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The Rationale behind Capital Controls in Todays Global Economy

Introduction

Towards the end of the 20th century, most financial markets underwent a process of liberalization,

where several controls on the capital accounts were removed in an attempt to increase the flow of

finances in the economies of several nations. In essence, this was fueled by globalization. In that

period, the end of the Cold War and the reorganization of alliances based on common interests

caused countries to open up their economies to the world. Essentially, this was motivated by the

increased economic growth that would result from leveraging on the comparative advantages that

a country had. Although deregulation of local economies and globalization saw the growth of

several countries from emerging countries to developed countries, especially in Asia, recent

economic problems have attracted attention to the topic of re-introducing controls to the capital

accounts of local economies. Even though financial liberalization is responsible for increasing

economic growth, it should be controlled for a number of reasons. The first reason is that too

much capital mobility causes a country to be sensitive to economic shocks that happen in other

countries. In addition, few capital controls can cause a country to experience low economic

growth rates since capital would be constantly flowing to other regions of the world where there

are higher interest rates. Notably, lack of capital controls could result to exchange rate problems
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for emerging economies, which are often the recipients of international capital flows. Capital

controls, in this context, are instruments employed to limit the amount of capital flowing into a

nation or into certain segments of an economys financial markets.

Background

Prior to the 2008 financial crisis, financial liberalization was recognized as a way of allowing

countries with little savings to attract capital for their own development. In essence, savings have

a direct positive relationship to investments and low savings would, without international capital

flows, imply that the countries in question would grow at a very slow rate. This was the logic

behind financial liberalization. That is, financial liberalization allowed countries with low

savings, and allowed investors in developed nations to invest in countries with high-interest

rates. The process allowed several countries to leverage on their comparative advantages for

growth even though they did not have adequate savings for investments. The rapid growth of

several Asian economies can be attributed to financial liberalization and globalization. However,

this resulted in deep financial interlinkages between economies so much that when the United

States went into a financial crisis in 2008, the effects of this crisis spread to other parts of the

world in what was dubbed the domino effect. Following the crisis and the economic recovery of

most of the affected countries, capital started to flow to developing countries. This has caused

policy makers to consider using capital controls to limit the rate at which capital flows into these

emerging economies.

Arguments

Economic theories suggest that capital controls would have undesirable effects. According to

Blundell-Wignall, Adrian, and Roulet (30), such controls would limit the availability of capital,
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increase the cost of financing, and result in more constraints for local firms that cannot directly

access international capital markets. In addition, the risk of corruption would be higher; there

would be less discipline in the decision-making processes of local financial markets, and increase

the risk of avoidance and the higher costs that come with enforcement. Notably, there would be

fewer property rights, which would exclude consent for long-run investors. In theory, the

elimination of capital controls should increase the chances that a country will experience higher

economic growth rates. However, there are cases where the introduction of capital controls has

had positive effects. For instance, the Chilean government used capital controls to control the

appreciation of the Peso in the 1990s (Buss, n.p.). At that time, globalization was causing capital

to flow to developing countries with the potential of causing the appreciation of local currencies.

In light of this problem, the Chilean government introduced capital controls that aimed at

reducing capital inflows, while at the same time relaxing some of the regulations that limited

capital outflows. The instrument used in the control of capital inflows was a reserve requirement

referred to as encaje. The encaje required that a fraction of capital flowing into the country be

deposited in a zero-interest account with the Chilean Central Bank. According to Shambaugh

and Sebastian (997), the encaje was initially set at 20% of all capital inflows with the exclusion

of trade credit. The encaje was flexible and it was used by the Chilean government to control

capital inflows into the country for ten years. That is, in the period between 1991 and 2001

(Shambaugh and Sebastian, 995). The encaje was successful at stemming the appreciation of the

exchange rate, and the depreciated exchange rate, in real terms, was considered to be the main

driving force behind the recovery of the Chilean economy. The introduction of capital controls

also gave the Chilean government some independence in terms of the monetary policies it
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instituted. Independence in monetary policy is hard to achieve in a liberalized economy due to a

large number of extraneous variables.

