What’s it: Capital flow control, or we will briefly call it capital control, is any action taken by the government, central bank, or other regulatory body to limit the flow of capital in the domestic economy. Control can take forms such as taxes, laws, and limits on transaction volume.
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.
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).
Types of capital flow control
In general, governments can enforce two types of capital flow controls:
- Capital outflow control. The government limits the money that goes out of the domestic economy. That limits the ability of domestic residents to acquire foreign assets.
- Control capital inflows. In this case, the government restricts foreigners from buying domestic assets such as stocks and bonds.
Restrictions may also be:
- Administrative control
- Market-based control
Under administrative control, the government established policies to prohibit direct cross-border capital transactions, for example, by tightening funds transfer procedures. The purpose of administrative control is to directly influence the volume of capital flows.
The government may be able to set limits on loans from foreign creditors. And, if the loan exceeds the ceiling, the domestic debtor must obtain government approval.
Meanwhile, under market-based control, the government tries to control the flow of capital by making it more expensive. So, not only affects capital transactions, but this policy also affects the price (cost) of a transaction.
There are various ways to implement market-based control, including:
- Special tax on international investment returns
- Tax on certain types of transactions
- Mandatory reserve requirements. Foreign creditors who wish to deposit money at a domestic bank must first deposit a certain amount at the central bank without interest for a certain period.
Purposes of capital flow control
The ultimate goal of controlling capital flows is to maintain economic stability. The flow of capital often creates instability and endangers the domestic economy.
For example, a short-term investment flow (we call it hot money) such portfolio investment is highly volatile due to speculative behavior. The capital inflows come suddenly to take short term profit, causing a sharp appreciation of the exchange rate. And when the economy worsens a little, foreign investors give up assets abruptly and out of domestic, leading to severe depreciation. Such a situation causes sharp fluctuations in the domestic currency exchange rate, creates instability, and disrupts various economic decisions.
Capital control pros and cons
Capital flow control is a topic of pros and cons. Critics believe that capital controls limit economic progress and efficiency.
Globalization and financial market integration have contributed to increasing access to cheaper and more abundant capital. Opening up the economy to foreign capital gives companies access to finance, which is important for financing investment. The application of capital controls will only result in high investment costs.
I will list arguments that criticize the control of capital flows and prefer the free flow of capital.
- The capital flow restriction policy raises administrative costs for implementing it.
- Control creates negative perceptions of the economy, making it difficult to access finance to cheaper foreign capital.
- The free flow of capital stimulates economic growth because savings can be channeled to its most productive uses.
- Foreign investment, especially foreign direct investment, enables the transfer of expertise to the domestic economy.
- Free flow allows companies to access cheaper funds, reducing the cost of investing in fixed capital.
- Controls such as taxes often end in corruption by bureaucrats, not for the benefit of the economy.
Proponents argue that capital controls are necessary. It increases economic stability by reducing risk exposures, such as capital flight.
Proponents argue that capital flow control is necessary to:
- Avoiding shocks to the economy due to short-term speculative action. The free flow of capital makes the economy more vulnerable to any changes in market conditions. Capital outflows or massive speculative attacks can harm the domestic economy. In fact, it has resulted in a crisis, as happened during the Asian financial crisis in 1998-1999.
- Enabling monetary and fiscal autonomy. When adopting a controlled floating exchange rate policy, the government needs to limit some of the flow of capital transactions across borders for the policy to be effective.
- The movement of capital flows is not positively correlated with growth. That means the free flow of capital does not necessarily lead to higher economic growth. As evidence, countries with high economic growth such as China and India, both apply capital controls.