Two types of capital controls exist: permanent and temporary. Both forms have developed a bad name among economists—as they distort markets and have obvious costs—yet countries continue to use them. Why? Permanent controls, which many advanced countries relied on in past decades and many developing countries use today, are part of a long-term development strategy. Temporary controls, on the other hand, are emergency measures imposed in response to hot money flows. If designed—and eventually dismantled—correctly, neither poses a threat to country welfare or to the global economy.
Permanent Capital Controls
Today, long-term capital control regimes are much more prevalent in developing countries than in advanced countries. Every advanced country, with the exception of Iceland, has a relatively open capital account. According to the Chinn-Ito Index,1 this was not always the case, however: less than one-third of advanced countries had open capital accounts in 1970 and only half did in 1984.
Developing countries are now where advanced countries were then: close to half of developing countries—which account for less than one-fifth of world GDP—are considered financially closed. Of these, countries in Asia, Africa, and Eastern Europe have generally maintained permanent capital controls, while those in Latin America have fluctuated between open and closed regimes.
Generally, countries use permanent controls as part of a longer-term strategy to reduce volatility, protect underdeveloped financial systems, and limit currency appreciation from large capital inflows that could impair export performance. Several countries have achieved rapid income and export growth with the use of permanent controls. By contrast, countries that maintained an open capital account while trying to fix their nominal exchange rate have faced booms and busts driven by volatile capital flows.2
Today, China is the most prominent example of a country with long-term capital controls. In addition to maintaining an undervalued exchange rate to support export growth, China’s controls help its state banks provide low-interest rate loans to businesses.3 These subsidized loans support China’s industrial production.
Capital controls also help China limit volatility that could otherwise impair the soundness of its commercial banks—especially given the country’s weak regulatory institutions—and induce price volatility in its real estate market, the main investment opportunity for Chinese households.
At the same time, however, permanent regimes like China’s limit a country’s ability to integrate into world capital markets and establish a modern financial sector. Controls on outflows limit investment opportunities for its citizens, while controls on inflows discourage foreign direct investment (FDI) in some sectors. The closed capital account also hinders prospects for the international use of a country’s currency and may encourage excess reserve accumulation. To the extent that controls are used to maintain an undervalued exchange rate, they also invite protectionist responses. More generally, capital controls—both short- and long-term—can increase the cost of capital, misdirect finance to investments favored by the capital control regime, and encourage corruption.
In addition to facing these costs, countries do not always reap the benefits of controls. Studies that aggregate cases disagree on whether capital controls lower the volume of inflows, though several find that controls can change the composition of inflows.4 By contrast, capital controls are notoriously ineffective in limiting capital outflows (“capital flight”), except perhaps where the domestic financial sector is state owned and/or severely controlled. This difference in effectiveness can bias capital control regimes toward an undervalued exchange rate.
Temporary Capital Controls
Though long-term controls are more common, short-term controls have recently gained traction as developing countries respond to surging capital inflows.5 The inflows have been prompted by the low interest rates, low growth potential, and high debt in advanced countries relative to that in emerging markets, as well as high prices for emerging markets’ commodity prices.6
The surge has placed upward pressure on emerging markets’ exchange rates, leading some countries—including Brazil, Indonesia, Korea, Peru, Thailand, and Turkey—to impose controls. Some measures are variations on old themes, such as Brazil’s tax on portfolio inflows—originally established in 1993, reinstated in 2009, and increased twice in 2010—while others are new, such as disincentives against holding central bank paper in Peru and Indonesia. Generally, currency appreciation slowed or halted around the time these measures were introduced, though the IMF expects their longer-term impact to be limited.
In addition to the costs discussed above, countries must also consider available alternatives before imposing short-term capital controls. When responding to surging inflows, for example, governments have several other options: rein in fiscal policy to decrease domestic demand; tighten financial regulations (for example, raise reserve or collateral requirements); issue securities to dampen the expansionary impact of rising foreign exchange reserves; or allow the exchange rate to appreciate.
A finance minister confronted by a short-term surge in capital flows would be unlikely to respond by adjusting fiscal policy, however, as that could involve distorting taxation or unnecessarily reducing the provision of public goods. And the formulation of fiscal policy often requires complicated political compromises that could hardly be held hostage to the vagaries of exchange-rate changes (imagine U.S. budget negotiations being interrupted with the news that more fiscal adjustment is suddenly required because bond flows were up last month!).
