Controls on Flows of Short-Term Capital between Countries

Introduction

Liberalization of the global market has brought with it several ills that many economists view as being detrimental to a particular nation. Some powerful economies take advantage of the liberal market and initiate an upsurge of inflows of their products into a foreign market. As a result, many nations have moved to initiate capital controls, which can either take two forms: long-term or short-term. This is essential for countries to guard themselves against unstable financial situation in the international market, as it has proven to be an effective measure in curbing effects of volatile flows of capital. In emerging market economies (EMEs), capital control is making a renaissance, due to various instances of financial crises occurring in these economies (Gallagher, 2012). Capital flows as well as capital mobility allow those countries with low savings to lobby for finances for their lucrative and viable projects, bolster their investment risk diversification, foster intertemporal trade, and make substantial contribution to financial markets’ development (Chang, 2010). In this regard, those benefits reaped from a free capital flow across different markets are similar to those of free trade, and any restrictions which limit on these sets of freedom means forfeiture of the outstanding benefits.

The risks of imposing restrictions on capital flows notwithstanding, several emerging market economies are put to task with the current increase in inflows of capital that they purport could cause massive problems to their respective economies (Stiglitz, 2000). Though most of the flows are ephemeral, reflecting differentials on interest rates that could be reversed in the event of normalization of interest rates, there is still a major concern creeping in the world of these capital flows regarding their irreparable effects on the economy. For instance, economists have largely reiterated that massive inflows could result into overshooting of exchange rates, or merely some significant appreciations that could complicate management of economies. In addition, they could have an effect on price bubbles, which can inflate significantly, thereby amplifying the fragility of financial crisis risk (Stiglitz, 2000). Moreover, policymakers are making considerations regarding the benign phenomenon of unfettered financial inflows, and their likelihood of turning foreign investors into being subjects of herd behavior, suffering from overarching optimism. The ultimate fear about such unfettered flows is their likelihood to cause collateral damage, such as asset booms, bubble rises, and busts.

The major question troubling policymakers and economists is how best to implement these capital flows, and the likely outcomes of such measures, which may cause both macroeconomic and prudential changes in policies (Stiglitz, 2000). Some of the most common tools used to implement such changes include intervention of foreign exchange market, fiscal policy, exchange rate policy, monetary policy, capital controls, and domestic prudential controls (Forbes, Marcel, Thomas & Roland, 2012). As aforementioned, a choice can be made between short-term and long-term capital controls. The latter are not associated with any forms of ancillary benefits, while the former usually take a bit longer to be withdrawn from an economy, such as foreign direct investment. However, policymakers must be aware of the consequences of imposing capital controls, both to their economy and to other nations of similar interests. This paper proceeds to analyze critically the effects of imposing controls on flows of short-term capital between countries involved in a trade.

Overview of Capital Controls

Capital controls have been used in many countries for a long time. The major question that economists ask is when particularly is capital controls justified? Despite the numerous benefits emerging market economies stand to benefit from allowing unguarded capital inflows and outflows, it has been mentioned that this system could go out of hand, and pose serious challenges to an economy (Forbes, Marcel, Thomas & Roland, 2012). Thus, in instances when the exchange rate has not been undervalued, or when the economy’s operations are taking place near potential, or if the conditions suggest that current flows have high chances of being transitory, or if the reserve levels of an economy are adequate, then the imposition of controls can be justified. This is employed as part of a broader policy toolkit that is used to manage inflows, and judicial use of these controls could extend their potency even after investors have devised some other strategies that could be more effective under such conditions.

Capital control is defined as any restriction imposed on free movement of capital between different countries, or economies. Whether they have worked in past history of practice is a judgment that can only be made through critical analysis of an individual economy, in relation to its trading partner. Generally, controls have proven to be effective in those countries which foster extensive restriction systems on almost all categories of capital flows. Capital controls include prohibitions on all or some transactions of capital accounts, taxes levied on specific sales of assets of international nature, or even regulations on the quantity of international purchases and sales of financial assets (Forbes, Marcel, Thomas & Roland, 2012). Some controls can be serious to an extent of affecting even individual citizens who may receive restrictions on the maximum amount of money one is allowed to carry past the border of an economy, though most of them target the financial sector.

