Global Policy Forum

By Robert Wade and Frank Veneroso

'The policy backlash is the most serious challenge yet to the free-market orthodoxy that the globe has embraced since the end of the Cold War'
The Wall Street Journal, 4 September 1998.

'There is an ideological battle going on over capital controls, and it is huge'
World Bank senior advisor on capital markets and Asian specialist, 1 September 1998.

'The relative stability of China and India, countries whose restrictions on international financial flows have insulated them to some extent from the current maelstrom, has led some to conclude that the relatively free flow of capital is detrimental to economic growth and standards of living. Such conclusions, in my judgement, are decidedly mistaken'
Federal Reserve Chairman Alan Greenspan, to US House of Representatives, 16 September 1998.

'It would be a catastrophe if countries were to develop the idea that somehow withdrawing from the global system was right and that building the foundation for a market economy was wrong.'
Treasury Secretary Lawrence Summers, 9 September 1998.

Former Federal Reserve Chairman Paul Volker said the IMF's stance was over influenced by the US Treasury, and left many small economies dangerously exposed to turbulent capital flows. 'The visual image of a vast sea of liquid capital strikes me as apt. The storms through which a great liner like the U.S.S. United States of America can safely sail will surely swamp even the sturdiest South Pacific canoe.'

'Financial markets are given to excesses and if a boom/bust sequence progresses beyond a certain point it will never revert to where it came from. Instead of acting like a pendulum, financial markets have recently acted more like a wrecking ball, knocking over one economy after another'
George Soros, international financier, to US House of Representatives, 16 September 1998.

'Marx's view of free enterprise is now being echoed by many business men who would rather be flogged than labelled Marxists'
John Cassidy, "The Next Great Thinker: the Return of Karl Marx" in The New Yorker, 20-27 October 1997.

We may well be on the verge of a world slump.(1) The Thai crisis of July 1997 soon became the Southeast Asian crisis, then became the Asian crisis in October, and now has become the Great Asian Depression. The sudden intensification of insecurity and poverty that of millions of people in Asia makes this one of the worst economic calamities of the twentieth century. Spending on education, health, and social assistance is shrinking rapidly, creating gaping "social deficits".(2) The abrupt shift to negative growth in what had been the world's fastest growing region has sent a contractionary wave coursing through the world economy, setting off a cycle of events elsewhere.

The Gathering Slump

Commodity prices have fallen to their lowest levels in more than twenty years.(3) From Venezuela to Chile to Canada to New Zealand to Nigeria to South Africa to Russia-and places in between-commodity-based economies are finding it hard to sustain economic growth and public spending.

The Asian crisis has also triggered a 'gestalt shift' in the minds of the owners and managers of banks, hedge funds, pension funds, and other forms of mobile capital. They now see danger everywhere. Their pullout from one market causes pullout from others. The Morgan Stanley Capital International Index of emerging market stocks plummeted 33 per cent between mid-July and late August. In Europe the knock-on effects of Asia have been strong enough to force the Italian central bank to intervene to support the lira. Figure 1 shows the path of an index of financial market performance covering the industrial and emerging markets from the start of 1997 to the start of September 1998. Since April it has been mostly in free-fall.

On the face of it, the dynamics are odd. In normal times, short-term capital has an incentive to move to countries with current account surpluses and flee from those with deficits. Asia is building up huge current account surpluses. Korea's is running at an annualized rate of about 10 per cent of GDP, which is enormous. Thailand's is nearly as big. Malaysia's surplus is likely to be about 2 per cent of GDP. But foreign bankers and portfolio investors have been fleeing these economies. China has the second biggest foreign exchange reserves in the world after Japan and an enormous current account surplus, yet there are fears of a renmimbi devaluation. Hong Kong has a current account surplus and $96 billion of reserves-about the biggest reserves per person in the world-and the Chinese government has pledged it will use its $I4o billion of reserves to support the Hong Kong dollar. Yet the Hong Kong dollar and stock market are under intense speculative attack. So is the Taiwan dollar, despite Taiwan's towering exchange reserves and current account surpluses. The Japanese current account surplus is a large 3 per cent of GDP and Japan has the biggest net creditor position in the world by far. Yet foreign capital is not racing to take positions in the expectation of yen appreciation.

The answer to the puzzle lies partly in the fact that the current account surpluses result from import compression more than export expansion. The four most badly affected economies-Korea, Thailand, Malaysia, Indonesia-have undergone import falls Of 30-40 per cent in the past year. The falls reflect deep recessions, which spell debt default, bankruptcies, still lower domestic interest rates and possible further 'beggar thy neighbour' currency devaluations.

The Crisis Spreads

The Asian surpluses, of course, must be matched by deficits elsewhere. The western hemisphere economies have been thrown into deficit, and Latin America has now entered a full-blown crisis. Since June money has been withdrawn from Latin American money funds at three times the rate of withdrawal from Asian and Pacific funds.(4) Venezuela's current account has gone deeply into deficit and a bolivar devaluation is imminent. Colombia has already devalued in early September. The Mexican current account deficit has widened and the peso has fallen against the US dollar. Chile now has a current account deficit of around 5 per cent of GDP and its currency has been devaluing. Despite a current account deficit of 4 per cent of GDP and a fiscal deficit of 7 per cent of GDP, the Brazilian government is intent on holding the peg between the real and the US dollar. The Argentinean government is also intent on maintaining the dollar peg despite a 4 per cent current account deficit. Given the much higher risk premium now demanded by the owners and managers of financial capital in emerging markets, the exchange rate pegs of Brazil and Argentina seem to be unsustainable. Even the Canadian dollar has fallen to its lowest level ever against the US dollar, partly because of the commodity collapse and partly merely because of the prophecy that it would fall. The OECD predicted in early 1998 that Canada would have the fastest growth of any OECD economy in the coming year, a prediction now seen as wildly inaccurate.

The huge current account imbalances--deficits in some regions and surpluses in others-are causing instability and contraction. Governments of economies experiencing Asian-imposed deficits are responding with some combination of, (i) currency devaluation; (ii) cuts in imports-including the reintroduction of quantitative restrictions; (iii) increases in export subsidies, that increase the effective devaluation; and (iv) cuts in domestic demand by monetary and fiscal contraction. The Asian surplus countries are trying to turn on the monetary gas and stimulate their exports as a way to regenerate growth and wipe out the debt mountain-but from very depressed levels of demand. Deflation + debt + highly integrated international financial markets = dynamite.

The US and Europe, at the core of the world economy, have so far benefited from debt repayments by the rest of the world, as well as by the flight to quality that boosts the value of their currencies and cheapens their imports.(5) But they are not the oases of expansion that they appear. As the rest of the world tries to escape from difficulties by exporting more to them and importing less, they are hurtling towards a deficit precipice. The US dollar is currently being held aloft by its safe haven status, making imports cheap and exports expensive, The US is already running a current account deficit of almost 3 per cent of GDP. On the ground, the US west coast's ports are at their busiest in 20 years. The number of containers arriving in August at the port of Long Beach, which together with the neighbouring port of Los Angeles handles a quarter of US seaborne trade, was 7 per cent higher than the previous all-time monthly record. But more than half of the returning containers were shipped out empty, a figure more than 100 per cent larger than in the same month last year.(6) These figures represent an echoing testament to the tumbling demand for US exports. The gathering Latin American and Canadian devaluations and contractions will cut us exports still further-some 30 per cent of us trade is with Canada and Latin America. As Asia cranks up its export machine and as Latin American and Canadian exports become more competitive at newly devalued exchange rates, US imports will surge again. The current account deficit will grow even bigger; profits will be squeezed even more.

At some point, footloose capital will flee from a country with so severe a balance of payments disequilibrium and profits squeeze. But the US has the lowest aggregate savings rate among the OECD countries--gross domestic savings equal to 15 per cent of GDP, equal with the UK at the bottom of the scale--and its household savings rate of 1 per cent of disposable income is the lowest of any major industrial economy since the Second World War. It needs foreign savings to sustain its consumption and investment. It also needs a high stock market for the same purpose. But the interest rates needed to pull in the foreign savings may be too high to sustain the stock market. Eroded profit margins and a fallen stock market will cause multiplying falls in both consumption and investment. So even the US may succumb to the gathering slump, as may Europe.

