From the late 1960s, Austria, the Federal Republic of Germany, and Switzerland were faced with excessive capital inflows. This led these three countries to impose stringent controls on capital imports in the early 1970s as the inflows continued. The type of control they set varied according to the magnitude and nature of the financial inflows—which partly resulted from the different exchange rate policies in these countries.
This evaluation of their experience focuses on the purposes of capital controls and on whether they could be effectively implemented. Capital controls are generally used as a substitute for one of three alternative measures: revaluing a pegged exchange rate or freeing it to float upward; easing domestic credit conditions; or neutralizing the domestic monetary impact of a balance of payments surplus. Both the purposes and the effectiveness of capital controls must be assessed in terms of the macroeconomic policy of the particular country and of the general economic conditions in the rest of the world at that time.
Until early 1973, capital controls in these three countries were intended to enable the authorities to pursue an independent monetary policy (that is, a restrictive policy in relation to the rest of the world) under fixed exchange rates in a world environment that had become increasingly inflationary. But there are certain theoretical impediments to achieving this independence through capital controls. Under fixed exchange rates, the degree of price stability in any country (unless it dominates the world economy) is determined not only by domestic monetary conditions but also by variations in external prices, insofar as these are directly transmitted from one economy to another.
|Germany, Fed. Rep. of|
|or deficit (-)||-3.06||5.99||4.68||4.92||9.89||-0.73||-0.90|
|or deficit (-)||0.04||0.18||0.35||0.35||-0.20||0.32||1.18|
|or deficit (-)||1.11||1.52||2.78||3.16||5.86||2.09||5.73|
Autonomous price developments abroad can significantly influence the domestic demand for money. If this demand exceeds the supply provided by the domestic monetary authorities, additional funds are imported from abroad. If capital flows are restricted, these funds will tend to be imported through current account surpluses, as Germany and Switzerland clearly illustrated, because a restrictive monetary policy increases exports and discourages imports through its effect on prices. The direct impact of foreign prices and the effects of international reserve flows both tend to ensure that domestic prices eventually adjust to the world price level, as long as fixed exchange rates are maintained. A restrictive monetary policy along with capital controls may, therefore, prove insufficient to achieve a substantially different rate of price change from that in the rest of the world.
The effect of a restrictive monetary policy under the fixed rates prevalent during the 1960s was the stimulation of money inflows. Central bank purchases of foreign exchange added to the domestic monetary base. Had the central banks not purchased the incoming foreign funds, the exchange rate would have appreciated. Because all three countries wanted both to limit the upward movement of their currencies and to avoid relaxation of domestic credit, they turned to capital controls as an alternative to exchange rate appreciation. The question at issue, therefore, was the effectiveness of these capital controls in limiting both the inflow of foreign funds and the exchange rate appreciation.
Federal Republic of Germany
The Federal Republic of Germany first introduced discriminatory minimum reserve requirements against the growth (and subsequently against the level) of banks’ liabilities to nonresidents in mid-1970. The purpose was to reduce capital inflows caused by the relatively higher degree of monetary restraint in the German economy than abroad. From May 1971 onward, the authorities also required prior authorization for the sale to nonresidents of money market paper and for the sale of domestic fixed-interest securities if it was agreed that these would be repurchased at a specific date (known as en pension transactions for money market investment). In March 1972, these measures were supplemented by requirements for a cash deposit for nonbank borrowing abroad. The requirement of prior authorization was gradually extended to cover all kinds of securities (including shares) in an effort to close loopholes that were widely used for evading the regulations. In early 1973, administrative restrictions were placed on such activities as borrowing by nonbank residents from nonresidents; certain types of direct investment from abroad; the sale of claims to nonresidents; and the sale by banks to nonresidents of their portfolio holdings of deutsche mark bonds of foreign issuers. These measures were complemented by the restriction of approvals for the payment of interest on bank deposits of nonresidents.
