Capital Controls on the Cross-Market Premium

In this section, we analyze the effects of capital controls on the cross-market premium. Capital controls are diverse, differing across countries in intensity and over time. Furthermore, there are different types of controls; the most notorious difference is between controls on inflows (typically used to discourage short-term flows) and on outflows (to prevent capital flight in the midst of a crisis). Though the effects will depend on the type and intensity of controls, if the introduction of capital control impedes arbitrage and thus effectively segments markets, this should be reflected in the cross-market premium, as the law of one price ceases to hold.

When controls on inflows are in effect, purchasing the underlying stock to sell the DR would require paying an inflow cost to re-enter the funds into the country. As a result, relatively low domestic prices will not be arbitraged away and the underlying stock will be bought at a discount compared to the DR, as investors need to be compensated for the costs they incur by moving capital into the country. Thus, controls on inflows would introduce a negative cross-market premium. Under 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. This makes it difficult for investors to profit from relatively high domestic prices, introducing a positive cross-market premium. Given that arbitrage takes place mostly within a day (as documented in Levy Yeyati, Schmukler, and Van Horen 2008a), we expect that controls would have an effect right after they are imposed (or lifted), not before, even when anticipated.

A. Brief Chronology of Capital Controls

Periods of capital controls are relatively easy to detect, as governments impose them through laws and a number of public institutions document them. Below we provide a brief summary of the capital controls in the countries under study, during the periods analyzed in this paper. Six countries in our sample experienced a period in which capital restrictions potentially affected the behavior of stock markets: Argentina, Chile, Indonesia, Korea, South Africa, and Venezuela.¹²

Argentina. When the financial and currency crises of 2001 became unsustainable, Argentina introduced controls on capital outflows on 2 December 2001, as well as restrictions on cash withdrawals from commercial banks (the so called “corralito”). Both foreign and domestic investors were prohibited from transferring funds abroad, wire transfers required central bank approval, and foreign currency futures transactions were prohibited. Exactly one year later, the corralito was lifted and capital was allowed to leave the country, albeit with some restrictions on capital outflows. Virtually all controls were eliminated in June 2003. However, authorities re-imposed controls on inflows of foreign capital in 2005. These controls consisted of two restrictions: the amount entering the country must remain within Argentina for 365 days and 30% 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 restrictions were enforced when local businesses obtained loans not falling within the exceptions of the decree (such as financing of foreign trade and direct investment), or when foreign investors bought public or private stocks or bonds in the secondary market. These controls were still in effect at the end of the sample period for Argentina.

Chile. In 1991, Chile had already introduced controls on inflows in the form of an Unremunerated Reserve Requirement (URR), but these controls only affected the DR market from July 1995 onwards. This was due to a 30% non-earning reserve deposit that had to be paid, with the holding equal to the loan maturity, with a minimum of three months and a maximum of one year. Primary DRs were considered capital additions and were therefore never subject to the URR. With markets in turmoil and the Chilean peso under attack, the reserve requirement was lowered to 10% in June 1998. In August, a few months later, the URR was eliminated for secondary DRs, and in September of the same year, reserve requirements on all inflows were eliminated.¹³

Indonesia. The Indonesian capital market was largely liberalized when the first publicly traded DR was introduced by an Indonesian company. However, foreigners were only allowed to purchase up to 49% of all companies' listed shares. In September 1997, this restriction was lifted and foreign investors were allowed to purchase unlimited domestic shares, with the exception of banking shares.