The other policies may be useful in small doses. Allowing modest exchange-rate appreciation may be an appropriate response to a rise in capital inflows, but a large appreciation could lead to costly reallocations of resources between traded and non-traded sectors if it is subsequently reversed. Given that the current surge in inflows is driven in part by unusually low interest rates in advanced countries, there is considerable danger that a reversal will occur as interest rates return to more normal levels.
Tighter prudential regulations could help calm capital-flow-induced lending booms—either across the board or in particular sectors, such as real estate—but excessive controls on lending can impair banks and encourage more difficult-to-regulate lending channels. Issuing securities could also help by mopping up excess liquidity, but this can be expensive—as governments would hold low-interest foreign bonds but issue higher-interest domestic bonds—and perhaps counterproductive, as raising domestic interest rates tends to attract more capital inflows. Thus, depending on the context, imposing controls can be an invaluable tool for achieving monetary policy autonomy and curbing currency appreciation.
As with instability in the broader international monetary system, much of the cause for increased capital flows originates in the core advanced countries—specifically, their low policy rates, low (potential) growth, and the diminished confidence markets have in them. Continuing to push for their own recoveries may be the best thing advanced countries can do to limit capital flow surges to developing countries.
The IMF, and other international institutions, also have a role to play in monitoring the spillovers that policies in core economies can have on the multilateral system. The reports the IMF is planning to issue on the spillover effects from the five biggest economies—the United States, the euro area, the UK, Japan, and China—are a step in the right direction. In addition, countries and international institutions should collaborate to better monitor capital flows. Currently, IMF data has a 3–6 month lag and is not available for all countries, while private-sector data is more limited in the types of flows and countries covered.
In the end, however, countries faced with the threat of surging capital inflows will make their own decisions. And, sometimes, that choice will—rightly—be to pursue capital controls. Even the IMF now recognizes their validity—a sharp turnaround from its 1997 attempt to amend its Article of Agreements to promote capital account liberalization. And, while economists often mention capital controls and trade protectionism in the same breath, the two differ significantly: capital flows carry obvious costs, while trade flows are more clearly beneficial, making controls against the former more justifiable.
In addition, long-term capital controls are perfectly consistent with robust growth, both at the country level (e.g., China) and at the systemic level (e.g., advanced countries following World War II). At the same time, openness to capital flows often accompanies development, and capital mobility can increase efficiency and facilitate diversification. As a country’s income rises, it will need to gradually dismantle controls to gain the benefits of a more open and competitive financial system. But lifting controls should be done cautiously, keeping in mind the explosive crises many emerging markets suffered due to volatile capital movements.
Thus the renewed imposition of capital controls by some emerging markets, and their maintenance in China, should not be looked upon as a serious impediment to development or as a challenge to the international economic order. Instead, they should be seen as what they are—a necessary action for domestic growth and stability.
William Shaw, co-author of the book Juggernaut, is a visiting scholar in Carnegie’s International Economics Program. Vera Eidelman is the managing editor of Carnegie’s International Economic Bulletin.
1 The Chinn-Ito Index measures the extent of openness in capital account transactions in 182 countries. It is composed of four factors: the existence of multiple exchange rates, restrictions on current account transactions, restrictions on capital account transactions, and any requirement that exporters surrender their proceeds. The Index ranges from -2.5 to 2.5; we consider any country with a positive score to have a relatively open capital account.
3 Without capital controls, deposits would flee to higher returns abroad, but, with capital controls, the government can freely limit the interest rates banks pay on deposits, thereby enabling banks to lend at similarly low rates.
4 In individual cases, the efficacy of capital controls—determined by context and design—is clearer. There is little doubt, for example, that China’s capital control regime has affected the volume and composition of its capital flows, while attempts across Africa to use controls to limit the impact of inflationary and distortionary policies during the 1980s and 1990s led to stagnant growth and unreported capital flight. These differences are due to a variety of factors, including the efficiency of public administration and the ability of markets to adjust through derivative instruments or fraudulent trade invoicing.
5 Gross inflows of bonds, equity instruments, and syndicated loan commitments to developing countries rebounded from a crisis-low of about $80 billion in the second half of 2008 to more than $300 billion in the second half of 2010, essentially reaching the pre-crisis peak.
6 A recent IMF study finds that capital flows to emerging markets are significantly and inversely related to U.S. Treasury yields and significantly and positively related to emerging markets’ GDP growth.