General Overview
Restrictions on capital flows are normally imposed to limit downward or—less commonly—upward pressure on the exchange rate.1 Capital controls seek to insulate the domestic economy from foreign disturbances and aim in particular at limiting large exchange rate movements caused by volatile capital flows. Restrictions on outflows have mainly been applied to short-term capital transactions to counter volatile speculative flows that threaten to undermine exchange rate stability and to deplete a country’s foreign exchange reserves (often associated with periods of balance of payments weakness). In many countries, residents have long been prohibited from holding deposits denominated in foreign currencies, preventing them from quickly converting domestic currency into foreign currency in the event of diminished confidence in the national authorities’ economic policies. Once restrictions on capital outflows have been imposed, there has been reluctance to abolish them for fear that policies would immediately be put to the test again by financial markets.
Controls on short-term capital inflows became a particular feature of European economies in the late 1960s, when the earlier process of liberalization was reversed. The underlying strains in the Bretton Woods system of fixed exchange rates, particularly the loss of confidence in the role of the U.S. dollar as an anchor currency, resulted in sizable capital flows toward countries experiencing low inflation such as the Federal Republic of Germany, the Netherlands, and Switzerland. Because monetary policy considerations also played an important role in this episode, these ideas are dealt with in Section III.
Most controls on inward flows were lifted in the 1970s, when an appreciation of the European currencies and the Japanese yen vis-à-vis the U.S. dollar was eventually accepted and the Bretton Woods system gave way to a system of flexible exchange rates. After the first oil crisis in 1973, when the U.S. dollar again became a safe haven, many advanced countries experiencing downward exchange rate pressure reimposed restrictions on outward capital flows. These controls proved to be longer lasting than the previous controls on inflows. When the European Monetary System (EMS) was established in 1979, it was taken for granted that these controls would remain in place and would help to ward off speculative attacks within both the EMS and third countries. In fact, it was widely believed that this was the only feasible way to maintain a system of fixed but adjustable exchange rates among advanced economies with diverging economic performances. Outside Europe, advanced countries such as Japan, Australia, and New Zealand have also imposed controls on short-term capital flows for extended periods.
The move toward free capital movements among EU countries in the 1980s coincided with significant progress toward European integration, which later culminated in monetary unification. As economic performance gradually converged, capital controls were felt to be less necessary. Moreover, controls were losing their efficacy in the changed international financial environment, characterized by financial deregulation and globalization.
In this chapter, exchange rate considerations in the use of capital controls are illustrated by the experiences of a number of advanced economies. First, the Japanese attempts to manage the yen exchange rate by using capital restrictions, tightening or relaxing them in accordance with the yen’s relative strength, are documented. Second, the experiences of France in the late 1960s and 1970s are analyzed as a typical example of the considerations weighed by policymakers in European countries. Other European economies, such as those of Italy and the United Kingdom, had similar experiences (not documented here), albeit with some differences. Third, lessons are drawn from the operation of the EMS, which started under conditions of severe exchange control but later was managed under conditions of liberalized capital movements. Only during the 1992–93 exchange crises was reintroduction of capital controls considered and, in a few cases, actually effected. The section concludes with general lessons to be drawn from these experiences.
Japanese Exchange Rate Policy During the 1970s
When the Japanese yen was floated in February 1973 (following the final demise of the Bretton Woods system), the Japanese authorities nevertheless sought to maintain a certain measure of exchange rate stability. This was seen as an important policy objective to promote the development of a strong, competitive domestic industrial base with a substantial export capacity. To this end, both capital controls and direct interventions in the foreign exchange market were used. The aim of the interventions was primarily to smooth out fluctuations (or to “lean against the wind”), rather than to completely offset changes in exchange rates.2 Controls were not applied as a substitute for direct interventions but instead were targeted at preventing large exchange rate movements. Typically, controls on portfolio inflows were tightened, and those on portfolio outflows loosened, when there was upward pressure on the yen. The reverse occurred when there was downward pressure on the exchange rate. This pattern was evident on several occasions during the 1970s, In contrast, rules concerning direct inward investment were not explicitly used to influence the exchange rate (although, given the complexity of administrative approval procedures, it is possible that exchange rate considerations influenced the speed with which applications were processed and the likelihood of approval).
