The rise and rise of capital controls

January 4, 2011

James Saft is a Reuters columnist. The opinions expressed are his own.

Look for a flood of new capital controls in 2011 as emerging market states seek a measure of protection against the easy money being generated by the United States, Europe and Japan.

In the short term this raises the chances of trade and currency conflicts, and may prove to be a button that was better left unpressed.

A laundry list of emerging market countries — including Indonesia, Thailand, Brazil and Korea — have already begun imposing capital controls, limits on who can take money in or out of their countries, under what circumstances and at what costs.

Their motivation is simple: curb “hot” money flows — much of it generated by extraordinary monetary policy in the developed world — that threaten to distort their economies, and, crucially, drive their currencies up and make domestic industries less competitive.

In Korea most recently this took the form of a levy on foreign currency debt held by banks, while in Brazil a tax on international capital was tripled from 2 to 6 percent.

Even a move by China to allow exporters to hold dollars offshore, widely trumpeted as a loosening of capital controls, is really simply a sort of a negative capital control, a step taken not as part of a commitment to liberalization but instead because China wants to keep foreign money out for the time being.

States have always faced an economic “trilemma,” in that you can only have two out of the following three: a fixed exchange rate, the right to set your own monetary policy and the free flow of capital. You can have two, any two, but in so doing you make the third impossible.

The U.S. has long had open capital markets and has set its own interest rates, but in consequence has had to live with currency market fluctuations, an example of the orthodoxy it and the International Monetary Fund long tried to impose on the rest of the world.

This worked well for many years, but independent monetary policy did not turn out to be the same as the ability to set the cost of capital, as flows of money directed back at the U.S. from China made borrowing too easy and too attractive.


While we’ve always known that capital controls “work” in that they give a country more influence over the shape of its economy, what they have not been, at least until recently, is legitimate, mostly because they impose a cost on other countries and are on a slippery slope to currency wars, tariffs and all that supposedly made the Great Depression so great.

Now even the IMF has accepted that capital controls can have a role in economic management and no less an establishment figure than Christian Noyer, of the governing council of the European Central Bank, has come out saying, not that they must be abolished, but that they must be coordinated internationally.

You can argue that the real story here is that economic activism — attempts by states at economic control — are everywhere on the rise and that capital controls are simply one form of that. What are quantitative easing, currency intervention and the European bailout funds if not economic activism? Expect more not less of this as time goes on, and expect more of it to generate more conflict. One of the ironies of the post-crisis era is that officials opted disproportionately for economic activism rather than effective banking regulation, perhaps because the influence of the financial sector was too great.

Capital controls are simply a tool of the small and weak when confronted with policies of the big and the strong which may damage them. That is perhaps why capital controls are not now drawing howls of outrage from Washington and Frankfurt; they help to channel the loose monetary policy where it is needed most: in Europe the U.S. and Japan. Borrowing cheaply in New York and investing in Sao Paulo may be a good way for investors to profit, but it does little to help the U.S. to recover or Brazil to remain stable.

Thus interests are aligned in Washington and Brasilia, but that alignment won’t last forever. At a certain point, especially if the recovery struggles and unemployment fails to drop quickly, it will be easy for defensive capital controls to turn into offensive ones, to bleed into currency wars.

It is easier to relax an old order than to impose a new one. Quantitative easing has driven up the price of assets, but the unleashing of capital controls may prove to be its lasting legacy.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

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