Reigning International Capital : Survey about Capital Controls
Kangkook Lee
I. Introduction
Since the 80s, so-called ‘neoliberalist’ idea and policy has been dominant all over the world and all part of economies. The financial sector was not exception and the belief that the market is always efficient led to the wave of financial liberalization in the 80s around developed countries and later in developing countries. The major argument is that the freer international capital mobility will lead to more efficient resource allocation all over the world and financial liberalization and capital account opening is inevitable along with the financial globalization. However, lots of concern was presented against this rosy picture related with the loss of national economic policy, instability and crisis due to rapid flow of international financial capital and so on. For these reasons, capital controls have been supported and the recent Asian crisis gave them a new momentum.
This survey focuses on theory and reality of capital controls. First, I will briefly examine the structure and motives of capital controls. Next part will survey recent debates on capital controls ranging from neoclassical to progressive arguments. Lastly I will mention recent interesting experiences of capital control in reality, which shows the feasibility and importance of capital control.
II. Structure and Motives of Capital Controls
1. How to Control International Capital Movement?
By ‘capital controls’ we mean various measures to restrain or explicitly and implicitly tax broad categories of international movement of capital. Thus, they include controls on foreign direct investment, portfolio investment, international borrowing and lending, transaction through deposit accounts and others, both of capital inflow and outflow (Rajan, 1998). First, about foreign direct investment, government can restricts the activity of either residents abroad or non-residents domestically, which takes the form of restriction on repatriation of profits and initial principals or share of ownership. Portfolio investment can be restricted by the regulation on the issuance or acquisition of securities by residents abroad or by non-residents domestically and limitations on the repatriation of dividends or capital gains. Also, governments can control the amount of borrowing and lending with specific ceilings or taxes on external debt accumulation and they can restrain forex deposits held by residents and deposits held in domestic currency by non-residents overseas. In addition, more broadly, exchange controls like currency transactions taxes and dual or multiple exchange rate system can be included in capital controls. While, these are measures adopted by national government, there is a proposal of restriction imposed on a global basis. So-called Tobin Tax, which is a permanent, uniform, ad-valorem transaction tax on forex transaction about 0.1-0.25%, recently draws more attention to diminish speculative forex flows.[1] It is a control over all of inflows and outflows in principle.
The following table shows the concrete types of control of cross-border capital movement.[2]
Table : Types of Capital Transactions Possibly Subject to Controls
InflowsOutflows
Capital and Money Markets
- Shares or other securities of a participating nature
Purchase locally by nonresidentsSale or issue locally by nonresidents
Sale or issue abroad by residentsPurchase abroad by residents
- Bonds or other debt securities
Purchase locally by nonresidentsSale or issue locally by nonresidents
Sale or issue locally by residentsPurchase abroad by residents
- Money market instruments
Purchase locally by nonresidentsSale or issue locally by nonresidents
Sale or issue locally by residentsPurchase abroad by residents
- Collective investment securities
Purchase locally by nonresidentsSale or issue locally by nonresidents
Sale or issue locally by residentsPurchase abroad by residents
Derivatives and other instruments
Purchase locally by nonresidentsSale or issue locally by nonresidents
Sale or issue locally by residentsPurchase abroad by residents
Credit Operations
- Commercial credits
To residents from nonresidetnsBy residents to nonresidents
- Financial credits
To residents from nonresidetnsBy residents to nonresidents
- Guarantees, sureties, and financial backup facilities
To residents from nonresidetnsBy residents to nonresidents
Direct Investment
Inward direct investmentOutward direct investment
Controls on liquidations
Real Estate Transactions
Purchase locally by nonresidentsPurchase abroad by resdents
Sale locally by nonresidents
Provisions Specific to Commercial Banks
Nonresident depositsDeposit overseas
Borrowing abroadForeign loans
Personal Capital Movements
To residents from nonresidentsBy residents to nonresidents
Transfer into the country by immigrants
Provision Specific to Institutional Investors
Limits on portfolio invested locally Limits on securities issued by
Non residents and portfolio invest
In Johnston and Tamria (1998) p. 6.
2. Motives of Capital Controls
There are several motives that lead governments to adopt capital controls. First of all, capital controls have been considered as an instrument for balance of payments that countries with very weak balance of payments have resorted to controls. And, macroeconomic policy autonomy of national governments like monetary and exchange rate policy is an important rationale for capital controls. Especially, governments could control international capital flow in an attempt to take expansive macroeconomic policies keeping interest rates low, without the fear of capital flight and volatility of exchange rate. In addition, capital controls have been widely justified as prudential measures to address the risk and volatility of international financial market, so that they can reduce systemic instability due to excessive foreign capital flow and foreign exchange exposure of domestic financial institutions. Meanwhile, countries with financial repression mostly take strong controls over foreign capital flows that are one of common factors like restrictions on interest rates and government directed credits to characterize the financial repression (Johnston and Tamirisa, 1998).
