On September 1st
1998, Malaysia became the first Asian country affected by the
to announce selective exchange and capital controls in an attempt
to lay the ground for a recovery programme. Until recently, capital
controls were a taboo subject. With its action, Malaysia broke
the policy taboo. Only a week earlier, the American economist
Paul Krugman had broken the intellectual taboo by advocating that
Asian countries adopt exchange controls.
The Malaysian moves
involved fixing the local currency to the US dollar, stopping
the overseas trade in ringgit currency and other ringgit assets,
restricting the amount of currency and investments that residents
can take abroad, and requiring a minimum one-year "stay period"
for foreign portfolio funds. (The last measure has since been
converted to an exit tax.) The measures were aimed at reducing
the country's exposure to financial speculators and the global
Malaysian policy package included:
official fixing of the ringgit at 3.80 to the US dollar,
thus removing or greatly reducing the role of market forces in
determining the day-to-day level of the local currency (the ringgit's value
in relation to currencies other than the dollar will still fluctuate
according to their own rates against the dollar). This measure
largely removes uncertainties regarding the future level of the
relating to the local stock market, including the closure of
secondary markets so that trade can be done only via the Kuala
Lumpur Stock Exchange (this
is to prevent speculation or manipulation from outside the country), and the requirement
that non-residents purchasing local shares have to retain the
shares or the proceeds from sale for a year from the purchase
is to reduce foreign speculative short-term trade in local shares). The one-year
requirement has since been replaced by a graduated exit tax on
the invested amount (for
funds invested before the September 1998 controls) and a tax
on profits and capital gains (for
funds entering after February 15th 1999 and staying less than
to reduce and eliminate the international trade in ringgit, by
bringing back to the country ringgit-denominated financial assets
such as cash and savings deposits via the non-recognition or
non-acceptance of such assets in the country after a one-month
will, however, be given under certain conditions.)
· Resident travellers
are allowed to import ringgit notes up to RM1,000 only and any
amount of foreign currencies, and to export only up to RM1,000
and foreign currencies only up to RM10,000 equivalent.
for payments for imports of goods and services, residents are
freely allowed to make payments to non-residents only up to RM10,000
or its equivalent in foreign currency (previously the limit was set at RM100,000).
of investments abroad by residents and payments under a guarantee
for non-trade purposes require approval.
*Prescribed manner of payment for exports will be in foreign
currency only (previously
it was allowed to be in foreign currency or ringgit from an External
*Domestic credit facilities to non-resident correspondent banks
and non-resident stockbroking companies are no longer allowed (previously domestic
credit up to RM5 million was allowed).
*Residents require prior approval to make payments to non-residents
for purposes of investing abroad for amounts exceeding RM10,000
equivalent in foreign exchange.
*Residents are not allowed to obtain ringgit credit facilities
imposing conditions on the operations and transfers of funds
in external accounts: transfers between external accounts require
prior approval for any amount (previously
transfers from external accounts to resident accounts will require
approval; and sources of funding external accounts are limited
to proceeds from sale of ringgit instruments and other assets
in Malaysia, salaries, interest and dividend and sale of foreign
the ringgit is still freely convertible to foreign currencies
for trade (export
receipts and import payments), inward foreign direct investment, and repatriation
of profit by non-residents. Convertibility up to a certain limit
is also allowed for certain other purposes, such as financing
children's education abroad. But convertibility
for autonomous capital movements for several purposes not directly
related to trade will be limited.
for the move was explained by the Malaysian Prime Minister Datuk
Seri Dr Mahathir Mohamed as a last resort. "We had asked
the international agencies to regulate currency trading but they
did not care, so we ourselves have to regulate our own currency,"
he said in a media interview in September 1998. "If the
international community agrees to regulate currency trading and
limit the range of currency fluctuations and enables countries
to grow again, then we can return to the floating exchange rate
system. But now we can see the damage this system has done throughout
the world. It has destroyed the hard work of countries to
cater to the interests of speculators as if their interests are
so important that millions of people must suffer. This is regressive."
the move to make offshore use of the ringgit invalid, Mahathir
said normally it was offshore ringgit that were used by speculators
to manipulate the currency. The speculators hold the ringgit in
foreign banks abroad and have corresponding amounts in banks in Malaysia.
also said that with the introduction of exchange controls, it
would be possible to cut the link between interest rate and the
exchange rate. "We can reduce interest rates without
speculators devaluing our currency. Our companies can revive.
