In his famous ‘Open’ Letter to the Malaysian Prime Minister Mr. Mahathir, Paul Krugman wrote,
“Currency controls are a risky, stopgap measure, but some gaps desperately need to be stopped.” (Krugman, 1998)
If one may delve into the history of capital controls, it is discovered that the modern capital controls emerged into picture in World War I to finance wartime expenditures by maintaining a tax base; but they began to disappear after the war, before re-emerging during the Great Depression of the 1930s – their purpose being to reflate the economies of the affected countries without the danger of capital flight. (Neely, 1999, p. 13) In fact, the Bretton Woods System insisted solely on current account convertibility but allowed controls on international flows of capital. All this began to change with the establishment of Organization for Economic Cooperation and Development (OECD) in 1961. The articles of OECD embraced capital account liberalisation, and based on the same there was a gradual easing of capital controls in those countries in 1960s, though some new controls were also introduced at the same time. Meanwhile, capital controls had been widely used in Less Developed Countries (LDCs), the same being a crucial part of Import Substitution Industrialisation (ISI) strategies, especially in Latin America and Asia . With the IMF beginning to strongly encourage all countries to liberalise in the late 1980s/early 1990s, some of the controls began to phase out. So strong was the IMF’s commitment to financial liberalisation that at the IMF Interim Committee Meeting in Hong Kong in April 1997, it was proposed to amend the IMF’s Articles to add a chapter on capital account convertibility, i.e. making capital account liberalisation a central part of its mandate. Owing to the South East Asian Crisis barely a few months later, the proposal not only faced a set-back before its implementation; but a little more than a year and a new round of meetings later the mood is very different, and the merits of a liberalized capital account, along with a long list of competing proposals for a new international financial architecture, are being actively debated once again. (McHale, 2005) The reason being that the countries with capital controls, like China , India (and subsequently Malaysia
There are a number of theoretical arguments put forth by the neoclassical economists citing benefits of capital account liberalisation. These theoretical models have identified a number of direct and indirect channels through which embracing international financial integration can help enhance economic growth in developing countries. With respect to the direct channels, it is argued that financial globalisation promotes growth by augmenting domestic savings (by way of increased investment in capital-poor countries while providing a higher return on capital than is available in capital-rich countries and thereby reducing the risk-free rate in the developing countries), reducing the cost of capital through better global allocation of risk (first, by increasing risk-sharing opportunities between foreign and domestic investors; second, by increasing the ability of the firms to diversify risks, thereby encouraging them to take more total investment; last, by introducing liquidity in the domestic stock market, further reducing the equity risk premium), effecting transfer of technological and managerial know-how (which have the potential to generate technology spillovers), stimulating domestic financial sector development (resulting from the increased liquidity of the domestic stock market due to international portfolio flows and various benefits of increased foreign ownership of domestic banks). Indirectly, financial liberalisation promotes specialisation (by helping the countries to engage in international risk sharing), encourages commitment to better economic policies (as the disciplining role of financial integration could change the dynamics of domestic investment in an economy to the extent that it leads to a reallocation of capital toward more productive activities in response to changes in macroeconomic policies), and signalises that it is going to practice more friendly policies toward foreign investment in the future. (Prasad et. al., 2003, pp. 13-14) These ideas, nevertheless, rest on a few assumptions, namely, (1) Resources are fully employed (else the countries would be more concerned about getting their resources fully employed rather than their reallocation from inefficient to efficient sectors); (2) Capital flows do not stand in the way of attaining full employment (in reality, however, capital flows have been observed to result in destabilising markets); and (3) International transfers are governed by long-term return on investment.
Furthermore, Kavaljit Singh explains that “the argument that removal of capital controls will enhance economic efficiency derives from two basic propositions in economic theory – the ‘Fundamental Theorem of Welfare Economics’ (FTWE) and the ‘Efficient Market Hypothesis’ (EMH). The FTWE deals with the efficiency of the real economy and presumes a perfectly competitive economy with no externalities while EMH portrays that financial markets are efficient gatherers and transmitters of information. Together, they present a picture of economic efficiency being dependent upon free markets for goods, labour and finance, and a minimalist state. In these theoretical propositions, removal of capital controls (which by definition are contemplated as inefficient) is considered beneficial.” This happens to be in perfect consonance with the neo-liberal ideology. (Singh, 2000, p.134)
Although it has been observed that the average per capita income for the group of more financially open (developing) economies grows at a more favourable rate than that of the group of less financially open economies, a few empirical studies have pointed out that there is no strong, robust, and uniform support for the theoretical argument that financial globalization per se delivers a higher rate of economic growth. In fact, some of the countries with capital account liberalization have experienced output collapses related to costly banking or currency crises. (Prasad et. al., 2003, pp. 2-3) As Christopher J. Neely points out, “The benefits of capital flows do not come without a price, however. Because capital flows can complicate economic policy or even be a source of instability themselves, governments have used capital controls to limit their effects.” (Neely, 1999, p. 15)
Joseph Stiglitz has time and again argued that financial markets behave differently from product markets. He has emphasised that the financial markets are characterised with the problems of asymmetric information, and hence, in reality, behave not like the way propagated by the theoretical models. Keynes, on the other hand, has criticised the price formation in the EMH, stating that markets are generally driven by herd behaviour and second guessing the market (like in a ‘beauty parade’) is commonplace. Furthermore, financial markets are prone to cumulative disequilibrium i.e. if in financial markets the price is falling, of a currency for example, then the people will sell the same to prevent themselves from holding something that has no value – unlike product markets, where other things being equal, if prices come down then people buy more of the commodity. Moreover, the post-keynesian economists contend that flexible exchange rates and free capital flows are not yet compatible with full employment and rapid growth.
