1. Introductory references
1.1. Research objectives of this study
The main objective of the present study is to examine the impact of capital controls on the Greek, Cypriot, Icelandic and Russian economies by integrating theoretical and empirical data revealing the pattern of stock market reaction to the announcements of changes in capital control made by the under-analysis countries. The study’s theoretical part consists of the literature background aspects regarding the capital controls framework while the empirical results aim at analyzing and comparing the countries’ stock market prices throughout the duration of their capital restrictions.
1.2. Definition of capital restrictions
Capital control refers to any measure taken by a government, central bank or other regulatory body limiting the flow of foreign capital in and out of the domestic economy. These controls include taxes, tariffs, outright legislation and volume restrictions, as well as market-based forces (European Central Bank, 2012). Capital controls can affect many asset classes such as equities, bonds and foreign exchange trades. Capital controls are put in place specifically to regulate financial flows from capital markets into and out of a country's capital account. These controls can be economy-wide or specific to either a sector or industry. Capital restrictions are enacted by government policy makers in order to restrict domestic citizens from acquiring foreign assets or restrict foreigners from acquiring domestic assets. The former is referred to as capital outflow controls and the latter is known as capital inflow controls. Tight controls are most often found in developing economies, where the capital reserves are lower and more susceptible to volatility.
2. Literature Review
2.1. Types of capital controls
Capital controls are imposed when the governments of nations restrict the inflow and outflow of capital into the economy. Countries struggle to ensure that their economies stay relatively stable in the long run, thus, impose some form of capital controls. The majority of the economies in the western developed world do not impose capital controls. Instead, economic movement of capital is left to the free will of the markets .
Types of Capital Controls:
Minimum Stay Requirements: A lot of countries have a sort of lock in period when it comes to capital investments. This means that they allow free movement of capital in and out of the country. However, there should be a certain time gap between the inward movement and the outward movement setting a lock in period or a minimum stay requirement.
Limitations: Some countries limit the amount of money that every entity can remit out of the country or restrict domestic citizens from acquiring foreign assets and foreigners from acquiring domestic assets.
Specific Transaction-based limitations: No interest-bearing reserve requirements, taxes on portfolio flows (e.g. Tobin Tax), discriminatory and disparate taxes on income resulting from foreign assets, credit rating requirements for borrowing abroad, multiple exchange rate systems, increased and discriminatory reporting requirements.
Caps on Asset Sales: In many countries certain groups of assets are classified as strategic. These assets are then not sold to foreigners. Such economies allow free movement of capital in and out of the economy in varying sectors. For instance, Canadians have protected their agricultural investments as foreigners are free to invest in multiple sectors of the economy except agriculture.
Limit the Currency Trading: Some countries aiming at limiting the amount of foreign currency that is available for trading in the foreign market at any given point of time with a view to maintain currency pegs, i.e. fixed exchange rates. This helps them plan their economic activity better especially if they are an export oriented economy.
2.2. Effectiveness of capital restrictions
Although the available literature on capital restrictions is widening over a long period of time, looking at different enforced regimes, the effectiveness of restrictions on capital controls still differs in the empirical studies conducted.
Through a comprehensive review of the empirical results of Magud and Reinhart (2006) on capital controls, little evidence suggests the effectiveness of capital restrictions, with Malaysia (1998) standing out as a paradigm for implementing effective capital controls, as they were indeed successful and favored the development of an autonomous monetary policy (Magud& Reinhart, 2006). However, several researchers support that Malaysia’s success was achieved due to the period imposed as capital restrictions had been implemented during the final stage of the Asian crisis when the Asian economy was already recovering (Demirgüç-Kunt&Servén, 2010; Edison & Reinhart, 2001).
To analyze the effectiveness of capital controls, researchers used a number of different methods, which largely depend on the frequency and quality of available data. In the study of Ariyoshi et al. (2000), descriptive statistics are used to achieve qualitative results of the capital restrictions effectiveness in Malaysia (1998), Spain (1992) and Thailand (1997). The researchers concluded that the capital outflow controls had only a temporary effect and, at best, provided the government with the necessary time to tackle macroeconomic abnormalities and implement structural reforms.
