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Swimming in a Sea of Finance: The Occasional Logic of Capital Controls

Jonathon Flegg

j.c.flegg@nus.edu.sg

j.c.flegg@lse.ac.uk

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Contents

Introduction ............................................................................................................................................ 3

What is Capital Account Liberalisation? ........................................................................................... 5

The Advent of International Capital Markets .................................................................................... 7

Capital Account Liberalisation in Theory ........................................................................................ 10

Capital Account Liberalisation and Risk ......................................................................................... 12

Capital Account Liberalisation and Growth .................................................................................... 14

Trade and Capital Liberalisation ...................................................................................................... 16

Capital Account Liberalisation as a Policy Proscription ............................................................... 18

Designing the Right Capital Control System .................................................................................. 23

Concluding Remarks ......................................................................................................................... 26

Bibliography ........................................................................................................................................ 28

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Introduction

For decades the International Monetary Fund (IMF) had argued against governments

creating barriers to capital flows in and out their countries. Then, on 10th February

2010, an initially insignificant-looking publication was released. The IMF staff position

note suddenly reversed this long-standing policy by stating capital controls on

international financial flows can now be “justified as part of the policy toolkit”

available for sovereign states in their execution of economic policy (Ostry et al, 2010;

Rodrik, 2010). The report also noted, “logic suggests that appropriately designed

controls on capital inflows could usefully complement” other prudential and

macroeconomic policies. The quietness of the announcement betrayed its true

importance. The IMF had argued that capital controls were counterproductive

because they denied the private sector in developing economies access to much-

needed investment finance. Only three months early they had chastised President

Lula of Brazil for attempting to restrict the entry of short-term financial flows into his

country, and now all of a sudden the organisation was reversing this blanket policy.

The IMF‟s decision has reignited a new round of debate on the logic behind capital

account liberalisation. While there is now almost unanimous agreement among

economists of the benefits behind liberalising international trade, the verdict on

liberalising international finance is far from settled. While Dani Rodrik, Jagdish

Bagwati, and Joseph Stiglitz all have been vocal critics of capital account

liberalisation, Stanley Fischer, Eswar Prasad and Lawrence Summers have all made

strong arguments in favour. That global financial integration facilitated the spread of

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the 2008 Global Financial Crisis into the first truly worldwide financial collapse since

the Great Depression has also contributed to a sense of urgency in the academic

debate.

This paper takes a fresh look at the evidence for and against national governments

deciding to open up their financial systems and allowing the free movement of capital

across their borders. Rather than as a temporary protection installed to protect

against immanent crises, I take the view that capital account liberalisation should be

considered as a mostly irreversible policy decision made within the context of the

long-term developmental trajectory of the real economy. Moreover it is most

optimally employed at a larger stage of economic development, after other important

reforms, such as trade liberalisation and floating of the currency. Rather than a

doctrinal approach I consider a range of characteristics that a country should have

before the benefits of capital account liberalisation outweigh the potential costs.

The paper will first consider what exactly is capital account liberalisation and a

history of its recent popularity since the end of the Bretton Woods system. Then

starting with a neoclassical approach I will review the theoretical literature on the

possible effects, benefits and costs involved in the decision to liberalise or preserve

financial autarky. I will conclude by assessing how the empirical literature can inform

the theory, and introductory guidelines for policymakers confronted with the decision

to liberalise or not to liberalise, and if so, what policy design might be most effective.

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What is Capital Account Liberalisation?

All of a country‟s economic dealings with the rest of the world are recorded in either

their current or capital accounts. While the current account is a measure of a

country‟s foreign income and expenditure1, the capital account covers changes in the

ownership of foreign and domestic assets. Assets can be real as well as financial,

and include direct investment, and any kind of equities, debt securities, loans, bank

accounts and currency. Specifically it is equal to the net change in:

Capital account = Change in foreign ownership of domestic assets –

Change in domestic ownership of foreign assets.

A capital account surplus is a net inflow of foreign capital, and occurs when a country

is financing a current account deficit, while a capital account deficit is associated with

a current account surplus. By definition the current and capital accounts must be of

equal magnitude and opposite signs, because the capital account effectively

represents the financing of the current account. The IMF has a slightly more

nuanced definition of the capital account, dividing it into both a financial and more

limited capital account, but here we use the traditional broader definition and

consider capital account as meaning both capital and financial flows between

countries.