Many economists, like Jagdish Bhagwati, feel that there is a huge difference between ‘Free Trade’ and ‘Free Capital Mobility’ and hence arguing for free capital mobility with the same arguments used for free trade is inappropriate. In Bhagwati’s words, “… when we penetrate the fog of implausible assertions that surrounds the case for free capital mobility, we realize that the idea and the ideology of free trade and its benefits – and this extends to the continuing liberalization of trade in goods and financial and other services at the World Trade Organization – have, in effect, been hijacked by the proponents of capital mobility… The pretty face presented to us is, in fact, a mask that hides the warts and wrinkles underneath.” (Bhagwati, 1998) Rodrik (1998), in his article ‘Who needs Capital-account Convertibility?’, looks at the South East Asian financial crises and presses upon the idea that financial markets are much too volatile to embrace liberalisation of capital accounts. “Keynes once wrote that economics would only be successful if economists had the same ability as dentists to address and solve practical problems. Well, here LDCs are faced with a practical economic problem if ever there was one: how to live with a liberated capital account, in a world with an already high, rapidly expanding, ever more volatile, and practically unregulated financial liquidity.” (Palma
A potent way to counter these problems is by imposing controls on capital flows. Singh argues that “if effectively used as an integral part of a strategy of state intervention in conjunction with other complementary policy measures, capital controls can be beneficial to the economies in several ways.” He discusses some important objectives of capital controls and their desired benefits. First, according to him, capital controls are the only effective and meaningful tools to protect and insulate the domestic economy from volatile capital flows and other negative external developments; especially in the wake of domestic countries’ experience with rapid capital flight, depletion of foreign exchange reserves and loss of autonomy in monetary policy. Second, he contends that some kind of social control over capital is desirable as well as critical; owing to the importance of capital for development for the enhancement of domestic savings and its direction (along with foreign borrowings) into productive domestic investment in accordance with their developmental plans. Third, capital controls help the countries to attain the bargaining power and assert its power during negotiations with their own private sector, foreign capital and multilateral financial institutions. Fourth, the governments can maintain the desired level of foreign reserves and channelise the terms of trade (in order to protect domestic products from international competition) by influencing the exchange rate. Fifth, capital controls are especially significant for developing countries because it helps them save foreign exchange for debt servicing, imports and capital goods. (Singh, 2000, pp. 135-139)
Among these the most cited benefit of capital controls is naturally their ability to protect an economy from the devastating financial crises. “The financial crises, which surfaced in Southeast Asia and East Asia with Russia and Brazil
Neely points out that “the conventional wisdom of the economics profession has been – whatever the problems with destabilizing capital flows or fixed exchange rates – that capital controls are ineffective and impose substantial costs on economies that outweigh any benefits. That generalization ignores distinctions among types of capital controls and varied criteria for success, however. Capital controls have many potential purposes and thus many potential standards by which to judge their efficacy.” (Neely, 1999, p. 26) So, there are Administrative Controls that range from prohibitive controls, to quantitative limits, to discretionary rules; and then there are Market-based Controls which may include dual- or multiple-exchange rates, tax on cross-border capital flows (or on income from foreign assets), indirect taxes (like unremunerated reserves), and regulatory controls on banks. Capital controls are also often classified as Quantity-based controls (involving explicit limits or prohibitions on capital account transactions); Price-based controls (seeking to alter the cost of capital transactions with a view to discouraging a certain class of flows and encouraging another set of flows); or Regulatory controls (which can be both price-based or quantity-based – this policy package usually treats non-residents less favourably than the residents e.g. unremunerated reserve requirement). (Singh, 2000, p. 122; Neely, 1999, p. 23) Still another way to classify controls is ‘Controls on Inflows’ as against ‘Controls on Outflows’. (Neely, 1999, p. 22) Whereas the former are often imposed to change the nature of capital flowing in the country (say, to encourage long-term flows while discouraging short-term flows; or, for example, in India foreign investment is prohibited in real estate); the latter are often used to prevent capital flight in case a crisis knocks at the country’s door (e.g. Malaysia after the South East Asian crisis).
