Capital Controls: Meaning, Types, Benefits and Downside

What are Capital Controls ?

Capital controls are when the governments of nations restrict the inflow and outflow of capital into the economy. In a free market economy, there should be and would be no borders. However, this is not the case in reality.

Countries want to ensure that their economies stay relatively stable in the long run. Some economies, therefore, impose some form of capital controls. The majority of the economies in the western developed world do not impose capital controls. Instead, economic movement of capital is left to the free will of the markets.

However, this is not the case all over the world as a wide variety of capital controls can be found in different countries.

Types of Capital Controls

• Minimum Stay Requirements: A lot of countries have a sort of lock in period when it comes to capital investments. This means that they allow free movement of capital in and out of the country. However, there should be a certain time gap between the inward movement and the outward movement. This is called as a lock in period or as a minimum stay requirement.

• Limitations: Some countries limit the amount of money that every entity can remit out of the country. Since the limitations are based on the number of entities, this provides an incentive for companies to form several legal entities and evade the law!

• Caps on Asset Sales: In many countries certain groups of assets are classified as strategic. These assets are then not sold to foreigners. Such economies allow free movement of capital in and out of the economy but not in certain sectors.

  For instance, Canadians have protected their agricultural investments. Foreigners are free to invest in other sectors of the economy but not in agriculture.

• Limit the Currency Trading: Some countries want to limit the amount of foreign currency that is available for trading in the Forex market at any given point of time. This is because they want to maintain currency pegs i.e. fixed exchange rates. This helps them plan their economic activity better especially if they are an export oriented economy.

  Changing forex rates means that their competitiveness in the international market changes every minute. Capital controls are an effective way to avoid this issue!

Benefits of Capital Controls

Implementing capital controls makes the economy stable. Stability must not be confused with growth here! Capital inflows restrict the inflow of funds into the economy. They do so by scaring the fly by night investors out of the market.

Only investors that see long term potential in a country will invest their own money even after capital controls are in place. Thus, since there is a smaller inflow of funds, the outflow is almost negligible. Nearly all the funds that come in the country stay for a long duration of time. Hence, both the upside and downside are bound by a limited range.

The biggest benefit of capital controls is that it prevents overheating in economies. This means that it prevents investors from pumping and dumping an economy.

Investors cannot flood the economy with funds drive up output and prices and then suddenly leave causing everything to crash! Till domestic investors do not become strong enough to compete with foreign capital, some form of capital controls needs to be in place.

Downside of Capital Controls

There are many economists that oppose capital controls as well. This is because they believe that it is against the functioning of a free market economy. Anything which is against the functioning of a free market economy cannot sustain for long.

As a result, capital controls lead to evasion and corruption on a large scale. Companies that want to take their money out of the country do so by any means. There are illegal channels. Also, often they are helped by bureaucrats who help them draft the right import invoice or the right accounting entry which would evade the long arm of the law.

Hence, capital control turns out to be a wasteful long and arduous exercise that is often based on political reasons than sound economic ones!

Case Studies of Capital Controls

• Economists often point to the Chinese implementation of capital controls to show the success story. The Chinese economy has flourished for more than three decades, and capital controls were fully present during that period. China is now gradually opening up its economy after the domestic sector has become equally strong.

• Malaysia also benefitted from capital controls during the economic debacle of 1998. Since money could not leave the country as fast as it could leave Thailand and Vietnam, Malaysia got some more valuable time to deal with the conflict.

• The opposite case has happened in India. The Indian economy was reeling during the period when capital controls were imposed. Post-1991, these controls were lifted, and the Indian economy started booming during that phase. Today, India is amongst the fastest growing countries in the world!

To sum it up, there are arguments both for and against capital controls. Whether such controls are suitable for an economy, depend upon the particular situation, and a generalization would be incorrect.