Capital Restrictions Explained | CFA Level I Economics

Welcome back as we discuss capital restrictions and the reasons why some governments impose them.

What are Capital Restrictions?

Capital restrictions are policies aimed at controlling the flow of financial capital across borders. Such controls are placed on foreigners’ ability to own domestic assets, or domestic residents’ ability to own foreign assets. Thus, in contrast with trade restrictions, which limit the openness of goods markets, capital restrictions limit the openness of financial markets.

Restrictions on capital inflow can include:

• Outright prohibition of foreign investment in the domestic economy.
• Requiring majority domestic ownership of certain firms.
• Prohibition of foreign investment in certain domestic industries.

Restrictions on capital outflow include:

• Taxes on the income earned on foreign investments by domestic citizens.
• Restrictions on repatriation of earnings by foreign firms operating in the country.

Economic Impact of Capital Restrictions

Economists consider free movement of financial capital to be beneficial because it allows capital to be invested where it will earn the highest return. So overall, capital restrictions are thought to decrease economic welfare in both the sources and recipients of capital.

In spite of the negative impact of capital restrictions, some governments place capital restrictions for various reasons.

Reasons for Imposing Capital Restrictions

1. Maintain fixed exchange rates: Limiting flows of capital in and out of the economy reduces the volatility of demand for the domestic currency. This makes it easier for the central bank to meet the exchange rate target. A stable exchange rate makes monetary and fiscal policy more effective to manage inflation and pursue the economic goals for the domestic economy. China is an example of a country that restricts capital flows, allowing policymakers to maintain the target exchange rate against the US dollar. With a stable exchange rate, the central bank is able to pursue monetary policy independent of concerns about its effect on currency exchange rates.
2. Keep domestic interest rates low: By restricting the outflow of investment capital, investors are unable to shift money out to pursue higher rates in foreign countries.
3. Protect strategic industries: Foreign entities are often restricted from investing in domestic firms considered important for national security, usually in the telecommunications and defense industries.
4. Reduce volatility of domestic asset prices: For countries with relatively small financial markets, massive speculative capital inflows can bring inflationary pressures, while massive outflows in a crisis can cause a stock market crash. By restricting the inflows and outflows of capital, developing countries can avoid such volatilities brought about by foreign speculation.

Economists agree that while capital restrictions can fix certain problems in the short run, the long-term costs can outweigh the short-term benefits. International investors may lose confidence in the domestic financial market and divert their investments elsewhere.