Switzerland felt compelled to resort to relatively severe and comprehensive controls in mid-1971—well after the Federal Republic of Germany had taken significant measures. The controls were designed to counteract increased exchange instability and to reduce the magnitude of speculative short-term capital inflows (large in relation to total financial flows) brought about by a wide variety of factors. When the complexity and severity of capital controls had almost reached their peak in early 1973, and again in early 1975, a negative interest rate was imposed on foreign-held Swiss franc deposits (instead of merely an approval requirement for interest payments as in Germany). Other measures were also more severe in Switzerland. Not only were higher discriminatory minimum reserves than those in Germany set on the growth and the level of nonresident bank liabilities but banks also had to balance daily their position in foreign currency. Borrowing abroad by nonbank residents was made subject to prior authorization in Switzerland, while in Germany it had been discouraged by a cash deposit. Nonresidents were prohibited, rather than restricted, from buying property. Toward the end of 1974, the supervision over the banks’ foreign exchange transactions was tightened considerably.
In March 1973, it was decided to let the exchange rate for the Swiss franc float independently of the concerted floating of some other European currencies. This was largely due to fears that joining the European “snake” would lead to further speculative capital inflows that would be detrimental to Switzerland’s economic stabilization efforts. Despite the floating of the Swiss franc, capital controls were maintained to forestall its appreciation (which would have impaired the competitiveness of the export sector), and to prevent large exchange rate fluctuations.
The severity and the comprehensiveness of these Swiss measures was in part to protect the domestic economy against liquidity which the authorities deemed excessive. These measures were also aimed at preventing the international intermediary function of the Swiss capital market from having adverse effects on Switzerland’s exchange rate. A number of regulations (absent in Germany and Austria) were specifically aimed at preventing this. The prohibition on the investment of foreign funds in fixed-interest securities denominated in Swiss francs (in effect between June 1972 and February 1974) was also applied to securities issued by nonresidents. This action was probably taken because there was a large volume of such securities in circulation, which would have offered a ready channel for capital imports.
All capital exports subject to licensing were to be converted immediately into foreign currency at the Swiss National Bank to counteract the liquidity and exchange rate effects of capital imports. A minimum quota was instituted for the allocation to residents of new bond and note issues of nonresidents denominated in Swiss francs. This was intended both to check the expansion of Swiss franc denominated debt instruments and to stimulate net capital exports. These measures were quite successful in raising capital exports. Once controls against capital inflows had been introduced, however, the Swiss authorities also found it necessary to regulate more tightly new foreign issues of bonds and notes on the domestic capital market, in order to avoid an excessive increase in interest rates that would have interfered with domestic economic activity and undermined the controls on capital imports.
Inward and outward capital flows before 1971 were subject to a higher degree of control in Austria than in the Federal Republic of Germany and Switzerland. In the earlier phase of large capital flows in 1971 and 1972, when these flows were perceived as interfering with domestic economic policy goals, Austria mainly relied on gentlemen’s agreements with domestic banks to reduce or to offset capital inflows. These agreements covered principally: the lodging of interest-free deposits with the National Bank against the growth in banks’ liabilities to nonresidents; the abstention of banks from increasing domestic liquidity and from calling in their foreign loans prior to maturity; and the setting of quantitative limits on net sales to nonresidents of domestic fixed-interest securities denominated in schillings. Approval by the National Bank was also needed before Free Schilling Accounts (convertible nonresident accounts) could be credited with schilling proceeds arising from sales of freely convertible foreign currencies (unless the conversion was used to make a current payment to a resident). In November 1972, the liberalization of certain inward capital movements was formally suspended, and the individual approval of the National Bank was required for many types of capital inflows and transactions that could lead to capital inflows. In resorting to this strong measure, Austria went beyond the selective measures applied up to that time by Germany and Switzerland.
Thus, during the early 1970s, both Switzerland and Austria built up capital controls by introducing a number of regulations simultaneously, while Germany applied selective measures. Of the three countries, only Austria possessed at the outset a comprehensive exchange control system that allowed wide latitude for the administrative adaptation of rules and regulations. Despite these differences, a clear trend in the three countries between 1970 and the end of 1973 is discernible, going from yield-affecting or cost- affecting controls of increasing restrictiveness to quantitative and administrative measures. Furthermore, controls were quickly extended to include long-term assets, as it became apparent how readily the market was able to substitute these for short-term assets to avoid restrictions. All three countries abstained from introducing a dual foreign exchange market and from introducing special exchange rates for individual types of transactions. They also abstained from blocking nonresident funds, or threatening to do so.
