The area and controls 1

Briefing note May 2015

The euro area and capital controls Contingency planning around the problems faced by inevitably turns to the possibility of capital controls, whether in the context of a default or a departure from the euro area. What are capital controls and how will they affect a party's ability to enforce its contractual rights? In this briefing, we consider the legal framework surrounding capital controls, what agreements they could affect, and how.

The answers to any questions about Capital controls are most commonly capital controls depend upon a imposed because of concerns about Key issues combination of international treaties outward flows, but controls can also and national law, though the be imposed to restrict inward flows if,  Countries are free to impose interpretation of the treaties by for example, an influx of funds risks restrictions on capital national courts is not always damaging an economy. movements, but can only restrict consistent. payments for current Capital controls were a common transactions with the consent of When dealing with national law, this feature of the global economic system the IMF. briefing focuses mainly on English law in the period after 1945, but fell out of  If the IMF consents to controls because it is commonly used as the favour in the 1970s with the collapse on current transactions, governing law for international of the (see contracts that breach those financial transactions, though other Box 1). In recent years, however, controls could be unenforceable laws may also be relevant. they have been used more - whether through the courts, but are to limit speculative inflows or, in the probably not void. Self-help Question 1: What are case of countries such as and remedies may still be available. capital controls? , to prevent potentially massive outflows.  EU law prohibits any controls in Capital controls can take many forms, all but extreme circumstances, but their immediate aim is to restrict According to a recent report, some though protecting banks or exit the buying and selling of a national two-thirds of the world's population is from the euro area could offer a currency or to preserve currency subject to some sort of capital justification.

within a country. Controls might controls. Indeed, the International include a ban on the conversion of the Monetary Fund (IMF) said that the proceeds of certain assets or by controls introduced by Iceland in 2008 Question 2: Is there an certain categories of person, an were "an essential feature of the international legal obligation to surrender foreign framework, given the framework for capital exchange proceeds to the central or scale of the potential outflows." local bank, authorisation requirements, Iceland's Prime Minister described controls? minimum stay requirements, them as one of the tools that ensured Yes, primarily in the IMF's Articles of quantitative limits, restrictions on that "the lion's share of the [Icelandic] Agreement. Most states, including all payments outside the country and/or banking collapse was borne by those in the euro area, are members restrictions on bank withdrawals; they foreign creditors." of the IMF and are thus bound by the may also include indirect methods, IMF's Articles of Agreement. These such as tax charges on capital flows. divide capital controls into two categories: controls on capital