The Crisis of Crisis Management

The crisis is also one of global crisis management. In Asia, the IMF not only led but in effect monopolized the international rescue effort, with conspicuously little regional coordination, and with the World Bank and the Asian Development Bank in distinctly subordinate roles. Japan's August 1997 proposal for a $100 billion Asia Monetary Fund, with pledges mostly from Japan, China, Hong Kong, Taiwan, and Singapore, was shot down by the US Treasury, not wanting a competitor to the IMF outside of its control.(7) The Asia Fund could probably have deterred the currency runs and stopped the crisis from becoming even a fraction of what it has become, because speculating against a currency backed by $100 billion is altogether less attractive than speculating against one backed by only $25 billion. The Treasury's failure to support it was a major mistake as regards dealing with the crisis, if not in terms of US foreign policy objectives in Asia.(8)

The Fund's basic strategy was two-fold. First, to promote the idea that the crisis represented the well-warranted punishment of Asian economies by international financial markets for the governments' gross mismanagement. As First Deputy Managing Director Stanley Fischer kept repeating, the crisis was due to 'homegrown causes'--that became, in the words of other commentators, 'Asian crony capitalism'. This was propounded by an organisation, that until September 1997, lavished praise on these countries' economic performance and attributed it in good part to their financial liberalization. Second, the Fund mobilized large stand-by credits and loans in return for changes in government policies. The changes included: (I) government guarantees of private sector foreign debt; (ii)domestic demand contraction by sharp increases in real interest rates and government budget surpluses; and (iii)structural reforms in finance, corporate governancce, labour markets, and so on, going far beyond what was necessary to stabilize the situation. These reforms targeted market-constraining institutional arrangements of a kind common in major European industrial countries, which the Fund would not dare demand be reformed--in the unlikely event that crisis-affected European countries called on it for help. Moreover, the Fund then disbursed the committed funds very slowly in order to force the restructuring, in its own version of the game of chicken: conditionality in pursuit of restructuring dominated disbursement in pursuit of ending the runs on the currencies.

A Failed Strategy

The strategy has been criticized from across the political spectrum, especially since it has been seen to have failed. The requirement that the government guarantee foreign private debt, thereby largely protecting foreign creditor banks from default, encouraged them to slow down rescheduling their short-term Asian loans.(9) This exacerbated the hard currency squeeze on local debtors and sent them rushing to buy foreign exchange to cover their increased dollar needs, adding to the downward pressure on the exchange rate. Domestic demand contraction accelerated the momentum towards corporate insolvency and social disorder, so that capital fled, or did not return, despite high interest rates. The insistence on major structural reforms sent a signal that the economies were basically unsound, redoubling capital exit. The IMF claims that the situation would have been even worse with any other strategy--such as one that emphasizes monetary and fiscal stimulus and limits policy reform to those things directly needed to bring about expansion.(10) But, by now, the Fund's claims ring hollow. The organisation has lost credibility in the region.

The Policy Backlash

There are three broad ways to escape the depressionary effects of debt and deflation. One is monetary and fiscal expansion sufficient to devalue or vaporize financial claims through inflation. This is not favoured by the holders of financial assets or organisations that rep- resent their interests. A second is bankruptcy and default that destroys the debt, but at the cost of crisis and collapse. A third is dogged repayment over a long period, accompanied by a painful squeeze of the real economy--the 'water torture' route(11). This tends to be the preferred option of financial capitalists and of the IMF.

Until recently, most Asian governments generally acquiesced in the IMF's strategy, in part because they needed its money and approval, and in part because they believed in it. Now that the cost of this option has become apparent, a policy backlash has begun. It constitutes what The Wall Street Journal calls 'the most serious challenge yet to the free-market orthodoxy that the globe has embraced since the end of the Cold War'.(12)

In the face of steep losses of output and the threat of social unrest, and with huge current account surpluses to cushion the need for western short-term capital, Asian governments are lowering interest rates and promoting a Keynesian fiscal expansion. Indeed, they are becoming more interventionist across the board in order to regain control of their economies. Some have described their actions as a rejection of Anglo-American capitalism, and look to China as a model for the way it has escaped relatively unscathed. Their turning away from the US and towards China may have important long-term implications. And the mood is spreading well beyond Asia. 'The "free market" path of development--from developing to emerging to a developed nation--has failed to live up to the expectations of the people of the South', said South African Deputy President Thabo Mbeki recently.(13)

This backlash may be the harbinger of the second stage of Karl Polanyi's 'double movement'. Polanyi identified a recurrent pattern in the evolution of capitalism, in which a period of free-market policies gave rise to such instability and inequality as to trigger a social and political response, resulting in tighter social and political controls over markets--especially over finance.(14) From this perspective, we have been in the first stage for the past twenty years--the stage of market supremacy over governments and society. The Asia crisis and its spreading contagion may be leading to the second stage, the reordering of power away from markets and towards governments.

The Swing to Capital Controls

In particular, Asian governments and policy analysts are urgently discussing whether they should continue to allow financial capital to flow freely across their borders, as the IMF and the US Treasury have insisted they should. They realize that whatever the balance between 'real' and 'financial' causes of the crisis, the capital account opening that they undertook mostly in the 1990s is centrally implicated. Capital account liberalization first allowed large and uncoordinated inflows and then torrential outflows in the second half of 1997 and on into 1998. The switch in flows between 1996 and 1997 amounted to some 11 per cent of the combined GDP of the five main crisis-affected countries--the ASEAN four plus Korea. No nation can survive such a whipsaw without great disruption, especially when weakly institutionalized political structures are unable to support a negotiated sharing of the burden. China has escaped the direct impacts of the crisis in large part because its currency was nonconvertible, preventing both inflows and outflows of hot money--but not preventing foreign direct investment, of which China has had lots. Much the same applies to India.

Malaysia

Malaysia, which had been amongst the most open economies on the capital account, has gone furthest in reintroducing capital controls-- explicitly following China. The new special functions minister, Diam Zainuddin, announced that 'Malaysia's new currency controls are based on China's model'.(15)

The exchange controls slapped on at the end of August in effect withdraw the ringgit from the international currency trading system.(16) Exporters are now required to sell their foreign exchange to the central bank at a fixed rate; that currency is then sold for approved payments to foreigners, mainly for imports and debt service. This system makes the ringgit convertible on the current--or trade--account, as before, but not on the capital account--it prevents buying of foreign exchange for speculative purposes. Residents cannot transfer ringgits to foreign bank accounts, and can take only a limited amount of foreign exchange for purposes of foreign travel. Non-residents can convert ringgits into foreign currency only with the approval of the central bank. Sellers of Malaysian securities can only convert their ringgits into foreign exchange once they have held the security for 12 months. Holders of offshore ringgit accounts have until 1 October to repatriate their ringgits, after which repatriation is illegal. With this last move the government ensures that the imposition of exchange controls, far from generating the always threatened punishment, capital flight, yields a short-term debt-free capital inflow.

Malaysia has not turned away from all forms of foreign capital. The controls are aimed specifically at short-term flows. They do not extend to foreign direct investment or the repatriation of interest, dividends and profits.(17) Current account transactions remain convertible; Malaysia remains committed to free trade. The Malaysian stock market rose in the days following the exchange controls.

Prime Minister Mahathir accompanied this move with a stinging indictment of free markets. 'The free market system has failed and failed disastrously', he said. He added, 'We have asked the International Monetary Fund to have some regulation on currency trading but it looks like they are not interested.' He proceeded to sack Anwar Ibrahim, the deputy prime minister and finance minister and his heir apparent. Anwar had reassured international investors with his orthodox free-market views and willingness to impose austerity measures. Although Malaysia had not take IMF money, and therefore had not come under a formal IMF program, Anwar had followed the IMF both in its broad strategy and in its specific advice to Malaysia. The previous week, Mahathir had prompted the resignation of the head of the central bank and his deputy over the forthcoming capital controls and monetary expansion.

