Capital Controls

What are Capital Controls?

Capital controls refer to the restrictions imposed by the Government or the Central Bank of a country to regulate the inflows and outflows of the capital account of the economy.

Imposing taxes, tariffs, volume restrictions, and complete bans are among the actions the governing authority might take to limit capital flows.

These policies might apply to the economy, a specific industry (the financial sector), or the entire population.

The controls might apply to all flows or differentiate based on flow type or duration (debt, equity, direct investment, and short-term vs. medium- and long-term).

Types of controls will include:

• Exchange control prohibits or limits the purchase and sale of a national currency at the market rate.
• Quotas limit the amount sold or bought internationally for various financial assets.
• Transaction taxes are taxes imposed on the transaction of exchange of currency.
• Minimum stay requirements.
• Mandatory approval requirements.
• Limits on how much money a private citizen can take out of the country.

Understanding Capital Controls

These policies are set up to regulate and limit the inflow and outflow from capital markets to a country's capital account. These restrictions may apply to the entire economy or just a certain sector or industry.

Monetary Policy can help with these controls. They may do so by limiting the purchase of foreign assets by domestic citizens or by limiting the purchase of domestic assets by foreigners.

Developing economies often use stricter controls to limit the fluctuations in the capital account compared to developed countries, as they are more sensitive to volatility.

These types of restrictions are often imposed after an economic crisis to prevent domestic and foreign investors from withdrawing their investments and to bring stability to the capital account of the economy.

Critics claim these controls impede economic development and efficiency, while supporters feel they are wise since they strengthen the economy's safety.

The world's top economies have flexible regulations over capital inflows and outflows and have phased out previous tighter laws.

However, most of these economies have implemented essential temporary measures to avoid a catastrophic flight of capital outflows during a crisis or a big speculative assault on the currency.

Objectives Of Capital Controls

One of the main aims of using such policies is to increase economic welfare by addressing flaws in the financial system, such as those brought on by informational asymmetries.

Proposals to address these flaws range from improved disclosure and stricter prudential standards to limitations on international capital flows.

When the exchange rate is fixed or highly controlled, control over capital may balance opposing policy objectives.

These justifications include keeping monetary policy's independence to steer it toward domestic goals and lessening pressure on the exchange rate.

The objective of such policies has been to protect monetary and financial stability. This is especially important when there are worries about;

•  The inflationary effects of large inflows or
•  A preliminary risk assessment by banks or the corporate sector.

The policies are also used to support financial repression policies to provide low-cost financing for government budgets and priority sectors.

Another goal of using such policies is to regulate capital-market financial flows into and out of a country's capital account.

Using strict policies on capital account inflows and outflows provides stability and less fluctuation for the country's importers and exporters. This provides economic stability. The goal is to reduce capital account volatility.

Effectiveness and Potential Costs of Capital Controls

The effectiveness of these policies is commonly based on their impact on capital flows and policy objectives, such as :

• Maintaining exchange rate stability, 
• Providing greater monetary policy autonomy, 
• Preserving domestic macroeconomic and financial stability.

While many argue that these regulations strengthen the economy and keep the capital account safe from extreme volatility, critics say these regulations limit economic growth and efficiency. 

Most developed economies worldwide have liberal capital control regulations and have gradually phased out more restrictive rules from the past.

In general, these types of controls are said to be effective. However, the effectiveness varies from developed to developing countries.

Developed countries have more stable financial markets, which means a more stable capital account. However, developing countries do not benefit from this and are vulnerable to volatility. 

If an economy were to remove its restrictions on cross-border transactions, any influential investor could have made the economy crash by withdrawing all of its investments.

There are no generally accepted and reliable measures of the intensity of these policies, and many studies use dummy variables to determine their presence or absence.

As a result, it is frequently challenging to determine whether differences in the variables under consideration are due to the control over the capital account or other factors, some of which are also difficult to quantify (e.g., the effectiveness of prudential supervision).

Long-term and short-term capital flows have proven difficult to distinguish in an economically meaningful way. For example, short-term loans are frequently rolled over, whereas long-term instruments can often be sold in secondary markets on short notice.

The Bretton Woods system

In 1944, a monetary management system was finalized, which promised a thoroughly negotiated monetary order that regulated monetary relations between independent states. Controls on capital accounts guaranteed monetary policy independence.

According to the Bretton Woods system, nations had to ensure that their currencies could be converted into US dollar bills to within 1% of predetermined parity rates, with the dollar being convertible into gold bullion for foreign governments and central banks at US$35 per troy ounce of fine gold.

The International Monetary Fund (IMF) was founded to monitor exchange rates and lend reserve currency to countries with balance of payments deficits. It also anticipated closer collaboration between states to stop future trade imbalances.

The Bretton Woods system was built on two main pillars: 

1. First, both World Wars were common, believing that the Second War was brought on by the First's failure to address economic issues.
2. Power is concentrated in a very handful of states.

The Bretton Woods agreement was signed by all of the delegates of 44 nations.

The key elements of the Bretton Woods system are listed below:

• International Monetary Fund (IMF).
• Fixed Exchange Rate.
• Exchange Rate.
• Gold Standard.
• Exchange Rate Regime.
• Euro.
• Special Drawing Right.
• Balance of Payments.
• Capital Controls

The Bretton Woods Agreement can be found here.

Types Of Capital Controls

The government or the central bank can take a widely diversified range of measures to bring stability to the country's capital account.

In many situations, capital controls have been used with other policy measures to cope with times of significant capital flows rather than independence.

These restrictions often take two broad forms:

1. Administrative or direct controls
2. Market-based or indirect controls

Administrative or direct controls often comprise explicit restrictions on cross-border capital transactions or an approval system.

