The illegal carry trade in China

How capital controls are not effective when it comes to the movement of goods across borders

When interest rates differ across countries, speculators who want to make profits have a strong incentive to borrow money at low interest rates and lend the money at higher interest rates.

For example, if banks in the United States gave out loans at 1% while banks in China paid an interest rate of 3% to depositors, investors would borrow from U.S. banks and lend to Chinese banks to capture a nice profit. This trade is popularly known as the carry trade. Such flow of capital across borders in search of higher yields would last till the interest rate difference between the two countries, after factoring in the various transaction costs, disappeared. The flow of capital across borders, however, is not always desired by central banks.

For instance, when capital flows into a country with high interest rates, this can cause the country’s currency to appreciate and affect the size of the country’s overall exports. So central banks often impose capital controls that limit the movement of capital across borders.