In late 1973, following the depreciation of the deutsche mark vis-à-vis the U. S. dollar in the wake of the “energy crisis,” the Federal Republic of Germany almost completely abolished the capital controls that had been in force. However, it also established new regulations that were not truly capital controls. These were aimed principally at the supervision of banks’ foreign exchange transactions in line with actions taken by a number of other industrial countries after the failure of the Herstatt bank. However, despite the floating of the European “snake” currencies the authorities chose not to liberalize capital movements completely—mainly because of the fixed exchange rates between the deutsche mark and a number of European snake currencies.
Austria maintained virtually all of the substantial restrictions on capital inflows introduced in 1971 and 1972 until the end of 1975. Following the worldwide recession in 1975 and the large-scale borrowing abroad since 1974 by the public sector, Austria essentially went back, on January 1, 1976, to the situation that had prevailed before the introduction of its stabilization program in November 1972.
Switzerland, after having dismantled most controls in 1974, deemed it necessary to re-establish some of them. These included the prohibition on the payment of interest on Swiss franc deposits and the setting of a “negative interest rate” on such funds. These measures were the result of the renewal of speculative capital inflows that began in late 1974. In addition, the Swiss National Bank tightened its supervision of banks’ foreign exchange transactions and of private placements of notes denominated in Swiss francs, notably those placed on behalf of foreign borrowers.
Chart 1.Comparison of rates of domestic credit expansion, 1969-75
Source: IMF, International Financial Statistics. In most years, the rates of domestic credit expansion differed relatively little in Austria, the Federal Republic of Germany, and Switzerland. Therefore, an average of the rates of credit expansion in the three countries was taken.
In 1976, Switzerland continued its effort to prevent volatile and disruptive inflows of short-term capital. Further limitations were placed on interest payments on nonresidents’ savings deposits denominated in Swiss francs; forward exchange regulations were tightened to reduce speculative transactions in Swiss francs, and substantially enlarged reporting requirements were introduced in respect of banks’ foreign assets and liabilities positions, both spot and forward. The sale of domestic and foreign Swiss franc securities to nonresidents has remained unrestricted since early 1974 in order to forestall an excessive rise of interest rates, which would dampen domestic economic activity and might lead to renewed pressure on the exchange rate.
Circumvention of controls
The empirical evidence derived from the study shows that controls were substantially less effective in reducing overall capital imports than they were intended to be, although they did succeed in restraining individual types of capital flows. Despite the imposition of increasingly severe controls, the Federal Republic of Germany experienced strong capital account and overall balance of payments surpluses between 1970 and 1973. The surplus in Austria’s capital account fell sharply only after the liberalization of most types of inward capital flows was suspended in late 1972. (The surpluses in subsequent years were due to official borrowing intended to stem the recession of the mid-1970s.) The complex capital controls operated by Switzerland appear to have been unable to prevent overall capital inflows or exchange rate movements that the authorities considered undesirable. This suggests quite persuasively that capital controls were circumvented to a considerable extent.
As Germany chose to apply selective controls, its experience is a good illustration of how capital flows can evade control measures. The principal ways in which Germany’s discriminatory reserve requirements were circumvented were: (1) by nonbanks borrowing directly abroad; (2) by banks and nonbanks selling securities; (3) by banks transferring loan business to their foreign branches which were not subject to minimum reserve requirements; and (4) by changes in the terms of payment. When a cash deposit requirement on foreign borrowings was introduced, sales of domestic and foreign fixed-interest securities rose sharply in response. After the purchase by nonresidents of domestic fixed interest securities was subjected to prior approval, capital imports continued, albeit at a much lower rate, through sales of foreign fixed-interest securities and domestic shares, and through the liquidation of external assets.
Chart 2Exchange rates, 1969-75
Source: IMF, International Financial Statistics.
When prior authorization was required before nonresidents could acquire from residents any type of domestic security, before residents could contract loans and other credits, and before certain inward direct investment could take place, capital imports were diverted to new channels. These included the acquisition by nonresidents of claims on residents (this method was subsequently subjected to prior authorization); the obtaining of commercial credits that were exempt from the cash deposit and authorization requirements; the recall of loans and advances to nonresidents; adjustments in the terms of payment and financial operations of non-bank enterprises; and some abuse of the regulations (“nonresident quotas”) concerning foreign portfolio investment.
