From the 1940s to the late 1980s, capital controls, or restrictions on the flow of money across borders, were the norm around the world. In Europe, anyone who needed foreign exchange to trade with another country (so-called “current account transactions”) to buy goods or services, could get it. But it was not so easy to get money that could be used for currency speculation, or to buy and sell stocks in other country’s stock markets. Often there was a special, less favorable, exchange rate for such transactions. Ordinary individuals confronted these capital controls when they wanted to take a trip abroad: typically, they were allowed only a limited amount of foreign exchange.
It hadn’t always been this way. In the 19th century there were no man-made restrictions on the flow of capital. But at least partly because of the lack of technology, capital moved far more slowly than it does today. Until the 1930s, the world was on the gold standard—a system by which all domestic money had to be backed, in full, by the government’s gold reserves. In essence, the government promised to convert any or all of the country’s local currency for gold at a constant rate of exchange. The idea behind the system was easy: if a country ran a balance of payments deficit, gold would leave the country as payments for imports went out faster than payments for exports came in. The government would have to take money out of circulation, that would make the money supply fall, and prices would decline. This would make local goods more attractive and imported goods less so. Exports would rise and imports would fall and the balance of payment deficit would, in theory, turn into a surplus. Gold would return and equilibrium would be restored. Thus, for the gold standard system to work, the capital account had to be liberal. Otherwise, gold could not be shipped from one country to another.
The gold standard broke down and was abandoned by the U.S. in the Great Depression: maintaining the system required a process of deflation that was simply too painful to sustain, especially during a period of deep economic contraction. Other countries also abandoned the system in droves, each hoping that freeing the exchange rate from the gold standard’s “strait jacket” would increase exports. But, of course, when all countries tried to do this simultaneously, nobody’s exports rose; imbalances remained and currencies weakened. Capital controls had to be imposed. As World War II came to an end and the advanced industrialized countries tried to reestablish the global economic order, a system of fixed exchange rates was again set up, and the International Monetary Fund (IMF) was created to help make it work. The system that was set up focused on trade; it centered on reducing foreign exchange restrictions associated with trade, a process known as current account liberalization. It was designed to maintain stability in exchange rates and a ready availability of foreign exchange, both of which were required to facilitate trade. Today, almost all countries have fully liberalized their current account.
Except for two brief periods, the Depression of 1929 and in the 1970s, the US always had open capital markets. But it was only in the 1960s that some European countries began to gradually ease restrictions and the trend spread very gradually until, by the 1990s, most developed countries in the world had full capital account liberalization. In countries that adopted these policies anyone could buy and sell any other currency that was fully liberalized, for whatever purpose. Supposedly, the only reporting requirements were those designed to ensure compliance with tax laws. Money could travel to buy stocks in other countries, to invest in other countries or to buy other currencies. Soon, enormous markets in foreign exchange developed with New York, London, Frankfurt and Tokyo becoming the major centers, and with active trade also being done in Hong Kong and Singapore.
The trend towards full capital account liberalization was part of a larger push for economic liberalization that began in the U.S. with the election of President Ronald Reagan, and in the UK with the election of Prime Minister Margaret Thatcher—both of whom were great believers in free markets. Economists didn’t do much research, either theoretical or empirical, as to whether liberalization was a good idea. Nonetheless, many believed the free flow of capital would enrich countries all over the world. At an intuitive level, it made sense: developing countries tend to have wealth of opportunities but little capital. Allowing developing countries to import capital freely would be a “win-win” situation for all: the developing countries’ growth potential is realized while, at the same time, profiting those foreigners who made the investments. After all, trade and investment had helped wealthy countries develop in the nineteenth century.
The UK lifted controls in 1979 and then Germany in 1984. The last European countries to lift controls were Portugal and Ireland in the early 1990s. European countries pegged their currencies to each other (See Foreign Exchange Crises) and traded in a band known as the European Exchange Rate Mechanism. Some developing countries, such as China, India, and Sri Lanka, largely kept their controls but others, especially in Latin America and East Asia, began to liberalize. In the developing countries, the process started with Chile in the early 1970s and soon spread to almost all Latin countries. Asia was a late comer into the game liberalizing capital accounts a decade or so later. As barriers were removed, money began to flow into many of these developing countries. Foreign investors eagerly bought the stocks and bonds issued by companies in developing countries, as well as lending them money directly. Indeed, by September, 1997, at its annual meeting in Hong Kong, the IMF lobbied member-states to change its charter to allow it to push countries towards full capital account liberalization.
