Capital Controls

What are Capital Controls?

Capital Controls can be defined as measures or the steps that are taken by the central bank, government, or any other relevant bodies which 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.

Explanation

  • 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 as capital outflow control, or the ability of foreigners’ to purchase the local assets, which can be called as the capital inflow control.
  • Stringent controls can be mostly found in the economies that are in the developing stage where the reserves for the capital are lower and that are more prone and susceptible to volatilities.
  • It’s important for any nation at an initial stage for the development of the economy to keep the rates of interest low, domestic capital in and foreign capital out, and these steps are generally taken by the developing countries and make effective use of capital.
Capital Controls

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Purpose of Capital Controls

The key purpose is the reduction of the volatilities of the currency rates in the nation and provides it with stability and support to it by protecting the currency rates from sharp movements and fluctuations. Major disturbances or say major concerns in the flow which occurs from the capital outflows, will result in a quick depreciation of currency. This could ultimately lead to things getting costly and import becomes costlier.

Examples of Capital Controls

Below are some examples.

Example #1

In 2013, the INR currency was weakening, the RBI that is the Reserve Bank of India had imposed restrictions on the outflow of the capital from the nation, and also a direct investment which was made in the foreign assets were reduced to 1/4th of the original. The bank also imposed a limit on remittances that were made overseas were reduced from $200 thousand to $75 thousand and 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 requirementsReserve RequirementsReserve Requirement is the minimum liquid cash amount in a proportion of its total deposit that is required to be kept either in the bank or deposited in the central bank, in such a way that the bank cannot access it for any business or economic activity.read more, and as a result, this incentive gave the commercial banksCommercial BanksA commercial bank refers to a financial institution that provides various financial solutions to the individual customers or small business clients. It facilitates bank deposits, locker service, loans, checking accounts, and different financial products like savings accounts, bank overdrafts, and certificates of deposits.read more 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 introduced capital controls so as to stabilize its economy. The 3 key banks namely Landsbanki, Kaupthing, and Glitnir – held assets that were 10 times more than the Gross Domestic Product of the economy of the nation. Investment in assets of the foreign nationals was abandoned and even the exchange of the currency for the purpose of tourism was monitored very strictly.

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 introduced certain capital controls. State running exporting firms that were large in size they were asked to maintain their foreign exchange assets for a prescribed level and were required to send to the government the weekly reports. Further, the trading of Currency was monitored by the newly appointed authorities strictly.

Critics of Capital Controls

  • If the capital is controlled that prohibits flowing capital in and out from an economy, then it would hamper the progress of the economy.
  • If the economy is in need of funds, then it has to either print the money and depreciate its value of currency or default on the payment of the foreign debt.
  • In the midst of 1998 when there were Asian crises, Malaysia the only country to imposed extensive capital controls did not benefit from those drastic measures.

Importance

Capital controls play a key role in the progress of a developing nation. The outflow and the inflow of the foreign capital from in and out of a nation is a bigger part of the globalization. And also, as a consequence, these outflows and the inflows will significantly affect the depreciation and appreciation of currencyAppreciation Of CurrencyCurrency appreciation is a rise in the value of a national currency over the importance of international currencies due to an increase in the demand for domestic currency in a global market, a rise in inflation and interest rates, and flexibility of fiscal policy or government borrowing.read more, as because of those flows, the reserves of the foreign exchange are impacted directly. Hence, it is very important for the management of such capital inflows and outflows as an essential policy measure for the central bank and the nation’s government.

Benefits

  • 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 the country’s economy will grow.
  • The money will flow in the country which will increase the velocity of flowing of the same and will help in boosting the country’s GDP.
  • At times of crisis, the sudden outflow of foreign capital from the economy impacts the economy badly and as a result, the stock market could crash, and hence if the flow is restricted then this can be avoided.

Limitations

  • Easily flow of capital internationally will make trade easier and if that is restricted then 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 growth of the economy.

Conclusion

Capital Controls are strict restrictions imposed on inflow and outflow of the foreign capital so as to save the economy’s currency value and make it stable and also help in preserving the foreign reserves.

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