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Capital controls are the legal and quasi-legal regulations that govern the movement of capital (money, credit and other financial assets; direct investment, and capital goods) across national borders, to restrict or stimulate outflows or inflows, particularly speculative and abnormal flows, of capital. In short, capital controls are government practices that influence the volume, direction, character, and/or timing of short- and long-term capital transfers. The capital control regulations a government uses are categorized into four types: foreign exchange regulations (and exchange rate regimes); tax and revenue-generating policies (surcharges); investment and credit regulations; and trade or commercial restrictions. The status and enforceability of capital controls range from official/legal restrictions that are fully enforceable (if the administration desires), to bureaucratic restrictions left to the policies and discretion of regulatory agencies (and their resources), to social/customary restrictions that are enforced more through custom, cultural mores, and goodwill between the parties than any explicit law or policy.
Purposes, Uses, and Functions
Although often maligned as counterproductive or ridiculed as ineffective, capital controls are used more than trade restrictions, and have been used throughout economic history by almost every country. Countries use capital controls for various purposes and for a wide variety of reasons, in particular to lessen the effects of volatile disequilibriating capital flows; to lessen capital flight; and to protect infant industries. Justifications for the use of capital controls include sheltering or isolating a country from volatile capital movements; saving foreign exchange and keeping domestic and foreign finances under national control; facilitating domestic full employment; forcing repatriation of nonreported capital; and generating government revenues.
In twentieth-century history the worldwide financial instability of the 1920s and 1930s led many economists and policy makers to advocate the use of capital controls. In the early 1930s, the English economist John Maynard Keynes was a strong proponent of capital controls and argued for their international institutionalization with the establishment of the International Monetary Fund (IMF) at the Bretton Woods conference in 1944. The IMF charter included a compromise, accepting the use of capital controls, particularly on capital account transactions, under specific conditions with a finite timetable, but promoting the principles of free trade.
Studies that have examined the use of capital controls find them to have helped countries control capital flight, maintain the desired exchange rate and desired level of international reserves, reduce exchange and interest rate volatility, retain domestic savings and protect labor’s wage share, increase government revenues, and maintain the domestic tax base.
In her Capital Control, Financial Regulation, and Industrial Policy in South Korea and Brazil (1996) Jessica Gordon Nembhard explained that capital controls have a purpose within a country’s development plan, in particular as the apex of a triad of complementary industrial development policies including credit controls and government entrepreneurship and economic planning. During the 1980s both the Republic of Korea (South Korea) and Brazil, for example, used similar financial strategies to encourage and support industrial development. These policies included capital controls, credit controls and preferential credit allocation, fiscal incentives, and trade restrictions to both control and reward the domestic public and private sectors for following the national development plans. There were structural differences, however, between the level of financial control, the types of restrictions used, and the two countries’ abilities to effectively implement and maintain policies and planning efforts. The Republic of Korea was more successful than Brazil because of the specific types and configuration of controls used, the high level of financial control held by the state, the comprehensiveness of the coordination of government planning, and the administrative skills and consistency of implementation and enforcement exhibited by the Korean bureaucracy. South Korea had a more commercially open but financially closed economy. This combination worked well for many years.
Contemporary Utilization of Controls and Trends in Use
Even with the international pressure for liberalization of capital controls coming mostly from the United States and the multilateral organizations such as the IMF and the World Bank, at the end of 2000 97.8 percent, or 182 of the 186 member countries of the IMF, maintained some level of restriction on capital account transactions (Monetary and Exchange Affairs Department [MEAD] 2003, p. 43). Most widely used restrictions were on transactions by commercial banks and other credit institutions, foreign direct investment, and real estate transactions. This was an increase in capital account restrictions from the 180 in 1997 and the 136 of 178, or 77.5 percent, of members in 1992. In addition, 133 countries, or 71.5 percent, continued to have controls on current account transactions in 2000 (MEAD 2003, p. 55), an increase from the 92 or 51.6 percent of countries in 1992. Most widely used were controls on import payments and on export proceeds, although few countries classified as “advanced” used current account restrictions. Among the group of countries categorized as “less developed” or “developing,” use of controls actually increased between 1975 and 1989, when many European countries (members of the Organization for Economic Cooperation and Development [OECD]) were reducing their use of controls, and were maintained for the most part (with some fluctuation) throughout the 1990s.
According to the Monetary and Exchange Affairs Department of the IMF (2003), between 1997 and 2001 the “momentum of liberalization” slowed even though financial globalization continued and exchange rate regimes tended to move toward greater flexibility. MEAD found an increased use of certain types of capital controls on selected capital transactions such as those affecting institutional investors. MEAD suggested that countries become increasingly concerned with “risks associated with capital account liberalization following a series of crises in emerging market economics,” which may explain the increased use of restrictions (MEAD 2003, p. 40).
Liberalization, Arguments Against, and Theory of the Second Best
Arguments against capital controls based on traditional economic theory assume that unrestricted capital movements and free trade are Pareto optimal (perfectly competitive) in a Walrasian economy. Restricted financial markets are assumed to be inefficient, to distort capital movements and to impede economic growth, because they misallocate resources, reduce investment opportunities, and hamper exchange rate flexibility and other automatic stabilizers. In addition, capital controls are considered ineffective because it is assumed that they cannot be enforced and only autarkic countries use them. Black markets, usury, and other illegal exchanges are presumed to be the evidence of inefficient markets and lack of enforceability. Governments, organizations, and scholars interested in promoting international economic integration, and the right of the owners of capital to take their resources and make their profits anywhere, support liberalization or easing of capital restrictions. Countries are supposed to use exchange rate and interest rate adjustment (flexible rates and devaluation) to address volatile capital movements and not use capital controls.
In traditional models capital controls are sometimes justified as a second-best solution in the face of temporary rigidities or distortions in the market, such as when it is necessary to defend an exchange rate disequilibrium, or when equalizing domestic with world interest rates limits the effectiveness of national monetary and fiscal policies. Some studies find that capital controls work well in the presence of other protectionist policies. Capital controls can, or should according to theory, be lifted or liberalized when the other distortions are removed, once a country’s economy is more advanced, and/or in order for a country to join the world economy and open up its markets. Proponents of capital controls find that the distortions and inequities are not temporary conditions, but perpetual market failures that require intervention. Empirical studies find that the use of controls continues. Restrictions on capital accounts can be rational and effective, evasion can be mitigated, and enforcement strengthened, especially when they are part of a set of strategic economic development policies.
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