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movements; and controls on transactions in a somewhat payments for current transactions. circular fashion as "payments Box 1 which are not for the purpose As to the first category, article VI(3) of of transferring capital" (article The Bretton Woods the IMF's Articles of Agreement XXX(d)), but the definition allows members to "exercise such goes on more helpfully to system controls as are necessary to regulate provide that current international capital movements, but The Bretton Woods Agreement was transactions include payments no member may exercise these negotiated by the Allied powers over the in connection with foreign controls in a manner which will restrict first three weeks of July 1944 at the Mount trade, payments in connection payments for current transactions..." Washington Hotel, Bretton Woods, New with short term banking and As a result, IMF members can, Hampshire. credit facilities, interest on without obtaining the consent of the loans and payments on other The participants were acutely aware of the IMF, impose capital controls as long investments, and payments of uncoordinated and frequently contradictory as those controls do not affect a moderate amount for "beggar thy neighbour" policies pursued "current transactions". amortization of loans and for during the depression of the 1930s, and On the second category, article depreciation of direct wanted commitments to convertibility of VIII(2)(a) provides that "no member investments. However, the currencies and to free trade. John shall, without the approval of the Fund, distinction between capital Maynard Keynes proposed a new impose restrictions on the making of and current transactions is international currency, the "bancor", but, payments and transfers for current distinctly blurred. reflecting US economic dominance, what international transactions." IMF emerged was a system of fixed exchange In addition to the IMF's members can, therefore, impose rates based on the US dollar, with only the Articles, a state may have restrictions on current transactions, dollar being required to be convertible into entered into a bilateral but they must obtain the consent of gold. investment treaty (BIT) with the IMF to do so. The IMF does not another state with a view to The commitment to free trade led to the automatically grant approval, but encouraging mutual direct prohibition on controls for current obtaining approval may not be difficult investment by nationals of the transactions, but states' ability to restrict for a country faced with a severe two states (e.g. there is a BIT capital flows gave them some control over crisis if certain safeguards are met. between Greece and their domestic economies and currencies. For example, in 2008 Iceland sought, Germany). Some BITs and secured, the IMF's consent to Revaluations and devaluations took place contain provisions relating to restrictions on certain current within the system, which continued until capital controls. A BIT may transactions on the basis that the 1971. Imbalances and a declining US gold give individual investors restrictions were to be temporary and coverage risked a run on Fort Knox and, on retrospective rights, usually were "imposed for balance of 15 August 1971, President Nixon enforceable through payments reasons and are non- unilaterally suspended the convertibility of arbitration, against a state that discriminatory" (though the controls the dollar into gold. By the mid-1970s, all introduces controls in breach did arguably discriminate against major currencies had been floated against of the BIT, but BITs seldom foreign bond holders). In 2013, the dollar. provide direct rights against a Cyprus obtained the IMF's consent to private sector counterparty or Fixed exchange rates might have gone capital controls (see Box 2). Cyprus's enable controls to be ignored. (though the euro arguably reintroduced controls were finally lifted in April them for some in a different guise), but the 2015, but Iceland's remain in place. The General Agreement on institutions and aspirations of the Bretton Trade in Services (GATS), a This begs the question as to the Woods Agreement remain. The IMF is still World Trade Organisation difference between controls on capital there, and the IBRD is part of the World treaty, also contains and restrictions on current Bank. Free convertibility of currencies for provisions about capital transactions. The IMF's Articles of trade purposes also remains key. controls. Article XI(1) Agreement define current

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provides that members must not sets a high hurdle, but it is what be able to squeeze some measures "apply restrictions on international Cyprus relied on, with the within article 66. transfers and payments for current acquiescence of the European If a state imposing capital controls transactions relating to its specific Commission, for the introduction of its were also to leave the EU unilaterally, commitments." Article XI(2) goes on capital controls in 2013. that state might not be concerned to allow members to introduce capital Article 65(3) goes on to provide that about legality under the EU’s treaties. controls in accordance with the IMF's measures under article 65(1) "shall However, courts within states Articles and with Article XII of GATS. not constitute... a disguised restriction remaining in the EU might be obliged Article XII of GATS permits capital on the free movement of capital and by EU law to regard internal laws controls if a member is faced with payments as defined in Article 63." passed in breach of the EU's treaties serious or The meaning of this is not entirely as invalid. If so, those laws might be external financial difficulties. It may clear - at one extreme, it could disregarded for the purposes not be difficult for a troubled euro area prevent any measures that in fact discussed below. The EU and any member to justify controls on those restrict the free movement of capital - state leaving the euro area would, bases. but it could merely indicate that nevertheless, have a strong incentive Question 3: Would capital controls must genuinely be for to resolve any issues between them controls be consistent reasons of public policy or security, in order to make the process as and not, for example, represent a orderly as possible, which could with the EU's treaties? disguised method of protecting involve treaty amendments after the Perhaps. Article 63 of the Treaty on domestic industries. Any measures event. the Functioning of the European must also be proportionate to the problems faced. Question 4: How do the Union (TFEU) prohibits "all provisions about capital restrictions" on the movement of The EU itself can take "safeguard controls in international capital and on payments between measures with regard to third Member States and between Member countries" that are "strictly necessary" law affect private rights States and third countries. if, in exceptional circumstances, under national laws? EU member states outside the euro movements of capital to and from It depends, but potentially severely. area are permitted to take "necessary third countries cause serious The basic rule under article 12 of the protective measures" when faced by difficulties for the operation of EU's Rome I Regulation on the choice "a sudden crisis in the balance of economic and monetary union (article of law for contracts is that the law payments" if the EU itself fails to act 66 of the TFEU). These measures governing a contract determines how sufficiently quickly (article 144(1)), cannot last longer than six months, the contract must be performed. If though the European Council can and are probably limited to capital the governing law requires payment in amend or suspend those measures flows rather than payments on current , then payment must in general (article 144(3)). Article 143 offers the transactions (though the definition of be made in euros, notwithstanding EU a menu of measures, ending with capital transactions in EU law is wider any capital controls imposed by the the Commission authorising the than for the purposes of the IMF's home state of one of the parties. This relevant member state "to take Articles of Agreement). is subject to practical and legal issues protective measures, the conditions Article 66 therefore offers the EU (e.g. the jurisdiction in which any and details of which the Commission scope to impose extensive restrictions, dispute is determined, the definition of shall determine." provided that the EU acts consistently the currency of payment in the with the IMF's Articles. The width of contract and the place of payment - The only licence given to euro area see our briefings relating to the Greek members is in article 65(1)(b) of the the power granted is not clear (eg can the EU restrict capital movements debt crisis for further details), but the TFEU, which provides that article 63 general rule remains that foreign is without prejudice to the right of EU within the EU or only between Member States and non-Member legislators cannot change the terms of member states to "take measures an English law contract. which are justified on grounds of States? can measures be re-imposed public policy or public security." This every six months?) but the EU may

