Capital Control: Is it necessary?
Like most economic topics out there the one that has been ongoing about capital control necessity is a very intriguing and important one to consider. Capital control is important to consider because the capital account makes up half of a country’s balance of payments (current account + capital account) so it is vital to know exactly what is happening with a country’s capital at any given moment. This information shows where and how a country’s assets are being allocated which in turn can tell the story of why other economic activities may or may not be happening. The question then is “Should capital be a controlled item or should it just be left alone to act and react naturally to everyday global economic conditions?”
A Capital Idea? Reconsidering a Financial Quick Fix
Sebastian Edwards
In 1999 Sebastian Edwards published a paper titled “A Capital Idea? Reconsidering a Financial Quick Fix” that sought to answer that question by looking at how recently observed financial crises in certain countries may have had underlying causal roots stemming from capital control policy. In particular Edwards looks at events that took place in Russia, Chile, South Korea, Brazil, Peru, and several Latin American countries in response to capital controls.
The first argument he makes against capital control comes from observations seen from the crises in Mexico in 1994, Thailand in 1997, Russia in 1998 and Brazil in 1999, Each country experienced high domestic interest rates, pseudo stability coming from steady exchange rates, and appealing market conditions that attracted foreign inflows of funds that lifted stock prices thus expanding current account deficits. Eventually these inflows of funds slowed and even reversed in some of the countries leading to a situation where macroeconomic policies were necessary to balance out the situations at hand.
The only problem was that these governments put into place reform/policies that were either inefficient or too delayed to actually address the problem when it needed to be. As a result of these poor reactions global investors became concerned about the risk in each country and began withdrawing the capital from these areas causing rapid capital outflow and alarmingly swift depletions of foreign exchange reserves. The argument goes that it was the fault of capital control policies put into place in these instances that eventually lead to the governments having no other choice but to allow their currencies to float in accordance to market conditions.
After these crises occurred, and the opportunity to look back on the events that transpired, academics simply said there needs to be a new international financial architecture put in to place. The new system would focus mainly on the control of short term capital inflows and controls on capital outflows with the idea being that these controls will reduce the sporadic and unpredictable movements of capital flows and promote more long-term investments. Edwards argues, and claims empirical evidence backs his argument, that as good intentioned as those ideas may be they simply do not work. Not only are they ineffective but they can also lead to corruption and higher costs associated with managing investments.
From 1978-1982 and again from 1991-1998 Chile decided to utilize short-term capital controls that required inflows of short-term funds to first be deposited in Chile’s central bank for an agreed upon amount of time garnering no interest in the meantime. The idea was that this would stabilize the volatility of capital, prevent the currency value from rising too quickly in response to accelerated capital inflows, and increase the central bank’s ability to conduct domestic monetary policy. Although the immediate response to these policies appeared to be positive Edwards argues that the results do not fully show what happened because of these capital controls.
In response to these capital controls the largely unregulated banking sector utilized many international loans since the inflow would have a frozen interest rate thus giving incentive to use the international loans in the first place. This caused an asset-price bubble that would eventually pop leading to the Chilean borrowers being unable to pay off their loans. This then lead to a government bailout and a complete reformation of the Chilean banking sector, thus feeding fuel to the idea that this problem arose from the initial short-term capital controls put in place that tempted domestic borrowers to utilize international loans in the first place. This situation brings forth what Edwards considers to be the main factor necessary for a country to have if capital controls are to be effective; which is that the country needs to have an effective and properly regulated banking industry if capital controls even want to stand a chance at being successful.
Edwards also goes on to implement the idea that capital controls can promote “complacent and careless” behavior from both investors and policy makers. South Korea experienced this in 1997 when Goldman Sachs incorrectly assessed the risk associated with South Korean investments due to complacency caused by the “security” provided by their capital controls. Along with that instance is the short-term capital inflow restrictions Brazil implemented in 1997 and 1998 which caused lawmakers to slip into a lulled state of inactivity with the thought that their capital controls would allow them to react before any possible currency issues got out of hand. However when the Brazilian real collapsed in late 1998 both domestic and foreign investors rushed to withdrawal from Brazil even with the capital controls in place.
