A Survey of Capital Controls and Black Market FX: A Refresher for Developed Market Investors

Published on February 19, 2021

For this first February post, I am stepping back to cover a broader topic important for international investors to understand. We will talk about FX regimes, capital controls, and black market FX—parallel market foreign exchange in PC lingo.

Few investors from the US or Europe born after 1980 have never had to deal with the uncertainty surrounding foreign exchange rules, buying, or selling international securities.  The dollar has been floating since 1971, and although many European countries have switched from Francs, Lira and D-Marks to Euros, the rules have been pretty straightforward.  We’ll let our currency float and occasionally talk it down (rarely up) if it appreciates (depreciates) too much.

This is not uniform across the globe and is unique historically.  Rarely have currencies representing most of the global economic production floated so freely for such a long time.

This post will show why I think this trend is receding and how investors may want to think about the implications.  Fortunately, in addition to history, we can look to Emerging Markets. This perspective can give us a bit of an overview of what can happen from a policy perspective over the coming years.  

The short answer is that investors should be prepared for various measures to curb capital movement as nations prioritize stable currency prices and monetary independence.  Investors, particularly smaller ones, will be better positioned to protect their capital when attuned to these developments.

We’ll cover:

• Foreign Exchange Systems and the Impossible Trinity
• Post World War II FX Systems and Capital Controls
• Emerging Markets Black Market FX
• What New Capital Controls in Developed Countries May Look Like

Foreign Exchange Systems and the Impossible Trinity

I will go out on a limb here and say that if you are reading this, you likely agree that monetary policy, trade, and foreign exchange rates are all interrelated.  With that supposition, I then want to introduce the Impossible Trinity. I believe it can simplify (perhaps oversimplify) the mechanics and theoretical background for the rest of the article.

The Impossible Trinity, others call it the Unholy Trinity or the Trilemma, are the basic constraints of monetary, trade, and capital movement policies. There are three policy objectives, which every country would like but can only have two:

1. Monetary Policy Independence:  A country can set its own interest rates and financial conditions.
2. Free Movement of Capital:  Investors and companies can invest and take out their money freely or with minimal restrictions.
3. A Fixed Exchange Rate:  Policymakers can target a specific foreign exchange policy or level.

The rule is that you can have two of these objectives in totality or incomplete control of all three.  The US, for example, has 1 and 2.  The UAE, an oil-rich gulf state, has 2 and 3 it imports its monetary policy from the US.  Problems usually arise when a country tries to manage the missing third piece because it moves too much, usually because of bad policy someplace else.  

A recurring example is developing countries choosing to control monetary policy and maintain free movement of capital.  Shockingly [sarcasm], this usually happens during an economic boom.  Everything is going great until things start to slow down and investors sell investments and remove their money.  This puts pressure on the foreign exchange, which has economic implications. If the depreciation of the currency is sharp enough, it can have politically unacceptable socio-economic consequences.  

So in an attempt to control the currency rate, the country will either involuntarily adjust monetary policy or restrict capital movement.  Either of these movements or a combination of the two, all else equal, stabilizes the FX rate.  If the country is a democracy or has accountability to the people, they will nearly always choose capital controls.  

Those imposing capital controls and those seeking to avoid them typically play a game of whack-a-mole in imposing and avoiding such capital rules.  Countries will impose taxes, regulations, and restrictions on specific activities and investments, and investors will find workarounds, usually creating distortions.  

The CFD markets have been a response to financial transaction taxes, and NDF markets respond to FX restrictions.  Modern-day investors in countries with capital controls can sometimes also buy a local dual-listed security and sell it for hard currency on the offshore exchange.  Original tactics included over- and under-invoicing exports and imports to earn as much extra foreign cash as possible.  You get the idea.  With that primer, we can dive into examples.

Post World War II FX Systems and Capital Controls

After World War II, the world was a mess.  Combined with the Great Depression, most countries had not seen a normalized set of monetary or fiscal policy rules in quite some time.  The US was the only real country left standing, and out of this came the Bretton Woods system. 