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"Exchange contracts" are a Luxembourg) take a wide approach, Box 2 significant exception to this general considering an exchange contract to rule. This is because article VIII(2)(b) be any contract that affects the Cyprus's capital of the IMF's Articles of Agreement exchange resources of the state in provides that "[e]xchange contracts question. This may extend to any controls which involve the currency of any contract that requires a party to member state and which are contrary discharge its obligations in a foreign Cyprus imposed capital controls in to the exchange control regulations currency, even its own currency. 2013 with the consent of the IMF. of that member maintained or These controls initially included: Secondly, other countries (e.g. the UK, imposed consistently with this the US and Belgium) take a narrower  Cash withdrawals were limited Agreement shall be unenforceable in view, confining exchange contracts to to €300 per person per day. the territories of any member." IMF contracts for the exchange, in members are obliged to take steps to  Cashing of cheques was substance or in form, of one currency carry out their obligations under the prohibited, but cheques could for another. The narrow view is IMF’s Articles of Agreement. The UK, be paid into bank accounts. therefore restricted to what would as well as the other EU member  Payments of up to €5000 per conventionally be called foreign states and the US, has fulfilled this exchange contracts, whether spot or day falling within the normal obligation by, amongst other forward, but it is likely that non- course of business and with measures, passing article VIII(2)(b) deliverable currency derivatives would supporting documentation were into domestic law. English and other also be caught. permitted. courts are, therefore, obliged to  Payments over €5000 required apply article VIII(2)(b). As a result, if litigation were to take approval. place in a jurisdiction that takes the Article VIII(2)(b) raises many legal  Payment of salaries for wide view, there is a greater chance uncertainties, including those employees was permitted upon of a contract being rendered discussed below, but, if a contract is presentation of supporting unenforceable by capital controls than an exchange contract and it is in documentation. if litigation were to take place in courts breach of capital control regulations that take the narrow view. Under both  Payments or transfers outside imposed by any IMF member schools of thought, a foreign Cyprus, whether via debit, consistently with the IMF's Articles of exchange contract will be credit and/or prepaid cards, Agreement, that contract will be unenforceable if it is contrary to could not exceed €5000 per unenforceable in the courts of any capital control regulations, but under person per month per bank. IMF member state whatever the the wide view a foreign currency bond  Cashless payments or transfers governing law of the contract. It may or loan agreement may, for example, of deposits to accounts held perhaps be arguable that certain also be unenforceable. abroad were prohibited. foreign capital controls could be  Fixed term deposits could not ignored on the ground that they Despite article VIII(2)(b) of the IMF's be broken other than to repay a offended public policy (eg because Articles of Agreement applying loan to the same bank. they are discriminatory) or that they regardless of the governing law of the breach EU law but, absent anything agreement, the governing law of an  When fixed term deposits of that sort, an exchange contract in exchange contract could still arguably matured, 10% could be breach of capital controls is be relevant. If the governing law is transferred to a current account, unenforceable. that of a country that takes the wide the maturity on the balance being extended for one month. view of what constitutes an exchange Question 5: What is an contract, it has been argued that all  Payments not completed before "exchange contract"? courts must give effect to the wide the controls came into force view because it forms part of the were subject to the controls. Difficult to say. There are two main governing law of the contract. That is, schools of thought. First, some however, unlikely. It is more plausible countries (e.g. France and that article VIII(2)(b) takes effect as a