Only partial success
The experience of these countries seems to support the conclusion that controls (short of a dual exchange market, which has its own limitations) intended to contain undesirable capital inflows will not be fully effective, especially in an environment of threatening, or actual, strong exchange rate fluctuations. This is so, even if partial success is achieved in limiting certain individual types of transactions. Exchange rates were fluctuating widely over the entire period of 1971-76. However, in the light of the theoretical considerations set out above and of the experience with controls on capital flows induced by interest rates, it could be said that capital controls would not have been fully effective even without large exchange rate fluctuations.
This study shows that, once such controls have been introduced, they inevitably become progressively tighter and more numerous, and eventually have to be extended to cover current transactions. Controls were set on the terms of payment in all three countries, although they do not appear to have restricted payments and transfers for current transactions. Evasion of controls is impossible to prevent, since one asset can be substituted for another so readily. In many important instances, the effective reduction of one type of capital flow was offset by increases in others. Moreover, even where, under fixed exchange rates, the controls are effective in restraining the expansion of domestic liquidity, they tend to stimulate both further inflows and exports, which then lead to money imports through balance of payments surpluses.
Similarly, where the controls are effective under floating rates in restraining the appreciation of the domestic currency, they tend to strengthen the current account and to enhance expectations of exchange rate appreciation. If restrictive monetary policy maintains a demand for money that exceeds the domestic money supply, the consequence will be either an inflow of reserves or an appreciation of the exchange rate. It is, therefore, not surprising that capital controls were unable to prevent exchange rate adjustment in the three countries discussed when they maintained anti-inflationary policies in the early 1970s. The floating of currencies since early 1973 did not lead to the immediate abolition of capital controls, since the three countries concerned did not want their currencies to float freely, but did want to use controls to reduce the resulting need for intervention. The Federal Republic of Germany dismantled capital controls only after a change in worldwide economic conditions had made large-scale speculative capital inflows less likely. Austria did not relax its capital controls before the recession of 1975 made capital imports more desirable. Volatile capital inflows caused by special institutional factors seem to be partly responsible for the maintenance of capital controls in Switzerland, in spite of a freely floating exchange rate.
The experience of these three countries with capital controls is an excellent illustration of the limited effectiveness of controls in the face of strong market forces.
Colombia combats malnutrition among poorest 30 per cent with Bank help
Colombia is combating widespread malnutrition among the poorest 30 per cent of the population with the help of a $25 million loan from the World Bank. The Colombian Government recognizes malnutrition as one of the country’s most acute development problems and has thus incorporated the first phase of a National Food and Nutrition Plan into its 1975-78 national program.
The $25 million Bank loan to Colombia is for a term of 17 years, including a grace period of four years, at an annual interest rate of 8 per cent. The Government of Colombia is providing $39.1 million for the project, while beneficiaries would finance around $4.8 million of the costs of the project’s health, water supply, and latrine services.
The project would include 7 of the country’s 22 departments and the district of Bogota, which represent two major heavily populated regions comprising high concentrations of Colombia’s poorest. There are several innovative features in this project. It will use an integrated approach, channeling a variety of nutrition investments through existing institutions. It will use the community level of the new national health care system as a conduit for nutrition surveillance and delivery of integrated nutrition and health services including nutrition education, food supplements, environmental sanitation, promotion of family gardens, and family welfare services. It will also test a new food distribution system directed specifically at the needs of the nutritionally most vulnerable groups.
Total beneficiaries of the health and nutrition education components of the project would be 1.8 million people, of whom 70 per cent are in rural areas. It is estimated that the project would reduce the number of sick days of the beneficiary population by 20 per cent and the infant mortality rate by 25 per cent. Overall, the project will not only improve nutrition, but also raise living standards and productive capacity. It will also help the National Food and Nutrition Plan sustain its effectiveness.
(In millions of U.S. dollars)
|Bangladesh||Inland water transport||5.0|
|Burundi||Development Finance Company||3.4|
|India (3)||Irrigation (two projects), agricultural|
|extension and research||141.0|
|Sri Lanka2||Development Finance Company||8.0|
|Tanzania||Sites and services||12.0|
Figure in parentheses is the number of credits approved for the country.
With an International Finance Corporation (IFC) equity investment of approximately $200,000.
Figure in parentheses is the number of credits approved for the country.
With an International Finance Corporation (IFC) equity investment of approximately $200,000.