FX International Payments
By Frances Coppola
For much of history, in fact, controlling the cross-border flow of money and the associated exchange rate has been a key element of economic management in many countries.1 In the post-World War II Bretton Woods system, capital controls were essential to maintaining the system’s fixed exchange rates. As capital controls were progressively weakened,2 fixed exchange rates proved hard to maintain. The failure of other attempts to stabilize exchange rates, such as the Plaza and Louvre accords in the 1980s and the European Exchange Rate Mechanism in 1992, reinforced the long-held "trilemma" theory that when there is free movement of capital, fixed exchange rates can’t be maintained unless countries coordinate their monetary policies regardless of domestic needs.
But for the last thirty years or so, the consensus among economists has been that capital controls can be economically damaging, impeding international trade and making it hard for businesses to invest in foreign countries.3 The International Monetary Fund, guided by the protocol known as the “Washington Consensus,”4 has typically encouraged the removal of capital controls.5
Now, in today’s world of freely floating exchange rates and global capital flows, controls on the movement of capital have become a rarity in mature economies. But they remain more common in developing countries, where fixed exchange-rate systems are more frequently employed.
Capital controls come in many forms. Historically, the most widely used capital control has been to limit the ability of foreigners and residents to exchange a domestic currency for foreign currency, and vice versa. This is known as “exchange control.” Exchange controls interfere with floating foreign exchange rates and can be disruptive for overseas businesses engaged in international trade: when a country’s official exchange rates differ considerably from market rates and residents are not allowed to obtain foreign currency, it may be difficult for foreign companies to do business there. In addition, the inability to convert local currency to foreign currency can prevent foreign businesses repatriating profits or using the money to obtain essential raw materials in international trade.
Other forms of capital control can be less disruptive to trade: financial transaction taxes, for example, can discourage short-term fluctuations in capital flows while permitting long-term foreign direct investment.6
Other common forms of capital control include restrictions on banks that restrict the inflow of money into the country or the outflow to other countries. Inflow restrictions can include preventing banks from paying interest on bank deposits held by non-residents, or raising capital requirements to limit bank lending. Outflow restrictions can include restrictions on residents’ ability to transfer bank deposits out of the country or convert them into physical cash.7
There may also be direct restrictions on investments by foreigners and residents. Preventing foreigners from investing in domestic assets is a common type of inflow restriction: preventing residents from buying foreign assets, such as shares in overseas companies or property in foreign countries, is a corresponding outflow restriction. Experts say that widespread controls of this kind, if maintained, can have a limiting effect on economic growth, as foreign businesses are discouraged from investing in the economy and residents are unable to benefit from income on foreign investments.8 However, some countries use selective controls of this kind to protect key strategic industries, such as energy and transportation, from foreign takeover.9
Restricting the movement of capital can affect the exchange rate of a country’s currency. Limiting inflows puts downward pressure on the exchange rate, while limiting outflows puts upwards pressure on it. Thus, if a country’s goal is to maintain the exchange rate within a narrow range, capital controls may be effective tools. Indeed, some analysis suggests that when there are very large outflows, capital controls may be important tools for preventing an FX crisis.10 In 1931, for example, after the failure of the Austrian bank Creditanstalt, Germany imposed strict capital and exchange controls when large outflows of capital drained its dollar and gold reserves.11 More recently, Iceland introduced capital and exchange controls in the 2008 financial crisis when enormous capital outflows in euros from its failing banks threatened to overwhelm the tiny country’s economy.12 China also uses capital controls, in part to manage its exchange rate.13
Following their recent use not only by Iceland, but also by Cyprus14 and Greece15 , experts say there is now growing acceptance that capital controls can in some cases help to protect economies from severe financial shocks.16 The IMF now recognizes that under some circumstances, capital controls may play a beneficial role.17 However, their use in mature economies remains relatively rare, and some experts doubt that capital controls can satisfactorily resolve the monetary policy “trilemma.”18
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1.“What’s in a name? That which we call Capital Controls,” International Monetary Fund; https://www.imf.org/external/pubs/ft/wp/2016/wp1625.pdf
3.“Capital Account Liberalization and the Role of the IMF,” Fischer https://piie.com/fischer/pdf/Fischer141.pdf
4.“Washington Consensus,” Harvard University; http://www.cid.harvard.edu/cidtrade/issues/washington.html
5.“A short history of the Washington Consensus,” Williamson; https://piie.com/publications/papers/williamson0904-2.pdf
6.“Retarding short-term capital inflows,” Zee; https://www.globalpolicy.org/component/content/article/216/45982.html
7.“Macau proposes new ATM curbs to tackle Chinese capital flight,” Financial Times; https://www.ft.com/content/2809e6e0-33c2-11e7-99bd-13beb0903fa3
8.“The Microeconomic Evidence on Capital Controls: No Free Lunch,” Kristin Forbes; http://www.nber.org/papers/w11372.pdf
9.“France issues law to block foreign takeovers of strategic firms,” Reuters; http://www.reuters.com/article/us-france-takeovers-idUSBREA4D0WG20140514
10.Regaining control? Capital controls and the global financial crisis,” Political Economy Research Institute; http://ase.tufts.edu/gdae/Pubs/rp/KGCapControlsPERIFeb11.pdf
11.“What’s in a name? That which we call Capital Controls,” International Monetary Fund; https://www.imf.org/external/pubs/ft/wp/2016/wp1625.pdf
12.“Iceland’s capital-controls saga,” The Economist; http://www.economist.com/blogs/economist-explains/2015/06/economist-explains-8
13.“China’s capital controls dent inbound investment,” Financial Times; https://www.ft.com/content/07392a72-241b-11e7-a34a-538b4cb30025
14.“Cyprus lifts all capital controls as banks recover,” BBC; http://www.bbc.co.uk/news/world-europe-32194092
15.“Greek debt crisis: What are capital controls?,” BBC; http://www.bbc.co.uk/news/business-33303540
16.“Regaining control? Capital controls and the global financial crisis,” Political Economy Research Institute; http://ase.tufts.edu/gdae/Pubs/rp/KGCapControlsPERIFeb11.pdf
17. “Liberalization and management of capital flows: an institutional view,” IMF; http://www.imf.org/external/np/pp/eng/2012/111412.pdf
18.“Domestic and multilateral effects of capital controls in emerging markets,” ECB working paper; https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1844.en.pdf?2219da99aa3f0c2569a5ab6b4d69132b