What are Capital Controls?

Explanation

  • The monetary policyMonetary PolicyMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc.read more 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 controls 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.

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Purpose of Capital Controls

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.

Examples of Capital Controls

Below are some examples.

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 1/4th 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 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 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.

Critics of Capital Controls

  • 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.

Importance

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 globalizationGlobalizationGlobalization is defined as the extension of trade, commerce and culture of an economy across different nations.read more. 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 to manage 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 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.

Limitations

  • 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.

Conclusion

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.

This has been a guide to what capital controls and their meaning. Here we discuss the purpose, examples, critics, and importance of capital controls and benefits and limitations. You may learn more about financing from the following articles –

  • Capital MarketMarket CapitalizationGDP Per CapitaExpenditure Approach for GDP