The monetary integration of Spain with the rest of Europe will culminate in the elimination of all capital controls by the end of 1992. In Discussion Paper No. 477, Research Fellow José Viñals considers the capital account of Spain's balance of payments in order to determine the extent to which the external liberalization of the trade account associated with Spanish entry into the Community in 1986 has been accompanied by an increase in effective capital mobility, and also to predict the macroeconomic effects of the elimination of remaining capital controls.

Viñals presents a brief overview of Spain's use of exchange controls over the last fifty years and notes that nowadays the controls are stricter on short-term than on long-term capital flows. Moreover, controls on capital outflows are both stricter and more numerous than on inflows. Viñals measures deviations from interest rate parity in order to examine the impact of existing controls on capital flows both before and after Spain's entry into the Community. He finds that effective short-term capital mobility before entry was much higher than was previously believed and that short-term effective capital mobility has been reduced since Spain's entry, and especially since 1987. Since then, controls have been binding on inflows only, and not on outflows, because interest rate differentials have strongly favoured peseta-denominated assets. This arose from the mix of easy fiscal and tight monetary policies and required the interdiction of controls on short-term capital inflows in order to avoid either an excessive appreciation of the peseta or a domestic monetary overflow.

The simple Mundell-Fleming model indicates that in countries with pegged exchange rates the effectiveness of fiscal vis-à- vis monetary policy increases with capital mobility. Since the peseta is now formally inside the EMS, increased capital mobility should make Spanish monetary policy less powerful and fiscal policy more powerful in affecting final domestic variables. Once capital controls are fully removed, the Spanish authorities will be unable to achieve money and exchange rate targets simultaneously, so the control of domestic inflation and the achievement of exchange rate stability will be harder to reconcile. Domestic and foreign interest rates will be closely linked, especially inside the EMS, so fiscal policy will have to be tighter than at present to facilitate the reduction of domestic rates. Hence, while the removal of capital controls will apparently reduce the effectiveness of Spanish monetary policy, it may also improve the effectiveness of fiscal policy, which will help to achieve lower and more stable interest rates.

Spain's Capital Account Shock
José Viñals

Discussion Paper No. 477, November 1990 (IM)