Capital Controls Use - Literature review Example

Capital Controls Use

Introduction

In the recent years, capital controls are subject to numerous debates, while some agree that they limit them from realizing economic efficiency and progress while others consider them prudent, as they allow economies to incorporate security measures. For many of the largest economies, they usually have liberal policies that govern capital controls after eliminating strict rules that governed them in the past. However, the same economies have basic makeshift measures, which they utilize to prevent them from witnessing numerous capital outflows whenever they witness a crisis or in the event of speculative currency assault (Prati, Schindler, & Valenzuela, 2011). When considering the emerging market economies, for instance, they encounter numerous challenges, which comprise of economic fluctuations, which result from large foreign investments, thus posing challenges in fostering effective monetary policies. As such, some countries are considering implementing safeguards through capital controls to allow them to remain stable in their operations. Thus, the paper discusses whether capital controls should be utilized particularly during a time when globalization and liberalization of financial sectors have dominated the world through evaluating its pros and cons in diverse sectors.

Discussion

Economic Background

Global forces, including globalization and financial markets integration, have played a major role in influencing the overall capital controls easing. When countries open up their economies to welcome the flow of foreign capital, they make it possible for companies to gain easier capital access, thereby leading to an overall rise in the demand for local products and services (Bill, 2016). Furthermore, a widespread belief exists that financial deregulation would create room for the allocation of resources in a more efficient manner, thus leading to the faster economic growth process. Capital liberalization is also considered as creating for enhancement of growth while supporting efficient global financial resources allocation. However, after, the past financial crisis that affected the world between 2007 and 2008, questions arise as to whether it is appropriate to impose capital controls despite the benefits their elimination have brought toward a liberalized and globalized global economy (Economist, 2015).

As the worldwide economy is emerging from the financial crisis, capital appears to be flowing to EMEs (emerging market economies). The flows of capital and the prevailing mobility allow nations limited savings for attracting financing constructive investment projects. However, they appear to be supporting investment risk diversification, boost inter-temporal trade, and improve the financial markets development (Edwards, 2013). In this perspective, the advantages associated with free capital flow across borders seem similar to those associated with free trade. As such, the foisting of capital controls would result to foregoing of some of the benefits, based on the distortions as well as the misallocation of resources, which the controls support (Flowers & Gallagher, 2011).

Capital Controls and Emerging Economies

Without considering the benefits affiliated with capital controls, a considerable number of EMEs are showing concerns mostly because of the recent capital inflows surge, which they anticipate might be problematic for their nations. Most of the flows are considered temporary, revealing differentials in interest rates, which may be reversed in a particle manner in case the interest rates of policies among developed nations return normal. Against the backdrop associated with capital controls, the discussions concerning their efficiency are running the news again (Durden, 2016). A concern has arose that massive capital inflows may result to overshooting of the exchange rate, or lead to strong appreciations, which may complicate the management of the economies. They are also anticipated to result to inflate the bubbles of the asset prices, which may intensify the fragility of the financial market as well as risks of crisis (Neely, 2015). More clearly, when considering the influences of the crisis, notable policymakers appear to reconsidering the notion that unregulated flows of capital reflect a situation whereby all financial flows might result from rational borrowing, investing, or lending decisions. Concerns that it is possible for foreign investors to be subject to hard behavior as well as suffer from extreme optimism have broadened, and even in the case where flows seem to be significantly sound. It is understood that they might result in collateral damage results to asset busts and booms as well as bubbles (Economist, 2015).

Need for Implementing Capital Controls

Without capital controls, countries, particularly the emerging economies, encounter challenges with respect to safeguarding their capital. Here, their major goal is to focus on smoothing their procyclicality during the short term. In the case of emerging markets, their capital flow is usually procyclical, meaning that they usually receive too much in the event of good economic conditions, whereas they can contribute to exchange rate appreciation and asset bubbles, or even volatility in the exchange rate. A country can also support capital controls in case it shows notable concern toward its banks’ balance sheets, such as in the event of maturity mismatches or currency mismatches. Here, capital controls would assist in addressing the issues before they get out of hand (Flowers & Gallagher, 2011).

