Controlling capital during COVID-19

Author: Bryan Mercurio, CUHK, Ross Buckley, UNSW and Erin Fu, HUST

While capital controls were the accepted economic orthodoxy of the 1950s and 1960s, they became distinctly heterodox and attracted the ire of the International Monetary Fund by the early-1990s. After Malaysia’s rather successful use of capital controls in response to the Asian financial crisis in 1997, they now enjoy increasing acceptance in mainstream economics while remaining controversial in some academic and governmental circles.

A Chinese bank clerk counts renminbi yuan and US dollar banknotes, Nantong, China, 1 March 2016 (Photo: Reuters).

The economic fallout from the COVID-19 pandemic has exposed weaknesses in national economies and international supply chains and further hastened the retreat from globalisation. Should ongoing economic uncertainty lead to a substantial retreat from financial globalisation we can expect some governments to implement controls on capital movements.

The use of short-term capital controls in times of crisis demonstrates their usefulness as a policy response for addressing volatile short-term capital flows. But capital controls are not a panacea and have costs — they restrict access to foreign capital for investment, increase real interest rates and require considerable administration.

While the use of short-term capital controls attracts headlines, it is their use as a long-term policy measure that may become more fashionable in the post-pandemic era. Lessons can perhaps be drawn from Beijing’s longstanding approach toward capital controls, even if China’s potential market size and history make it inherently different to most other countries. It is also important to understand that China’s use of capital controls has undergone several distinct phases.

In phase one (1979–1993), capital controls were adopted to implement an ‘easy in and difficult out’ regime to avoid a balance of payments crisis. While restrictions on foreign direct investment (FDI) were gradually relaxed, controls on non-FDI inflows were strictly enforced and some transactions were entirely prohibited.

In phase two (1994–2000), China underwent major market-oriented exchange reforms. This included abolishing its foreign exchange retention system and allowing domestic enterprises to buy and sell foreign exchange through designated foreign exchange banks. China also dramatically restructured its banking system and strengthened controls after the 1997 Asian financial crisis.

In phase three (2001–2012), China’s entry into the World Trade Organization caused its trade surplus to surge. Speculative capital inflows greatly increased, putting upward pressure on the renminbi. China’s primary focus was therefore to control capital inflows. As overseas investment by Chinese enterprises also became less restricted, the monitoring of capital inflows was simultaneously strengthened.

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 loosen regulatory controls over foreign exchange income payments in respect of both current and capital account cross-border transactions. Portfolio flows that had been restricted were encouraged, although the State Administration of Foreign Exchange retains its power to impose temporary restrictions on repatriation when required.

China will not fully liberalise capital flows and make the renminbi fully convertible anytime soon, meaning a multitude of capital controls will remain into the foreseeable future.

The use of capital controls raises questions about state compliance with international commitments. While economists have long debated the effectiveness of capital controls, their legality has been widely ignored in the literature. We have filled this gap in a recent paper.

The absence of a single international law regime governing capital controls means they are regulated by an intersecting web of monetary, trade and investment law. The legality of a specific control measure depends on the language in a country’s international treaties and in its commitments to international organisations.

While the IMF rules and General Agreement on Trade in Services (GATS) can be viewed as floors that provide some policy space for members to adopt restrictions on cross-border capital flows, over 3000 bilateral investment treaties (BITs) and free trade agreements (FTAs) regulate capital flows with typically stronger treaty language and higher-level commitments.

China has entered into many FTAs since its accession to the WTO. Yet due to different treaty language and commitments made under different FTAs, some Chinese capital control measures may be consistent with some agreements and inconsistent with others.

One Chinese control measure prohibits transferring money overseas for the purpose of purchasing life insurance and investment-type insurance. While China made no GATS commitments for these sectors, it did make market access and national treatment commitments in FTAs with both Singapore and South Korea on the cross-border supply of insurance and non-insurance-related services.

Since both life insurance and investment-type insurance are included in China’s FTA commitments, China’s prohibition on residents purchasing life and investment-type insurance from non-residents appears inconsistent with its commitments to allow the cross-border supply of such services.

Another issue is the potential for regime conflict in the multilateral governance of capital flows, with the scenario of the IMF recommending the imposition of restrictions on the capital account despite such measures being inconsistent with a member’s specific commitments under the GATS or FTAs and BITs.

Given the patchwork of varying agreements with differing treaty language and levels of commitments, one cannot determine whether specific controls are consistent with the international legal framework without carefully reading multiple treaty texts. Governments must understand the potential risks of locking in commitments which prevent prudent fiscal and monetary measures being implemented and negotiate treaties with appropriate safeguards to ensure capital controls are consistent with those obligations. At the same time, countries wishing to use capital controls to retreat from the globalised financial system must carefully review their existing treaty and other commitments.

Bryan Mercurio is the Simon F S Li Professor of Law at the Chinese University of Hong Kong.

Ross Buckley is Professor of International Finance Law at the University of New South Wales.

Erin Fu is Associate Professor of International Trade at the Huazhong University of Science and Technology.

This research is supported by Hong Kong General Research Fund (GRF) Project No. 14613717, entitled: When Regimes Clash on Capital Controls: Managing the Conflicting Norms and Standards of the IMF, WTO and International Investment Agreements.

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Controlling capital during COVID-19