The deal was that everyone would fix their exchange rates to the US Dollar.  To keep the US honest in its policies, the US Dollar would be set to gold at $35 an ounce.  Since US citizens were still barred from owning gold, this rate applied effectively only to foreign countries.  Most countries then elected to have some share of monetary policy independence.  Remembering the Impossible Trinity, these priorities meant that nearly every developed country had some form of capital controls going out of World War II.  While initially covering both trade and capital, FX exchange restrictions were gradually limited to capital.  

Controls in the UK 

Honestly, summarized details on these controls have proven hard to find, but this paper from the Bank of England provides a good summary of the restrictions the UK put in place during WWII up through 1967.  There are elements of licensing requirements, outright quotas on exporting capital, the movement of sterling assets between non-UK residents, and various “forms” of sterling depending on the sterling source (trade, capital transactions) and location of the holder.  It is complicated to follow and a mess for anyone trying to navigate it.   

These measures aimed to limit the exchange of sterling for foreign currency, mainly US Dollars.  While such complicated systems may work initially, they require constant refinement as private participants exploit loopholes and, in many cases, can become even more complicated. Given the UK’s role in international trade and finance before the war, it built an administrative infrastructure for these controls at scale.  Agreements with other countries for administration, and, at least in the beginning, the Commonwealth served as a natural block for consolidation of control.  

Exchange controls lasted until 1979, or 40 years.  They ebbed and flowed in the UK based on various crises but were always there in some form. That seems unfathomable now.

There was, perhaps, one silver lining.  The systems in place solidified London as an international financial center for the non-US world and, combined with the US restrictions discussed below, led to the offshore finance necessary for the rapid growth seen globally at the end of the last century.

Controls in the US

The US also had many controls during this period, though many were more a hybrid of the monetary policy control.  An important one I was unaware of was Regulation Q from the Federal Reserve. It currently sets out capital requirements for US banks, but before 1986, it also set the maximum rates banks could pay for deposits and banned paying interest on demand (checking) accounts.  For example, between 1935 and 1957, the top rate for deposits was 2.5%.  In 1957 it rose to 3%.

Regulation Q also played a role in the development of money market funds.  When “market” (treasury bill, commercial paper, etc.) rates rose above the Reg Q ceiling, investors would seek alternatives to deposits.  For internationally-minded readers, which should be all of you, caps on US deposit rates probably also stimulated the development of the offshore dollar or Eurodollar market. International investors could earn greater return rates by depositing their dollars in non-US banks or bond issues offshore.

Under Bretton Woods, exchange rates were fixed, and all countries had interest rates higher than those of the US.  Capital from the US naturally gravitated towards these markets.  To stem the tide, the US created the Interest Equalization Tax in 1963, which taxed Americans on the purchase of particular foreign securities.  Longer-dated bonds and equities were taxed at 15%, while commercial loans were untaxed along with Canadian securities.  The tax was not repealed until 1974.  

As these examples should demonstrate, the developed world coming out of crises has a track record of regulations and measures to control capital through various tools.  As we look at Emerging Markets, many have taken this playbook.  

Emerging Markets Black Market FX

Europe and the US largely removed capital controls in the 70s and 80s. As capital flowed, Emerging Markets have become a major destination and, in some cases, a source of new capital.  Most have been an importer of capital, while some, like the Gulf States, are an exporter.  Many of these countries currently employ capital controls, which have usually spawned black markets for hard currency as participants circumvent the official channels for a better deal.  

Brazil

Brazil does not have a parallel or black market for FX at the moment, but it does employ tools to regulate or influence capital movement, both going out of and into the country.  The most recognizable is the country’s IOF, or financial transactions tax in Portuguese.  While it applies to many financial transactions like loans, insurance and investments, it also applies to foreign exchange.  

According to TransferWise, the rate IOF for foreign exchange transactions is between 0.38%-1.1% depending on where the money is going (in or out of the country) and to whom (yourself, another Brazilian resident or someone else).  This rate has fluctuated greatly.  During the earlier part of the last decade amid the BRICs craze, charges for inbound capital and investments were much higher to dissuade international investors.  Now it is the opposite, with the taxes skewed to discourage capital from leaving the country.  

