Importance of Capital Controls in Economic Policy

Globalization of capital investment and finance has surfaced for a long period of time in the world of global financial market. Capital flow liberalization has brought up the importance of capital controls for some countries to achieve their economic growth.

The Description of Capital Controls

Since the failure of Bretton Woods system in 1971, the international capital movements within developed and developing countries become unstable and for some countries the capital flows need to be controlled. Capital controls are restrictions to regulate the movement of capitals which are flowing in or out of the country. Capital flows may be in forms of bank loans, portfolio investment and foreign direct investment. The controls of short terms portfolio investment and bank loans are quite necessary since they are quite risky because of the roll-over risks. For long term credits and FDI are less risky if they are politically guaranteed.

Looking back to the history of capital controls there were two different perspectives. The first was John Maynard Keynes who was the pioneer of the capital controls regime. Keynes was supported by other known economists such as James Tobin, Dani Rodrik and Joseph Stiglitz. The main ideas behind their view are that financiers are really powerful to pursue profits in every part of the world and ignoring other factor such as labor. Keynesian view assumes that a fragile financial system is caused by the free movement of capital as volatile capital flows and it will lead to destructive of important asset prices such as exchange rate, equities and real estate. The second was neoclassical view which supports capital liberalization. Neoclassical view considers capital controls as a bad policy because they are not effective and not useful because markets are perfect and that financial and real assets have no differences.

The Description of Economic Policy

Economic policy is a policy that analyzes the action in public economies. It analyzes three different stages such as the choice of the level of institution, the preferred choices of government and the identification of objectives and social preferences. In relation with capital controls the main of economic policy that will be discussed are monetary policy and fiscal policy.

1. Monetary Policy

Monetary policy is tasked mainly to control supply of money and interest rate. The capital flows have to be under controlled by a prudent monetary policy and capital controls. Monetary policy should control interest rate to achieve low inflation and stability of financial economic system. One of the main instruments of monetary policy is the exchange rate. The exchange rate is used to defend the national currency with domestic inflation rate. There are two purposes of exchange rate:

  1. Exchange rate needs to provide confidence of domestic currency with a stable economic development.
  2. Exchange rate also needs to guarantee international competitiveness and prevent high foreign debt and current account deficit.

In order to fulfill those purpose, exchange rates needs to combine high competitiveness such as current account surplus with stable nominal exchange rate and low inflation rate with interference of capital controls to avoid current account deficit and control depreciation.

In developing countries monetary policy should aim to stable nominal currencies, monetary policy needs to be subjected to exchange rate target. Monetary policy will be deteriorated if such exchange rate peg is in constellation of domestic currency’s full convertibility. Such examples will be high real of interest, the fragile economic situation such as big amounts of short term portfolio investment and short term bank credits that needs the usage of capital controls to stabilize the situation. In addition for those countries that implement inflation targeting as part of the monetary policy strategy, selective capital controls are also needed.

2. Fiscal Policy

Fiscal policy is policy that related with the government revenue, spending, taxation and borrowing for the economy. Government revenues contain the current revenues and the capital account revenues. Current revenues are resulted in direct and indirect taxes and social security contributions. Capital account revenues are resulted in public sector enterprises, sale of government property and repayment of loans. Government revenues may support the domestic investment with the proper policy and stability. With capital controls such as government tax and quantitative restrictions, capital flows can be controlled to insulate the domestic economy from the foreign shock. Capital controls will restrict the quantity of borrowing of domestic residents and government in the world market to preserve the domestic real interest rate

Importance of Capital Controls in Economic Policy

Capital controls can be used effectively as part of the state intervention’s strategy with the combination of other complementary policy measures, and then capital controls can bring benefits to the economies in few ways.

