For most of the developing countries, capital flows from other countries, especially from developed nations, is one of the key factors towards the attainment of their economic growth. Financial industry of the developing country improves as more investors move their investments towards the economy of the developing countries. For most of the economists, this is the kind of view that they have, that cash flows from foreign investors would stir up the financial industry of developing nation, thus, giving way for that economy to have an impressive growth.
But the advent of Great Economic Depression, those countries who relies most on foreign cash flows suffered from major economic losses and finds it hard until now to recover the said losses that they have incurred from the said economic turmoil. Because of this, the idea of treating foreign cash flow would help developing countries to boosts their economic growth was put into question and thus giving birth to group of individuals that are promoting the regulation of cash flows into their country so as to make their country less vulnerable to financial crises made by external market forces.
Well, I do believe that there is a need for developing countries to impose capital control to reduce the amount of capital inflow on the economy and at the same time prevent the massive outflow of capital caused by various market forces like speculations. With this, as what I have already stated above, would make the economy of developing countries protected from the adverse effects of financial crises.
Furthermore, regulating the flow of foreign capitals into their market would give the government chances of monitoring the degree of response of the domestic market and evaluate whether there are some domestic industries that are being affected negatively by the influx of foreign capitals. Moreover, this kind of policy would give the government of developing nations the needed flexibility in protecting their domestic industry especially the infant industry.
I just want to clarify that I am not saying that influx of foreign capitals into the economy of developing countries would distort the equilibrium condition of the market, but to some degree there is a possibility, and by having a regulation for the flow of foreign capitals into the economy there is a room for the government to prevent the further losses of the welfare of the domestic market. Aside from the fact that capital control would give the government flexibility especially during the times of crisis, another benefit of having a capital control policy would be the government could regulate the outflow of investment from their economy.
As we all know, financial market is being guided mostly by market predictions of market analysts and because of this, there are times that predictions causes panics in the market that forces the investors to immediately pull out their capitals in the market and invest it to other country. If the government would allow the full entry and exit into their financial market there would be a major problem in terms of the financial shortage of the economy with the abrupt withdrawal of capitals from the market.
As we can see here, it is only through regulation wherein the government or the state could have the right to intervene into the inflow and outflow of the capitals in the financial market. On the other hand, the trade off of relying mostly to capital controls of most developing countries would be the doubt of the foreign investors to out their capital into this kind of economy wherein there is a restriction as to when and how they could withdraw their investment into the market.
Because of this there is a big possibility that the level of capital flow of those developing countries that uses capital control would experience a sudden drop or they could find foreign capitalists less enthusiast in making transaction with into their financial market. Aside from this, there is a possibility that the growth of the financial market of developing countries that uses capital control would decline since less foreign investors now are interested in investing into their economy.
Another trade-off that developing countries could face would be the depreciation of their currency against other currencies since there would be less foreign investors that would want to invest into their country, thus, having a low demand for their currency which give pressure for depreciation to occur. With the depreciation of their currencies, domestic importers are harmed due to the fact that the costs of their imported materials would be now relatively expensive since they have to spend more of their currency in exchange for foreign currency (Lopez, 2006).
Oftentimes, this imported materials are being used as an input in making products in the market, thus, there is a great possibility that this producers would pass into the consumers the burden of the said increase in the prices of imported materials by increasing the prices of their products or output. In the end, the consumers are the one to shoulder the burden of the side effects of the policy of the government and that is the regulation of inflow and outflow of capitals into their economy.
These are the possible danger that might happen if the government of a developing country would control the outflow and inflow of capitals on their market. But the point is, the above mentioned problems are can be solved by the government through monetary and fiscal policies. They could use their international reserves to revitalize their currency so as not to affect the export-import industry of their economy as well as giving incentives to those investors that would still invest into their country despite of the fact that there exists a capital control and it could be in a form of a subsidy and lower tax rate charges.
I think, with the said monetary and fiscal policy of the government, there is a possibility that foreign investors would still be attracted to invest into their economy. The fact that the government is capable of finding ways on how to reinforce their policies, then, there is really nothing to worry about the controlling of capital outflow and inflow of their economy. Moreover, this is also a great chance for the domestic industry to become more competitive since there would be now less available foreign investors in the market.
They could now improve their operation and serve more customers in the market. As we all know, the existence of foreign capitals in the market produces tight competition wherein in the end they are the one who would receive the highest gain out of their operation in the market. The only loophole that I can see here in my opinion would be the possibility of the ineffectiveness of the government policies so correct the side effects of the capital control in the market.
There is the possibility of running out of international reserves to back up the currency in the market so as to protect the export-import industry. Moreover, there might happen that the government has a large budget deficit and giving subsidies and cutting down the taxes of these foreign investors will not be a possible choice since the government has a limited budget to spend. I think it is already up to the discretion of the government of developing countries to evaluate the effectiveness of their policies to back up their decision of controlling the capital inflows and outflows of their economy.
If they think that the current polices are enough to back up the regulation of influx and outflow of foreign capital in the market, then, go on with the said policy. But if not, then, it would be best for that country not to regulate or intervene in the outflow and inflow of capital into their economy. As for the limitation of by stand, this argument of mine only considered the environment of a developing country and the treatment would be much different if the one being considered here is a developed country or those countries that belongs to the first world countries.
In this regard, I would again stressed that for the government of developing countries should use capital control policy to cut capital inflows and prevent massive capital outflows to have the ability to protect their economy against negative external forces like the 1990 financial crisis, it would be best for them to have a control over the outflow and inflow of capital into their economy side from the fact that this policy would also give the government of developing countries enough flexibility to treat the negative effects of the outflow and inflow of capitals into their domestic market especially for the infant industries.
This analysis are all based on the assumption that the government has enough and effective number of polices that could neutralize the side effects of the said policy of the government.
Lopez, J. (2006). On Floating Exchange Rates, Currency Depreciation, Income Distribution