Capital Controls – Good or Bad?

July 27, 2015
Editor(s): Edward Zhang
Writer(s): Wen Lin Ong

The term “capital controls” has been heavily featured in the media right across the world of late, as the Syriza-led Greek government placed restrictions on the outflow of capital from the country after its prime minister Alexis Tsipras failed to negotiate a deal with its creditors. Deposits were being withdrawn at record pace, as the European Central Bank announced that it would cap its “emergency liquidity assistance” – emergency loans given by the Bank of Greece to commercial banks –   to Greek banks.

From fear that it would spark a major bank run and, as a result, trigger a complete meltdown of the financial system, the Greek government was left with no choice but to impose capital controls on June 29 2015. The restrictions include daily cash withdrawals limited to 60 euros, the prohibition of foreign payments and transfers, with urgent transactions subject to approval by the government.

Capital controls are measures taken by a government to limit the flow of capital in and out of the economy; such measures include taxes or restrictions on international transaction in assets like stocks or bonds. Post 1970s, an increasing number of economies, in particular developed nations, began to favour free market operations; capital controls were cast in a negative light, as it restricted the movement of capital in and out of a country. Between 1995 and 2010, there have been 37 countries that have restricted the outflow of capital, each to varied degrees of success.

The Asian Financial Crisis had begun in the late 1990s with South Korean companies defaulting, which spread to Thai companies that also eventually defaulted. The contagion from Thailand had created panic amongst investors in Malaysia, resulting in capital flight from the country. In response to the crisis, the Malaysian government, led by then Prime Minister Mahathir Mohammad, adopted a controversial decision to refuse assistance from the International Monetary Fund (IMF) but to instead, impose capital controls on September 1 1998. Malaysia was relatively successful in its imposition of capital controls, as the economy recovered swiftly soon after. Perhaps equally important, the role that capital controls played in the revival of the Malaysian economy remains hotly debated; other countries like South Korea that were badly hit by the financial crisis had recovered as well.

Source: Litverse

Not all countries that imposed capital controls have resulted in success stories like Malaysia. Plagued with economic malaise, the Argentinian government had passed a law in 1991 that pegged the peso to the U.S. dollar at parity. The initial economic effects were largely positive – Argentina’s chronic inflation was curtailed, whereas foreign investment poured in. Driven by strong economic growth in the U.S., the U.S. dollar appreciated on the foreign exchange market; the Argentine peso followed suit. However, the strong peso hurt exports from Argentina, which caused a protracted economic downturn. In 2001, Argentina defaulted on $US95 billion of debt. In order to uphold its fixed exchange rate, the Argentinian government imposed the corralito, a form capital control, to stop a bank run. The corralito, which was implemented for 12 months, almost completely froze all bank assets and prohibited the withdrawals of U.S. dollars. The move resulted in backlash from many enraged Argentines, causing widespread civil unrest and riots in the country.

Source: Reserve Bank of India

Capital controls are often linked to the “Impossible Trinity” trilemma, which postulates that it is impossible for governments to manage the exchange rate, maintain an independent monetary policy and allow the free flow of capital simultaneously. Instead, governments can only choose two out of the aforementioned three options. For example, suppose the U.S. government wants to lower interest rates to jumpstarts its economy during a recession. In order to do so, the country will need to increase the supply of money in its economy. The lower interest rate environment, nonetheless, will encourage people to invest elsewhere, where they are able to earn a higher rate of interest. They will do so by selling U.S. dollars in the foreign exchange market, increasing the supply of dollars and hence, putting downward pressure on the dollar. If the government wishes to maintain a fixed exchange rate, it will need to sell foreign exchange reserves to purchase dollars in the market to effectively increase the demand for dollars. This is not only an unsustainable, as the country will eventually run out of foreign reserves, but it is also increasing the supply of U.S. dollars within the economy. Hence, the government has already lost autonomy over its monetary policy, as stipulated by the trilemma.

Subject to much debate, capital controls, if implemented appropriately, can be beneficial for the country, as they provide the government with temporary breathing space to devise long-term solutions. However, capital controls are certainly not foolproof. More often than not, they tend to do more harm than good and result in long-term consequences for the economy, exacerbating the country’s economic troubles.

The CAINZ Digest is published by CAINZ, a student society affiliated with the Faculty of Business at the University of Melbourne. Opinions published are not necessarily those of the publishers, printers or editors. CAINZ and the University of Melbourne do not accept any responsibility for the accuracy of information contained in the publication.