Mixed Reactions

A Chinese official commented with evident satisfaction, 'Malaysia is returning to the route which China has been taking'.(18) 'Tokyo supports capital control by Asian economies', said the headline about the Japanese response. The story reports that 'Japanese officials and analysts are supporting the recent moves by Malaysia, Hong Kong and Taiwan to step up capital controls to defend themselves from global speculators or erratic flows of short-term capital.' As an official at japan's Ministry of Finance put it, 'Japan was once a developing country and we had restrictions of all kinds, including controls in the foreign exchange market.'(19) The former president of the Philippines, Fidel Ramos, said, 'One must sympathize with Kuala Lumpur's effort to defend itself from what it sees as a kind of global laissez-faire capitalism which is going out of control'.(20)

The IMF's managing director, Michel Camdessus, claimed that Malaysia's exchange controls were 'dangerous and indeed harmful'.(21) First Deputy Managing Director Stanley Fischer said that foreign exchange controls introduced by Malaysia were a step backward and would bring no long-term benefit.(22)

US Treasury Secretary Rubin said that dramatic economic policy shifts by Malaysia were of concern to the US and were not the best way to promote economic growth. 'I think the actions Malaysia took yesterday are of concern and obviously it is not the path that we think best tends itself to economic growth and stability over time. I think we'll be watching what happens in Malaysia and see what occurs there over time'.(23) The US undersecretary for international trade said Asian nations must not follow Malaysia's lead, but adhere to open market principles. 'The supposed alternatives--exchange controls, import substitution and state management--do not work. The failed nostrums of the past are not the answer'.

Western financiers chorused disapproval. Salomon Brothers described Mahathir's measures as 'regressive' and 'ultimately destined to failure'. Credit Lyonnais Securities (Asia) said that capital controls would turn Malaysia into 'an equity black hole' for foreigner investors. Indosuez WI. Carr said the measures make 'Malaysia virtually uninvestable'.

The underlying assumption is that Malaysia, notwithstanding one of the highest savings rates in the world-37 per cent OFGDP in I 995needs Western finance not only for immediate refinancing purposes but also in the longer term. 'With capital controls slapped on many investors will not return to Malaysia for a decade or more, regardless of how attractive their asset values become. The capital account problems will be dragged out for many years. Any prospects of getting this crisis over with by "doing the right thing" have been shot.'(24)

Mahathir has been voicing anti-market sentiments for some time, earning himself the reputation for being what might politely be called a lone voice. But even in economies that had been celebrated as exemplars of free-market capitalism, policies are being implemented that make free-market economists throw up their hands in horror.

Hong Kong

Hong Kong is the most dramatic case. The economy is likely to experience a contraction of gross domestic product by over 4 per cent in 1998, and throughout the summer of 1998 faced intense attacks by hedge funds against the Hong Kong dollar--pegged to the US dollar in a quasi-currency board arrangement. The hedge funds calculated that, when competitor countries had devalued by 30-40 per cent and more against the US dollar, the Hong Kong dollar would have to be devalued as well. In what came to be known as the 'double play', hedge funds sold the Hong Kong dollar short--borrowing HK dollars, selling those borrowed dollars back to the Hong Kong Monetary Authority at the fixed rate, expecting that, by the time they had to repay their borrowed dollars, the exchange rate would have fallen. At the same time they sold Hong Kong stocks short--borrowing stocks they did not own (from an investment bank with a stock lending operation, such as Morgan Stanley) and selling the borrowed stocks, in the expectation of later repaying the borrowed stocks at a lower cost. If the Hong Kong Monetary Authority raised domestic interest rates to defend the currency peg, the local stock market would fall, and the speculators would benefit by being able to repay their borrowed stock at a lower price. If the strain of higher interest rates became so great that the government devalued the currency, the speculators could repay their borrowed HK dollars at a cheaper price--and the currency fall would allow them to repay their borrowed equities at a cheaper price, even if the stock market did not fall. Either way, the hedge funds would win.

Hedge Funds Versus the National Interest

In response the government has been intervening to restrict various forms of trading o the stock market so as to ease the pressure on the Hong Kong dollar. And it has bought up about 6 per cent of the stock market, acquiring a national stake in the private sector at the cost of 15 per cent of its foreign exchange reserves in the last two weeks of August alone. The aim was to hit the speculators by intervening to keep the price of stocks high, to show them that selling stocks short was not a one-way bet. It worked: the hedge funds took big losses and retreated. 'After Hong Kong markets shut (on 28 August) Hong Kong's Financial Secretary Donald Tsang said the government would propose new laws to restrict short selling and stock borrowing, which enable people to bet against stocks. He said it was in the public's interest to do so.' (25) In the public's interest to restrict the right of the owners and managers of financial assets to buy and sell freely? This is not what one expects from Hong Kong. The government is also considering ways to restrict large movements of money into and out of Hong Kong's markets.

The Hong Kong events constitute a telling illustration of the purely casinoesque nature of the hedge fund operations. It is ironic that the hedge funds, arch champions of free financial markets, have driven Hong Kong to adopt policies that resemble those of China more than those of British colonial Hong Kong--and have driven Hong Kong into dependence on China. The Chinese government was not only well informed about the Hong Kong government's interventions, it was a player in the game, providing an amply-endowed fire-fighting fund specifically for use in protecting the Hong Kong dollar.

Western bankers and investors are furiou with the Hong Kong Monetary Authority for daring to intervene to fend off unwanted speculation, notwithstanding the government's meticulously explained defence. Without a level playing field, they say, Hong Kong will be passed over by investors, falling into well-deserved economic oblivion.(26) 'Does any country where the regulator has a 10 per cent stake in its number one company have financial credibility? The answer in No", said the head of research at a derivatives trading firm.(27) 'Spiteful Capital Controls' was the headline in a Morgan Stanley newletter, which went on to say, 'Policymakers [in Hong Kong and elsewhere] appear to believe that speculative attacks on their currency have nothing to do with economic fundamentals and everything to do with evil speculators'.(28)

Taiwan

Even Taiwan, which has weathered the crisis better than most others, has seen a 7 per cent fall in its export earnings in the first half of 1998 compared with first half of 1997, and a 20 per cent stock market fall between March and August 1998. Notwithstanding its huge foreign exchange reserves, it too faces intense speculative pressure against its currency. Asked 'Is your currency under pressure from the yen?', the prime minister replied, 'Yes, day after day, day after day'.(29)

The policy response has been to insulate the New Taiwan dollar from the region's currency decline, and bar foreign short-term investors while encouraging local investors. The government has been intensifying existing controls since May. The central bank virtually shut down trade in futures instruments which had been used to pressure the local currency. Inflows of funds destined for the stock market are subject to central bank approval, allowing the authorities to influence demand for the currency. The offshore market in New Taiwan dollars has been closed. At the end of August, the central bank issued a sharp warning that foreign currency speculators such as George Soros would find 'no quarter' to operate in domestic currency markets. (30)

On 1 September President Lee Teng-hui met with a group of 20 investment professionals and announced a variety of further interventions. As a Taiwan currency analyst said, 'The president coming out and meeting with brokerages is very rare. The government is getting serious. They are trying to block speculation as much as they can.'(31)

Korea

Throughout this period, Korea has kept in place some capital account restrictions on the convertibility of the won. Also, as noted, Korea is now earning huge current account surpluses; its foreign exchange reserves as of August 1998 stand at $41 billion, an all-time record, exceeding the IMF's target of $40 billion by the end of 1998. This reflects, however, savage import cut-backs, including in raw materials and capital goods.

Though the Korean government has not moved to re-impose Malaysian-type exchange controls, it has become much more interventionist--and much more authoritarian. Many labour leaders are in jail, and riot police are deployed in force against strikers or demonstrators against the government. But capital, as well as labour, is being disciplined. The new labour law gives firms the right to fire more or less at will; but the government has pressured the big firms not to fire en masse. The government is pressing the big companies to merge and restructure in order to manage the problems of excess capacity--in semiconductors and petrochemicals, for example. The companies are demanding that the government take on all the bad debts of the merged entities. The government is offering less. The result is a standoff. The government is also committed in principle to bringing in more foreign ownership, and the big companies are resisting. The result is another stand-off--though, in practice, the situation is less than straightforward, because the government has prevented Microsoft from taking over Korea's biggest software firm, and has resisted the sale of Kia Motors and two large banks to foreigners.

