Capital Controls – It Can Happen To You, ‘Cause It Happened to Me

There’s a famous episode of The Trailer Park Boys where oft maligned rapper/producer/small time dope dealer/knowmsayn enthusiast JRoc unintentionally shares an indecent moment with a few of his pals (bad) and his mother (very bad). Watching the scene is funny, but I’d be lying if I said it didn’t give me a terrible feeling at the same time – can you imagine? There’s just no way I would ever be caught in a compromising situation like that. It’s just not possible – maybe for other people, in other places, but not me.

You sure? How sure?

JRoc issues a warning and reminder later in the episode for those of us with the gusto to claim we’re beyond this – It Can Happen to You, Cause It Happened to Me.

We’d be wise to revisit some of the recent, surprising, instances of capital flow restrictions. The situation then was dire and may yet become dire again – if it’s not dire already, that is.

First, let’s talk about what we mean.

In some situations, governments may (and have) decide to restrict capital flow, either by imposing taxes, tariffs, laws, quotas, bans, or other measures on their citizens, businesses or other economic actors. These restrictions are known as capital controls. As it turns out, citizen of a democratic nation, you only get to vote on mostly irrelevant things – I can assure you that you won’t be given a chance to cast a ballot on whether your capital will be locked down after a period of poor decisions leading to economic catastrophe.

Capital controls can be used for various reasons, such as:

To prevent capital flight, which is the sudden and large-scale withdrawal of money and assets from a country due to economic or political instability.
To protect the domestic currency from depreciation or appreciation, which can affect the competitiveness of exports and imports, as well as the purchasing power of the population.
To maintain monetary policy autonomy, which is the ability of the central bank to set interest rates and control money supply according to the domestic economic conditions, without being influenced by external factors.
To reduce external vulnerability, which is the exposure of the country to shocks and fluctuations in the global financial markets, such as currency crises, debt crises, or contagion effects.

However, capital controls also have costs and drawbacks, obviously, though it doesn’t seem to make any difference when the alternative is failure or loss of dominance:

Distorting market signals and incentives, which can lead to inefficiency, misallocation, and rent-seeking behaviors in the financial sector and the real economy.
Reducing financial development and integration, which can limit the access to foreign capital, technology, and innovation, as well as the diversification of risks and opportunities.
Eroding credibility and confidence, which can damage the reputation and trust of the country among investors, creditors, and trading partners, as well as the public and private sectors.

Clearly these things should never be used – they completely destroy faith in markets, faith in governments and – of course – faith in currencies. But, here we are, so let’s review a few examples to make sure we don’t repeat them, yeah?

There are four examples we should discuss – and by discuss, I mean that I dug up with search/GPT and added my own commentary to.

Thailand (1997)

Thailand was one of the countries hit by the Asian financial crisis in 1997-98, which was triggered by the collapse of the Thai baht and the subsequent contagion to other emerging markets in the region. The crisis exposed the weaknesses and vulnerabilities of the Thai economy, such as:

A large current account deficit, which reflected the excess of imports over exports, as well as the reliance on short-term and speculative foreign capital inflows to finance the gap.
A fixed exchange rate regime, which pegged the baht to the US dollar, and prevented the currency from adjusting to the changing market conditions and external shocks.
A weak and fragile financial system, which suffered from excessive lending, poor regulation, and high exposure to foreign currency risk, as many loans and debts were denominated in US dollars, while the assets and incomes were in baht.

As the crisis unfolded, Thailand faced a severe balance of payments crisis, as the foreign reserves dwindled and the capital outflow intensified. To restore confidence and stability, the Thai government adopted a series of measures, including:

Abandoning the fixed exchange rate regime and allowing the baht to float freely in the market, which resulted in a sharp depreciation of the currency, from 25 baht per US dollar in June 1997 to 56 baht per US dollar in January 1998.
Seeking external assistance from the International Monetary Fund (IMF), which provided a $17.2 billion bailout package, conditional on the implementation of a strict and comprehensive economic reform program, involving fiscal austerity, monetary tightening, financial restructuring, and structural adjustment.
Imposing capital outflow controls, which aimed to stem the capital flight and stabilize the exchange rate. The controls included:
- A 10 percent withholding tax on interest payments on foreign loans and bonds issued by Thai residents.
- A 15 percent reserve requirement on non-resident baht accounts, which were used by foreign investors to speculate on the baht.
- A prohibition on commercial banks from engaging in offshore baht transactions, which were also used for currency speculation.
- A limit on the amount of foreign currency that residents could purchase or hold without documentation.

