Capital Controls, EMU and the Crisis of the European Monetary System

Table of Content

Introduction

1. What are capital controls?
1.1 Types of capital controls
1.1.1 Controls on capital outflows
1.1.2 Controls on capital inflows
1.2 Arguments for and against the imposition of capital controls

2. How effective are capital controls?

3. Capital controls and the crisis of the EMS
3.1 Conditions for the viability of a pegged exchange rate system
3.2 Causes of the crisis
3.2.1 Inevitable policy shifts
3.2.2 Multiple equilibria and self-fulfilling speculation
3.3 Implications
3.4 Solutions
3.5 The right choice?

Conclusion

References

Introduction

For European monetary affairs, 1992 was a watershed: In January, the European Monetary System (EMS) celebrated five years of stability; by November, it was all but falling apart. Two of its members had been driven from the system, two others had experienced steep and involuntary devaluations. The EMS was undergoing the worst crisis of its existence.

When analysing these events, they inevitably lead to the issue of financial liberalisation. If the argument that the lack of control over international capital flows is at the heart of such crises is true, their costs must be weighed against the benefits of the liberalisation process.

But can the use of capital controls be in any way compatible with the process of European financial integration? Does the idea not go against the entire philosophy embodied in the project of economic and monetary union (EMU)? Some authors argue that not only can capital controls be made compatible with the integration process but that they are in fact the only option available to safeguard any pegged exchange rate system against the excesses of occasionally irrational and overwhelmingly powerful financial markets.^[1]

The resulting question, though merely speculative in retrospect, is thus two-fold: Could capital controls have helped to prevent the 1992-crisis of the EMS and would it therefore have been beneficial to allow for this instrument afterwards, instead of widening the fluctuation bands to 30 per cent? And, resultingly, could capital controls exist within a fixed exchange rate system like the EMS then and the EMSII in the future?

I shall, as preliminaries, first briefly summarise the main arguments of the discussion on the desirability of capital controls. Subsequently, I shall discuss, whether capital controls can actually achieve what they were designed for. In the main section, I shall analyse what causes for the 1992-crisis seem probable, why the post-1992 re-constitution of the system took the form it actually did and whether capital controls could have been relevant in this context or will do so in the future.

1. What are capital controls?

Capital controls are mechanisms or instruments to consciously limit the amount of capital that is flowing in and/or out of a country. Usually administered by governments, they are sometimes seen as protectionism, a way of preventing domestic savings from being invested abroad.^[2] On the other side, capital controls are also employed as a way of dealing with destabilising currency speculation, and this is the context in which they will be important for the issue at hand. Modern analyses of currency markets identify important market failures which lead to occasionally destabilising speculation and justify some form of intervention: asymmetric information giving rise to herd behaviour, and multiple equilibria which make self-fulfilling crises possible. Capital controls are put forward as one way of keeping such speculation in check and retaining room to manoeuvre for national monetary policy by effectively breaking the link between domestic and international interest and inflation rates.

1.1 Types of capital controls

Capital controls can coarsely be grouped according to the kind of capital flows they attempt to regulate: Controls on inflows and controls on outflows.^[3]

1.1.1 Controls on capital outflows

Controls on capital outflows have been advocated as a way of dealing with financial and currency crises. It is useful to further distinguish between two types of outflow controls, preventive and (temporary) curative.

Preventive Controls are imposed when a country has not yet been subject to substantial pressure on its exchange rate but may have been experiencing balance of payments difficulties, so as to make the development of a currency crisis likely. These controls can take a number of forms, the most usual ones being dual exchange rates (with a lower rate for capital account transactions), taxes imposed on outbound transfers and limits on or even outright prohibition of transfers abroad (as in France during part of the 1980s^[4] ). The idea is that these measures will stop the haemorrhage of funds out of the country. Seen from a temporary (and probably the only realistic) point of view, the goal would be to give the authorities time to implement more sustainable policies and to fend off speculators.^[5]

Curative controls are imposed when a country is already facing a currency crisis.^[6] The argument runs much along the same lines as for preventive controls: The outflow of funds is supposed to be stopped in order to buy time to restructure the economy and to prevent the massive crowding out of investment associated with using interest rates as a defensive mechanism. Behind the shield of outflow controls, interest rate differentials can exist for a limited amount of time, pro-growth policies can be put in place and the financial sector be restructured in an orderly fashion. Once the economic fundamentals no longer justify a massive devaluation via speculative attacks, the controls are to be dismantled. Malaysia followed this path after the Asian Crisis in 1998.^[7] The instruments employed by and large correspond to those of preventive controls, only with increased intensity.

1.1.2 Controls on capital inflows

Especially after the collapse of the South East Asian growth economies, there has been increasing support for the imposition of controls on capital inflows rather than outflows.^[8] Most often, these take the form of mandatory non-interest bearing deposits, equivalent to a tax on capital inflows, thereby discouraging short-term speculative investment^[9]. These measures subscribe to a somewhat preventive logic, too; if capital does not come in, it cannot be suddenly withdrawn and plunge the country into a crisis, either. Furthermore, this type of capital controls is also supposed to allow for the pursuit of an independent monetary policy over an extended period of time, allowing for a more stable and growth-oriented economic environment. Some of the countries that have relied on such instruments include Brazil, Malaysia, the Czech Republic and Chile. In particular the latter has attracted considerable attention and has been widely hailed for its remarkable record of growth and stability during much of the 1990s.^[10] The reason for this, it is argued, has been Chile’s ability to discourage destabilising short-term inflows while still attracting long-term productive investment.^[11]

Other types of capital controls include credit ceilings and quotas as well as other domestic measures, as employed by many European countries (e.g. France, Belgium and Italy) until as late as the 1990s. However, these instruments have other goals, such as providing a cheap source of public debt, than the avoidance of cross-border currency crises and will therefore not explicitly be dealt with here.^[12]

1.2 Arguments for and against the imposition of capital controls

The detailed rationale behind the various types of controls can be easily recognised from their descriptions above. All controls are based on the same underlying logic: That markets, including international currency markets, are not perfect and thus need to be subjected to regulation. Market failures and asymmetric information can occasionally lead to destabilising misallocations of capital streams, creating major disruptions in the affected countries.^[13] Also, speculative attacks can, by their sheer size, become self-fulfilling: Since the volume of funds that international capital markets can mobilise dwarfs any reserves central banks could possibly muster in defence of a currency, intervention in such capital flows is justified.

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^[1] B.Eichengreen / C.Wyplosz, The Unstable EMS, CEPR Discussion Paper 817, London, 1993, pp.75

^[2] C.Wyplosz, Financial Restraints and Liberalization in Postwar Europe (preliminary version), Geneva, 1990, pp.16

^[3] S.Edwards, How Effective are Capital Controls?, NBER Working Paper 7413, Cambridge/MA, 2000, pp.6

^[4] Wyplosz, p.10

^[5] Edwards, p.6

^[6] prominently supported by Krugman (1998)

^[7] Edwards, p.8

^[8] B.Eichengreen, Toward a New Financial Architecture: A Practical Post-Asia Agenda, Institute for International Economics, 1999, pp.10

^[9] Edwards, p.11

^[10] M.P.Dooley, A Survey of Academic Literature on Controls over International Capital Transactions, NBER Working Paper 5352, Cambridge/MA, 1995, pp.17

^[11] Edwards, pp.10

^[12] for an extensive overview, see Wyplosz, pp.8

^[13] Edwards, p.25