If our currency is revalued upwards, the companies can buy imports
as they don't have to pay so much."
the Malaysian measures were aimed at putting a spanner in the
works of speculators, to take speculators out of currency trade.
He added the period of highest economic growth was during the
Bretton Woods fixed exchange system. But the free
that followed the Bretton Woods system has failed because
of abuses. "There are signs that people are now losing
faith in this free market system, but some countries benefit from
the abuses, their people make more money, so they don't
see why the abuses should be curbed."
analysis of the measures
The measures constitute a bold attempt to give the economy a
reasonable chance to recover. By restricting the availability
of ringgit in offshore markets and restricting the international
trade in ringgit, the measures are aimed at greatly reducing
the conditions and opportunities for speculators to make profits
on fluctuations in the ringgit's value. The move to have the
ringgit's rate fixed by the financial authorities, rather than
by the market, has also restored greater financial stability
by reducing the uncertain conditions under which businesses and
consumers now have to operate.
of fixing the exchange rate through a Currency Board system (where money supply and domestic
interest rates are determined by the foreign reserves and inflows
and outflows of funds), Malaysia has chosen the route
of controlling the flows of ringgit and foreign exchange. The
advantage of this approach is that it allows the government greater
degrees of freedom to determine domestic policy, particularly
in influencing domestic interest rates. The government can now
reduce interest rates without being overly constrained by the
reaction of the market and by fears of the ringgit falling. Since
the introduction of the measures, interest rates have fallen by
about five percentage points. This has eased the debt servicing
burden of businesses and consumers (especially house buyers), and the financial
position of banks.
decision to make ringgit held abroad invalid after one month
is meant to encourage an inflow of ringgit to return to the country.
It has also dried up sources of ringgit held abroad that speculators
borrow from to manipulate the ringgit, for example by "selling
short." No doubt some Malaysians who hold ringgit accounts
abroad, or who travel frequently and who need to transfer funds
abroad, may suffer some inconveniences. But these personal sacrifices
can be taken as contributions to generating some conditions that
are needed to get a serious recovery going.
control measures are a response to the basic causes of the crisis
afflicting both the country and the region. The crisis began with
funds being allowed to freely move in and out of the affected
countries. Those countries had recently liberalised their financial
allowing locals and foreigners alike to freely convert foreign
currency into local currency, and vice versa.
convertibility was allowed not only to finance current transactions
of trade and direct investment (which
in the past had also been permitted), but also in the capital account,
ie, for short-term flows such as investment in the stock markets,
loans from and to abroad, and remittances to abroad by individuals
and companies for savings or property purchases overseas. By introducing
this "capital account convertibility", the countries
exposed themselves to autonomous inflows and outflows of funds
by foreigners and locals, subjecting their local currency to speculation
as well as exchange-rate volatility.
was sparked by speculation and a stampede of foreign funds moving
out, followed shortly by locals also sending their money abroad,
whilst the local currencies fell sharply. Now that the countries
are in deep recession, capital account
convertibility is causing another equally vexing problem. It is
preventing them from taking policies they need for recovery.
policy needed is to lower interest rates (to relieve consumers and companies from
their heavy debt service burden) and increase spending (so that there is more
demand for businesses and incomes for workers). Countries are constrained
from this line of action, however, because speculators may again
attack the local currency. Also, some residents may be tempted
to send more of their savings abroad in search of higher interest
rates. The possibility of funds exiting in an environment of
free capital account convertibility of the local currency thus
puts a damper on measures that are needed for recovery.
one logical move would be for the affected countries to partly
re-impose some control over the convertibility of the local currency.
