Capital Control in Theory and Practice

Abstract

The global financial crisis of 2008 triggered intense fluctuations in cross-border capital flows, prompting a reevaluation of how to effectively manage such movements for structured global capital flows. This paper addresses the challenges arising from the increased volatility in cross-border capital flows, particularly as China integrates further into the global economy. Existing academic literature lacks comprehensive studies analyzing capital control policies from both theoretical and practical perspectives, while also considering the evolving dynamics of cross-border capital flows and contemporary reflections from scholars.

To fill this gap, our paper systematically reviews the theoretical foundations of implementing capital control policies, the International Monetary Fund’s stance on managing cross-border capital flows, practices of emerging economies in capital account management, various models of capital account openness, and the associated risks, challenges, and policy responses linked to China’s pursuit of capital account liberalization. While recognizing potential drawbacks, such as setbacks to national welfare and the transmission of adverse signals, the literature also acknowledges the instrumental role of capital control policies in maintaining the stability of domestic economic and financial systems and safeguarding the autonomy of domestic monetary policies. Moreover, it emphasizes that capital control policies effectively address the pecuniary externalities and aggregate demand externalities arising from private sector decisions.

Practically, many emerging market economies employ policy tools like capital taxes and unremunerated reserve requirements. During the initial stages of significant public health crises in 2020, some emerging market economies deployed strategies such as local currency-to-US dollar swap contract auctions and reductions in foreign exchange reserve ratios to enhance the liquidity of domestic currencies. Additionally, with the emergence of new characteristics in cross-border capital flows in recent years, the IMF believes that the future efforts in managing cross-border capital flows will primarily focus on three aspects:
① Assessing the necessity of implementing preemptive macroprudential policies;
② Evaluating and categorizing capital controls targeting illegal financial activities;
③ Identifying abnormal capital flows and devising responsive measures.

Despite China’s relatively stringent capital controls, a discernible trend towards relaxation is evident. However, compared to developed countries, China’s current capital flow managements remain incomplete, and various activities evading capital controls persist. As China moves towards widening capital account accessibility, a comprehensive fusion of various capital flow management measures is advocated to mitigate the macroeconomic impacts of capital flow volatilities.

Our paper goes beyond the traditional focus on the “ex-post” effects of capital control policies, emphasizing their “ex-ante” theoretical imperative. It also contributes by extensively reviewing capital account management measures in other emerging market economies and delineating distinctive capital account openness models observed in Japan and Hungary. Consequently, it provides insightful guidance for China’s pursuit of a broader, more inclusive, and deeply ingrained framework for financial openness, facilitating a more tailored and efficient implementation of capital controls to shield against external shocks.