The arguments for capital account liberalization and against capital controls can be summarized thus:
- Flows of foreign capital into a country can help improve productivity and this, in turn, brings about a major increase in living standards. It also promotes integration of economies into the world financial system; the increased availability of capital and diversity of its source is good for growth.
- Open capital accounts promote good policies: countries which have stable governments, fair and consistent regulations, and attractive investment climates will attract more funds. Capital market liberalization provides both a carrot and a stick; countries that pursue such policies will find that they can attract more capital; those that do not will find capital rapidly leaving.
- Capital controls are micro-economically inefficient in that they hinder the optimal allocation of resources ie, money isn’t allowed to naturally flow to the most efficient or successful companies, or investments. Controls also have large administrative costs, are widely evaded, and give rise to corruption.
But the downside of the process proved to be painful, and a series of global financial crises beginning in the late 1990s helped to start the reversal in the trend of rapid capital market liberalization. True, the heavy inflow of capital into developing countries that liberalized their capital accounts had pushed the value of those countries’ currencies upwards against the U.S. dollar. But when foreign investors lost confidence in the economies of these countries, they began to pull their money out. The value of the currencies then fell sharply against the U.S. dollar, making it ever more difficult for the developing countries to pay back their debts and causing foreign investors to lose even more confidence. The years after capital market liberalization spread were punctuated by a series of financial crises, including the Asian crisis in 1997, the Russian crisis in 1998, the Brazilian crisis in 1999, the crises in Turkey and Argentina in 2001. Over a hundred countries have faced crises in the past 30 years. While a number of different factors have contributed to each, capital market liberalization has usually been an important factor: Most of the crises have been precipitated by the rapid flow of money out of the country, and in some cases, such as Thailand, the country’s problems prior to the crisis had been exacerbated by rapid flows of money into the country.
In 1997 the Asian crisis began when foreign exchange speculators began selling off Asian currencies. The countries were stuck in a tight place. The way to stop money going out of a country is to raise interest rates, but developing countries found that raising interest rates was terrible for their banking sector. Higher interest rates mean that people and companies who have borrowed money find it harder to pay it back. When they stop repaying, banks go out of business and stop lending. Less developed countries don’t have strong stock markets and so rely far more on bank finance to grow the economy and create jobs. Bank closures can mean the economy stops growing. After currencies collapsed in Thailand, South Korea and Indonesia, so did their banking systems. As things got worse, commercial banks with long-term relations with many of the affected countries also reduced their credit lines. The end result was massive bankruptcies and an increase in unemployment. Ultimately some 12%-15% of Gross Domestic Product left these countries as capital flowed out.
Of course, Thailand, South Korea, and Indonesia did not have perfect economies and there were problems with some of their companies and banks, including shaky lending practices; overinvestment in bubble assets, such as real estate; lack of regulation and oversight—all of which contributed to the weakness in the region’s banks. But despite these serious flaws, the crisis itself was triggered by the massive outflows of capital. Many people began to question whether rapid widespread capital market liberalization was really a good idea—what was the point of bringing in millions of dollars of foreign capital, driving up the value of your own currency and then seeing it leave again? They noted that countries such as China, India and Vietnam that have capital controls were relatively unaffected by the crisis. In 1998 Malaysia imposed controls on hot money (see Malaysia case study) and, to some extent, was vindicated when it turned out that these worked far better than people had predicted before they were imposed.
Another aspect of capital liberalization that has challenged policy-makers in developing countries over the past few years has been the strengthening of their currencies as the value of the US dollar has declined. This has made their exports relatively more expensive in the US market and has led to a chorus of complaints from businesspeople about the “strong baht” or the “strong rand” or the “strong peso”. In fact, some governments have been tempted into new capital controls specifically to stop their currencies strengthening further. One example that drew probably the most attention was the imposition in 2006 by Thailand of controls that required foreign investors to lodge 30% of incoming funds with the central bank at no interest (and pay a 10% tax if the funds were withdrawn in less than a year) – similar to the Malaysian measures already referred. A 15% fall in the stock market the day the curbs were announced led the shocked Thai authorities to exempt investment in stocks from the new controls, and eventually they lifted the 30% reserve requirement just over a year later, replacing it with some less stringent limits on Thai institutions borrowing abroad.
