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The Malaysian Capital Controls: A Success Story?

Prema-chandra Athukorala

Division of Economics Division of Economics Research School of Pacific and Asian Studies

Australian National UniversityPrema-chandra.athukorala@anu.edu.au

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Purpose/MotivationPurpose/Motivation

MalaysiaMalaysia’’s s radicalradical crisis resolution strategy crisis resolution strategy –– controls on short term capital inflows + controls on short term capital inflows + Keynesian the therapyKeynesian the therapy–– the first case of an emerging market economy the first case of an emerging market economy temporarilytemporarily reversing the course of capital account reversing the course of capital account opening in a crisis context.opening in a crisis context.

Rapid/smooth recovery following the policy shift, Rapid/smooth recovery following the policy shift, but the economists are divided on whether this but the economists are divided on whether this episode makes a case for using capital controls as episode makes a case for using capital controls as a crisis resolution tool. a crisis resolution tool.

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Three alternative views:Three alternative views:

(1)(1) Capital controls made no difference to the recovery Capital controls made no difference to the recovery processprocess(Fischer 2003; Dornbusch 2003, IMF 1999)(Fischer 2003; Dornbusch 2003, IMF 1999)

-- a case of a case of ‘‘locking the stable door after the horse has locking the stable door after the horse has boltedbolted’’Capital had already left Malaysia, and the pressure for Capital had already left Malaysia, and the pressure for capital outflow from the region was coming to an end at the capital outflow from the region was coming to an end at the timetime

Malaysia's recovery was much the same as that of the Malaysia's recovery was much the same as that of the other crisisother crisis--hit countries in the regionhit countries in the region

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(2)(2) Capital Controls have adversely affected longCapital Controls have adversely affected long--term term growth dynamism of the economy (even if they were growth dynamism of the economy (even if they were instrumental in the recovery)instrumental in the recovery)--discouraged new foreign investment, both FDI and discouraged new foreign investment, both FDI and portfolio investmentportfolio investment

-- controlcontrol--based political patronage imposed undue based political patronage imposed undue economic costseconomic costs

-- provided an excuse to ignore/slowdown needed provided an excuse to ignore/slowdown needed reforms.reforms.

(3)(3) Capital controls were instrumental in achieving Capital controls were instrumental in achieving recovery, while minimizing potential economic recovery, while minimizing potential economic disruption and related social cost.disruption and related social cost.

-- provided the leeway to implement expansionary provided the leeway to implement expansionary monetary/fiscal policymonetary/fiscal policy

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A systematic analysis of the Malaysian A systematic analysis of the Malaysian ‘‘experimentexperiment’’ is important, given the newis important, given the new--found found interest in temporary capital inflow controls as interest in temporary capital inflow controls as a crisis resolution measure a crisis resolution measure (see King 1999, (see King 1999, KrugmanKrugman 1999, Cooper 1999, 1999, Cooper 1999, CordenCorden 2003, )2003, )

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StructureStructure2.2. Capital account opening, capital inflows and Capital account opening, capital inflows and

signs of vulnerabilitysigns of vulnerability3.3. Onset of the crisis, policy muddling through Onset of the crisis, policy muddling through

and economic collapseand economic collapse4.4. Policy UPolicy U--turn: Capitalturn: Capital--control based crisis control based crisis

resolution packageresolution package5.5. The recoveryThe recovery6.6. Have capital controls worked?Have capital controls worked?7.7. Conclusions/inferencesConclusions/inferences

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2.2. Capital account opening, capital inflows Capital account opening, capital inflows and signs of vulnerabilityand signs of vulnerability

Policy historyPolicy history-- longlong--standing commitment to maintaining an open foreign standing commitment to maintaining an open foreign trade and foreign direct investment regime. trade and foreign direct investment regime. -- until the miduntil the mid--1980s, binding restrictions on short1980s, binding restrictions on short--tem (tem (‘‘mobilemobile’’) ) capital flows.capital flows.-- Significant capital opening since then.Significant capital opening since then.

ButButRestrictions on foreign currency borrowing by Restrictions on foreign currency borrowing by residents and domestic currency borrowing by nonresidents and domestic currency borrowing by non--residents were never lifted.residents were never lifted.