Upward pressure on the yen in 1971, reflecting U.S. dollar weakness, led the Japanese authorities to progressively tighten controls on capital inflows and to liberalize rules on capital outflows during 1971–72. For example, controls on the receipt of advances of export proceeds were tightened; the purchase of Japanese securities by foreigners was limited to the amount sold by foreign investors; and a reserve requirement was introduced (and later increased) on nonresident free yen accounts.3 On the outflow side, restrictions on the purchase of foreign securities by Japanese banks were eased and the purchase of foreign real estate by Japanese residents was liberalized.
This pattern was reversed following the oil crisis of October 1973, which put strong downward pressure on the yen. Official reserves fell substantially as the authorities intervened in the exchange markets (Figure 2.1). At the same time, the authorities sought to encourage capital inflows by abolishing the limits on the acquisition of Japanese equities and bonds by nonresidents. Controls on the receipt of advances for exports were also eased. As the depreciation continued in 1974, inflows were further encouraged while capital outflows were restricted. Restrictions on outflows included a prohibition on the purchase of short-term foreign currency securities by residents, and foreign currency accounts held by residents were curtailed. Japanese institutional investors faced “voluntary” restrictions on their foreign securities investments (net investments were not allowed to increase), and Japanese banks were instructed to refrain from financing “non-urgent” direct investment offshore.
Japan: Foreign Exchange Reserves and Nominal Exchange Rate, 1970–79
Source: IMF, International Financial Statistics (Washington), various issues.The pattern was again reversed in 1977, when the appreciation of the yen led to a relaxation of controls on outflows and a tightening of controls on inflows. In 1979, the yen depreciated, leading to a relaxation of controls on inflows. However, in a departure from previous episodes, controls on outflows were not reintroduced. This marked the end of the period in which capital controls were actively used to try to offset exchange rate pressures.
Evaluation
There appears to be some agreement that capital controls were partially effective in insulating Japan’s short-term capital markets from world markets until 1980.4 Fukao argues that the controls were usually able to limit undesirable capital flows, although not during periods of severe exchange rate tension, particularly in 1971.5 Once the exchange rate floated, some of the incentive for capital flows (relating to parity changes) was removed and, in any event, capital flows remained relatively low throughout the decade (Figure 2.2). The partial success of the controls was due to the heavily regulated domestic financial system, which gave the authorities the ability to exercise moral suasion. Controls were relatively effective as long as financial markets remained underdeveloped and market participants did not act in a particularly, sophisticated manner.
Japan: Portfolio Flows, 1970–80
(Percent of GDP)
Sources: IMF, International Financial Statistics (Washington), various issues; Thomson Financial; and Bank of Japan.Although capital flows may have been limited to some extent, it is difficult to determine how effective the controls were in offsetting exchange rate movements considered undesirable by the authorities (although the exchange rate moves were generally in line with fundamentals and reflected current account flows that were not fully matched by capital flows). The limited effectiveness of controls in influencing the exchange rate was partly due to the fact that some avenues for capital flows remained open. In addition, it was difficult to encourage flows that would support the authorities’ exchange rate objectives. For example, during periods of upward exchange rate pressure, there were attempts to encourage capital outflows by allowing greater foreign investment. Investors were unlikely to move funds abroad, however, if they anticipated a yen appreciation that was not compensated for by a higher expected return on foreign investments. Accordingly, even with extensive capital controls and foreign exchange interventions, the authorities were not able to simultaneously stabilize the exchange rate and conduct an independent monetary policy. The relatively large exchange rate movements during this period suggest that although controls may have reduced the speed of the exchange rate adjustment, they were not able to alter its direction.
