Example Of Report On Capital Controls
Businesses require capital in order to start up a new venture or expand their operations in a current industry . There is one key requirement for businesses to be able to start up a new venture or expand their operations on a current one and that key requirement is cash; that is cash in the form of capital. Now, there are two general sources of cash in the form of capital. It may either come from the earnings generated by the company itself, perhaps from the net income it accrued in the previous fiscal years; or it may also come from other forms of financing such as loans and sales of new shares to retail and institutional investors . The objective of this report is to discuss capital and capital controls in general, focusing on the advantages and disadvantages of capital controls.
The total amount of cash that will be generated as a result of any of these two processes would be considered as capital. Within the context of economics, capital can, in fact, pertain to many things aside from the cash necessary to maintain current business operations and fund the creation of new ones. It may also refer to the financial resources that are available for use by the company that owns it. There is also a general principle that applies to capital and this general principle suggests that companies and governments that have a larger amount of capital (i.e. available financial resources) are better off compared to those that have a smaller amount of it .
This is mainly because of the fact that the larger the capital a company or a government has, the larger the degree of freedom it gets . If, for example, there are two countries that are vying to be the top performing country, economically, in the region, the country that has access to a larger amount of capital would most likely be the first one to achieve this goal because this means that it would have a larger amount of cash to finance the projects that would make it the most economically productive country in the region.
It would be unwise to say that the country that has access to a smaller amount of capital would not be able to reach the same goal because it surely can, only that the process would take longer. Simply put, for businesses and governments who want to accomplish the next big thing for their company or country (respectively), cash and or capital is king, for without it, it would be impossible to go to the next steps; because every single one of which apparently requires cash.
Capital, aside from the typical financial resources, that it is associated with, may also pertain to other forms of investment that may lead to the ability to generate revenue in the future such as software products, patents, automobiles, and even brand names . Basically, the term may be used to describe anything that may be used to generate wealth. Based on the premise that was generated earlier about the disadvantages that countries and businesses with a smaller amount of capital one can safely assert that countries that are experiencing the economic phenomenon called capital outflow are expected to face some serious problems. Now, the question is, what are the negative effects of this economic phenomenon and what are some of the effective strategies that may be used to counteract its effects, if not prevent the phenomenon causing the negative effects altogether.
Capital outflow can be defined as “the movement of assets of a country that is considered undesirable and results from political or economic instability that occurs when foreign and domestic investors sell off their assets in a particular country because they no longer perceive it as a safe haven for their investments” . There are many real-life economically relevant examples of this phenomenon. One good example is Russia. Russia has been one of the hottest topics of article and news headlines lately. This is largely due to the fact that it is, based on the reports, stirring chaos in Europe, after it illegally invaded a portion of Ukraine’s territory, specifically the Crimean Peninsula. As a result of the allegedly illegal actions that Russia took when it annexed the Crimean Peninsula, regardless of the casus belli (i.e. rationale) it declared for doing so, western countries, particularly the United States and the member countries of the European Union (EU) issued economic sanctions against Russia .
The economic sanctions were meant to encourage Russia to bring back the geopolitical status quo in the region and more importantly, to serve as warning to the aggressor country that more economic and possibly military sanctions may follow if it continues to head towards the geopolitical path it is traversing. As a result of the economic sanctions, some key companies that are based in Russia got blacklisted from the U.S. and EU capital and consumer markets.
For Russian companies that heavily rely on export revenues (i.e. companies that sell their products to the U.S. and EU consumer markets) and those whose liquidity are heavily dependent on access to cheap cash and credit made available by U.S. and EU member counties’ banks and financial institutions, the economic sanctions could be a huge blow. Months after the economic sanctions were implemented, the Rubble, Russia’s currency, collapsed. It started to lose its value in the foreign exchange market by double digits. One of the results of a currency collapse is an above average, if not an extremely high level of inflation—as a direct result of the currency losing its value. This is exactly what happened to Russia.
It is important to note that all of these events were the result of the political and economic instability that Russia itself caused. Because of the rapidly depreciating currency, investors and asset owners in the country decided to liquidate their investments which meant to practically pull out their assets from Russia and store it in a bank or use the proceeds to buy assets that may be considered as safe havens because at that point, keeping their assets denominated in Russian currency would lead to significant losses in value. This is what fueled the outflow of capital in Russia’s case. There are of course a lot of other examples of this phenomenon but it is important to remember that in most cases, political and economic tensions are the main causes of the loss of investor confidence which in turn leads to the phenomenon called capital outflow.
So, now that some of the major and most common causes of capital outflow have been identified, the next step would be to know the different strategies how capital outflow can be stopped. Perhaps the most direct solution to capital outflow is a strategy called capital control. Capital control can be defined as “any measure taken by a government, a central bank or any other regulatory body to limit the flow of foreign capital in and out of the domestic economy including manipulation of taxes, tariffs, outright legislation and volume restrictions, as well as market-based forces” .