1 The current account includes an economy’s net exports, net factor income and net transfer payments.

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Capital flows between countries consist of movements in: foreign direct investment,

portfolio investment, other investment and changes in foreign reserves. Foreign

direct investment (FDI) is defined as the acquisition or construction of capital assets.

Portfolio investment is simply purchases of debt and shares. The other category is

dominated by capital in various bank accounts, while the reserve account is the net

foreign assets held by the central bank.

In a broad sense, capital account liberalisation is a policy decision by a government

to ease restrictions on movement of capital in and out of its economy. Very few

scholars have attempted a precise definition of the term, although Fane (1998)

defines capital controls as being, “measures which impose quantitative restrictions,

or explicitly or implicitly tax broad categories of capital movements and which apply

to all firms and households.” The IMF (1988) defines capital account convertibility as

the:

Freedom from quantitative controls, taxes, and subsidies - that affect

capital account transactions between residents and non-residents.

Examples of such transactions include all credit transactions between

residents and non-residents, including trade- and nontrade-related credits

and deposit transactions, and transactions in securities and other

negotiable financial claims.

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Important to note here is that the definition does not include restrictions on the

underlying transactions themselves, although in practice limitations are often placed

on them as well (Quirk et al, 1995: 1). The assumed result of liberalisation is usually

a greater level of financial integration between a given economy with global financial

markets.

The Advent of International Capital Markets

The advent of widespread international capital markets is one of the defining

features of the current period of globalisation. During the last era of globalisation at

the turn of the 20th century, capital was totally free to move but the need to physically

transfer gold still made it a difficult proposition. From WWII until the early-1970s

capital account restrictions were the norm under the Bretton Woods international

monetary system. As the well-known „Impossible Trinity‟ of monetary policy

succinctly illustrates in Figure 1, while the Bretton Woods system of internationally

pegged exchange rates has the virtues of stability in exchange rates and monetary

independence for sovereign states, it prohibits the use of open international financial

markets. If a currency system attempts to embody all three of these virtues, capital

market participants could engage in arbitrage by borrowing in a low-interest

jurisdiction and lending in the high-interest jurisdiction. Without capital controls these

flows would happen in large enough volumes as to be extremely destabilising to the

economy.

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Figure 1: The Impossible Trinity of Monetary Policy

Figure 2: The Post-Bretton Woods Reduction in Capital Controls (Kose and Pasad, 2004: 51)

During the Bretton Woods period very little foreign investment existed, and the

majority of international financial flows were official loans or concessional grants to

governments. However with the ending of the system of currency pegs many

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governments, including in some developing countries, began to reconsider the need

for capital restrictions. As Figure 2 shows, by the 1980s a large number of advanced

economies had completely removed capital restrictions. Firms in the United States,

Europe and Japan were also discovering a plethora of new investment opportunities

in what became known as „emerging markets‟. In developing economies with stable

political institutions and reasonable stocks of human capital and infrastructure, the

opportunities for yield compared very favourably with alternative opportunities in

advanced economies. In between 1980 and 2005 the growth in international capital

flows have outstripped growth in world production, moving from around 5 to 18

percent of world GDP. As can be seen in Figure 3, flows of international capital really

took off in the early 1990s, particularly in portfolio and money market flows, while

foreign direct investment has increased at a more modest pace. In short the biggest

increases have been in institutional capital.

Figure3: Gross International Capital Movements, 1980-2005 (Becker and Noone, 2008)

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Financial innovation also paved the way for the development of global capital

markets. Information and transactions in overseas markets became virtually real

time, including in overseas equity markets. The converse is was also true: Financial

innovation was also undermined the sustainability of maintaining capital controls.

The plethora of new financial instruments provide the market with novel new ways to

evade traditional capital barriers. The expansion of international trade has also

permitted the evasion of capital controls through the practice of under-invoicing and

over-invoicing (Mathieson and Rojas-Suárez, 1993; Pasad and Rajan, 2008).

