The 1980s and 1990s: Capital Account Liberalization and the Demise of Capital Controls

Capital controls have been part and parcel of the macroeconomic toolkit of developed countries throughout their history. For example, Gosh and Qureshi (2016) show that restrictions on the import and export of currency into and out of England had existed as early as the Middle Ages. Even during the late nineteenth century, often considered the golden era of financial globalization, the leading capital exporters of the day (Britain, France, and Germany) at times restricted issuances on their markets (albeit mainly for political rather than for economic reasons). Probably the most prominent episode of capital controls in the modern history of developed countries, however, has been the Bretton Woods system. After a period of instability and financial crises in the interwar period, often accompanied by ad hoc unilateral exchange controls (mostly on outflows), trade restrictions and competitive devaluations, the new postWorld War II system of fixed exchange rates was supported by extensive and institutionalized regulations on the movement of international capital. For the key architects of the Bretton Woods System, John Maynard Keynes and Harry Dexter White, it was clear from the interwar experience that a system of free trade and free capital account convertibility could not be combined. Moreover, they saw that open capital accounts were incompatible with autonomous economic policies directed towards domestic demand in combination with fixed exchange rates (Gosh and Qureshi 2016; Helleiner 1994). Interestingly, at that time most restrictions were imposed on outflows rather than inflows (Dierckx 2011).

Capital controls in the developed world started to be dismantled as early in the 1950s and 1960s, a process which gathered pace in the 1970s. By the 1980s, most capital controls in the developed world had disappeared. It was arguably the tolerance and rise of the Eurodollar market which started to undermine the use of capital controls through providing a completely unregulated repository for the dollar at a time when rates in New York were still limited by New Deal regulations (Panitch and Gindin 2009). During the 1960s managers, investors, and speculators creatively began to find their way around the myriad regulations designed to constrain their practices. Moreover, the 1970s, and to an even greater extent the 1980s, saw an ideological shift towards reduced government intervention in the economy more generally, which included the use of measures on the free movement of capital. Abdelal (2007) argues that it was in particular the European countries, led by the French, who supported a further removal of the restrictions on international capital movements. French socialists, catering to their middle-class electorate, felt that “capital controls did not work to prevent the rich and well connected from spiriting their funds out of the country, but that they worked all too well to lock up the bank accounts of their working and middle-class constituents and voters” (p. 4).

As Gosh and Qureshi (2006) point out, the experience of DECs runs slightly counter to those in developed countries, at least until the 1980s. Whereas there were hardly any restrictions on international capital movements during the Gold Standard and Bretton Woods era, in the late 1960s and early 1970s large parts of the developing world introduced restrictions on international capital movement in order to support domestic industrialization strategies. Capital flows to DECs during the Gold Standard era were largely dominated by long-term capital inflows, mostly foreign direct investment (and some lending to domestic sovereigns). Although some boom-and-bust dynamics could be observed, the main conflict and implications were over the conditions on labour and existing socioeconomic structures. As a result, capital accounts in these countries remained relatively open all the way during the Bretton Woods era (Gosh and Qureshi 2016).

In Latin America this changed with the military coup in Brazil in 1965 and the subsequent adoption of an import-substituting industrialization strategy. The model was emulated broadly by other countries in the region and beyond as their own political climate changed. For example, in South Asia countries also experimented with inward-looking policy frameworks in the late 1950s and 1960s and became significantly financially closed. East Asia, which had traditionally been less financially open, further tightened their capital account restrictions in the 1960s and 1970s as they pursued development through active government intervention (Gosh and Qureshi 2016). As Gosh and Qureshi (op. cit.) show, these restrictions in DECs were also mostly outflow controls. It was only in the early 1970s that some form of prudential measures on capital inflows emerged.[1]

As early as the 1970s, these national development models slowly came to an end. In the mid-1970s three Southern cone countries, Argentina, Chile and Uruguay, rapidly liberalized their capital account (French-Davis and Griffith-Jones 2011) . Concurrently, DECs experienced their first wave of private international capital flows as petrodollars were recycled though the international banking system. These flows were mostly in the form of syndicated dollar-denominated bank loans and were directed towards national sovereigns. This first wave of more short-term capital flows ended in the external debt crisis of the 1980s. Rising interest rates in developed countries meant that many DEC governments found themselves unable to service their debt service payments. The external debt crisis started with the Mexican default in 1982 and soon engulfed a wide range of countries, including Brazil, Argentina, Venezuela and the Philippines. The experiment of Southern countries collapsed in the early 1980s after speculative bubbles, appreciated exchange rates, current account deficits, credit booms, low domestic savings and huge external debts (Diaz-Alejandro 1985; Ffrench-Davis and Griffith-Jones 2011).

