How capital controls work

ON JUNE 26th Alexis Tsipras, Greece's prime minister, announced a plan to put Europe's latest bail-out offer to a public vote, in a referendum scheduled for July 5th. The plan quickly triggered a nasty chain of events: euro-zone leaders refused to extend Greece's current bail-out programme beyond June 30th, when it is scheduled to expire, and the European Central Bank announced that it would cap its emergency lending to Greek banks. That "emergency liquidity assistance" had been replacing the money leaking out of the Greek banking system, as nervous Greeks withdrew their savings. Facing the loss of ECB top-ups—and the prospect of empty vaults—the Greek government declared Monday, June 29th, a bank holiday and imposed capital controls. How will they work?

There was a time when capital controls were an instrumental part of macroeconomic management; in the early postwar decades, rich-world citizens taking holidays abroad faced strict limits on on the amount of foreign-exchange they could carry with them. Yet since the great financial liberalisation of the 1970s and 1980s capital controls have been seen as an anachronism, generally imposed in the thick of crisis to prevent matters from spiralling out of control: as in Iceland and Cyprus. They are usually used to minimise banking-system losses. Bank deposits are effectively loans to banks, who then lend out some of their depositors' money (along with financing raised in markets) to finance economic activity. Banks can run into trouble in a number of ways. A rash of bad loans can push a bank into bankruptcy: where the value of its assets is too small to cover its liabilities. A rush to pull deposits can also bring on bank failure, since banks are often unable to call in their long-term loans in order to provide the necessary cash. Depositors' expectations matter; fear of losses can spark a run, which then pushes the bank into failure. (Deposit guarantees can break the cycle but in the Greek case depended upon a flow of money—the ECB's ELA—which is no longer available.) The greater the panic, the greater the potential losses to remaining depositors, creditors or taxpayers. Capital controls slow or halt the run. Bad loans aren't the only reason depositors might flee. The possibility of a currency devaluation could also spark capital flight. If Greece left the euro area then deposits in its banks would be converted to a new currency, which would almost certainly be less valuable than the euro. Greek banks have been squeezed by each sort of pressure.

What might these measures mean for the Greek economy? That depends heavily on how long they are in place. If voters signal their acceptance of the European programme on July 5th, then ECB emergency funding may soon be restored. But the longer controls persist the more damage they will do. Domestic consumption will plunge as cash-constrained Greeks curtail spending; foreign investment will slow to a trickle while capital stowed in Greece looks vulnerable to freezing or devaluation. Controls can aid crisis management, as Malaysia's experience in the late 1990s shows. But Malaysia's controls freed its central bank to loosen monetary policy, buoying the domestic economy. Were Greece to try something similar, or to devalue, that would imply an outright exit from the euro area. That outcome is avoidable, but at a cost; Cyprus's economy shrank roughly 5% in 2013 and a further 2% in 2014. For the people of Greece, where real output remains more than 20% below the pre-crisis level, additional pain of that severity is almost certainly too great a burden to bear.

Dig deeper:
The use of capital controls is growing (April 2013)
Economists are softening their position on the costs of capital controls (October 2012)

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