Capital Account Liberalisation in Theory

Broadly there are two ways to theoretically approach the issue of capital account

liberalisation. The first is to view it as a means of achieving allocative efficiency and

the second is to focus on assessing the risk introduced with exposing a domestic

economy to the vicissitudes of international financial markets. In this section we will

first consider the former neoclassical literature before discussing the newer risk

literature in the following section.

The neoclassical approach begins with the Solow (1956) exogenous growth model. If

capital is free to move internationally it will naturally move from capital-rich, labour-

scarce advanced economies to where it can be more productively employed in the

capital-scarce, labour-rich economies of the developing world. The movement of

capital into developing economies reduces the cost of capital and delivers a boost to

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investment and provides permanently higher living standards (Fischer, 1998; Henry,

2007). Investors in developed economies should also enjoy a greater return on their

capital, as a wider range of investment opportunities becoming available to them.

While a simple neoclassical explanation provides a strong basis for advocating

capital account liberalisation, a number of other possible equilibrium effects make

the effects on economic growth more ambiguous. Firstly, while foreign capital flows

into a country can improve the level of investment, it can also lead to foreign

exchange rate appreciation, and hence lower exports, returns on investment, and

overall growth (Ostry et al, 2010). Conversely, if a central bank is struggling to

accumulate an adequate level of foreign reserves, capital account liberalisation

might be just the panacea that makes such a policy objective possible.

Financial liberalisation may also have indirect positive benefits that promote

economic development. Kose et al (2006) has called these potential “collateral

benefits” and, unlike the traditional neoclassical channel, should yield permanent

rather than temporary improvement in economic growth. For this reason they may

even be more important that the direct neoclassical effects on investment and growth

(Kose et al, 2006). Firstly, liberalisation is likely to develop the efficiency of domestic

financial markets through greater competition in the financial sector and the

introduction of new financial instruments and banking processes. Secondly,

liberalising might act as a commitment device that imposes discipline on the

domestic government‟s macroeconomic policies (Pasad and Rajan, 2008). This

commitment may also be a signal to international markets of the government‟s sound

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economic policies (Kose and Pasad, 2004). Finally, it may also improve public

governance and institutions, particularly corruption and prudential regulation. All

these indirect effects should lead to higher levels of investment and economic growth

in the economy.

Possible Effect of Capital Account Liberalisation

Direct/Indirect Possible Out-products

Lower cost of capital Direct Higher investment and economic growth

Exchange rate appreciation

Direct Lower exports and economic growth

Foreign reserve accumulation

Direct Higher net foreign assets

Financial market development

Indirect Lower cost of capital and more diverse financial instruments available, higher investment and economic growth

Institutional development/public governance

Indirect Higher investment and economic growth

Sound macroeconomic discipline

Indirect Lower fiscal deficits, higher investment and economic growth

Figure 4: Possible Effects of Capital Account Liberalisation

Capital Account Liberalisation and Risk

While most of the proposed theoretical channels between capital account

liberalisation and the real economy are positive, a large body of newer research has

also been assembled pertaining to increased macroeconomic risk. Greater exposure

of an economy to the global financial system possibly entails idiosyncratic and

aggregate risk. Idiosyncratic risk is defined as the possibility of macroeconomic

crises that might impact only the liberalising the economy, while aggregate risk

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exposure is the susceptibility to crises that the particular national economy has no

functional control over.

Exposure to international risk may increase as an economy with liberalised capital

accounts is now more heavily linked to the fluctuations and imbalances in

international financial markets. Potential sources of crises become more numerous,

through greater contagion-transmitting interconnections. The severity of imbalances

and hence subsequent crashes may also become greater. Reinhart and Rogoff

(2008) have shown that in the post-Bretton Woods era financial crises are more

frequent due to widespread liberalisation of international capital movements. The

international closure of widespread capital account movements during the Bretton

Woods period effectively acted as insulation between financial crises spreading

between countries.

Risk Sources Insurable

Idiosyncratic (or country-specific) risk

Capital flight, speculative attacks, sudden stops, domestic asset price or banking crises

Yes, through international capital pooling

Aggregate (or international) risk

International financial crises transmitted through contagion effects

No

Figure 5: Sources of Macroeconomic Risk from Capital Account Liberalisation

Idiosyncratic risk might also increase, although this is subject to much debate.

