Liberalization of Capital Flows
and Services
European Economic Integration
Oldřich Dědek
Institute of Economic Studies, Charles University
Terminological notes
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Capital
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Service
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Economic concept: factor of production (along with labour and land)
Free movement for capital: abolition of all controls on financial
transactions registered on the balance-of-payments‘ capital account
(now called financial account) – in contrast with transactions registered
on the balance-of-payments‘ current account
Capital account transactions cover much wider range of financial flows
than those linked solely to productive purposes (foreign direct
investment)
Economic concept: intangible asset offered for purchase by a service
provider at a given price – in contrast with tangible assets called goods
Freedom for services: abolition of all controls that discriminate nonresidents in providing services in host countries
Blurred dividing line between free movement of capital and liberalization
of financial services
Home vs. host country
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Home country: A state in which the business organization with crossborder operations is headquartered
Host country: A state in which the business organization with crossborder operations carries out its activities
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Division of income between labour and capital
C .. amount of capital
P
P .. price paid for capital
(interest rate)
b
MPC
a
C
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MPC … marginal product of capital
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a + b … value of total production
a … income for capital
b … income for labour (residual variable)
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Effects of capital market integration
H … Home
MPCH
Transfer
of capital
MPCF
F … Foreign
FM ... Free market
PH
PFM
PFM
PF
CFM
CH
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CF
Capital inflow into home economy pushes interest rates down:
lower income for domestic capital is more than compensated by
higher income for labour
Capital outflow from foreign economy pushes interest rates up:
lower income for labour is more than compensated by higher
income for capital (including repatriated profits)
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Classification of capital controls (1)
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Capital controls encompass a wide range of
diversified and often country-specific measures
Administrative or direct controls
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Capital transactions are restricted by outright prohibitions
Areas of control: currency convertibility, purchases of
government securities, foreign holdings of pension funds,
credit arrangements, bank deposits, reinvestment
requirements on profits, mandatory repatriation of export
earnings
Market-based or indirect controls
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Capital transactions are discouraged by making them more
costly
Examples: non-interest-bearing deposits, discriminatory
taxation, dual exchange rates for current and capital
transactions
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Classification of capital controls (2)
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Long-term vs. short-term capital flows
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Inflow vs. outflow of capital
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Traditional view about the difference between “safe capital“ (FDI)
and “hot money“ (portfolio investment)
Caveats: advanced techniques of financial management,
interdependences between short-term and long-term financial
operations, artificial dividing lines between safe and hot money
Numerous examples of sudden stops: „In crisis all money is hot“
Inclination to benevolent treatment of capital inflows while raising
barriers to capital outflows
Objectives: preserving savings for domestic use, protection of
balance of payment against hot money
Dutch disease: troubles arising from excessive capital inflows
Easier outflows stimulate inflows
Residents vs. non-residents
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Practice of imposing stricter controls on residents
Objectives: keeping control over domestic assets, protection of
strategic industries, national safety and self-sufficiency
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Pressures to deregulate capital controls
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General tendency towards deregulation of national financial markets
by 1980s
Technical innovations in telecommunications
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Innovations in financial instruments and emergence of financial
conglomerates
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Complex nature of regulation
Competitive pressure from unregulated off-shore markets
Declining efficiency of capital restrictions
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Lower information and transaction costs
Increased speed of capital movement
Simpler evasion of controls
Bureaucratic intrusion into business decisions
High cost of enforcing effective regulation
Measuring efficiency of capital controls
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Interest rate differentials between domestic and offshore financial
markets
Comparison of capital flows between liberalized and non-liberalized
economies
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Liberalization of capital flows in EU
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Rome Treaty (1958)
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Directives 1960 – 1962
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Fully free (linked to free movement of goods and employees): foreign
direct investment, short-term trade credits, repatriation of wages and
investment, purchase of real estate, purchase of quoted stock, etc.
Partly free: issuance and placement of shares on national exchanges,
non-resident holdings of shares by foreigners, long-term trade credits,
etc.
No commitment to liberalise: opening bank accounts, purchases of
government bonds, etc.
Two-speed liberalization
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Principle of free movement of capital
Ban on national discrimination (equal treatment on national basis)
Right to impose controls in case of balance of payments difficulties
(securing autonomous monetary policy and exchange rate stability)
Fast track: Belgium, Germany, Netherlands, UK
Slow track: France, Italy, Spain
Directive 1988 (in tandem with Single European Act)
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Complete elimination of capital controls between MS and with third
countries by the end of 1992
Safeguard clause: possibility to reintroduce certain controls in case of
threat to the monetary and exchange rate stability (for maximum of six
months and with Commission‘s approval)
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Reimposition of controls during crisis period
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Iceland introduced some controls in October 2008
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Defence against disruptive capital outflows and excessive
exchange rate depreciation
Areas of controls: repatriation of profits and investments, outward
foreign investment, purchases of foreign currency
Capital controls remained in force after 5 years since their
adoption
Capital controls in Cyprus
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Maximum cash withdrawal of 300 € per day
Maximum payments by a Cypriot credit or debit card abroad of
5,000 € per month
Maximum transfers of cash abroad totalling 1,000 €
Maximum non-cash transfers abroad by an individual totalling
5,000 € per month
Maximum non-cash transfers by a company to abroad of 5,000 €
daily; higher transfers must be approved by the central bank
Source: EU News Monthly Journal, April 2013
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Characteristics of service sector
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High diversity
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Economic importance
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Finance: banking, insurance, securities, consulting, etc.