Unlike the case of Malaysia (1998), Edison and Reinhart (2010) stated that exchange rate volatility in Thailand (1997) increased during the capital controls period and that capital restrictions failed to reduce the level of neither interest rates, nor even fluctuations in volatility. In addition, empirical analyses by Edison and Reinhart indicate that capital flows in Thailand increased during the period of the capital controls.
Unlike previous studies, data by Binici et al. (2009) report that capital outflow controls can be effective towards their objective. The authors made a fixed-effect panel of 74 countries over the period 1995-2005 in order to determine the effectiveness of capital outflows using a panel with annual data of the net capital inflows and net outflows. Binici et al. argue that by separating net capital flow into net inflows and net outflows, research shows precise conclusions about the effectiveness of capital controls, as economically strong countries appear to be able to effectively impose capital controls.
2.3. Advantages and disadvantages of capital controls implementation
It is difficult to identify the advantages and disadvantages of capital controls as they are directly linked to strategic choices of policy-makers to achieve objectives related to the regulation of national economies.
Advantages of capital controls :
• Capital controls are necessary in a system of fixed exchange rates if the monetary authority wishes to pursue an independent monetary policy centered on the domestic economy. This is a well-known option called Impossible trinity (also The Trilemma), which describes that only two of the following may occur in an open economy: i) Free flow of capital ii) Fixed exchange rate and iii) Independent monetary policy. Therefore, if it is desired (ii) and (iii) to abandon (i) and impose some form of capital controls.
Calvo & Reinhart found that many emerging market economies follow a de facto fixed exchange rate regime even when their exchange rate system is characterized as floating. Therefore, many of these countries have some kind of capital control.
• Contribute to reducing exchange rate volatility. If exchange rate fluctuations in a country are high, then exchange rate fluctuations are passed on to the country's economy as a sharp change in inflation. Small, open, emerging market economies are particularly sensitive to the outflow of money from domestic capital markets. Capital controls can be used to limit this impact. For example, the Indian central bank has a ceiling on the percentage of foreign currency loans that Indian companies can buy abroad. The bank regularly reviews the quota (upwards or downwards) according to the Rupee / Dollar exchange rate situation. Another example is recorded in 2013 when the Indian central bank lowered the outflow of personal capital to mitigate panic in the foreign exchange market .
• Normally, domestic firms and households in emerging markets can borrow at lower rate from international markets, usually in a hard currency like Dollar, Euro etc. If done unrestricted over a long time, large amount of foreign currency debt can accumulate in the economy, limiting the central bank's ability to play the lender of last resort. That could lead to large scale bankruptcies in crises and financial turmoil and is a recurring problem in open emerging markets.
Disadvantages of capital controls :
• Very difficult to enforce – Special practical conditions and time for enforcement and optimization of controls are required, even then it is difficult to avoid capital flows.
• Negative effects for domestic investors and businesses – In the absence of capital controls, domestic investors can diversify their portfolio, invest in international markets and (theoretically) achieve better risk-adjusted returns. Businesses can benefit from lower lending rates on international markets.
• In the presence of capital controls, governments will have to pursue difficult economic policies without worrying about the reaction of the market for some time. Central banks have the ability to pursue inflation-enhancing policies as well as the government should manage large, long-term fiscal deficits and force domestic institutions to buy state debts, etc.
• The immediate effects of the capital controls implementation are on the financial markets; by affecting asset prices and returns, policy makers influence economic behavior in ways that help to achieve their macroeconomic goals. Prior studies (Alexander et al., 1987; Bonser-Neal et al., 1990) suggest that the cost of capital decreases due to a reduction in risk premium that compensates for foreign investment barriers. Therefore, it can be argued that the installation of investment barriers that hamper international capital flows will increase risk premium, and therefore result in the increase in the cost of capital. In addition, countries with stronger securities’ regulation and extensive disclosure requirements are likely to lower the cost of capital for firms.
