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The Return of Capital Controls? YIANNI & DE VERA 1/16/2011 THE RETURN OF CAPITAL CONTROLS? ANDREW YIANNI* CARLOS DE VERA** I INTRODUCTION One of the consequences of the global financial crisis is that advanced economies, such as the United States and United Kingdom, currently have very loose monetary policies with very low interest rates. A number of the stronger economies in the emerging markets—China, India, and Brazil, for example— have suffered less than many industrial countries. Not surprisingly, therefore, there has been a tendency for capital to flow to certain emerging markets in search of higher returns. Emerging-market economies with freely floating (or close to freely floating) exchange-rate regimes, open capital accounts, and solid fundamentals, have seen their currency appreciate as a consequence, as Brazil did in 2009. Clearly, this economic consequence creates a policy challenge for the affected emerging markets. If the decision is made to allow the currency to appreciate, exports will become relatively more expensive and imports relatively less expensive. This policy will have an adverse effect on domestic employment and will move the current account towards deficit (or into greater deficit). Such a policy could also make the system vulnerable to a future shock if the capital inflows were subsequently rapidly reversed. In this environment, there will be a tendency for those in the affected emerging markets to consider a range of measures, including implementing capital controls to slow down or ration the inflow of capital. Clearly, any such step would run counter to the trend towards liberalization of capital movements specifically and globalization generally. The global financial crisis has also brought capital controls back into focus as a means of responding to a crisis. In the early stages of the current global financial crisis, foreign investors sought to move capital invested in a range of emerging-market economies into safe havens, forsaking the higher risk premium embedded in the higher yield. A number of such economies therefore faced a rapid outflow of capital. For those with freely floating (or close to freely floating) exchange-rate regimes and open capital accounts, the result was a weakening of the exchange rate. The classic policy response would be to Copyright © 2010 by Clifford Chance, LLP. This article is also available at http://www.law.duke.edu/journals/lcp. * Partner, Clifford Chance, LLP (London). ** Former Associate, Clifford Chance, LLP (London) (2007–2010). YIANNI & DE VERA 1/16/2011 358 LAW AND CONTEMPORARY PROBLEMS Vol. 73:357 increase the domestic interest rate and to intervene in the foreign-exchange market by using reserves to seek to dampen excessive short-run volatility in the exchange rate. Clearly, significant increases in the domestic interest rate will reduce domestic investment and make raising new domestic debt more expensive. Increasing the domestic interest rate is not a policy well suited as a response to a looming recession. If the country has, or a large proportion of its residents have, borrowed in foreign currency, a weakening exchange rate will also increase the local currency cost of servicing external debt. One of the measures which will inevitably be considered in this context is the imposition of capital controls to slow the speed at which capital is removed from the country. It may be helpful to refer to this tendency as one driven by a desire to respond to a crisis. II WHAT ARE CAPITAL CONTROLS? Capital controls can take many forms. They range from familiar arrangements—such as prohibitions, the requirement for prior approval, or authorization in respect of inward and outward movements of capital—to far more subtle arrangements under which movements of capital are permitted but discriminatorily taxed. Taxation of inward investment may be calibrated by reference to its duration, with longer-term investments taxed at a far lower rate or not at all. Chile employed such a system through its so-called encaje for many years to discourage short-term speculative inflows of capital and to encourage medium- to long-term investment. (This took the form of a mandatory one year, noninterest-paying, variable deposit with the central bank.) Exchange controls are a type of capital control that regulates the way the domestic currency relates to international currency markets. These may include prohibitions, restrictions (or limits) on the ability to exchange domestic currency for foreign currency, or multiple currency practices in which differing exchange rates are used for different purposes. Repatriation requirements, under which foreign exchange earned through the export of goods or services need to be sold to the home-country central bank, are also a common feature of exchange-control regimes. III THEORY OF INTERNATIONAL ECONOMICS Economic theory tells us—through the Mundell–Fleming model, or the “impossible trinity”—that it is impossible to have all three of the following at the same time: 1. A fixed exchange rate; 2. Free capital movement; and YIANNI & DE VERA 1/16/2011 Fall 2010 THE RETURN OF CAPITAL CONTROLS? 