Korea. When the first publicly traded DR was introduced in the Korea, there were restrictions on foreign investments in the stock markets. In particular, there was a ceiling on the share of foreign investor ownership, which was gradually increased over time. In May 1998, the government lifted the foreign investment restrictions on Korean securities, with the exception of Kepco, Posco, mining and air transportation companies, and information and telecommunication companies. Cross-listed stocks using DRs faced an additional restriction: until January 1999, the conversion of underlying shares into DRs was severely restricted, requiring the approval of the issuing company's board. In November 2000, Korea changed its regulations so that underlying shares could be converted to 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.”¹⁴ For four of the stocks in our country portfolio, SK Telecom, Kepco, Posco, and KT Corp, this rule has often prevented arbitrage: in effect, these stocks still faced controls on capital inflows at the end of the sample period (2004). Two other stocks in our portfolio, Kookmin Bank and Hanaro Telecom, were unaffected by the rules during the period covered by our sample, so controls were not effectively in place. These two stocks were not used in the event studies that are presented in the next section. In order to examine the impact of the gradual relaxation of the controls, we divided the control period of Korea into three distinct sub-periods. The first period, which lasted until January 1999, was termed “very restrictive.” The second period, which lasted from January 1999–November 2000, when free conversion started to be allowed but conditioned by the rule, was termed “restrictive.” The third period, which started in November 2000 and lasted until the end of the sample period was termed “less restrictive.”

South Africa. A dual exchange rate system that effectively controlled capital outflows was already in place from 1961–1995, although it was temporarily abandoned from 1983–1985. The dual exchange rate informally existed during the “blocked rand” system (1961–1976) and the “securities rand” system (1976–1979), until it evolved into a formal dual exchange system called the “financial rand” system (1979–1983 and 1985–1995).

The “blocked rand” system introduced restrictions on the repatriation of funds invested in South Africa by non-residents, while residents were prohibited to transfer funds abroad. The proceeds of sales of South African assets by non-residents could not be transferred abroad and instead had to be deposited in “blocked rand” accounts at commercial banks within South Africa. Therefore, non-residents were able to obtain rands in two ways: the direct channel (the official commercial exchange rate) or by buying “blocked rands” through the indirect channel.¹⁵ Since the “blocked rand” exchange rate traded at a discount to the commercial exchange rate, the indirect mechanism was mostly used. The “securities rand” system did not greatly modify the restrictions imposed on residents, but introduced some changes to boost non-residents' investment in South Africa.¹⁶

The “financial rand” system put in place a formal dual exchange rate system with a “commercial rand” subject to intervention by the monetary authorities and a free-floating “financial rand,” which traded at a discount to the commercial rand. The “financial rand” was applied to all current account transactions and the “commercial rand” to capital account transactions for non-residents.¹⁷

In March 1995, the “financial rand system” was abolished and all exchange rate controls were lifted. Only then were non-residents able to invest and repatriate funds, and transfer capital and current gains without restrictions.

Venezuela. The country experienced two periods of controls on capital outflows. The first one started in June 1994, when the foreign exchange market closed, and controls on capital outflows were introduced to stop the severe speculative attacks against the Bolivar. The controls implied an outright prohibition of capital outflows, including the repatriation of nonresident investment, excluding flows related to the repayment of external debt. Furthermore, the measures restricted the availability of foreign exchange for import payments. In May 1996, these controls were abolished, and by January 2003, exchange rate trading was suspended and limits to dollar purchases were introduced. Originally, the measure was introduced as a temporary measure, but remained in place at the end of our sample period (2004) and was accompanied by a new set of stringent capital controls introduced in January 2003.

B. Effects of Capital Controls

To examine the impact of capital controls on financial market integration we performed event studies on a stock level basis.¹⁸ Table 2 [ PDF 21.7KB | 1 page ] presents the summarized results of the event study tests for capital control events, showing the number of cases in which the post-event mean is significantly different from the pre-event mean. The event studies examined whether the post-event mean was significantly different from the pre-event mean. The event date is marked as the date that capital controls change. Pre- and post-event periods are equal in length and add up to a 260-day window. Event studies were done at the stock level but are presented at the country level, averaging across stocks. The upper row displays event study results with respect to controls on outflows, while the bottom row shows the events with respect to controls on inflows. Mean and variance significance tests were done at a 10% significance level.

In addition, we show the behavior of the average cross-market premium changes in controls on outflows (Figure 1 [ PDF 20.4KB | 1 page ]) and changes in controls on inflows (Figure 2 [ PDF 24.6KB | 2 page ]).¹⁹ Figures 1 and 2 display, on a per country basis, the behavior of the cross-market premium before and after the introduction and lifting of capital controls on outflows. The solid line on each graph represents the average cross-market premium across stocks and the dashed line represents the pre- and post-event mean of the average cross-market premium. The horizontal axis represents the number of days prior to or elapsed from the event. For both Figures 1 and 2, we used a 130-day window.