Regardless of theories behind them, it is interesting that lots of developing countries have adopted capital controls in reality despite the trend of deregulation and liberalization. According to the IMF’s survey, 119 developing countries among 155 imposed any form of controls on foreign capital inflow in 1994. 107 countries did capital controls on foreign direct investments, 61 on portfolio investments and 78 on financial transactions. But the international organizations like the IMF strongly recommend them to scrap these control measures supporting capital account liberalization.[3] This reality makes us examine the theoretical argument to oppose and support capital controls more extensively and the recent experiences of several developing countries, which we will do in following sections.
III. Pros and Cons on Capital Controls
1. Against Capital Controls and Orderly Financial Opening
Major neoclassical arguments emphasize gains from financial liberalization and international capital mobility based on the belief on efficient market. According to them, the incorporated world financial market can contribute to enhancing efficiency in resource allocation all over the world, the capital will move into the country where the return or interest rate is higher. It is natural they strongly support capital account liberalization, thus against any of capital controls.[4] They argue capital account liberalization and free international capital movement increase the availability of foreign savings to supplement domestic resources to produce economic growth of host country. Another benefit is from the fact that it can reduce the costs of the intertemporal misalignments and make investors be able to diversify risks around the world (Guitian, 1997; Edwards ed., 1995). This course of argument leads to the rejection to capital controls because it will limit international market opportunity and restrict domestic financial market competition. That is, capital controls naturally introduce market distortion and generate inefficiencies in the domestic financial system and economy as a whole (Dornbush, 1998). In addition, capital controls may enable governments to sustain imbalance of the economy and bad economic policies. Kim shows capital account liberalization tend to reduce the budget deficit, which is presented as an evidence of ‘disciplining effect’ of the international capital market on the government (Kim, 1999). Besides, capital controls are rarely effective due to the effort of evasion and limit of the control measures. Edwards argues capital controls are neither good nor effective, saying most of cases a control on capital flow failed and private capital can evade this control almost always (Edwards, 1999).
But these arguments are valid only based on ‘efficient’ financial market. Unlike the belief, many theorists have showed that it is not true due to information problem, irrational behaviors like herding and other market distortions. It leads to support for capital controls, at least in part, as we will examine next section. In addition, capital controls may be implemented effectively in reality as we examine in the last chapter. We need more sophisticated studies about capital controls as such.[5]
Of course, faced with this critic and reality that mere financial opening and international capital inflow tend to destabilize economies like the case of several financial crises, neoclassicals also point to the importance of some preconditions for capital account liberalization (Mckinnon, 1991; Williamson, 1993). So there is some consensus among economists about capital account liberalization including the preconditions and sequence for that.. Several conditions like macroeconomic stability and establishment of sound financial sector with strong supervision system are considered essential for the success of capital account liberalization. And it should be the last step after trade liberalization and domestic financial liberalization and must be developed gradually. With these conditions, financial opening and the international capital flow can enhance economic welfare according to them. Now, this line of argument so-called ‘orderly financial opening’ is in fashion and most of major international organizations and policy makers follow this argument (Eichengreen and Mussa, 1998; Fisher, 1998). But, their argument doesn’t seem to go far to support capital controls.[6] Though recent financial crises show instability of international financial market and danger of financial liberalization so well, to them, it is still not the capital control as such but the prudential regulation with the financial opening that must be adopted.
However, as Rodrik argues the prudential regulation cannot be established overnight, in particular in developing countries (Rodrik, 1999). In this regard, proper capital controls are needed at shortest, till the developing countries set up good institutional framework for prudential regulation. Moreover, considering the crises took place even in countries with relatively good regulation like Sweden and Finland, they quite underestimate the problem of international financial market and limit of national regulation after financial opening.
2. Case for Capital Controls and National Management
In theory, since the financial market suffers from serious market failures due to incomplete information, capital account liberalization can just lead to more instability. Most of all, financial market suffers from the problem of incomplete information and investors shows ‘herd’ behavior not related to the real economic fundamentals (Luxx, 1995; Kim and Wei, 1999). Besides, the problem of moral hazard, serious in financial market, can give a rise to the situation of ‘overborrowing’ or ‘overlending’ (Mckinnon and Pill, 1999). This means financial opening and free movement of international capital has a tendency to generate not efficiency but more instability, aggravating boom-and-bust cycle, as shown in recent financial crises. In practice, recent financial crises are explained by many models with ‘self-fulfilling’ character related to attack on specific currency and the contagion effect through the international financial market is considered so strong in crisis (Eichengreen et al., 1997). It means capital movement rather concentrates the risk not diversifying. These theories may justify capital controls against careless capital account liberalization, especially the controls to address the economic instability due to rapid movement of short-term capital.