Although the active use of capital controls was abandoned in 1979, the degree of financial repression remained high, and eventually led to sizable current account imbalances and perceived exchange rate misalignments (as the exchange rate was prevented from acting as an adjustment instrument). Overall, it appears that the eventual increase in capital flows in the second half of the 1980s was due at least as much to the deregulation of domestic financial markets as it was to capital account liberalization and the relaxation of administrative controls. (See Section IV for further discussion.)
Experiences in France in the Late 1960s and Early 1970s
Severe foreign exchange shortages and persistent downward pressure on the French franc characterized the immediate postwar period in France, and a relatively tight exchange control system was kept in place. After the general return to current account convertibility in 1958, a monetary reform aimed at restoring confidence was undertaken and the new franc was introduced on January 1, 1960. When France experienced favorable economic circumstances in the 1960s, with a strengthening of the balance of payments and a rise in official reserves, capital controls were gradually relaxed. France abolished its devises-titres market 6 in April 1962, facilitating cross-border transactions in shares. Toward the end of 1966, France liberalized most capital controls (including those on short-term capital) and introduced a positive exchange control system that permitted all capital transactions unless they were explicitly prohibited. A decisive factor encouraging this relaxation of controls was the relative strength of the French franc, which partly reflected the weakness of the U.S. dollar.
Capital account liberalization was also motivated by a desire to enhance the international role of the French franc. French proposals for international monetary reform in the second half of the 1960s aimed at replacing the Bretton Woods gold-dollar standard with a multicurrency standard, which included the French franc.7 Freedom of capital movements was considered a precondition for these proposals and was also necessary if Paris was to develop as a world financial center. Substantial reforms in the banking sector were implemented (the so-called Debré reforms, named after Michel Debré, who was then the minister of economic affairs and finance) to restructure and liberalize the financial sector. At the same time, the central bank introduced a system of minimum reserve requirements with a view to moving from a direct to an indirect system of monetary control that operated through changes in short-term interest rates. The resulting period of relatively liberal capital movements in France lasted for less than 18 months, until the spring of 1968.
Following serious civil unrest in May 1968, which disrupted the financial system and undermined confidence, capital controls were reintroduced to stem the ensuing outflow of funds. For the first time, the safeguard clauses under the European Community (EC) capital regime, which allowed a member state confronted with a sudden balance of payments crisis to take protective measures, were invoked. Initially, the measures were thought to be temporary. Indeed, they were abolished in September 1968, only to be reintroduced a few months later when the exchange rate again came under downward pressure. In 1969, the devises-titres market was also reestablished; it was subsequently merged, in 1971, into a more encompassing dual exchange market, separating the official market for trade-related transactions from a financial franc market for all other transactions. By that time, most of the earlier liberalization measures had been reversed.
In the face of the U.S. dollar crisis in the early 1970s, France, like Japan and other European countries, took measures to limit excessive inflows in order to discourage an appreciation of the French franc.8 Those controls in themselves were unable to stem the inflows, however, and therefore had to be complemented by interventions in the foreign exchange markets, resulting in a substantial increase in official reserves and stabilization of the exchange rate vis-à-vis the U.S. dollar. On the whole, the authorities did not consider the controls on inflows to have been very effective, although such flows might have been larger in their absence.
The 1973 oil crisis caused a reversal of sentiment in the foreign exchange markets, requiring a tightening of capital controls to prevent speculative outflows in the face of an expected sharp deterioration in the balance of payments. The authorities believed that these controls were more effective than those on inflows. This discrepancy can be partly explained by the fact that in outflow crises, controls needed to be directed mainly at discouraging residents from moving funds abroad—the French franc was not a widely held international reserve asset despite earlier attempts to increase its role. In contrast, in inflow crises, it was nonresidents who moved funds into European currencies, including the French franc. Capital movements by residents were controlled more effectively because the French commercial banks, which were under firm government control, were responsible for implementing the exchange control measures and complied with the rules (unlike, for example, the private German commercial banks, which were prepared to help clients circumvent controls). Moreover, a large administrative control apparatus was available for enforcement.