2.4. Indicative examples of capital control practices
Economists often pinpoint the capital controls imposed by the Chinese government to refer to good practices of capital controls. The Chinese economy has flourished for more than three decades and capital controls have been happening throughout this period. China is gradually opening up its economy, as the domestic sector has become equally strong. Malaysia also benefited from capital controls during the economic recession of 1998. Since capital could not flow out of the country as fast as they could from Thailand and Vietnam, Malaysia gained more valuable time to face this difficult situation. Opposite results were recorded in India, with the Indian economy collapsing during the period capital controls were imposed. After 1991, these controls were lifted, and the Indian economy started to grow relatively smoothly. Today, India is one of the fastest growing countries in the world.
2.5. The cases of the countries concerned
2.5.1. The case of Greece
Capital controls were imposed on Greece on June 28, 2015, when Greece's government came to the end of the rescue bail-out period without further agreement with its creditors, and therefore the European Central Bank decided not to increase the level of the emergency liquidity assistance (ELA) for Greek banks. The banks and the Athens Stock Exchange were closed until July 6th. In the wake of the decision to hold a referendum by the country's prime minister, an upheaval on the Asian and European stock exchanges occurred on 29 June.
Controls on bank transfers from Greek banks to foreign banks, and limits on cash withdrawals (only €60 per day permitted) took place, to avoid an uncontrolled bank run and a complete collapse of the Greek banking system. Electronic transactions within the country were unaffected as all transactions using a credit or debit card and other electronic payment methods were normally conducted. The Government set up a special Bank Transactions Committee, the State Treasury, in cooperation with the Ministry of Finance, the Bank of Greece, the Hellenic Bank Association and the Cyprus Securities and Exchange Commission. The Committee's mission was to deal with requests for urgent and necessary payments, which could not be met by the cash withdrawal or electronic transactions.
Greek stock market suffered as international players and hedge funds liquidated their positions and could not be replaced by Greek investors who could not buy stock, resulting in the collapse of Greek companies as their market value lost up to 90 percent of their value in three days. The Athens stock exchange ended its torrid first day of trading 16.2 percent lower, after it reopened for the first time in five weeks.
In September 2015, certain aspects of the imposed capital controls were relaxed. Four months after capital controls were imposed on 28 June 2015, the government published two important modifications: while still limiting withdrawals to €420 per week, account holders could withdraw the whole sum in one transaction instead of up to only €60 per day, thus significantly reducing the amount of time spent queueing at the banks and ATMs, and, furthermore, up to 10% could be withdrawn from funds deposited in Greece from abroad.
In the third quarter of 2015, shortly after the implementation of the capital controls, the Greek economy returned to negative growth rates (-1.7% in annual base) after 5 consecutive quarters of positive real GDP growth (+ 0.8% on average). Despite the negative impact of the restrictions on capital movements, the recession in the whole of the previous year proved to be much milder than the original projections . At the same time, domestic demand had a negative contribution, mainly due to the large drop in inventories while net exports moved in the opposite direction due to the significant contraction in imports.
Private sector deposits (non-financial corporations and households) showed stability following the restrictions on capital flows. In particular, according to the latest data deriving from the Bank of Greece, deposits in June 2016 increased by approximately € 1 billion (+ 0.9%) on a monthly basis and by € 1.9 billion (+ 1.6%). compared to July 2015 (the first month of implementation of restrictions). In addition, it is estimated that € 4 billion total bank notes have returned to the domestic banking system in the last 12 months .
Greece remains under the restrictions of capital controls and is not expected to lift them, any sooner than the end of 2018. Bank account holders in Greece since September 2017 can withdraw a total of 1,800 euros in cash per month.