For details see Athukorala (2002)For details see Athukorala (2002)

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Capital inflows and signs of vulnerabilityCapital inflows and signs of vulnerability

Massive inflow of volatile capital (Massive inflow of volatile capital (predominantly portfolio predominantly portfolio flowsflows) in the early 1990s ) in the early 1990s -- Share of portfolio capital in total net capital inflows: Share of portfolio capital in total net capital inflows:

19871987--89 1990 1991 1992 1993 1994 1995 1996 mid89 1990 1991 1992 1993 1994 1995 1996 mid--1997199727 74 60 59 72 8027 74 60 59 72 80 81 74 7281 74 72

-- Reserve adequacy ration (RAR, foreign reserves as % of Reserve adequacy ration (RAR, foreign reserves as % of mobile capital)mobile capital)

19871987--89 1990 1991 1992 1993 1994 1995 1996 mid89 1990 1991 1992 1993 1994 1995 1996 mid--19971997162 158 171 149 124 94 162 158 171 149 124 94 80 72 5680 72 56

-- RAR of other crisisRAR of other crisis--hit countries, Mid 1977:hit countries, Mid 1977:Indonesia 71; Korea 18; Thailand 45; Philippines 6Indonesia 71; Korea 18; Thailand 45; Philippines 64 4

Source Athukorala and Source Athukorala and WarrWarr (2002)(2002)

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Share market boomShare market boom-- market capitalization to GDP ration in 1996 = market capitalization to GDP ration in 1996 = 300%, the highest ever in any country300%, the highest ever in any country-- market leaders were foreign investorsmarket leaders were foreign investors

The close link between the Malaysian and The close link between the Malaysian and Singapore stock and money markets Singapore stock and money markets –– rapid rapid internationalization of the ringgit.internationalization of the ringgit.

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Policy slippage that made share market boom a source of Policy slippage that made share market boom a source of vulnerability :vulnerability :

Poor corporate governance Poor corporate governance –– equity market liberalization was not accompanied by equity market liberalization was not accompanied by attempts to redress weaknesses of corporate governanceattempts to redress weaknesses of corporate governance

Massive domestic credit expansion with a heavy exposure Massive domestic credit expansion with a heavy exposure of bank to share trading and the real estate sectorof bank to share trading and the real estate sectorOutstanding back credit to GDP ratio:Outstanding back credit to GDP ratio:19851985--8989 85%85%19941994 120%120%midmid--19971997 160%160%

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33 Onset of the crisis, policy muddling Onset of the crisis, policy muddling through and economic collapsethrough and economic collapse

Onset of the crisis Onset of the crisis –– From early July 1997, massive selling From early July 1997, massive selling pressure on the ringgit combined with share market collapsepressure on the ringgit combined with share market collapse

Policy muddling trough until August 1998 Policy muddling trough until August 1998 (This was possible because of low foreign debt exposure)(This was possible because of low foreign debt exposure)

The economy was in a precarious state by the third quarter of The economy was in a precarious state by the third quarter of 1998 (whereas economies in Thailand and Korea had 1998 (whereas economies in Thailand and Korea had become stabilized and begun to exhibit signs of recovery) . become stabilized and begun to exhibit signs of recovery) .

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4. Capital4. Capital--control based crisis resolution control based crisis resolution strategystrategy

Two policy optionsTwo policy optionsEntering into an IMF package (Entering into an IMF package (‘‘obtaining a good obtaining a good housekeeping sealhousekeeping seal’’))Resorting to capital controls to combine fixed exchange Resorting to capital controls to combine fixed exchange rate with the Keynesian therapyrate with the Keynesian therapy

Malaysian government (or, rather, Dr Mahathir!) opted for Malaysian government (or, rather, Dr Mahathir!) opted for the latter. (why?)the latter. (why?)

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Capital controlCapital control--based Policy Packagebased Policy Package

•• Strong, but narrowly focused capital controls Strong, but narrowly focused capital controls •• [Adjustable] Pegged exchange rate (RM 3.80 per [Adjustable] Pegged exchange rate (RM 3.80 per

US$)US$)•• Expansionary fiscal and monetary policyExpansionary fiscal and monetary policy•• Banking and corporate restructuringBanking and corporate restructuring

The role of capital controlsThe role of capital controls•• Supporting the exchange rate pegSupporting the exchange rate peg

andand•• Breaking the link between domestic and world Breaking the link between domestic and world

interest rates.interest rates.