Capital controls were also intended to provide a margin for maneuvering to allow for an accommodating monetary policy and for expansionary fiscal policies. Interest rates were in double digits in nominal terms but remained negative in real terms from the 1973 oil crisis until the end of the 1970s (see Figure 2.3). Macroeconomic policies therefore did not support the goal of stabilizing the exchange rate vis-à-vis other European countries within the snake.9 The diverse macroeconomic policy responses to the oil crisis among European countries made it very difficult to maintain stable bilateral exchange rates. Whereas France, Italy, and, to a lesser extent, the Benelux countries opted for expansionary policies aimed at compensating for the consequent demand reduction, the Federal Republic of Germany adopted relatively stringent anti-inflationary policies. In spite of France’s extensive capital control system, the French franc had to be withdrawn from the European snake on two occasions. Initially, after the first withdrawal in January 1974 had been followed by a relatively large devaluation, the further substantial tightening of controls on outflows exerted some influence on net capital flows, which turned positive in the course of that year.10 The spreads between euro-franc short-term interest rates and domestic interest rates during 1974 averaged 500 basis points (5 percentage points), indicating that the controls were relatively effective in separating domestic markets from external influences. However, when the French franc’s reentry into the snake in July 1975 coincided with a substantial relaxation of monetary policy in the course of the year, confidence in the exchange rate deteriorated and French participation in the snake was suspended again in March 1976. From 1976 until the establishment of the EMS in 1979, the French franc depreciated vis-à-vis the deutsche mark by a further 30 percent despite France’s repeated tightening of its capital controls (Figure 2.4).
France: Interest Rates, 1971–79
(Percent per annum)
Source: Thomson Financial.France: Nominal Exchange Rates, 1970–79
Source: Thomson Financial.Evaluation
With the benefit of hindsight, the French system of exchange controls applied in the 1970s was generally ineffective in safeguarding the exchange rate from external pressures. The effectiveness of capital controls had eroded over time, reflecting the incentives for circumvention provided by persistent inflation differentials between France and the Federal Republic of Germany (Table 2.1). During the decade, repeated episodes of exchange rate pressure resulted in substantial devaluations of the French franc vis-à-vis the deutsche mark and other European currencies. As long as the fundamental causes of exchange rate adjustment—inflationary pressures emanating from expansionary policies—endured, capital controls could not stem the outflows. In contrast, the controls may have allowed interest rates to remain somewhat lower than they would have been otherwise. France was able to maintain relatively high growth rates, although it is not possible to assess the extent to which capital controls influenced growth. As long as there were serious national divergences, intra-European exchange markets remained unsettled. Expectations that more flexible exchange rates would enlarge the scope for autonomous domestic economic management were shattered when exchange rate movements quickly led to inflation-depreciation spirals.