The history of capital controls can be traced back to the time of Bretton Woods agreement, which was established towards the end of World War II (Desai, Foley & Hines, 2006). Following this agreement, many nations moved to imposed various forms of capital controls so as to regulate large flows of finance out of or into their economy. This strategy was considered to be a permanent facet of the international economy. The emerging market economies as well as established or advanced economies imposed capital controls. In theory, it is assumed and almost practical that large financial inbounds could foster a speedy development of a young economy, but empirical evidence disagrees with this notion, by revealing that large inflows can irreversibly hurt economic development of a nation, by appreciating its currency, causing the occurrence of inflation, and creating an upsurge of economic bubble cycles, which are prerequisites of a financial crisis (Forbes, Marcel, Thomas & Roland, 2012). The move to initiate capital controls was, however, reversed by the introduction of free market policies, which displaced the policy in favor of Keynesianism. However, lately, the Global Financial Crisis that was experienced in 2008 has seen many economies embrace the contribution of capital controls as part of prudential and macroeconomic policies to correct the negative consequences of volatile capital inflows. The IMF has also moved to not stigmatize the application of capital controls alongside other macroeconomic policies, as debates continue to rage among policymakers (Patnaik & Shah, 2012). Though it has been found to be quite effective in addressing issues of capital inflow volatilities, there is still widespread debate on the use of capital control as a tool, due to the load of multilateral coordination concerns that accompany it, thus reiterating the sentiments voiced by White and Keynes many years ago.

Benefits of Short-Term Financial Controls to Economies

Several economists in favor of capital controls have given numerous benefits of such a move. Moreover, the view that the regulation of short-term capital flows, and their likelihood of increasing the vulnerability of growing economies to financial crisis, is gaining a wide audience. Following the Chilean example, economists have suggested that emerging markets should follow suite and impose controls on speculative short-term capital flows (Desai, Foley & Hines, 2006). Usually, the objectives of setting up capital controls include but are not limited to: reduction of the volume of flows of capital; altering capital flows composition, especially towards long-term flows; reduce the pressure posed by real exchange rates; and allow for an increased autonomy of monetary policy. The overall aim, though, is to tackle problems associated with volatilities of large capital flows. The most common measure taken to impose restrictions on short-term capital flows, as suggested by Keynes and other economists, is taxation of all foreign exchange transactions.

According to the case study of Latin America, it is revealed that imposition of taxes as a form of capital control helped save the economy from the consequences of short-term capital volatility (DEMIR, 2009). In this country, the Chilean Central Bank liberated the capital market, and allowed unregulated inflow of capital. However, due to the large magnitude of operations for sterilization, domestic interest rates were pushed higher, and this further gave rise to a surge in the short-term inflows of capital. When the policymakers got concerned that the inflows could reverse, steps were taken to regulate and discourage these inflows, which had been proven t be highly volatile. They then introduced taxes on every foreign exchange transaction, and 20% of the total amount was to be deposited in the central bank (El-Shagi, 2012). As a result, sterilized activities were significantly scaled back, and capital controls sufficiently took their toll. Chile experienced a stabilization of its capital market, and its currency survived a consequence that could have led to a resurgence of the financial crisis of 1980s (Desai, Foley & Hines, 2006). In this case of Chile, it succeeded in lengthening the maturity capital inflows, where the balance of the capital account fell to 2.4% from 10% between 1990 and 1991 (Jinjarak, Ilan. & Huanhuan, 2012). In addition, foreign direct investments also rose at this time, in contrast to a decline in short-term inflows. This case study explores and supports the effectiveness of capital controls on stabilizing economies, though opponents of this opinion may not agree.

