The Capital Controls: Dilemma or Trilemma

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Anand Singh's picture

Anyone who has taken a preliminary economics course in school must have been taught that capital controls are bad for the growth of the economy and they often have substantial economic costs. Capital controls are a taboo word in the field of finance and economics and emerging economies like India have voiced that they are willing to exercise full capital account convertibility (Since the 1980’s, India has been slowly deregulating its capital account, and during the balance of payments crises in 1991 it has accelerated the deregulation to encourage foreign capital flows). This view was strengthened after the dot-com crash when capital was flowing into emerging economies and was creating mad rush everywhere.

However the subprime mortgage crisis (2008) and a slew of research findings have started to change the view. Capital controls have slowly started to gain traction. The most recent convert is the Japanese central banker Haruhiko Kuroda who suggested that China should use capital controls to arrest the fall of its currency. IMF, the age old foe of capital controls has also softened. In a speech at university of Maryland, IMF director Christina Lagarde advocated for safer capital controls: “A stronger monetary system should include a framework for safer capital flows.” She cited concerns that “a growing recognition that the short-term nature and inherent volatility of global capital flows are problematic”.

These pro-control views, however gets developed every time there is a big financial crash and they fizzle out as soon as the crisis get over. The same views that developed after the 1997 Southeast Asian crisis which led countries like India to pause their plans of full Capital account convertibility (CAC). George Soros wrote a strong piece against free capital flow in the Washington Post in 1997: ‘South Korea and other Asian countries—like Mexico in 1994-95—are being punished for offences they did not commit. They have inflation and government budgets under control. They are not sinners, but victims of a flawed international exchange rate system that, under US leadership gives the mobility of capital priority over all other considerations. It is simply too easy for banks, governments, businesses and speculators to buy and sell huge blocks of a country’s currency in panicky movements. Such flows of capital can throw a country literally overnight into a crisis’.

But the early 2000s again renewed the global movement for CAC.  Huge amount of capital sloshing in the world markets due to decreased interest rates and extensive deregulation by emerging economies helped private capital to enter the domestic emerging economies. Major emerging economies experienced their biggest absolute growth rates. Such was the support for free capital flows in emerging markets that in 2005 the mere mention of levying taxes on foreign capital flows by Y.V. Reddy (Governor of the Reserve Bank of India) in a development report, raised a market furore to such an extent that not only was it immediately refuted by the finance minister but the governor himself had to say that personally he was “not in favour” of a ceiling on foreign fund inflows.

However recent academic research shows that the obsession with full CAC is misplaced in this era of financial globalisation. The more interconnected and persistent global capital flows has changed the way we think about the impossible trinity. In a recent paper titled “Dilemma not Trilemma” Helene Ray, a London Business School economist explains “The global financial cycle transforms the trilemma into a “dilemma” or an “irreconcilable duo”: independent monetary policies are possible if and only if the capital account is managed.”

Also the recent experiences with countries like Iceland and Spain which suffered from deep recessions when foreign investors backed off have made many leaders wary. On the other hand Switzerland struggled to keep its economy balanced amid massive inflows. Despite the efforts of the central bank, they were not able to keep the franc from rising sharply which adversely affected the exports.

This time due to various serious episodes of economic failures due to massive outflows and inflows the tide against full CAC is here to stay. Many countries have strengthened their defences. Poland has stopped new lending in foreign currencies for most people. India and Nigeria have also tightened restrictions. Also China is fiddling with multiple forms of currency controls. They have ramped up the measures after getting a tacit approval in the form of growing support for capital controls.

The major question that arises, however, is whether foreign capital flows are good or bad for emerging economies. The question is complex and so the answer cannot be in black or white.  According to an IMF discussion paper by Mr Ostry, Ghosh and Korinek, if there are good enough reasons to put up defences —for example, to prevent a domestic bubble—then the country is better off with the controls in place. The authors suggested that there should be greater co-ordination between the countries that are exporting capital and countries receiving it. While macro policy coordination among nations is very hard in practice yet “prudential” measures that limit the exposure of domestic economy to high-risk foreign investments (hot money) and at the same time provide sufficient long term capital for development of emerging economies are the way forward.