Essay Example. A Critical Evaluation of The Rationale for The Regulation of Financial Services

Capital controls are measures taken by regulatory bodies, central banks, or governments to limit the flow of foreign capital into and out of the domestic capital account. These controls are tighter in economies that are deemed to be more susceptible to volatility, particularly those whose capital reserves are low. Financial recessions also constrict the capacity of domestic economies and call for the implementation of capital controls, as was the case after the 2007 global financial crisis (Ghosh 2016). Capital controls are intended to ease the procyclicality of debt inflows and outflows within volatile markets within the short term. Ghosh notes that, following the 2007 financial crisis, Brazil introduced a six percent tax on all foreign currency converted into short-term debt. Capital controls help countries to counter exchange rate volatility, and realize independent monetary policy but undermine individuals' freedom to move their money as they wish.

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Arguments for Capital Control

Small economies, particularly developing nations, respond better to long-term debt and direct investment than short-term debts and portfolio investment (Forbes et al. 2016). The proper use of inflow controls permits the use of the most appropriate approaches. Short-term indebtedness poses a danger to developing economies, as was evident in Thailand, South Korea, and the Philippines. The three Asian countries experienced the danger of excessive short-term inflows first hand in the 1990s (Prates and Fritz 2016). It is noteworthy that financial crises can be predicted from the ratio of short-term debts to foreign currency reserves. International financial flow is, by default, designed to transfer capital from high-saving economies to low-saving economies. This structure implies that such a transfer would flow from poorer countries to developed ones. However, capital controls allow capital inflow into developing countries in the most appropriate currency. In this regard, capital controls are vital measures for such economies during financial crises.

Capital account regulations allow economies to establish independent monetary policies. The current globalized financial environment eliminates most of the traditional financial restrictions. Such openness reflects in the manner that capital accounts are coordinated across economies. The resulting environment has the potential of making textbook monetary policies counterproductive. Loose monetary policies affect countries with low-interest rates and favor those with higher interest rates.

Following the 2007 financial crisis, the high-interest rates in Brazil acted as a pull factor (Prates and Fritz 2016). The country could easily borrow dollars, convert them into local currency, and invest in its domestic economy. Such controls, therefore, allow a country to set up a hedge on the relative movement of currencies and profit from its leverage factor. Developing the right controls allow developing countries to incentivize their short-term capital flows, such as by raising their interest rates.

Four types of capital controls help developing countries to maintain stability during financial crises. The first, minimum stay requirements, establish lock-in periods for their capital investments. These financial windows permit the free flow of capital in and out of their economies. Controls allow countries to invest and profit from such flows when periods are created between inflows and outflows.

The second type of control is limitations. Limiting the amount of money that a single entity can remit out of the economy helps the economy to maintain some level of performance even during financial crises. Placing caps on asset sales by classifying some as strategic allows an economy to maintain sovereignty and freedom from control from external entities. In Canada, for instance, agricultural investments are considered strategic and restricted. Placing limits on currency trading also helps to maintain currency pegs even during financial crises. Maintaining fixed foreign exchange rates helps to maintain the competitiveness of the economy.

While capital control does not translate to the growth of an economy, they help to realize stability. Capital inflow restrictions prevent external funds from entering the economy and so prevent an untrustworthy investor from disrupting the conditions of the economy. This approach allows investors who help to pursue the long-term potential of the economy to invest with such restrictions. The resulting equilibrium helps the country to maintain a favorable environment that can allow easy recovery after a financial recession.

Restricting capital inflows also helps to prevent outflows since money that enters the economy is held longer, preventing downside and upside constraints. Capital controls prevent an economy from overheating, meaning that investors cannot recklessly pump and dump capital into the economy without any long-term expectations. If such restrictions are not created, investors can easily pump capital into the economy, excite prices and output, then withdraw. Such actions would result in a crash.

There are at least three notable beneficiary countries of capital control. China’s implementation of capital controls is credited for its economic growth (Gan 2019). The country established capital control measures throughout the three decades that it experiences exponential growth in its economic fortunes. At the time that the economy opened for the global factors, it was sufficiently stable and robust. Another country that has benefited from capital control is Malaysia. The Asian country employed capital controls to overcome the economic crisis of the late 1990s (Prates and Fritz 2016). Compared to Vietnam and Thailand, Malaysia’s decision to restrict capital outflows allowed it to hold more capital internally and to deal with the financial situation. India has also been a beneficiary of capital controls. Its use of capital controls allowed the successful revival of the economy into a strong one.

