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Capital Controls: Malaysia

Anya Schiffrin

When Malaysia imposed capital controls in 1998 after seeing the ringgit collapse during the Asian financial crisis, foreign economists predicted the move would be a disaster for the country. The new rules would scare off future investors and give rise to an overseas black market in the Malaysian ringgit, the economists warned. On top of that, the artificial protection of the controls, by insulating the country from market discipline, would stop Malaysia from carrying out necessary improvements to its economy, they said. Now, almost five years later, many economists believe that the capital controls were not as bad an idea as they first seemed.

Over the past few decades, mainstream economists had generally supported the free flow of capital (Capital Controls). But when the Asian crisis swept the region, it came with a ferocity that startled everyone and made many analysts and economists realize that removing all restrictions on the movement of capital may not be the only way to economic growth and prosperity. For a while it looked as though the whole world could fall into a recession because of Asia's woes, and it seemed the time had come to try new measures to prevent this from happening.

The most famous advocate of capital controls for Asia was Massachusetts Institute of Technology economist Paul Krugman, who, in a widely-publicized article in Fortune magazine, advised Asia's leaders to take drastic action. “There is a virtual consensus among economists that exchange controls work badly,” Krugman wrote in a piece entitled “Saving Asia: it's time to get radical” which ran on September 7, 1998. But “when you face the kind of disaster now occurring in Asia, the question has to be: badly compared to what?” Krugman asked.

The Asian crisis was sparked in 1997 by a loss of confidence on the part of foreign investors. In Malaysia the situation was dire. Funds were pulled out of Malaysian markets and investors speculated against the local currency, the ringgit. By September 1998, the local currency had fallen 40% from pre-crisis levels and $140 million had been wiped off the value of the stock market. As the currency slid, pressure increased to raise interest rates to try to keep money in the country. But higher interest rates hurt businesses. The Malaysian economy contracted 2.8% in the first quarter of 1998. Prime Minister Mahathir bin Mohammed was enraged by the disruption to the country's recent history of steady economic growth and accused financier George Soros, the Jews and “rogue speculators” of trying to destroy Malaysia's currency. He railed against the world financial order and said that countries that insulated themselves had a better chance of survival.

Calling for reform of the entire world financial system, Mahathir imposed capital controls on September 1, 1998. The ringgit's value was fixed at 3.80 ringgit to the dollar (about 10% higher then where it was trading in the market at the time). All ringgit that had been taken out of the country was ordered to be repatriated by the end of the month—although that deadline was later extended. The government then imposed tight limits on transfers of capital abroad by residents in Malaysia and froze all foreign portfolio investment (in stocks, bonds, etc.) from being taken out of the country for 12 months.

The controls were not just intended to stop speculation but also to give the government a “breathing space”. Controls shielded the ringgit from speculative pressures, reducing the need for extremely high interest rates. And, as pressure on the ringgit eased, the government was free to spend money on public works projects in order to pump domestic demand and stave off a recession. Loose monetary and fiscal policies like these had been incompatible with an open capital account. They would have allowed too much liquidity in the money supply, which would have automatically placed pressure on the currency as the markets reacted by moving money away from low Malaysian interest rates and towards higher yields elsewhere. Capital controls helped the government prevent this from happening.

Mahathir's moves were controversial in Malaysia as well as abroad. Just before they were announced, Malaysia's central bank governor, Ahmad Mohamed Don, and his deputy, Fong Weng Phak, both resigned, reportedly because they disagreed with the imposition of the controls. Finance Minister Anwar Ibrahim--once viewed as Mahathir's most likely successor—opposed the controls, instead favoring an austerity program and high interest rates. He was arrested shortly after the controls were imposed and later accused of sodomizing his chauffeur. Those accusations were widely seen as politically motivated and lacking in credibility. Indeed, criticism of Mahathir's human rights policies is widespread and may underlay some of the criticisms made of his economic policies.

Nevertheless, soon after the controls were imposed, the Kuala Lumpur Stock Exchange's KLSE index rose by 80% as repatriated ringgit moved back into the market. Foreign reserves rose to $27 billion, or five months of import cover, from $20 billion in the four months after the controls were imposed. Economic growth came in at 5.4% in 1999, rebounding from a contraction of 7.5% in 1998. According to press reports, foreign businessmen active in Malaysia did not object to the controls as they believed a stabilized currency and rising stock market would boost the local economy and make it easier to plan ahead, although harder to seek financing from overseas.

The positive effects surprised mainstream economists who had expected the country to suffer from such old-style government intervention. Mahathir, naturally, said the results vindicated his policies. “The Malaysian economy is recovering but it is recovering because we have certain controls in place. We are not certain that if we lifted those controls, attacks on the currency would not be mounted again,” Mahathir told reporters on January 29, 2000 after a meeting with French president Jacques Chirac. He reiterated that the controls will remain until there is a global accord on an international framework that would prevent speculative attacks on currencies.

Controls Loosened:

To date, no such framework has been seriously proposed. But afraid that there would be a massive outflow of funds once the 12-month freeze on investments leaving the country expired, Malaysia began loosening some of the controls on capital in February 1999. Instead of the 12-month holding period, the government replaced the rule with a system of exit charges on money leaving the country, mostly aimed at portfolio equity investments. For capital brought in before February 15, 1999, the one-year holding period was replaced with a declining scale of exit levies. For capital brought in after that date, an exit levy was imposed on the profit (but not capital) being repatriated. The amount of the levy would depend on the length of time of the investment.

