Download An Introduction to Capital Control Christopher J. Neely

An Introduction to
Capital Control
Christopher J. Neely - Nov 1999
ECON511
International Finance and Open Macro Economy
Presented by: Sareh Rotabi
Pg 13-18
Outline
Introduction
 Defining Capital Flows
 Benefits of Capital Flows
 Purpose of Capital Control
 Balance of Payment Crisis

Introduction
The concern among economies has been that Capital Control like tariffs on goods,
are obviously detrimental to economic efficiency because they prevent productive
resources from being used where they are most needed.
That’s why it has been phased out in many DEVELOPED ECONOMIES in 1970s,
1980s and by 1990s there was substantial pressure on LESS DEVELOPED
COUNTRIES to remove their restriction too.
However, several recent development have renewed interest in the use and study
of capital control:



The resumption of a large capital control trade in assets to developing countries
during late 1989,1990s created new problems for policy makers
A group of exchange/ financial crisis during the 1990s focused attention on the
asset transactions that precipitated them:
1.
2.



3.
The collapse of the European Monetary System 1992-1193
The Mexican crisis of 1994
The Asian financial crisis in 1997-98
Malaysia's Adoption of capital control in Sep 1998 has prompted increased media
attention and has renewed debate on the Topic of CAPITAL CONTROL.
Introduction
The objective of this Article:
To introduce review readers to the DEBATE on Capital
Controls, to EXPLAIN the PURPOSE and Cost of
Control and why some advocate their reintroduction.
Capital Flows
Trade in REAL and FINANCIAL ASSETS. International purchases and
sale of existing real and financial assets are recorded in the CAPITAL
ACCOUNT.

Real assets: Production Facilities, and Real Estates
Financial assets: Stocks, Bonds, Loans, and Claims to Bank Deposits
Capital account transactions are classified into:
1.
2.
3.



Portfolio Investment: Trade in securities like Stocks, Bonds, Bank loans, Derivatives, and various
form of Credits( Commercial and Financial guarantees), e.g. US investors buy Mexican Gov Bonds
Direct Investment: Purchases of the Real Estates, Production Facilities or Substantial Equity
Investment, e.g. BMW building an automobile factory in US
The CURRENT ACCOUNT record trade in Goods, Services and Unilateral
Transfers. Capital account balance must be EQUAL TO AND OPPOSITE in SIGN
from its current account balance as a nation that import more goods and services
than it export MUST PAY FOR THOSE EXTRA IMPORT BY SELLING ASSETS
OR BORROWING MONEY. In Such case, the country is running a CAPITAL
ACCOUNT SURPLUS
Capital FLows

Surplus in Capital account
A country is said to have a Surplus in the capital account if the rest
of the world is accumulating claims on it (borrowing from abroad –
capital inflow > capital outflow).

Deficit in Capital account
A country is said to have a deficit in the capital account if it is accumulating
net claims on the rest of the world by purchasing more assets and/ or
making more loans to the rest of the world than it is recording (More
investment abroad – capital outflow> capital inflow).
Benefits of Capital Flows

Economist have long argued that trade in assets (capital flows) provide substantial
economic benefit by enabling residents of different countries to capitalize on their
differences.
1.
Fundamentally, capital flow permit nations to Trade Consumption TODAY for Consumption
in the Future to Engage in international trade (Eichen-green.1999), e.g. Japan buy US
assets.
Capital flow allow countries to avoid large fall in the consumption from ECONOMIC
DOWNTURN or NATURAL DISASTER through selling assets or borrowing from the rest of
the world, e.g. Italy ran a capital surplus after 1980’s earthquake.
It allows countries to borrow in order to IMPROVE their ABILITY to Produce goods and
services in the Future, e.g. Korea borrowed fund from the rest of the world back in 19601980
2.
3.

The benefits of capital control are similar to free trades. Countries with different Age
Structure, Saving Rates, Opportunities for Investment, Risk Profiles can benefit from trade
in assets.

