The free flow of money across national borders: That’s the soul of the modern global economy. It puts capital where it’s most useful, maximizing prosperity. What’s not to like? People in not-so-modern economies have an answer: It exposes them to disastrous busts after giddy booms. To fight back, 37 countries restricted the flow of money out of their economies between 1995 and 2010. Sometimes it seemed to work. Sometimes not. It’s hard to control the flow of capital without scaring away foreign investors. From 2010 to 2012 investors poured $3.6 trillion into developing countries, seeking bigger returns there while interest rates slumped in major economies. Then the pendulum swung the other way in mid-2013, when the U.S. markets started becoming attractive. Stocks in countries from Brazil to Turkey plummeted as investors left; corporate borrowing costs soared and currencies crashed. No wonder capital controls retain their appeal.
Ukraine was the first 2014 test of the wisdom of restricting investment during a crisis. The central bank limited foreign-currency purchases and withdrawals from bank deposits in February, as unrest sent investors fleeing and weakened the hryvinia to record lows against the dollar. It eased controls two months later after securing a $17 billion loan from the International Monetary Fund. Ghana curbed foreign-exchange transactions on Feb. 5 after its currency lost 23 percent in the previous year. In June it reversed some restrictions after companies complained that it had become too hard to obtain cash. Venezuela and Argentina eased restrictions in early 2014 after years of capital controls caused an investment drought and shortages of everything from food to medicine, fueling the world’s highest inflation. Cyprus began dialing back restrictions on domestic cash transfers after becoming the first country in the euro area to impose capital controls, during a banking crisis in 2013. In Iceland, controls remain in place more than five years after they were imposed as part of the government’s response to the banking collapse in 2008. China struggles to relax controls that have anchored the economy for three decades while preventing its markets from becoming overwhelmed.
To discourage foreign money from flooding a national economy or leaving it high and dry, a government can restrict withdrawals from banks, limit foreign-exchange transactions or tax the purchase of stocks and bonds. These measures were uncommon until the 1930s, when countries started using them to keep scarce resources from flowing away during the Great Depression. After World War II, rules restricting capital flows became an established part of a world financial system. Only in 1971, when U.S. President Richard Nixon abandoned the dollar’s peg to gold, did major currencies start floating and countries lift controls. A new consensus favoring open capital markets lasted until the Asian financial crises of the late 1990s provided provisional evidence that capital controls could work: Malaysia recovered swiftly after imposing restrictions in September 1998. (South Korea recovered too, without them.) By 2010, the IMF was ready to acknowledge that capital controls can forestall financial crises.
Many economists now say there’s a time and place for limited capital controls. Still hotly debated is how well they work. Few doubt that capital flows across borders usually provide financing for high-return investment and bring technology, innovation and growth. Nor that the dismal economic performance of countries such as Venezuela and Argentina over the past few years shows that enduring capital controls distort allocation of resources and discourage investment. Limited controls on capital inflows are thought to prevent currency overvaluation and financial bubbles. In a financial crisis, restrictions on outflows give policy makers some breathing space to address the shortcomings in their economies and ward off panic selling. Controls are neither foolproof nor cost free. Investors find ways around them through financial innovation and bribery and they can prevent productive foreign investment. Then there’s the impossible trilemma — one cannot control capital flow, interest rates and exchange rates all at the same time. Something has to give.
The Reference Shelf
- Federal Reserve Bank of St. Louis reviewed the history of capital controls in 1999.
- Economist Paul Krugman went against the conventional wisdom by endorsing Malaysia’s capital controls during the Asian Financial crisis.
- The IMF revealed its historical shift in its view toward capital controls in 2010.
- Economists including Kristin Forbes study the spillover effects of capital controls.