Possibly the greatest source of potential idiosyncratic risk is that of capital flight. If

the short-term state of the world changes in an economy with liberalised capital

accounts, foreign investors might withdraw capital relatively quickly causing a

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collapse in investment and asset prices. However the counterpoint to this argument

is that, as Pasad (2011) has argued, banking crises are more disruptive and occur

more frequently in closed economies. This is because the globalisation of capital

availability may actually facilitate insuring against such domestic crises through

international risk pooling. Risk that is idiosyncratic to a single economy can be

mitigated by accessing global finance in the event of a domestic macroeconomic

shock that affects the domestic ability to consume (Lucas, 1982; Pasad, 2011; Flood

et al, 2011). For small and open economies this is likely to be the case, although is

more difficult to substantiate for shocks to large economies such as the United

States or China. The bigger the economy the more likely it is that a domestic shock

is to take on the characteristics of an international shock, at least in terms of the

ability of the international financial system to insure against it are concerned.

In summary, while aggregate risk for countries can only increase as a consequence

of capital account liberalisation, the effect on idiosyncratic risk is ambiguous, given

that the extent to which international finance can facilitate risk pooling is unknown.

Empirically it does appear that overall capital account liberalisation does increase the

frequency and costliness of macroeconomic crises (Kose et al, 2003; Pasad and

Rajan, 2008; Flood et al, 2011). This fact can be regarded as the major drawback

associated with capital account liberalisation.

Capital Account Liberalisation and Growth

A large body of econometric evidence now exists that shows capital account

liberalisation is not associated with improved economic growth or levels of

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investment (Rodrik, 1998; Pasad et al, 2003; Henry, 2007). In a survey of 14 studies

on the topic, Kose et al (2003) found only three have shown a significantly positive

effect. The authors concluded:

…an objective reading of the vast research effort to date suggests that

there is no strong, robust, and uniform support for the theoretical argument

that financial globalization per se delivers a higher rate of economic

growth.

Pasad (2011) has since extended this survey to 25 papers, and still only three

empirical studies have shown a significantly positive effect. As Henry (2007) has

noted, this result is not necessarily inconsistent with the neoclassical approach, as

direct growth and investment improvements as a result of capital mobility should be

temporary rather than permanent. This can be explained because productivity

growth, rather than just accumulation of inputs, is the main determinant of long-term

growth (Hall and Jones, 1999). Long-term positive growth effects of capital account

liberalisation, where they exist, would be limited to the indirect improvements in

governance and financial institutions (Pasad and Rajan, 2008).

However an even deeper problem exists between the neoclassical theory and

economy growth. In 1990 Lucas published an important paper the highlighted the so-

called „Lucas Paradox‟: The neoclassical prediction – that in a world with liberalised

capital markets financial resources should flow from countries with high capital-

labour ratios to those with low capital-labour ratios – is not borne out in reality. In fact

often the reverse has been the case. As Pasad and Rajan (2008) have put it:

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… emerging market economies have, on net, been exporting capital to

richer industrial economies, mostly in the form of accumulation of foreign

exchange reserves, which are largely invested in industrial country

government bonds. These “uphill flows” of capital have had no discernible

adverse impact on the growth of developing economies, which suggests

that the paucity of resources for investment is not the key constraint to

growth in these economies.

A more nuanced view then is that there might be two different types of developing

economies, one which is characterised as net exports of capital to be invested

“uphill” in advanced economies, and others that are net importers who fail to reach

the growth potential suggested by the neoclassical model because they suffer from

more fundamental issues that discourage investment, such as a lack of private

property rights, adequate infrastructure or human capital or significant political risk.

In both groups of countries capital account liberalisation will fail to have a

discernable positive effect on economic growth.

Trade and Capital Liberalisation

Many authors have argued that financial liberalisation should be treated with more

caution that trade liberalisation (Stiglitz, 2002; Baghwati, 2004; Kose and Pasad, 2004;

Prasad and Rajan, 2008). The reason that the effects of capital liberalisation can be

considered different from trade liberalisation is because capital is different in kind to

trade. While trade is the exchange of economic products, capital has the duel

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characteristics of being both a production input and economic product. There is little

disagreement that in as much as capital is a tradable service, constituting the

product of an economic process, capital account liberalisation has positive indirect

effects. Corresponding with the “collateral benefits” argument of Kose et al (2006),

introduction of foreign financial providers has the effects of:

(a) reducing market power and rents accruing to domestic financial providers;

(b) increasing welfare through reductions in commercial interest rates and

expanded access to finance; and

(c) stimulating innovation within the financial services industry through

introducing a range of new technology („instruments‟ in the financial sector)

and efficient processes.

