Capital Thinking

What are capital controls, and why do countries have them?

Capital controls are restrictions on money flows. Countries enact them to control the flow of cash into and out of their economy. They can take the form of alternative exchange rates, market regulation, and sometimes outright prohibitions. Most countries have some kinds of rules around money flows. In the US, we regulate cash movements into and out of the country, and we take special note of large cash transactions by bank customers, primarily to fight drug trafficking and terrorism.

But capital controls are usually associated with developing economies. In a hyper-connected always-on world, they have a kind of fusty “past-the-expiration-date” sort of feel to them. In theory, removing them creates benefits for both the recipient country and the investor, as transaction costs are reduced and money flows to the most profitable segment of an economy, improving efficiency.

But theory and practice differ, sometimes remarkably. Capital flows aren’t quiet mountain streams in the global economy—investment fads and aggressive funds can make them torrents, deluges that are more like Niagara Falls. They can quickly overwhelm a favored economy, bidding up asset prices and creating an investment bubble. Then, when conditions reverse, markets can come crashing down and domestic banks can face capital pressures, creating a local credit crunch.

Many countries therefore restrict capital outflows, trying to manage the consequences of a bursting bubble. A more effective approach, however, is to control inflows in order to prevent bubbles from forming in the first place. But this is hard, politically. It’s hard for a government to say no to someone who wants to build a factory or invest in a mine.

It’s easier to keep bubbles from forming than it is to clean up the mess afterwards, though. As economies mature, they can handle increasing flows. Rational leaders try to look ahead in this way.


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