two graphs: one including stocks that have been subject to restrictions over the whole sample period, and one including only the unrestricted stocks. Moreover, the control period in Korea is divided into three sub-periods, to reflect the fact that the severity of restrictions lessened during the sample period as explained above.

Figure 5 [ PDF 107.2KB | 1 page ] shows that during no-control periods the cross-market premium oscillates around zero. Indeed, in countries where no controls were introduced during the sample period (Brazil, Mexico, and Russia) the premium never diverges from zero for an extended period. By contrast, the average premium turns positive in periods when capital outflows are restricted (Argentina, South Africa, and Venezuela) and negative in periods of controls on inflows. As expected, the exception is Indonesia, where the limits on foreign participation appear to have been non-binding at the time, and where domestic investors could still do the arbitrage pushing the cross-market premium towards zero. By contrast, in Korea, where a similar ceiling is combined with a rule restricting the convertibility of the DRs, arbitrage is impeded regardless of whether the ceiling is binding. The evidence that the discount is much lower in Chile than in Korea, on the other hand, directly reflects the different nature of the restrictions: quantitative limits that prevent arbitrage in Korea, and an implicit tax that weakens arbitrage in Chile. Note that the Chilean “tax” on inflows effectively increases the price of the underlying stock, which should therefore fluctuate around the average value of the tax from the investor’s standpoint. According to the figure, that is roughly two percent.

Table 4 [ PDF 50.6KB | 1 page ] displays summary statistics of the average cross-market premium during no-control and control times.³⁶ The table complements Figure 6 [ PDF 39.1KB | 1 page ]. The presence of controls on outflows is associated with a sizeable positive premium, ranging from 6.4 percent in the case of Argentina to over 50 percent in the case of Venezuela. By contrast, controls on inflows are characterized by a substantial discount, ranging from -2.1 in Chile to -31.2 percent in the period of most restrictive controls on inflows in Korea.³⁷ The only exception is, again, Indonesia, where the small positive premium is associated with the presence of controls on inflows.

In addition, a comparison with no-control times shows that the volatility of the premium increases significantly during control periods, as expected. In particular, the volatility and the mean of the average premium are positively correlated. Thus, the volatility is, to a large extent, proportional to the premium generated by the controls, in line with the view that the latter induce a zone of inaction that allows for wider (and more persistent) deviations from LOOP. In the following sections, we explore this preliminary evidence more closely.

6.4. Integration during Control Periods

For the AR model, we expect the persistence to be much higher when controls on inflows or on outflows are in place. Furthermore, we examine whether the control period affects the volatility of the premium. To identify the impact of controls on the premium, the AR model is specified as follows:

D_cont is a dummy equal to one during the control period and zero otherwise. k is the autoregressive length, p the number of ARCH terms, and q the number of GARCH terms. For each stock, a different model is estimated, in which k, p, and q are set in such way that the residuals do not contain any serial correlation or heteroskedasticity up to lag 10.

While we expect persistence to be positively affected by both controls on inflows and outflows, we expect the impact on the band of no-arbitrage to differ between the two types of controls. When (binding) controls on capital outflows are introduced, the premium can become positive as the upper band of no-arbitrage becomes larger, while the lower band is unaffected by the controls. In the case of controls on inflows, we expect to observe exactly the opposite.

For each stock in the portfolio that was traded during a period of controls, we estimate the TAR model in the following way. First, the model is estimated for the no-control period. Next, a TAR model is estimated for the control period, setting the threshold of the no-arbitrage band that should not be affected by the introduction of the controls equal to the value estimated for the no-control period, and estimating the remaining threshold. Thus, the impact of controls should be reflected in an asymmetric widening of the band.³⁸

Table 5 [ PDF 45.1KB | 1 page ] shows the simple averages of the half-lives and volatility changes from the AR model and the estimated thresholds and half-lives from the TAR model.³⁹ AR estimates indicate that deviations from LOOP are, as expected, much more persistent in the periods when capital controls are in effect.⁴⁰ The notable exception is, again, Indonesia, where halflives are virtually identical, suggesting that arbitrage was taking place as in the no-control period. In addition, our results show that periods of controls on outflows are associated with an increase in the volatility of the premium, in line with the widening of the band. In Indonesia, by contrast, we see a slight decline in volatility in the control period compared to the no-control period. This, once more, is consistent with the finding that controls did not impede arbitrage at the time.

The TAR results show that the upper threshold goes up when controls on outflows are introduced (Argentina and South Africa). For example, in Argentina the average upper threshold equals 0.29 in the no-control period but increases to 7.85 when controls on outflows are in effect. By contrast, the introduction of controls on inflows in Chile lowers the average floor of the band from -0.23 to -3.11. Indonesia, by contrast, yields mixed results: the average shows only a slight widening of the band under the control period, which is driven by one of the two stocks in the portfolio.

6.5. Case Study: Argentina 2000-2007

To complement the analysis above, Argentina offers an ideal case to evaluate the behavior of the cross-market premium in the presence of capital controls. The country witnessed a dramatic episode of capital flight in 2001-2002, but imposed controls on outflows only by the end of 2001, which allows us to identify the effect of controls on the cross-market premium beyond the influence of the crisis event. Moreover, in mid-2005, and in the context of renewed capital inflows and a strong rebound of asset prices already underway by end- 2003, the country imposed tax-like controls on inflows in the form of two restrictions: the amount entering the country must remain within Argentina for 365 days, and 30 percent of the total amount must be deposited in a local bank in the form of usable funds for the bank's minimum reserve requirement. These controls are still in place.

To take advantage of this unique situation in which one country introduced both types of controls, we extended the sample period for Argentina until June 2007.⁴¹ Figure 6 [ PDF 39.1KB | 1 page ] shows the evolution of the average premium for Argentina over the period 2000-2007. As expected we see that the premium oscillates around zero in no-control periods, becomes positive when controls on outflows are present, and slightly negative when controls on inflows are in effect. Indeed, when looking at the summary statistics (upper part of Table 6 [ PDF 47.7KB | 1 page ]) the mean of the premium in the no-control period equals 0.32, during controls on outflows the average premium amounts to 5.97, while in the control on inflows period the average premium is negative at -0.62. The evidence that the premium resulting from the controls on outflows is much higher than the discount characterizing the control on inflows is a direct reflection of the type of control: qualitative controls on outflows preventing arbitrage and an implicit tax on inflows weakening arbitrage.

To examine further the impact of controls on financial market integration, we estimate AR and TAR models for the three different periods (Table 6 [ PDF 47.7KB | 1 page ], lower panel). The AR model is very similar to model (4) except that in this case two control dummies are introduced: one to capture the impact of controls on outflows on the persistence of a shock and another one to capture the impact of controls on inflows. The results, presented in the bottom part of Table 6 [ PDF 47.7KB | 1 page ] indicate that, as expected, the persistence of a shock is much higher in the control period.⁴²

In addition, we estimate a TAR model to see whether the band of no-arbitrage is affected by the introduction of controls. We use the same procedure as highlighted in the pervious section. First, the model is estimated for the no-control period. Next, the model is estimated for both control periods, where the lower (upper) band is set equal to the value estimated in the no-control period in the case of controls on outflows (inflows). The results confirm our previous findings: the upper band increases when controls on outflows are in effect, and the lower band increases (becomes more negative) when controls on inflows are present.⁴³ Furthermore, although the persistence is highest during the control on outflows, when nonlinearities are taken into account, the half-life once outside the band of no-arbitrage is almost equal for both types of controls.

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