Critics of rapid capital account liberalization market say:
- There is a difference between foreign direct investment (FDI), (that is, investment in factories, businesses, and things that produce goods and services) and portfolio investment in stocks and bonds, which tends to be more speculative. FDI is money that is sunk into ownership of companies and property that can’t be pulled out of a country overnight. Early supporters of capital account liberalization did not really think about the differences between these two kinds of capital flows, but now while pretty much everyone agrees that FDI is important, they worry about unregulated portfolio investment and the effect it has on developing countries.
- Many advocates of capital market liberalization claim that without capital market liberalization, countries will not be able to attract foreign direct investment but there is little evidence to support that conclusion. China, for example, is the largest FDI recipient in the world and has a closed capital account (the Chinese government has made verbal commitments to liberalize, but few measures have yet been taken).
- Capital market liberalization was pushed even on countries where there was no shortage of capital—those in East Asia, that were having a difficult time investing their savings well. This is not necessarily a problem if a country has a strong regulatory framework and financial sector. The G-7 group of developed countries, for example, have liberalized capital accounts and have not suffered major crises as a result.
- Free capital mobility makes macro-economic management difficult, in good times, as well as bad. In good times, the rush of money into a country can lead to an overvalued exchange rate. That swells the country’s liquidity which, in turn, fuels inflation. To avoid inflation, countries often raise interest rates, but this simply makes matters worse, as more capital is attracted into the country.
- While many countries have had problems implementing capital controls, some have done so with remarkable success, such as Chile and Malaysia. Even if controls are imperfect and partially evaded, they still may help stabilize the economy (as Paul Volcker, former chairman of the U.S. Federal Reserve, put it, a leaky umbrella still may provide some protection on a rainy day.) But it’s important to distinguish between controls that stop capital from coming in, as in Chile, and those that stop capital from flowing out, as in Malaysia. The two types of controls have very different implications.
- International financial markets are capricious. Even countries that have reasonably good economic policies may find themselves suddenly facing higher interest rates, or a broader loss of confidence as money is quickly pulled out.
- Changes in technology have exacerbated the increase in volatility associated with capital market liberalization. When capital movements were first liberalized, foreign exchange trading was far less developed and communications were slower, so it was hard to imagine that it would be possible for speculators and banks to take hundreds of millions of dollars out of a country overnight.
By the summer of 1999, the IMF’s chief economist, Michael Mussa, had publicly acknowledged these risks, and the issue of the change in the charter was dropped. In November 2001, the IMF’s new first deputy managing director, Anne Kreuger, acknowledged that it might be desirable to impose capital controls in the event of a crisis. The debate over capital controls has remained highly contentious, but even mainstream economists have began to say that capital market liberalization should be done slowly and only after certain conditions had been met such as:
Development of a strong banking sector that is able to handle large inflows and channel them into productive investments.
- A restructured and efficient corporate sector that can use inflows effectively and not throw “good money after bad”.
- A strong regulatory and legal regime that restricts monopolistic practices, ensures prudential banking practices, and, when needed, regulates bankruptcy of debt-burdened corporations.
- A sound macroeconomic environment that avoids large fiscal deficits, which exacerbates the overheating associated with capital inflows, and inflexible exchange rate regimes, which can not handle the volatility of capital flows.
- A strong system of prudential regulation, and laws that mandate proper accounting, auditing, and reporting
- No implicit government guarantees that encourage excessive inflows of short term capital.
As well, the idea of controls used as a preventive measure—to stop the build up of excessive short -term liabilities—has become increasingly accepted by some top economists:
Columbia University professor Jagdish Baghwati, a top economist in the field of trade, asserts that although free trade helps developing countries, the risks from unfettered capital market liberalization are very high. He points out that there is no evidence that capital market liberalization provides more benefits then you would get from opening up to foreign investment, and that the benefits that do come from free movement of capital can be wiped out by crises that cause growth to collapse.
