Definition
Capital controls are measures taken by either a government or a central bank to limit the flow of foreign capital in and out of a domestic economy. They include taxes, tariffs, legislation, and volume restrictions. These controls can be applied to various types of transactions such as inflows and outflows of capital, and mergers and acquisitions.
Key Takeaways
- Capital Controls refer to the measures taken by a government or a regulatory body to restrict the flow of capital in and out of the domestic economy. These controls can be in the form of tariffs, restrictions, volume controls or price-based restrictions.
- These controls are often used in emerging markets and developing countries to prevent capital flight, maintain stability in domestic financial market and manage exchange rates. However, they can also create limitations in terms of investment flexibility and may discourage foreign investment.
- Capital Controls also have pitfalls. These may introduce distortions to the market, lead to an unwarranted expansion of the shadow economy, and if not managed properly, can lead to financial crises. Therefore, they should be used judiciously and prudently.
Importance
Capital controls are essential in the realm of Finance as they constitute measures employed by countries to regulate the flow of foreign and local currency across their borders.
These controls are crucial for financial stability, particularly in suppressing extreme volatility, managing exchange rates, and protecting local economic integrity during financial crisis.
Restrictions on capital movements, like incoming foreign investments or locals investing abroad, can reduce potential economic vulnerabilities, such as speculative financial behavior, that could lead to substantial economic disruptions.
However, its overuse could discourage foreign investment or stifle financial markets development.
Therefore, the balanced use of capital controls represents a key part of governments’ macroeconomic and financial strategies.
Explanation
Capital controls refer to measures taken by either a government or a central bank to restrict the flow of foreign capital in and out of the domestic economy. These controls can include taxes, tariffs, legislation, volume restrictions, and market-based forces.
The purpose of these controls is to manage the balance of payments, prevent capital flight from destabilizing the economy, protect domestic financial markets from volatile short-term “hot money” flows and to maintain a fixed or managed exchange rate. These controls can be used in both developed and emerging economies, but their use is relatively more common among emerging markets where financial systems might not be sufficiently developed to handle large influxes or outflows of capital.
They can be enacted to prevent sudden surges of foreign investment which could lead to asset bubbles, or to stop rapid withdrawals which could disrupt the economy. It’s worth noting that there are critics of capital controls who suggest they may cause a lack of economic efficiency, reduced economic growth, and risks of capital flight.
However, for some countries, they are viewed as a necessary tool to maintain economic stability and control.
Examples of Capital Controls
China’s Capital Controls: China is one of the most well-known countries for implementing capital controls. The Chinese government limits the ability of individuals and businesses to move money in and out of the country to maintain economic stability, slowdown capital flight, and control exchange rates. For instance, Chinese citizens are limited to exchanging $50,000 per year, foreign businesses often need government approval to repatriate earnings, and investment in overseas property by Chinese companies has been restricted.
Cyprus’ Banking Crisis and Capital Controls: During the 2013 banking crisis in Cyprus, the government imposed capital controls to prevent a massive outflow of funds from the country, which could have caused further destabilization. These controls included daily withdrawal limits, restrictions on overseas transfers, and rules against cashing checks.
Iceland’s Capital Controls Post-2008 Financial Crisis: Following its economic meltdown in 2008, Iceland implemented extremely strict capital control measures. These included restricting residents from investing abroad, foreigners from investing in Iceland, and prohibiting the outflow of currency from Iceland without governmental approval. While these capital controls were initially put in place as a temporary measure, they lasted until 2017 as the country gradually recovered from the crisis.
FAQs About Capital Controls
What are Capital Controls?
Capital controls are regulatory measures taken by countries to control the flow of foreign capital in and out of their domestic economies. These controls may include tariffs, volume restrictions, or outright legislation.
Why are Capital Controls implemented?
Capital controls are often employed to stabilize a nation’s economy. They are typically used in response to financial crises, exchange rate complications or macroeconomic instability. These controls aim to prevent the capital flight, regulate money supply, and control inflation.
What are the disadvantages of Capital Controls?
While capital controls can offer stability, they can also limit economic growth. They may deter foreign investment, restrict businesses’ ability to conduct global transactions, and create inefficiencies in the market. However, the impact varies case by case, depending primarily on the specific regulations and the overall economic environment.
Can Capital Controls be easily bypassed?
Capital controls are regulations put in place by a government to restrict the flow of capital, but in a globalized world, these can sometimes be bypassed. Methods of bypassing may include over-invoicing exports, under-invoicing imports, or other forms of illegal activities. However, bypassing such controls can lead to severe legal consequences.
How do Capital Controls impact investors?
For investors, capital controls can create difficulties in moving money into or out of a country. This can affect both portfolio investment and direct investment. For individual investors, such controls might reduce potential returns and discourage investment in the controlled country.
Related Entrepreneurship Terms
- Exchange Rate Management
- Foreign Direct Investment (FDI)
- Financial Stability
- Balance of Payments
- Macroprudential Policy
Sources for More Information
- Investopedia: An expansive online financial encyclopedia, Investopedia offers detailed articles, tutorials, guides, and videos covering many different financial topics, including capital controls.
- International Monetary Fund (IMF): This international organization offers articles and papers about all aspects of finance and economy, including capital controls.
- Bank for International Settlements (BIS): Known as the bank for central banks, BIS provides in-depth reports, research papers, speeches and articles on financial topics including capital controls.
- Bloomberg: A leading provider of financial news and information, Bloomberg offers latest insights and analysis on global finance including cases and effects of capital controls.
