Merits of Using Capital Controls for the Emerging Markets - Example

Name: Tutor: Title: Report Course: Date: Executive summary Capital controls are restrictions made on the in and out movement of capital across the boarders of a country and they take different forms. The report provides the merits of using capital controls for the emerging markets as well as developing economies. A focus has been given on the current state of capital movement freedom in Chile, China, Malaysia, Taiwan and Russia. In the report, potential costs and benefits associated with the use of capital controls are described. In addition, evaluation of the empirical literature on the impact of applying capital controls is made. Introduction Capital controls take a variety of forms such as quantity-based, price-based or a sole focus on capital movement into and out of the country. Such restrictions can as well be directed at distinctive forms of capital flows, for instance, at bank loans, portfolio investment and foreign direct investment or at differentiated actors that comprise of governments, banks, companies and individuals. A number of developed countries consider the benefits achieved as a result of free movement of capital across the borders of a country offset the costs and thus, the countries have limited capital control put in place. However, this is not the case with emerging markets or developing countries where a long-standing debate on the need to have capital control has been observed (Günther 2010). The reports provides the benefits and costs of the capital controls, empirical evidence on the use of capital controls with a focus on the current state of capital movement freedom in Chile, China, Malaysia, Taiwan and Russia. Body Benefits and costs of using capital controls Most economists argue that trade in assets or the capital flows contributes substantially to the economic development of a county by enabling the residents to effectively capitalize on the differences. According to Eichengreen (2003) capital flows allows nations to involve in today’s trade consumption for future consumption to engage them in the inter-temporal trade. Capital inflows provide financial benefits in terms of high-return investment. This in turn contributes to high growth rates. Furthermore, capital inflows when implemented in terms of direct investment contribute to improved technology, management roles as well as access to global networks that entirely raise economic growth and development of a country. On the other hand, capital outflows enable domestic citizens and organizations to achieve higher return and diversify risk. This reduces the consumption and income volatility rate within the country (Eichengreen 2003). This implies that free movement of capital in and out of the country fosters market discipline, and thus promotes efficient allocation of resources and increased productivity. Therefore, implementation of the capital controls limits a country from achieving such multifaceted benefits. However, free inflow and outflow of capital across the borders of a country involves costs. This means that countries that depend more foreign financing become vulnerable to the sudden stops within the capital inflows which in turns leads to financial crisis or increased currency depreciations. In addition, free movement of capital complicates the capability of a country to practice its own monetary policy, particularly where fixed exchange rate is involved. Inefficient investment of capital inflows as a result of market distortions leads to overinvestment that creates extra challenges. It is quite clear that capital controls are potential measures to reduce such costs caused by free movement of capital (Günther 2010). Although the long-term controls are commonly imposed, short controls are gaining traction whilst developing countries respond to the rising and falling capital inflows. Apparently, the inflows may have been prompted by reductions in interest rates, growth potentials as well as high debts within the advanced countries in comparison to the emerging markets and the high prices for commodities in such markets (Shaw 2011). The current state of capital movement freedom in Chile, China and Malaysia Generally, the current state of capital controls in Chile shows that the country has taken positive measures. This is because of Chile’s strong economic performance due to its successful implementation of the capital controls. It is apparent that the inflow of capital controls strengthens monetary policy a country to be more independent, changes the composition of its capital flows, and thus reduces the exact pressures experienced on exchange rates (Forbes 2010). In Malaysia, the controls imposed in the country have minimized the capital outflows, allowing the more free monetary policies than it is the case with Chilean controls on the inflows which appear not to be conclusive. The Malaysian experience also lacks sufficient systematic evidence of how effective the implementation of capital controls has been achieved (Hood 2011). Based on the empirical study of the impact of capital controls on Chile’s economy, the general conclusions to be made is that Chile still lacks evidence on how capital has moderated the appreciation of its currency. Although there is some evidence on how the controls increased the domestic interest rates of Chile, little evidence is made on how the controls have protected the country from external shocks. It is also evident