Importance of Capital Controls in Economic Policy

Capital controls can be implemented as an effective tool to protect and defend domestic economy from the negative impact of external development and the volatile of capital flows. The example can be given in context with open economies in developing countries which often experience high capital flight, the decreasing of foreign exchange reserve, and the loss control of the independence of monetary policy because of huge inflows and outflows of capital. The rapid capital flight could direct a country to the crisis of balance of payment, low economic growth, raising inflation, decreasing in savings and resources in financing productive investment. Some of the countries which experienced high capital flight are Brazil, South Africa, and Mexico. Without capital controls the authorities have some difficulty to create an independent monetary policy. In case of interest rate when there is an effort to amend the interest rate, it will lead to unwanted movement of capital. If interest rates are maintained low to support domestic investment then capitals will tend to move out to other country which offers better interest rate. On the contrary if interest rates become high, domestic investment will be declining and there will be transfer of resources from outside country. With capital controls countries may pursue the independent of their monetary policy, keep the differential interest rate, or even protect their currencies from devaluation or speculative attacks.

Capital controls are believed to be crucial for development and essential for the enlargement of investment and domestic savings. When countries use capital controls, they are not only able to keep the domestic or foreign finances under the national control but also to lead the domestic savings in relation with foreign borrowings into productive of domestic investments. Capital controls may keep the domestic capital inside national borders by holding private sector from investing abroad. In relation with the use of capital controls on the productive purposes, capital controls need to be assisted with complementary policy measures in form of credit controls. Credit controls are one of the ways for the authorities to control the credit to particular companies or sectors for promoting the economic development to achieve the planned objectives. With capital control, credit allocation can be ensured to be utilized productively. The relation of capital controls, credit controls and industrial strategy can be implemented in the developing countries to regulate the productive investment, high industrialization and to support the income growth.

Capital controls have abilities to raise the strength of bargaining of countries to negotiate with their private sector, foreign capital and the multilateral financial institution. Capital controls may support countries to maintain their own right and construct their economic policy so that the bad effects of globalization and the policies of structural adjustment could be avoided. The wise use of capital controls may raise the strength of bargaining of countries’ citizens and working classes. When capital become abroad and lead to global capital flexibility, it will tend to benefit the rich either domestically or internationally. Using the capital controls can be favorable to secure the interests of domestic labor. Furthermore with combination of other policy measures, capital controls may accomplish the equality of economic development with better generation of employment, income distribution and raised public investment.

Capital controls may also help the country to maintain the stability of the real exchange rate. In order to affect exchange rate, the authorities will need the required stage of foreign reserves and manipulate the terms of trade to protect the domestic products from foreign competition. One of the ways for a country to make its exports competitive is by devaluing its exchange rate and not to encourage imports. As a matter of choice a country is often to use the exchange controls with the combination of tariffs and trade controls.

Capital controls may support countries to secure its foreign exchange for capital goods, debt servicing and capital goods. This is often experienced in developing countries which have small foreign exchange reserves. Capital controls may also help the government by generating government revenue through custom duties, taxes and the controlled exchange rate.

China is an apt example for implementing capital control measures in their economic policy. China has been successful to avoid the Asian financial crisis in 1997 with the help of implementing capital controls. China governments have supported financial stability by using independent monetary policy and fixed exchange rate. The use of capital controls mainly use to reduce the capital flight by restricting short term inflows and outflows and encouraging long term capital inflows. China has received mostly its capital flows in form of foreign direct investment. The policymakers have been encouraging inflows of FDI by reducing tax policies and other regulation. China has been tightly enforcing restrictions in international capital flows via issuance and investments in bond and equities, implementing strict limits on quantity of money that can be taken in and out by its citizens, and cross border fund raising and bank lending. Those strategies have supported China to build its enormous foreign reserves, current account surplus, and large domestic savings.

To conclude, capital controls have been implemented for some countries in order to achieve their economic growth. It can be concluded that capital controls are indeed useful for supporting the economic policy and may bring benefits to the countries. It is essential to know that capital controls should be used as part of the government development plan and the intervention strategy to achieve the development growth.