In the financial sector, the government is moving quickly, unlike Japan, to buy up bad loans from the banks and force small banks to the road to merge with larger ones, putting the banking sector on the road to recovery--though many firms are still finding credit difficult to obtain, because banks continue to try to meet the Basle standards of capital adequacy, as demanded by OECD membership. The major question now is whether the government will take the banks off the Basle standards, which might greatly alarm international financial markets. The even more important question concerns the source of finance for the promised fourfold package: Keynesian expansion; social safety net--the absence of which could cost the government its survival; public bailout of the banks; and public purchase of the debt of some of the biggest companies.(32)

Japan

Potentially, the most dramatic development of all may come from the current discussion within Japan on the subject of reintroducing capital controls. Finance Minister Miyazawa, giving a press conference in early September, was asked whether Japan was studying the option of erecting capital controls to protect against speculative attacks. In the words of the Reuters report, 'He said it was too early to discuss that at the government level but added he had asked Toyo Gyohten, a special advisor to Prime Minister Keizo Obuchi, to study the issue'.(33) For the finance minister of the world's second biggest economy to say this just before meeting us Treasury Secretary Rubin and Federal Reserve Chairman Greenspan--the two most powerful financial officials in the world--who are passionate opponents of capital controls, is quite remarkable.

At the end of the Japan-US meeting, 'Japanese officials bristled at the mounting American pressure and suggested they were being made scapegoats for problems that are unrelated to Tokyo's seven years of economic mismanagement. A senior Japanese official [said], "Japan has been overly criticized. My concern is that if anything happens to the US economy, everyone will point to Japan and say it is responsible".(34)

Later, Japan's vice-minister of finance for international trade, Eisuke Sakakibara, said that Japan wants the G7 countries to review policies towards capital liberalization. He admitted that the move by Malaysia to impose capital controls has been greeted with considerable sympathy in some parts of the Japanese government. Separately, the minister of international trade and industry said, 'I believe that there are certain sound reasons for adopting capital controls'.(35) These comments are the public face of the Ministry of Finance's private encouragement to both Malaysia and Hong Kong to intervene in the way that they did. If Japan itself goes on to reintroduce capital controls, this would further boost their legitimacy elsewhere.

The Chinese government has called for Japan to reintroduce some form of capital controls--to take 'measures to limit the flow of yen out of Japan or directly intervene in currency markets'.(36)

In short, capital curbs are an idea whose time has returned, in the minds of many Asian government officials. It is telling that a respected Thai economist, who is a contender to head the World Trade Organisation, has announced that he finds Malaysia's capital controls 'reasonable' and 'understandable'.(37) He presumably calculates that sentiment in Asia and in the world has moved sufficiently in favour of capital controls for his views not to cost him the position of head of the WTO, a staunchly free-trade body.

New Proponents of Capital Controls in the West

Meanwhile, a number of prominent American economists are cautiously embracing the need for some forms of capital controls. The most prominent convert is Paul Krugman, professor of economics at MIT. Writing in Fortune magazine in early September, he makes exchange controls the linchpin of his radical plan to save Asia'. Asian governments must lower interest rates and push fiscal expansion, he argues. But without exchange controls the currency will plummet even more as hot money and domestic savings exit in response to lower interest rate differentials. Therefore, for all their costs, exchange controls must be re-imposed.(38) Krugman stresses that exchange controls are the least bad of a very bad set of alternatives, and that they must be seen to 'clearly be temporary'.(39) Once they help engineer domestic expansion, they can be removed, for interest rates can be raised to the point where the monetary leakage stops without them.

The reaction from Wall Street has again been swift and predictable. The investment firm, CLSA Global Emerging Markets, told its clients, 'Paul Krugman has a lot to answer for. Not content with getting the analysis of the current Asian downturn completely wrong in his famous article ('The Mvth of Asia's Miracle', Foreign Affairs, November-December 1994) he has sallied forth again with a much more dangerous solution in his latest Fortune magazine musings. The reason his solution of exchange controls--not an unreasonable option for developing countries per se--is so dangerous is that he has no conception of the capacity of some of the leaders in Asia for self-delusion.'(40)

Others have voiced support for capital curbs. Former Federal Reserve Chairman Paul Volker said that the IMF's stance was over-influenced by the US Treasury, and left many small economies dangerously exposed to turbulent capital flows. 'The visual image of a vast sea of liquid capital strikes me as apt. The big and inevitable storms through which a great liner like the U.S.S. United States of America can safety sail will surely swamp even the sturdiest South Pacific canoe.'(41)

Divisions in the IMF

Surprisingly, even the IMF, which almost always speaks in public with a single disciplined voice, has shown signs of internal differences. Shortly after Managing Director Camdessus and First Deputy Managing Director Fischer made the passionately anti-capital controls remarks quoted above, the head of the IMF's Asia-Pacific Department, Hubert Neiss, said in Seoul that 'Short-term capital controls may be adopted to avert the kind of regional contagion that caused a serial swoon among Asia's economies last year'. He declined to elaborate on what the controls might entail. 'My only prediction is that it will lead to some measures that will make it difficult for banks to run up short- term debts to foreigners'. He also said that the IMF 'was keenly watching Malaysia's experiment with more sweeping capital controls. This is an experiment that everybody will be carefully watching, and whether it succeeds over a short while or on an enduring basis'.(42) Neiss's open-minded statement presumably reflects a calculation that the IMF needs to be seen to be responsive, to some degree, to sentiment in the crisis-affected region, and not only to the wishes of the US Treasury. It is all the more remarkable given that the Fund is anxious to avoid doing or saying anything that might upset the US Congress as it deliberates whether to pay over the US share of the IMF'sbudget.(43)

The European Response

In continental Europe, support for some form of capital controls is growing. French Prime Minister Lionel jospin recently provided an umbrella justification, though without mentioning capital controls by name. 'Capitalism is its own worst enemy', he declared. 'The crises we have witnessed teach us three things: capitalism remains unstable, the economy is political, and the global economy calls for regulation. (44) French Finance Minister Dominique Strauss-Kahn further declared, 'Public authority ought to set the rules of the game and clearly delimit the place of competition in the economic regulation of different sectors'. Apart from the general European sympathy for governing markets, two more specific considerations lie behind European support. Firstly, emergency capital controls can stop a currency crash, and banks which are heavily exposed in Latin America--especially southern European banks--are, like passengers on the stern of the Titanic, desperately looking for anything that floats. Indeed some US commercial and investment banks are said to be privately pushing the US Treasury to endorse exchange controls for Latin America, fearing that they simply could not survive another loss on the Russian scale. Secondly, European governments have serious concerns over the January 1999launch of the 'euro', including the dependence of European banks on interest income for the bulk of their profits and the relatively weak and nationally different banking supervision and regulatory standards. Exposing such a structure to free capital flows could be disastrous.

This is the new reality. Asia, which accounts for roughly a quarter of world GDP, is moving strongly towards capital controls. Two of its biggest economies, China and India, have maintained capital controls all along and are now less likely to remove them any time soon. Several other crisis-affected countries have adopted exchange controls or tightened other kinds of financial controls, or are moving in that direction-Japan and Brazil are the most important cases to watch. In continental Europe, too, support for capital controls is growing as the Asia crisis spreads and as the euro launch date nears.

The Case for Capital Controls

Opponents of capital controls commonly cite all the possible things that can go wrong in all kinds of countries as reasons for not having them anywhere. We broadly agree that some forms of capital controls are needed in Asia. But we make an important distinction between two types of control. One is on inflows, especially of borrowing in foreign currency. The other is on outflows. By and large, controls on outflows are more difficult to make effective, especially in the midst of crises. Over- or under-invoicing is a favourite technique for getting money out, because it is difficult to police. Inflows are much easier to control. There are plenty of ways by which hedge funds and portfolio investors can be discouraged. Chile's inflow controls require investors to leave a portion of their funds with the central bank for a minimum period without interest before being able to put them to use. The sooner the funds are taken out of the country, the higher the effective tax. Malaysia's Mahathir holds up Chile as a model, for all that he is presented in the West as 'severing Malaysia's ties to world markets'.

Krugman argues that Asian countries should introduce controls on outflows as a short-term emergency measure. We argue that--with the important exception of Japan--there is a stronger case for controls on inflows, of a semi-permanent kind.

