III Experience with Capital Account Liberalization in Industrial Countries

Owen Evens, and Peter Quirk
Published Date:
October 1995
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As of June 1995, all industrial countries had eliminated exchange controls on both capital inflows and outflows. This follows the unique period in the history of international financial relations after the Second World War in which most countries maintained substantial restrictions on capital movements in attempts to fend off destabilizing external financial influences and to retain national savings for use in domestic reconstruction and development. Canada, Switzerland, and the United States maintained a liberal environment for most types of capital movement throughout the period, although there were temporary exceptions. The evolution of capital account liberalization in other industrial countries was relatively slow in the early stages and did not gain full momentum until the late 1980s. Germany made an early start in 1958, when it removed all controls on capital outflows. It continued to maintain tight controls on capital inflows because balance of payments surpluses engendered pressures toward an appreciation of the deutsche mark and threatened its exchange rate parity under the Bretton Woods system. Controls on inflows were removed in 1969 but were subsequently reintroduced on two occasions before being removed again in 1981.

Although the floating of exchange rates following the breakdown of the Bretton Woods system in the early 1970s provided a degree of freedom to national monetary policies, this action did not by itself cause industrial countries to liberalize capital controls immediately. The shift was instead largely influenced by the increasingly global nature of financial markets and the changing political attitudes toward controls on financial and capital markets. The controls were also removed in part as a response to the pressure from corporations in the home countries to permit financing of expansion of their production facilities abroad and from domestic banks facing competition from international financial markets. The development of multinational corporations and international banks, in particular, increased the opportunities for evasion of restrictions imposed by home governments and also for exit from the home market.32 As the globalization proceeded and the sophistication of market techniques that sidestepped controls (e.g., swaps) progressed, governments increasingly recognized the ineffectiveness of the remaining controls and their costs in terms of preventing domestic agents from participating fully in international activities.33 The process of liberalization accelerated in the 1980s and early 1990s throughout the group of industrial countries. A significant shift toward complete liberalization was initiated with the rapid removal of capital controls by the United Kingdom (1979) and the completion of liberalization by Japan (1980). Next came the quick removal of all capital controls by Australia (1983) and New Zealand (1984) and extensive liberalizations by European countries.

In the context of the EU, where capital account liberalization was viewed as another step in the eventual monetary integration of the area,34 a number of countries completed a first round of decontrols: Netherlands (1986), Denmark (1988), France (1989), Belgium, Ireland, Italy, and Luxembourg (1990). Several members of the European Free Trade Association (EFTA)—Sweden (1989), Austria, Finland, and Norway (1990)—followed suit. The final set of liberalizations took place in those EU members for whom more distant deadlines had been set; thus, Portugal and Spain liberalized on January 1, 1993, and Greece on July 1, 1994. On January 1, 1995, Iceland became the last industrial country to adopt full capital convertibility.

Characteristics of Capital Flows and Related Controls

One notable feature of capital account liberalization in industrial countries has been the close relationship between the removal of capital controls on inflows and outflows and the strength of the balance of payments position. Countries that had a strong balance of payments position (e.g., Germany and Japan) tended to rely on controls on inflows, whereas those that had a generally weaker position (e.g., France and Italy) maintained controls on capital outflows. Germany and Japan began dismantling the systems of heavy controls on capital flows as they moved from a position of weak balance of payments and low international reserves to one of balance of payments surpluses and abundant reserves. Controls on capital outflows were removed first, while those on capital inflows were retained. The latter were eventually eliminated in the late 1970s after being removed and reimposed periodically. By contrast, France and Italy had experienced capital outflows in the 1970s and early 1980s and did not eliminate controls on such flows until the late 1980s.35

Another notable feature of capital account liberalization has been the differentiation that countries usually made between short-term and other flows. Inward or outward short-term flows were viewed as potentially destabilizing and, therefore, were usually subject to more stringent controls than long-term flows, such as foreign direct and portfolio investment. The removal of controls on short-term capital movements therefore took longer than that on long-term capital. Similarly, when reimposing capital controls, countries normally focused on short-term capital movements. In recent years, however, with the exception of direct investment, the relevance of the differentiation between long- and short-term capital movements has tended to diminish because of the spread of secondary markets and derivative instruments.

A distinction has often been made between the financial transactions affecting capital movements and the underlying real transactions. This distinction applies primarily to foreign direct investment but is often also relevant for other closely related transactions, such as ownership of real estate by nonresidents. Although most countries removed controls on capital-related financial transactions long ago, the deregulation of the underlying transactions has been a relatively drawn-out process, frequently involving difficult multilateral or regional negotiations. Experience with deregulating cross-border controls on underlying transactions has been similar to that with deregulating trade in services, including, for instance, the right of establishment of branches of banks and other financial institutions in host countries.

