The Costs of International Capital Controls

These widespread effects of capital controls suggest that even though they may yield limited benefits in certain circumstances, they also have substantial and often unexpected economic costs.

During much of the 1990s it was widely accepted that countries would achieve greater economic growth if they relaxed their "capital controls," a reference to various laws and regulations that restrict foreign investments in such areas as stock markets, banks and domestic firms. Then, in the late 1990s, the Asian financial crisis hit. And, it seemed that the countries that suffered the most were the ones whose laws recently had been changed to make it easier for foreign investors to move money into and out of their markets. In the aftermath of the crisis, conventional wisdom shifted to embrace a view that maybe some types of capital controls were not so bad after all.

NBER Research Associate Kristin Forbes argues, however, that a closer look reveals that capital controls have significant economic costs. She believes policymakers have become increasingly reluctant to criticize controls because they previously lacked clear evidence of their detrimental effects. In The Microeconomic Evidence on Capital Controls: No Free Lunch (NBER Working Paper No. 11372), Forbes reinvigorates the argument in favor of financial liberalization by drawing on an abundance of microeconomic analysis showing the many ways in which inhibiting the cross-border flow of money damages domestic economies.

Forbes said the problem with previous efforts to justify the lifting of capital controls is that they looked for evidence of large effects on the entire country -- a "macroeconomic" approach -- rather than looking at a variety of "individual experiences and specific effects" or a "microeconomic approach." So, instead of focusing on how capital controls affect entire economies, such as in their growth rates, Forbes looked for evidence of more discrete impacts, such as on certain types of companies or groups of investors.

What she found was a host of economic studies demonstrating the many ways that capital controls can weaken economies and how lifting them leads to substantial improvements. Forbes observes that, among other things, restricting foreign investment increases financing costs by reducing the amount of capital available to domestic firms. Controls also prompt corporations to engage in a variety of market-distorting behaviors designed to minimize the costs of the controls or to evade them altogether. In addition, capital controls encourage inefficiency by insulating markets from competition. And, they can be difficult and costly to enforce, even in countries with strong government institutions.

"These widespread effects of capital controls suggest that even though they may yield limited benefits in certain circumstances, they also have substantial and often unexpected economic costs," Forbes concludes. "Capital controls are no free lunch."

In fact, Forbes found that if there is a downside to lifting the restrictions, it may be attributable to the perverse effect of the controls themselves. Liberalization can make life more difficult for companies that enjoyed preferential treatment under the old protectionist schemes or for companies that already had found various ways to evade the controls.

But liberalization appears to be a clear win for small companies. For example, Forbes points to a study finding that when publicly listed domestic firms become eligible for foreign ownership, their stock prices improve dramatically. She also cites evidence that lifting capital controls makes it much easier for small firms to get the investment they need to expand their operations. "This impact of capital controls on small firms can be particularly important for some emerging markets in which small and new firms are often important sources of job creation and economic growth," she writes.

Studies looking at the effect of capital controls in particular countries and at the company level also support the idea that they are bad for business. For example, capital controls enacted in Chile in the 1990s, often cited as protecting the country from the jarring impacts of globalization, had a considerable downside. Forbes points out that when capital controls were in place in Chile, smaller firms paid a steep price as the evidence indicates that "investment growth" flowing to small companies "plummeted."

Capital controls also tend to skew corporate behavior in ways that ultimately stymie investment. One study found that as U.S.-based multinational firms try to avoid being penalized by capital controls, the net effect of such behavior is to shrink investments in foreign markets by 13 to 16 percent. Meanwhile, in Russia, capital controls have prompted domestic firms to embrace a variety of evasive tactics, such as creating fictitious enterprises and import contracts to disguise transactions, which, Forbes notes, have "increased corruption and lowered economic efficiency."

Forbes acknowledges that since this paper focuses "on individual experiences and/or specific effects of capital controls," it's fair to question whether her analysis can be the basis of a generalized argument in favor of financial market liberalization. But she considers the cumulative weight of the evidence to "present a series of convincing results on the effect of capital controls and the benefits from capital account liberalizations.

-- Matthew Davis