Author: Bryan Mercurio, CUHK, Ross Buckley, UNSW and Erin Fu, HUST
While capital controls were the accepted economic orthodoxy of the 1950s and 1960s, it became distinctly heterodox and drew the wrath of the International Monetary Fund in the early 1990s. After the rather successful use of capital controls by the Malaysia in response to the Asian financial crisis in 1997, they now enjoy growing acceptance in the mainstream economy while remaining controversial in some academic and government circles.
The economic fallout from the COVID-19 pandemic has exposed weaknesses in national economies and international supply chains and further accelerated the exit from globalization. If the persistent economic uncertainty were to lead to a substantial withdrawal from financial globalization, we can expect some governments to put in place controls on the movement of capital.
The use of short-term capital controls in times of crisis demonstrates their usefulness as a policy response to deal with the volatility of short-term capital flows. But capital controls are not a panacea and come with costs – they restrict access to foreign capital for investment, raise real interest rates, and require extensive administration.
While the use of short-term capital controls grab the headlines, it is their use as a long-term policy measure that may become more fashionable in the post-pandemic era. Perhaps lessons can be learned from Beijing’s long-standing approach to capital controls, even though the size of the potential market and China’s history make it inherently different from most other countries. It is also important to understand that China’s use of capital controls has gone through several distinct phases.
During the first phase (1979-1993), capital controls were adopted to implement an âeasy entry and difficult exitâ regime in order to avoid a balance of payments crisis. While restrictions on foreign direct investment (FDI) have been gradually relaxed, controls on non-FDI inflows have been strictly enforced and some transactions have been banned altogether.
During the second phase (1994-2000), China underwent significant market-oriented foreign exchange reforms. This included abolishing its currency retention system and allowing domestic companies to buy and sell currency through designated foreign exchange banks. China also significantly restructured its banking system and tightened controls after the 1997 Asian financial crisis.
During the third phase (2001-2012), China’s entry into the World Trade Organization blew up its trade surplus. Inflows of speculative capital increased sharply, putting upward pressure on the renminbi. China’s main objective was therefore to control capital inflows. As foreign investment by Chinese companies also became less restricted, controls on capital inflows were simultaneously tightened.
Since President Xi Jinping took office, China has established a more balanced approach to its capital control regime. In October 2019, China introduced several measures to ease regulatory controls on foreign currency income payments with respect to cross-border current account and capital transactions. Portfolio flows that had been restricted were encouraged, although the State Exchange Administration retains its power to impose temporary restrictions on repatriation when necessary.
China will not fully liberalize capital flows or make the renminbi fully convertible anytime soon, meaning a host of capital controls will remain for the foreseeable future.
The use of capital controls raises questions about the respect by States of international commitments. While economists have long debated the effectiveness of capital controls, their legality has been largely ignored in the literature. We filled this gap in a recent article.
The absence of a single international law regime governing capital controls means that they are governed by an intersecting web of monetary, trade and investment laws. The legality of a specific control measure depends on the language of a country’s international treaties and its commitments to international organizations.
While IMF rules and the General Agreement on Trade in Services (GATS) can be seen as floors that provide some leeway for members to adopt restrictions on cross-border capital flows, more than 3,000 bilateral treaties investment (BIT) and free trade agreements (FTA)) regulate capital flows with generally stronger conventional language and higher-level commitments.
China has concluded numerous FTAs ââsince joining the WTO. However, due to the different wording of treaties and commitments made under different FTAs, some Chinese capital control measures may be compatible with some agreements and incompatible with others.
A Chinese control measure prohibits the transfer of money abroad for the purpose of purchasing life insurance and investment-type insurance. Although China has made no GATS commitments for these sectors, it has made market access and national treatment commitments in FTAs ââwith Singapore and South Korea on cross-border supply. insurance and non-insurance services.
Since life and investment-type insurance are included in China’s FTA commitments, China’s ban on residents purchasing life and investment-type insurance from of non-residents seems incompatible with its commitments to allow the cross-border supply of these services.
Another problem is the risk of regime conflict in the multilateral governance of capital flows, with the IMF scenario recommending the imposition of capital account restrictions despite these measures being inconsistent with a member’s specific commitments under of GATS or FTAs ââand BITs.
Given the mosaic of varied agreements with different treaty terms and levels of commitment, one cannot determine whether specific controls are compatible with the international legal framework without carefully reading several treaty texts. Governments need to understand the potential risks of lockdowns that prevent the implementation of prudent fiscal and monetary measures and negotiate treaties with appropriate safeguards to ensure that capital controls are consistent with these obligations. At the same time, countries that wish to use capital controls to withdraw from the globalized financial system must carefully review their existing treaty and other commitments.
Bryan Mercurio is Simon FS Li Professor of Law at the Chinese University of Hong Kong.
Ross Buckley is Professor of International Financial Law at the University of New South Wales.
Erin Fu is Associate Professor of International Business at Huazhong University of Science and Technology.