Capital controls: From heresy to orthodoxy


Principles for formulating capital control policies must take local conditions into account.

ON Sept 1, 2011, it would be 13 years to the day when Malaysia first introduced capital controls to stem the effects of the Asian financial crisis on the domestic economy. In 1998, it was heresy to introduce capital controls on capital flows, since it was the International Monetary Fund (IMF) orthodoxy to liberalise the capital account.

From the perspective of history, one tends to forget that in 1945, when the IMF was first established, the consensus opinion among bankers and academics alike was for hot money to be controlled. Indeed, the intellectual father of the IMF, John Maynard Keynes, remarked that “what used to be heresy is now endorsed as orthodoxy.”

In the old days, courtesy to living persons and the statute of limitations would allow history to be written only after 60 years when official archives are opened to the public.

Today, we live in an age of unfettered information, when oral and documented history can be published rapidly, from authorised biographies issued shortly after a leader leaves office to unauthorised leakages from Wikileaks.

The publication of a new book by Datuk Wong Sulong, former group chief editor of The Star, called Notes to the Prime Minister: the Untold Story of How Malaysia Beat the Currency Speculators, only two months after the IMF announced in April 2011 new thinking on capital inflows, is a remarkable achievement.

Sixty-six years after the IMF was formed, capital controls have moved full circle from orthodoxy to heresy and back again to (qualified) orthodoxy.

The book comprises 45 Notes written by Tan Sri Nor Mohamed Yakcop, Minister in the Prime Minister’s Department, between Oct 3, 1997 and Aug 21, 1998 to then Prime Minister Tun Dr Mahathir Mohamad.

In short, they were the key briefs that helped Dr Mahathir make up his mind on the key economic policies to help combat the Asian financial crisis.

Book offers deep insights

For both historians and practicing policymakers, this new book offers deep insights into the serendipity and the practice of successful policy decision-making. There is an element of serendipity, because Dr Mahathir recalled that he spotted Nor Mohamed walking down a street in Kuala Lumpur just before he left for Buenos Aires in September 1997 via Hong Kong, where he attended the World Bank Annual Meetings and clashed publicly with George Soros on currency trading.

On Sept 29, 1997, he summoned Nor Mohamed to meet him in Buenos Aires, because he needed someone who understood currency trading. It is a tribute to a politician trained as a doctor that he was willing to spend repeated sessions with an experienced currency trader to understand the intricacies of modern financial markets.

Reading the 45 Notes in historical sequence, one gets a far better appreciation of how the decision to impose capital controls was arrived at. The Notes not only have historical value, but also current-day applicability, as they explain not only offshore currency, the psychology of fear and greed that drive markets, but also market manipulation in thinly traded emerging market currencies.

The major problem of the proponents of the Washington Consensus in 1997 was that most of them were macro-economists who had little understanding or experience of how the markets actually worked. Free markets became a dogma and objective in their own right, rather than the means to an end for better livelihood for all.

The Notes also revealed that in complex decisions under uncertainty, it was vital to understand clearly the key parameters for action. Note 7 clearly pointed out that Malaysia was different from other countries under currency attack because it did not have large short-term external debt. Note 11, dated Oct 21, 1997, spelt out the factors that determined exchange rates, with a particularly illuminating explanation of market manipulation.

Market manipulation was seen as due to concerted effort by hedge funds, using large gearing and available tools and then triggering the element of fear among the long-term investors who have legitimate currency risk.

In other words, if the wolves can trigger the herd to move, then the fundamentals can move. The perception of fear changes the whole game.

Effect of CLOB

Note 39 dated July 9, 1998 is an important study of the effect on Malaysia of the central limit order book (CLOB) for trading of Malaysian shares in Singapore. The Note identified that the CLOB was a convenient way for capital outflows.

Hence, one of the most effective ways for exchange control was to impose the condition that Malaysian shares could only be traded on a Malaysian exchange, which came on Aug 31, 1998, with exchange controls imposed on the following day.

