High Debt, Dollar Strength: Capital Controls on U.S. Dollar Likely

Capital Controls in USThe possibility of capital controls coming to the U.S. is not as much of a stretch as you may think. Consider the precedents and don’t be caught off guard.

Capital controls are any measure taken by a government authority that limits the flow of foreign capital into and out of the domestic economy. In its ugliest forms, capital controls in the U.S. would restrict bank withdrawals and limit foreign currency transactions, including overseas stock purchases.

While capital controls can be seen as strong measures, they are often needed to curb weak economic conditions. Several recent examples come to mind: Cyprus 2013, the continued “Grexit” crisis, and less dire events like January 2015’s Swiss franc surprise.

Let me explain…


Where Capital Controls Happened: Cyprus

Record-breaking debt levels in Cyprus forced the government to seek external funds to bail out its beleaguered banks in April 2013. The eventual 10-billion-euro bailout stabilized the tiny nation, producing roughly 25 billion euros annually in gross domestic product (GDP). On the other hand, it terrified depositors and money began flowing out of the tiny country.

If banks run out of deposits, they can’t make loans. If there are no loans, there is no liquidity, businesses stall, spending plummets, and the economy enters a recessionary period. To keep money within its borders, Cyprus imposed measures restricting fund transfers abroad with the only exceptions being tuition and salary payments. (Source: Central Bank of Cyprus, February 13, 2015.)

This was, of course, bad news for Russian billionaires who used Cyprus to protect their assets from Russian authorities. Cyprus is also attractive for billionaires looking to park their assets offshore because of lower tax rates and other tax avoidance benefits.

Where Capital Controls Are Likely to Happen: Greece

It hasn’t happened yet, but all the ingredients are in place for capital control measures in Greece. A largely unemployed labor force, skyrocketing public deficits, and a stagnant economy have forced the country to negotiate and renegotiate debt relief packages as recent as February of this year. More of the same could very likely follow.

Fears of Greece exiting the eurozone could force the country to follow Cyprus’ lead and initiate any number of capital controls. After all, an exit from the eurozone would lead to a run on bank withdrawals before the money could be converted from safe-haven euros to a new devalued Greek currency.

The fear is already there. Deposits have been pouring out. Some estimates suggest that anywhere from 11 to 15 billion euros (USD$11.65 billion to $15.88 billion) was withdrawn this January. (Source: Bloomberg News, February 5, 2015.) Even though enacting capital controls is technically against the European Union treaty, they were used in Cyprus. Capital controls could be enacted in Greece if future negotiations with the European Central Bank (ECB) fail.

But Cyprus and Greece are so distant and small, and their economic situations are so dire; could any of this really happen in the U.S.?

Capital Controls in Wealthy Nations

I am not comparing the “wealthiest” economy in the world, the U.S., to Cyprus or Greece; however, capital restrictions are not as dire as they sound. They can be used to support the economy, just like monetary policy, adjusting interest rates to set a desired economic speed.

In fact, wealthy nations and their central banks can use capital controls to manage their currencies.

For three years, the Swiss National Bank was intentionally keeping its currency cheaper than the euro to support exports, but it was requiring more and more effort, as many were piling into the safe-haven currency. The national bank had negative interest rates of -0.75%, effectively meaning it was charging depositors. The next step to control its currency was to enact capital controls.

In the case of Switzerland, the central bank was just shy of enacting capital restrictions; it decided not to fight the market and let the currency float.

But why would the U.S. enact money flow restrictions? Is its currency too strong or debt levels too high?

How Capital Controls Could Affect the U.S.

First off, capital controls are just another tool in an economist’s toolbox. Economists from the Federal Reserve Banks of Dallas and Boston believe that temporary collateral controls could improve welfare by smoothing out the often irrational foreign capital flows. (Source: Federal Reserve Bank of Dallas, June 2014.)

Capital restrictions in light of the Fed’s unprecedented bond-buying measures are not unreasonable.

Since 2009, the Federal Reserve has purchased more than $3.0 trillion worth of mortgage-backed and Treasury bonds, pushing its total assets to $4.5 trillion as of March 2015. (Source: Board of Governors of the Federal Reserve System web site, last accessed March 16, 2015.)

The Federal Reserve’s asset purchase program brings us to the disconnect between the staggering level of U.S. debt and a strong U.S. dollar. Both factors tip the scales in favor of enacting some form of capital controls if things go sour.

The total U.S. public debt outstanding comes in at $18.1 trillion. In 2007, the year before the Great Recession, the country’s total public debt stood at just $9.0 trillion. (Source: TreasuryDirect web site, last accessed March 16, 2015.) With the country’s annual GDP at roughly $16.8 trillion, the debt-to-GDP ratio comes in at 102.4%. This means America is spending more than it makes. By comparison, in the first quarter of 2007, the debt-to-GDP ratio was just 62.17%! (Source: Federal Reserve Bank of St. Louis web site, last accessed March 17, 2015.)

So debt levels are staggering and adding to the concern is the continued rally in the dollar.

The U.S. dollar index (measured against major global currencies) is at its 10-year highs. However, as the Federal Reserve begins to normalize its near-zero interest rates, probably in the second half of this year, borrowing costs will rise. Higher rates may also flood the U.S. market with capital, as investors seeking yield will come rushing in from abroad.

US dollar Index

Chart courtesy of www.StockCharts.com

While the final effects of massive debt loads and a fragile economy with a strong currency are yet to be seen, capital controls are clearly not out of the question.

This is a topic that has always been relevant economically, but historically, it has only surfaced following major crises. Examples include the East Asian financial meltdown of the late 1990s or the global financial crisis of 2008, when the world suddenly realized how interconnected it was. Investors should not be caught off guard this time around.