What’s it? Capital flow control, often shortened to capital control, is a tool employed by governments and central banks to manage the movement of money across their borders. This strategy aims to influence the flow of capital, which encompasses investments, loans, and other financial assets, into and out of a domestic economy.
Capital controls can take various forms, including taxes on international transactions, specific laws restricting certain types of investments, or even limitations on the total amount of money that can be transferred in or out of the country. The use of capital controls sparks debate as they attempt to strike a balance between maintaining economic stability and fostering long-term growth.
How capital flow control works
Capital control aims to regulate the flow of capital in an economy to support economic stability. For example, when there are no controls, a deteriorating domestic economy will drive a significant capital outflow. It caused severe depreciation. If uncontrolled, this situation creates uncertainty for the domestic economy and can lead to an exchange rate crisis.
The government may establish controls for all cross-border or specific transactions based on sector, asset, or flow duration (short-term vs. long-term).
Goals of capital flow control
The primary objective of capital flow control is to safeguard economic stability. Unfettered capital flows can introduce significant volatility and pose risks to a domestic economy.
Curbing hot money: Short-term investments, often referred to as “hot money,” are particularly susceptible to speculative activity. Foreign investors may rapidly enter a market seeking quick profits, driving up asset prices and potentially causing an overvalued currency. However, when economic conditions change or sentiment sours, these investors may just as quickly pull their money out, triggering a sharp depreciation of the currency and financial market instability.
Exchange rate management: Capital flows can significantly impact exchange rates. Sudden surges in foreign investment can lead to an appreciation of the domestic currency, making exports more expensive and potentially harming export-oriented businesses.
Conversely, capital flight (large outflows of capital) can cause rapid depreciation, increasing the cost of imports and potentially sparking inflation. Capital controls can moderate these fluctuations and promote a more stable exchange rate environment.
Protecting strategic industries: Governments may also use capital controls to shield critical industries, such as telecommunications or energy, from foreign ownership. This can ensure domestic control over essential infrastructure or protect sensitive technologies.
Types of capital flow control
Governments have two main tools at their disposal when implementing capital flow controls:
Capital outflow control. This strategy restricts the amount of money that domestic residents can invest or transfer outside the country. This can limit their ability to purchase foreign assets such as stocks, bonds, or real estate in overseas markets. One example might be a limitation on the amount of foreign currency individuals can purchase each year.
Control capital inflows. This approach focuses on limiting foreign investors’ ability to purchase domestic assets. This can be achieved through restrictions on foreign ownership in certain sectors, quotas on foreign investment in specific asset classes, or even special taxes levied on foreign investment returns. For instance, a government might limit the percentage of a domestic company’s shares that foreign entities can own.
Methods for implementing control
Governments have two main approaches to implementing capital flow controls:
Administrative controls: This method involves direct regulations established by the government to limit capital flows. Here are some examples:
- Tightening transfer procedures: Governments can make it more cumbersome and time-consuming to transfer funds overseas. This could involve increased scrutiny of transactions, additional paperwork requirements, or even limitations on the frequency or size of permissible transfers.
- Prior approval requirements: For specific types of transactions, such as large investments overseas by domestic companies, the government might require prior approval before the transfer can occur. This allows for greater oversight and control over the outflow of capital.
- Foreign ownership restrictions: In certain sectors deemed strategically important, governments might limit or even prohibit foreign ownership of domestic companies or assets. This can be done to safeguard national security interests or protect sensitive technologies.
- Loan restrictions: Authorities may also limit the amount of money that domestic borrowers can borrow from foreign lenders. This can help prevent excessive foreign debt accumulation and potential financial instability.
Market-Based controls: This approach uses economic levers to indirectly influence capital flows by making them more expensive:
- Special taxes: Governments may levy additional taxes on international investment returns earned by foreign investors or on specific types of financial transactions involving foreign capital. This tax burden discourages foreign investment and reduces its attractiveness.
- Mandatory reserve requirements: Foreign investors depositing funds in domestic banks might be required to set aside a portion of their investment as a reserve with the central bank for a specific period. This essentially reduces the amount of readily available capital for investment in the domestic economy, making it less enticing for foreign investors.
- Interest rate adjustments: Central banks can manipulate interest rates to influence capital flows. Raising interest rates can attract foreign investment seeking higher returns while lowering them can discourage capital inflows. However, this approach needs to be balanced with other monetary policy objectives.
The choice between administrative and market-based controls depends on the specific goals and economic context. Administrative controls offer a more direct way to limit capital flows, but they can also be bureaucratic and potentially create distortions in the financial system. Market-based controls are more flexible and market-driven, but they may not always be as effective in achieving the desired outcome.
Examples of capital flow control
In 2013, India’s central bank, the Reserve Bank of India, imposed capital outflow controls to prevent the rupee from depreciating. The limit on remittances abroad has been cut from $200,000 to $75,000. The government also prohibits companies from spending more than their own book value on direct investment abroad unless they get approval from the central bank.
Greece introduced capital controls in 2015 during the bailout extension period ending. The European Central Bank disagrees with extending the Emergency Liquidity Assistance. As a result, the Greek government was forced to suspend commercial bank operations in the country for about 20 days. Massive control is exercised on transfers of funds from Greek banks to foreign banks. The government limits cash withdrawals (only €60 per day is allowed) to avoid an uncontrolled bank run and Greek banking system collapse. Greece then gradually reduced capital controls until they were abolished entirely on September 1, 2019.
The pros and cons of capital flow control
While capital flow control offers potential benefits for economic stability, it also comes with drawbacks that can hinder growth. Let’s delve deeper into both sides of the argument.
Pros
Reduced risk of capital flight: Sudden outflows of large amounts of capital, often triggered by economic anxieties or market turmoil, can cause a rapid depreciation of the domestic currency and financial instability. Capital controls can act as a buffer, limiting these outflows and protecting the currency’s value.
Exchange rate management: Uncontrolled capital flows can lead to sharp fluctuations in exchange rates. Capital controls can moderate these fluctuations, creating a more stable exchange rate environment that benefits businesses engaged in international trade.
Monetary and fiscal policy independence: When a large amount of foreign capital flows into a country, it can limit the effectiveness of central bank policies. For instance, if a central bank tries to raise interest rates to curb inflation, foreign investors might be attracted by these higher returns, further inflating the currency and undermining the intended effect. Capital controls can provide policymakers with more autonomy in managing domestic interest rates and fiscal spending.
Protecting strategic industries: Governments may use capital controls to safeguard critical sectors, such as telecommunications or energy, from foreign ownership. This can be done to ensure domestic control over essential infrastructure or to protect sensitive technologies.
Cons
Reduced access to foreign capital: Capital controls can make it more difficult for domestic companies to access foreign investment funds for financing expansion or innovation. This can stifle economic growth, particularly for developing economies that rely on external capital inflows.
Discouraged foreign investment and innovation: Strict capital controls can create a perception of a less open and transparent economy, discouraging foreign investors from entering the market. This can limit the transfer of expertise and technology, hindering innovation and productivity growth.
Increased administrative costs and potential corruption: Implementing and enforcing capital controls requires a significant administrative burden for governments. Additionally, complex regulations can create opportunities for corruption by bureaucrats who might exploit loopholes for personal gain.
Market distortions and inefficiency: Capital controls can distort market mechanisms by making it more expensive or difficult to allocate capital efficiently. This can lead to misallocation of resources and hinder overall economic efficiency.