Notice how the introduction of competition from foreign financial services has

identical effects to those that are generally attributed to liberalisation of trade other

goods and services (Rodrik 1988; Pavcnik 2002). In that sense financial services are

no different to any other liberalised industry.

However in as much capital is a production input, its wholesale movement into and

out of an economy may be problematic. The risk of macroeconomic volatility

associated with capital control liberalisation is mainly due to the way it can rapidly

inflate and deflate the real economy because it is a prerequisite input into the

production process. Unlike labour inputs there is often a maturity mismatch between

short-term flows of capital and long-term changes in production in the real economy.

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Moreover the extent that particular capital inflows are bound to a particular

investment is proportional to its desirability to the overall economy. That is why so

called “hot money”, short-term flows of capital that simply follow interest rate

differentials, is generally regarded as the most dangerous form of capital inflow into

an economy.

Capital Account Liberalisation as a Policy Proscription

Experiences over the last two decades show that the decision of a government to

liberalise its capital account is fraught with difficulties, particularly in the years

immediately following a liberalisation episode. Moreover when a country decides to

open up to financial integration it is a difficult process to reverse. Even during the

Asian Financial Crisis, Malaysia‟s decision to temporarily impose selective exchange

and capital controls elicited incredible international controversy. This apparent

irreversibility might be partially explained by the implications for the political economy

when restricting existing foreign capital has an immediate and negative level effect of

asset prices. For example, in 2006 when the Thai central bank attempted to

implement a tax on short-term portfolio inflows on the stock market, the subsequent

15 percent collapse in stock prices prompted the government to quickly repeal it

(Pasad and Rajan, 2008: 18).

For capital inflows to be beneficial to an economy a number of assumptions need to

be made. Firstly, it assumes that investment in the domestic, presumably

developing, economy is credit-constrained. However as shown by the “Lucas

Paradox” the widespread adoption of open trade policies in many developing

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economies in recent years has contributed to a vast over-supply of capital in many

instances.

Secondly, in economies where capital does appear to be constrained, the cause of

underdevelopment might in fact be that domestic investment opportunities are of

limited profitability because of the poor quality of domestic institutions. While we

might accept the argument put by Kose et al (2006) that capital account liberalisation

has an indirect quality-enhancing effect on domestic institutions, it might also be the

case that more direct policy action is required to improve them. Simply liberalising

the capital account will not be enough to solve most countries difficulties with

achieving economic development.

Thirdly, as many recent experiences have attested to, such as the Argentinian

financial crisis in 1999-2002, there are strong reasons for treating capital account

liberalisation with suspicion in economies with fixed exchange rates. Croce and Khan

(2000) and Pasad and Rajan (2008) have both noted that in the presence of capital

mobility the fixed exchange rate mechanism makes domestic economies susceptible

to speculative attacks and sudden stops.

The presence of a large list of prerequisites for capital account liberalisation has led

many scholars to look favourably on a conditional argument for capital account

liberalisation. Pasad and Rajan (2008) describe their argument as “pragmatic”, while

the approach of Ostry et al (2010: 15) concludes: “There is no surefire one-size-fits-

all way to deal with the impact of potentially destabilizing short-term capital inflows.”

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Figure 6: IMF Staff Position on Imposing or Strengthening Capital Controls (IMF, 2010: Figure 1)

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The approach of this paper is broadly in line with such thinking. When making such a

decision with large implications for a country‟s economic policy it is prudent to weigh

up all the conclusions of economic theory in the light of the econometric evidence.

