Question

9-10. What is capital control? How is it different from tariff, subsidies and trade ban? Why do you think small open economies need to rely on this capital control measure, rather than relying on market-friendly sterilization intervention in the currency market? What is the potential benefit and cost of this capital control? Discuss and write a short essay.

Answer 1

Capital controls are residency-based measures such as transaction taxes, other limits, or outright prohibitions that a nation's government can use to regulate flows from capital markets into and out of the country's capital account. These measures may be economy-wide, sector-specific (usually the financial sector), or industry specific (for example, “strategic” industries). They may apply to all flows, or may differentiate by type or duration of the flow (debt, equity, direct investment; short-term vs. medium- and long-term).

Types of capital control include exchange controls that prevent or limit the buying and selling of a national currency at the market rate, caps on the allowed volume for the international sale or purchase of various financial assets, transaction taxes such as the proposed Tobin tax, minimum stay requirements, requirements for mandatory approval, or even limits on the amount of money a private citizen is allowed to remove from the country. There have been several shifts of opinion on whether capital controls are beneficial and in what circumstances they should be used.

While capital controls are outright measures, tariff, subsidies andn trade bans are forms of non tariff barriers. These trade barriers work on the same principle: the imposition of some sort of cost on trade that raises the price of the traded products. If two or more nations repeatedly use trade barriers against each other, then a trade war results.

Capital control measures may act as a monetary policy tool, rather than trade barriers explicitly. This is the case in small open economies.

Capital controls are able to:

1. Reduce the volume of capital flows

2. Alter the composition of capital flows (towards longer maturity flows)

3. Reduce real exchange rate pressures

4. Allow for a more independent monetary policy

Capital control measures are chosen by small open economies because sterilization intervention raises following fears:

1) Fear of Appreciation

Being the darling of investors in global financial centers has the decided, albeit often temporary, advantage of having ample access to funds at favorable cost. With the capital inflow comes upward pressure on the exchange value of the currency, rendering domestic manufacturers less competitive in global markets, and especially so relative to their close competitors who are not so favored as an investment vehicle. A desire to stem such an appreciation (which Calvo and Reinhart, 2002, refer to as “fear of floating”) is typically manifested in the accumulation of foreign exchange reserves. Over time, though, sterilizing such reserve accumulation (the topic of Reinhart and Reinhart, 1998) becomes more difficult, and more direct intervention more appealing.

2) Fear of “Hot Money”

For policymakers in developing countries, becoming the object of foreign investors’ attention is particularly troubling if such affection is viewed as fleeting. The sudden injection of funds into a small market can cause an initial dislocation that is mirrored by the strains associated with their sudden withdrawal. Such a distrust of “hot money” was behind James Tobin’s initial proposal to throw sand in the wheels of international finance, an idea that has been well received in at least some quarters. Simply put, a high-enough tax (if effectively enforced) would dissuade the initial inflow and pre-empt the pain associated with the inevitable outflow.

3) Fear of Large Inflows

Policymakers in emerging market economies do not universally distrust the providers of foreign capital. Not all money is hot, but sometimes the sheer volume of flows matters. A large volume of capital inflows, particularly when it is sometimes indiscriminate in the search for higher yields, causes dislocations in the financial system. Foreign funds can fuel asset price bubbles and encourage excessive risk taking by cash-rich domestic intermediaries. Again, recourse to taxation may seem to yield a large benefit.

4) Fear of Loss of Monetary Autonomy

The interests of global investors and domestic policymakers need not always-or even often-align. But a trinity is always at work. It is not possible to have a fixed (or highly managed) exchange rate, monetary policy autonomy, and open capital markets. If there is some attraction to retaining some element of monetary policy flexibility, something has to give up. However, in the presence of the aforementioned fear of floating, giving up capital mobility may seem more attractive than surrendering monetary policy autonomy. Whatever the reason for action, some forms of capital control were intended to control exchange rate pressures, stem large inflows, and regain an element of monetary autonomy. And this is more relevant for those policymakers who impose controls to reduce capital flight, because investors seeking safety–including, most important, domestic residents as well as foreigners–are seldom dissuaded by regulatory restraint.