Reimposition of Capital Controls

In the postwar years, countries faced with difficulties in achieving domestic and external balance have periodically reimposed controls. Among the countries liberalizing at an early date, Germany, Switzerland, and the United States introduced selective capital controls at various times until the end of the 1970s. Some industrial countries also invoked national “derogations” to the OECD Code of Liberalization of Capital Movements in the 1980s.36 More recently, in the aftermath of market disturbances within the exchange rate mechanism (ERM) of the EU, Ireland, Portugal, and Spain temporarily tightened controls on outward short-term capital movements in 1992.

In the face of sustained current account deficits and capital outflows, the United States (1964–73) imposed a “voluntary restraint” on direct investment abroad and an interest rate equalization tax, the latter with a view to maintaining domestic interest rates below foreign rates on comparable financial instruments.37 These measures were lifted in the aftermath of the general floating of currencies in 1973. The latter provided an extra degree of freedom for national monetary policies and thus reduced the need to maintain measures to restrict capital outflows.

Both Germany and Switzerland reintroduced controls on short-term capital inflows in the 1970s to ward off excessive appreciation of the domestic currency and an expansion of monetary aggregates. Germany twice imposed reserve requirements on external liabilities of banks and nonbank financial intermediaries (1971–75 and 1977–81).38 Switzerland (1972–80) maintained a ban on interest payments on nonresident deposits in the country and a penalty rate on any increase in nonresident deposits.

A number of industrial countries also retained derogations to the OECD Code of Liberalization of Capital Movements after 1980 in addition to existing reservations. Such derogations were applied by Denmark (1979–83), Finland (1985–91), Iceland (1961–90), Norway (1984–89), Spain (1982–85), and Sweden (1969–86).39

Three EU countries (Ireland, Portugal, and Spain) reintroduced or reinforced capital outflow controls, albeit for a very short period, in the face of disruptions in the ERM in the second half of 1992.40 Spain had already given up all controls by mid-1992. Faced with a severe currency crisis in September 1992 and with a sharp tendency for the peseta to depreciate out of the band, the authorities reintroduced some measures to stem capital outflows in September-November 1992 in the form of taxes on certain short-term transactions.41 Ireland and Portugal also intensified the controls on capital outflows (September-December 1992), which they were allowed to retain until January 1, 1993.42 The effectiveness of these actions in stemming capital outflows seems likely to have been short lived. All three countries not only lifted all the remaining controls by the agreed EU deadline, but also did not reintroduce them during the subsequent episodes of exchange rate tension within the EU.

Relationship to Domestic Financial Sector Liberalization

In some industrial countries—for instance, Japan, the United Kingdom, and the United States—the liberalization of capital controls preceded the deregulation of domestic financial markets in the context of generally comprehensive systems of prudential supervision.43 The disparity of regulatory treatment between domestic and external activities tended to induce cross-border activity. For instance, the strict regulatory environment on domestic banking operations maintained by the United States after the Second World War in contrast with the liberal environment for external operations contributed significantly to the initial development of the Eurodollar market—a form of activity conceived by domestic banks to circumvent local restrictions. Similarly, the development of specialized offshore banking centers owed much to the arbitrage opportunities offered by the restrictiveness of the domestic regulatory environments in most countries, in comparison with those prevailing in the offshore centers.44 In such cases, somewhat paradoxically, the national authorities either permitted access by domestic banks to the offshore centers or otherwise were unable or unwilling to enforce the existing external controls. The reason for this, as noted by many observers, was that countries that did not allow access by their financial institutions and multinational companies to offshore markets and that were more restrictive in the application of controls were losing ground in the emerging worldwide competition for funds, relative to the countries that had fewer controls or that applied them more liberally.

Deregulation of domestic financial operations was phased in Japan over a long period from the late 1970s onward, displaying a significant lag in relation to the liberalization of external financial transactions, which was completed in 1980. This lag led to some arbitrage opportunities arising from domestic regulation and, in particular, to the strong growth of both short-term capital inflows and outflows. In the United Kingdom, capital controls were abolished rapidly at the outset of a significant wave of reforms initiated in 1979, whereas quantitative controls on the banking system, already circumvented through the offshore market, were not lifted until 1980.

More recent financial liberalizations in industrial countries have tended to avoid issues of sequencing external decontrol measures before reforming the domestic financial markets. For instance, in France the dismantling of capital controls took place with domestic deregulation between 1985 and 1990, thus avoiding the circumvention of domestic restrictions by arbitrage flows through foreign markets. In Spain, a major phase of trade and financial market liberalization began in the context of its accession to the European Community in 1986. The elimination of the remaining controls on interest rates and the development of open market operations were effected in the reform process, whereas key capital controls were retained until later.

