The trouble with excess global capital:
Before talking about what are "capital controls", it is first important to understand what is the problems that countries face (what are they trying to stop?);
- excess inflows of international capital can cause the currency to appreciate (making exports un-competitive in the international markets). Countries such as Colombia put in place capital controls so that money doent flood into the stock market, appreciating the currency.
- excess outflows of domestic capital can cause a local banking collapse. We saw this in Argentina with the crisis of 2002 as the government tried to stop locals from pulling money out of the county. We also currently see capital controls in China, as they limit local Chinese options for investing overseas.
Other concerns (less spoken about)
- foreign ownership of local banks has the potential to weaken the local monetary policy: if there is increasing levels of foreign banking, there is the potential of a weakening of local monetary policy (since banks can borrow internationally). Also, it is yet to be seen what will happen if there is a banking crisis (will local governments back up a foreign bank?)
but do Capital Controls really work?
see our discussion on Mundell trilemma
Capital controls have been largely criticized in the literature, both for their ineffectiveness and for creating market distortions. Some governments in the 1990’s commonly used them, as an instrument to control short-term investment flows, in order to reduce the vulnerability of the economy, and to prevent financial crisis
"How can developing countries drink from the waters of international capital markets without being drowned by them? "
"antiglobalists who have never met a capital control they didn't like"
"The trouble is that capital controls often breed corruption and always engender distortions. Human ingenuity usually ensures that their effectiveness is eroded over time, through avoidance and evasion. And to sustain effective capital controls indefinitely, a government has to be prepared not only to intervene heavily throughout the trade and financial system—a policy that has highly undesirable side effects—but it must also be disciplined enough (which few are) to limit excessive capital inflows during boom times.
Don't discourage FDI or equities
Which types of capital flows are we talking about controlling? Certainly not foreign direct investment (FDI), which tends to be by far the most stable form of external finance and is often accompanied by transfers of foreign managerial skills and technology. And, hopefully, not foreign holdings of equities, which provide great benefits in terms of risk sharing. True, sudden reversals by foreign investors can be a problem for countries with rigidly fixed exchange rates, but that says more about fixed rates than it does about cross-border holding of equities.
Excessive debt flows a worry
All of which supports the view that the right starting point for thinking about capital controls must be on very focused, temporary measures aimed at stemming massive temporary inflows or outflows of debt
read more: IMF paper on capital controls
Examples:
Colombia has (4/2008) imposed capital controls to limit excessive short-term inflows that will cause high currency appreciation. These controls, which require foreigners to make a deposit of 40% of their portfolio investment for six months at the Central Bank without earning interests, have been ineffective in stopping the strengthening of the peso, and have had a negative impact in the equity market.
On October 20, Brazil surprised investors with a 2% tax on capital inflows to both equity and bond markets. Likewise, in March 2008, Brazil used a 1.5% tax on fixed income inflows only to contain the Brazilian real’s appreciation at the time. The tax was eventually lifted in October 2008 shortly after the Lehman collapse. This time around, taxation on equity investment was included to contain short-term capital flows, while FDI was exempted
Trouble with Capital Controls-
The risk is that capital controls are seen as punitive measures against capital markets. They raise uncertainty about future policy actions, hurt the credibility of the central bank, and increase the costs of external funding for local businesses.
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