Countries such as Korea and Thailand, which are racking up huge trade surpluses accompanied by foreign exchange inflows, can probably lower domestic interest rates and generate monetary expansion without appreciably weakening the currency. Most of the 'hot' money that went into emerging, Asia over the 1990s has now left, so controls are not needed to prevent further outflows of institutional funds. Malaysia may need them, for Krugman's reason, given that its current account surpluses are not nearly as large, and given peculiarities of its situation in relation to Singapore that have made its currency especially exposed to short-selling speculators. All of this is compounded by the fact that its planned stimulus package is very large.

Exchange controls or other forms of capital controls are nevertheless needed for two reasons. One is to avoid entrapping themselves like this in future-to protect against excessive inflows. Here we need to distinguish between three types of inflows: first, short-term capital to refinance foreign loans, until current account surpluses grow to the point where the loans can be paid back from the surpluses; second, foreign additions to domestic savings available for investment-- including foreign portfolio investment; and, third, foreign investment that goes along with technology, capital equipment, and management and marketing expertise. These economies do need immediate help in refinancing their top-heavy foreign debt, and they do need technology, capital equipment and some kinds of foreign expertise. But they do not need the huge inflows that they had been receiving--that is, of the second type of short-term financial capital. They have the highest savings rates in the world, and account for over half of world savings. East Asia and the Pacific saved an average of 38 per cent of GDP in 1995, compared to South Asia's 20 per cent, Latin America's 19 per cent, and the high income countries' 21 per cent.(45)

Weaknesses of the Asian Model

As many critics of the Asian model have pointed out, these countries overinvested in some manufacturing sectors and in essentially speculative ventures in real estate, infrastructure and equities, resulting in inefficient investment, asset bubbles, credit excesses and exchange rate overvaluation--the ills that led to the current crisis. They have not been able productively to absorb even domestic savings, let alone extra foreign savings. It is ironic that most of the critics who point to excessive, crony-steered investment as the root of the crisis insist that Asia will suffer if it limits inflows of short-term financial capital.(46)

Capital controls are needed, secondly, to make these fairly small, fairly open economies less vulnerable to the whims and stampedes of portfolio and hedge fund managers, and more generally to re-establish stable growth. This is especially the case in economies with high corporate debt-to-equity ratios. Korea is a classic example of how free capital movements in the context of high domestic and foreign debt can destabilize an economy with good 'fundamentals'. But the Hong Kong case shows how the same thing can happen in a small, open economy with low debt, large exchange reserves, and a current account surplus, once short-selling speculators wielding vast financial resources make it the target of an attack.

Krugman's argument does hold, however, for the case of Japan--though he does not make the distinction between Japan and the rest. Japanese nominal interest rates are below foreign rates. An aggressive monetary policy sufficient to jump-start demand requires negative real interest rates, which itself necessitates nominal rates much lower than foreign rates. At some point, the disincentive of keeping savings at home will outweigh the risks or a Wall Street crash and a dollar crash. There is now a large potential for savings exports to occur. Until as recently as April 1998, such financial exports were restricted. In April they were allowed as part of the first stage of 'Big Bang' financial liberalization. The financial outflows since then have contributed to yen weakness. More aggressive monetary expansion would probably cause more outflows and further yen depreciation, which could destabilize yet further other currencies in the region.

In short, Japan needs exchange controls to stop yen depreciation in response to monetary expansion. Many argue that such controls will not work. But the recently relaxed exchange controls did work, and could be made to work again. The other Asian countries need exchange controls not primarily in order to stop currency depreciation, but, rather, in order to buffer corporate sectors with high debt-to-equity ratios from external shocks, in order to encourage the resumption of the flow of massive domestic savings through banks to firms. They also require controls in order to protect against excessive capital inflows in a situation of extraordinary high domestic savings, where the inflows are likely to blow up speculative bubbles.

Weighing Up the Evidence

What is the empirical evidence on the impact of keeping or removing capital controls? On the one hand, the benefits of removing them have yet to be demonstrated in empirical research.(47) On the other, the risks of removing them are illustrated by the comparison between countries with convertible and nonconvertible currencies in the Asian crisis: China and India, with strict controls, have both been relatively untouched. The risks are also suggested by early twentieth-century history. The free-market financial system in place at the beginning of the twentieth century was directly implicated in the financial crises and depression of the 1920s and the 1930s. The post-war Bretton Woods system of regulated currencies and closed capital accounts was a carefully designed response to those crises, and it worked. We enjoyed twenty-five years or more of economic success. As late as the beginning of the 1980s only the US, Switzerland and Britain allowed the free flow of capital, and Germany followed in 1984. Economic performance has not improved since the bulk of the OECD countries removed their controls--by many measures it has deteriorated.(48)

We conclude that, at least in Asian conditions--with very high rates of domestic savings, underdeveloped equity markets, underdeveloped institutions of financial regulation (which make unrealistic the appeal to 'prudential regulation' instead of capital controls), and corporate sectors with high ratios of debt-to-equity--such controls, or speed limits, need to be longer-term, not temporary.

The Push for Capital Freedom

In short, Asia is moving strongly in the direction of capital controls, and there are good theoretical reasons why it should. The region saves more than can be productively invested at plausible rates of growth. It does not need to open itself to still more short-term inflows from abroad, given the evident risks. As we have noted, support in Europe for the capital controls case is growing.

Yet it would be quite wrong to conclude that the movement to capital controls is robust. The shift on the ground in Asia has already encountered vehement opposition from the US and the UK, and from the IMF. The owners and managers of western financial capital see great dangers in it and can be expected to mount tough resistance once the immediate emergency passes.

Consider the hyperbole with which Alan Greenspan, Lawrence Summers and other us officials denounce the moves in Asia. Greenspan's testimony to the House Banking Committee is particularly striking. He normally testifies blandly and ambiguously, and about many subjects at the same time. This time, on 16 September, he talked passionately, clearly, and about one subject only: the perils of capital controls. He equated the sort of exchange controls introduced by Malaysia with 'closing the economy to foreign investment', which in turn amounted to depriving the economy of 'the benefits of new technologies', causing it to be 'mired at a suboptimal standard of living'.(49) This is the voice of panic in the face of a threat to years of success in opening developing countries more completely to both trade and finance. He and other US financial officials see it as imperative to make sure that the troubles in Asia are blamed on the Asians, and that free capital markets are seen as key to world economic recovery and advance--so that the idea does not take root that international capital markets are themselves the source of speculative disequilibria and retrogression.

Indeed, until a few months ago, a campaign to establish free capital movement world-wide was in full swing. The IMF, the OECD, the World Trade Organisation (WTO) have all been pushing in this direction, supported by many governments, banks and financial service firms.

Structuring the IMF around Capital Freedom

Of these efforts, the one intended to be most irreversible is the revision of the IMF's constitution--its articles of agreement--in order to make open capital accounts a condition of Fund membership. The proposed revision to Article 1, which describes the purposes of the Fund, says the promotion of the orderly liberalization of capital os one of the Fund's main purposes. The revision to Article VIII, which describes the jurisdictions of the Fund--and hence the matters subject to sanctions of a legal character--says that the Fund shall have the same jurisdiction over the capital account of its members as it has over the current account. This means, in effect, that the Fund shall oversee and approve any capital account restrictions. Moreover, the language requires countries to commit themselves to open the capital account.

The WTO has negotiated a financial services agreement that frees up markets in financial services world-wide, agreeing to it in December 1997. The OECD has been negotiating the Multilateral Agreement on Investment (MAI), that will make differences in the treatment of foreign investors and domestic investors illegal--differences that were fundamental to the nurturing of new industries in East Asia(50) The MAI, though often presented as being only about foreign direct investment, in fact covers much more liquid forms of investment as well.(51) The point is important, because many more people agree on the desirability of removing restrictions on foreign direct investment than on removing those against highly liquid capital.

The New Justification

The Fund and the other bodies have justified the Big Push by saying that capital controls foster the long-term and world-wide misallocation Of capital and protect unsound financial systems from salutary crashes or other corrective mechanisms. They have provided remarkably little evidence to substantiate their argument. And they have modified it hardly at all in response to the Asian crisis. For the first several months after the crisis broke in mid 1997, Fund people were to be found lamenting that, 'Capital account convertibility is dead'. But, soon, a counter-argument was developed: the Asia crisis shows that capital account liberalization should not be slowed down. Quite the contrary, efforts to liberalize while creating appropriate regulatory systems should be speeded up. The buzz-words are 'sequencing', 'orderly capital account liberalization', 'regulations, yes, restrictions, no'.(52) It is difficult to escape a sense of deja-vu: for just the same was said after the disasters following the opening of capital accounts in the Southern Cone in the early 1990s. 'We must learn that opening to highly liquid forms of capital should be the last step in the sequence', was said then. Now it is being said again.