As a country, Brazil has mostly elected to have an independent monetary policy and free capital movement. As noted above, it uses modest capital controls, such as the IOF, to dampen its currency volatility.

Nigeria

Nigeria’s system is more complicated than Brazil’s for a variety of reasons.  Nigeria needs to import more tradable goods and capital than Brazil, and its only current source of foreign exchange is oil.  Thus the country is at the whim of things it cannot control.  In terms of the Impossible Trinity, they target independent monetary policy and a fixed exchange rate.

Currently, holding most financial assets in Nigeria is not appealing.  The current yield curve is as follows:

While the curve is steep and nominally higher than any developed country, inflation is currently running in the teens, which means that real yields are profoundly negative across the entire curve. Investors are losing purchasing power by investing in basic Nigerian savings products.

To add gasoline to the fire, Nigeria must import a lot of fixed capital and essential goods.  To prevent the discord from rising import prices, the Nigerian government (via the central bank) has greatly restricted access to foreign currency and prioritized specific tradable segments (think medical supplies, essential imports).  Such items get a better exchange rate than other transactions. 

Because there has been more demand than supply of dollars at the official rate, a black market has developed.  To address some of these imbalances, the country created a tiered system in 2017.  Priority transactions can still take place at the official exchange rate, currently 380 USD/NGN.  Investors, exporters, and non-priority importers can use the I&E window, which is currently trading at 400 USD/NGN.  For everyone else who wants dollars, they have to use the black market, currently 480 USD/NGN.

Beyond the monetary items above, there is an administrative burden.  I have been invested in the Nigerian market for the past several years and recently have started taking out a portion of the dividends received.  I had to present full bank statements and wait about a week for my transaction to be processed.  Compared to other crises in other markets (Egypt during the Arab Spring), this is not terrible but worth understanding.  This also says nothing of the populace whose savings are being eroded.

This also explains why the Nigerian central bank has recently made headlines by reminding regulated financial institutions that cryptocurrencies are not legal tender and to close accounts facilitating cryptocurrency transactions.

Argentina

No survey of emerging market capital controls would be complete without covering Argentina.  For as long as I have been involved in the markets, the country has struggled to balance policies and maintain macroeconomic stability.  Currently, the government effectively operates one official FX rate and a highly standardized but informal second-tier rate.  While under President Macri, between 2016 and 2020, capital and exchange controls were liberated, but by the end of the period, Macri had begun to reimpose many of the regulations he had repealed.

Currently, Argentines face a blanket cap on the amount of foreign currency they are allowed to purchase.  Argentina also has a wealth tax, and offshore, non-peso wealth is taxed at 2x the peso-rate.  Exporters are required to immediately remit their foreign exchange earnings and sell to the government at the less advantageous official rate.  

For those who want dollars but cannot get them at the official rate or import dollars (by exporting goods) and want to get better than the official rate, there is the blue-chip market.  This market is also called the Contado con Liquidación.  What effectively happens is that the same securities are bought and sold in two different currencies.  

If you are trying to get money out of Argentina, you will buy an Argentina bond with pesos and then sell it for dollars after that.  The difference between the ratio of the expense and proceeds gives you the FX rate.  Argentina’s current official fx rate is around 88 (it was less than 15 five years ago), and the blue-chip is currently 148.  You can also see the rate reflected in other ways.  

As discussed in the first section, the price difference between dual listings can also show unregulated rates.  Compare the price of YPF (the state oil company) shares in Argentina vs. the ADR listed in New York.  The ADR represents one share.

As you can see, the rate is about 152, which is not too far off the blue-chip price.

Greece & Cyprus

No offense to my Greek and Cypriot friends, but Greece and Cyprus display many EM characteristics and went through a dramatic crisis in the last decade.  Greek and Cypriot depositors faced strict restrictions on withdrawals and transfers of money outside of their respective countries. In Greece, banks were closed for nearly a month and cash withdrawals were limited.  While they were gradually related over a multi-year period, they were not fully withdrawn until four years later, in 2019.

 In the Cypriot case, larger depositors were converted into equity holders of their banks at predetermined rates in addition to large-scale restrictions on moving capital abroad. I remember there being a market for these frozen deposits offshore as existing depositors were willing to sell claims at a discount for cash outside of Cyprus.  

