Street Macro: capital controls

“Original Sin” and “The Impossible Trinity” evoke biblical imagery of difficult choices and devilish corruption. These racy terms are not lifted from a religious studies textbook, however. They are used to describe far less sexy macroeconomic phenomena.

Original sin refers to the difficulties of borrowing from foreign investors in one’s own currency. The Impossible Trinity is the choice governments make between fixed exchange rates, monetary policy independence, and free-flowing capital markets – you can only have two. Even with such vivid language, the best professors can sometimes struggle to bring these concepts to life from the sanctuary of a classroom. The streets of Addis Ababa offered a more comprehensive lesson.

The idea of a capital control seemed to be the hardest concept to grasp in the Impossible Trinity. If a government wanted to maintain a fixed exchange rate, and maintain monetary policy independence, they had to give up the free movement of capital. In our current economic era, and in most countries where our classmates had lived, free movement of capital was a given. Restricting it seemed impossible. How could they stop you from taking your money out? And why would they want to do this?

In 2016, once you landed in Bole airport and wanted to get some cash, you could exchange your foreign money for Ethiopian birr at a bank or withdraw from an ATM. It was practically impossible to legally change it back. This is a capital control. The government simply would not give you dollars or pounds when you brought them your birr to exchange. This was annoying as a tourist if you accidentally withdrew too much money, or if you were paid in birr but had bills to pay in Europe or the US. The impact on businesses was even starker.

Capital controls meant that shops frequently stocked out of imported products, sometimes needing to wait up to a year to gain approval to use precious foreign currency, by which time the latest fashion fads had passed. Businesses also struggled to repatriate profits abroad. Wily companies had figured out transfer pricing schemes to get around the restriction, like importing expensive glass bottles produced by a parent company to fill with locally produced beer, but for the most part these controls deterred foreign investment.

Capital controls seemed to be the lesser of three evils for the Ethiopian government, the other two being floating exchange rates and losing monetary policy independence.

A floating exchange rate, like the US dollar against the British Pound, is set by the market based on supply and demand for the two currencies. In 2022, there was a catastrophic market reaction to Liz Truss’s misjudged budget. The pound almost hit parity with the dollar, the lowest levels since the mid-1980s, and has since recovered to $1.25 per pound.

A fixed exchange rates offer the benefit of stability, as only the government can change the rate, not the market. Fixed rates also allow a country to make its imports cheaper, by overvaluing the currency, or make its exports seem more competitive, by undervaluing it. Ethiopia’s exported a lot of commodities, which were priced in foreign currency already, and imported more than it exported, so it made sense that it would try to keep imports inexpensive.

The birr’s true value was reflected in the black-market rate. Friends with American dollars would exchange money on the dirt road behind our office in Bole, at a premium of up to 30%. They would return gleefully from their transactional adventure like gangsters, carrying bricks of green 100-birr bills (in 2016, one US dollar bought you 22 birr and 100 was the highest denomination).

An inflated fixed exchange rate comes with a challenge. If the currency is overvalued, it means that there is more supply of birr than there is demand. In other words, more people want to take money out of the country (e.g. to pay for imported goods) than want to bring it in (e.g. to buy coffee from an Ethiopian farmer, who has no use for dollars). If a government chooses to overvalue its exchange rate, and starts with a given supply of foreign currency (“reserves”), this means that over time, those reserves will eventually run out.

One way they could stop this is by paying investors more for the privilege of owning birr through increasing interest rates (i.e. monetary policy). However, this might not be desirable if, like Ethiopia, you are trying to develop your economy. If locals can be paid more by the government than by investing a business, they will stick their money in a bank account and leave it there.

Instead of raising interest rates, then, you can simply stop people from taking money out of the country, artificially increasing the demand for birr. This is the choice the Ethiopian government made.

However, capital controls over time can worsen the economic conditions that necessitated them in the first place. Foreigners stop investing in a country because they can’t get their profits out, companies can’t produce goods to be exported or to serve the local market, or get the imported goods they need to operate. More imports are needed to fill the gap, in a reinforcing cycle. This is partly why most countries in the world have given them up, and in doing so they relinquish one of their monetary independence or the predictability of their exchange rate.

Ethiopia is only recently starting to loosen capital controls, permitting certain energy, mining and “other FDI projects deemed eligible” to hold offshore bank accounts in 2023. With freer flowing capital, one of monetary policy or exchange rates will have to give. The birr has already started giving, having devalued over 50% since I first arrived in Addis Ababa almost eight years ago. As capital controls loosen, the government may have to reluctantly float the birr, or they may need to give up their ability to tame inflation or stimulate the economy through interest rates. Soon they will have to make their choice, though it is a much less impossible one than deciding to let go of one of the son, the father or the holy ghost in that other famous Trinity.