In Dr Mahathir’s words, “during the financial crisis, we faced two parallel situations; the ringgit was falling rapidly and Malaysian shares were also falling rapidly. So we had to put an end to both.”
50th Mederka Malaysian National Day celebratio...Image via Wikipedia
The IMF has come out with six key principles for formulating capital control policies.

The first is that there is no “one-size-fits-all” policy mix. The second is that capital controls should fit long-term structural reforms. Third, capital controls are only one tool and not a substitute for the right macro policies. Fourth, capital controls can be used on a case-by-case basis, in appropriate circumstances. Fifth, the medicine should treat the ailment, and finally, the policy must consider its effect on other market participants.

It is hard to argue against these common sense “motherhood” principles. The trick in real life policy-making is how to apply them to local conditions.

On of the features of the current Chinese capital controls is that China also has a large amount of Chinese shares listed outside capital controls, such as Chinese shares listed in Hong Kong, Singapore and New York.

This is a book that is a must read for all emerging market policymakers interested in liberalising their capital accounts and for IMF experts to ponder emerging market experience.

I recommend that this new book be translated into Chinese, so that Chinese policymakers interested in internationalising the renminbi can look at the Malaysian experience.

Tan Sri Andrew Sheng is author of the book, From Asian to Global Financial Crisis.

Related post:

The untold story of Malaysia foreign exchange controls


The ‘trilemma’ of capital controls

What Are We To Do By Tan Sri Lin See-Yan

MY last column examined principles underlying the international monetary system (IMS) as we know it today. I also explained why the IMS isn’t working. Today, I want to dwell on one of these principles, namely, the free international movement of goods, services & capital. We have since come a long way in freeing the movement of goods and services.

As a result, currencies of many emerging nations are today readily convertible for current transactions of the balance of payments (BOP). Unfortunately, failure at the Doha Round to further liberalise trade is a setback. Convertibility on capital transactions remains an issue.

First, some history: in the intermediate years after WWII, controls on capital movements were common. Unlike today’s controls, directed at slowing down massive inflows of capital, these post-war controls mainly aimed at slowing down outflows. After the UK lifted exchange controls under Margaret Thatcher in 1979, more governments have come to allow freer movement of money into and out of their economies.

Developed countries led by the US blame China’s policy for tightly controlling its currency value, driving “capital into economies with freer exchanges.”

While increasing free capital flows can help spur economic growth by enabling more productive investment, the growing volume of inflows into emerging nations has raised concerns. Today, capital controls refer to taxes or other administrative measures meant to regulate those flows.

Exchange control directly violates one of the precepts upon which the IMS is predicated: the world economy relies primarily upon decentralised decision making by billions of individuals and businesses responding to market forces. Government, to be sure, is responsible for influencing these market forces consistent with national objectives, but always without attempting to direct and interfere with individual transactions.

The Bretton Woods accord set up the IMS in 1945 based on this principle and changes made over the years have kept faith with it. Of course, as a matter of practical expediency, in the transition to free capital movements, countries in (what IMF calls) fundamental BOP disequilibrium, that is, with persistent payment imbalances, could temporarily impose exchange controls (previously called Article XIV nations) to enable them to better adjust under IMF supervision.

The French connection

Ironically, it was French socialists who brought global financial liberalisation home to the IMF. According to Harvard’s Rawi Abdelal, when capital flight forced socialist French President Mitterand to abort his programme in 1983, it set in motion developments that ultimately enshrined free capital movements as a global objective. And this started first in the European Union in late 1980s, then on to the Organisation for Economic Co-operation and Development (OECD) and eventually, at the IMF under French socialist CEO M.Camdessus (Governor, Bank of France under Mitterand). It was again a French socialist, recently resigned CEO Dominique Strauss-Kahn (now in a New York prison) who distanced the IMF from its long-standing tenet on free capital movements. Speaking in Asia in January 2011, he said: “Capital controls can also play a role, particularly where the surge in capital flows is expected to be temporary or where exchange rate over-shoot is a real danger As long as it’s temporary, it may be the only way.”