Argument Against Capital Control

Despite the advantages of capital control, there are also several arguments against its implementation. The first such argument is that capital markets go against the spirit of free markets that support globalization. According to free-market economists, when countries establish capital controls, they prevent the flow of capital to environments where they are deemed most profitable. Consequently, domestic investors are forced to rely on a lower rate of return gains on their investments. They thus end up with lower incomes than would be the case under free markets. It is important, therefore, that markets allow free movement of capital so that it becomes easier for investors to predict and invest in the most profitable markets. This argument is pursued in the belief that economies are globalized and should always be outward-looking and not entirely inward-looking.

Foreign direct investment is critical for the sustenance of developing economies. However, capital controls restrict the free movement of capital, which would allow substantial foreign direct investment to flow into such economies. With the minimal foreign direct investment, developing countries are unable to accelerate their rates of economic growth in a manner that would allow them to catch up with more established economies. As has been indicated by China, opening the economy for capital inflow and outflow allows the economy to grow substantially (Gan 2019). Besides slowed economic growth, capital controls also create an environment that enables the evasion of such controls, which makes them counterproductive.

One of the challenges that countries face while implementing capital controls is that the resulting environment becomes predictable and easy to penetrate. Markets devise complex means that enable them to overcome capital controls. This challenge is particularly aided by improved technology. New technologies currently allow internet payments that allow investors to bypass government restrictions. For instance, at the time that Brazil imposed capital control restrictions after the 2007 financial crisis, it was unable to exhaustively map out the extent of such restrictions on the movement of currency (Prates and Fritz 2016). Even when capital restrictions are successful at sealing all the loopholes, they are capable of scaring investors from an economy. For instance, Partes and Fitz also not that, following the 1980s financial debacle, most Latin American economies imposed capital controls. However, these measures were counterproductive because they deterred foreign investors. The markets became unattractive as investors could not predict the long-term impact of the restrictions.

Capital controls create a conflict in the sense that they intrude on the right of individuals to control their spending. The government transfers its austerity measures to personal finance. The resulting environment requires that such restrictions are transferred to individuals. When the UK imposed capital restrictions in the 1960s, it had to limit tourist spending to only 50 pounds (Alfaro, Chari, and Kanczuk 2017).

Whereas these restrictions were easier to impose then, the gains made towards globalization may not allow their reintroduction. Similar approaches have been witnessed in China. However, in the case of China, it is not a democracy, and there is extended state control. Capital controls aim to ensure that financial crises do not affect the livelihoods of citizens. However, when the restrictions designed to disrupt the normal operations of the country and do not allow citizens to make personal decisions about their money, it denies it the key element of support and trust.

Conclusion

Arguments for capital control outweigh those against it, but a middle ground is needed to ensure the success of restrictions. It is noteworthy that capital controls are well-intentions, designed to ensure that a country does not suffer a collapse of its economy during a financial crisis. Capital controls help an economy to maintain stability during financial strains and allows the country time to evaluate the best approach to its recovery. A country does not need to have divided attention during a financial situation. The control allows it to audit the financial trails and to determine how best it can benefit from the situation.

When a country restricts capital inflows, it is able to prevent outflows since money that enters the economy is held longer, preventing downside and upside constraints. Capital controls prevent an economy from overheating, meaning that investors cannot recklessly pump and dump capital into the economy without any long-term expectations. If such restrictions are not created, investors can easily pump capital into the economy, excite prices and output, then withdraw. Such actions would result in a crash.

Sometimes interest rate increase is important for allowing stability. Some other times, it is important that capital outflows are prevented, or exchange rates are sustained. Nonetheless, a country must remain cognizant of the fact that capital controls can be counterproductive. While a country might have the best intentions for establishing regulatory controls, there might be individuals that focus on bypassing the controls. A country must ensure that all stakeholders are involved so that there is a shared understanding of the decision to put controls on the economy. Also, a country must only use such measures for short-term cushioning.