Beating the system: The risk of capital controls

By Ian Bremmer and David Gordon

The risk is rising that a number of countries — including those that resisted the urge last year — will impose capital controls in 2011. This trend is driven by two factors: in general, emerging markets are recovering more quickly than the United States, the European Union, and Japan from the global recession, and it’s increasingly unlikely that G-20 members can agree on a coordinated strategy to tackle current account imbalances. This is a byproduct of our Top Risk for 2011: the G-Zero. The opportunity for political and commercial advantage raises the value of using capital controls and a lack of global governance lowers the cost.

Investors looking for high long-term growth rates are moving huge sums of cash into emerging market economies, generating upward pressure on the value of currencies in those countries. This, in turn, undermines domestic firms by making their exports more expensive and by intensifying import competition.

In response, policymakers in some countries have turned to currency management, in the form of direct market intervention, to protect local companies. If these interventions can’t take the edge off this upward pressure, some governments will begin to look more seriously at capital controls as a way to counter appreciation. This is more likely given the qualified legitimation of capital controls given by both the International Monetary Fund and the G-20 last year. Already, a handful of countries — Brazil, South Korea, and Taiwan — have telegraphed plans to move in this direction.

Governments weighing the possibility of a resort to capital controls must answer three questions: 1) Are they confident that the country’s investment climate is strong enough to continue to attract foreign capital despite the controls? For Brazil, Korea, and Taiwan the answer is yes. 2) How strong are the political pressures to contain appreciation? Singapore, overriding exporters’ views, decided to accommodate appreciation to strengthen its role as a financial center. 3) Do policymakers believe in an active industrial policy and the viability of capital controls? In Malaysia, for instance, if the government finds itself in political trouble, the answer is probably yes on both counts.

If appreciation pressures continue, the countries most likely to enact capital controls this year are Colombia, Peru, and Thailand. Turkey, Mexico, and the Philippines, on the other hand, are unlikely to move in this direction. But contagion will be an important factor. When state officials see their trade competitors move to stem appreciation, or if policymakers perceive controls as effectively stemming appreciation, they’re much more likely to follow suit to avoid a competitive disadvantage.

On Friday, we’ll examine the risk of U.S. policy gridlock, which takes its places as Top Risk no. 7 this year.

Ian Bremmer is president of Eurasia Group. David Gordon is the firm’s head of research.