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55 RecoveryRecoveryRapid/smooth recovery from about the first quarter of 1999Rapid/smooth recovery from about the first quarter of 1999The economy regained preThe economy regained pre--crisis (1996) level of GDP by crisis (1996) level of GDP by midmid--20002000Public expenditure led the recovery, but because broad Public expenditure led the recovery, but because broad based.based.Rapid export expansion (on the back of a boom in world Rapid export expansion (on the back of a boom in world electronics industry and favourable primary commodity electronics industry and favourable primary commodity prices (rubber and palm oil) played a pivotal role, but prices (rubber and palm oil) played a pivotal role, but domesticdomestic--oriented industries and nonoriented industries and non--tradable sectors too tradable sectors too played an important part in recovery.played an important part in recovery.Turnaround of the economy was accompanied by a notable Turnaround of the economy was accompanied by a notable strengthening of the external payments position. By 2000 strengthening of the external payments position. By 2000 MalaysiaMalaysia’’s fiscal position remained perhaps the healthiest s fiscal position remained perhaps the healthiest among the crisisamong the crisis--hit countries. hit countries.

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66 Have Capital Controls Worked?Have Capital Controls Worked?The Malaysian economy did recover following the policy The Malaysian economy did recover following the policy

turnaround.turnaround.But But precedenceprecedence does not necessarily imply does not necessarily imply causationcausation..

Two inferences based on comparison of Malaysian Two inferences based on comparison of Malaysian experience with that of the IMFexperience with that of the IMF--program countries:program countries:Capital had already left Malaysia and speculative pressure Capital had already left Malaysia and speculative pressure for capital outflow from the region was coming to an end at for capital outflow from the region was coming to an end at the time (controls were a ritualistic locking of the barn door the time (controls were a ritualistic locking of the barn door after the horse has bolted)after the horse has bolted)Not only Malaysia, but also the IMF program countries Not only Malaysia, but also the IMF program countries began to recover about the same timebegan to recover about the same time

Thus, capital controls did Thus, capital controls did notnot make a make a ‘‘distinctdistinct’’ contribution to contribution to the recoverythe recovery

((DornbuschDornbusch 2003, Fischer 2003) 2003, Fischer 2003)

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My inferencesMy inferences

‘‘Closing barn doorClosing barn door’’ analogy is wrong for two reasons:analogy is wrong for two reasons:

The purpose of capital controls was to set the stage for The purpose of capital controls was to set the stage for monetary and fiscal expansion by preventing outflow of monetary and fiscal expansion by preventing outflow of funds, both foreignfunds, both foreign--owned and local, in response to owned and local, in response to lowering of the domestic interest rate relative to world lowering of the domestic interest rate relative to world interest rates under expansionary macroeconomic interest rates under expansionary macroeconomic policypolicy

The potential threat of capital exodus was much greater The potential threat of capital exodus was much greater in Malaysia than in other crisis countries because of in Malaysia than in other crisis countries because of the close financial links with Singapore.the close financial links with Singapore.

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There is no evidence to suggest that Malaysia has lagged There is no evidence to suggest that Malaysia has lagged behind the IMF program countries in the recovery process is behind the IMF program countries in the recovery process is not consistent with facts. not consistent with facts. (Table 2, Figure 1) (Table 2, Figure 1)

Paper by Kaplan and Paper by Kaplan and RodrikRodrik (2003)(2003)-- provide econometric evidence in support of the hypothesis provide econometric evidence in support of the hypothesis that Malaysiathat Malaysia’’s economic recovery was superior to that of s economic recovery was superior to that of Thailand, Indonesia and Korea during the first twelve months Thailand, Indonesia and Korea during the first twelve months following the implementation of capital controls.following the implementation of capital controls.

-- Their results are however sensitive to the particular Their results are however sensitive to the particular counterfactual used in the comparison.counterfactual used in the comparison.