The trilemma’

Capital will go where it finds the best returns. In the past year, it has been Asia and also Latin America. Recipients of large capital inflows have begun to fret about their impact and on how to “manage” them. Indeed, emerging markets states seek some measure of protection against the new flows of cheap and easy money generated in the US, Europe & Japan. The massive inflows (estimated by the IMF at over US$1 trillion in ’11, against a high of US$1.3 trillion in ’07) have raised the chances of trade and currency conflicts. A long list of emerging nations from Indonesia, Thailand, South Korea, Taiwan, Philippines, India China to Turkey to Chile, Mexico and Brazil have already imposed capital controls, motivated simply to curb “hot money” that threatens to distort their economies, drive up demand and exert undue pressure on their currencies, and pose dangers of asset bubbles.

In China, besides monetary moves, exporters are allowed to hold more US$ offshore a negative capital control to keep foreign monies out, rather than a loosening of capital controls. Malaysia this week announced more liberal capital measures to promote large investments abroad. In South Korea, a levy was imposed on foreign currency debt held by banks while in Brazil, the tax on capital inflows was tripled to 6%. Indonesia set a minimum one-month holding period for investors of its bonds and India imposed a capital gains tax on all stock trades.

Nations face an economic choice: often 2 out of 3 (trilemma): fixed exchange rate, freedom to set monetary policy and free flow of capital. Having all 3 is impossible; only any 2 of the 3. The US has long had free capital flows and the right to set monetary policy. So, it is forced to live with currency fluctuations. The same orthodoxy is imposed by IMF on the world. The case of Japan in the late 1980s (Plaza’86 and Louvre’87) is classic. However, the IMF faces problems imposing it on China which prefers to give up free flow of capital; it likes very much for China to be like the US.

Smoke but do not inhale’

Notwithstanding the blaring narrative about peaking in global growth, sovereign debt risks in Europe, fiscal austerity, and “unusually uncertain” outlook for the US economy, many emerging nations continue to be saddled with massive capital inflows, if left unchecked could make some of them self-destruct. While these factors are worrisome, fortunately many of them have built-up enough “fat”. Consider their massive foreign reserves totalling more than US$7 trillion, exceeding 10% of global GDP. These reserves will be used as emerging nations move gradually to adjust to face the structurally impaired consumer demand in the west. This reminds me of FT’s Martin Wolf who observed that emerging markets “smoke but do not inhale” global capital. While emerging nations welcome capital inflows (smoke it), it is concerned about speculation, quick exit and reversals, and large net inflows (inhaling is bad for health). This is reflected in their preference to intervene in the forex markets and to recycle the monies (through current BOP accounts and capital flows) into foreign exchange reserves.

Preventing capital inflows from reaching the real economy has been their best insurance against the impact of rising currencies on competiveness, inflation and stroking domestic demand.

Conventional wisdom has it that a nation’s reserves are adequate if they are (i) equivalent to 3 months’ imports, and (ii) equal to or exceed short-term debt. Most emerging nations easily pass these rules of thumb. China’s reserves (at US$3.15 trillion) far exceeded its short-term debt. The reserves to debt ratio of Russia, India and Brazil also points to large excesses. Saudi Arabia and Algeria have reserves that cover more than 2-years imports; Brazil, a year and India, 9-months. Their robust financial health augurs well for the future.

After successfully weathering one of the worst financial crises in history, growth in 2011 and 2012 will slacken saving less and spending more. This policy switch comes at a time when emerging nations recognise that future growth rests in their own hands, and not on the fortunes (or lack of it) of the much indebted west. Although forced to “smoke” massive inflows (including collateral smoke), they should heed Prof Stigliz’s (Nobel laureate in economics 2001) advice: “Now that the IMF has blessed such interventions (exchange control) should be a key part of any system to ensure financial stability; resorting to them only as a last resort is a recipe for continued instability it is best if countries use a portfolio of them as management tools.”