However, CAPITAL CONTROL does not come without a PRICE!!
Since Capital Flow can complicate ECONOMIC POLICY or even be a source of
INSTABILITY themselves, government have used CAPITAL CONTROL to Limit their
EFFECT
Benefits of Capital Flows
Purpose of Capital Control


Capital control is any policy or measure taken by a government, Central
bank or other regulatory body to limit the flow of foreign capital in and out of
the domestic economy. This include Taxes, Price or quantity control, or
outright prohibitions on international trade in assets.
Revenue Generation and Credit Allocation:

The first modern capital control was developed after World War I to finance war
time expenditure. The restrictions raised revenue in 2 ways:



By keeping capital in the domestic economy, it facilitated the Taxation of wealth and
interest income
It permitted higher inflation rate, which generated more revenue. Capital control also
reduced the interest rate and therefore the government cost of borrowing on its own
debt.
Since WW I, a lot of other developing economies used similar method to generate
revenue for government or to permit them to allocate credit domestically without the risk
of capital flight
Balance of Payments Crisis



1.
2.
3.
4.
5.
During great depression, controls were used simultaneously to achieve greater
freedom for monetary policy and exchange rate stability.
To understand why control have been used in this way, it is necessary to
understand BOP Problems and their Solutions.
BOP DEFICIT:
At a given EXCHANGE RATE, a country often wants to collectively purchase more
goods, services and assets than the rest of the world will buy from it. Such an
imbalance is called BOP DEFICIT, which could be due to the following factors:
The domestic business cycle maybe out of sync with that of the rest of the world.
They may have been a rapid changes in the world price of key commodities like oil
price.
Expansionary domestic policy may have increased demand for the rest of the
world’s goods
Large foreign debt interest obligations may surpass the value of the domestic
economy’s exports
A perception of a deteriorating economic policy may have reduced international
demand for domestic assets
Balance of Payments Crisis
Policies to correct an imbalance in international payments:

1.
2.
3.
4.
Permit the Exchange rate to change
Use Monetary policy
Attempts to sterilize the monetary change to isolate the domestic
economy from the capital flows
Restrict capital flows
Each of these solutions has its own disadvantage!!
Permit the exchange rate to change
1.


Under flexible exchange rate, the currency will depreciate till the imbalance
gets corrected. Under the fixed exchange rate, a country may correct a
balance of payment deficit by changing the exchange rate peg-devaluing the
currency.
This option will firstly forgoes the benefit of EXHCNGE RATE STABILITY for
International Trade and Policy Discipline. Secondly, it will reduced the Public
Confidence over the Authorities of Anti-Inflationary program
Balance of Payments Crisis
2- Use Monetary Policy




Using monetary policy to the deficit in BOP while keeping the
exchange rate fixed is known as Unsterilizing foreign exchange
intervention.
Using monetary policy to effect Monetary Base through selling bond
or selling foreign exchange to effect the monetary base. Therefore
MS will decrease, interest rate increase and thus, the domestic
demand for import decreases, while reducing the domestic prices of
goods, services, assets in domestic economy.
The deficit in BOP would be eliminated. However, this requires the
monetary policy to devote solely to maintain the exchange rate. Thus,
Central bank lose its power to control inflation or employment.
In this situation, contractionary policy reduced the domestic demand
for foreign goods but it also reduced the employment too, which might
be undesirable.
A country that uses Monetary policy to defend the exchange rate in the face of
imbalance in the international payment is said to SUBORDINATE DOMESTIC
MONETARY POLICY TO EXCHANGE RATE CONCERN.
Balance of Payments Crisis
3- Attempts to sterilize the monetary change to isolate the
domestic economy from the capital flows

Sterilization of sale of foreign exchange (foreign bond) would require
the CB to buy an equal amount of domestic bond, leaving the
domestic interest rate unchanged.
It generally believed that sterilized intervention does not affect the
exchange rate and so it is not very effective in recapturing monetary
independence
Balance of Payments Crisis
4- Restrict capital flows

By directly reducing demand for foreign assets and the potential for
speculation against the fixed exchange rate, control on capital outflows
allow a country to maintain Fixed-rate and an independent monetary
policy while improving BOP deficit
 The monetary authority can meet both their internal goals (inflation and
employment), and external goal (BOP).
Conclusion

1.
2.

Capital flows play a crucial rule in BOP crisis:
In the free capital flow, a country wishing to maintain fixed
exchange rate must use monetary policy solely for that purpose.
According to Mc Kinnon and Oates:
No government can maintain Fixed-Exchange rates, Free
Cappital Mobility and have and independent monetary policy, one
of the 3 options must give. This is known as “Incompatible Trinitiy”
or the “Trilemma” (Obstfeld and Taylor. 1998).
Capital control are sometimes describe in term of choices the
country wants to avoid. Preventing capital outflow might either
influence an Independent monetary policy , or Fixed Exchange
rate.