This could reduce the conditions in which currency speculators
can profitably operate, reduce the exit of funds and discourage
the inflows of undesirable forms of short-term capital.
point to China and India as examples of
countries that have not been subjected to volatile capital flows
and currency instability because they do not allow full convertibility
of their currencies. The lesson is that developing countries that
want to shield themselves from externally-generated financial
crises should retain (or
some controls over the convertibility of their currency.
of reintroducing some capital controls has till recently not been
openly discussed, however, because it is considered a "taboo"
subject. The prevailing ideology held and spread by the International Monetary Fund
(IMF) and the Group
of Seven rich countries is that countries should liberalise
their capital account, and that countries that have done so will
suffer damage if they re-impose controls.
in the affected countries are worried that even to discuss the
advantages of capital control means black-listing by the IMF,
the rich countries and financial speculators. By keeping silent,
their countries will continue to be subjected to the views and
interests of "market players", suffer the consequences
of a relatively high interest rate policy, and be prevented from
the academic level, the taboo against capital controls was broken
in August 1998 when the Massachusetts Institute of Technology
Paul Krugman advocated that Asian governments should re-impose
capital controls as the only way out of their crisis. In his
Fortune article, entitled "Saving Asia: it's time to get
RADICAL", Krugman agrees with the IMF critics that high
interest rates imposed by the IMF would cause even healthy banks
and companies to collapse. Thus, there is a strong case for countries
to keep interest rates low and try to keep their real economies
growing. However, says Krugman, the problem is that the original
objection to interest rate reductions still stands, that the
region's currencies could again go into free fall if the interest
rate is not high enough.
said there is a way out, "but it is a solution so unfashionable,
so stigmatised, that hardly anyone has dared to suggest it. The
unsayable words are exchange controls." Exchange controls,
he adds, used to be the standard response of countries with balance
of payments crises. "Exporters were required to sell their
foreign-currency earnings to the government at a fixed exchange
rate; that currency would in turn be sold at the same rate for
approved payments to foreigners, basically for imports and debt service. Whilst some countries
tried to make other foreign-exchange transactions illegal, other
countries allowed a parallel market. Either way, once the system
was in place, a country didn't have to worry that cutting interest
rates would cause the currency to plunge. Maybe the parallel exchange
rate would sink, but that wouldn't affect the prices of imports
or the balance sheets of companies and banks."
why China has not been so badly hit as its neighbours, Krugman
answers that China "has been able to cut, not raise,
interest rates in this crisis, despite maintaining a fixed exchange
rate; and the reason it is able to do that is that it has an
inconvertible currency, that is to say, exchange controls. Those
controls are often evaded, and they are a source of lots of corruption,
but they still give China a degree of policy leeway that the
rest of Asia desperately wishes it had".
more economists like Krugman speak up, capital controls are being
recognised as a respectable option for governments wanting an
effective policy instrument to prevent further financial turbulence.
After the announcement of the Malaysian measures, Krugman published
an open letter to the Malaysian Prime Minister stating that he
fervently hoped the dramatic policy move pays off. He warned,
however, that these controls are risky with no guarantee for
success. He gave four guidelines: that the controls should aim
at minimal disruption of business; that they be temporary; that
the currency should not be pegged at too high a level; and that
they serve to aid reforms and not be an alternative.
of using capital controls
for developing counties to make use of capital controls to prevent
and manage financial crises has also been stressed by UNCTAD. In fact, UNCTAD has been the international
agency that has consistently been warning about the dangers of
financial liberalisation and the risks posed
by a policy of allowing freedom for the inflows and outflows of
UNCTAD's Trade and
Development Report 1998 makes a central point that to protect
themselves against international financial instability, developing
countries need to have capital controls, since these constitute
a proven technique for dealing with volatile capital flows. The
report comes to this conclusion after surveying several other
as more disclosure of information and greater banking regulation) that have
been proposed by the industrial countries and the International
Monetary Fund. The agency finds these proposals to have merit
but inadequate to deal with the present and future crises. It
therefore stresses that developing countries should be allowed
to introduce capital controls, as these are "an indispensable
part of their armoury of measures for the purpose of protection
against international financial instability."