The Cypriot example served as a template for the EU’s “bail-in” rules for financial institutions.

Takeaways from Emerging Markets

I believe the above modern-day examples provide useful context for the current tools used by policymakers and participants and should be noted by investors in developed markets as the existing state of play. 

What New Capital Controls in Developed Countries May Look Like  

All the examples above deal with a balance of payments/external financing crisis, but I think it is worth thinking about political means for capital controls.  After all, many developed economy capital controls last century arose from political circumstances and the world wars.  The assets of enemy combatants were the first frozen.

Below are a few different areas to think about.

Climate

Many believe climate change is an existential battle.  Without running through the gauntlet of that debate, I think both sides agree there is a good chance that there will be further regulation in this space.  The subsidies provided to most renewables are a form of control, and the environmental E in ESG investing is a consensus societal control.  

While ESG is currently voluntary, we are not necessarily far from a world where stricter regulation applies to debt and equity investments into industries or companies that do not meet specific environmental criteria.

China

Maybe the US administration change delays any real action, but one should at least plan for the contingency of further capital controls between the rest of the world and China.  Such rules already exist for those looking to get their money out of China, but countries have already begun to restrict inward capital as well.   

Although there is a chance it might get reversed, the NYSE has delisted Chinese telco’s from the NYSE, and these companies have been removed from many of the indices used for building ETFs.  Further regulation could restrict both portfolio investments and FDI.

US Investments

In both a search for government funding and to help finance infrastructure, the US could persuade or force investors to deploy more of their capital back into the US.  Climate and ESG are a subcategory of this, but this could also take the form of a new IET tax, burdensome regulatory requirements, or incentives.  Opportunity zones are a carrot version of this, but one can imagine more coercive means of trying to accomplish the same thing. 

Exceptions

There are usually exceptions to the rules, and once any rules are out, they will be found.  Canadian mutual funds became a conduit for US citizens investing abroad during the IET tax of the 60s and 70s, and Emerging Markets were entirely exempt from the tax.  

Pieces in Place

If you think the reversion to such controls would be difficult, the anecdotes above suggest we are already trending this way.  The administrative pieces are also in place to make this more straightforward in the future.  

FATCA in the US and the CRS in the rest of the developed world were started to reduce tax evasion by making the global financial system responsible for reporting accounts to various tax authorities around the world.  The annual filings related to FATCA and CRS are disclosures, and you are fined for non-compliance.

It would be straightforward to use this information to formulate new taxes.  The IRS knows where the assets are located and, with a moderate amount of research, can estimate possible taxes in addition to the dividend, interest, and profits taxes someone should already be paying.  An example of this was the disclosure and subsequent legislation in the US around controlled foreign corporations in the 1960s.  The IRS first asked for information, which was then used to formulate a new tighter tax policy.

Finally, given the globalized nature of brokerage accounts now, restricting access to international markets would be simple.  Legislation can be put in place to restrict access to certain countries, or legislators could regulate index providers, which effectively dictate most ETFs’ composition.  There would be plenty of narratives to justify intervention, whether it be national security, undue risk, etc.  

Conclusion

This post is an attempt to raise the issue of capital controls to an investing public that has invested largely unchecked for a couple of decades.  I am not saying additional rules will be put into place or what specific form they will take.  However, this piece illustrates that such controls have a historical precedent and that their prior justifications rhyme with many of the issues we’re seeing in the market and society today.

Capital controls are generally a pain, which many in Emerging Markets today understand too well.  Those of us in North America and Europe may have to adapt and adjust if they expand here.  

 If done prudently and in moderation, there may be an efficient way to achieve particular societal objectives.  More often than not, they either outlive their purpose or are a band-aid for a more significant problem.

However, such rules typically generate distortions and volatility, which also create opportunities.  The key is awareness.

For those looking for more, Russell Napier has raised the return of capital controls on many public occasions. Coincidently in a recent interview on RealVision, he covered the topic with Stephen Clapham. I highly recommend it.

To your investing adventure,

The Castaway Capitalist

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