Thursday, 8 Oct 1998

The following article on "Using Capital Controls to Reduce a Crisis" is the third in a series on the

UNCTAD report.



by Martin Khor, Director, Third World Network


Capital controls are not a new measure but have instead been used by most countries until recently, and many nations still have them. The recently released UNCTAD Report describes a wide range of capital controls that have been or can be used, and for which purposes. It concludes that in the light of the Asian crisis and the current international financial turbulence, governments should be allowed to make use of such controls to insulate their economies from the effects of speculation and volatility. (This is the third in a series on the UNCTAD report). 

To protect themselves against international financial instability, developing countries need to have capital controls, since these constitute a proven technique for dealing with volatile capital flows. 

This is a key part of proposals to prevent and deal with financial crises contained in the Trade and Development Report 1998 published recently by UNCTAD (the UN Conference on Trade and Development). 

The report comes to this conclusion after surveying several other measures (such as more disclosure of information and greater banking regulation) that have been proposed by the industrial countries and the International Monetary Fund. 

UNCTAD finds these proposals to have merit but inadequate to deal with the present and future crises. 

It therefore stresses that developing countries should be allowed to introduce capital controls, as these are "an indispensable part of their armoury of measures for the purpose of protection against international financial instability." 

Although it was released on 16 September, the UNCTAD report was finalised in July. The writing of the report thus predates the sweeping capital control measures taken by the Malaysian government on 1 September. 

The new Malaysian policy seems to be consistent with the rationale and advice provided by the UNCTAD Report, which in turn marks the first time since the Asian crisis began that an influential international agency has called for the use of capital controls. 

The Report notes that good economic fundamentals, effective financial regulation and good corporate governance are necessary may be needed to avoid financial crises, but by themselves they are not sufficient. 

Experience shows that to avoid these crises, a key role is played by capital controls and other measures that influence external borrowing, lending and asset holding. 

Control on capital flows are imposed for two reasons: firstly, as part of macroeconomic management (to reinforce or substitute for monetary and fiscal measures) and secondly to attain long-term national development goals (such as ensuring residents' capital is locally invested or that certain types of activities are reserved for residents). 

Contrary to the belief that capital controls are rare, taboo or practised only by a few countries that are somehow "anti-market", the reality is that these measures have been very widely used. 

UNCTAD notes that they have been a "pervasive feature" of the last few decades. 

In early post-war years, capital controls for macroeconomic reasons were generally imposed on outflows of funds as part of policies dealing with balance of payments difficulties and to avoid or reduce devaluations. 

Rich and poor countries alike also used controls on capital inflows for longer-term development reasons. 

When freer capital movements were allowed from the 1960s onwards, large capital inflows posed problems for rich countries such as Germany, Holland and Switzerland. They imposed controls such as limits on non-residents' purchase of local debt securities and on bank deposits of non-residents. 

More recently, some developing countries facing problems due to large capital inflows also resorted to capital controls. 

For example, when faced with a surge of short-term capital inflows, Malaysia in January 1994 imposed these capital controls: banks were subjected to a ceiling on their external liabilities not related to trade or investment; residents were barred from selling short-term monetary instruments to non-residents; banks had to deposit at no interest in the central bank monies in ringgit accounts owned by foreign banks; and banks were restricted in outright forward and swap transactions they could engage in with foreigners. 

These measures were gradually removed from 1995 onwards. 

When Chile was faced with large capital inflows in the early 1990s, it took measures to slow short-term inflows and even to encourage certain types of outflows. The main step was that foreign loans entering Chile were subjected to a reserve requirement of 20 percent (later raised to 30 percent). 

In other words, a certain percentage of the each loan had to be deposited at the central bank for a year, without being paid any interest. 

Also to prevent excessive inflows, Brazil in mid-1994 imposed controls such as an increase in the tax paid by Brazilian firms on bonds issued abroad, a tax on foreigners' investment in the stock market, and an increase in tax on foreign purchases of domestic fixed-income investments. 

The Czech Republic faced large inflows in 1994-95 and it imposed a tax of 0.25 percent on foreign exchange transactions with banks, and also imposed limits on (and the need for official approval for) short-term borrowing abroad by banks and other firms. 

Besides the specific cases above, the UNCTAD Report also lists down examples of capital controls on inflows as well as outflows. 

Controls on inflows of foreign direct investment and portfolio equity investment may take the form of licensing, ceilings on foreign equity participation in local firms, official permission for international equity issues, differential regulations applying to local and foreign firms regarding establishment and permissible operations and various kinds of two-tier markets. 