2.5.2. The case of Cyprus
During the major financial crisis in 14th April 2013, Cypriot banks remained closed for 12 days following a common decision of the Cyprus Government and the Central Bank of Cyprus. The closure of the banks was considered necessary to avoid the "bank run" phenomenon, i.e. the massive turnout of depositors with take-back requests because of the reduced confidence in the banking system. It should be noted that the size of the banking sector in Cyprus was disproportionate to the Cypriot economy, as it reached 800% of GDP .
In order to overcome the crisis, Cyprus, the International Monetary Fund and the European Union signed an agreement that consisted of 40% "haircut" in the deposits exceeding 100,000 Euros. The merger of the two major country’s banks of the, the Laiki Bank and the Bank of Cyprus was the result of the joint agreement. Capital controls had been maintained for 2 years after their implementation and have led to significant economic difficulties in Cyprus; blowing off the country's credibility and reporting tourism’s decline. The capital controls were lifted in 2015, with the last controls being removed in April 2015.
The main points of the imposed restrictive measures were the following:
• A daily take-over cap was set at € 300.
• Foreign travelers were allowed to have up to 2,000 euros with them.
• Especially for students abroad they were allowed to receive a wire transfer of up to 5,000 euros per quarter.
• Any currency export for foreign investment was banned.
• It was possible to use a check only for deposits in the name of the beneficiary.
• The intra-Cypriot transactions required supporting documents for the transfer of funds.
• The tourists who were in Cyprus at that time were not allowed to leave the island with more than 1,000 euros in cash with them.
2.5.3. The case of Iceland
The Icelandic financial crisis was a particularly important economic and political event succeeding the global financial crisis, that involved the default of all three of the country's main private commercial banks at the end of 2008, following their difficulties in refinancing their short-term debt and the mass outflow of deposits in the Netherlands and the United Kingdom. The capital controls were introduced in November 2008, after Iceland was struck by an unusually severe banking crisis in October 2008. In relation to the size of its economy, the collapse of the Icelandic banking system was the largest one in the history of economics (The Economist, 2008). The crisis has led to a severe economic recession in 2008-2010 and major political changes.
The financial crisis has had a serious negative impact on the Icelandic economy. National currency declined substantially in value, foreign currency transactions were virtually suspended for weeks and the stock market value of the Icelandic stock exchange fell by more than 90%. As a result of the crisis, Iceland suffered a severe economic downturn, the country's gross domestic product declined by 10% in real terms between the third quarter of 2007 and the third quarter of 2010. The positive GDP growth launched in 2011 contributed to the promotion a gradually decreasing trend in the unemployment rate. The government budget deficit fell from 9.7% of GDP in 2009 to 0.2% in 2010 while in 2014 the gross debt to GDP ratio dropped to less than 60% .
During March 2017 Iceland’s government lifted the remaining capital controls that had been in place since the financial crisis in 2008, easing restrictions on households and businesses.
5.4. The case of Russia
In December 2014, the ruble reached its highest levels, resulting in unofficial capital controls designed to prevent a recurrence of inflation accompanied the financial crisis in Russia in 1998 . The Russian stock market experienced large decline, with a 30% drop in the RTS Index during December of 2014. The Russian government set limits on the net foreign exchange assets of state-owned exporters, while officials and bank sources reported that the central bank had installed supervisory authorities in the foreign exchange branches of top state-owned banks. The government ordered five state-owned exporters including energy groups Gazprom and Rosneft to sell their foreign currency reserves. Economists support that the measures imposed on Russia were an effectively imposed mild version of capital controls.
Unofficial capital restrictions implemented in the December of 2014 are treated as a short-term occasional measure adopted by the Russian government with a view to protect its strong currency. Nowadays, Russian legal entities may buy foreign currency on the local currency market in order to pay invoices of foreign suppliers or to make interest and dividends payments. To this end, they authorize their bank to purchase foreign currency prior to acquiring foreign currency for making payments for imported work, services and results of intellectual activity exceeding the equivalent of 10,000 USD. Russian legal entities must obtain a statement from currency control authorities confirming that the necessity to acquire foreign currency to make such payments is justified.