Controls stir debate

In Hong Kong, at its 1997 annual meetings, the IMF tried to push deep into capital market liberalisation. The timing was bad as the East Asia crisis was just brewing. The crisis exploded soon enough in a region of high savings with little need for more capital inflows. The crisis showed that free and unfettered markets are “neither efficient nor stable” (Stigliz). Studies have shown that capital controls have helped small nations (e.g. Iceland) to manage. The far reaching surge of cheap and loose money from the US, Europe and Japan into emerging markets loomed so large that even finance ministers and central bank governors who are ideologically adverse to intervention, now believe they have no choice but do so. Hence, the change of stance at the IMF.

At its April meetings, IMF’s “guidelines” on managing capital inflows was rebuffed by most emerging nations as an attempt to restrain them, rather than help. As a result, they were delayed for further study. The IMF’s recent reversal of its long standing opposition to limits on free capital flows was based on the compelling need by emerging markets to curb surging inflows, which they recognise can fuel asset bubbles and inflation (e.g. China, India and Brazil), and hurt exporters by driving currency value higher.

IMF wanted nations to use exchange controls as a last resort, after they had used other tools including interest rates, currency values and fiscal adjustments. But emerging nations objected vehemently viewing the proposals as hamstringing their policies. Brazil’s finance minister called capital controls, “self-defence” measures. Ironically, some major advanced countries, most responsible for the global crisis and have yet to resolve their own problems, are most eager to prescribe “codes of conduct to the rest of the world, including countries that have become over-burdened by the spill-over effects of policies adopted by them.”

Who’s to blame?

The controversy is centred on “blame.” Emerging nations blame the US “as a fountain of excess cheap capital because it is holding short-term interest rates near zero and pumping money into the economy by buying government bonds.” Developed countries led by the US blame China’s policy for tightly controlling its currency value, driving “capital into economies with freer exchanges.” IMF has a tough-sell to establish a shared understanding around the use of capital controls. It tries to create a “comfort zone” which nobody wants because there is nothing comforting about being judged negatively at the Fund’s annual review if they did not follow the rules.

Nations need all the tools at their disposal to prevent financial crises and mitigate massive capital flows. Controls may not always be the first-best response, but they are easy to understand and implement, and have a strong “announcement” impact.

There are of course many pitfalls to controls. Most important is the danger from a self-feeding system of continuing tightening of controls. There is Prof. Cohen’s Iron Law of Economic Controls: “to be effective, controls must reproduce at a rate faster than that at which means are found for avoiding them.” Moreover, a partial system of controls would readily breakdown as funds flowed through uncontrolled channels spurred by fear of still further controls.

In the end, a complete system of controls is required. Any policy of attempting to “muddle through” via adopting certain controls only reduces and distorts the volume of international trade and investment. Controls can breed revival of a brand of mercantilism which cannot be for the global good.

Any shake-up of conventional wisdom and comfortable modes of behaviour is bound to pose a challenge.

J.M.Keynes once said “what used to be heresy (restrictions on capital flows) is now endorsed as orthodoxy.” That happened in 1945 at the dawn of the Bretton Woods era. More than 65 years later, it is ironical that we need a similar shift in mindset to effectively meet the challenge.

Former banker, Dr Lin is a Harvard educated economist and a British Chartered Scientist who now spends time writing, teaching and promoting the public interest. Feedback is most welcome; email:

In China we trust,again

Will China crash economically?

Capital Talk

CHINA bashing by now must surely be the most popular sport among Western investors, mass media and institutions. China crashing now, China crashing a few years later, China crashing anytime and crashing forever is the mantra.

A mantra is like a hymn. If you chant it endlessly and repeatedly, it gets stuck in one’s head. However, the fact that it may get stuck in one’s head does not mean that it will happen or that it represents the reality.

In fact, a mantra based on superfluous analysis or worse, an inherent bias, would block the real realities from surfacing. An objective analysis of the global economic conditions would show that this is what is actually happening.

With all the high profile, high publicity given to China bashing, all eyes are centred on China in general and its property sector in particular. Will China crash? When will China crash? i Capital’s managing director gets these questions all the time.

In contrast to all the dire predictions about China, i Capital expects China’s economy to nicely soft land this year. When the Lehman Panic broke out in September 2008, and almost collapsed the world economy, China was ahead of every other economy in implementing economic expansion measures.