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Figure 1: GDP in Malaysia, Korea and Thailand, Figure 1: GDP in Malaysia, Korea and Thailand, 1993q11993q1--2006q42006q4

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In any caseIn any case,,

There is little justification for posing the question as, There is little justification for posing the question as, ‘‘whether Malaysia has recovered faster than the whether Malaysia has recovered faster than the IMFIMF--program countriesprogram countries’’. .

The real issue is whether the unorthodox policy choice The real issue is whether the unorthodox policy choice was a viable alternative for the IMF route in was a viable alternative for the IMF route in achieving recoveryachieving recovery

(Efficacy of a capital(Efficacy of a capital--control based policy package as control based policy package as a crisis resolution strategy, failing an early and a crisis resolution strategy, failing an early and gracious arrival of the IMF and/or sociogracious arrival of the IMF and/or socio--political political resistance to going alone the IMF path)resistance to going alone the IMF path)

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Capital controls and policy autonomyCapital controls and policy autonomy

Imposition of capital controls brought about a dramatic Imposition of capital controls brought about a dramatic turnaround in the domesticturnaround in the domestic-- international interest rate international interest rate differentials (Figure 2)differentials (Figure 2)

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Figure 2: Differential Between Domestic and Figure 2: Differential Between Domestic and International Money Market Interest Rates in International Money Market Interest Rates in

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The breathing space provided by capital controls, exchange The breathing space provided by capital controls, exchange rate stability and the resultant macroeconomic policy rate stability and the resultant macroeconomic policy autonomy were instrumental in speedy implementation of autonomy were instrumental in speedy implementation of banking and corporate restructuring. banking and corporate restructuring.

Unlike in Thailand, no contraction is real bank credit to the Unlike in Thailand, no contraction is real bank credit to the private sector (Figure 4)private sector (Figure 4)

Banking restructuring in turn facilitated Banking restructuring in turn facilitated ‘‘broad basedbroad based’’recovery. recovery.

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Figure 4: Real Bank Credit to the Private Sector: Figure 4: Real Bank Credit to the Private Sector: Malaysia, Korea and Thailand, 1990Malaysia, Korea and Thailand, 1990--2006 (1990 =100)2006 (1990 =100)

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Growth ImplicationsGrowth ImplicationsNo evidence to suggest that capital controls have had an No evidence to suggest that capital controls have had an adverse impact on FDI flows (evidence is inconclusive at adverse impact on FDI flows (evidence is inconclusive at best). best).

No evidence to suggest that portfolio investors would shun No evidence to suggest that portfolio investors would shun Malaysia for ever as a punishment for its recalcitrant act. Malaysia for ever as a punishment for its recalcitrant act.

There is anecdotal evidence of There is anecdotal evidence of ‘‘inappropriateinappropriate’’ rescue rescue operations of banks and corporations, but one can argue that operations of banks and corporations, but one can argue that economic gains associated with speed recovery (and more economic gains associated with speed recovery (and more importantly avoiding economic collapse) might have importantly avoiding economic collapse) might have compensated for the alleged efficiency costs. compensated for the alleged efficiency costs.

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77 Concluding RemarksConcluding Remarks

The The ‘‘Malaysian experimentMalaysian experiment’’ has demonstrated that carefully designed has demonstrated that carefully designed temporary capital controls can provide policy makers with temporary capital controls can provide policy makers with beathingbeathingspace in crisis resolution through the standard Keynesian therapspace in crisis resolution through the standard Keynesian therapyy

However, other countries should not treat MalaysiaHowever, other countries should not treat Malaysia’’s radical policy choice as s radical policy choice as a a ‘‘readyready--mademade’’ alternative to the conventional IMF recipe. alternative to the conventional IMF recipe. A number of factors specific to Malaysia may have conditioned tA number of factors specific to Malaysia may have conditioned the he actual outcome actual outcome —— a well disciplined banking system, a competent a well disciplined banking system, a competent central bank, strong leadership.central bank, strong leadership.