Profit was defined as excluding dividends and interest earned. As well, some types of funds were exempted from the levies. These included investment in immovable property (already subject to capital gains tax), repatriation of principal relating to foreign direct investment, and profit, dividend, interest and rental income from investment of immovable property and foreign direct investment. The Ministry of Finance was given the right to exempt any transaction from the levy system and the MESDAQ (a new over-the-counter share market) was exempted from the levy.

The market viewed the news favorably and when the agencies that rate debt upgraded their views on Malaysia in April, 1999, they mentioned the February changes in their reports.

On September 1, 1999, the controls were loosened again. At that time, Malaysia lifted the exit levies imposed in February but kept a 30% levy on the profits of foreign portfolio investments that were to be repatriated within a year. Profits taken out of the country after a year's time would be subject to only a 10% levy. Then, on September 21, Bank Negara, Malaysia's central bank, relaxed the restrictions again, cutting the levy to 10% across the board, regardless of when the money was to be repatriated, a move foreign investors welcomed.

Conclusion:

Economists generally agree that the controls were effective in stemming short-term outflows of capital from Malaysia and preventing the kind of upheaval and pain neighboring economies suffered during the crisis. But there is still debate as to how helpful they have been over the long run, and how difficult they could be to apply in other countries.

Some, such as MIT economist Rudy Dornbusch, say that the controls did not help Malaysia recover faster than other countries hit by the 1997 Asia crisis. Others, such as Paul Krugman and Harvard's Jeffrey Sachs say the Malaysian economy may have picked up without Mahathir's efforts. And in October 1999, the International Monetary Fund's then-deputy managing director, Stanley Fischer, said the effects of the controls were hard to measure. He noted that they were imposed at a time when capital flows to the region had already started to pick up and were never tested against severe downward pressures.

In fact, Foreign Direct investment did fall after capital controls were imposed, falling 28% to 9.04 billion ringgit ($2.38 billion) in 1999 from 12.6 billion ringgit in 1996.

FDI recovered in 2000 to $3.4 billion from $1.6 billion the year before, but it was overshadowed by flows of $6 billion to Thailand and $10.45 billion to South Korea, countries that never imposed any controls on capital. A regional downturn in 2001 brought Malaysia's FDI inflows back down to $2.4 billion that year.

Harvard's Dani Rodrik, however, believes that Malaysia grew far more than it would have had it adopted an IMF-style austerity program, such as that pursued by South Korea and Thailand. Instead it was able to pursue more a Kenynesian-reflationary policy and the fact that it didn't have to worry about speculation was generally good for confidence. Rodrik also claims that, correctly measured, Malaysia's downturn was shorter and shallower than that of the other East Asian countries, partly because of the controls. And the Malaysian Central Bank claims that because interest rates were lower, there were fewer bankruptcies. With a lower cost of restructuring, and with lower interest rates allowing greater reliance on monetary rather than fiscal policy to reactivate the economy, Malaysia was left with less of a legacy of debt than the countries that had not imposed capital controls.

What To Look For Before Capital Controls Are Imposed:

Most economists caution that capital controls must be accompanied by domestic economic reforms if they are to work properly. In its August 1999 report on Malaysia, the IMF cited these reasons for Malaysia's success:

  • The adequacy of foreign exchange reserves permitted the central bank to credibly fix the exchange rate. If it hadn't already possessed enough reserves to defend the ringgit, it might not have been able to prevent local savers to flee fearing a collapse in the new exchange rate regime.
  • The fact that the Malaysian economy had relatively strong fundamentals when the controls were adopted and that the controls were accompanied by an economic reform program.
  • The ringgit was somewhat undervalued at 3.8 ringgit to the dollar as other regional currencies were starting to strengthen, so there was less reason for people to evade the peg.
  • The fact that the controls were so wide-ranging meant they closed a lot of possible loopholes.
  • Strict implementation by the central bank and a disciplined banking system willing to obey the controls.
  • Transparent and clear information about the controls, why they were imposed and how they would work.

Here Are Two Ways To Measure The Success Of Capital Controls:

  • Check the health of the banking sector: Halting the outflow of capital with controls gave Malaysia room to lower interest rates. Making it easier for businesses to pay back debts may well have been one reason that Malaysia had a far lower level of non-performing loans (NPLs) than other countries in the region. (Another reason that should be noted is that Malaysia's banking sector, pre crisis, was widely seen as having been sounder and better regulated, than that in other Asian countries). Malaysia's NPLs were estimated at around 18% of all loans during the period of the controls and Standard and Poor's debt rating agency estimated that this would have risen to 30% if Malaysia had raised interest rates. However, some faulted the Malaysian government for not using the capital controls' “breathing space” to restructure a corporate sector whose reckless borrowing had caused the bad loan problem in the first place.
  • Check the health of the foreign exchange market: The Malaysian controls clearly blocked capital outflows and basically halted speculation offshore without creating a major black market in ringgit.

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