Capital control

Pre World War I

Prior to the 19th century there was generally little need for capital controls due to low levels of international trade and financial integration. In the first age of globalisation which is generally dated from 1870–1914, capital controls remained largely absent.

World War I to World War II: 1914–1945

Highly restrictive capital controls were introduced with the outbreak of World War I. In the 1920s they were generally relaxed, only to be strengthened again in the wake of the 1929 Great Crash. This was more an ad hoc response to potentially damaging flows rather than based on a change in normative economic theory. Economic historian Barry Eichengreen has implied that the use of capital controls peaked during World War II, but the more general view is that the most wide ranging implementation occurred after Bretton Woods. An example of capital control in the inter war period was the Reich Flight Tax, introduced in 1931 by Chancellor Brüning. The tax was needed to limit the removal of capital from the country by wealthy residents. At the time Germany was suffering economic hardship due to the Great Depression and the harsh war reparations imposed after World War I. Following the ascension of the Nazis to power in 1933, the tax was repurposed to confiscate money and property from Jews fleeing the state-sponsored anti-Semitism.

The Bretton Woods Era: 1945–1971

At the end of World War II, international capital was "caged" by the imposition of strong and wide ranging capital controls as part of the newly created Bretton Woods system—it was perceived that this would help protect the interests of ordinary people and the wider economy. These measures were popular as at this time the western public's view of international bankers was generally very low, blaming them for the Great Depression. Keynes, one of the principal architects of the Bretton Woods system, envisaged capital controls as a permanent feature of the international monetary system, though he had agreed current account convertibility should be adopted once international conditions had stabilised sufficiently. This essentially meant that currencies were to be freely convertible for the purposes of international trade in goods and services, but not for capital account transactions. Most industrial economies relaxed their controls around 1958 to allow this to happen. The other leading architect of Bretton Woods, the American Harry Dexter White, and his boss Henry Morgenthau, were somewhat less radical than Keynes, but still agreed on the need for permanent capital controls. In his closing address to the Bretton Woods conference, Morgenthau spoke of how the measures adopted would drive "...the usurious money lenders from the temple of international finance".

Following the Keynesian Revolution, the first two decades after World War II saw little argument against capital controls from economists, though an exception was Milton Friedman. However, from the late 1950s the effectiveness of capital controls began to break down, in part due to innovations such as the Eurodollar market. According to Dani Rodrik it is unclear to what extent this was due to an unwillingness on the part of governments to respond effectively, as compared with an inability to do so. Eric Helleiner has argued that heavy lobbying from Wall Street bankers was a factor in persuading American authorities not to exempt the Eurodollar market from capital controls. From the late 1960s the prevailing opinion among economists began to switch to the view that capital controls are on the whole more harmful than beneficial.

While many of the capital controls in this era were directed at international financiers and banks, some were directed at individual citizens. For example, in the 1960s, British individuals were at one point restricted from taking more than £50 with them out of the country for their foreign holidays. In their book This Time Is Different, economists Carmen Reinhart and Kenneth Rogoff suggest that the use of capital controls in this period, even more than its rapid economic growth, was responsible for the very low level of banking crises that occurred in the Bretton Woods era.

post Bretton Woods era: 1971–2009

By the late 1970s, as part of the displacement of Keynesianism in favour of free market orientated policies and theories, countries began abolishing their capital controls, starting between 1973–4 with the U.S., Canada, Germany and Switzerland and followed by the United Kingdom in 1979. Most other advanced and emerging economies followed, chiefly in the 1980s and early 1990s. During the period spanning from approximately 1980–2009, the normative opinion was that capital controls were to be avoided except perhaps in a crisis. It was widely held that the absence of controls allowed capital to freely flow to where it is needed most, helping not only investors to enjoy good returns, but also helping ordinary people to benefit from economic growth. During the 1980s many emerging economies decided or were coerced into following the advanced economies by abandoning their capital controls, though over 50 retained them at least partially. The orthodox view that capital controls are a bad thing was challenged following the 1997 Asian Financial Crisis. Asian nations that had retained their capital controls such as India and China could credit them for allowing them to escape the crisis relatively unscathed. Malaysia's prime minister Mahathir bin Mohamad imposed capital controls as an emergency measure in September 1998, both strict exchange controls and limits on outflows from portfolio investments - these were found to be effective in containing the damage from the crisis. In the early nineties even some pro-globalization economists like Jagdish Bhagwati and some writers in publications like The Economist, spoke out in favor of a limited role for capital controls. But while many developing world economies lost faith in the free market consensus, it remained strong among western nations.

