The Problem with Capital Controls

Grexit Greece Euro CrisisGreece continues to face a potential default by the end of this month, prompting many Greek citizens to withdraw their savings from banks. This in turn has led to intensified calls for capital controls. Capital controls are seen as a necessary action by many banks and government finance ministers. However, they are not a solution to the underlying problem and will only create more distortions and economic problems the longer they remain in place.

Greece’s IMF repayment is due by the end of this month, and if a deal with their creditors is not reached they will likely default. The possibility of default or removal from the Eurozone has caused many Greek citizens to withdraw their savings for fear of bank closures or currency devaluations.

Greeks have pulled at least 20 percent of their deposits this year, with 3 billion euros withdrawn this last week, Monday through Thursday. Another 2 billion euros were withdrawn this past Friday and 1.6 billion on Monday. Of course, anyone who is familiar with how fractional reserve banking works (or has seen movies like It’s a Wonderful Life  or Mary Poppins,) knows why this surge in withdrawals is a problem – banks do not have depositors’ money just sitting in the vault ready for them to withdraw.

At the end of April, Greek banks had approximately 143 billion euros in domestic deposits but only 2 billion of cash in hand – the rest is tied up in loans and other bank assets. So where is the cash coming from to give to all of these depositors taking their money out? From the European Central Bank’s “Emergency Liquidity Assistance” (ELA) facility. This is renewed weekly and the ECB could stop it any time.

If the ELA does stop, banks will not have enough cash to cover requests which is why capital controls are now being discussed. Capital controls are rules put in place to help stem the flight of capital out of banks and out of the country.

Capital controls can take a number of forms. A common one is to limit how much cash can be withdrawn from a bank or ATM as well as a limit to the amount that can be transferred electronically. When Cyprus banks failed and shut down for weeks in 2013, they reopened with a cash withdrawal limit of 300 euros per day and 5,000 euro electronic transfers. Other forms could include the requirement of government approval for foreign transactions, and there may even be physical controls and checkpoints to prevent cash or other assets from crossing the border. Although technically not a direct capital control, the government may also choose to heavily tax transactions or implement time requirements.

EuroklemmeSome of the problems with capital controls are obvious, but it is helpful to examine how far reaching and crippling to an economy they can be. First, they slow down all economic activity. As former Governor of the Central Bank of Cyprus noted, “curbs on withdrawals ‘erode the ability of business to carry out normal day-to-day transactions’ and amount to a long-lasting tourniquet on commerce.”

Second, it undermines trust in the banking system and government, further deteriorating the nation’s banking system and the rule of law in general. Third, it distorts other prices and exchange rates. This can clearly be seen as sales of luxury autos in Greece has skyrocketed, obviously not because Greek citizens are so much wealthier, but because they are trying to find some kind of real asset to buy with all of their withdrawn cash.

The U.K. Royal Mint has also seen an increase in demand of gold coins from Greek citizens. This also illustrates how currency controls ultimately do not work as citizens will find loopholes and ways around them; the controls merely delay the inevitable.

Finally, currency controls prevent regular citizens from escaping any kind of currency devaluation should it occur. If Greece is kicked out of the eurozone and implements a new currency, depositors could potentially see their savings converted to the new currency overnight in the bank.

Let’s hope the everyday Greek citizen can get most of their savings out before any of this happens. Further, let this be a lesson on how fragile our current banking regime still is and why it is always prudent to hold some wealth, cash and assets outside of the banking system.

Chris Kuiper CFA is currently a student and researcher at George Mason University, pursuing a Master’s of Economics. His previous experience includes asset management, investing and banking.