What are capital controls?

What Are Capital Controls? 

The IMF recently published a report regarding the experiences that countries across the world have had with capital controls. The full document, entitled Country Experiences with the Use and Liberalization of Capital Controls, can be found on the IMF web page at http://www.imf.org/external/pubs/ft/op/op190/index.htm. 

This FAQ summarizes key aspects of the IMF report. Please refer to the full document for further information. 

 I. What Are Capital Controls? Capital controls restrict the free movement of capital. Countries use these controls to restrict volatile movements of capital entering (inflows) and exiting (outflows) their country. These increased volatile movements in capital can be attributed to the expanding global economy and a country's willingness to liberalize its financial system by allowing free convertibility of its currency. Analysts say currency convertibility has normally been allowed to finance current trade and direct investment transactions. Only recently has currency convertibility also been allowed in the capital account. By introducing this "capital account convertibility," countries expose themselves to autonomous inflows and outflows of funds (capital) by foreigners and locals, thus subjecting their currency to speculation and exchange rate volatility. 

Restrictions can be placed on capital inflows and outflows. The IMF report states that most countries impose controls on inflows to respond to the macroeconomic implications of the increasing size and volatility of capital inflows. Outflow controls are used to limit the downward pressure on their currencies. Such controls are mainly applied to short-term capital transactions to counter speculative flows that threaten to undermine the stability of the exchange rate and deplete foreign exchange reserves. 

A. Why Capital Controls? 

The report states that many countries implement capital controls to help reconcile conflicting policy objectives when their exchange rate is fixed or heavily managed. The most common argument for the implementation of capital controls is to preserve the autonomy of monetary policy or of domestic objectives regarding direct monetary policy, as well as to reduce pressures on the exchange rate. A related argument is to protect monetary and financial stability during persistent capital flows. This is particularly important when there are concerns about the inflationary consequences of large capital inflows or when banks or the corporate sector inadequately assess their risk. 

Inadequate assessment of risk typically occurs in the context of a heavily managed exchange rate that, by providing an implicit exchange rate guarantee, encourages a build-up of unhedged foreign currency positions. The report also states that capital controls have been used to support policies of financial repression to provide cheap financing for government budgets and priority sectors. 

 B. Types of Capital Controls 

Capital controls encompass a wide range of diversified and often country-specific measures. These restrictions to capital movements usually take two broad forms: (a) "administrative" or direct controls and (b) "market-based" or indirect controls. Although these controls are usually applied separately during heavy capital flows, they are often applied in tandem. Administrative or direct controls restrict capital transactions and associated payments and transfer of funds through outright prohibitions. These controls are designed to directly affect the volume of cross-border financial transactions. 

They typically impose administrative obligations on a country's banking system to control the flows of capital. Market-based or indirect controls make transactions more costly thereby discouraging capital movement and the associated transactions. These capital controls may take the form of dual or multiple exchange rate systems, explicit taxation of cross-border financial flows, indirect taxation of cross-border flows and other indirect regulatory controls. 

 II. Disadvantages 

 The report states that regardless of whether capital controls are effective, their use may come at a cost. First, restrictions on capital flows, particularly when they are comprehensive or wide-ranging, may interfere with desirable capital and current transactions along with less desirable ones. 

Second, controls may entail non-trivial administration costs for effective implementation, particularly when the measures have to be broadened to close potential loopholes for circumvention. 

Third, there is also the risk that shielding the domestic financial markets by capital controls may postpone necessary adjustments in policies or hamper private-sector adaptation to changing international circumstances. 

Finally, controls may give rise to negative market perceptions, which may in turn make it costlier and more difficult for the country to access foreign funds. 

 III. Conclusions of Report 

 The effectiveness of the controls to achieve their intended objectives has been mixed. In most countries, the controls had some effect initially, but fell short of meeting each country's objectives. The report further breaks down its conclusions into short-term capital inflows and capital outflows. 

 A. Capital Inflows 

 The report suggests two tentative conclusions. First, to be effective, the coverage of controls needs to be comprehensive and the controls need to be implemented forcefully. Considerable administrative costs are incurred in continuously extending, amending, and monitoring compliance with the regulations. Second, although capital controls appeared to be effective in some countries, it is difficult to be certain of their role given the problems involved in disentangling the impact of the controls from that of the accompanying policies, which included the strengthening of prudential regulations, greater exchange rate flexibility and adjustment in monetary policy, as they are often imposed and modified for macroeconomic rather than microeconomic reasons, for example, at times of downward pressure on exchange rates. 

 B. Capital Outflows 

 The reimposition of controls on capital outflows during episodes of financial crisis has provided only a temporary respite of varying duration to the authorities. The experiences of the countries studied suggests that: (a) to be effective, the controls must be comprehensive, strongly enforced and accompanied by necessary reforms and policy adjustments; (b) controls do not provide lasting protections in the face of sufficient incentives for circumvention (in particular, attractive return differentials in the offshore markets and strong market expectations of currency depreciation); (c) the ability to control offshore market activity may have been instrumental in containing outflows and stemming speculative pressures; and (d) effective measures risk discouraging legitimate transactions, including foreign direct investment and trade-related hedging transactions and may raise the cost of accessing international capital markets.

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