Capital controls are justified only as emergency measures. CapitCapital controls are justified only as emergency measures. Capital account al account liberalisation is the ultimate destination in the process of gailiberalisation is the ultimate destination in the process of gaining ning economic maturity through global integration.economic maturity through global integration.But, some prudential regulation of foreignBut, some prudential regulation of foreign--currency denominated bank currency denominated bank borrowing and of short term capital inflows are desirable until borrowing and of short term capital inflows are desirable until the the domestic financial system gain maturity.domestic financial system gain maturity.

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ReferenceReference

Athukorala, PremaAthukorala, Prema--chandra (2002), chandra (2002), Crisis and Recovery in Malaysia: Crisis and Recovery in Malaysia: The Role of Capital ControlsThe Role of Capital Controls (2nd (2nd EdnEdn). Cheltenham: Edward ). Cheltenham: Edward ElgarElgar..

Athukorala, PremaAthukorala, Prema--chandra and Peter G. chandra and Peter G. WarrWarr (2002), (2002), ‘‘Vulnerability to a Vulnerability to a Currency Crisis: Lessons from the Asian ExperienceCurrency Crisis: Lessons from the Asian Experience’’, , World EconomyWorld Economy, , 25(1), 3325(1), 33--57.57.

Cooper, Richard N. (1999), Cooper, Richard N. (1999), ‘‘Should Capital Controls be Banished? Should Capital Controls be Banished? ‘‘,,Brooking Papers on Economic ActivityBrooking Papers on Economic Activity. 1 (1999), 89. 1 (1999), 89--141.141.

CordenCorden, W Max. (2003), , W Max. (2003), Too Sensational: On the Choice of Exchange Too Sensational: On the Choice of Exchange Rate RegimesRate Regimes. Cambridge Mass: MIT Press.. Cambridge Mass: MIT Press.

DornbuschDornbusch, , RudigarRudigar (2003) (2003) ‘‘MalysiaMalysia’’ss Crisis: Was it Different?Crisis: Was it Different?’’, in , in Preventing Currency Crises in Emerging MarketsPreventing Currency Crises in Emerging Markets edited by Sebastian edited by Sebastian Edwards and Jeffrey A. Frankel, pp 441Edwards and Jeffrey A. Frankel, pp 441--455. Chicago: Chicago 455. Chicago: Chicago University Press.University Press.

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Fisher, Stanley (2004), Fisher, Stanley (2004), IMF Essay from a Time of Crisis: International Financial IMF Essay from a Time of Crisis: International Financial System, Stabilization and DevelopmentSystem, Stabilization and Development. Cambridge . Cambridge MasMas: MIT Press.: MIT Press.

IMF (1999), Public Information Notice No. 99/88: IMF Concludes AIMF (1999), Public Information Notice No. 99/88: IMF Concludes Article rticle IV Consultation with Malaysia, Washington, DC.: IMF IV Consultation with Malaysia, Washington, DC.: IMF ((www.imf.org/external/np/sec/pn/19999/pn9988.htm).www.imf.org/external/np/sec/pn/19999/pn9988.htm).

King, King, MervynMervyn (1999), (1999), ‘‘Reforming the International Financial System: The Reforming the International Financial System: The Middle WayMiddle Way’’, , Finance Stability ReviewFinance Stability Review (Bank of England), 7: 203(Bank of England), 7: 203--211.211.

KrugmanKrugman, Paul (1999), , Paul (1999), The Return of Depression EconomicsThe Return of Depression Economics, New , New York: Norton and Company. York: Norton and Company.

KalpanKalpan, E. and , E. and DaniDani RodrikRodrik (2003) (2003) ‘‘Did the Did the MalasianMalasian Capital Controls Capital Controls Work?. In Work?. In Preventing Currency Crises in Emerging MarketsPreventing Currency Crises in Emerging Markets edited by edited by Sebastian Edwards and Jeffrey A. Frankel, pp 393Sebastian Edwards and Jeffrey A. Frankel, pp 393--431. Chicago: 431. Chicago: Chicago University Press.Chicago University Press.

King, King, MervynMervyn. (1999), . (1999), ‘‘Reforming the International Financial System: Reforming the International Financial System: The Middle WayThe Middle Way’’, , Finance Stability ReviewFinance Stability Review (Bank of England), 7: 203(Bank of England), 7: 203--211.211.