Dornbusch, Rudiger. "Capital Controls: An Idea Whose Time Has Passed". Princeton Essays in International Finance, No.207 (1998): 1-6.

Dornbusch, Rudiger. "Capital Controls: An Idea Whose Time Has Passed". Princeton Essays in International Finance, No.207 (1998): 1-6.

• In the aftermath of the 1994 Mexican Peso Crisis and the 1997 Asian Financial Crisis, there has been an increased call for greater invention in international capital flows and many have questioned the desirability of open capital markets. In the aftermath of the Asian Financial Crisis, even the IMF has recognized the need for short-term capital controls (1).
• The primary capital controls advocated for after the Asian Financial Crisis have been ad hoc suspension of convertibility to prevent investors from withdrawing capital, depreciating currency value, and thus amplifying the crisis (3).
• This is a bad solution because the suspension of convertibility by one country would have a broader impact on financial markets, as investors elsewhere would fear similar moves and pull money from all emerging markets. This mass withdrawal of capital would then trigger widespread freezes on convertibility by more emerging states. This system would thus ultimately encourage greater capital flight, and reduce the term length and increase the interest rates of loans to emerging markets (3).
• Unrestricted capital mobility is the best economic options, largely because discretionary policies towards capital flows are no longer an effective option and will result in countries being punished by financial markets. Additionally, large-scale capital flows are only beneficial in well-regulated financial systems. Failure to maintain fully open capital markets and to reform the financial system will result in major crises (1). Developing countries cannot afford to displease international capital markets (4).
• Previous suggested solutions to international financial crises have been foreign exchange taxes, recommended by James Tobin as a way to penalized short-term capital flows and thus shelter the goods market from capital market volatility, and the prioritization of capital account payments over current account payments, proposed by Ronald McKinnon and Huw Pill to prioritize free capital markets over free trade (1-2).
• In developing countries, the transaction cost associated with capital markets is already so high as to already constitute a 'Tobin tax' on capital flows. Moreover, such fees for exchange increase greatly during a financial crisis, greater another tax-like barrier to capital outflows (2).
• The Tobin tax would certainly have a positive effect on reducing speculation and short-term capital flows, but it could not have prevented the 1997 Asian Financial Crisis because it is not large enough to discourage capital flight during a general collapse in asset and currency value. In other words, a 1% tax on currency exchange will not prevent capital flight facing 30% asset depreciation (2).
• Drs. McKinnon and Pill ask the wrong questions regarding free markets, as both capital markets and goods markets should be opened as rapidly as possible. Gradual opening of markets leads to market distortions that reduce efficiency and can precipitate financial crises, so both kinds of markets should be opened and immediately (2).
• The 1994 Peso Crisis and the Asian Financial Crisis were only possible due to dereliction of duty by national governments, banks, rating agencies, the IMF, and international lenders (4).
• One of the major contributing factors to the Asian Financial Crisis was the poor quality of banks in the region, largely due to political control in previous decades. Of the major banks involved, only 11% were rated C or higher, B banks were concentrated entirely in Hong Kong or Singapore, and there were no A banks. These bad banks borrowed extensively abroad to cover bad loans on their domestic books, but, as new foreign banks siphoned off their customer base, their financial situation worsened. As a reflection of this deteriorating financial situation, these banks were viewed as less creditworthy and thus given access to shorter loans with high servicing obligations, further increasing their risk of insolvency (2-3).
• "The rating agencies are next in line for criticism. Their analysis of risk is absurdly outdated, their competition to provide upbeat ratings to drum up demand for business is very questionable. [...] it is doubtful that there existing staff and technical resources are anywhere near an ability to assess country risk. The focus on debt export ratios, for example, highlights how little they perceive balance sheet crises as the issue rather than old fashioned current account problems" (4).
• One easy way to reduce future risk would be having the IMF demand that governments institute a mandatory value-at-risk assessment of all financial institutions to test for bad loans, as well as having the IMF report on the national value-at-risk of these countries. Any country deficient in these tests would not qualify for IMF loans, thus allowing the market to discipline irresponsible banking practices (4-5). Under this system, the IMF would relieve genuine crises but let speculative crises, like the Asian Financial Crisis, burn to discipline and punish those countries for their poor decisions (5).
• The irresponsible behavior of international lenders and national governments are also to blame, as national governments in Asia kept expending reserves to pay interest on increasingly short-term loans they should have known could fail; lenders are equally at fault for continuing to extend these loans despite the attendant risks (4).
• Another fix to this problem of national governments exhausting their reserves and thus becoming unable to serve as lenders of last resort would be to set up an international reserve system, similar to that created for Argentina. This would dampen crises by providing the capital necessary to relieve failing financial systems, but its international character would mean that national governments would be held accountable and bailouts would only be available on certain conditions (5).
• The best solution to financial crisis is not the prevent capital flight during crises, but to implement a system that limits capital inflows or restricts their maturity to longer term loans. This means preferential treatment for equity investments and long-term bonds. These time of investments mean that capital flight is less of an issue in the first place and that, should a financial crisis occur, skyrocketing exchange rates for foreign debt will not immediately trigger bankruptcy, as they did in the case of short-term debts (3).
• This system will also make governments more concerned about bond markets, thus disciplining them into more responsible financial policies as dictated by international bond markets (4).