Capital Controls

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21 Aug, 2024

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Table Of Contents

What Are Capital Controls?

Capital Controls can be defined as measures or the steps taken by the central bank, government, or any other relevant bodies that shall limit the inflow or the outflow from the domestic capital markets.

These controls can be specific to an industry or sector or even economy-wide. Capital Controls are strict restrictions imposed on the inflow and outflow of foreign capital to save the economy’s currency value and stabilize and help preserve the foreign reserves.

What Are Capital Controls?

Capital controls are measures or steps taken by the Central Bank, government, or any other suitable bodies to limit the inflow or the outflow from the domestic capital markets. In addition, these controls may be particular to an industry or sector or even economy-wide.
The essential purpose is the volatility of the nation's currency rate reduction. In addition, it enables stability and support by safeguarding the currency rates from well-defined movements and fluctuations.
The foreign capital inflow from a nation's in and out is a more significant part of globalization.

Capital Controls Explained

Capital controls are the steps of measures that the governments of the central banks of the country implement in order to control or regulate the inflow or outflow of capital. The main intention of implementing this process is to maintain economic stability in the domestic economy.

The monetary policy of the government may enact the capital controls, and this could include restriction of the ability of local citizens to own the foreign assets, and that can be referred to as capital outflow control, or the ability of foreigners to purchase the local assets, which can be called as the capital inflow control.

Stringent capital control systems can be mostly found in the economies in the developing stage where the reserves for the capital are lower, more prone, and susceptible to volatilities.

Any nation at an initial stage needs to develop the economy to keep the rates of interest low, domestic capital in, and foreign capital out. These steps are generally taken by the developing countries and make effective use of capital.

Types

These types controls implemented by the government of the country can take various forms. They are as given below:

Exchange Control – This kind of control will put a restriction on the foreign exchange transactions. It may take the form of limiting the buying and selling of currencies that individuals or businesses do. Thus, there will be a restriction on currency conversion.

Transaction Control – This type of capital control systems will put a restriction on the types of transactions like capital movement related to purchase of property and real estate, fund remittance out of the country or capital outflow for investment purpose.

Liquidity control – Here, the government manages the liquidity in the system through methods like imposing or changing the reserve requirements of banks or setting a limit to the amount of loan that banks can give out to borrowers.

Purposes

Here are some main reasons of implementing the same in the economy.

The key purpose is the reduction of the volatilities of the currency rates in the nation. It provides stability and support by protecting the currency rates from sharp movements and fluctuations. Major disturbances or concerns in the capital outflows will quickly depreciate the currency. It could ultimately lead to things getting costly, and import becomes costlier.

From the above point it can be derived that through control of currency volatility, the government is also able to put restriction of the speculation of currency. Many investors try to make quick money by speculating on this fluctuating currency and earn money within a very short time. This is highly risky and affects the economic stability if done on large scale.
Capital control is also implemented with the aim to protect the domestic market from foreign competition. This is done by putting restriction of on the import of goods.
Another important purpose is to control and preserve the foreign exchange level of the country by limiting the capital outflow during economic crisis.
Managing risk is a very important purpose or objective. Excessive outflow of capital can increase the risk of destabilizing the economy. The financial condition may deteriorate, resulting in economic crisis.

It is essential to understand the fact that the effectiveness of implementation of capital control will depend on the type of economy, the objective of implementation and also the ability of the government to manage in case of any deviation from the intended procedure. Different economies may have different approaches to it.

Examples

Below are some capital controls examples that will help us to understand the concept better.

Example #1

In 2013, the INR currency was weakening. The RBI, the Reserve Bank of India, had imposed restrictions on the outflow of the nation's capital. A direct investment made in the foreign assets was reduced to 1/4^th of the original. The bank also imposed a limit on overseas remittances, which reduced from $200 thousand to $75 thousand. If there were any exceptions to be made, then special permission was required to be obtained from the Reserve bank of India. US dollar deposits were excluded from its reserve requirements, and as a result, this incentive gave the commercial banks a boost to raise more deposits. When the currency showed a sign of stability, all these measures were relaxed.

Example #2

In 2008, after the collapse of the banking system in Iceland, the government had to introduce capital controls to stabilize its economy. The three key banks, namely Landsbanki, Kaupthing, and Glitnir – held assets that were ten times more than the Gross Domestic Product of the nation's economy. Investment in assets of the foreign nationals was abandoned, and strictly monitored the exchange of the currency for tourism.

Example #3

Similar to the above example of INR, a sharp fall in the currency value of the Russian ruble against the US dollar, the government of Russia had to introduce certain capital controls. State running exporting large firms were asked to maintain their foreign exchange assets for a prescribed level and were required to send the government the weekly reports. Further, the trading of Currency was monitored by the newly appointed authorities strictly.

Thus, the above capital controls examples clearly state the different situation where the system was successfully implemented by different governments and how it repeatedly helped in bringing the crisis under control. The above examples prove the ability of the procedure to manage economic crisis and lack of stability.

Benefits

Capital controls play a key role in the progress of a developing nation. The inflow of foreign capital from in and out of a nation is a bigger part of globalization. Hence, it is very important to manage such capital inflows and outflows as an essential policy measure for the central bank and the nation's government. Some of its benefits are highlighted below:

The exchange value of the local currency can be kept under control and will stabilize the same.
The domestic companies will boost up and grow as they compete among themselves, and their economy will grow.
The money will flow in the country, which will increase the velocity of the same and will help in boosting the country’s GDP.
At times of crisis, the sudden outflow of foreign capital impacts the economy badly. As a result, the stock market could crash, and hence if the flow is restricted, it can avoid this.
As a consequence, these outflows and the inflows will significantly affect the depreciation and appreciation of currency, as because of those flows, the reserves of the foreign exchange are impacted directly.

Limitations

Some important limitations of the process are given below:

Easily flow of capital internationally will make trade easier, and if that is restricted, it becomes difficult for the country to negotiate had they imposed the capital controls.
Funds cannot be raised easily in times of requirement, which could hamper the economy's growth.
If the capital is controlled, which prohibits flowing capital in and out from an economy, it would hamper its progress.
If the economy requires funds, it has to either print the money and depreciate its currency value or default on the foreign debt payment.
In 1998, when there were Asian crises, Malaysia, the only country to impose extensive capital controls, did not benefit from those drastic measures.

It is important to understand advantages and limitations so that the government is able to use it successfully in conditions that are suitable and urgently require the same.

Frequently Asked Questions (FAQs)

Why do countries implement capital controls?

Countries may implement capital controls for several reasons. Some common objectives include stabilizing the domestic currency, preventing capital flight during times of economic crisis, protecting local industries from foreign competition, and maintaining control over monetary policy.

Are capital controls a common practice?

The use of capital controls varies across countries and over time. Some countries have implemented capital controls to respond to specific economic conditions or crises, while others have liberalized their capital accounts to encourage foreign investment and promote economic growth. The prevalence of capital controls depends on a country's economic policies and objectives.

Can individuals or businesses bypass capital controls?

Individuals and businesses may sometimes attempt to circumvent capital controls through various means, such as using informal channels, offshore accounts, or engaging in illegal activities. However, such practices are generally unfair and can carry significant legal and financial risks.