France and Germany: Key Macroeconomic Indicators
(In percent)
France and Germany: Key Macroeconomic Indicators
(In percent)
| 1972–75 (Average) | 1976–79 (Average) | 1980–83 (Average) | ||||
|---|---|---|---|---|---|---|
| Germany, | Germany, | Germany, | ||||
| France | Fed. Rep. of | France | Fed. Rep. of | France | Fed. Rep. of | |
| Inflation rate | 10.9 | 6.4 | 10.9 | 3.7 | 13.5 | 5.1 |
| GDP growth rate | 2.7 | 1.3 | 3.5 | 18 | 1.5 | 0.5 |
| Current account/GDP | 0.0 | 1.5 | 0.3 | 0.6 | –1.1 | –0.2 |
| Fiscal deficit/GDP | –0.2 | –0.6 | –1.1 | –2.7 | –2.0 | –3.1 |
France and Germany: Key Macroeconomic Indicators
(In percent)
| 1972–75 (Average) | 1976–79 (Average) | 1980–83 (Average) | ||||
|---|---|---|---|---|---|---|
| Germany, | Germany, | Germany, | ||||
| France | Fed. Rep. of | France | Fed. Rep. of | France | Fed. Rep. of | |
| Inflation rate | 10.9 | 6.4 | 10.9 | 3.7 | 13.5 | 5.1 |
| GDP growth rate | 2.7 | 1.3 | 3.5 | 18 | 1.5 | 0.5 |
| Current account/GDP | 0.0 | 1.5 | 0.3 | 0.6 | –1.1 | –0.2 |
| Fiscal deficit/GDP | –0.2 | –0.6 | –1.1 | –2.7 | –2.0 | –3.1 |
Although their limited effectiveness was generally recognized, capital controls were kept in place as a complement to the centralized approach to economic development, characterized by macroeconomic planning, industrial policy, and sectoral differentiation. Such an environment called for protective shields at the borders. Monetary policy was used to channel savings to priority sectors, and capital controls were regarded as a useful complement to direct credit controls. During periods of calm financial markets, controls may indeed have helped to shield domestic monetary policies, but they were not effective in the face of large-scale speculation. Nevertheless, after the brief experiment with nearly full capital account liberalization in 1967, serious domestic and international disturbances, although unrelated to liberalization as such, made the authorities very apprehensive regarding any relaxation of controls. They felt that their abolition would encourage additional capital outflows, which might further exacerbate exchange rate pressures. There was, therefore, a political preference for being cautious as long as controls were considered relatively harmless for economic performance.
Lessons from Operation of EMS
European countries established the EMS in 1979 to restore exchange rate stability in Europe and thus give a new impetus to regional economic integration. The first four years of its operation achieved, at best, mixed results and saw repeated speculative attacks, large-scale interventions, and, eventually, sizable exchange rate realignments. Proposals to intensify monetary cooperation by expanding intra-European credit mechanisms to facilitate interventions in support of bilateral exchange rates met with resistance from countries with strong currencies, particularly the Federal Republic of Germany, because they feared that the implicit shifting of the burden of adjustment would jeopardize monetary stability. Moreover, there was a concern that divergences would continue because any sharing of the burden might encourage countries with exchange rates under downward pressure to postpone necessary economic adjustment.
Capital controls were initially kept in place and then, in 1981, tightened even further by Italy and France; the latter reintroduced the devises-titres market. In 1983, after a further general realignment, which forced a devaluation of the French franc vis-à-vis the deutsche mark for the third time in 18 months (for a cumulative devaluation of 25 percent), capital controls in Europe—including a severe curtailment of foreign travel allowances for French residents—were at their tightest. Exasperation among the authorities with the functioning of the system led to a renewed appraisal of the instruments available to maintain exchange rate stability and of the effectiveness of capital controls in this respect. Some observers thought that the liberalization of capital movements would increase market discipline on countries with weak currencies by making the external consequences of domestic policy mistakes visible at an earlier stage.
The renewed interest in liberalizing capital controls in continental Europe was stimulated by the liberalization drive elsewhere, particularly in the United Kingdom and Japan. From 1983, liberalization of capital movements was included in the agenda of the European Community (EC), after an absence of more than a decade, including the resumption of annual examinations (stopped in the early 1970s) of member countries with a view to determining whether existing derogations under the EC Treaty safeguard clauses could be repealed (Table 2.2). Because a political link was established between capital account liberalization and the strengthening of EMS mechanisms, they became the subject of European negotiations. Gradualism was advocated because of the perceived risk of liberalizing in a situation of still-high inflation and large external imbalances. Therefore, liberalization needed to be supported by policies aimed at achieving economic convergence.