Whenever the term capital control is used in a public policy discussion or debate, it often generates a negative impression or connotation because it often means that the government or any regulatory body would have to intervene manually or simply to manipulate the market’s otherwise normal behavior just so an economic collapse or any serious effects of negative phenomenon like capital outflow can be prevented . It is also important to note that despite the fact that capital outflow is a negatively perceived phenomenon, it is completely normal .
In Russia’s case, the capital control strategy that the government implemented is this: the president and the finance minister, conducted a meeting with the owners and executives of the largest corporations and businesses in the country and asked them to not participate in the large scale exodus of capital out of the country; the president also asked them to recall their assets denominated in foreign currencies and those that are stationed in overseas markets so that they may be brought back to Russia. The effect of this would be the opposite of the effects of capital outflow because should the business leaders follow the country’s president’s call, that can be considered as a form of capital inflow.
However, the problem with this approach is that the president does not really have any form of leverage to convince, if not threaten, the parties in the said meeting to oblige to his request. So, in a nutshell, this government strategy may not be considered effective. Another reason that adds up as evidence to the fact that this government strategy is not effective is the fact that no business owner or corporate executive and or leader would want to just sit down and watch while his or her assets are getting burned as a result of the massive capital outflow happening in the country . What would prevail in a scenario where there is an ongoing capital outflow phenomenon happening is the investors and asset holders’ herd mentality . So, if the herd mentality kicks in despite the government’s capital control strategy, such as what the president of Russia did to mitigate the impact of the large scale capital outflow in the country, the net flow of capital into the country would still fall into the negative territory.
Once the phenomenon called capital outflow kicks in, a vicious cycle of asset liquidation and pull-outs get created. This is because every investor and asset holder in a particular country that experiences capital outflow is afraid that their holdings would lose value as a result of other investors and asset holders pulling out their possessions. This is, in fact, what causes most economies to crash. The creation of this vicious cycle is what most capital control strategies aim to counter. If these things get countered, then, the market would have enough time to realize the real depth of the situation and adjust their behaviors accordingly. It is also important to remember that most economic downturns as a result of capital outflows are just caused by investors and asset holders panicking. However, it is important to remember that the number one disadvantage of capital controls is that they do not really solve the underlying problem causing the capital outflows—they merely address the manifestations.
In the recent Great Financial Crisis, countries like Malaysia, Thailand, Chile, Brazil, and even developed and industrialized economies such as the United States have suffered from the destructive effects of large scale capital outflows. A lot of investors and asset holders got afraid that their holdings would lose value as a result of the financial crisis and as a result, the turned into cash and other investment safe havens. As a result, countries from around the world experienced the much dreaded phenomenon called capital outflows. At that time, no capital control method really worked because the problem was so severe.
According to an article published in the Journal of International Money and Finance, the market is a force that is hard, if not impossible, to control . This is why, most, if not all government or other regulatory group-induced capital control methods and strategies fail to do what they are meant to do—to prevent excessive capital outflow in the country.
In cases where the capital outflow is caused by political and economic instabilities and one of the manifestations is the loss of the country’s currency’s value, which is similar to what happened recently to the Russian economy, the country’s central bank has the option to intervene. The central bank may do so by increasing the standard interest or borrowing rates in the country significantly. Doing so would lead to a proportional increase in the interest rates that bonds and other fixed-income instruments that are required to be transacted using the country’s currency would yield. If, for example, the key interest rate prior to the capital outflow phenomenon’s start was set at 5%, raising it to higher levels, say, to 10% or even 15% would make it more attractive for investors and other asset-holders to leave their assets in the country that is experiencing the capital outflow.
However, it is important to note that this is basically a form of central bank manipulation. In this case, they merely increased the interest rates so that bank deposits and other fixed income instruments would generate higher yields; in reality, however, the factors that caused the capital outflow (i.e. the economic and political instabilities) are still present. In an academic journal published in the Transition Studies Review, the authors explored the savings investment relationship in the context of different financial liberalization and flexible exchange rate regimes. The authors in that paper concluded that “in the presence of inadequate capital mobility within the country, domestic investors have financed investment projects from international market; furthermore, devaluation and inflation have stimulated investment activities in the country and significantly contribute in closing the gap between the domestic savings and investment” .
In summary, most, if not all, capital control methods are just means of mitigation, of addressing the symptoms and manifestations of the real problems. The real problem in this case is not the capital outflow because it merely is the manifestation of the real problem. The real problems are the economic and political turmoil. The loss of the confidence of the investors and asset-holders are only normal market reactions that appear in times of economic panic and crisis. The main advantage of capital control methods is that they enable the government or the responsible regulatory body to buy time to solve the problems causing the capital outflow. Its main disadvantage, however, is that they do not really solve the main problem that causes the capital outflow; they are merely a form of remedy.
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