V Capital Account Convertibility

Joshua Greene, and Peter Isard
Published Date:
March 1991
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Discussions of capital account convertibility center on three issues: (1) whether capital account convertibility should be delayed until late in the transformation process or introduced simultaneously with current account convertibility; (2) whether restrictions on capital account convertibility are likely to be effective once current account restrictions have been removed; and (3) if capital account convertibility is delayed, what types of capital account restrictions should still be removed in the short run.

A decision to delay the introduction of capital account convertibility depends ultimately on a determination that the risks involved in unrestricted capital movements would outweigh the benefits. These benefits include the likelihood of greater inflows of direct investment capital and associated managerial and technological resources, which are widely acknowledged as critical for the transformation process, and the opportunity for residents, via capital outflows, to pursue higher expected yields and to diversify their asset portfolios in the presence of various types of uncertainty.

One major risk of eliminating all restrictions on capital flows is the possibility of extensive capital flight, which is widely believed to generate large negative externalities. To the extent that the success of a reform program depends critically on the strength of domestic investment, the residents of a country undertaking reforms may well be better off individually when they are collectively prevented from moving capital abroad. Effective controls on capital outflows may thus be essential for the reform program to succeed. Without such controls, risk-averse residents could have strong incentives to send capital abroad, even in the presence of sound macroeconomic policies, and the resulting capital outflows could undermine the reform program.

Another risk of allowing unrestricted capital flows is the possibility of greater macroeconomic instability arising from the volatility of short-term capital movements. Such movements can intensify any macroeconomic difficulties that develop during the implementation of a reform program. At the same time, the threat of volatile capital flows can be a source of policy discipline, heightening the authorities’ concern to keep their macroeconomic policies sound.

Whether restrictions on capital flows are likely to be effective once current account restrictions have been removed is unclear. To some extent, these restrictions can be circumvented through leads and lags in the timing, or distortions in the invoicing, of current account payments. Whether they are effective, therefore, is likely to depend on the strength of the incentives for circumvention. Past experience has shown that controls are generally ineffective when a country’s macroeconomic policies and prospects are poor.

Countries that choose to delay the introduction of capital account convertibility, primarily to limit the risks of capital flight and volatile, short-term capital flows, may nevertheless want to modify some restrictions to encourage long-term capital inflows. To support these objectives, countries could enact rules guaranteeing nonresidents the right to repatriate assets, investment earnings, and compensation (including pension earnings) from employment in domestic enterprises. These changes could be part of more general investment code reforms allowing nonresidents to own, manage, and exercise control over domestic enterprises—reforms now under way in a number of Eastern European countries. Such measures would encourage long-term capital inflows by providing safeguards for repatriation and future transfers for nonresidents. At the same time, but subject to the provisions of Article VI, Section 3 of the IMF’s Articles of Agreement, restrictions limiting capital transfers by domestic residents could remain, as could limitations on short-term capital inflows that might create instability in domestic financial markets.

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