After 2008 global crisis: 2009 and later

By 2009, the global financial crisis had caused a resurgence in Keynesian thought which reversed the previously prevailing orthodoxy. During the 2008–2012 Icelandic financial crisis, the IMF proposed that capital controls on outflows should be imposed by Iceland, calling them "an essential feature of the monetary policy framework, given the scale of potential capital outflows."

In the latter half of 2009, as the global economy started to recover from the Global Financial Crisis, capital inflows to emerging market economies—especially, in Asia and Latin America—surged, raising macroeconomic and financial-stability risks. Several emerging market economies responded to these concerns by adopting capital controls or macroprudential measures; for example, Brazil imposed a tax on the purchase of financial assets by foreigners and Taiwan restricted overseas investors from buying Time deposits.

The partial return to favor of capital controls is linked to a wider emerging consensus among policy makers for the greater use of macroprudential policy. According to economics journalist Paul Mason, international agreement for the global adoption of Macro prudential policy was reached at the 2009 G-20 Pittsburgh summit - an agreement which Mason said had seemed impossible at the London summit which took place only a few months before.

Pro capital control statements by various prominent economists, together with an influential staff position note prepared by IMF economists in February 2010 (Jonathan D. Ostry et al., 2010), and a follow-up note prepared in April 2011, have been hailed as an "end of an era" that eventually led to a change in the IMF's long held position that capital controls should be used only in extremis, as a last resort, and on a temporary basis.

In June 2010 The Financial Times published several articles on the growing trend towards using capital controls. They noted influential voices from the Asian Development Bank and World Bank had joined the IMF in advising there is a role for capital controls. The FT reported on the recent tightening of controls in Indonesia, South Korea, Taiwan, Brazil and Russia. In Indonesia recently implemented controls include a one-month minimum holding period for certain securities. In South Korea limits have been placed on currency forward positions. In Taiwan the access that foreigner investors have to certain bank deposits has been restricted. The FT cautioned that imposing controls has a downside including the creation of possible future problems in attracting funds.

By September 2010, emerging economies had experienced huge capital inflows resulting from carry trades made attractive to market participants by the expansionary monetary policies several large economies had undertaken over the previous two years as a response to the crisis. This has led to countries such as Brazil, Mexico, Peru, Colombia, Korea, Taiwan, South Africa, Russia and Poland further reviewing the possibility of increasing their capital controls as a response. In October, with reference to increased concern about capital flows and widespread talk of an imminent Currency war, financier George Soros has suggested that capital controls are going to become much more widely used over the next few years. But several analysts have questioned whether controls will be effective for most countries, with Chile's finance minister saying his country had no plans to use them.

In February 2011, citing evidence from new IMF research (Jonathan D. Ostry et al., 2010) that restricting short-term capital inflows could lower financial-stability risks, over 250 economists headed by Joseph Stiglitz wrote a letter to the Obama administration asking them to remove clauses from various bilateral trade agreements that allow the use of capital controls to be penalized. There was strong counter lobbying by business and so far the US administration has not acted on the call, although some figures such as Treasury secretary Tim Geithner have spoken out in support of capital controls at least in certain circumstances.

Econometric analyses undertaken by the IMF, and other academic economists found that in general countries which deployed capital controls weathered the 2008 crisis better than comparable countries which did not. In April 2011 the IMF published its first ever set of guidelines for the use of capital controls. At November's 2011 G-20 Cannes summit, the G20 agreed that developing countries should have even greater freedom to use capital controls than the IMF guidelines allow. A few weeks later the Bank of England published a paper where they broadly welcomed the G20's decision in favor of even greater use of capital controls, though they caution that compared to developing countries, advanced economies may find it harder to implement efficient controls. Not all momentum has been in favor of increased use of capital controls however. For example, in December 2011 China partially loosened its controls on inbound capital flows, which the Financial Times described as reflecting an ongoing desire by Chinese authorities for further liberalization. India also lifted some of its controls on inbound capital in early January 2012, drawing criticism from economist Arvind Subramanian who considers relaxing capital controls a good policy for China but not for India considering her different economic circumstances.

In September 2012, Michael W. Klein of Tufts University challenged the emergent consensus that short-term capital controls can be beneficial, publishing a preliminary study that found the measures used by countries like Brazil had been ineffective (at least up to 2010). Klein argues it was only countries with long term capital controls, such as China and India, that have enjoyed measurable protection from adverse capital flows. In the same month, Ila Patnaik and Ajay Shah of NIPFP published an article about the permanent and comprehensive capital controls in India, which seem to have been ineffective in achieving the goals of macroeconomic policy. However, other studies have found that capital controls may lower financial stability risks, while the controls Brazilian authorities adopted after the 2008 financial crisis did have some beneficial effect on Brazil itself.