Some of these controls can also be imposed on capital inflows associated with debt securities, including bonds. Such inflows can be subject to special taxes or be limited to transactions carried out through a two-tier market. 

Ceilings (as low as zero) may apply to non-residents' holdings of debt issues of firms and government; or foreigners may need approval to buy such issues. Foreigners can also be excluded from auctions for government bonds and paper. 

UNCTAD also lists other controls commonly used to restrict external borrowings from banks. 

They include a special reserve requirement concerning liabilities to non-residents; forbidding banks to pay interest on deposits of non-residents or even requiring a commission on such deposits; taxing foreign borrowing (to eliminate the margin between local and foreign interest rates); and requiring firms to deposit cash at the central bank amounting to a proportion of their external borrowing. 

As for controls on capital outflows, they can include controls over outward transactions for direct and portfolio equity investment by residents as well as foreigners. 

Restrictions on repatriation of capital by foreigners can include specifying a period before such repatriation is allowed, and regulations that phase the repatriation according to the availability of foreign exchange or to the need to maintain an orderly market for the country's currency. 

Residents may be restricted as to their holdings of foreign stocks, either directly or through limits on the permissible portfolios of the country's investment funds. 

Two-tier exchange rates may also be used to restrict residents' foreign investment by requiring that capital transactions be undertaken through a market in which a less favourable rate prevails, compared to the rate for current transactions. 

Some of these techniques are also used for purchases of debt securities issued abroad and for other forms of lending abroad. Bank deposits abroad by residents can also be restricted by law. 

UNCTAD also notes a current trend where accounts and transactions denominated in foreign currencies are increasingly made available to residents. It says that capital controls can include restrictions on residents' bank deposits denominated in foreign currencies and on banks' lending to residents in foreign currencies. 

Such loans and deposits can increase currency mismatching, which is a potential source of financial instability, as it enables large shifts between currencies during crises, putting pressure on the exchange rate and resulting in insolvencies among debtors. 

Besides capital controls, UNCTAD also makes two other proposals for better managing external assets and liabilities. 

Firstly it warns of the dangers of a country allowing its residents to undertake easy borrowing in foreign currencies, and allowing them to make bank deposits denominated in foreign currencies. 

To guard against this UNCTAD says there should be strict enforcement of prudential rules that match the currency denominations of financial firms' assets and liabilities with measures that increase the costs of foreign borrowing (through imposing taxes, special reserve requirements or cash deposits at the central bank). Also, limits can be placed on bank lending and deposits in foreign currencies. 

Non-interest bearing reserve requirements can be imposed on deposits in bank deposits in foreign currencies, thus reducing or eliminating the interest paid on them and diminishing their attractiveness.  

Secondly, UNCTAD says the Asian crisis starkly showed the risks of failure to enforce separation between the onshore and offshore activities of a country's banks. 

Some countries set up offshore centres whose activities are subject to lighter regulations and some tax privileges. 

One such centre, the Bangkok International Banking Facility (BIBF), set up in 1992, was a conduit for funds received from abroad, which were recycled to the domestic market, much of it used to finance speculation in stocks and property. As much of 95 percent of the funds raised by the BIBF was lend domestically. 

In contrast, the Asian Currency Units, which conducts offshore banking in Singapore, has stricter rules that restrict the use of the Singapore dollar as an international currency and control the ACU's involvement in domestic banking business. In 1996, 63 percent of the ACU's liabilities were from overseas sources and 42 percent of its assets were loans to banks abroad. 

Pointing to this contrast between the Thai and Singapore offshore centers, UNCTAD says it is feasible to have measures that insulate offshore banking from the domestic market, and thus contribute to financial stability. 

In conclusion, UNCTAD says recent financial crises and frequent use of capital controls by countries to contain the effects of swings in capital flows point to the case for continuing to give governments the autonomy to control capital transactions. It questions recent moves in the IMF to restrict the autonomy or freedom of countries to control capital flows. 

Ways have not yet been found at a global level to eliminate the cross-border transmission of financial shocks and crises due to global financial integration and capital movements. 

Thus, conclude UNCTAD, for the forseeable future, countries must be allowed the flexibility to introduce capital control measures, instead of new obligations being imposed on these countries to further liberalise capital movements through them.

The UNCTAD report has quite clearly made out the case for capital controls. It is important to note, however, that these controls should not be treated as a panacea that by themselves can cure recession ills.

Capital controls can also have some disadvantages, and have their own limitations. They however can be an important part of a set of policies that can protect a country facing a turbulent and hostile external situation, so that it can reduce exposure to financial and economic chaos, at least for some time.