Direct controls are used to put a quantitative restriction or complete ban on cross-border transactions. For example, putting restrictions on the banking system to control flows.

Indirect controls make these transactions costly by imposing high taxes or using multiple exchange rate systems. For example, the Tobin tax was used in 1978 to restrict foreign transactions.

These restrictions can take many forms, including explicit or implicit taxation of cross-border financial transactions and dual or multiple exchange rate systems. 

Market-based regulations can influence a certain transaction's price or the price and volume.

One of the most commonly employed market-based controls is the indirect taxation of cross-border movements in the form of non-interest-bearing compulsory reserve/deposit requirements, referred to as unremunerated reserve requirements (URR).

Why do countries use capital controls?

Economies adopting these restrictions share the following goals:

• to bring long-term stability to their capital account,
• reduce volatility, 
• protect underdeveloped financial systems,
• and limit currency appreciation from large capital inflows that could impair export performance.

Capital movements between countries may be quite beneficial. They enable investors to diversify their risks and boost profits, enabling inhabitants of receiving nations to fund high investment rates and economic growth while increasing consumption.

The IMF has played a vital role in helping set the policies to restrict the fluctuations in the capital account in most economies. 

The IMF issued a full paper regarding capital controls, which can be found here.

Developed nations are easing protectionist policies on capital transactions to liberalize their capital accounts and benefit from economic efficiency and growth.

Liberalization requires careful proper sequencing and pace of changes in capital account regulations, along with strong supporting policies.

Economies like Argentina, Kenya, and Peru have implemented a moderately quick capital account liberalization.

The Big Bang approach was used by Argentina and Peru when they liberalized their financial accounts. Kenya took five years to liberalize its accounts.

Real World examples

A few of the countries that recently implemented such policies will include the following:

1. Argentina: The economy restricted the involvement of domestic companies with international markets. It required every company to seek permission from the government before international transactions and authorization before distributing dividends to international shareholders.
2. China: The citizens of China are restricted to a $50,000 per year cap for moving money out of yuan. For investors, both inflows and outflows are subject to a quota.
3. India: India liberalized its capital account by removing trade restrictions. Foreigners can buy and sell without limit, but a cap system is used on how many bonds are purchased in rupees.
4. Nigeria: The central bank has compiled a list of approximately 45 imported items, ranging from rice to textiles, for which foreign exchange purchases are prohibited. Nigerians are restricted from buying dollars to invest in Eurobonds. 
5. Malaysia: In 2005, the central bank lifted the currency peg. This made it easier for investors to hedge their local-currency investments and provide flexibility on non-resident financial institutions' transactions.
   • The central bank still uses a ban on offshore currency trading.
6. South Africa: Foreign investors can buy and sell at their own will. However, South African citizens do observe certain rules. For example, the Reserve bank limits domestic individuals and firms from moving money out of the economy.
   • Exporters have to resettle foreign earnings within six months.
7. Turkey: Over the years, the central bank has started regulating foreign-exchange purchases, forced exporters to repatriate some of their hard-currency revenue, and made companies quote contracts only in liras. 
8. Ukraine: Following the pro-Russian uprising in the east, Ukraine declared capital control in 2014. As a result, the IMF advised the economy to include a one-day ban on all currency trade, obligatory conversion of export receipts, and dollar purchase limitations for households.

Capital controls to limit short-term inflows

Short-term capital inflows are often viewed as less risky from a bank's and investor's point of view, but they act as a destabilizer at the aggregate level. 

Long-term capital inflows are more beneficial to the economy as they bring stability and fewer fluctuations in the capital account compared to short-term inflows.

Making an economically relevant distinction between short-term and long-term flows can take time and effort.

Some of the economies using controls to limit capital inflow are listed below:

• Brazil (1993–1997)
• Chile (1991–1998)
• Colombia (1993–1998)
• Malaysia (1994)
• Thailand (1995–1997)

The aim of imposing such controls in all five economies mentioned above was:

• To reduce the reliance on sterilization and, in some situations, to delay other adjustments.
• To target concerns about the macroeconomic implications of the increasing size.
• The volatility of capital inflows.
• To preserve or enhance monetary policy autonomy.

In general, the basic outline of the policies used was similar. All of the countries used indirect controls to limit the fluctuations of the capital account in the form of direct or indirect taxation.

Some countries used direct control to assist the indirect controls. For example, Brazil imposed explicit tax, also known as entrance tax, on certain foreign transactions.

Capital outflow controls During Financial crisis

Similar regulations were also imposed during the Financial crisis of 2007. A few of the economies that focused on these controls during the crisis are mentioned below:

• Malaysia (1998–present)
• Spain (1992)
• Thailand (1997–98)

To cope with the financial crisis, these economies used a selection of effective controls on capital outflows to control the fluctuations in the capital account. 

These policies were implemented:

• To limit downward pressure on their currencies.
• To counter volatile speculative flows that threatened to under - the stability of the exchange rate and depleting foreign exchange reserves.
• To serve as an alternative to the prompt adjustment of economic policies and thus helped the authorities “buy time."
• To insulate the real economy from volatility in the international financial market.

Although all three economies took different approaches to their policies, the main idea was to restrict non-residents' access to domestic currency funds.

The controls excluded current international transactions, foreign direct investment flows, and specific portfolio investments.

In Spain, the controls took the form of a mandatory, non-interest-bearing 100% deposit requirement on local banks to discourage speculation by making certain transactions with non-residents more expensive for the banks.

Following that, these restrictions were reduced to a single deposit requirement on growth in banks' swap operations with non-residents.

Researched & Authored by Laiba Kamran Shamsi | Linkedin

Reviewed and edited by Parul Gupta | LinkedIn

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