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conflict of laws rule or as public policy performed. Though far from clear, it unenforceable but not void is that rather than as part of a country's seems likely that article VIII(2)(b) will courts may be able to assist parties contract law. affect these contracts, rather than once the capital controls are lifted. At only contracts entered into after the that point, the bar on court Question 6: Does article capital controls were introduced. involvement will have been removed. VIII(2)(b) apply to capital Iceland's and Cyprus's capital Question 9: What can I do as well as to current controls were retrospective in effect, and it would reduce significantly the to improve my position? transactions? effectiveness of controls if they had Probably not a lot, though appropriate no impact on agreements extant at Probably not. Article VIII(2) as a structuring of transactions may the time of the controls' imposition. If, whole is headed "Avoidance of reduce the impact of capital controls. however, article VIII(2)(b) is not restrictions on current payments", If an EU member state defaults on its retrospective in effect, much of threat which suggests that article VIII(2)(b) debts, abandons the euro or needs to arising from article VIII(2)(b) would be is limited to current transactions. This protect its banks, it may well impose removed. is the conclusion reached by the capital controls, though what form German courts because of the Question 8: Is self-help those controls would take and wording of article VIII(2) and because available? whether they will comply with EU law the IMF's Articles of Agreement leave or be approved by the IMF can only sovereignty over capital controls with Probably. The general (but not be a matter of speculation. member states. This does produce a universal) view, at least under English If controls are imposed, those with curious result economically: controls law, is that article VIII(2)(b) renders security or other self-help remedies on capital movements, which IMF an agreement unenforceable but not exercisable outside the country in members are free to impose, would illegal or void: the agreement exists, question may be able to protect their generally not be enforceable outside but the courts will not enforce it. That interests (though this will depend the state that imposed those controls; probably allows the parties to upon local law). If not, the position but controls on current transactions in exercise self-help remedies. respect of exchange contracts would could be affected by the location of be rendered unenforceable by article Some contracts (including, in any litigation. Foreign denominated VIII(2)(b) provided that the IMF particular, derivatives) may include obligations may turn out to be approved their imposition. That does, provisions that address capital unenforceable if proceedings must be however, appear to be what the IMF’s controls. Even where the contract is brought in the courts of the state in Articles of Agreement say. silent on the point, if, for example, one question, but those same difficulties party holds security, that party may be may also extend to courts that take This issue is of less relevance in able to enforce against its security the wide view of an "exchange those countries that take a narrow provided that doing so does not contract". However, even if a view of what constitutes an exchange require court assistance (and, in judgment can be secured, the contract. On the narrow view, practice, the security is outside the judgment is only of value if it can be exchange contracts form a distinct country that has imposed the capital enforced against assets owned by the category outside either capital or controls). Similarly, if one party has a debtor. Finding assets outside the current transactions. right of set-off, it can exercise that debtor's home state may prove Question 7: Is article right notwithstanding the inability to difficult. enforce one or more of the payment VIII(2)(b) retrospective in obligations through the courts. It is Conclusion its effect? unlikely that there would be any At a conference in late 2011, the restitutionary remedy to recover Confederation of Icelandic Employers Probably. At the time capital controls money or other assets taken by self- complained that Iceland's capital are introduced, it is inevitable that help remedies. controls had proved an expensive there will be numerous contracts, mistake, and that Iceland still had no some very long term, that have been Another consequence of article viable strategy for lifting them. Many entered into but not yet fully VIII(2)(b) rendering an agreement others, including the IMF, disagreed,

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even though offshore krona holdings worth about 30% of Iceland's GDP have been held captive by Iceland's controls. Iceland's controls remain in place; Cyprus's only lasted two years, their severity diminishing over time. Capital controls are now very much back in the contemplation of states facing economic crises. If the international community uses its sovereign and legislative power to impose capital controls, there may not ultimately be much that private parties can do to combat them. This is an updated version of a briefing first published in July 2012.

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