At almost the same time, Malaysia also imposed controls, as well as Thailand. Between the years 1992 and 1996, Malaysia enjoyed massive inflows of portfolio, though at the end of that period, the economy registered a net account of outflows, and as a result, imposed a $2 million restriction on all domestic banks concerning side swap with foreign clients. With these efforts, Malaysia made grater strides than its neighboring economies. Some of the effects of these limitations realized in Malaysia include monetary independence, where the interbank rate was substantially reduced from 7.75% to 3.15%; reverse on foreign exchange; and increased administrative compliance (Guo & Hutchison, 2006). Overall, the Malaysian case presents two major benefits of short-term capital controls: one, they brought a safeguard of the national economy against any international financial markets’ turbulence, and ensured increase autonomy of financial policy. This helped to reduce the volatility of Malaysian equity markets and currency, thus providing a greater degree of currency certainty. Secondly, the controls created a breathing space for the economy to engage in economic adjustment plans, which it could use to accelerate structural reforms that are prerequisites for a lasting economic recovery (Ostry et al., 2010). In this sense, the controls were crucial in providing a margin of safety to insulate the economy against any external shocks.

The two case studies present a plausible platform to argue for imposition of capital controls. Other numerous economies have succeeded in using this tool alongside other prudential measures and macroeconomic policies to safeguard themselves against capital volatilities. These volatilities present themselves in the form of liabilities of short-term capital flows, which are considered to most likely causes of financial crisis risks (Williamson, Olivier & Arvind, 2012). These inflows can also lead to booms in domestic lending, as well as herding behavior of foreign lenders coupled with myopic borrowers, which increase the fragility of financial position of an economy. However, it must not be assumed that these controls come without reprisals. Since there are benefits that countries, especially the emerging market economies, stand to enjoy in the event of a free trade, with unregulated cash flows, it therefore implies that issuing controls on capital flows would lead to a forfeiture of such benefits.

Arguments of Proponents of Free Capital Flows

Apart from the numerous advantages of free capital flow between countries, some economists have also delved into some of the problems faced in the event of implementing capital controls. First, they posit that a unified and lucid framework for analyzing the macroeconomic consequences of capital controls has not been developed; that there is an alarming heterogeneity across economies on the time and technique of implementing controls; that there are several paradigms of what constitutes success of controls; and that even empirical studies are devoid of a common methodology for imposing controls, and the little existing case studies have been significantly outweighed by the cases of Chile and Malaysia (Ocampo & Stiglitz, 2008; Guo & Hutchison, 2006). In addition to these problems associated with implementation of capital controls, there are additional fears that economists are aware of, which are believed may not augur well with this strategy as a component of a comprehensive toolkit to correct a destabilized economy (Williamson, Olivier & Arvind, 2012).

Free capital movement is essential for economies, especially those that have established themselves up to some level of stability. Generally, it allows funds to be put to productive uses, through enhancing the economic welfare by allowing free channeling of savings (GEZICI, 2013). In addition, developing economies are able to benefit from foreign expertise through foreign direct investment that is made possible by free capital flows. States are also able to find temporary mitigation to their financial recessions, by raising funds from the external markets. Moreover, free capital flows allow both the borrowers and savers to access and enjoy the best market rates (Magud, Carmen & Rogoff, 2011). Controls by use of tax imposition usually lead to funds siphoning off by fraudulent agency and officials, which are channeled for personal use. In this respect, the economy would not be able to realize the benefits or impacts of using capital controls to regulate inflows and outflows. Lastly, some traders can always effectively evade capital controls, and continue with their business as usual, which impacts negatively on monetary value and performance measurements. In lieu of all these advantages, it is sometimes unfavorable for a country to engage in short-term capital flow controls, since it might lose more than it stands to gain.

The imposition of capital controls also has costs, which may make them unfavorable as measures used to curb financial instability. One of the most outstanding consequences is that foreigners are usually scared by the introduction of such controls, and an aura of uncertainty is created, which rapidly erodes their confidence on an economy (Magud, Carmen & Rogoff, 2011). As a result, even after the stabilization of that economy, these investors might be afraid to venture in a lasting and long-term engagement. As in the case of Malaysia, rating agencies downgraded its sovereign credit and risk ratings, due to its imposing controls on capital flows. This greatly widened the spread of its sovereign debt, which was considered to be much larger than that of any other economy (Vithessonthi & Tongurai, 2011). This implies that the controls employed by Malaysia contributed to the adverse effects on its international relations. Following this example, it is questionable whether capital controls are absolutely effective.

