Global capital flows come with flaws

by Michael Collins, Investment Commentator at Fidelity International

September 2016

In 1968, Prime Minister John Gorton, fearful that looser controls on capital in Europe and the US would lead to foreign takeovers of Australian companies, told the then state-based stock exchanges to force their listed companies to restrict voting rights to locally based shareholders.[1] Such was the blanket distrust of foreign capital in that era.

Within little more than a decade, though, the mentality had changed. Authorities in many countries eased controls on money crossing their borders at a time when technology, enhanced communications, the freeing of exchange rates and greater information flows gave capital more ability and motive to swish around the world. Thus was born the phenomenon of global capital flows, an essential ingredient in the mix of free-market policies that became orthodox thinking from the early 1980s. The values of these swirls of money are estimated to have ballooned from about 2% of global GDP in 1980 to a peak of 20% of the world’s output in 2007.[2]

Global capital flows, which essentially amount to global trade in financial and physical assets, can take the form of bank deposits, bank loans, investment in projects (so-called direct investment) or the trading of securities such as equities or bonds (commonly known as portfolio flows). In the absence of policy missteps, these flows can do much good as they head into countries. Foreign funds, however, come with two flaws. The first is that they can cause problems, sometimes political, if they gush, rather than trickle, in. The other, usually bigger, problem is that foreign capital can vanish suddenly – in far greater magnitude than suggested by any change in a country’s economic fundamentals – and cause havoc on the way out. Authorities in vulnerable countries have but one option to steady their economies against mobile global capital; overturn 30 years of financial liberalisation by reinstating capital controls. More countries are taking this option, another sign that globalisation has peaked.

To be sure, global capital flows come with many benefits. They, for instance, boost productivity by bankrolling productive projects at lower rates than otherwise. They smooth consumption by financing the purchase of imports. They help financial sectors develop. They subject policymakers to the scrutiny of global investors, typically a tough audience, and thus limit populist tendencies. At a global level, the free flow of money prompts a better allocation of capital around the world and helps smooth adjustments between countries. But in a post-financial-crisis world these benefits are now balanced with mounting evidence that capital flows come with costs. Expect more restrictions.

Emerging woes

Greater constraints on global capital movements may be no bad thing as the free-market thinking of recent decades overhyped the benefits of foreign inflows. All too often, even a rush of foreign money is followed by upheavals. The list of crises includes Latin America in 1982, Scandinavia in 1991, Mexico in 1994-95, east Asia in 1997-98, the US in 2007-08 and Europe since 2008.

Foreign money comes with drawbacks, especially if a country’s financial sector is too backward to cope with surges. Excessive amounts of foreign capital can lead to booms in domestic demand and asset bubbles, and thus inflation or current-account deficits, if authorities keep interest rates lower than warranted and banks go on lending binges. This is what happened in Australia in the mid-1980s when the entry of foreign banks drove takeover sprees that often ended in tatters. As well as adding to inflationary pressures, capital inflows can boost currencies far beyond their true worth and make exports uncompetitive. They strengthen the link between the fate of emerging economies and monetary policies in the rich world. A country can end up having too many short-term foreign liabilities if it attracts too much hot money.

Many countries, especially emerging ones, are learning these lessons now. Emerging countries attracted massive inflows in recent years – estimated at up to US$8 trillion (A$11 billion) – when interest rates fell close to zero in developed countries. Too much of this came in the form of portfolio flows, which is the most capricious type of foreign investment. Thus restrictions on inflows are justified.

Excessive foreign inflows can often set up the capital flight that is an even bigger woe for the countries involved. A vicious cycle can often develop when capital flees, even if the cause is more panic-driven than justified by fundamentals, as Argentina, Brazil, Chile, India, Indonesia, Russia, South Africa, Turkey and Ukraine have experienced recently. (Greece’s capital outflows are locals sending money out; it’s a bank run.) These emerging countries are suffering capital outflows as their political and economic challenges mount at the same time that the Federal Reserve is raising US interest rates, even if slowly.

When capital departed, these countries saw their currencies tumble and raised interest rates to stop higher import prices fanning inflation. While that might entice some foreign capital to stay, higher rates crush economies and the darkening outlook prompts more capital flight.

The cycle essentially means that emerging countries with loose capital controls have lost influence over their monetary policies. The cycle is so hard to break that policymakers have resorted to border controls, the ultimate weapon governments have to combat international financiers. These curbs can be implicit or coercive. They can be more designed to manage, rather than stop, inflows. They can take many forms. Volume limits, reserve requirements, taxes and fees, foreign-exchange controls and trade restrictions are just some of the constraints governments can impose on capital outflows (including from its citizens).

