The return of capital controls

Willem Buiter

20 February 2009



When Iceland’s banking system and currency collapsed last September, a key component of the emergency package that was introduced under the auspices of the IMF was controls on capital outflows, implemented through rigorous foreign exchange controls. This made sense. The currency was in free fall. The foreign exchange markets had seized up. There was no level of domestic interest rates the Central Bank of Iceland (which had zero credibility at this stage) could set that would induce domestic and foreign investors to hold on to their Icelandic kroner rather than converting them into euro, US dollars, sterling or any other serious convertible currency.

Capital controls in Central and Eastern Europe

Iceland is about to have company. The most likely candidates for the imminent imposition of capital controls are in Central and Eastern Europe (CEE) and among the CIS countries. We can expect to see capital controls imposed even by some of the EU members from Eastern Europe that have not yet adopted the euro as their currency (the Baltics, Bulgaria, the Czech Republic, Hungary, Poland, and Romania).

All these countries have banking sectors that are overwhelmingly foreign-owned. With the de-globalisation and repatriation of the cross-border banking sector that is underway, parent banks (mainly in Western Europe) have become progressively less able and/or less willing to finance their subsidiaries in Central and Eastern Europe. The resulting financial stresses in the host countries have led the ECB to take the extremely unusual step of making swap facilities available to the central banks of two non-Eurozone EU members, Hungary and Poland. Hungary, which suffers from long-standing fiscal incontinence, has an IMF program as well.

The financial support from the ECB (and from the EC) is probably not unrelated to the fact that a number of Eurozone commercial banks are heavily exposed in CEE and the CIS. Austrian banks, in particular, have a massive exposure to the former Austro-Hungarian empire, as does Unicredit (an Italian bank) and several Nordic banks are at risk throughout the region, from the Baltics to Ukraine.

In most CEE countries, households and non-financial corporations played the reverse carry trade by borrowing in the foreign currencies with the lowest interest rates, oblivious to the exchange risk this involved. These CEE counterparts of Mrs Watanabe did so without having any natural foreign exchange hedges (foreign currency assets or income) and without taking out any synthetic hedges. Households throughout CEE have Swiss-franc-denominated residential mortgages. I am surprised there weren’t more yen-denominated residential mortgages taken out! With the sharp decline in the external value of their currencies (the Polish zloty has declined against the euro by more than 35% since its peak in mid-2008, the Hungarian forint by 26% and the Czech koruny by 22%), the real value of their debt and debt service has increased sharply. Fortunately, most of these mortgages have long remaining maturities.

The same does not hold for the foreign currency debt taken on by the non-financial corporate sector in CEE. Much of this has a short maturity. In addition, during the period prior to the middle of 2008, when their currencies were appreciating, many CEE corporates bet on further appreciation of their currencies by writing puts on them. With their currencies way down, these corporates find themselves having to buy zloty, say, from the buyers of these puts, in exchange for euro at a much higher price for the zloty in terms of the euro than the current spot exchange rate, let alone the exchange rate anticipated when these CEE corporates wrote the puts. A further collapse of the currency would raise the likelihood and incidence of defaults among corporate borrowers.

he banks in CEE may have both assets and liabilities denominated to a large extent in foreign currency. Because their clients are not currency-matched, the banks have replaced currency risk on their balance sheets with credit risk.

Some of the CEE countries were the victims of wild domestic credit and asset market booms and bubbles even before they were hit by the global credit crunch (through the drying up of funding for the local subsidiaries by the parent banks). Latvia is the most extreme example, but Estonia and, to a lesser degree Lithuania, were also caught up in classic, post-reform unsustainable emerging-market booms, with out-of-control construction industries and epic current account deficits. Bulgaria, which like the Baltics has a currency board vis-à-vis the euro, Romania and Poland (both with floating exchange rates) also ran growing current account deficits that had unsustainability warning lights flashing.

All CEE countries, including those that had unsustainable domestic credit and asset market booms, are being hit hard by the domestic impact of the global credit crunch and by the collapse of world trade. The Czech Republic and Poland are the two CEE non-Eurozone members least likely to impose capital controls. The rest ranges from possible to quite likely.

The imposition of capital controls on a temporary basis to deal with a foreign exchange crisis/balance of payments emergency is compatible with the EU Treaties. Indeed, de-facto informal foreign exchange rationing has been taken place for quite a while in some countries. When I was in Latvia a year ago, local commercial bankers told me that if someone wished to borrow lat (the local currency), they would not lend it to him if the bank thought he was likely to use it to speculate against the currency peg of the lat with the euro. This is against the rules - indeed against the law — but it happened. Where could the frustrated would-be short seller of the lat go to complain? To the Latvian central bank?

