The Trojan Horse


Author: Tanya Rawat

Published in Global Risk Insights

J.M. Keynes, one of the architects of the Bretton Woods agreement, considered capital controls key to a global economy. However, soon after, in the 1970s, countries started abandoning capital controls as the international financial system started displaying hues of an asymptotic convergence to a pre-Bretton Woods era of fragmented Adam Smith’s ‘beggar thy neighbour’/free market oriented philosophy.

Today, as the euphoria of cheap and easy money eases off, the emerging markets are grappling with withdrawal symptoms owing to gradual weaning off by the US Federal Reserve. The current debate for considerable capital account convertibility (CAC) has many more downfalls. The rhetoric being that, if international trade is beneficial when it concerns goods and services, why not financial and physical assets too? Clearly there lies a fundamental difference in the way that markets operate in these different areas. Markets for goods and services are rarely textbook-perfect, but they operate in most instances with a certain degree of efficiency and predictability. Financial markets are fundamentally different. Market failures arising from asymmetric information, incompleteness of contingent markets, and bounded rationality (not to mention irrationality) are endemic to financial markets. There is no empirical evidence in the data that countries without capital controls have grown faster, invested more, or experienced lower inflation. Or even that, countries that have a tremendous gap between domestic investment and savings that holds back growth can be plugged by foreign capital. As Prasad and Rajan iterate in their paper, some simply don’t have good investment opportunities (and the factors that depress investment may depress domestic savings even further, forcing these countries to rely on foreign capital), while those that have investment opportunities may also be able to generate adequate domestic savings.

The Asian crisis of 1996 saw South Korea, Indonesia, Malaysia, Thailand and Philippines buckle under the freedom of capital account convertibility. In layman’s terms, capital account convertibility (CAC) — or a floating exchange rate — means the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. This means that capital account convertibility allows anyone to freely move from local currency into foreign currency and back.  It refers to the removal of restraints on international flows on a country’s capital account, enabling full currency convertibility and opening of the financial system. Current account convertibility allows free inflows and outflows for all purposes other than for capital purposes such as investments and loans. In other words, it allows residents to make and receive trade-related payments — receive dollars (or any other foreign currency) for export of goods and services and pay dollars for import of goods and services, make sundry remittances, access foreign currency for travel, studies abroad, medical treatment and gifts, etc. Capital account convertibility is considered to be one of the major features of a developed economy. It helps attract foreign investment. It offers foreign investors a lot of comfort as they can re-convert local currency into foreign currency anytime they want to and take their money away. At the same time, capital account convertibility makes it easier for domestic companies to tap foreign markets.

The question is whether it makes sense to link up domestic financial markets tightly with international ones, and therefore speed up this process. There are two major risks in doing so: First, we increase the liquidity to which borrowers in an individual country have access, thereby greatly magnifying the effects of any turnaround in market sentiment. Second, we increase systemic risk through contagion from one market to another. On the other hand, the benefits of removing capital controls remain to be demonstrated.

To the extent that capital account liberalization places pressures on weak domestic banks, and to the extent that adequate prudential supervision is absent, liberalization can encourage individually rational but socially harmful activities such as excessive risk-taking and “gambling for redemption” which can culminate in full-blown and costly banking crises. As a result, any benefits of capital account liberalization may easily be obscured by the costs of the greater financial fragility it brings, especially in economies with poorly-regulated financial sectors. More generally, one might expect the benefits of capital account liberalization to be more pronounced in countries characterized by a sound macroeconomic framework and strong institutions.

Put simply, CAC may turn out to be the Trojan horse for emerging markets fragile financial systems.


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