China very quickly bottomed out and pulled the global economy out of its worst conditions (which, of course, no Western country has given China any credit). While the US led the world economy into possibly the worst recession in a long time, China and the rest of Asia quickly pulled the world economy out of a US-created catastrophe (see charts).

As China’s economy recovered quickly and strongly, the Chinese government has subsequently acted very quickly and effectively again. Measures to cool the hot property sector down have already been announced months ago.

China’s government is ahead of the property “bubblet” curve. However, it takes time for the impact to be felt, which is expected to take place in the coming months.

Selected segments of the property sector will cool down but the rest of the economy will still be performing well. China’s economy is huge and a cooling of the property sector will not crash the continental economy.

The decision by The People’s Bank of China not to raise interest rates so far is correct. Why kill the rest of the economy when there is no need to? There are many other effective ways to tackle the property “bubblet”, especially when the cause of the rise in property prices is not low interest rates.

Another unnoticed development that favours China soft-landing this year is that the current global economic recovery is not synchronised. The recovery in the United States is behind that of China and the rest of Asia but it is gathering momentum.

The growth in US exports and the recovery in the industrial sector have led the US recovery. Consumer spending is also recovering and will gather momentum as the US job market improves further. The US housing sector is also expected to contribute positively this year.

As 2010 progresses, the US economic recovery will play a greater role in global economic growth. This is ideal, as it will allow China to turn to other economic sectors for growth while it tackles its property bubblet.

In short, as the US economic recovery gathers momentum in 2010, China’s GDP growth would slow to a healthy, high single-digit rate.

Based on the economic outlook of the United States and China, i Capital sees a benign global economy. Unlike 2006 or 2007, 2010 will see a healthy unsynchronised global recovery. This upbeat view can, of course, be turned topsy-turvy by unexpected events. There seems to be plenty nowadays.

One, while the currency pressure on China seems to have reduced somewhat, the United States is now cleverly turning to other countries and US-dominated global institutions to crack China’s position. Apparently, even India and Brazil are now joining in the bandwagon as prominently headlined on the front page of the Financial Times.

So, although the currency pressure cooker is not boiling over for now, the threat of a trade war needs close watching.

Is China crashing the real worry? Or is the eurozone breaking up the real worry? Actually, an economy that has crashed but that has not been described in this way is the eurozone a.k.a a continent of discontent.

First, it was the PIGS (Portugal, Ireland, Greece and Spain). The budget deficit for Iceland is 14.3%, Greece 13.6%, Spain 11.2%, Portugal 9.4% and China 2.2%. The China bashers say that China’s budget deficit is actually higher because it does not include the local governments. We wonder why the clever Greeks did not think of this simple trickery.

Anyway, the Greek civil servants are on strikes and the budget deficit is running at unsustainable levels. No wonder the Greek economy is not in a sustainable mode. This continent of 35-hour working week but with wages paid equivalent to 350-400 hours of work in China or India is declining fast, faster than what is generally realised or acknowledged.

Greece, supposedly the birthplace of democracy, has transformed itself into a “debtmocracy”. Will China crash, as we all are led to believe, or will Greece be the Sword of Damocles for the eurozone and thus the global economy?

Then, as if Greece et al is not enough, as if an evil spell has been cast on Europe, we all discovered that cash-starved Iceland is actually rich with ashes. Imagine Iceland, more than 1,800km away from London and more than 2,100km away from Germany, taking revenge on the eurozone. Who would imagine that?

The hiatus caused by the volcanic eruption is not small. That a volcano from Iceland is causing so much havoc in the eurozone is symbolic of the very difficult period that this fledgling economic bloc is undergoing.

Almost every economy in the eurozone, including that of the United Kingdom, is in trouble. As i Capital wrote above, this is the reality, this is what is actually happening.

China and the rest of Asia are not crashing. The United States crashed and the eurozone has crashed. Should the East follow the West?

i Capital does not think so although there are many out there who would want to see this happening.

Once again, we have to say, In China We Trust. As i Capital advised previously, “This decoupling is here to stay”.

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