The work of IMF staff members on issues related to the use and liberalization of capital controls has focused on the experiences of emerging market economies and of a few advanced economies during the 1990s and, to a lesser extent, during the 1980s. This paper seeks to complement the IMF staff’s work by examining the experiences of advanced economies with the use and liberalization of capital controls since the middle of the twentieth century.
In the 1980s, many advanced countries made significant progress in liberalizing capital movements. Virtually all capital controls have now been abolished among industrial countries, and there are no formal barriers to cross-border flows of capital. This is in striking contrast to the 1960s and 1970s, when most countries still maintained restrictive regimes. Over time, there has been a major shift in the assessment of the pros and cons of free capital flows. The focus of this study is on the economic and political forces behind this changing perception, as well as the implications it has had for policies. Policymakers’ assessments of the effectiveness of capital restrictions in achieving goals, such as the preservation of the exchange rate or domestic monetary stability, are of particular interest.
In the period immediately following World War II, trade liberalization generally took precedence over capital account liberalization. Capital controls have often been regarded as having negative allocation and growth effects that are substantially smaller than those of trade restrictions. In order to support trade, current account convertibility was achieved within a relatively short period after the war ended. In accordance with its mandate, the IMF has been instrumental in promoting such convertibility. Full current account convertibility had been achieved in most advanced countries by 1958. In that year, the Treaty of Rome established the European Economic Community (EEC). It provided for the eventual freedom of capital movements in Europe, but this objective was circumscribed by a clause specifying that such liberalization should be carried through only to the extent necessary to ensure the proper functioning of the Common Market. The year 1958 is therefore a natural starting point for this study.
Although capital restrictions have been a major policy tool in most industrial countries, different traditions and country-specific institutional arrangements have resulted in restrictions taking many forms, varying in intensity, and often being camouflaged by complex administrative rules. Capital controls have been generally closely linked to regulation in other policy areas (particularly banking and financial markets) and have covered the whole spectrum of capital movements from long-term direct investment flows and foreign equity transactions to changes in the short-term external positions of commercial banks and foreign exchange transactions by residents. Capital controls have thus greatly restricted cross-border financial transactions, limited portfolio decisions of nonbank residents, and hindered the internationalization of companies. They also affected citizens’ freedom to travel abroad by limiting the amount of foreign currency they could obtain.
Capital controls have not been a generalized phenomenon across all industrial countries. In particular, the two major postwar reserve currency countries, the United States and Germany, have traditionally adopted liberal policies in this area. The United States, which has provided the dominant world reserve currency in the postwar period, generally did not impose outright restrictions on capital flows. Nevertheless, in the final years of the Bretton Woods system, the United States did take measures aimed at discouraging capital outflows. Germany, whose currency gradually started to play a major role in the international monetary system, likewise has not used capital restrictions to the same extent as the other industrial countries, apart from a brief, albeit intensive experiment in the immediate post–Bretton Woods period. Canada and Switzerland have also generally adhered to a liberal regime. By contrast, Belgium and Luxembourg (which had been tied together in a monetary union since 1922), while not operating an outright capital control system, maintained a dual exchange rate system until 1990. Current account transactions occurred at the managed exchange rate while the exchange rate for capital account transactions was allowed to float.
The liberalization of capital movements during the 1980s has been a global phenomenon in advanced countries, coinciding with a general shift toward market-oriented economic policies aimed at achieving noninflationary sustainable growth. This process has been advanced by cooperation within the framework of multilateral organizations such as the Organization for Economic Cooperation and Development (OECD) and the European Union (EU). The OECD code on capital liberalization has provided a helpful instrument for exerting pressure on member countries to lift controls (Box 1.1). In Europe, the political willingness of countries to work toward European Economic and Monetary Union (EMU) has encouraged the lifting of all capital controls (although the objective of capital account liberalization was established before moves to establish EMU were begun). The IMF has generally supported capital account liberalization in advanced countries in the context of its Article IV surveillance but has not played a major role in these countries’ progress in this area.
An important caveat should be kept in mind when drawing lessons from the experiences of advanced countries. The financial environment in which countries now operate has changed drastically, partly because liberalization and deregulation have resulted in rapid changes in the way global financial markets function. Financial markets react more swiftly to changed circumstances; the range of financial instruments has increased; and, more generally, financial markets have become more complex and extensive (with closer links between the short-and long-term markets, as well as among countries). This implies that capital controls are likely to be less effective now than in the more financially repressed environment of the 1960s and 1970s. Second, the process of capital account liberalization in continental European countries has to be understood in the institutional context of the EU integration process, culminating in monetary unification.