In relation to Chile’s case, it is acknowledgeable that the effectiveness of that strategy was mixed, and it does not present an embodiment of a successful use of short-term flows control. While economies strive to alter the composition of capital flows in favor of longer maturing flows, they have not achieved the goal of reducing the magnitude of inflows or funds entering a given country (Guo & Hutchison, 2006)y. Cumulative costs incurred while distorting unfettered financial transactions add on to the ineffectiveness of the scheme (Vithessonthi & Tongurai, 2011). It is therefore arguable that short-term capital controls might not be as effective in reducing the vulnerability of a growing market economy to succumbing to financial crises, thereby reducing the amount of capital flowing into an economy, as has always been believed. While it is generally accepted that imposing taxes on short-term financial transactions may reduce the vulnerability of an economy to facing financial crises, it is not obvious that the amount of capital inflows can be reduced simultaneously (Williamson, Olivier & Arvind, 2012). Taxes can prevent situation of bank runs, which in turn can increase returns received from investing in an emerging market economy (Sudeep, 2011). Measuring the effectiveness of short-term capital controls in reducing the volume of investments by foreigners is pointless, since they can actually skyrocket the volume of capital inflows (Ma & McCauley, 2008). Successful capital controls, according to empirical studies, are effective instruments in reducing emerging market economies’ vulnerability to financial crises. The only serious consideration is how to strategize a judicious measure that would not result into a reverse in capital flows.

Effectiveness of Short-Term Capital Controls

As aforesaid, many economies have imposed capital controls in order to stabilize their markets and monetary power. Capital controls usually present Macroprudential policy, which is effective in reducing risks of financial crises as well as any other externalities associated with free trade. Some critical economists like Dani Rodrik have not found any substantial merits of free capital movement, as a positive correlation with upward growth of an economy (Ma & McCauley, 2008). However, he argues that during the periods of Bretton Woods, when capital controls were used widely, global economic growth was higher than during market liberalization, a case which presents capital controls as a better alternative for both local and international markets (Petriș, 2012). In addition, it is arguable that capital controls which limit residents of a nation from engaging in foreign investments and going through with foreign transactions can ensure availability of cheap domestic credit to the locals, which would foster economic development within a country. In China and India, this system of control is still evident, where residents are encouraged to provide cheap finances directly to their local government, which presents an inexpensive source of funds to investors.

The effectiveness of capital controls have been marred by the upsurge of its adoption by almost all emerging market economies, which is feared to have the probable consequence of worsening global imbalances, especially when the global market is sustained in terms of growth, demand, and policies (Hutchison, Pasricha & Singh, 2012). It has been found that controls imposed by a given country which is a partner of the global market could influence other participants to introduce similar or more stringent controls as well. This trend could pose serious challenges on the stability of the global economy, as well as the strength of financial integration, which may be seen to revert to the less liberal market of the antique times (Ma & McCauley, 2008).

Actually, the use of prudential regulation on the system of a domestic bank to prevent the adverse effects of capital inflows is usually adequate, for instance, creating limits on foreign exchange, and putting restrictions on capital requirements (Inoguchi, 2009). Large capital inflows which threaten to destabilize an economy may call for capital controls to bolster the system of prudential regulations. For this reason, emerging economies must have the flexibility of being able to impose controls whenever they deem fit, since it has proven to be effective in insulating an economy against financial crisis. However, this move should be approached very cautiously, since in some economies, short-term capitals are used to finance long-term ventures, thus imposing controls would be largely detrimental (Williamson, Olivier & Arvind, 2012). Capital controls should also be used only as buttressing tools alongside other measures like prudential and macroeconomic policies to revert the vulnerability of an economy to financial crisis.

Conclusion

The use of capital controls by countries to regulate capital inflow and outflows has both advantages and disadvantages. This strategy has been on the increase since the agreement of Bretton Woods, when several economies embraced this move to prevent large capital flows, thereby strengthening themselves against volatilities of short-term capitals. The overarching concern is whether the impact of such controls can be measured, and whether they are worth venturing into, considering the forfeiture of all benefits associated with free capital movement. It is in the backdrop of these concerns that policymakers have put the effectiveness of capital controls in question. The overall agreement is that some conditions warrant imposition of controls, and these controls are essential for reduction of an economy’s vulnerability to financial crisis.

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