Network: telecommunication, transport, energy, broadcasting,
postal services, etc.
Retail: tourism, entertainment, advertising, customer services,
gambling, etc.
Social: health, security, education, childcare, work agencies,
state administration, etc.
Services account for 70 % of EU economic activity and 70 % of
EU employment
Services account for only 20 % of intra EU cross border trade
(Monti Report 2010)
Potentially high gains from opening up national markets
Slow progress in liberalization
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Complex nature of regulation in service sector (natural
monopolies, information asymmetries, special features of
financial services)
Tailor-made approaches to individual segments of service sector
instead of some general liberalization formula
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Reasons to regulate services
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Information asymmetries
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Imperfect competition
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Low degree of contestability of market implies low threat of potential
competition (typical for network services)
Reasons: high economies of scale, high sunk costs
Systemic risk in banking industry
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They arise when quality of the service cannot be credibly assessed by
consumers
Moral hazard: providers of services may earn higher profits by lowering
quality below expected standards
Adverse selection: providers of higher quality goods are pushed out of
market
Market solutions can be time-consuming and inefficient (agreed
minimum standards, standardised contracts, build-up of reputation,
promotion of trademarks, grievance procedures)
Bank run may undermine credibility of healthy financial institutions
(contagion effect)
Owners’ capital represents only a small fraction of total liabilities
Social considerations
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High share in employment (particularly of women), high share of SMEs,
weak labour unions, etc.
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Attributes of free movement of services
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Rome Treaty called for two types of freedoms
Right to provide services
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Right to set up establishment
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Any company of a MS can provide services in other MS without
having to set up an office there
Any company from one MS may set up an establishment in
another MS on the same conditions as nationals of the other MS
Typical restrictions on free trade in services
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Authorization procedures
Local content rules
Reserving a certain share of the market for home producers
Recognition of qualification and experience
Government procurement
Requirements with regard to labour qualifications
Technical requirements and standards
Exchange controls
Subsidies to domestic service providers
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Service Directive
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Commission‘s effort to create an effective single market in the
service sector (directive adopted in December 2006)
Unsuccessful attempt to introduce the country of origin principle
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Adopted principles
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If a service operator is operating legally in one MS it could offer its
services freely in others
Fears of „Polish plumber“ – widespread concerns about influx of lowpaid workers from Central and Eastern Europe
Member states can apply restrictions that are non-discriminatory,
necessary and proportionate considering protection of public safety,
social security, health and environment
One-stop shop: one place for granting permits for doing business in each
member state
Mutual evaluation: cooperation of national authorities in supervising
service operators backed by an electronic system for the exchange of
information
Some harmonization of national rules
Services excluded from the Directive and covered by special
legislation
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Financial services, telecommunications, transport, broadcasting,
recognition of professional qualifications
Posted workers (employees working for a time in a MS other than the
country in which work is normally carried out)
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Liberalisation of banking industry
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Directive 1973
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First Banking Directive 1977
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Home country principle: home country of the parent bank is primarily
responsible for supervising the bank’s activities in other EU countries
Many loopholes in division of responsibilities between supervision of
home and host countries
Second Banking Directive 1989
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Equal treatment: all foreign banks operating in one country are subject to
the same non-discriminatory regulation and supervision as local banks
Absence of any coordination among national supervisors, widespread
capital controls impaired competition from foreign banks
Single passport: any bank licensed in an EU country can: a) establish
branches or supply cross-border financial services in the other country
without further authorisation, b) open subsidiaries on the same
conditions as nationals of the host state
Host country can impose specific regulation if they are deemed to be in
the public interest
Financial Services Action Plan 1999 (FSAP)
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Objective: full integration in banking and capital markets by 2005
Limited progress
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Financial trilemma
Financial stability
Financial
integration
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Vicious circle between sovereigns and banks
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National
financial policy
Problems in banking sector  problems in government finances (sharp
increase in borrowing costs in anticipation of costly rescue programmes)
Problems in government finances  problems in banking sector (banks
are major holders of downgraded government bonds, capital outflow in
anticipation of sovereign crisis paralyzes interbank money market)
Negative influence of national-based banking regulation on
fragmentation of financial markets during crisis period
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Four pillars of banking union
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Single rulebook
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Single Supervisory Mechanism (SSM)
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Unified supervisory framework in care of ECB – effective since Novermber 2014
Compulsory for Euro Area MS and open to non-euro MS
ECB will directly supervise significant banks and banks drawing financial support
from EU rescue funds
ECB will monitor supervision of national authorities to ensure consistent
application of supervisory standards
Single Resolution Mechanism (SRM)
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Single set of supervisory rules across the single market covering all financial
institutions and products
Responsible authorities: EBA (banks), ESMA (capital markets, rating agencies),
EIOPA (insurance)
EU-wide framework for resolution of banks in difficulties
Bail-in mechanism: shareholders and other investors into bank capital will bear
losses first, protection of insured deposits (up to € 100 000)
Single Resolution Fund – contributions paid by SSM member banks, gradual
mutualisation of national compartments
Financial backstop: financial assistance to banks from public funding as last resort
measure (direct recapitalization from ESM)
Unified system of deposit insurance
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Agreement about a common network of national deposit guarantee schemes (no
supranational arrangement envisaged so far)
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