Deputy Treasury Lawrence Summers takes the argument forward. How can countries build up a regulatory regime adequate to allow capital account opening? By bringing in foreign financial firms. 'One of the best ways to accelerate the process of developing such a system is to open up to foreign financial service providers, and all the competition, capital and expertise which they bring with them.'(53) This is the entry route under IMF auspices that the big Wall Street and City firms want. They will be invited to help the country build an appropriate regulatory system and thereby meet the new conditions for IMF membership.

Money Politics

Behind this campaign by the Fund and the other multilateral organisations are the US and UK Treasuries. The US has a powerful national interest in establishing the free movement of capital worldwide--there is probably no more important foreign economic policy issue for the US than this. For one thing, the US savings rate is very low by international standards. To maintain its high level of consumption and investment--the overarching economic priority--the US must borrow from the rest of the world's savings, which is much easier if world financial markets are highly integrated.

For another, Wall Street firms want to do business in the rest of the world using the rest of the world's savings. They can exploit the great US privilege of being the issuer of the international reserve currency. This allows them to borrow cheaply from the rest of the world using Treasury bills, and recycle the savings in the form of foreign direct investment, portofolio investment, and loans, at much higher returns. The US Treasury under the Clinton administration has been unusually responsive to the interests of Wall Street, particularly since 1995--for reasons related less to Treasury Secretary Rubin's former career on Wall Street than to the need for the Democrats to elicit the help of Wall Street in overcoming their chronic electoral campaign finance shortage. And behind the Wall Street investment firms are savers and pensioners who wish to ensure that their savings are put wherever returns are highest, who are 110 per cent behind them in bull market times and 8o per cent behind them in bear market times as long as the memories of good times linger.(54)

More than this, the US sees free capital movements as a battering ram to force other economies to adopt free market structures not only in finance but across the board. Once an economy adopts a regime of free capital movements, it can sustain market-steering arrangements of the 'Asian political economy' kind only with difficulty, as the Asian crisis shows. The US national interest is to have the rest of the world play by American rules of both cross-border capital movement and domestic arrangements for finance, corporate governance, labour markets, and the like. Not only Wall Street but most of the bigger US manufacturing and service companies want this broader agenda, for which the Wall Street free capital movement agenda is the most powerful instrument.

How then did the goals of Wall Street and the City come to be translated into the top-priority goal of amending the constitution of the IMF? US and UK banks and other financial enterprises have long wanted all countries to commit themselves to two simple conditions: (i) free entry and exit; (ii) national treatment--same treatment as domestic counterparts, or better. Initially, around 1994-95, the US Treasury--shorthand for US and UK Treasuries--sought to advance these goals by writing them in to the constitution of the WTO as it was being formed out of the GATT. But many developing countries objected. Developing countries are powerful in the WTO, compared to the IMF, because of the one-country one-vote rule and the arbitration board that allows appeals against WTO rulings.

The US saw that the WTO route would be messy and compromising, with many conditions and qualifications. Likewise, the OECD's Multilateral Agreement on Investment, beginning to be negotiated among the OECD countries with the intention of later 'inviting' developing countries to sign-or risk being by-passed by foreign investors--seemed to be too complicated.

The IMF Route

Then it occurred to the Treasury that the goals could be advanced more effectively through the IMF by revising the articles of agreement. A plausible argument for revision could be made along the following lines. Trade flows dominated capital flows at the time when the Fund began. And the architects believed that capital controls were a necessary condition for the successful freeing up of trade around the world. The articles mandated the Fund to be the custodian of current account convertibility-open trade flows-and endorsed the use of capital controls. Now capital flows dominate trade flows. And capital markets are sufficiently sophisticated in the use of hedging instruments for the earlier concerns about exchange rate volatility and financial crises to be mitigated. Thus the need for an Organisation to be the custodian of capital account convertibility, and for that Organisation to be the Fund. The Fund's articles need to be modernized to reflect the new realities of capital flows.

This shifts the focus away from the pros and cons of capital account convertibility and towards the advantages and disadvantages of Fund membership. A finance minister who has doubts about the wisdom of capital account convertibility is unlikely to want to signal doubts about Fund membership. Besides, redefined in this way, the revision looks to be no more than an overdue balancing of the articles, as between the current account and the capital account. Transitional arrangements are allowed, so that countries can take their time-four years, six years. Therefore, the revision does not commit members to rapid changes. Its implementation in any particular case can be tailored to specific conditions. In the words of Deputy Treasury Secretary Summers, 'Each country must choose the approach that is right for them [sic]. Amending the Articles is entirely consistent with this. Under the proposed approach, countries will accept the obligation to liberalize the capital account fully, but what that means precisely will be up to them to decide in cooperation with the IMF. Until they are ready, they could avail themselves of transitional arrangements as approved by the Fund. They would simply have to commit not to backtrack, without IMF approval.'(55) All this should reassure doubters.

Power to the Fund

In practice, once the new articles are approved, the Fund will acquire much more power, at least over all but the biggest developing countries. In its bilateral consultations with the country it will have the justification of the articles of agreement to push the country to liberalize its finances--as it does not now. The country has no recourse to an appeals procedure, nor can it join with other countries in negotiating with the Fund--both of which are open in the WTO. The Fund's dissatisfaction with the country's progress in opening the capital account can be a very credible threat. When the Fund's dissatisfaction becomes known to the owners and managers of international capital, this capital is likely to flee--or risk being sued by shareholders. Even if the information does not become public, the Fund can use its new authority to withhold bailout money in the event of difficulties. It is not hard to imagine situations where the Fund thinks the country--India or Brazil, for example--should come off transitional arrangements long before the ministry of finance does, let alone other parts of the government.

Politics of the US Congress

For the moment, the constitutional revision is proceeding quietly and in low gear at the request of the US Treasury. The Treasury's first priority is to get the Congress to pay over the US's $18 billion quota to the Fund. A decision must be reached before the Congress goes into recess in the run-up to the November 1998 elections for the House and the Senate. The Treasury does not want to muddy the quota waters with the prospect of the Congress being asked to ratify a change in the articles.

The Democratic Party and the Clinton administration badly need Wall Street to contribute 'generously to the campaign costs of their candidates in the 1998 election.(56) Wall Street wants capital account opening world-wide, and hence supports revision of the IMF's articles of agreement. To secure the revision, the US must lead, and the US cannot lead if Congress refuses to pay its quota. Once the Congress approves the quota payment and the 1998 election is out of the way--and once the US banks most exposed in Latin America survive the current emergency--the Treasury will begin to push the revision more aggressively. But it will now face an uphill battle in much of the rest of the world.

The OECD's Multilateral Agreement on Investment

Meanwhile, the OECD has postponed consideration of the draft Multilateral Agreement on Investment until the end of October 1998, or in effect until after the us elections. Then we can expect to see it reactivated. Multinational firms are especially keen to see the MAI ratified, for it is, to a remarkable extent, a charter for their untrammelled freedom. It is about their rights, and says little about their obligations to host countries, to civil society.(57) It simply assumes that what is good for multi-national corporations (MNCs) is good for host countries. It says that MNCs are not to receive worse treatment than domestic firms, but pointedly does not say they are not to receive better treatment--which should be equally against the logic of world efficiency. It seems strange that so much fuss is being made to negotiate a charter for the untrammelled freedom of MNCs when the direction of change has been so clearly in this direction anyway. The fact that the fuss is being made shows just how thoroughgoing is the push for capital freedom coming from the West.(58)

More Power to the Fund

The capital liberalizing agendas of the IMF, the WTO and the OECD are being tied together by a little noticed but important addition to the new world economic architecture. The IMF is to be given--if the US Congress and the US Treasury have their way-- the power of cross-conditionality with respect to agreements such as the WTO'S financial service agreement and the OECDs Multilateral Agreement on Investment. The legislation in Congress regarding the US payment of its quota to the IMF--the Senate version of the IMF funding legislation, approved in March 1998, as well as the House version that, as of mid September 1998, awaits approval--specifies that US funds may not be paid until the US Treasury certifies to Congress that all the G7 countries have agreed that they will require the Fund to withhold loans from countries that fail to meet certain conditions. These conditions require borrowing countries, among other things, to eliminate government-subsidized credit to 'favoured' businesses or institutions;(59) and to liberalize restrictions on both trade and investment, as called for in international trade and investment agreements. The language is tough. The IMF would be required deny future loans to countries in non-compliance with the WTO's financial services agreement or the prospective OECD Multilateral Agreement on Investment.(60)

It is paradoxical, on the face or it, that the Congress, deeply hostile to the IMF, wishes to increase its powers. The legislation reflects a combination characteristic of the Republican-controlled Congress since 1994, of isolationsim plus overreaching hegemony that translates into, 'We will participate in international coordination only if we get to write the rules.'

