Capital Controls, which can take the form of taxes conversion rules, limitatinos on debt purchasing and direct investments by foreigners, are a key consideration when investing abroad.
Q. Many of the most interesting investments these days are in developing economies. But they involve a lot of risks that don’t pertain to typical US investments. And one of those is imposition of capital controls, right?
A. Yes. When it comes to investing in foreign countries and currencies, capital controls are always high on the list of things to be wary about. The basic idea here is that high-growth developing countries are prone to getting whipsawed by hot money coming in, and then flying out, of the country. So they impose various taxes, conversion rules, limitations on debt purchases and investments, collectively called “capital controls”.
Q. What do you mean by “whipsawed”? What are they specifically trying to protect against?
A. Too much money coming in too quickly can cause the local currency to appreciate rapidly, meaning inflation for the people who live there. It can also displace local financial intermediaries. And on the flip side, a sudden exit (as happened after the 2008 crash, when everybody pulled their money out to meet the crisis at home) can suddenly leave the monetary infrastructure too small to support expansion and cripple partially completed projects.
Q. Could you give us some examples?
A. Sure, two of the hottest growth countries now: Brazil and India. Brazil has imposed taxes many equity and debt purchases with foreign certain that, they hope, the velocity of money into the country, and also help ensure it doesn’t leave too quickly. India, frankly, is a much more difficult situation. It has a crazy quilt set of rules governing everything from direct investment into Indian projects, to limiting the ability of foreigners to buy Indian debt. The worst thing about the situation in India, is that changes are really unpredictable.
Q. And I guess the point is that rules like this can have a big adverse impact on your investment.
A. Sure. At a minimum, these might impact liquidity… you want to pull your money out quickly and suddenly find that you can’t, at least without paying a bunch of unexpected expenses. And, of course, rules like that tend to make the currency or country less attractive, and so directly impact the value of the investment.
The big point is that the rules can change quite quickly and without warning, so you want to understand how your investment manger prepares for or risks like this. It’s one time you want to know about the “hedge” in “hedge fund”.