Report notes that good economic fundamentals, effective financial
regulation and good corporate governance are needed to avoid
financial crises, but by themselves they are not sufficient.
Experience shows that to avoid these crises, a key role is played
by capital controls and other measures that influence external
borrowing, lending and asset holding. Control on capital flows
are imposed for two reasons: firstly, as part of macroeconomic
reinforce or substitute for monetary and fiscal measures) and secondly
to attain long-term national development goals (such as ensuring residents' capital
is locally invested or that certain types of activities are reserved
to the belief that capital controls are rare, taboo or practised
only by a few countries that are somehow "anti-market",
the reality is that these measures have been very widely used.
UNCTAD notes that they have been a "pervasive feature"
of the last few decades. In early post-war years, capital controls
for macroeconomic reasons were generally imposed on outflows
of funds as part of policies dealing with balance of payments
difficulties and to avoid or reduce devaluations.
Rich and poor countries alike also used
controls on capital inflows for longer-term development reasons.
When freer capital movements were allowed from the 1960s onwards,
large capital inflows posed problems for rich countries such as
Germany, Holland and Switzerland. They imposed controls such as
limits on non-residents' purchase of local debt securities and
on bank deposits of non-residents.
recently, some developing countries facing problems due to large
capital inflows also resorted to capital controls. For example,
when faced with a surge of short-term capital inflows, Malaysia
in January 1994 imposed several: banks were subjected to a ceiling
on their external liabilities not related to trade or investment;
residents were barred from selling short-term monetary instruments
to non-residents; banks had to deposit at no interest in the
central bank moneys in ringgit accounts owned by foreign banks;
and banks were restricted in outright forward and swap transactions
they could engage in with foreigners. These measures were gradually
removed from 1995 onwards.
Chile was faced with large capital inflows in the early 1990s,
it took measures to slow short-term inflows and even to encourage
certain types of outflows. The main step was that foreign loans
entering Chile were subjected to a reserve requirement of 20%
In other words, a certain percentage of each loan had to be deposited
at the central bank for a year, without being paid any interest.
Also to prevent excessive inflows, Brazil in mid-1994 imposed
controls such as an increase in the tax paid by Brazilian firms
on bonds issued abroad, a tax on foreigners' investment in the
stock market, and an increase in tax on foreign purchases of
domestic fixed-income investments. When the Czech Republic faced
large inflows in 1994/95, it imposed a tax of 0.25% on foreign-exchange
transactions with banks and limits on (and the need for official approval for) short-term
borrowing abroad by banks and other firms. Besides the specific
cases above, the UNCTAD Report also
lists examples of capital controls on inflows as well as outflows.
on inflows of foreign direct investment and portfolio equity
investment may take the form of licensing, ceilings on foreign
equity participation in local firms, official permission for
international equity issues, differential regulations applying
to local and foreign firms regarding establishment and permissible
operations and various kinds of two-tier markets. Some of these
controls can also be imposed on capital inflows associated with
debt securities, including bonds. Such inflows can be subject
to special taxes or be limited to transactions carried out through
a two-tier market. Ceilings (as
low as zero)
may apply to non-residents' holdings of debt issues of firms
and government; or foreigners may need approval to buy such issues.
Foreigners can also be excluded from auctions for government
bonds and paper.