The capital outflow controls were effective in reducing the pressure on the baht and the foreign reserves, as well as in discouraging short-term and speculative capital flows. However, they also had negative side effects, such as:

Increasing the cost and reducing the availability of foreign financing for Thai businesses and households, which hampered their ability to service their debts and meet their obligations.
Creating distortions and segmentation in the foreign exchange market, which resulted in different exchange rates for different types of transactions and agents, as well as arbitrage and evasion opportunities.
Reducing the attractiveness and competitiveness of Thailand as an investment destination, which affected the long-term growth and development prospects of the country.

The capital outflow controls were gradually relaxed and removed as the economic situation improved and the confidence was restored. By 2001, most of the controls were lifted, and Thailand resumed its integration with the global financial system.

Malaysia (1998)

Malaysia was another country affected by the Asian financial crisis in 1997-98, which also originated from the devaluation of the Thai baht and the subsequent contagion to other emerging markets in the region. The crisis revealed the vulnerabilities and challenges of the Malaysian economy, such as:

A large current account deficit, which reflected the excess of imports over exports, as well as the dependence on volatile and reversible foreign capital inflows to finance the gap.
A fixed exchange rate regime, which pegged the ringgit to a basket of currencies, mainly the US dollar, and prevented the currency from adjusting to the changing market conditions and external shocks.
A weak and fragile financial system, which suffered from excessive lending, poor regulation, and high exposure to foreign currency risk, as many loans and debts were denominated in foreign currencies, while the assets and incomes were in ringgit.

As the crisis unfolded, Malaysia faced a severe balance of payments crisis, as the foreign reserves dwindled and the capital outflow intensified. To restore confidence and stability, the Malaysian government adopted a series of measures, including:

Abandoning the fixed exchange rate regime and allowing the ringgit to float freely in the market, which resulted in a sharp depreciation of the currency, from 2.5 ringgit per US dollar in June 1997 to 4.9 ringgit per US dollar in January 1998.
Rejecting external assistance from the IMF, which offered a $3.9 billion bailout package, conditional on the implementation of a similar economic reform program as in Thailand, involving fiscal austerity, monetary tightening, financial restructuring, and structural adjustment.
Imposing capital outflow controls, which aimed to stem the capital flight and stabilize the exchange rate. The controls included:
- A 12-month lock-in period for portfolio investments by non-residents, which required them to keep their funds in Malaysia for at least one year before repatriating them.
- A ban on offshore ringgit transactions, which prohibited non-residents from trading or holding ringgit outside Malaysia.
- A limit on the amount of foreign currency that residents could purchase or hold without documentation.

The capital outflow controls were effective in reducing the pressure on the ringgit and the foreign reserves, as well as in isolating the Malaysian economy from the volatility and turbulence of the global financial markets. However, they also had negative side effects, such as:

Increasing the cost and reducing the availability of foreign financing for Malaysian businesses and households, which hampered their ability to service their debts and meet their obligations.
Creating distortions and segmentation in the foreign exchange market, which resulted in different exchange rates for different types of transactions and agents, as well as arbitrage and evasion opportunities.
Reducing the attractiveness and competitiveness of Malaysia as an investment destination, which affected the long-term growth and development prospects of the country.

The capital outflow controls were gradually relaxed and removed as the economic situation improved and the confidence was restored. By 2005, most of the controls were lifted, and Malaysia resumed its integration with the global financial system.

Iceland (2008)

Iceland was one of the countries hit by the global financial crisis in 2008-09, which was triggered by the collapse of the US subprime mortgage market and the subsequent contagion to other advanced and emerging markets. The crisis exposed the weaknesses and vulnerabilities of the Icelandic economy, such as:

A large current account deficit, which reflected the excess of imports over exports, as well as the reliance on massive and unsustainable foreign capital inflows to finance the gap.
A flexible exchange rate regime, which allowed the krona to appreciate rapidly and significantly, fueled by the carry trade, which involved borrowing in low-interest rate currencies and investing in high-interest rate currencies, such as the krona.
A large and overleveraged financial system, which expanded rapidly and aggressively, both domestically and internationally, taking on excessive risks and liabilities, far exceeding the size and capacity of the Icelandic economy.

As the crisis unfolded, Iceland faced a severe banking crisis, as the three largest banks, which accounted for more than 80 percent of the financial system, collapsed and were taken over by the government. The banking crisis led to a balance of payments crisis, as the foreign reserves dwindled and the capital outflow intensified. To restore confidence and stability, the Icelandic government adopted a series of measures, including:

Seeking external assistance from the IMF, which provided a $2.1 billion bailout package, conditional on the implementation of a comprehensive economic reform program, involving fiscal consolidation, monetary stabilization, financial restructuring, and structural adjustment.
Imposing capital outflow controls, which aimed to stem the capital flight and stabilize the exchange rate. The controls included:
- A comprehensive and complex set of rules and regulations, covering all types of capital transactions, such as direct investment, portfolio investment, trade credit, loans, deposits, derivatives, and transfers.
- A requirement for all residents and non-residents to convert their foreign currency holdings into krona, and to keep them in domestic accounts, subject to approval and supervision by the central bank.
- A prohibition on the purchase or transfer of foreign currency or foreign assets, except for essential imports, debt service, or humanitarian purposes, subject to approval and supervision by the central bank.