However, even the advocates of capital controls might admit that they do not come without a price. Although they are often evaded, even successfully at times, they impose substantial costs in subduing international trade in assets. Most notable among these costs are confining the benefits of capital flows: risk-sharing, diversification, growth, and technology transfer. Capital controls are believed to be even more harmful when they are used to defend inconsistent policies that produce an overvalued currency. Poorly designed or administered capital controls can even adversely affect direct investment and the ordinary financing of trade deals and not to mention that controls can worsen the problem of destabilizing capital flows (as acknowledged by the Korean government with respect to restriction on offshore borrowing by Korean corporations). Evasion of controls encourages corruption and imposes administrative costs on the governments. (Neely, 1999, pp. 27-28)
The critics of capital controls further argue that capital liberalisation, as opposed to controls, promotes higher growth (though this argument is not sufficiently supported by evidence). Furthermore, they impress upon the fact that there are problems of evasion and implementation of capital controls. Though it may be counter-argued that this does not mean that one should abolish controls – as it is with criminal law, if people get around the law and commit crimes, it does not prove to be good enough reasons to do away with the law – rather one should improvise them. At this point, one might say that the conventional economic theories often tend to overplay the downside of capital controls while totally underplaying their benefits. Although Keynesian theory recognises the advantages of state intervention and capital controls (the experience of the Great Depression led Keynes to argue, “above all, let finance be primarily national.”), it considers these controls as ‘second-best’ solution. It justifies the use of such channels only as emergency measures to be used for short duration when the governments face specific problems. (Singh, 2000, pp. 125 ff.) “In this world of already high, rapidly growing, extremely volatile, and almost totally unregulated international liquidity, capital controls can, of course, be of some help; but one cannot expect them to be able to hold the fort on their own!” (Palma
The debate among the proponents of capital controls and the opponents of the same clearly has no victors as both cases have advantages and disadvantages. However, controls on international capital flows do appear to be lesser of the two evils, especially after the experience of more financially integrated economies with the financial crises. This has even prompted IMF’s economic counsellor Kenneth Rogoff to admit that even though he favours capital market integration, nevertheless the countries embracing the same should keep an open mind but not a blind eye to the dangers that come as part of the package. “Hard work remains to be done on capital account liberalisation and its sequencing with other policies to find the point at which the benefits to further capital market integration stop exceeding the costs… making sure that financial market liberalisation does not get too far ahead of trade liberalisation” (Rogoff, 2002) Therefore, as is apparent from this statement, the IMF, though it has not shifted from its pro-financial liberalisation policy, is not any more encouraging the ‘big-bang’ method of financial integration. Many authors now favour tackling of fiscal imbalances first and attaining a minimal degree of macroeconomic stability during the early process of reform process. They also agree that the capital account should be liberalised only after the domestic financial sector has been reformed and the liberalisation of trade in goods has been consolidated. “At practical policy level the debate has centered, not so much on whether capital controls should be eliminated, but on when and how fast this should be done. This discussion has come to be known as the ‘sequencing and speed of reform debate’.” (Edwards, 1999, pp. 66-67) Hence, one may presume this to be a sort of compromise emerging between the two groups debating this issue with both sides neither conceding defeat nor emerging as clear winners.
Refrences:
Edwards, Sebastian. How effective are capital controls?, Journal of Economic Perspectives, Vol. 13, No. 4, Fall 1999.
Evans, Trevor. Lecture Notes, Financial Institutions and Development, MIDE Program (WS05-06) at FHTW, Berlin
Krugman, Paul. An Open Letter to Prime Minister Mahathir, September 1, 1998.
McHale, John. Capital Controls and Crisis Management, NBER Website, December 16, 2005. (http://www.nber.org/crisis/capital_report.html)
Nayyar, Deepak. Capital Controls and the World Financial Authority: What can we learn from the Indian Experience?, in John Eatwell, Lance Taylor ed. ‘International Capital Markets: Systems in Transition’, Oxford University Press, 2002.
Neely, Christopher J. An Introduction to Capital Controls, Review, Federal Reserve Bank of St. Louis, November/December 1999.
Palma, Gabriel. The Three Routes to Financial Crises: The need for Capital Controls, in John Eatwell, Lance Taylor ed. ‘International Capital Markets: Systems in Transition’, Oxford University
Prasad, Eswar; Kenneth Rogoff; Shang-Jin Wei; and M. Ayhan Kose. Effects of Financial Globalization on Developing Countries: Some Empirical Evidence, IMF, 2003.