Harvard economist Dani Rodrik, who has also criticized excessively rapid trade liberalization, concluded that there is no statistical evidence supporting the view that capital market liberalization boosts economic growth or leads to more real investment.
Studies at the World Bank and elsewhere showed that capital market liberalization was systematically related to instability and crises.
Types of controls
Taxes. Chile imposed taxes on capital into the country; Malaysia on capital leaving the country. Some countries have discussed limiting the tax deductibility of foreign denominated short-term debt. The point of taxes is that they affect the incentives to borrow abroad, and they can be fine-tuned; for instance, discouraging short-term borrowing without discouraging long-term borrowing.
Bank regulations. Banks regulations can make sure that banks limit foreign borrowing as a ratio of their foreign denominated assets. After all, it is this so called “currency mismatch” that often gives rise to problems. Restrictions can also be placed on the extent to which banks lend to firms that have an excessive exposure to short-term foreign-denominated liabilities. Such regulations are today typically considered part of prudential bank regulations, and thus are not as subject to as much criticism.
Direct controls. China, India, and many other countries continue to impose direct controls on foreign exchange transactions. In Vietnam, companies need to get permission to buy foreign exchange and have to show what they need it for. Companies involved in construction get higher priority than companies that are selling things.
There are examples of success and failure. Critics point to the failures, suggesting that the success requires a high level of sophistication. Advocates argue that we now know much more about how to make such systems work. Malaysian bank regulations succeeded in limiting the foreign exchange exposure of companies in their country, resulting in that country having a shorter downturn than other countries in the region and being left with less debt. But critics say that Malaysian capital controls were imposed “after the horse left the barn.” In other words, by the time the controls were imposed, capital had already flowed out and the controls were superfluous. For example, South Korea and Malaysia ended with a similar post-crisis outcome even though the former did not impose controls and the latter did. Chilean controls succeeded in reducing inflows of short-term capital, with little adverse effect on long term flows. But Chile later abandoned the system, at a time when the problem was a shortage of flows rather than an excess of flow. Ultimately, while the capital controls did not isolate the country from the vagaries of the international market place, it did reduce the impact.
Economists now generally agree that rapid liberalization of capital markets can be dangerous for developing countries unless they have strong banking sectors and developed ways of overseeing the financial sector. The idea of controls on short-term borrowing has also become increasingly accepted, even if the idea of imposing controls during a crisis is still controversial. However, it is unlikely that the past trend of liberalization will be reversed. Countries that have liberalized will find it difficult to go back to the old system, but it seems likely that countries that have not fully liberalized (China, Vietnam, Laos, Malaysia) will not rush to do so.
The Arguments for and Against Capital Controls
- Can prevent crises from happening by stopping large inflows.
- Gives countries flexibility so they can lower interest rates and promote growth without worrying about their currency collapsing.
- Gives countries breathing room during a crisis so they can reorder the financial sector.
- Ensures domestic savings are used locally. Countries like Vietnam and Laos don’t want to see local savings invested abroad as these countries need capital to grow their own economies.
- Hard to enforce.
- Ineffective even when they are enforced. Sebastian Edwards and other opponents say that countries which stepped up capital controls after crisis, such as Argentina, Brazil and Mexico experienced slower growth.
- Produces distortions.
- Encourages smuggling.
- Lulls countries into a false sense of security, not changing policies because they feel protected from market discipline and are protected from capital flight.
Tips for reporters
- What kinds of controls govern your country’s currencies now and are they effective?
- Is there a need to change the rules? If so, why?
- What would the consequences be if the regulations were changed? What would the consequences be if they were not changed?
- What is the level of short-term borrowing in your country?
- What is the level of dollar-denominated debt your country owes?
- Are banks in your country excessively exposed to short term dollar-denominated loans? Will they suffer if there was to be a large movement in the currency?
- Do firms in your country face a currency mismatch? Have they heavily borrowed in dollars even though their earnings are predominantly in local currencies?
- What are the major vested interests in your country that would benefit from freer capital movements? Which will be hurt?
- Are there sufficiently advanced institutional frameworks that could monitor capital flows and, if needed, influence them through direct and indirect controls?
- What is the level of foreign direct investment (FDI) in your country compared to the level of portfolio investment?