Moreover policymakers must be clear about the potential costs and benefits when

deciding on such a course of action. My approach differs most from the IMF position

displayed in Figure 6 in that Ostry et al (2010) are trying to determine the short-term

macroeconomic and prudential conditions necessary to implement temporary capital

controls in response to a crisis (similar to the situation faced by Malaysia during the

Asian Economic Crisis). My conditions in Figure 7 are an attempt to assess what

structural attributes are favourable for an economy to maintain longer-term capital

control arrangements. Also rather than a series of necessary conditions, my

approach is a list of characteristics that together make capital controls more useful or

less harmful to an economy‟s development.

Given that many of the characteristics are time-dependent, this raises the obvious

issue of policy sequencing. Is there a time-optimal stage in an economy‟s

developmental trajectory where capital account liberalisation becomes optimal, or at

least advisable? Many of the characteristics listed are correlated with stages of

economic development, and therefore this policy formulation does have a

sequencing component, much like the old sequencing literature in development

economics. Generally speaking, integration with global financial markets should only

be entertained after trade protectionism has been abandoned and the currency is no

longer a pegged regime (Obstfeld and Rogoff, 1995; Pasad and Rajan, 2008). A

sequenced approach also exposes one of the major shortcomings of the

effectiveness of liberalising capital, as most of the characteristics that would make

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liberalisation most beneficial to a country are also the characteristics of an economy

less in need of external capital at the higher-levels of economic development.

So what characteristics should we look for to determine whether capital account

liberalisation is a good policy idea for a given country? Here I will discuss just some

of the characteristics raised in Figure 7. Firstly, as stated above, a floating currency

is necessary to ensure the chances of adverse macroeconomic events such as

speculative attacks will not also increase. Secondly, trade openness is necessary as

there is a robust empirical relationship between trade openness dampening the

frequency and costliness of crises associated with financial liberalisation (Prasad

and Rajan, 2008). Strong monetary management is also very important to successful

capital account liberalisation. If an economy already has poor management of its

currency chances are it is not going to be able to successfully absorb the resultant

instability that comes along with exposure to international financial markets.

Two characteristics that favour liberalisation that are shared by many developing

economies are a lack of financial competition and a low level of reserves.

Liberalisation of the capital account might provide significant benefits for developing

economies seeking to make gains in these areas. Countries with high public debt

generally suffer more intensely and for a longer period after macroeconomic crises,

although a resultant appreciation might make the chances of a public debt crisis

more remote. Finally, a country should consider what type of capital inflow mix they

are likely to receive before liberalising. Speculators might be attracted to certain

economies for the purposes of currency speculation or the possibility of earning

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higher interest rates, however these kinds of capital flows may do more harm than

good in the long-run.

Characteristics in Favour of Liberalisation

Characteristics Against Liberalisation

The domestic currency is a float or managed float.

The domestic currency if pegged.

Trade protectionism has been dropped. Trade protectionism is an active government policy.

Monetary policy has a history of sound management and the currency is generally stable.

Monetary policy has a history of poor management and the currency is unstable.

Domestic investment is higher than domestic savings.

Domestic savings are higher than domestic investment.

A lack of competition within the financial services sector.

Adequate competition within financial services sector.

Foreign reserves are low by international standards.

Foreign reserves are already quite high.

External public debt is low. Government is already carrying a large stock of external debt.

There are adequate opportunities for FDI investment.

Investment opportunities are more speculative, including currency speculation or high interest rate earnings.

Figure 7: Characteristics That Influence the Potential Costs and Benefits of Capital Account Liberalisation

Designing the Right Capital Control System

All types of capital controls cannot be considered equal. For instance, most

governments prefer foreign direct investment over portfolio capital as it less

susceptible to capital flight. Here we consider some of the design features of

workable capital control policies. Generally we can judge the design of various

capital control systems by how well they manage to achieve any of the following four

possible criterion:

(a) extend the maturity of capital investments;

(b) encourage a particular type of capital flow;

(c) prevent procyclical withdrawal of capital; and

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(d) possibly direct flows to specific capital-constrained sectors of the economy.

The first design consideration is whether governments apply capital controls to

inflows or outflows. As a general principle it is possible for governments to control

inflows much more than outflows, particularly because when capital wants to leave it

typically is in a hurry (Reinhart and Smith, 2002). While Malaysia was generally

considered to have successfully managed to stem the outflow of capital during the

Asian Financial Crisis because it had tight control over the banking system, a

number of Latin American economies that have implemented similar outflow controls

have not been so successful (Pasad and Rajan, 2008). On most accounts outflow

restrictions fail on most of the four criteria for good capital control design, and if

administered well may qualify on criterion (c). As a result control of inflows is usually

regarded as superior to attempting to control outflows.

