Magazine article EconSouth

Capital Controls Gain Currency in Today's Global Economy: Global Investors Have Poured Money into Some Emerging-Market Economies (EMEs) Because They Offer Higher Returns Than Do the More Advanced Economies. That's a Win-Win for Everyone-Right? Not Necessarily. for Many EMEs, This Deluge of Foreign Capital Can Create Economic Imbalances That Traditional Monetary Policy Alone May Not Be Able to Fix. What Can EME Policymakers Do?

Magazine article EconSouth

Capital Controls Gain Currency in Today's Global Economy: Global Investors Have Poured Money into Some Emerging-Market Economies (EMEs) Because They Offer Higher Returns Than Do the More Advanced Economies. That's a Win-Win for Everyone-Right? Not Necessarily. for Many EMEs, This Deluge of Foreign Capital Can Create Economic Imbalances That Traditional Monetary Policy Alone May Not Be Able to Fix. What Can EME Policymakers Do?

Article excerpt

Policymakers often argue for a particular policy with the intention of making their country, state, or city a good place to invest or more attractive for foreign capital. The flow of capital into the United States, for example--whether through a Japanese automaker building a plant in Georgia or a Swiss banker purchasing shares of Apple--is considered by most a desirable outcome. But for some EMEs experiencing high rates of growth and growing inflows of foreign capital, such investment demand can bring many challenges.

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But isn't foreign capital a good thing?

What sort of challenges do these fast-growing EMEs face? Doesn't development theory predict that it's exactly these countries that should have higher rates of return on investment? China, for one, has had sustained growth rates of more than 10 percent for most of the past two decades. Likewise, India and Brazil have seen their economies expand with enormous speed in recent years. But an influx of foreign capital brings with it a host of unintended side effects. Exchange rate appreciation, for example, can occur rapidly, which can harm the competitiveness of domestic exporters. It's precisely this concern that has compelled China to implement strict domestic investment restrictions and deliberate exchange rate management. The country's policymakers want to prevent the renminbi from appreciating so rapidly that it puts its export-oriented growth model at risk.

Foreign capital inflows can also be fickle. Receiving countries may be susceptible to "sudden stops," when foreign investors quickly run for the exits at the first sign of trouble in an economy. The Asian financial crisis of the late 1990s was a painful reminder of how foreign capital--at first a sign of burgeoning growth--can severely exacerbate an emerging financial crisis. Following a run-up in asset prices, which were fueled by foreign investment, the economies of Indonesia, Thailand, and South Korea, for example, saw their currencies depreciate sharply as foreign credit abruptly fled their troubled financial systems.

The experience of these Asian countries has been an important lesson for EME policymakers, especially in the recovery from the recent, global financial crisis. Many global investors have poured money into some of these EMEs because they offer higher returns than the more advanced economies. This deluge of capital combined with the fear of overheating and of "sudden withdrawal" has led some countries to implement capital controls. By imposing limits on the amount or type of foreign capital flowing into or out of a country, these tools help EMEs manage their risk.

Capital controls may take the form of a tax on foreign capital inflows or quotas on investment. EMEs can also limit volatility in flows by requiring that a certain percentage of foreign investment be held in reserve for a specified number of days at the receiving country's central bank. This type of control, called a "lock-in" policy, prevents sudden withdrawals of capital.

Although EME policymakers are increasingly turning to capital controls, these tools have not necessarily been popular, at least among most economists and policymakers in developed countries, not to mention in the financial services industry. Advocates of international financial liberalization see capital controls as having inefficient, distortionary effects for any country adopting them. Sebastian Edwards of the University of California, Los Angeles, for example, argued in a 1998 paper that the 1980s Latin American implementation of capital controls was counterproductive. And until recently, the International Monetary Fund (IMF), seen as the global authority on matters of foreign capital management, had maintained a policy that capital controls were ineffective (at best), if not harmful (at worst). However, capital controls are increasingly being called for by domestic-oriented manufacturers and exporters in EMEs with strong currencies--and, under certain circumstances, even approved by the IMF. …

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