The focus of this study is advanced countries’ experiences with capital account liberalization. Given that, the study does not seek to make a comprehensive assessment of the operation of capital controls or the effectiveness of different forms of controls. Such a comprehensive assessment would be difficult to make with any degree of precision, because the effectiveness of controls depends not only on the objectives sought and the exact specification and operation of controls but also on the extent to which they are complemented by regulations in other policy areas. Nevertheless, doubts about the effectiveness of capital controls in general, particularly in the face of the rapid evolution of financial markets, have often been a factor in the decision to liberalize. Finally, the case-study approach, focusing in particular on periods of macroeconomic instability, implies that less attention is paid to episodes during which controls may have played a discrete (but effective) stabilizing role, particularly in the early 1960s.
Capital Account Liberalization in a Multilateral Context: The OECD Process
Since its establishment in 1961, the Organization for Economic Cooperation and Development (OECD) has promoted the progressive liberalization of capital movements. Member countries voluntarily enter into obligations to liberalize capital movements. Once accepted, the obligations become binding and are regularly updated in the Code of Liberalization of Capital Movements. The code implicitly suggests that the process of liberalization be gradual and, by putting liberalization in the context of economic cooperation, makes capital account liberalization subject to multilateral negotiations. Regular examinations of capital controls are carried out by the Committee on Capital Movements and Invisible Transactions (CMIT), which requires countries to justify remaining restrictions.
Lacking enforcement mechanisms or sanctions, the OECD code has not been very powerful, particularly when capital controls were widely applied in member countries. Major liberalization moves often occurred primarily for domestic reasons rather than because of multilateral pressure. Despite this, once liberalization became more widespread, the OECD process may have provided a useful forum for discussion and for pressuring those countries that were lagging behind. In contrast, the code has been more influential for countries aspiring to OECD membership. Japan, for example, was requested to ease controls on foreign direct investment before it attained OECD membership in 1964.
A range of interrelated motives for capital controls—including exchange rate policy, monetary policy, industrial policy, or tax policy considerations—are often apparent. In practice, it can be difficult to distinguish between these various motives. By influencing capital flows—and therefore the demand for, and the supply of, currency—capital controls are, by definition, part of exchange rate policy.
Countries imposed controls on outflows for several reasons: to avoid downward pressure on the exchange rate, keep domestic savings at home, avoid tax evasion, and prevent depletion of foreign exchange reserves. When these controls are effective, they also reduce the need for domestic interest rates to respond to such pressures and preserve a degree of national monetary policy independence. Countries typically used controls on inflows to contain upward pressure on the exchange rate and avoid the inflationary consequences of capital inflows. Some countries explicitly sought to shield their domestic capital markets, favor domestic industrial sectors, or restrict the participation of foreign capital in sensitive sectors. Although the differences between motives cannot always be clearly identified, drawing distinctions between them is useful from an analytical viewpoint. Section II and Section III deal with the exchange rate policy and monetary policy motives, respectively, on the basis of experiences with capital controls in selected advanced economies. Other motives are discussed throughout the study where relevant.
Subsequent sections deal with the experiences selected countries have had with liberalizing capital movements. It has generally been accepted that liberalization should be a gradual process, and most countries have followed such an approach. Following trade liberalization, many advanced countries began to dismantle capital controls in the 1960s, but these attempts stalled when problems emerged in the Bretton Woods system in the early 1970s. Only in the early 1980s did countries again develop strategies to dismantle their control systems. In Europe, this took place within the framework of the move toward EMU. Japan developed its own plan for gradually phasing out controls in the wake of bilateral yen-dollar discussions with the U.S. authorities. Major lessons of the gradual approach are drawn in Section IV. However, there are also important examples of countries that have attempted a more rapid approach to undoing capital controls, usually accompanied by a radical overhaul of macroeconomic and structural policies. The United Kingdom (1979), Australia (1983), and New Zealand (1984) opted for a shock-therapy approach by eliminating all capital restrictions in one stroke. Experiences with rapid liberalization and its possible effects on financial stability are dealt with in Section V.
In Section VI, lessons are drawn from these diverse experiences for the relationship of liberalization to other policies. It also briefly discusses how liberalization measures can be sequenced in order to minimize destabilizing effects on exchange rate and monetary policies.