IMF Policy Treatment

In recent years, because the process of capital account liberalization in most industrial countries has largely been completed, Article IV consultations have tended to give prominence selectively to this issue. Attention has been given in consultations with countries where such liberalization has had an important bearing on the IMF’s exercise of surveillance over exchange rate policies. During recent consultations with industrial countries, the issue of capital controls received prominence in countries that have only recently fully liberalized capital flows. The Executive Board welcomed the move in these cases, echoing the consensus expressed earlier when other industrial countries liberalized their systems. In 1977, in the case of the United Kingdom, which, along with Italy, was one of the last industrial countries to implement IMF-supported stabilization programs (through stand-by arrangements), the IMF urged a relaxation of controls over capital outflows. In the event, there was initially a modest relaxation of certain exchange controls on capital, and the authorities subsequently decided to progressively remove all capital controls. The IMF welcomed these steps, noting at the time the beneficial effects that they would have on reducing upward pressures on the exchange rate. This general sentiment has also been evident in the IMF’s support of the multilateral initiatives under the OECD code and the EU directives.

See John B. Goodman and Louis W. Pauly, “The Obsolescence of Capital Controls? Economic Management in an Age of Global Markets,” World Politics, Vol. 45 (October 1993), pp. 50–82.

For an overview of the ineffectiveness of capital controls, see Mathieson and Rojas-Suarez, Liberalization of the Capital Account.

The EU directives not only required members to remove controls within the area, but also encouraged their removal with respect to the rest of the world.

See Goodman and Pauly, “The Obsolescence of Capital Controls?”

As noted in Section VII, derogations to the OECD code refer to the introduction of new restrictions on transactions under List A that did not exist before or to the reintroduction of formerly abandoned restrictions. In contrast, “reservations” refer to the continued maintenance of restrictions that existed as of the entry into force of the code and that were not subsequently removed.

For a time (1968–70), the United States also maintained a re-serve requirement on Eurodollar borrowing.

Other measures included restrictions on the sale of money market instruments to nonresidents and authorization requirements for the acquisition of domestic bonds, and subsequently equities, by nonresidents. These measures were circumvented, as direct borrowing offshore was replaced by sales of corporate bonds to nonresidents, and promoted disintermediation. The Bundesbank was therefore faced with having to introduce an ever-widening range of indirect and quantitative controls aimed at closing loopholes in the regulations. Nevertheless, the bank was unable to prevent short-term capital inflows as expectations of exchange rate appreciation grew.

In addition, Turkey, an OECD member not counted by the IMF among the industrial countries, applied derogations (1962–85).

Controls were also considered, but not implemented, in Sweden and Finland in the late 1980s, when capital inflows surged as the authorities attempted to tighten their respective monetary policies to slow overheating economies while at the same time maintaining stable exchange rates. The inflows abated within a few years, however, as economic growth slowed down (a sharp contraction in the case of Finland) and the outlook for the two countries’ currencies deteriorated.

The intent of the Spanish measures was to raise the cost and lower the attractiveness of engaging in particular transactions.

Unlike Spain, these countries relied on enforcing existing controls consisting of quantitative restrictions on some forms of short-term capital transactions.

See C. Maxwell Watson, “Financial Liberalization and the Economic Adjustment Process,” Centro Studi Luca d’Agliano (Italy) and Queen Elizabeth House (University of Oxford), Development Studies Working Papers, No. 61 (April 1993), pp. 1–83.

For a recent overview of experience of offshore financial centers, see Marcel Cassard, “The Role of Offshore Centers in International Financial Intermediation,” IMF Working Paper 94/107 (Washington: International Monetary Fund, September 1994). This paper finds that, over the last decade, the role of off-shore financial centers has been increasingly challenged by the established large financial centers offering considerable economies of scale, as the financial industry experienced massive deregulation, capital and financial controls were dismantled, markets were opened, lax rates were reduced, and international cooperation was improved.

Note: Section IV was prepared by Arto Kovanen, Mark O’Brien, Przemyslaw Gajdeczka, and Kal Wajid. MAE staff prepared case studies on the experiences of selected countries adopting full convertibility, with the year of adoption in brackets: Argentina (1991), Costa Rica (1992), El Salvador (1992), Estonia (1993–94), The Gambia (1992), Guyana (1991), Indonesia (1970), Jamaica (1991), Latvia (1992), Lithuania (1992), Malaysia (1973), Mauritius (1994), Peru (1991), Singapore (1978), Trinidad and Tobago (1993), and Venezuela (1989). The countries were chosen to provide a representative sample across the various regions. PDR staff prepared case studies of IMF policy treatment of capital account liberalization among a group of transition economies that included Albania, Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, and the Slovak Republic.

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