Figures 1 and 2, and Table 2 suggest a common pattern. Before capital controls on outflows were introduced, the cross-market premium was close to zero with a very low volatility, however it rose significantly after controls were imposed. For example, in Argentina the average cross-market premium went from -0.02% to 11.54%. In the case of Venezuela, it went from -1.29% to 24.56%. When controls were lifted, the reverse happened; for example, when Argentina removed the controls on capital outflows, the mean of the average premium decreased from 2.33% to 0.76%. In the case of South Africa, the mean of the average premium decreased by 15.79%, from 17.71% to 1.92%. This result is highly consistent across stocks (as noted in Table 2). The introduction of capital controls significantly increased the cross-market premium for all stocks tested. The lifting of controls resulted in a drop of the premium in all but two stocks (in the case of Argentina).

Note that the premium during the period of capital controls was not only relatively volatile, but also displayed persistence. This persistence reflects capital flowing into and out of the country, since during the periods shown, the intensity of the controls did not change. That is, given a certain restriction to shift funds abroad, the cross-market premium seemed to reflect the pressure exerted by investors by shifting (or trying to shift) funds abroad in any way possible, which was especially evident in the case of Argentina. The mean of the premium six months after controls were imposed was 11.54%. However, the mean had already dropped to only 2.33% in the six months prior to the lifting of the same controls.²⁰ When Argentina imposed controls it was in the midst of its crisis, so these controls became very binding, which explained the very large and sudden shift in the cross-market premium (reaching highs of 32.82 on 7 December 2001 and 34.3 on 20 December 2001). When the controls were abolished, the desire to shift funds out of the country was substantially less, explaining the much lower premium at this time.²¹

As expected, the introduction of controls on inflows had exactly the opposite effect compared to the introduction of controls on outflows: the cross-market premium turned negative. In Argentina, the average cross-market premium dropped to -0.31 from 0.21. While in Chile, the drop was even more pronounced as it fell to -1.63 from 0.03.

When controls on inflows were lifted in Chile, the average cross-market premium again immediately started to oscillate around zero. In the case of Indonesia however, the average cross-market premium fell instead of rising when controls on inflows were lifted. This suggests that the limits on foreign participation may not have been binding at the time, and allowed domestic investors to perform arbitrage. A ceiling on foreign investment did not affect arbitrage by foreign investors as long as foreign participation was well below the limit.

Moreover, in the case of Indonesia, the restrictions on capital movement did not seem to be binding.²² In contrast, in Korea, a similar ceiling combined with a rule restricting the convertibility of the DRs impeded arbitrage, regardless of whether the ceiling was binding. However, when controls on inflows were changed to a less stringent level, the cross-market premium in Korea reacted and the discount became smaller. The evidence that the discount was much lower in Argentina and Chile than in Korea directly reflected the different nature of the restrictions: quantitative limits that prevented arbitrage in Korea, and an implicit tax that weakened arbitrage in Argentina and Chile.

Note that “tax” on inflows effectively decreased the price investors were willing to pay for the underlying stock, as investors add the entry tax to the price of the domestic stock when comparing it to the price of the “un-taxed” DR.

As with controls on outflows, the results were highly consistent across stocks. The introduction of controls on inflows in Argentina and Chile generated discounts for all stocks. On the other hand, the lifting of controls in Chile raised the cross-market premium for all stocks, and the cross-market premium of Indonesian stocks significantly dropped when the controls were lifted. In Korea, the discount for all but two stocks significantly decreased when the intensity of the controls was reduced.

In summary, our results provide evidence that capital controls do affect the size and persistence of deviation of the cross-market premium from zero and cause the law of one price to break down. In other words, regulations on capital movement can prevent investors from engaging in arbitrage-related activities, effectively segmenting the domestic market from the international capital market.

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