Secondly is the specific choice of capital control. Moore (2010) lists three different

basic types:

(a) exchange or quantitative limits;

(b) taxes on financial transactions; and

(c) dual exchange rate systems.

In terms of administrative complexity, the list follows an ascending order.

Quantitative limits are either restrictions on any foreign ownership or a ceiling on the

proportion of foreign ownership of assets in a particular class. While they are quite

effective in directing foreign capital away from specific sectors (criterion (d)), they are

not generally successful at preventing capital flight (criterion (c)) or ensuring capital

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investment is long-lived (criterion (a)). In this sense quantitative limits are generally

about maximising the benefits of foreign capital for investment rather than minimising

the potential costs of economic crises.

Taxes on foreign transactions can take a number of forms, such as:

… interest equalisation taxes, attempts to eliminate the difference in yields

between domestic and foreign investments and restrict either inflows or

outflows. A mandatory reserve requirement is one example of a price-

based capital control. This type of capital control requires foreign

investors to deposit a percentage of their capital investment with the

central bank for a minimum period (Moore, 2010: 7).

A successful example of mandatory reserve requirements was introduced by Chile in

1991. Short-term debt inflows where required to be accompanied by a 20 percent

reserve requirement (Pasad and Rajan, 2008). These measures have been arguably

the most successful in disincentivising short-term capital flows (criteria (a) and (c))

without limiting productive foreign investment.2 To the extent that certain types of

capital, such as FDI, are more likely to be attracted to longer-term investment

opportunities, taxes on foreign transactions also can satisfy criterion (b).

The final form of capital control is dual exchange rates, where commercial

transactions enjoy a stabilised exchange rate, while financial transactions face a fully

floating rate. Financial transactions hence face the disadvantage of having to

2 Brazil, Chile, Colombia, the Czech Republic and Malaysia have all attempted such measures with some

success.

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assume exchange rate risk. The system fails on all the criteria, except perhaps on

criterion (b), as it may only encourage short-term currency speculation, the exact

type of capital inflows that are entirely unproductive to the real economy. The only

possible virtue of dual exchange rates is that they discourage most forms of foreign

capital transactions, but in this case it is likely to be administratively simpler to just

implement quantitative restrictions.

In essence the most appropriate form of capital controls, when necessary, are either

quantitative restrictions or simple taxes on short-term foreign transactions. They are

the least distortionary to the economy, simplest to administer, and achieve the

greater number of policy goals. Taxes should be applied to incoming capital where

possible and are most effective in protecting domestic economies against potential

macroeconomic crises.

A final comment is necessary about capital control design. Like most regulatory

systems, simplicity has its virtues. All capital controls are generally administratively

burdensome and require constant vigilance in monitoring developments within the

economy. To work at all they require competent prudential regulators otherwise

private markets will easily find ways to evade the system.

Concluding Remarks

The heightened academic and political debate on the validity of capital controls has

led many to find satisfaction in a pragmatic, non-proscriptive approach. So too has

this paper. Liberalising capital has the benefit of allowing financially-constrained

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economies to reach their developmental potential and may even induce other

institutional and technological changes in the same way as trade liberalisation is

thought to do. However it also entails significant costs by exposing fragile domestic

financial systems to the „open waters‟ of trillions of dollars swimming around in

international financial markets. Governments that fail to anticipate the risks involved

with such a move could likely be the victims of financial crises that are so

devastating they negate any of the international financial system‟s possible growth

benefits. If a government decides to move forward with capital account liberalisation

they need to carefully consider a number of prerequisites before doing so, and the

design of the system must learn from other country‟s experiences or run the

additional risk of being redundant in the face of innovative capital markets. Ultimately

a Catch-22 exists with the decision to liberalise: The characteristics that would make

liberalisation most beneficial to a country are also the characteristics of an economy

less in need of external capital at the higher-levels of economic development.

Perhaps this why the post-Bretton Woods era is replete with so many examples of

failure and so few sterling examples of success.

28 | P a g e

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