NOVEMBER/DECEMBER1999 Christopher J. Neely is a senior economist at the Federal Reserve Bank of St. Louis. Kent Koch provided research assistance. study of capital controls. First, the resump- An Introduction tion of large capital flows—trade in assets— to developing countries during the late to Capital 1980s and early 1990s created new prob- lems for policymakers. Second, a string of Controls exchange rate/financial crises during the 1990s—the European Monetary System Christopher J. Neely crises of 1992-93, the Mexican crisis of 1994 and the Asian financial crisis of Moreover, it may well be asked whether 1997-98—focused attention on the asset we can take it for granted that a return transactions that precipitated them. In to freedom of exchanges is really a ques- particular, Malaysia’s adoption of capital tion of time. Even if the reply were in the controls on September 1, 1998, has affirmative, it is safe to assume that after prompted increased media attention and a period of freedom the regime of control has renewed debate on the topic. will be restored as a result of the next Modern capital controls were devel- economic crisis. oped by the belligerents in World War I —Paul Einzig, Exchange Control, to maintain a tax base to finance wartime MacMillan and Company, 1934. expenditures. Controls began to disappear after the war, only to return during the Currency controls are a risky, stopgap Great Depression of the 1930s. At that measure, but some gaps desperately time, their purpose was to permit coun- need to be stopped. tries greater ability to reflate their econo- —Paul Krugman, “Free Advice: mies without the danger of capital flight. A Letter to Malaysia’s Prime Minister,” In fact, the International Monetary Fund Fortune, September 28, 1998. (IMF) Articles of Agreement (Article VI, section 3) signed at the Bretton-Woods conference in 1944 explicitly permitted nlike many topics in international eco- capital controls.1 One of the architects of nomics, capital controls—taxes or those articles, John Maynard Keynes, was Urestrictions on international transac- a strong proponent of capital controls and tions in assets like stocks or bonds—have the IMF often was seen as such during its received cursory treatment in textbooks and early years. During the Bretton-Woods era scant attention from researchers. The con- of fixed-exchange rates, many countries sensus among economists has been that cap- limited asset transactions to cope with bal- ital controls—like tariffs on goods—are ance-of-payments difficulties. But, recog- 1 “Article VI. Section 3. Controls obviously detrimental to economic efficiency nition of the costs and distortions created of capital transfers: Members because they prevent productive resources by these restrictions led to their gradual may exercise such controls as from being used where they are most need- removal in developed countries over the are necessary to regulate inter- ed. As a result, capital controls gradually last 30 years. The United States, for exam- national capital movements, had been phased out in developed countries ple, removed its most prominent capital but no member may exercise during the 1970s and 1980s, and by the controls in 1974 (Congressional Quarterly these controls in a manner which will restrict payments for 1990s there was substantial pressure on less- Service, 1977). During the last 10 years current transactions or which developed countries to remove their restric- even less-developed countries began to will unduly delay transfers of tions, too (New York Times, 1999). The topic liberalize trade in assets. funds in settlement of commit- almost had been relegated to a curiosity. The purpose of this article is to intro- ments, except as provided in Several recent developments, however, duce Review readers to the debate on capi- Article VII, Section 3(b) and in have rekindled interest in the use and tal controls, to explain the purposes Article XIV, Section 2.” FEDERALRESERVEBANKOFST. LOUIS 13 NOVEMBER/DECEMBER1999 and costs of controls and why some advo- outflow. Accumulating claims on the rest cate their reintroduction. To lay the ground- of the world is a form of national saving. work for understanding restrictions on Conversely, a country is said to have a sur- capital flows, the next section of the article plus in the capital account—or a capital describes capital flows and their benefits. inflow—if the rest of the world is accumu- The third section characterizes the most lating net claims on it, as is the case with common objectives of capital controls with the United States.5 Just as individuals an emphasis on the recent debate about must avoid borrowing excessively, policy- using controls to foster macroeconomic makers must make sure that the rest of the stability. Then the many types of capital world does not accumulate too many net controls are distinguished from each other claims on