that the imposed controls did not cause negative impact on the amount of capital inflows, but made the maturity period of capital inflows to be too long (Forbes 2009). China has been considered the most prominent country with long-term capital controls. The country’s controls enable its state banks to extend low-interest rate loans to clients or business. Such subsidized loans support the industrial production of China. Furthermore, capital controls help China to limit volatility rate that if ignored could impair the reputation of its commercial banks (Shaw 2011). Chinese government is always cautious to untie the control of its portfolio investment to free financial derivatives. This is because the portfolio capital flow is considered to be more volatile and speculative. Therefore, Chinese government has removed the main obstacles on its inward and outward measures on direct investment with the view that such an international investment will always be stable and productive. The liberalization of capital accounts in China still lags the country behind its neighbor economies more significantly. It has been discovered that China is currently suffering a more welfare cost than its neighbor Chile (Huayong 2011). Research indicates that capital controls play a significant role to the economic growth and development of a country because they act as protection measures against volatility. It is relevant to argue that capital controls if imposed successfully, helps to prevent any striking reversals in a country’s capital flows. Therefore, controls are crucial measures to prevent contagion through safeguarding the country against the financial tension caused by its neighboring economies. The main argument for controls as effective measures applied as temporary last resort is maintenance of a stable exchange rate. Most of the financial institutions in developing nations are fragile, and thus considered not competent enough to deal with the increased global issues of financial management. It is in view that capital controls are perceived to be the most appropriate measures to protect the developing or infant financial markets from financial crisis. This is because implementation of capital controls provides the needed shelter from a speculator’s point of view that offers institutions some time develop as well as gain their financial ability (Forbes 2009). Recommendation Emerging markets as well as developing countries that implement capital controls need to be prepare adequately. This will help to address the future financial shortcomings within their economies whilst liberalizing their capital accounts. In order for countries to remove their capital controls in a more simultaneous manner, they must under various structural changes that involve a range of reforms. This makes it easy for the countries consider the impacts associated with the removal of controls rather than to isolate them. Due to the costs incurred in the use capital controls, countries must take into consideration the available alternatives prior to imposing the controls, particularly short-term capital controls. This is because responding to the surging inflows involves other government options such as reining in the fiscal policy so as lower domestic demand, make financial regulations tighter and issuing of securities so as to reduce the expansionary impacts increasing the foreign exchange reserves. An increase in a country’s income leads to gradual dismantling of its controls so as to gain the benefits associated with open and more competitive financial system. When countries decide to increase their controls, they should do it cautiously with consideration to the many explosive crises that most of the emerging markets suffer as a result of the volatile capital movements (Shaw 2011). Conclusion Different capital flows and controls cause different impacts on the growth and development as well as other macro-economic variables of a countries economy. The impact of removing capital controls depend on various factors such as the country’s financial institutions and systems, corporate governance that may prove to be difficult to capture within the cross-country regressions. Capital controls may at times be difficult to enforce particularly for countries that have already developed their financial markets. It is quite clear that same capital controls provide distinctive levels of effectiveness within different countries. Capital inflows when implemented based on direct investment contribute to improved technology, management roles as well as access to global networks that entirely raise economic growth and development of a country. Bibliography Eichengreen, B., (2003), Capital Flows and Crises. Cambridge, The MIT Press. Forbes, K., (2009), One Cost of the Chilean Capital Controls: Increased Financial Constraints for Smaller Traded Firms. Journal of International Economics. Forthcoming. Forbes, K., (2010), One Cost of the Chilean Capital Controls: Increased Financial Constraints for Smaller Traded Firms. Journal of International Economics. Günther, S., (2010), The Political Economy of Capital Controls, New York, Cambridge University Press. Hood, R., (2011), Malaysia Capital Controls,World Bank Working Paper no. 2536, p. 1. Huayong, G., (2011), The Prerequites and Strategies to promote the basically convertibility of Capita Account, China Finance, No.14. Shaw, W., (2011), Why Are Capital Controls So Popular? Vera Eidelman International Economic Bulletin. Read More