Yet capital controls may have externalities: some empirical studies find that capital flows were diverted to other countries as capital controls were tightened in Brazil. An IMF staff discussion (Jonathan D. Ostry et al., 2012) note explores the multilateral consequences of capital controls, and the desirability of international cooperation to achieve globally efficient outcomes. It flags three issues of potential concern. First is the possibility that capital controls may be used as a substitute for warranted external adjustment (for example, when inflow controls are used to sustain an undervalued currency). Second, the imposition of capital controls by one country may deflect some capital towards other recipient countries, exacerbating their inflow problem. Third, policies in source countries (including monetary policy) may exacerbate problems faced by capital-receiving countries if they increase the volume or riskiness of capital flows. The paper argues however that if capital controls are justified from a national standpoint (in terms of reducing domestic distortions), then under a range of circumstances they should be pursued even if they give rise to cross-border spillovers. But if policies in one country exacerbate existing distortions in other countries, and it is costly for other countries to respond, then multilateral coordination of unilateral policies is likely to be beneficial. Coordination may require borrowers to reduce inflow controls or an agreement with lenders to partially internalize the risks from excessively large or risky outflows.

On December 3, the IMF published a staff paper which further expanded on their recent support for the limited use of capital controls.

The impossible trinity trilemma

The history of capital controls is sometimes discussed in relation to the impossible trinity – the finding that its impossible for a nation's economic policy to simultaneously deliver more than two of the following three desirable macroeconomic goals: 1) A fixed exchange rate, 2) an independent monetary policy, 3) free movement for capital (absence of capital controls). In the first age of globalization, governments largely chose to pursue a stable exchange rate while allowing freedom of movement for capital. The sacrifice was that their monetary policy was largely dictated by international conditions, not by the needs of the domestic economy. In the Bretton woods period, governments were free to have both generally stable exchange rates and independent monetary policies at the price of capital controls. The impossible trinity concept was especially influential during this era as a justification for capital controls. In the Washington consensus period, advanced economies generally chose to allow freedom of capital and to continue maintaining an independent monetary policy while accepting a floating or semi-floating exchange rate.

Capital controls in the EU and EFTA

There have been three instances of capital controls in the EU and EFTA since 2008 – all of them triggered by banking crises.

Iceland (2008–)

In its 2008 financial crisis, Iceland (which is a member of the European Free Trade Area but not the European Union) imposed capital controls due to the collapse of its banking system. As of 2015, Iceland's capital controls have still not been lifted – although Iceland's government said in June 2015 that it planned to lift them. However, since the announced plans include a tax on taking capital out of the country, arguably they still constitute capital controls.

Republic of Cyprus (2013–2015)

Cyprus, a Eurozone member state which is closely linked to Greece, imposed the Eurozone's first temporary capital controls in 2013 as part of its response to its 2012 banking crisis. These capital controls were lifted in 2015, with the last controls being removed in April 2015.

Greece (2015–)

See Capital controls in Greece

Adoption of Prudential Measures

The Prudential Capital Controls measure distinguishes itself from the general capital controls as summarized above as it is one of the prudential regulations that aims to mitigate the systemic risk, reduce the business cycle volatility, increase the macroeconomic stability, and enhance the social welfare. It generally regulates inflows only and take ex-ante policy interventions. The "prudence" requirement says that such regulation should curb and manage the excessive risk accumulation process with cautious forethought to prevent an emerging financial crisis and economic collapse. The "ex-ante" timing means that such regulation should be taken effectively before the realization of any unfettered crisis as opposed to taking policy interventions after a severe crisis already hits the economy.

Free movement of capital and payments

Full freedom of movement for capital and payments has so far only been approached between individual pairings of states which have free trade agreements and relative freedom from capital controls, such as Canada and the U.S., or the complete freedom within regions such as the European Union, with its "Four Freedoms" and the Eurozone. During the first age of globalization that was brought to an end by World War I, there were very few restrictions on the movement of capital, but all major economies except for the United Kingdom and the Netherlands heavily restricted payments for goods by the use of current account controls such as tariffs and duties.

Arguments in favour of free capital movement

Pro free market economists claim the following advantages for free movement of capital:

Arguments in favour of capital controls

Pro capital control economists have made the following points.