In previous writings, this author presented several articles focused on the balance-of-payments’ position over a period of time, central bank net foreign assets, and the relationship with exchange rate stability. To these ends, it was posited that, with weaker exports, rising imports and in turn a widening balance-of-payments’ deficit, coupled with a depleting position of the net foreign assets of the central bank, pressure will be placed on exchange rates; and that would have implications for the strength and stability of the domestic currency being pegged against the United States dollar.
Today’s article therefore explores the theoretical and empirical construct of capital controls as a mechanism to foster macroeconomic stability.
Capital controls are regulations that restrict or prohibit the movement of capital across national borders. The regulatory measures are designed to govern the capital account of a country’s balance-of-payments, and therefore include restrictions on the movement of capital into or out of a country. Capital controls can regulate a wide range of cross-border transactions carried out by non-residents and residents in a country. These transactions may include money transfers, direct investment, portfolio investment, bank loans, and other financial assets.
For example, a tax applicable only on non-residents’ investments in domestic bonds or equities is a capital control. Similarly, caps on foreign equity investments in specific sectors (such as banking and defence), or limits on overseas investments by residents, are classified as capital controls because these measures regulate the inflow and outflow of capital in a country.
The findings of recent research suggest that foreign exchange (FX) policy management has been a central motive for policy-makers to use capital controls. Countries with high levels of capital controls and countries actively raising existing controls are those that tend to have undervalued exchange rates and high degrees of exchange rate volatility.
Moreover, the choice of capital flow restrictions is closely linked to countries’ choices about the exchange rate regime and the monetary policy regime. To this end, empirical evidence has shown that countries with a high level of capital flow restrictions tend to be those with fixed exchange rates and those with regimes other than inflation targeting (IT). Moreover, countries with fixed exchange rates and non-IT regimes have been much more likely to raise capital controls over the past decade.
Further, research has found no systematic evidence of a link between capital controls and a high volume or volatility of capital flows per se. There is also no compelling evidence that policy decisions about capital controls are related to a high degree of financial market stress or volatility.
It would appear that choices about capital flow restrictions, particularly over the past decade, have been rather motivated by concerns about an overheating of the domestic economy in the form of high credit growth, inflation, and output volatility.
Altogether, evidence suggests that both an FX policy objective and concerns about domestic overheating have been the key motives for capital flow management policies over the past decade. Thus capital controls have not merely been associated with preventing an overvaluation or appreciation of the domestic currency, but rather with a significant undervaluation of the exchange rate.
Moreover, the evidence indicates that capital controls may frequently be used to compensate for the absence of autonomous and independent monetary policy.
Countries that have shallow financial markets, like Guyana, have little ability to use monetary policy to deal with domestic overheating pressures. Hence even relatively modest capital inflows or volatility inflows pose serious challenges to domestic policy-makers, and may induce them to use capital flow restrictions.
The caveat of this article puts forward a provocative proposition of such risks to the Guyanese economy against the backdrop of the oil wealth to come. That is, the risk of overheating. Overheating simply means an economy that is growing at a rate that is unsustainable, wherein there is excessive spending. This can fuel hyperinflation, especially since contesting politicians are strongly considering initiatives such as cash transfers.