During Chile’s second attempt at utilizing capital controls in the 90’s a few more side-effects were seen from the implemented controls. Even with the capital controls in place Chile’s foreign-denominated debt was nearly 50 percent of all debt from 1996-1998. Along with that the capital controls failed to slow the strengthening of Chile’s currency, which can be seen from a 30-plus percent increase in Chile’s real exchange rate over that period. This second utilization of capital controls by Chile failed to show whether or not it actually strengthened the central bank’s control of domestic monetary policy. Perhaps the most interesting effect of capital control to arise from this time period is the idea that capital controls actually inflated the cost of capital for domestic firms. This does not affect big businesses like it does small or medium sized businesses due to the concept of economies of scale and scope. In essence, the idea here is that capital controls may discriminate against small to medium-sized businesses by inflating their costs of capitals while allowing larger firms to remain normally operational.
Edwards’ idea of what capital controls should be is that they are put into place so as to allow implementing policies such as lowering interest rates to promote growth without fear of losing investors who fear the ensuing devaluation in currency. The capital controls should be there to reassure the investors that things will return to normal (and the controls removed) after the policy runs its course and accomplishes its goal. However, two studies done of 31 major currency crises in Latin America concluded that the countries that tightened controls in response to major devaluations did not post better performances in economic growth, job creation, or inflation than those that did not implement controls.
In fact, it is most important to look at the Latin debt crisis of the 1980s to see reinforcement of all the things that can go wrong when capital controls are utilized and/or the wrong kinds are implemented. The main countries that implemented controls (Argentina, Brazil, Mexico, and Peru) all experienced rising inflation, worsening unemployment, and an arduous decline in growth. The problem arose because these countries implemented stricter controls that encouraged neither macroeconomic restructuring (the necessary financial architecture Edwards mentioned was needed for useful capital controls) nor orderly reforms aimed at increasing efficiency and competitiveness. Rather than go that route policy makers in these countries chose to experiment with populist policies that only made the crisis worsen.
Specifically, Mexico decided to nationalize the banking sector and confiscate dollar-denominated deposits. Argentina and Brazil launched new currencies and set price controls while expanding public spending. In Peru strict controls were placed on outflows which led to a withering of their once healthy and productive economy, wasting international reserves and pursuing a hyperinflationary policy. Another commonality that all these countries shared through this period was that even with controls on capital outflows in place it did not keep capital investment from fleeing the country.
Edwards then points out the contrasting view of what can happen without capital control on outflows with the events that transpired in Chile and Colombia during the same time period. Instead of focusing on capital control both of these countries worked toward restructuring their economies. Chile even went a step further and put into place a modern bank supervisory system, which in turn reduced domestic financial fragility. Edwards says it is because of these restructuring efforts, rather than capital controls, that both Chile and Colombia were able to emerge from the debt crisis in a much better position than the rest of the region.
After considering all of these world crises and events Edwards puts it best in his own words on the necessity for, and the effectiveness of, capital controls; “…despite their new popularity, controls on capital outflows and inflows are ineffective. The best prescriptions to combat financial turmoil, now as then, are sound macroeconomic policies, sufficiently flexible exchange rates, and banking reforms that introduce effective prudential regulations and reduce moral hazard and corruption. Without a solid financial groundwork, emerging markets will remain as fragile as a house of cards, easily blown down by the first breezes of turbulence.”
The Unholy Trinity
In 1999 Paul Krugman Published a paper titled “The Return of Depression Economics” and in it explains a concept called “The Unholy Trinity”. The concept stemmed from Robert Mundell who inferred that common economic logic states that countries can not attain all it is they want and that every exchange rate system requires people to give up one important objective in order to achieve another. Based on fundamental international financial logic the unholy trinity is unattainable as a whole. At most two conditions can be met at any given time. The “trillemma” explained by the unholy trinity is extremely helpful when assessing the true difficulties that are associated with utilizing capital controls.
The first objective of the trinity is that countries would like to have a solid grasp and control on their interest rates. Achieving this objective allows a country the ability to raise interest rates in order to counter inflation or lower those rates to fight recession. The second objective countries seek is to try and attain stable exchange rates. By having stable exchange rates it protects against volatile movements in the value of that country’s currency. This in turn creates stable business conditions and prevents extreme disruptions in the financial system. The third objective of the trinity states that countries would like to assure businesses that money can be freely moved in or out of the country without any obstacle caused by bureaucracy, paperwork, and opportunities for corruption that can typically be associated with a country’s attempt to limit capital movements.