Of course, an EU country that imposes capital controls could forget about joining the Eurozone in the foreseeable future, unless the Maastricht criteria for EMU membership were waved or scrapped. Although the unconditional offer of immediate full EMU membership to all EU members would be a wise and wonderful contribution to the stabilisation of the region, I consider it unlikely that such wisdom will indeed be found in Frankfurt, Brussels and the national capitals of the EU - inhabited as these locations are by bears of very little brain. With Eurozone membership years away, the cost of imposing capital controls, in terms of further delays in EMU accession, would be minor.

Some of the non-EU countries in the Balkans (Albania, Bosnia-Herzegovina, Croatia, Macedonia, Serbia) are also likely to have recourse to capital controls before long. Montenegro already has the euro as its currency, despite not being a member of the Eurozone. Among the CIS countries that are likely candidates for the imposition of capital controls are Ukraine, Russia and Kazakhstan.

Capital controls in Russia, Ukraine and Kazakhstan

Ukraine is in an economic and political mess. Its banking system is a triumph of hope over fair value. Its currency is weakening rapidly. Its export-oriented heavy industry and its agricultural sector have been hit hard by declining prices and world demand. It has an IMF program.

Russia has gone from Himmelhoch jauchzend to zum Tode betrübt in the space of less than a year. With oil at $140 a barrel and $460 billion of foreign exchange reserves, Russia felt and acted like a would-be super power. With oil at $40 a barrel and reserves draining fast in an unsuccessful attempt to stabilise the Rouble without raising interest rates, Russia looks increasingly like Venezuela with nukes. Industrial production has collapsed and the public finances are under severe strain. Russia’s industry has borrowed heavily abroad, in foreign currency, and on a short-term basis. Its banking system can no longer fund itself in the international wholesale markets. Russia 2009 looks more and more like Russia 1998. Capital controls would be an obvious tool to regain control of the Rouble without having to engage in immediate heroic monetary and fiscal policy tightening. Even if the anti-capital controls faction in the Russian leadership wins the ongoing argument with the pro-capital controls faction, events may well force the hand of the authorities.

Kazakhstan may have enough financial resources and gas/oil revenues (despite the decline in oil prices) to get through the financial storm and the global slump without being forced to impose capital controls. It already had one major bail-out of its banks, however, and if Russia and Ukraine were to impose capital controls, Kazakhstan may well follow.
The joys and pain of an open capital account
For countries with a minor-league currency (every currency except for the US dollar, the euro and the yen), an open capital account will always be a mixed blessing. The joys of an open capital account - the undoubted benefits from decoupling domestic capital formation from national saving and from unrestricted international portfolio diversification and risk trading - cannot be enjoyed without the pain; the risk of its domestic financial institutions, capital markets, non-financial enterprises, consumers and public finances becoming the flotsam and jetsam on massive and mindless killer waves propelled by an out-of-control global financial storm.

Capital controls permit monetary and fiscal policy to be directed to the stabilisation of economic activity without having to worry about a collapse of the currency and its deleterious effects on the sectoral and national balance sheets. Of course capital controls will leak. They always leak. But provided they are enforced aggressively, say, with transgressors stoned to death in public after a fair trial, they can be made to work well enough to regain control of monetary and fiscal policy. And capital controls will leak progressively more copiously, the longer they are in place. This is why their imposition should be viewed as temporary, with a gradual relaxation as economic conditions improve and global financial stability returns. Capital controls create rents whose allocation is at the discretion of public officials. They therefore encourage bribery, graft and corruption, which is again why they should only be temporary.

The emerging markets of CEE and the CIS (and indeed emerging markets everywhere) have been progressively cut off from new external funding as the crisis deepened. At this stage, imposing capital controls (only controls on capital outflows really matter, at this stage; controls on capital inflows should have been imposed earlier) would not bring with it a heavy cost in terms of a sudden stop on capital inflows. That stop has happened already. Imposing capital outflow controls may discourage future capital inflows. The example of Malaysia, which imposed capital controls during the Asian crisis of 1997 suggests that foreign capital either has a short memory or can be convinced.


I predict that at least some of the emerging market countries of CEE and the CIS will impose capital controls before long. I recommend that emerging markets everywhere consider this option seriously.

Editors' note: This column is a Lead Commentary on Vox's Global Crisis Debate where you can find further discussion, and where professional economists are welcome to contribute their own Commentaries on this and other crisis-linked topics.



Topics:  Financial markets Global crisis

Tags:  Central and Eastern Europe, capital controls

Willem Buiter

Chief Economist of Citigroup and CEPR Research Fellow