The aftermath and the resolution of the international debt crisis also laid the foundation for further capital account liberalization, which gathered pace in the early 1990s with the rise of the Washington Consensus.[2]

Under the auspices of the IMF and the World Bank and guided by the Washington Consensus, the early 1990s saw a widespread move to financial deregulation, financial liberalization and the more general withdrawal of the state from the economy. The theoretical underpinnings and potential benefits of these liberalization measures were rooted in the beneficial effects of capital account liberalization set out in Sect. 7.2 and the extensive literature on ‘finance and development’, pioneered by the work of McKinnon (1973) and Shaw (1973).[3] [4] As a result, DECs experienced their second boom in private, short-term capital flows. These flows were still dominated by international bank lending, but portfolio flows to alternative domestic asset markets, such as equities and domestic bonds, and short-term time deposits steadily increased. As Ffrench-Davis and Griffith-Jones (2011) point out, these changes in international capital flows were, in principle, considered as beneficial because they involved a greater diversification and reduced flows with variable interest rates, which had contributed to catastrophically to the external debt crisis. At the same time, faced with a more liberal financial environment, domestic financial agents started to participate more actively in financial markets.

In practice, though, rather than increasing resources for investment and allowing for consumption smoothing, financial liberalization led to increased volatility and instability in DECs. High and persistent interest rates attracted yield-seeking capital flows and increased financing costs for investment. Domestic economic conditions became increasingly dependent on international financial markets. Rather than acting stabilizing, the diversification into different types of capital flows concentrated on highly reversible forms (Ffrench-Davis and Griffith-Jones 2011). Moreover, international capital flows and increased financial openness created domestic vulnerabilities, which ultimately led to the severe financial crises of the late 1990s and early 2000s. First, strong capi?tal inflows and domestic demand contributed to appreciating exchange rates, resulting in rising current account deficits and even higher needs to import foreign capital. Second, financial openness increased domestic agents’ articulation into (international) financial markets, rendering them vulnerable to changes in financial market conditions. As capital flows reversed following the onset of the financial crises, vulnerabilities in the balance sheets of domestic economic agents led to widespread default, severe contractions in demand, growth and employment.

However, not all countries had liberalized their capital accounts uncompromisingly during this time. Several countries maintained some, others even extensive restrictions on international capital movements during this decade. For example, in 1991 the central bank of Chile introduced a 20 percent unremunerated reserve requirement (URR) on foreign borrowing, regulatory requirements on corporate foreign borrowing, and extensive reporting requirements for banks’ capital transactions. In a similar vein, beginning in September 1993, the central bank of Colombia required that non-interest-bearing reserves of 47 percent be held for one year against foreign loans with maturities of 18 months or less. Moreover, foreigners were simply precluded from purchasing debt instruments and corporate equity. At the same time, China and India maintained widespread and comprehensive restrictions on international capital movements (Epstein et al. 2003). Epstein et al. (2003) show that these controls were largely successful in reducing these countries’ currency, foreign investor and fragility risk. Moreover, measures in Chile and Colombia were successful in changing the maturity structure of flows and reducing the vulnerability to the Asian crisis.

Probably the most famous example of outflow controls at that time was Malaysia. In 1998 the country had introduced a comprehensive and well-designed package to reduce exchange outflows and ringgit speculation in the wake of the Asian crisis. Measures imposed included a system of graduated exit levies, with different rules for capital already in the country and for capital brought in after that date. The controls were successful in segmenting financial markets, providing breathing space for macroeconomic policy and a speedier recovery than would have been possible via the orthodox IMF route (Epstein et al. 2003; Kaplan and Rodrik 2001).

Despite these successes, Epstein et al. (2003), however, also show that many of these capital account regulations were dismantled in the wake or aftermath of the Asian financial crisis. Indeed, despite the devastating effects of free capital account convertibility in the 1990s, the 2000s heralded another wave of short-term, private capital flows, again larger than anything seen before.

  • [1] For example, Brazil introduced safeguards against the excessive use of foreign credits by commercial and investment banks by limiting the foreign obligations that each bank could assume (Goshand Qureshi 2016).
  • [2] Painceira (2011) and Kaltenbrunner and Karacimen (2016) show that the (failed) debt restructuring of the Brady Plan was an important catalyst for further capital account liberalization and finan-
  • [3] cialization in DECs. That occurred through creating tradable securities, making DECs dependenton future capital flows to service their debt payments, and increasing the role of internationalfinancial institutions in the economy.
  • [4] According to this literature, financial repression, that is state involvement in financial markets,hinders economic development through maintaining artificially low interest rates, creating an inefficient allocation of resources, and hampering productivity growth through insufficient competition. Creating space for private financial markets, in turn, should work against these forces andsupport sustainable economic growth.
 
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