The capital outflow controls were effective in reducing the pressure on the krona and the foreign reserves, as well as in shielding the Icelandic economy from the volatility and turbulence of the global financial markets. However, they also had negative side effects, such as:

Increasing the cost and reducing the availability of foreign financing for Icelandic businesses and households, which hampered their ability to service their debts and meet their obligations.
Creating distortions and segmentation in the foreign exchange market, which resulted in different exchange rates for different types of transactions and agents, as well as arbitrage and evasion opportunities.
Reducing the attractiveness and competitiveness of Iceland as an investment destination, which affected the long-term growth and development prospects of the country.

The capital outflow controls were gradually relaxed and removed as the economic situation improved and the confidence was restored. By 2017, most of the controls were lifted, and Iceland resumed its integration with the global financial system.

China (2015-2016)

China has historically maintained a high degree of capital account regulation, with various restrictions and controls on cross-border capital flows, especially on outflows. However, in recent years, China has also pursued a gradual and selective liberalization of its capital account, as part of its broader economic reform and internationalization agenda.

In 2015-2016, China faced a surge of capital outflows, driven by several factors, such as:

The slowdown and rebalancing of the Chinese economy, which reduced the attractiveness and profitability of domestic investment opportunities.
The depreciation and devaluation of the Chinese currency, the renminbi (RMB), which increased the incentives and expectations for further currency weakening.
The uncertainty and volatility of the global financial markets, which heightened the demand for safe-haven assets and diversification.

According to the Institute of International Finance, China experienced capital outflows of over $670 billion in 2015. This put downward pressure on the RMB exchange rate and depleted China’s foreign exchange reserves, which fell by $513 billion in 2015

In response, the Chinese authorities implemented a series of measures to tighten and enforce the existing capital controls, as well as to introduce new ones, with the aim of stemming the capital flight and stabilizing the exchange rate. Some of these measures included:

Increasing the scrutiny and approval requirements for outbound foreign direct investment (FDI), portfolio investment, loans, transfers, and other capital transactions by residents and non-residents.
Imposing quotas and limits on foreign exchange purchases and conversions by individuals and firms, as well as on cross-border cash transactions and transfers.
Enhancing the monitoring and regulation of capital flows through the Shanghai Free Trade Zone (FTZ) accounts, which were initially designed to facilitate capital account liberalization.
Intervening in the foreign exchange market and using other policy tools, such as interest rate policy, macroprudential policy, and communication policy, to support the RMB exchange rate.

The capital controls were effective in reducing the magnitude and volatility of capital outflows and in restoring some confidence in the RMB exchange rate. However, they also had some negative consequences, such as:

Increasing the cost and reducing the availability of foreign financing for Chinese businesses and households, which affected their ability to service their debts and meet their obligations.
Creating distortions and inefficiencies in the allocation of resources and in the functioning of the financial system.
Reducing the attractiveness and competitiveness of China as an investment destination and as a global financial center.
Undermining China’s credibility and commitment to further capital account liberalization and RMB internationalization.

The capital controls were gradually relaxed and removed as the economic situation improved and the pressure on the RMB eased. By 2018, most of the controls were lifted or eased, and China resumed its integration with the global financial system.

So What?

Take a look at these examples – some of them, one might expect. Economic crises only happen in emerging markets, you might say – if you invest in a country where warlords are riding around with gold machine guns, then you deserve to have your capital frozen. Fine.

What about Iceland? The Iceland world rankings (whatever that means, fine, fair, but still) Wikipedia page doesn’t exactly look like a place that would rug you with capital controls. Being forced to convert your foreign reserves and accounts to the local currency? Forced to go down with the ship?! That would have been quite a rude surprise, and one that could easily be repeated in an age where information about failing currencies, deficits and more have become daily occurrences, damn near commonplace dinner table chatter at this point.

China, of course, has a history of extreme (relatively speaking) capital and broader economic controls – this wouldn’t normally be an issue either though, as we’ve seen, the issue isn’t necessarily one of domestic policy, but one of contagion stemming from that policy. Stock trading halted, extreme currency protection measures, stimulus bazookas and more can lead to instability via economic repercussions that would spread quickly in today’s world.

Bitcoin is the solution for this, among other, problems like sudden, drastic capital controls. Ignore the attempts to sway you and your assets back into a system that will betray you in a heartbeat as a means to ensure the status quo (or something resembling it) remains even as the corpse of its once integral legitimacy rots and decays.