359 3. An independent monetary policy.1 As Paul Krugman once put it, The point is you can’t have it all: A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain—or Canada); or it can choose to leave capital free and stabilise the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession.2 Restricting capital flows is, perhaps, the most controversial of policy alternatives that a country may use. The global financial crisis has shown us that, in extremis, we reside in a world of financial markets prone to herding, panics, and contagion. In this context, the key rationale for capital controls is that global financial turbulence can have severely negative effects on a domestic economy. Exchange controls used to be the standard response of countries with balance-of-payments crises. The classic 1970s model required exporters to sell their foreign-currency earnings to the state at a fixed exchange rate; that currency would, in turn, be sold at the same rate for approved payments to foreigners, basically for imports and debt service. Although some countries tried to make other foreign-exchange transactions illegal, other countries allowed a parallel market. Creating such a system is burdensome, but with it in place, there may be more stability. For example, in such a system, a country needing to cut domestic interest rates would have far less concern that the value of its currency would plunge. Exchange controls suffer from manifest problems in practice, most significantly that they are subject to abuse. Exporters have an incentive to hide their foreign-exchange receipts; importers have an incentive to pad their invoices. Exchange controls are distortionary. There is also the problem that administrative officials may be invited to agree to special arrangements. Most economists feel that exchange controls work badly, particularly if they are in place for an extended period. There is also a significant concern that exchange controls imposed to stem capital flight arising after a bank run, for example, can replace necessary domestic reform (for example, increased prudential supervision and higher capital ratios) rather than effectively buy time for reform to take place. 1. For a discussion on the Mundell–Fleming model, see Maurice Obstfeld, International Macroeconomics: Beyond the Mundell-Fleming Model 5–8 (Univ. of Cal., Berkeley Ctr. for Int’l and Dev. Econ. Research, Working Paper No. C01-121, 2001), available at http://129.3.20.41/eps/if/papers/ 0303/0303006.pdf. For a discussion on the “impossible trinity” of open-economy macroeconomics, see PETER MONTEL, MACROECONOMICS IN EMERGING MARKETS 339 (2002); see also John McHale, Capital Account Convertibility and Capital Controls in Emerging Market Countries: Some Themes from the First Meeting, NAT’L BUREAU OF ECON. RESEARCH, http://www.nber.org/crisis/capital_report.html (last visited Nov. 21, 2010); Paul Krugman, The Eternal Triangle, http://web.mit.edu/krugman/www/ triangle.html (last visited Nov. 21, 2010). 2. Paul Krugman, O Canada: Neglected Nation Gets Its Nobel, SLATE (Oct. 19, 1999), http://www .slate.com/id/36764. YIANNI & DE VERA 1/16/2011 360 LAW AND CONTEMPORARY PROBLEMS Vol. 73:357 Exchange controls can therefore shield inaction. Yet Krugman observed that although exchange controls worked badly in practice, China’s exchange controls enabled it to ride out the Asian financial crisis of 1997 and 1998 rather well compared to its neighbors: Because [China] has been able to cut, not raise, interest rates in this crisis, despite maintaining a fixed exchange rate[,] and the reason it is able to do that is that it has an inconvertible currency, a.k.a. exchange controls. Those controls are often evaded, and they are the source of lots of corruption, but they still give China a degree of policy leeway that the rest of Asia desperately wishes it had.3 IV RECONCILING CAPITAL CONTROLS WITH INTERNATIONAL-LAW OBLIGATIONS Whether as a result of a desire for crisis prevention or as a crisis-response measure, the imposition of capital controls also raises a host of international- law considerations, including those arising under the International Monetary Fund (IMF) Articles of Agreement and Bilateral Investment Treaties (BITs). A. The IMF Articles of Agreement The IMF Articles of Agreement recognize exchange control in three principal provisions, namely Article VI(3), Article VIII(2)(a), and Article XIV.4 1. Article VI(3) Under Article VI(3), member states have discretion to “exercise such controls as are necessary to regulate international capital movements.”5 Sir Joseph Gold, former General Counsel of the IMF, explains that Article VI(3) was necessary “because of the destabilising effects that flows of ‘hot money’ had in the period before the IMF came into existence.”6 The global financial crisis has made those words, written well over twenty years ago, resonant.
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