The Siren Song of Exchange Controls

August 31, 1998 • Commentary
This article first appeared in The Wall Street Journal Asia, August 31, 1998.

Paul Krugman , professor of economics at MIT, has recently completed an Asian tour during which he sang the praises of exchange controls. Asian leaders should be wary of this flawed advice.

Currency convertibility is a simple concept. Essentially it means residents and non‐​residents are able to exchange domestic currency for foreign currency. However, there are many degrees of convertibility, with each denoting the extent to which governments impose controls on the exchange and use of currency.

The idea of exchange controls can be traced back to Plato, the father of statism. Inspired by Sparta, Plato embraced the idea of an inconvertible currency as a means to preserve the autonomy of the state from outside interference. It’s no wonder that the so‐​called Red‐​Brown (communist‐​fascist) coalition in the Russian Duma has, in recent weeks, rallied around the idea of exchange controls and an inconvertible ruble. This also explains why the leadership in Beijing finds the idea so user friendly.

The temptation to turn to exchange controls in the face of disruption caused by “hot money” flows is hardly new. Tsar Nicholas II first pioneered limitations on convertibility in modern times, ordering the State Bank of Russia to introduce in 1905-06 a limited form of exchange control to discourage speculative purchases of foreign exchange. The bank did so by refusing to sell foreign exchange, except where it could be shown that it was required for imports; otherwise, foreign exchange was limited to 50,000 German marks per person. The tsar’s rationale for exchange controls was to limit hot money flows, so that foreign reserves and the exchange rate could be maintained. The more things change, the more they remain the same.

…[T]he imposition of exchange controls leads to an instantaneous reduction in the wealth of the country, because all assets are worth less.

But before Asia’s politicians come under the spell of exchange controls, they should ponder the following footnote in Nobelist Friedrich von Hayek’s 1944 classic, “The Road to Serfdom”: “The extent of the control over all life that economic control confers is nowhere better illustrated than in the field of foreign exchanges. Nothing would at first seem to affect private life less than a state control of the dealings in foreign exchange, and most people will regard its introduction with complete indifference. Yet the experience of most continental countries has taught thoughtful people to regard this step as the decisive advance on the path to totalitarianism and the suppression of individual liberty. It is in fact the complete delivery of the individual to the tyranny of the state, the final suppression of all means of escape not merely for the rich, but for everybody.”

Hayek’s message about convertibility has regrettably been overlooked by many contemporary economists. Exchange controls are nothing more than a ring fence within which governments can expropriate their subjects’ property. Open exchange and capital markets in fact protect the individual from exactions because governments must reckon with the possibility of capital flight.

From this it follows that the imposition of exchange controls leads to an instantaneous reduction in the wealth of the country, because all assets are worth less. To see why, let’s review how assets are priced.

The value of any asset is the sum of the expected future installments of income it generates, discounted to present value. For example, the price of a stock represents the value to the investor now of his share of the company’s future profits, whether issued as dividends or reinvested, stretching out over time. The present value of future income is calculated using an appropriate interest rate that is adjusted for the various risks that the income may not materialize.

When convertibility is restricted, risk increases, and so the risk‐​adjusted interest rate employed to value assets is higher than it would be with full convertibility. That’s because property is held hostage and subject to a potential ransom through expropriation. As a result, investors are willing to pay less for each dollar of prospective income and the value of property is less than it would be with full convertibility.

This, incidentally, is the case even when convertibility is allowed for profit remittances. With less than full convertibility, there is still a danger the government will confiscate property without compensation. This explains why foreign investors are less willing to invest new money in a country with such controls, even with guarantees on profit remittances.

So investors become justifiably nervous when it seems a government is considering imposition of exchange controls. At that point, settled money becomes “hot” and capital flight occurs. Asset owners liquidate their property and get out while the getting is good. Contrary to popular wisdom, restrictions on convertibility do not retard capital flight, they promote it.

This type of capital flight (and dollarization) has been occurring on a grand scale in capital‐​starved Russia. Indeed, Russians swapped $13 billion worth of rubles for greenbacks in 1997, a year in which the dollar‐​ruble rate was stable and inflation was falling rapidly. This dollarization amounted to a capital export that exceeded all capital imports to Russia that year. Clearly, the Russians have better memories than the IMF technocrats. The actions of the Russian people in 1997 indicate that they anticipated the great Duma exchange control debate of 1998.

Restrictions on convertibility also promote other noxious activities. For example, if capital account convertibility is restricted or limited and convertibility on the current account is allowed, a two‐​tier currency market will be either formally or informally established. In that case, the “investment currency” will trade at a premium over the price of the relevant foreign currency on the official market for current account transactions. With two prices for the same currency, there are profits to be derived form having capital account transactions “reclassified” as current account transactions. That ad hoc reclassification can usually be bought by crony capitalists, for a price.

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