A nation can also consider imposing regulations on its capital account to allow it realize an independent monetary policy. Today’s world is considered as globalized fairy in financial terms, indicating that limited restrictions exist compared to the past global financial endeavors (Durden, 2016). Considering capital accounts in different parts of the world, things such as carry trade might make it possible for the monetary policy to work contrary to what was originally expected. For instance, in the present environment, the U.S. monetary policy is relatively loose, an indication that the country will witness a lock in its interest rates for the coming few years (Bill, 2016). A country such as Brazil has also imposed such regulations. The interest rates within the country as high at approximately 12%, meaning that is profitable to undertake trade activities whereby hedge funds, as well as other investors, might look at the U.S. low interest and Brazil rates, hence borrow dollars and convert them to reach Brazilian funds. Therefore, it would be possible to realize profits depending on the ways the interests are spread, as well as depending on the ways the hedge are set up in relative to the ways the two currencies move. Here, the monetary policy mismatch builds up (Flowers & Gallagher, 2011). Globally, notable real short-term incentives exist for capital flow to the emerging markets, such as the prevailing 8.5 exchange rate in India. In this case, capital regulations can assist a country by offering it the capacity to adopt an independent monetary policy. For example, in case a country is getting all the inflows, it might witness bubbles, raising concern for its inflation or real estate market. In this sense, the ideal thing to embark on revolves around raising the rate of interest to facilitate in cooling the economy. Nevertheless, by raising the interest rates, capital flows would stop coming in (Neely, 2015).

Capital Controls Concerns

Considering a period before the financial crisis, during an era that was characterized by global capital liberalizations, imposing capital controls was considered unwise. The concept has changed in the cent years as countries have devised various ways of thinking concerning the controls. Traditionally, however, three major concerns prevailed regarding capital controls (Economist, 2015). During the 1990s, for instance, theoretical economists were concerned about an open account’s optimality, while focusing on freeing capital in the same manner a country would consider freeing its current account or even its trade. Notable momentum also prevailed concerning the notion that the need for changing the International Monetary Fund or the agreement articles by the IMF to facilitate in covering the capital account. Presently, the IMF requires the availability of free goods and services flow via the current account as well as the profits and investments realized after that. However, countries are currently open, especially after the forging of Bretton Woods, which required capital accounts and flows restrictions (Flowers & Gallagher, 2011). However, during the 1990s, the move was subject to numerous questions when classical economics started rising as well as the emergence of the new classical microeconomics. Significant theoretical research needed to be undertaken to reveal that countries would remain optimal by having open accounts. Traditionally, the countries had low savings, while having an open account would provide an avenue for allowing funds flow from well-off countries to nations that needed savings, thus allow them to accumulate for development purposes (Prati, Schindler, & Valenzuela, 2011). A considerable number of countries tried the move, although no correlation prevailed between open capital accounts and growth of economies. This led to the emergence of the financial crises that took place during the 1990s as well as the late 1990s, which started with Asia before spreading to Latin America and other countries. Thus, the need for changing the way of thinking concerning open accounts initiated during the 1990s (Neely, 2015).

Another major concern revolving around capital controls revolves around the “beggar-thy-neighbor” notion. Here, in case capital controls are utilized to serve as a tool for sustaining exchange rates relatively low, then the effect would be spillover influences to the neighbors (Neely, 2015). The last concern in this case capital controls would not work in the past while they were not effective as wells. Recently, however, all that has changed particularly with the prevalence of notable econometric evidence. While looking at research carried out by National Bureau of Economic Research, the institution has significant literature review, which reveals that indeed, the countries that apply capital controls manage to change their flows composition toward long-term debts, minimize volatility of the exchange rate as well as gain an independent monetary policy (Economist, 2015). This has received the support of recent econometric initiatives carried out by the International Monetary Fund, which has revealed that the countries that utilize capital controls served as among the least hit during the recent financial crisis (Durden, 2016). As such, the IMF is focusing on recommending that certain countries should use certain controls in the current economic environment since the speed of recovery is high, as well as the gap in interest rates that causes massive developing countries inflows (Flowers & Gallagher, 2011).

Conclusion

Concerning the issue of capital controls, it is apparent that their elimination has played a vital role in the liberalization and globalization of the global economy. This is apparently the case in the case of emerging economies have realized an influx of capital. These have played a vital role in growing their economies while raising the demand for certain products and services. Nevertheless, in the case of the developing economies, it is appropriate to consider implementing certain levels of capital controls, particularly in terms of permitting them to gain increased freedom with regard to monetary policy in the event crises facing balance of payments. Therefore, given the present state of the global economy, even though the elimination of capital controls supports liberalization and globalization efforts, they should be adopted in limited degrees in developing countries to safeguard them from the autonomy exercised by developed economies.