Capital Flow Restriction: Meaning, Types, Pros, and Cons

What’s it: Capital flow restriction is re controls that are in place to limit the ability of certain parties to invest or transfer their capital. Although this generally applies to foreign investment, the government can also restrict citizens from investing abroad.

Free market advocates criticize the control of capital flows. They view it as stifling economic growth and creating inefficient allocations of capital. On the other hand, supporters view, control of capital flows is necessary to support economic stability and national interests.

Types of capital flow restrictions

Governments can limit foreign investment in terms of how much and in which industry. For example, they impose tighter controls on foreign portfolio investment and a little more lenient on foreign direct investment.

Restricting the flow of capital can take many forms. 

The first is taxes. For example, the government imposes special taxes on investment returns or on certain types of transactions.

The second is by enforcing mandatory reserve requirements. Foreign investors must first deposit a certain amount of money at the central bank with a specific interest and period.

The third is by limiting the volume of transactions. For example, the government sets the maximum lending when domestic borrowers access to credit in international markets. Or, the government requires specific authorizations for certain types of transactions. Another alternative is to limit transactions in certain currencies.

Benefits of capital flow restriction

The main objective of restricting capital flows is to maintain economic stability. It represents a macroprudential policy to reduce the risk of the financial crisis.

Capital flows are often short term and prone to sudden reversals. Thus, limiting the flow of capital prevents their adverse effects. An exodus of capital outflow or a massive speculative attack can destabilize and trigger an exchange rate crisis.

Likewise, capital inflows can lead to economic overheating. Foreign investment is pouring into the domestic economy. They buy domestic assets such as real estate and securities. The high demand triggers an asset bubble.

Bubbles can burst at any time when there is a change in market sentiment. Foreign investors are pulling out their capital and leading to capital flight. This, in turn, destabilizes the domestic economy.

Following are the specific objectives of capital flow restrictions:

• Protect domestic strategic industries
• Supports a stable trade balance
• Maintain foreign exchange reserves
• Supports financial system stability
• Reduce exchange rate fluctuations

Protect strategic industries

Several countries limit foreign direct investment to strategic industries such as electricity and telecommunications. Its purpose is to protect domestic firms from foreign competition and protect domestic employment.

Moreover, the two industries also usually operate under natural monopolies. Such a market structure would be more efficient if it had fewer players, perhaps even one company. In this way, the industry gains a higher economy of scale, allowing lower average costs and selling prices.

But, if competitive pressures increase, economies of scale are lower, and average costs are higher. As a result, consumers bear higher prices.

Usually, natural monopolies are under the strict supervision of the government. It aims to prevent the monopolist’s abuse of market power.

Supports a stable trade balance

Capital flow controls limit currency appreciation due to large capital inflows. Sharp appreciation can disrupt export performance by increasing the price of domestic products on the international market. Foreign buyers reduce demand, placing more significant pressure on export performance.

China is the most prominent example in this case. The Chinese government maintains a low exchange rate to support export growth. A weak exchange rate makes their product cheaper on the international market.

Maintain foreign exchange reserves

The government can place restrictions on investment outflows and capital inflows. It reduces the use of international currencies in the domestic economy.

Supports financial system stability

Massive capital outflow causes a sharp depreciation. It makes repayment of foreign currency-denominated debt much more expensive, hence, increases the chance of default.

Apart from that, the flight of capital out can also cause the financial system to collapse. Investors are massively withdrawing their deposits in domestic banks, and this can trigger a bank run. This condition forced the bank to go into bankruptcy due to a lack of deposits.

Reduce exchange rate fluctuations

When adopting a fixed exchange rate, the government must intervene in the foreign exchange market. One way is through capital flow control. Fixed exchange rates reduce uncertainty in economic and business decision making.

Furthermore, under controlled floating exchange rates, controls are also essential to limit the exchange rate’s harmful excess. When exchange rates fluctuate, it creates uncertainty in the economy. Therefore, the government intervenes in the forex market when the exchange rate moves in a dangerous direction.

Drawbacks of capital flow restriction 

Several reasons why capital flow control is negative.

First, the allocation of capital becomes inefficient. Control prevents investors from getting the best rate of return on investment. On the other hand, free flow allows capital to be invested wherever it will get the highest return.

Second, controls limit economic growth. Foreign capital flows make a vital contribution when the domestic saving rate is low. It is a source of loanable funds, which is useful for increasing the economy’s productive capacity. So, if the capital flow is restricted, it ultimately prevents the domestic economy from growing high in the future.

Third, low competition and innovation in the economy. When foreign companies enter domestic industries, they increase competition. This is useful for reducing the monopoly power of local companies. The competition also promotes local companies to remain efficient and innovative so that they remain competitive. Furthermore, foreign direct investment is also important for technology and knowledge transfer to the domestic economy.

Fourth, the implementation of the restrictive policy raises administrative costs. To enforce adequate controls, it entails high administrative costs. Besides, control through taxes often leads to corruption by government officials.

Fifth, control creates negative perceptions among international investors. Global creditors’ confidence falls, making it difficult for governments and the private sector to raise funds on international financial markets.