Capital Controls

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The free flow of money across national borders: That’s the soul of the modern global economy. It puts capital where it’s most useful, maximizing prosperity. What’s not to like? The disastrous busts that can come after giddy booms. To fight back, 37 countries restricted the flow of money out of their economies between 1995 and 2010. Sometimes it seemed to work. Sometimes not. It’s hard to control the flow of capital without scaring away foreign investors. But what about when investors run away on their own? From 2010 to 2012 investors poured $3.6 trillion into developing countries as they chased higher returns than they could find at home. When the U.S. markets perked up and the pendulum swung the other way, stocks in countries from Brazil to Turkey plummeted, corporate borrowing costs soared and currencies crashed. The collapse of oil prices in late 2014 threatened to set off yet another round of instability. No wonder capital controls retain their appeal.

The Situation

As the ruble continued to tumble in December 2014, Russia’s economy minister denied that capital controls were being considered. But the failure of a series of interest rate hikes and $80 billion in central bank interventions to stop the ruble’s rout led many to conclude that some limits were likely, increasing the pressure to sell. Russia had already urged exporters to convert more foreign revenue into the local currency, a step some authorities say is tantamount to capital controls. The only countries to impose controls in 2014 were Ukraine, which acted as its conflict with Russia grew, and Ghana. Both eased the restrictions within months, in Ukraine after securing a $17 billion loan from the International Monetary Fund. Other countries rolling back limits imposed earlier included Argentina and Venezuela, where a currency crunch caused shortages of food and medicine and fueled the world’s highest inflation, and Cyprus, which had become the first country in the euro area to impose capital controls during a banking crisis in 2013. Iceland said in December it was ready to unwind controls six years after they were imposed as part of the government’s response to the banking collapse in 2008. China is starting to relax controls that have anchored the economy for three decades.

Source: EPFR Global
Source: EPFR Global

The Background

To discourage foreign money from flooding a national economy or leaving it high and dry, a government can restrict withdrawals from banks, limit foreign-exchange transactions or tax the purchase of stocks and bonds. These measures were uncommon until the 1930s, when countries started using them to keep scarce resources from flowing away during the Great Depression. After World War II, rules restricting capital flows became an established part of a world financial system. Only in 1971, when U.S. President Richard Nixon abandoned the dollar’s peg to gold, did major currencies start floating and countries lift controls. A new consensus favoring open capital markets lasted until the Asian financial crises of the late 1990s provided provisional evidence that capital controls could work: Malaysia recovered swiftly after imposing restrictions in September 1998. (South Korea recovered too, without them.) By 2010, the IMF was ready to acknowledge that capital controls can forestall financial crises.

The Argument

Many economists now say there’s a time and place for limited capital controls. Still hotly debated is how well they work. Few doubt that capital flows across borders usually provide financing for high-return investment and bring technology, innovation and growth. Nor that the dismal economic performance of countries such as Venezuela and Argentina over the past few years shows that enduring capital controls distort allocation of resources and discourage investment. Limited controls on capital inflows are thought to prevent currency overvaluation and financial bubbles. In a financial crisis, restrictions on outflows give policy makers some breathing space to address the shortcomings in their economies and ward off panic selling. Controls are neither foolproof nor cost free. Investors find ways around them through financial innovation and bribery and they can prevent productive foreign investment. Then there’s the impossible trilemma — one cannot simultaneously have free capital flow and control of interest and exchange rates. Something has to give.

The Reference Shelf

  • Federal Reserve Bank of St. Louis reviewed the history of capital controls in 1999.
  • Economist Paul Krugman went against the conventional wisdom by endorsing Malaysia’s capital controls during the Asian Financial crisis.
  • The IMF revealed its historical shift in its view toward capital controls in 2010.
  • Economists including Kristin Forbes study the spillover effects of capital controls.

(This QuickTake includes a corrected reference to the “impossible trilemma.”)

First Published March 20, 2014

To contact the writer of this QuickTake:

Ye Xie in New York at yxie6@bloomberg.net

To contact the editor responsible for this QuickTake:

Jonathan I. Landman at jlandman4@bloomberg.net