Academic journal article Asian Development Review

How Effective Are Capital Controls? Evidence from Malaysia

Academic journal article Asian Development Review

How Effective Are Capital Controls? Evidence from Malaysia

Article excerpt

This paper examines the role of capital controls as a macroeconomic policy tool in light of the Malaysian experience. It consists of an econometric analysis of quarterly data over the period 1990-2010 using newly constructed capital inflow and outflow policy indexes as well as analytical narratives of episodes of controls imposed on inflows (1994) and outflows (1998-1999). The findings suggest that well-targeted controls have the potential to tame both short-term capital inflows and outflows without exerting a backwash effect on foreign direct investment, at least in the short to medium term. Controls on capital inflows introduced in the first half of 1994 helped moderate accumulation of short-term capital flows, particularly short-term bank credit. During 1998-1999, carefully designed temporary capital controls were successful in providing Malaysian policymakers a viable setting for applying the standard Keynesian therapy.

JEL classification: F32, F41, O53

(ProQuest: ... denotes formulae omitted.)

L INTRODUCTION

The orthodox thinking on capital account convertibility during the Bretton Woods era was that capital account opening should be done cautiously and only after substantial progress had been made in restoring macroeconomic stability, liberalizing the trade account, and establishing a strong regulatory framework to foster a robust domestic financial system. Abrupt dismantling of capital controls at an early stage of reforms without achieving these preconditions was thought to be a recipe for exchange rate overvaluation, financial fragility, and eventual economic collapse (Edwards 1984, Corbo and de Melo 1987, McKimion 1993, Michaely, Papageorgou, and Choksi 1991).

There was, however, a clear shift in policy emphasis in favor of greater capital account opening from about the late 1980s, with the IMF and the United States (US) Treasury adopting this view as a basic tenet of their policy advocacy for developing countries (Bhagwati 1998, Rodrik 2011). This new policy emphasis was reflected in a major decision by the International Monetary Fund (IMF) to pursue capital account opening as one of its operational objectives. In September 1997, at its annual meeting in Hong Kong, China, the Interim Committee of the IMF proposed an amendment to the IMF Articles of Agreement with a view to extending the definition of currency convertibility, which was then limited to current account transactions, to encompass capital account transactions.

The push towards capital account opening came under serious reconsideration, however, following the onset of the Asian financial crisis (19971998) and the global reverberation that impacted a number of other emerging economies. The observation that the countries succumbing to the crisis had for some years received substantial foreign capital flows raised questions about the role of capital inflows in creating the conditions that generated the crisis or favored its dissemination. Informed opinion swung towards the thinking that those countries still maintaining closed capital account regimes should undertake the liberalization of short-term capital movements only gradually and with extreme caution (Cooper 1999, Bhagwati 1998, Eichengreen 2003, Furman and Stiglitz 1998, Stigliz 2002, Radelet and Sachs 1998, Williamson 1993).

Even the IMF, despite its continuous flirting with mandatory capital account convertibility, became more sympathetic to this cautious approach to the opening of the capital account (Fischer 2004). Krugman (1999) added variety to the debate in the context of the East Asian crisis by arguing in favor of the Keynesian advocacy of using controls on capital outflows as a means of regaining macroeconomic policy autonomy in countries where the currency crisis had rapidly translated into painful economic collapse. In recent years, the case for not only retaining exit controls but also imposing new controls to tame short-term capital inflows gained added emphasis because of the increase in capital inflows to emerging market economies as part of the rapid globalization of capital, a process that intensified following the onset of the global financial crisis (2008-2009). …

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