Capital Controls Explained: Definition, Types, and Impacts

What Is Capital Control?

Capital controls are government or central bank measures designed to regulate the flow of foreign capital in and out of a country's economy. These controls, which can include taxes, tariffs, legislation, and transaction limits, aim to stabilize financial markets and protect domestic economies from volatility.

While they can help maintain economic stability, particularly in developing nations or during crises like Greece's financial collapse, they also spark debate, as excessive restrictions may deter foreign investment and slow economic growth.

How Capital Controls Function in the Economy

Capital controls are established to regulate financial flows from capital markets to and from a country's capital account. These controls can be economy-wide or specific to a sector or industry.

Government monetary policy can enact capital control. This strategy may restrict the ability of domestic citizens to acquire foreign assets, referred to as capital outflow controls, or foreigners' ability to buy domestic assets, known as capital inflow controls.

Tight controls are most often found in developing economies. They are crucial to the development of these markets because capital reserves are lower and often more susceptible to volatility. A developing economy's currency can depreciate when disruptions occur from capital outflows. Capital controls can help reduce these unpredictable changes in currency rates in the foreign exchange market.

Pros and Cons of Capital Controls

Critics believe capital controls inherently limit economic progress and efficiency while proponents consider them prudent because they increase the safety of the economy. Most of the world's largest economies have liberal capital control policies and have phased out stricter rules from the past.

However, most of these same economies have necessary stopgap measures in place to prevent a mass exodus of capital outflows during a time of crisis or a massive speculative assault on the currency. Factors such as globalization and the integration of financial markets have contributed to an overall easing of capital controls.

Opening up an economy to foreign capital typically provides companies with easier access to funds and can raise the overall demand for domestic stocks.

Real-World Example: Greece's Capital Control Measures

Capital controls are often established after an economic crisis to prevent domestic citizens and foreign investors from extracting funds from a country. For example, at the end of June 2015, the European Central Bank froze support to Greece during the European sovereign debt crisis.

Greece responded by closing its banks and implementing capital controls from June 29 through July 20, 2015, out of fear that Greek citizens would initiate a run on domestic banks. The monetary capital controls put limits on allowable daily cash withdrawals at banks and placed restrictions on money transfers and overseas credit card payments.

On July 22, 2016, Greece's Finance Minister reported that the country would ease its capital controls to increase confidence in Greek banks. The easing was expected to increase the amount of money held at Greek banks.

According to The Guardian, while Greece was putting the worst of the economic crisis behind it as it exited the bailout program. The government loosened the limits on cash withdrawals and increased the allowance for business cash transfers.

The Bottom Line

Capital controls are measures used by governments or central banks to regulate the flow of foreign capital and maintain financial stability. By managing a country's capital account, they help reduce currency volatility and prevent economic crises.

While these controls can protect developing economies or stabilize markets during crises, critics argue they may hinder growth, encourage corruption, and limit investment opportunities across asset classes like equities, bonds, and foreign exchange.