Ukraine, for instance, in 2014 capped how much foreign currency a person can buy for non-trade purposes, banned the purchase of foreign securities, forbade early debt repayments and imposed a waiting period on selling the hryvnia. The same year, Russia apparently installed supervisors at the currency desks of top state banks to prevent a collapse in the rouble while ordering state-owned exporters to sell forex reserves, steps that are softer ways to control capital.[3] In 2013, India, which has never relaxed capital flows to any extent, slashed the amount of money people could whisk out of the country when the rupee plunged. In 2012, Cyprus effectively ended the European monetary union when it imposed capital controls at the height of the banking crisis – after all, what is a monetary union if money can’t move around freely? Brazil imposed charges on foreign purchases of stocks and bonds in 2009 to stifle inflows and stop the real rising. Argentina, Indonesia, Korea, the Philippines and Thailand are others to strengthen capital controls in recent years though Argentine President Mauricio Macri removed most currency controls on taking office in December last year, prompting a 27% one-day plunge in the peso.[4]

Developed countries, too, have acted to hinder, even freeze, the flow of capital. In 2008, Iceland slapped controls on removing kronurs when its banking sector collapsed, to be the first industrialised country to freeze money movements since Spain did likewise in 1992 during the European exchange-rate crisis. Recent moves to restrict Chinese investment in real estate by Australia, Hong Kong and Singapore are nothing more than targeted controls on foreign capital. These are usually shining examples of populist politics; that is, governments wanting to show they are acting to stop house prices soaring or to placate xenophobes. Only in August, a mix of populism and national-security concerns prompted Canberra to block foreign companies from buying a majority stake in NSW-state-owned power network Ausgrid. Any break-up of the eurozone would no doubt trigger Cyprus-like moves across Europe to stop capital flight.

The test

Countries impose controls in capital outflow because they can relieve a crisis. In 1997 when the Asia crisis erupted, Malaysia became an advertisement for how resorting to capital controls can stem disaster when its restrictions steadied its economy as the more open-border-minded Indonesia, Korea and Thailand called in the IMF for help. Kuala Lumpur avoided this fate when it imposed vast restrictions on capital flows, fixed its exchange rate, cut interest rates and tried to reflate its economy, almost the opposite of what the IMF prescribed at the time for its wards.

These moves to restrict capital upset free-market apologists. But even some of the most ardent fans of anything-goes capitalism concede global capital flows are too mobile and can too easily swamp countries, especially in the absence of any global co-ordination on monetary policy. In a surprise U-turn, the IMF in 2012 ditched decades of calling for the unhindered movement of capital across frontiers. The IMF said it is prepared to advise troubled countries to impose capital controls when their economies are crippled by outflows and authorities have few other policy options. “In certain circumstances, capital flow management measures can be useful,” the body said.[5] “They should not, however, substitute for warranted macroeconomic adjustment.”

Therein lies the great challenge for countries that impose capital controls as short-term solutions to emergencies. While they grant more control over monetary policy, take pressure off currencies and can improve the mix of inflows, capital restrictions are rarely installed as part of a package of reforms designed to win back the confidence of foreign investors. They prove hard to remove once installed, even if economies recover. Malaysia took 14 years to remove its controls of 1997. Iceland is yet to fully abolish its capital controls of 2008 even if it is inching that way. In August, the Iceland government loosened restrictions on household foreign investment and on inbound direct investment.[6]    

Global investors will keep directing capital flows where risk and returns demand but they might soon face greater hurdles. The whipsaw nature of these flows will most likely prompt more countries to opt for stability over the discredited free-market ideology, especially in the emerging sphere. After all, China has spawned three decades of the world’s most astonishing industrialisation while snubbing portfolio flows and foreign lending. Beijing stuck to just welcoming direct investment.

While the reappearance of capital controls will arguably slow global growth to some extent – though the evidence is clouded that countries with open capital accounts build stronger economies – investors can take heart that capital is still much freer to travel than it was in the 1960s.

Financial information comes from Bloomberg unless stated otherwise.

[1] The Australian Financial Review. Editorial. “Spooked by foreign ownership in the ‘60s”. 14 February 2014.

[2] International Monetary Fund. Paper issued 14 November 2012. The liberalisation and management of capital flows: An Institutional View. Box 1. Capital flows: Trends and composition. Page 9.

[3] Reuters. “Informal capital controls arrest Russian rouble’s slide.” 23 December 2014.

[4] Bloomberg News. “Argentina looks to lift final currency controls in coming months.” 28 April 2016.

[5] IMF news article. Capital flows. “IMF survey: IMF adopts institutional view on capital flows.” 3 December 2012.

[6] Bloomberg News. “Iceland takes ‘large step’ in exciting capital control regime.” 17 August 2016.