UNCTAD also lists
other controls commonly used to restrict external borrowings
from banks. They include: a special reserve requirement concerning
liabilities to non-residents; forbidding banks to pay interest
on deposits of non-residents or even requiring a commission on
such deposits; taxing foreign borrowing (to eliminate the margin between local
and foreign interest rates); and requiring firms to deposit cash
at the central bank amounting to a proportion of their external
for controls on capital outflows, they can include controls over
outward transactions for direct and portfolio equity investment
by residents as well as foreigners. Restrictions on repatriation
of capital by foreigners can include specifying a period before
such repatriation is allowed, and regulations that phase the
repatriation according to the availability of foreign exchange
or to the need to maintain an orderly market for the country's
currency. Residents may be restricted as to their holdings of
foreign stocks, either directly or through limits on the permissible
portfolios of the country's investment funds. Two-tier exchange
rates may also be used to restrict residents' foreign investment
by requiring that capital transactions be undertaken through
a market in which a less favourable rate prevails, compared to
the rate for current transactions. Some of these techniques are
also used for purchases of debt securities issued abroad and
for other forms of lending abroad. Bank deposits abroad by residents
can also be restricted by law.
UNCTAD says recent
financial crises and frequent use of capital controls by countries
to contain the effects of swings in capital flows point to the
case for continuing to give governments the autonomy to control
transactions. It questions recent moves in the IMF to restrict
the autonomy or freedom of countries to control flows.
have not yet been found at a global level to eliminate the cross-border
transmission of financial shocks and crises due to global financial
integration and capital movements. Thus, concludes UNCTAD, for the foreseeable future,
countries must be allowed the flexibility to introduce capital
control measures, instead of new obligations being imposed on
these countries to further liberalise capital movements through
an international environment of big financial players with huge
blocs of money for speculation and investment, financially small
countries are now subjected to great volatility and financial
and economic danger. For instance, the LTCM affair revealed that a hedge fund with
USD 4-5 billion
equity could manage to raise so much credit that the banks had
USD 200 billion
exposure to it. Few governments can withstand a determined bid
by a few big hedge funds to speculate on their currencies and
financial markets. And besides the hedge funds, there are other
gigantic investment funds (such
as mutual and pension funds) as well as investment banks, commercial
banks, insurance companies etc.
total freedom given to international investors and speculators
has wreaked financial and now economic and social chaos. The time has now
come to regulate these big players. But there are serious doubts
whether there is the political will to act, as the financial institutions
and those that own and manage them are very powerful and it is
in the vested interest of politicians and their parties to cater
to these powerful institutions.
countries need to protect themselves from the free flow of funds.
Capital controls are thus a necessary part of economic instruments
that must be an option. In these days of financial turbulence,
they may even be a necessary option. This does not mean that capital
controls by themselves are a panacea or "magic bullet".
They should be accompanied, eg, by an international mechanism
for debt standstill to help
seriously indebted countries.
there are weaknesses and loopholes in capital controls, such as
leakages through transfer pricing mechanisms, false invoicing,
possible black markets, etc. Also, capital controls should not
merely be a shield for a country to protect itself from having
to carry out changes and reforms made necessary by the financial
crisis, or reforms that are structurally
needed for the longer run.
of efforts to revive a financially viable economy will also depend
greatly on the effectiveness, efficiency and fairness (in
of recapitalisation, restructuring and reforms in the financial
institutions and corporations. It will also depend
on the right mix of monetary and fiscal policies that can spur
recovery without causing greater financial or economic burdens
on ordinary citizens, especially the poor. In other words,
capital controls are a necessary but not sufficient condition
to protect a country from unresolvable crisis and to enable conditions
for recovery. They have to be accompanied by other measures.
fact that there are weaknesses in capital controls, and that
other measures are also needed, does not make capital controls
a wrong or evil policy option, as some opponents of capital controls
appear to portray them. Total freedom for capital flows is a
principle championed by the big financial players and institutions
that stand to gain from extreme financial liberalisation. Capital
controls to limit such freedom are needed from an objective point
of view and from the viewpoint of ordinary citizens who need
to be protected from predatory speculation and from economic
*Published in Social