Global Policy Forum

Breaking the Taboo on Capital Controls

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By Martin Khor

Third World Network August 30, 1998

For many economists and serious analysts observing the Asian economic crisis, it has become obvious that the problem began with the free flows of funds moving in and out of the affected countries.


Those countries had recently liberalised their financial systems, allowing locals and foreigners alike to freely convert foreign exchange into local currency, and local currency into foreign exchange. This currency convertibility has been allowed not only to finance current transactions of trade and direct investment (which in the past had also been permitted), but also for other transactions and short-term flows such as investment in the stock markets; loans from and to abroad; remittances to abroad by individuals and companies for savings or property purchases overseas.

Since these short-term flows are not recorded in the current account of the balance of payments, the ability to convert local into foreign currency for these purposes is termed "capital account convertibility." Many economists have concluded that when countries introduce capital account convertibility, they expose themselves to autonomous inflows and outflows of funds by foreigners and locals, subjecting their local currency to speculation as well as exchange- rate volatility.

The Asian crisis 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 now causing another equally vexing problem. It is preventing or discouraging the countries from taking the policies they urgently need to get the recovery process moving. To counter the recession, the government needs to lower interest rates (to relieve consumers and companies from their heavy debt service burden) and increase its spending (so that there is more demand for businesses and incomes for workers).

However they are constrained from this line of action because of fears that managers of investment funds and currency speculators (known as "market players") will attack the local currency because a lower interest rate makes it less attractive for people to park their money in the country. Also, there is fear of local capital flight, as 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 dampener or even a stop to measures that are needed for a recovery. Therefore, one logical move would be for the affected countries to consider partly re-regulating their financial system, and re- imposing some forms of control over the convertibility of the local currency. This could reduce the conditions in which currency speculators can profitably operate. It could also reduce the exit of funds and discourage the inflows of undesirable forms of short-term capital.

Many observers point to China and India as examples of countries that have not been subjected to volatile capital flows and currency instability or speculation, because the two countries do not allow full convertibility of their currencies. Although the local currency can be converted for trade and direct investment purposes, there are restrictions and regulations for changing local currency to foreign exchange (and vice versa) for other purposes. The lesson is that developing countries that want shield themselves for externally-generated financial crises should retain (or regain) some controls over the convertibility of their currency.

However, the option of reintroducing some capital controls has till recently not been openly discussed, because it is considered a "taboo" subject.
The prevailing ideology held and spread by the International Monetary Fund and the Group of Seven rich countries is that countries should liberalise their capital account, and those that have done so will suffer damage if they reimpose controls. Policy makers in the affected countries are worried that if they were to even discuss the advantages of capital control, their country would be black-listed 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 speedy recovery.

Recently there was a major breakthrough against the taboo when the prominent economist Paul Krugman of the Massachusetts Institute of Technology launched a personal campaign to persuade Asian governments to reimpose capital controls as the only way out of their crisis. To be fair, it must be noted that Krugman is not the first person to advocate capital controls as a way out of the Asian crisis. Indeed he is, as he admits, a new convert. But as he is so much a part of the economics establishment, his radical proposal will carry more weight. Now that the taboo is broken, capital controls could become a respectable option for governments wanting an effective policy instrument to prevent further financial turbulence.


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FAIR USE NOTICE: This page contains copyrighted material the use of which has not been specifically authorized by the copyright owner. Global Policy Forum distributes this material without profit to those who have expressed a prior interest in receiving the included information for research and educational purposes. We believe this constitutes a fair use of any such copyrighted material as provided for in 17 U.S.C § 107. If you wish to use copyrighted material from this site for purposes of your own that go beyond fair use, you must obtain permission from the copyright owner.