What are capital controls? Why they are important?

Cross border capital mobility or inflow and outflow of capital is a leading feature of globalization. Such flows create many effects including appreciation/depreciation of the currency, stock market bubble/burst etc.

Now, managing such capital inflows from other countries is an important policy measure in most developing countries. In the developed countries since there is no shortage of foreign currencies, the inflow and outflow of capital doesn’t create much disturbances.

Thus the developing countries often put restrictions on inflow and outflow of foreign capital and they are called capital controls.  

Capital control refers to measures taken by the government or the central bank to restrict the inflow and outflow of foreign capital in and out of a country.

To control the inflow and outflow of foreign capital, government and the central bank may bring measures like imposition of taxes on the flows, restricting the quantity of dollar or foreign currency purchase, and bringing legal measures to limit foreign currency dealings.

The purpose of capital control is to limit the instabilities created by capital flows. For example highly fluctuating type of foreign capital like short term bank deposit or investment by foreigners in domestic shares etc. are treated as destabilizing. They are very volatile and makes their entry and exit quickly. Their inflows and outflows may be sudden; causing sharp fluctuations in the value of domestic currency.

Here, the central bank may make several measures like imposing a tax on capital inflows or laws to regulate them or to increasing the staying period of such capital in the domestic country etc.

The most important disturbance comes during the time of capital outflows. High level of outflows creates sharp depreciation of the currency and perhaps a currency crisis. Here, the central bank like the RBI or government may bring restrictions on the outflow of dollar or capital by putting limits on dollar purchase or payment abroad. Sometimes the central bank sells dollar in the foreign exchange market to increase the availability of dollar.