Countries face a tough decision when trying to implement these objectives because time has shown that regardless of what attempts are made only two, at most, will be attained. This trillemma forces countries to choose their path amongst three basic exchange rates. Firstly is the route of a floating exchange regime, which allows freedom of international transactions and government use of monetary policy but it is done at the cost of volatile changes in market conditions. The second of the choices would be a fixed rate, which establishes stability but at the cost of monetary independence. The last of the choices is to utilize capital controls. Capital controls can have positive effects toward stabilizing the exchange rate all the while maintaining some monetary independence but at the cost of other sporadic problems.
Capital Control Thoughts
I incorporated the unholy trinity into this paper because it seems like every example that was given throughout Edwards’ paper can be broken down into how that country was trying to achieve all three objectives and what went wrong. By walking through some of the crises examples he gives and relating what that country was doing in regards to the objectives of the unholy trinity perhaps better information can be inferred about what truly caused those crises, whether capital controls were to blame or not.
In Edwards’ first example with the crises in Mexico, Thailand, Russia and Brazil there was said to be high domestic interest rates, pseudo stability coming from steady exchange rates, and appealing market conditions that attracted foreign inflows of funds that lifted stock prices thus expanding current account deficits. Eventually these inflows of funds slowed and even reversed in some of the countries leading to a situation where macroeconomic policies were necessary to balance out the situations at hand. Before the crises began each of these countries had a fixed exchange rate policy which accounted for the pseudo stability from the fixed exchange rates. This is important because when the inflows began to slow and even reverse each country went about trying to make policies/implement capital controls so as to bring markets back to equilibrium. In this case however the controls were ineffective and with a fixed exchange rate monetary independence was limited so these countries relied heavily on those inflows to maintain equilibrium.
My perception here is that the original problem stemmed from the fixed exchange rate. It created pseudo stability in their business markets in the first place that attracted the inflows. When those inflows began to diminish regardless of the attempted capital controls there was going to be a currency value problem eventually since a fixed exchange rate would have restricted their monetary independence in the first place. This is not to say that capital controls did not play a part in these crises but it doesn’t appear to be the instigating factor, merely a catalyst that made it happen quicker.
In the case with Chile the attempt to fulfill the unholy trinity leads to the use of capital controls, which in theory should have positive effects toward stabilizing the exchange rate all the while maintaining some monetary independence but at the cost of other sporadic problems. It seems here like the problem Chile faced was that they indeed were trying too hard to attain the unholy trinity that one of the desired objectives ended up being its downfall. Chile was in control of their interest rates (or at least imposed interest rate controls on short-term inflows) and was trying to stabilize their currency and promote the strengthening of fiscal policy-making by using capital controls that sent inflows to the central bank. The third objective states that countries would like to assure businesses that money can be freely moved in or out of the country without any obstacles. By forcing businesses to put their money into the Chilean central bank it caused an obstacle in the flow of business.
This however does not seem to be the main cause of what brought about the Chilean crisis though. It was not only the fact that inflows were being held by the central bank but also the fact that those inflows were interest-free for the Chileans (at least for a certain time). This led to what seems to be fault by human error. Chilean banks made the mistake of rushing out to get international loans at a rate that caused a price-asset bubble to occur and eventually pop. The capital controls Chile imposed may have allowed for this situation to arise but in the end it seems to be the banking industry’s fault for being unwise in their international borrowing and lending.
With all this back and forth data that suggests capital controls are or are not necessarily to blame for crises I think it is important to focus on the possibility of HOW capital controls could be necessary, not just if they are as a whole. I think Edwards is right on the mark when he says that if capital controls were to work the country needs to have an effective and properly regulated banking industry. This could have been the factor that stopped the lending and borrowing problem Chile faced and the driving factor of a successful capital control implementation.
As with a lot of questions that get asked on economic topics the one concerning the necessity for capital control seems to be inconclusive to this point. Arguments are made on both sides of capital control but just looking at case studies from countries it appears that an overall assumption should be that capital controls are not necessary and all we really need, as Edwards would say, is “sound macroeconomic policies, sufficiently flexible exchange rates, and banking reforms that introduce effective prudential regulations and reduce moral hazard and corruption.” Having said that, do I think capital controls can be helpful? I think so, but only if implemented correctly. The only problem with that statement is that to date, it does not appear that anyone knows just how to properly do it.