Application of Safeguard Measures in the European Community
Application of Safeguard Measures in the European Community
| Country | Began | Ended | Treaty Basis |
|---|---|---|---|
| France | 1968 | 1986 | Balance of payments crisis |
| Italy | 1974 | 1977 | Balance of payments crisis |
| 1981 | 1987 | Balance of payments crisis | |
| United Kingdom | 1975 | 1977 | Balance of payments crisis |
| 1977 | 1979 | Threat of balance of payments difficulties | |
| Denmark | 1977 | 1979 | Threat of balance of payments difficulties |
| 1979 | 1984 | Capital market disturbances | |
| Ireland | 1977 | 1988 | Threat of balance of payments difficulties |
| Greece | 1985 | 1990 | Threat of balance of payments difficulties |
Application of Safeguard Measures in the European Community
| Country | Began | Ended | Treaty Basis |
|---|---|---|---|
| France | 1968 | 1986 | Balance of payments crisis |
| Italy | 1974 | 1977 | Balance of payments crisis |
| 1981 | 1987 | Balance of payments crisis | |
| United Kingdom | 1975 | 1977 | Balance of payments crisis |
| 1977 | 1979 | Threat of balance of payments difficulties | |
| Denmark | 1977 | 1979 | Threat of balance of payments difficulties |
| 1979 | 1984 | Capital market disturbances | |
| Ireland | 1977 | 1988 | Threat of balance of payments difficulties |
| Greece | 1985 | 1990 | Threat of balance of payments difficulties |
The liberalization process (called “active gradualism”) sought to abolish the use of safeguard clauses, expand liberalization obligations, and identify and remove informal restrictions. 11 In 1985, EC member states agreed on the Single Act aimed at removing all remaining obstacles for the Internal Market by 1992 and achieving the highest possible degree of capital account liberalization. 12 In 1986, a new directive liberalizing certain financial transactions was adopted. Although its practical implications were limited, its adoption was an important political sign, since it was the first new liberalization obligation undertaken by European member states since 1962. Eventually, a dynamic process aimed at the full liberalization of capital movements was set in motion, since it was realized that distinguishing between different types of short-term capital flows would not be effective, given financial innovations. In the improving economic climate of the second half of the 1980s, enhanced by a general adherence to stability-oriented policies that resulted in sharply diminished inflation differentials between countries (Figure 2.5), the liberalization process gathered momentum.
The willingness to further liberalize was repeatedly tested. After a general realignment in April 1986, new pressures in the exchange markets emerged toward the end of the year, even though convergence was proceeding relatively well. A further realignment in January 1987, which underlined the difficulty of maintaining a regional system of fixed but adjustable exchange rates with increasingly high capital mobility, prompted efforts to strengthen the operating mechanisms of the EMS. A three-pronged line of response to speculative attacks on the exchange rate was developed (known as the Basel/Nyborg agreement), comprising (1) use of the interest rate to defend the exchange rate; (2) a flexible use of the fluctuation margins around the central rate to create two-way risks in the exchange markets; and (3) relatively small and infrequent realignments. Large-scale interventions were discarded as a line of defense, because they could be counter productive and at times were themselves a cause of instability. The new set of instruments was designed to both deter speculation and penalize speculators by showing that speculation was costly (because of high interest rates) and unrewarding (the full use of the fluctuation band in combination with small realignments implied only limited changes in actual exchange rates after a realignment).
The Basel/Nyborg agreement constituted one of the distinct turning points in the history of capital account liberalization in Europe. It was now recognized that economic policies should aim at achieving convergence among European countries as a precondition for exchange rate stability. Technical refinements of the EMS, including the use of capital controls, had been unable to discourage destabilizing capital flows. The increased policy attention to economic fundamentals resulted in a considerable decrease in the number and size of realignments and marked the beginning of a long period of quasi-exchange rate stability. This stability provided the right environment for the adoption of a new directive in June 1988 in which full capital account liberalization was agreed upon, granting differentiated transitional periods to member states (Table 2.3).