their countries—in other words, 2 The U.S. Department of and their effectiveness and costs are con- that their countries do not sell assets/bor- 6 Commerce does not recognize sidered. In addition, accompanying shad- row at an unsustainable rate. “real” assets as a separate ed inserts outline specific case studies in class. The purchase of assets capital controls: the U.S. Interest Equali- such as foreign production facili- zation Tax of 1963, the Chilean encajeof Benefits of Capital Flows ties is recorded under financial the 1990s, and the restrictions imposed Economists have long argued that assets in their accounts by Malaysia in September 1998. trade in assets (capital flows) provides (Department of Commerce, substantial economic benefits by enabling 1990). residents of different countries to capitalize 3 The capital account records CAPITAL FLOWS on their differences. Fundamentally, capi- both loans and asset purchases To understand what capital controls do, tal flows permit nations to trade consump- because both involve buying a it is useful to examine capital flows—trade tion today for consumption in the future— claim on future income. A in real and financial assets. International to engage in intertemporal trade (Eichen- bank making a car loan obtains purchases and sales of existing real and green, et al. 1999). Because Japan has a a legal claim on the borrower’s financial assets are recorded in the capital population that is aging more rapidly than future income. account of the balance of payments.2 Real that of the United States, it makes sense 4 Equity investment is considered assets include production facilities and real for Japanese residents to purchase more portfolio investment in national estate while financial assets include stocks, U.S. assets than they sell to us. This allows accounts until it exceeds 10 bonds, loans, and claims to bank deposits.3 the Japanese to save for their retirement by percent of the market capital- Capital account transactions often are classi- building up claims on future income in the ization of the firm, then it is fied into portfolio investment and direct United States while permitting residents of considered direct investment. investment. Portfolio investment encom- the United States to borrow at lower inter- 5 The current accountrecords passes trade in securities like stocks, bonds, est rates than they could otherwise pay. trade in goods, services, and bank loans, derivatives, and various forms A closely related concept is that capital unilateral transfers. A nation’s of credit (commercial, financial, guaran- flows permit countries to avoid large falls capital account balance must tees). Direct investment involves the pur- in national consumption from economic be equal to and opposite in chase of real estate, production facilities, downturn or natural disaster by selling sign from its current account or substantial equity investment.4 When a assets to and/or borrowing from the rest of balance because a nation that German corporation, BMW, for example, the world. For example, after an earth- imports more goods and ser- vices than it exports must pay builds an automobile factory in South quake devastated southern Italy on Novem- for those extra imports by sell- Carolina, that is direct investment. On the ber 23, 1980, leaving 4,800 people dead, ing assets or borrowing money. other hand, when U.S. investors buy Italians borrowed from abroad (ran a capi- The sum of the current account Mexican government bonds, that is portfo- tal account surplus) to help repair the balance and the capital account lio investment. damage. Figure 1 illustrates the time balance is the balance of pay- A country is said to have a deficit in series of the Italian capital account from ments. the capital account if it is accumulating net 1975 through 1985. 6 The composition as well as the claims on the rest of the world by purchas- A third benefit is that capital flows magnitude of capital flows also ing more assets and/or making more loans permit countries as a whole to borrow in may influence the sustainability to the rest of the world than it is receiving. order to improve their ability to produce of policies, as will be discussed A country, like Japan, with a capital account goods and services in the future—like in section 3. deficit is also said to experience a capital individuals borrowing to finance an educa- FEDERALRESERVEBANKOFST. LOUIS 14 NOVEMBER/DECEMBER1999 tion. To cite just one example, between Figure 1 1960 and 1980 Koreans borrowed funds from the rest of the world equal to about 4.3 Italian Capital Account Surplus percent of gross domestic product (GDP) as a Percentage of GDP annually to finance investment during Korea’s Percent 2 period of very strong growth (see Figure 2). November 23, 1980 These arguments for free capital mobili- 1.5 Earthquake ty are similar to those that are used to sup- 1 port free trade.