And besides, since all of the markets are not perfect and efficient in reality, the positive relationship between the capital account liberalization and economic efficiency is also hard to be justified in practice. When there is trade barrier free movement of international capital can result in misallocation of the world’s capital and difference in tax rate on capital brings out the international capital movement to evade tax, not enhancing efficiency at all (Brecher and Diaz-Alejandro, 1977; Cooper, 1999). That is, according to ‘the theory of the second best’ there is no reason that free international capital movement will enhance the efficiency.[7] If it is the case, capital controls may be helpful to economic efficiency and development. Empirical studies also show it is hard to justify the neoclassical argument about the capital account liberalization and economic growth (Rodrik, 1998).
Meanwhile, other important support for capital controls concern macroeconomic management of national economy. With open capital market incorporated into the international market, government cannot help losing the autonomy of macroeconomic policy (Crotty, 1989). In particular it is difficult to adopt expansive monetary policy when there is freedom of capital movement due to the possibility of capital outflow and even attach on the currency, which leads governments to resort to restrictions on it. Progressives go further to consider these measures as a way of promoting national economic management and development, incorporated into a broader national strategy. Crotty and Epstein emphasize the necessity of capital controls for government to implement expansive policies and egalitarian policies as well. (Crotty and Epstein, 1996). Actually, the ‘golden age’ of capitalism was based on strong capital control measures among developed countries that enabled them to adopt Keynesian macroeconomic management cooperatively (Helleiner, 1994). But financial deregulation since the 80s and international capital movement made it hard to manage national economy to attain full employment, taking away policy autonomy from the government. In addition, the international capital mobility has a detrimental effect on workers in developed countries with the threat of capital retreat, which blocks egalitarian policies (Crotty et al., 1994) Their argument strongly emphasizes the political will for capital controls and its feasibility in practice, presenting some practical measures.
Moreover, in history, many countries that achieved rapid economic development intentionally used capital controls in line with broad national development strategy (Collier and Mayer, 1989). Countries like Japan or Korea established strong capital control system that should be understood in terms of national development plan. In those countries, capital control was essential element for government intervention together with credit control and national plan, called ‘government intervention triad’ by Nembhard. He contends that capital control could be very useful policy for economic development when implemented by capable government, in particular with the other complementary policies (Nembhard, 1992). Similarly many scholars acknowledge the importance of the role of the government in financial market for economic development which may include capital controls (Stiglitz, 1994).
As we examined, there are enough arguments for capital controls from the concern about instability to broader national management. While the former limitedly focuses on concern of the crisis related to volatile international capital flow underscoring the inherent problem of the financial market, the latter doesn’t consider capital controls separately from other policies. It is important progressives shed light on capital controls in view of broader national management and political effect. However, it seems that still more rigid empirical and case study about the effect of capital controls are being requested. Especially, we need to focus more on the political economy of the capital controls and decontrols like the power relationship among government and social groups (Louriax, 1997; Chung et al, 2000).
3. The Asian crisis and Reviving Support for Capital Control
The Asian crisis in 1997 was a kind of watershed in the argument about capital controls, at least over short-term international capital movement. Careless financial opening policies without proper regulation system in this region leading to high short-term debt was essential in the crisis, so that many theorists have reconsidered danger of financial opening and international financial market (Furmand and Stiglitz, 1998; Radelet and Sachs, 1998). In addition, because the panic in the financial market unrelated to economic fundamentals triggered massive capital outflow, lots of arguments for capitals control and new international financial structure are being presented. Recently, many prominent economists have joined this debate and supported the capital control to some extent, a bit different from the major neoliberalist idea and policies.
Krugman’s argument about control over capital outflow got most attention among those. He proposed the crisis-hit countries in East Asia might well adopt temporary exchange controls when IMF program seemed to fail to recover these economies (Krugman, 1998). It can help governments to take expansionary monetary policies to address the crisis, without the fear of capital flight and weakening exchange rate.
While Krugman’s proposal presents the controls over capital outflow as emergency measures, others’ concern is more sophisticated. Rodrik obviously points to the problem of capital account liberalization in the East Asian countries, which led to the crisis (Rodrik, 1999). Accordingly, developing countries must be careful in financial opening and capital controls are needed to prevent the crisis, usually following financial liberalization. Stiglitz also recognizes the East Asian crisis is more related to destabilizing international financial market and bad process of financial opening than to the economic fundamentals. That makes him rather against so-called ‘Washington Consensus’ including financial liberalization, and underscore very careful stance to financial opening. In addition, Bhagwati is against the process of rapid financial opening due to the inherent market failures in financial market unlike goods market (Bhagwati, 1998). He argues when there is serious problems in financial market, capital controls, not capital account liberalization, can be helpful to the economy considering ‘the theory of the second best’. All of them have the common concern about serious volatility of short-term capital flow and importance of careful financial opening or capital controls in part, over international short-term capital.