The World at a Turning Point

On one hand, the world is in the grip of destructive deflationary dynamics. On the other hand, the recent moves to expansion behind capital controls signal that Asian countries--that account for a quarter of world GDP and half of world savings--are no longer prepared to accept the 'water torture' route to debt reduction. The same moves, and variants designed specifically to protect against destabilizing currency speculators--as in Hong Kong--also signal that Asian countries are no longer prepared to accept that there is only one game in town: the one that gives banks, hedge funds and pension funds of the West freedom to enter and exit their markets at will. Their moves are finding echoes in Latin America, Russia, Europe, and elsewhere. China's stock has risen. We now have a live case-study of a sharp alternative to the IMF model: Malaysia. If successful, it will have a powerful demonstration effect.

There is no doubt that capital controls have costs--not least the army of people needed to administer them and the difficulty of plugging leaks on outflows. Malaysia and other countries may be able to clamp down hard for twelve months, but will later have to relax somewhat, at which point the hunger for US dollars may destroy the currency.

It is important to use this interval to erect supplementary or alternative defences. First, Asian governments, having experienced the full force of neighbourhood contagion effects, should promote an Asia Financial Facility that would draw on some of the region's $700 billion of reserves, so that national governments do not have to fight off speculators on their own.(61) Second, they should unpeg their currencies to the US dollar and loosely peg to a basket of currencies in which the yen carries substantial weight, so as to dampen their vulnerability to fluctuations in the dollar-yen rate. Third, they should consider instituting Chilean-type controls on capital inflows, by which some significant proportion of inflows must remain at the central bank for some minimum time without interest.

The Lines of Battle

Financial capitalists are deeply alarmed by the growing talk about public intervention. They recognize that it entails a reordering of power from markets to governments and society. 'We think few countries are actually safe because virtually all have populists in the wings threatening forex [foreign exchange] controls', warned one investment house in response to the Malaysian controls.(62) Using the language of efficiency and justice they are saying that having enjoyed huge returns in emerging markets over the past several years they want a risk-free exit route and they want to re-enter when they wish. The major qualification is that some of those now facing huge losses from a Latin American currency collapse are coming around to sup- port emergency exchange controls.

Many economists are deeply alarmed. Capital controls impede the flow of capital to its most efficient uses world-wide, they say, thereby lowering the returns to capital. They presume that free short-term financial movements do maximize returns to capital--rather than create such instability as to yield well below maximum returns, that maximizing the returns to capital and promoting development goals generally coincide, and that developing countries benefit more than they lose by receiving these inflows.

The US and UK Treasuries are deeply alarmed. They have been waging a campaign to equip the IMF with great powers to require its borrowers to liberalize the capital account. The US Congress, partly for its own reasons, partly at the behest of Treasury, has insisted that the IMF be given powers of cross-conditionality as a way to strengthen the teeth of other international organisations' agreements for free trade and free investment; moreover, it has demanded that all the other G7 countries must agree to this cross-conditionality as a condition of the US paying its IMF quota.

Capital controls themselves are only the tip of the iceberg. The US and UK governments wish to ensure that the current troubles do not derail the construction of a new international financial architecture, built on the premise that free capital movements are the key to world-wide prosperity. They wish to remake other countries' financial systems in their own image. For the high-consuming, low-saving US economy this is the most important foreign economic policy issue of all; on this depends its capacity to attract savings from the rest of the world in order to finance high investment-and remain the dominant economy.

A new political landscape has opened up. The US has no choice but to promote free capital flows. The Asians and the Europeans have no choice but to resist. Latin Americans and others will also hold out. It is by no means sure the US will win, though it has the biggest and richest economy and can use the IMF and the World Bank as its spearheads. With a fallen dollar and stock market, the US will carry less clout--its capitalism will look less inviting. Many on Wall Street will continue to insist, 'You need our capital', but Asians will be more confident in saying, 'We have more savings than we can use productively, so, no thanks'. The battle would be still less one sided if those who favour capital controls agree to ban that phrase and use only 'capital prudential regulations' to denote the same thing, for words are weapons and no-one can oppose prudential regulations.

1. This paper, which stops the clock on 17 September 1998, updates and extends 'The Asian Crisis: the High Debt Model Versus the Wall street-Treasury-IMF Complex', NLF 228, March-April 1998, pp.3-23. See also Wade, 'The Asian Debt-and-Development crisis of 1997-?: Causes and Consequences', World Development, August 1998; 'From "Miracle" to "Cronyism": Explaining the Great Asian Slump', Cambridge Journal of Economics, November 1998; and 'Asian Water Torture', Personal View, The Financial Times, 23 June 1998. We thank Marshall Auerback, Manfred Bienefeld, Robert Brenner, James Crotty and Ronald Dore for comments.

2. Tamar Manuelyan Atinc and Michael Walton, 'East Asia's Social Model after the Crisis', Poverty Reduction and Economic Management Unit, East Asia Region, The World Bank, April 1998; 'The Road to Recovery', Poverty Reduction and Economic Management Unit, East Asia Region, The World Bank, draft, 20 August 1998.

3. Gary Mead, 'Commodity Price Index at 21-Year Low,' The Financial Times, 28 August 1998, p. 24.

4. Jonathan Fuerbringer, 'The Emerging Markets: Uncovering Few True Deals in a Global Bargain Basement', The New York Times, 6 September 1998.

5. On the long build up to turbulence see Robert Brenner, 'The Economics of Global Turbulence', NLR 229, May-June 1998. Brenner's argument centres on the growing and long-term overcapacity in manufacturing. The problem has been made much worse in the 1990s by the slow growth of world demand, resulting mainly from cuts in government spending and a squeeze on wage growth. This has forced all countries to orient toward exports in the face of stagnant domestic markets (pp.141, 251-262).

6. Christopher Parkes, 'Record Container Trade Hides Tumbling US Sales to Asia', The Financial Times, 1 September 1998.

7. Wade, 'The Asian Debt-and-Development Crisis'.

8. David Felix, 'Is the Deepening Asian Crisis the Fault of Japan or the IMF?' Journal of Commerce, 9 July 1998.

9. David Felix, 'Is the Deepening Asian Crisis the Fault of Japan or the IMF?'.

10. 'The basic approach of the IMF to these crises has been appropriate--not perfect, to be sure, but far better than if the structural elements had been ignored or the fund had not been involved', Stanley Fischer, 'In Defense of the IMF: Specialized Tools for a Specialized Task', Foreign Affairs, vol.77, no.4, July-August 1998, pp. 103-6, at p.106.

11. See Wade, 'Asian Water Torture'.

12. David Wessel and Bob Davis, 'Currency Controls Gain a Hearing as Crisis in Asia Takes Its Toll: Curbs Seem to Limit Damage in Some Nations, Leading Opponents to Reconsider', The Wall Street Journal, 4 September 1998, p. A1-2.

13. Mbeki was speaking at the twelfth heads of state meeting of the Non-Aligned Movement, in South Africa, 3 September 1998.

14. Karl Polanyi, The Great Transformation, Boston 1957.

15. 'Malaysia's Forex Curbs to Depends on World Economy', Kuala Lumpur, 4 September 1998, Reuters.

16. Sheila McNutty, 'Kuala Lumpur Curbs Offshore Share Trading', The Financial Times, 1 September 1998; Robert Choate, ' A Backlash Begins', The Financial Times, 4 September 1998.