Abolition of Capital Controls in European Countries
Abolition of Capital Controls in European Countries
| United Kingdom | 1979 | Belgium/Luxembourg | 1990 |
| Germany, Fed. Rep. of | 1981 | Austria | 1991 |
| Netherlands | 1986 | Finland | 1991 |
| Denmark | 1988 | Spain | 1992 |
| France | 1989 | Portugal | 1992 |
| Sweden | 1989 | Ireland | 1993 |
| Italy | 1990 | Greece | 1994 |
Abolition of Capital Controls in European Countries
| United Kingdom | 1979 | Belgium/Luxembourg | 1990 |
| Germany, Fed. Rep. of | 1981 | Austria | 1991 |
| Netherlands | 1986 | Finland | 1991 |
| Denmark | 1988 | Spain | 1992 |
| France | 1989 | Portugal | 1992 |
| Sweden | 1989 | Ireland | 1993 |
| Italy | 1990 | Greece | 1994 |
In the run-up to the final negotiations on monetary union in 1991, market sentiment increasingly reflected the view that the EMS had, in fact, developed into a quasi-monetary union in which the exchange rates need no longer be adjusted. The lifting of capital controls was favorably received in financial markets as a sign of strength. This sentiment changed abruptly when doubts arose about whether all member states would participate in monetary union.13 Market attention again shifted to the differences in macroeconomic policies between countries. Strong pressures developed against the weak currencies within the EMS. Following a devaluation of the Italian lira in mid-September 1992, speculation focused on the pound sterling and the Spanish peseta. A few days later, the EMS memberships of sterling and the lira, which had come under renewed attack, were suspended and the Spanish peseta was devalued. This episode was followed by repeated speculative attacks on most other currencies in the European Exchange Rate Mechanism (ERM). Temporary capital restrictions were reintroduced in some countries, leading some critics of the abolition of capital controls to feel vindicated.
The debate on free capital flows was opened once more following another wave of volatility in the ERM in the summer of 1993. After repeated speculative attacks, the fluctuation bands were widened from 2¼ percent to 15 percent on August 2, 1993. It was felt that by creating two-way risks in the market and maintaining firm and consistent policies, destabilizing forces in the exchange markets could be overcome. Some observers suggested that capital controls be reintroduced. Others favored shortening the timetable for adopting a single European currency and thus resolving the perceived incompatibility of full capital mobility, monetary policy autonomy, and exchange rate stability. However, the hard-currency countries, particularly Germany and the Netherlands, which blamed the exchange rate unrest on diverging economic performance, resisted this idea. Strict adherence to the Maastricht convergence criteria was seen as the only viable way to gain credibility in financial markets.
During these crises, Spain and Portugal temporarily reintroduced or tightened capital controls—in particular, restrictions on lending in national currency to nonresidents—in order to limit speculation against their currencies.14 Empirical evidence suggests that the effect of these measures was generally limited and short lived.15 Although these measures did buy some time, they had a negative indirect effect on other capital flows. Both countries were confronted with sales of securities by international fund managers who were unable to cover their positions and decided to bring down the peseta and escudo shares in their portfolios, contributing to a sharp drop in domestic bond and share prices. The negative repercussions on long-term capital flows were costly, given the dependence on external finance in the catching-up process. In view of these negative confidence factors, the restrictions were abolished in both countries after a second devaluation of the Spanish peseta and the Portuguese escudo in November 1992. Ireland experienced similar long-term capital outflows following a clampdown on hedging possibilities in the aftermath of the 1992 EMS crisis as nonresidents sold Irish government bonds in the second half of that year.
Finally, some favored the introduction of a Tobin tax in order to discourage speculative flows. 16. However, a proposal by the president of the European Commission to study its merits was quickly discarded, since the tax was viewed less favorably than traditional control mechanisms. European policymakers felt that the Tobin tax would be worse than direct controls, since the tax would aversely affect “normal” capital flows, as well as possibly trade in goods and services, and would negatively affect the liquidity of foreign exchange markets. Conversely, at times of large speculative disturbances, the tax was considered to be less effective than traditional controls, since the gains from devaluation would more than offset the costs of the tax. Moreover, for the Tobin tax to be effective, it needed to be introduced worldwide.
