By Shuyang Li

Capital controls lay under some of the largest economic stories of the recession, painted by many as key indicators of the magnitude of the economic mires the global economy suffered. Recently Iceland, Ukraine, and Cyprus have reportedly considered lifting capital controls, a sign of confidence in their markets. The start of the European Debt Crisis was followed by a swift governmental reaction from within the European Union. This, in many cases, included capital controls. These regulations sound highly restrictive and carry an ominous feeling with them, but they can vary widely in form and degree of severity.

The concept of capital controls was introduced in the early twentieth century, after large-scale globalization, when international trade became less dominated by a few world powers, such as Denmark, Britain, and Spain had in earlier centuries. Capital controls revolve around the need for a stable national capital account and limit foreign investment.

During a crisis, foreign investors concerned for the value of their investments may seek to pull their money out of a country, reducing the value of the country’s capital account. Mass divestments from a nation not only destabilize the country’s capital account but also can provoke internal destabilization through runs on national banks and panic selling.

Because of its broad purpose, capital controls must cover a variety of different ways that investors move money. Indirect trades include taxes and tariffs on trade. To protect against bank runs, countries can impose regulations limiting withdrawals of funds from within the country. To stabilize national currencies, countries can limit travelers carrying currency outside as well as the amount of currency one can exchange.

The risk of a bank run was precisely why Cyprus became the first nation in the European Union to impose capital controls. In 2012, Cypriot banks reeled as their large exposure to Greek debt rapidly resulted in bond downgrading and a lack of funding for governmental operations.

Investors and citizens grew antsy as Cyprus closed its banks, only allowing them to open for limited hours every few weeks. Expecting a bank run when the banks reopened again, Cyprus imposed controls in March of 2013, limiting account holders to withdrawing 300 euros in cash daily and requiring bank transfers of amounts greater than five thousand euros to be approved by the central bank. Finally, travelers were only permitted to take three thousand euros or less with them outside of the country.

While opponents point to capital controls limiting capital access for domestic companies, the Cypriot government is confident that these particular set of controls calmed the business environment on the island. No panic selling occurred and bank runs were not observed for the duration of the capital controls, which were slowly eased until April of 2015, when the last foreign capital transfer controls were lifted.

Capital controls have also been active in Ukraine for over a year. In this case, the disturbance was not entirely due to the European Financial Crisis. Instead, riots in Kiev and a pro-Russian insurgency in Crimea both contributed to investor unease. Much like the Cypriot government, the Ukrainian government heavily limited foreign exchanges and transfers. The primary focus was on the foreign currency exchange, since the primary impact from the unrest was the devaluation of the Ukrainian Hryvnia, down 48% in the past year.

The impact of the capital controls on Ukraine is harder to measure than in Cyprus. The unrest continues in the south, and investors remain antsy. The Ukrainian government expects these capital controls to work, and may consider releasing controls by June if all goes well.

Another prominent source for capital controls in the past decade has been Iceland. Before the 2008 Icelandic Financial crisis, the major Icelandic banks engaged in rapid expansion using short-term financing. As their volatility grew along with the global financial crisis, investors grew wary of the island. While companies that took advantage of Icelandic registration had invested considerable amounts in the country, their investments became unpalatable as the Icelandic krona fell.

Once again to prevent panic selling and bolster the value of the krona, Iceland instituted capital controls focusing on foreign exchange – namely, initially barring all foreign currency exchange. In comparison to Cyprus and Ukraine, Iceland has had its performance dramatically improve since instituting capital controls measured by the IMF. In March of 2013, the IMF declared that Iceland has rebounded from 2008.

Indeed, Iceland is on track to lift all capital controls, with a brief exit tax on all currency leaving the country – a stability tax to ensure a smooth transition.

Supporters of capital controls argue that they are an essential tool for countries to preserve currency and economic stability through taxes, tariffs, and limiting regulations. They point to the recovery of states such as Iceland, Ukraine, and Cyprus as evidence of capital controls’ success.

Meanwhile, opponents suggest that capital controls did not contribute to those nations’ recoveries, but in fact hindered them. They contend that capital controls are overzealous regulation that counteract natural market forces that tend to stabilize the economy. Furthermore, they argue that capital controls, by limiting foreign investment, unfairly penalize domestic businesses.

The debate continues, but capital controls are here to stay, and will continue to be the first tools explored by countries in times of financial crisis.

Written by thefinancier

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