Buss (n.p.) asserts that the introduction of capital controls can help cushion a country

against economic shocks such as crises that happen in other parts of the world. For an example,

take the case of the 2008 financial crisis. Before the crisis, financial innovations such as credit

default swaps and mortgage-backed securities that had higher rates of returns that traditional

financial products, caused international investors from Europe and the Middle East to invest in

these financial products. The investors included commercial banks, investment banks, and

individual investors. These investments implied a net capital outflow from Europe into the

United States of America. As it happened, when the housing bubble burst, triggering the financial

crisis, the securities that European investors had purchased suffered a decrease in value. This

caused the financial institutions that had invested in these products to experience liquidity

problems. The effect was transferred to the economies in Europe thereby spreading the effects of

the crisis. In such a case, it would be wise for advanced countries to limit capital outflows so as

to cushion themselves from the possible effects of an economic crisis. While this seems prudent,

it might result in stagnation of the advanced economies, which have low economic growth rates.

A more appropriate measure would be to introduce capital controls for some types of outflows.

For example, controls can be introduced for foreign currency transfers, and eliminated for trade

capital.

Capital controls can also be introduced in advanced economies to prevent the outflow of

capital from a country so that the finances can be used for the growth of the local economy.

Milne (n.p.) asserts that the policy of quantitative easing, which was implemented through the

purchase of bonds by the Bank of Japan, the Bank of England and the Federal Reserve Bank,
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caused the long run yields to decline in these advanced economies. In essence, this was attributed

to the outflow of finances to emerging economies. The phenomenon can be attributed to the fact

that emerging economies offer higher yields than advanced economies for capital investments.

The outflow of funds from advanced countries would derail the attempts of governments from

these countries to institute economic recovery and growth programs.

However, capital flows do not present a challenge to advanced economies. Rather, it is

the developing countries which have to deal with the problems brought about by huge capital

inflows such as currency appreciation, stock market volatility and increased exposure to the spill-

over effects of external economic shocks (Ostry, 136). In essence, this can be attributed to the

fact that developed countries have stronger institutions. That is, advanced countries have flexible

foreign exchange markets and stronger institutional participation that allows the stock market to

be stable even with variations in the yields expected by foreign investors. Conversely, emerging

economies do not have strong institutions or flexible foreign exchange markets that could enable

them to approach the subject of capital controls with the same as much as ease advanced

countries do.

Conclusion

Capital controls involve the use of instruments to control the amount of capital flowing either

into a country or out of a country. The easy flow of capital around the world allows countries

with low savings to experience high levels of economic growth while allowing foreign investors

to enjoy greater returns on their investments than they would in advanced countries. Although

capital controls limit the growth prospects of emerging economies, they are potentially effective

in cushioning local economies from external economic shocks such as crises. In addition, capital
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controls can limit the amount of finances leaving a country to retain a level adequate for the

growth of the domestic economy. The importance of capital controls for emerging economies is

that they can use capital controls to make sure that the stock markets do not experience volatility,

and prevent the appreciation of the domestic currency. In essence, capital controls should be used

to ensure stable economic growth, but they should be used in conjunction with financial de-

regulation to target the key segments of an economy.

Works Cited
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Blundell-Wignall, Adrian, and Caroline Roulet. "Capital controls on inflows, the global financial

crisis and economic growth: Evidence for emerging economies." OECD Journal:

Financial Market Trends 2013.2 (2013): 29-42.

Buss, Adrian. "Capital controls and international financial stability: a dynamic general

equilibrium analysis in incomplete markets." (2013).

Milne, Alistair. "The Control and Management of International Capital Flows: A Review of the

Literature.." (2014).

Ostry, Jonathan D., et al. "Capital inflows: The role of controls." Revista de Economia

Institucional 12.23 (2010): 135-164.

Shambaugh, Jay C., and Sebastian Edwards. "Capital Controls and Capital Flows in Emerging

Economies: Policies, Practices, and Consequences." (2008): 994-1000.