General Lessons
On the whole, the effectiveness of capital controls in maintaining exchange rate stability has been relatively limited in advanced economies. Their effectiveness has been greater in countries, such as Japan, where domestic financial repression has been more extensive and the administrative apparatus to effectively execute controls was in place. In addition, their effectiveness has been greater at times of relative calm in the exchange markets, allowing for more accommodative monetary policies and probably playing a discrete role in stabilizing the exchange rate. For the European countries trying to stabilize their bilateral exchange rates after the demise of the Bretton Woods system, however, controls were not able to check speculative flows or forced realignments. Instead, controls may have had the undesired side effect of postponing necessary adjustment of domestic policies, thus leading eventually to sharper exchange rate adjustments than otherwise might have been required. Increasingly, it was realized that capital controls did not address the fundamental causes of short-term capital flows and therefore did not necessarily influence exchange rate expectations in a significant and lasting way.
The political economy dimension of capital controls should not be underestimated. Even if their effectiveness in the medium term may be doubtful, the imposition of capital controls in the face of strong speculative pressures can temporarily help to calm markets, thus providing a breathing space during which to adjust policies. Considerable political prestige has been attached to maintaining the level of countries’ exchange rates. Capital controls have therefore generally entailed fewer political costs than a devaluation of the national currency. The general public has not normally felt the impact of tightening capital controls, whereas political resistance to devaluation has been strong. The authorities’ desire to have controls available if necessary may also help explain their longevity. They knew that once the administrative apparatus had been dismantled, it would not be easy to reinstate controls because of a lack of operational experience with them.
Capital controls became less effective when they were used repeatedly, especially when controls were not able to prevent exchange rate devaluations. More generally, their effectiveness tended to erode as financial markets became more sophisticated. The emergence of derivative financial products, which blurred the traditional distinctions between market segments, contributed to the diminished effectiveness of controls over time. Because mild control systems could easily be evaded, it became more difficult for policymakers to steer a middle course between very strict capital control systems and full freedom of capital movements.
Moreover, systems in which restrictions can be reintroduced as the need arises have the disadvantage that foreign investors will anticipate such moves and may shy away from making longer-term investments to avoid the risk of their assets being trapped. Over time, currencies subject to such controls became perceived as “mousetrap” currencies: investors can bring assets in but may find it difficult to legally withdraw them. Short-term capital controls that hinder intra-company finance of foreign subsidiaries or branches may also negatively affect the country’s investment climate. Controls intended to deter outright speculators may therefore inadvertently discourage long-term investors.
All in all, the experiences of advanced countries do not provide evidence that countries facing major currency crises have clearly benefited from the temporary imposition (or tightening) of controls on outflows, particularly when the exchange rate was clearly inconsistent with fundamentals. Although controls may have bought time in some cases, countries generally did not take sufficient advantage of the opportunity provided to make the necessary economic adjustments that would have allowed controls to be lifted (and, in some cases, controls were used to permit the adoption of expansionary fiscal and monetary policies). Instead, the experiences of European countries show that sustained exchange rate stability between countries can best be pursued when similar economic policies are followed. In particular, the reduction of inflation differentials between countries, supported by monetary policies aimed solely at price stability, has helped maintain relative exchange rate stability in the face of increased capital mobility. Under such circumstances, with the exchange rate moving broadly in line with fundamentals, capital controls may have limited short-term fluctuations. Countries that had gained considerable credibility in maintaining a hard currency policy—such as the Netherlands and, at a later stage, Belgium. France, and Austria—no longer needed such controls.
The distinction between countries that have applied controls on inflows and those that have mainly targeted outflows is of analytical importance. On the one hand, controls on capital outflows for exchange rate considerations typically became associated with accommodating monetary policies. On the other hand, a country shielding itself, under fixed exchange rates, from capital inflows can follow restrictive monetary policies more easily than it could otherwise without having to fear offsetting inflows from countries with loose monetary policies. At the beginning of the 1970s, such inward capital controls were imposed to limit speculative inflows of “hot money.” This episode is discussed in detail in Section III.