17. Research should be mounted immediately to monitor the implementation and effects of these controls.

18. Pizzey, quoting an official in the international business department of Bejing-based CITIC Industrial Bank.

19. Chikafumi Hodo, 'Tokyo Supports Capital Control by Asian Economies,' Tokyo, 11 September 1998, Reuters.

20. Thomas Crampton, 'In Asia, Rethinking Free Markets,' International Herald Tribune, 17 September 1998.

21. Ibid.

22. Chikafumi Hodo, 'Tokyo Supports Capital Control by Asian Economies'.

23. Reuters, Washington, 3 September 1998.

24. 'Capital Controls: the Latest Shoe to Fall', Bridgewater Daily Observations, 8 September 1998, Bridgewater Associates.

25. Hong Kong, 28 August 1998, Bloomberg.

26. 'West Winces at the Bitten Bite Back', Analysis, The Times, 2 September 1998.

27. Louise Lucas, 'Hong Kong Dilutes its Free-Market Image as it Grapples with Financial Crisis,' The Financial Times, 1 September 1998; John Ridding, 'One Country, Two Systems, Big Crisis,' The Financial Times, 1 September 1998.

28. Tim Condon, 'Asia/Pacific: Spiteful Capital Controls', Global Economic Forum (Hong Kong), Morgan Stanley Dean Witter, 6 September 1998.

29. Andrew Tannzer, 'As I See It: an Interview with Vincent Siew', Forbes, 24 August 1998, p.88.

30. James Kynge and William Lewis, 'Stay Away, Taiwan Warns Currency Speculators', The Financial Times, 1 September 1998.

31. 'Taiwan President Mulls Further Intervention to Boost Stocks', Taipei, 1 September 1998, Bloomberg.

32. Thailand has not introduced exchange controls, because, (a) it has no reserves left ot defend and, (b) it is entirely dependent on the IMF standby facilty. But reaction in Bangkok recognizes that Mahathir, in Malaysia's situation, is not out of his mind. see Chet Chaovisidha, 'Mahathir and the Ringgit: Should Thailand Follow Suit?', The Bangkok Post, 9 September 1998. Chet has been an economic advisor to several past Thai governements. Thanks to Richard Donor for this reference.

33. 'Miyazama Says No Comment on Specific dlf/yen', Tokyo, 4 September 1998, Reuters.

34. David Sanger, 'US and Japanese Confer but Differ on Economic Cures', The New York Times, 6 September 1998.

35. Gillian Tett and Michiyo Nakamori, 'Downturn in Japan "Set to Continue"', The Financial Times, 11 September 1998.

36. Beijing, 12 August 1998, Reuters. One of the most bizarre stories to appear in the whole of the crisis came on the front page of The Financial Times (James Harding, 'China Cuts Yen Holdings to Under 25% of Reserves', 11 August 1998). It reported that china had 'sold off billions of dollars worth of Japanese bonds to cut exposure to the yen', from about a third of the [$140 billion] portfolio to less than a quarter. A Chinese officila said, 'We will sell more yen in the market, nobody can yet see the florr of the Japanese yen.' China has been criticizing the US and Japan for not doing more to support ot yen, and threatening renmimbi devaluation. It then announces to the world that it had been selling the yen all aong in amounts that dwarf the US intervention in June to support to yen. It also announces that it will go on selling yen. Yet China wants the yen to go up?

37. Thomas Crampton, 'In Asia, Rethinking Free Markets', referring to Supachai Panitchpakdi.

38. Paul Krugman, 'Saving Asia: the IMF Cure Has Failed. It's Time to get Radical', Fortune, 7 September 1998, pp. 27-32.

39. Quoted in Wessell and Davis, 'Currency Controls Gain a Hearing as Crisis in Asia Takes its Toll.'

40. 'Malaysia Capital Controls: Kiss Foreign Investors Goodbye', Emergenomics Infofax, CLSA Global Emerging Markets, 2 September 1998.

41. From a statement in April 1998, quoted in 'Summers: Open Capital Accounts Need Strong Financial Supervision', Dow Jones Newswires, 9 September 1998.

42. Bill Tarrant, 'IMF Sees Short-Term Capital Controls in Asia', Seoul, 14 September 1998, Reuters.

43. A UN agency, the United Nations Conference on Trade and Development, lent support to the idea of capital controls in its annual Trade and Development Report, released on 16 September 1998. It said that sound economic policies and prudent bank regulation and corporate governance had taken years to establish and could not insulate countries from speculative attacks, which are often triggered by external events, such as rises in US interest rates. It said that 'capital controls will remain an indispensible part of developing countries' armoury' againts financial instability.

44. 'Flawed Capitalism Requires Regulation, State Role, Jospin Says,' Paris, 9 September 1998, Bloomberg.

45. World Bank, World Development Report 1997, New York 1997, table 13, p. 239.

46. Such as those who embrace the Austrian approach. See Jim Walker, 'The Unbearable Knowledge of Impotence: from Austria to Asia', The New Australian, no. 88, 7-13 September 1998.

47. Dani Rodrik, 'Who Needs Capital-Account Convertibility?', in Stanley Fischer et al., Should the IMF Pursue Capital-Account Convertibility?, Essays in International Finance, 207, Economics Department, Princeton University, May 1998; Jagdish Bhagwati, 'The Capital Myth: the Difference Between Trade in Widgets and Dollars', Foreign Affairs, vol.77, no.3, May-June 1998, pp.7-12; Joseph Stiglitz, 'Knowledge for Development: Economic Science, Economic Policy, and Economic Advice', Annual Bank Conference on Development Economics, World bank, April 1998; James Crotty and Gerald Epstein, 'In Defence of Capital Controls', Socialist Register 1996, pp. 118-49. For evidence of some benefits, see Dennis Quinn, 'The Correlates of International Financial Deregulation,' American Political Science Review, vol.91, September 1997, pp.531-51.

48. See Brenner, 'The Economics of Global Turbulence'.

49. Alan Greenspan, Testimony of Chairman Alan Greenspan before the committee on banking and financial services, US House of Representatives, 16 September 1998.

50. The article on national treatment makes it mandatory for member state to allow the entry of any foreign company or organisation in all sectors (unless specifically covered by a reservation list of the country), and to ensure that the foreign investor is treated at least as well as local investors. See Martin Khor, 'A Commentary on the Draft Text of the Multilateral Agreement on Investment (MAI)', Third World Network, 228 Macalister Rd., Penang, Malaysia.

51. 'Investment is defined as 'every kind of asset owned or controlled, directly or indirectly, by an investor'. The broad definition was chosen to go, in the OECD's words, 'beyond the traditional notion of FDI to cover virtually all tangible and intangible assets and which applies to both pre-and post-establishment'. It specifically includes 'shares, stocks and equity participation; bonds, loans and forms of debt'. See Khor, 'A Comentary on the Draft Text'.

52. 'An "Irreversible Trend": Seminar Discusses the Orderly Path to Capital Account Liberalization', IMF Survey, vol.27, no.6, 23 March 1998, p.1. The communique from the Group of 24 Ministers, 14 April 1998, says, 'Capital account liberalization: Ministers recognize that the benefits of further liberalization of capital movements depend on the prevailing circumstances of each country. Given the universal nature of the IMF's membership, Ministers believe that the IMF can play a leading role in promoting an orderly and gradual liberalization of capital movemetns, while being sensitive to the particular situation of each country and in the context of well-specified policies and, where, needed, adequate technical assistance. To this end, andy amendment of the Articles of Agreement should be designed to promote cautious and well-sequenced capital account liberalization. This would also entail amending the Articles of Agreement to eliminate current limitations of the use of IMF resources in the event of capital outflows.' A growing number of Fund officials do have doubts about the wisdom of capital account converibility, but--in an organisation as tightly disciplined as a crack military regiment--they keep them to themselves.

53. 'Summers:Open Capital Accounts Need Strong Financial Supervision'.

54. To quote from The Wall Street Journal, 'As Goldman, Sachs and Co. economists note in their newsletter this week, "So far, countries whose currencies have not been freely convertible have done best. This raises the risk that at some point, other countries decide to impose capital controls. The exact consequences for the US outlook are not clear, but they would certainly be negative." The Goldman economists see a threat to the profits of US multinational corporations, particularly financial institutions, that have benefited form an increased opennes to foreign direct investment', Wessell and Davis, 'Currency Controls Gain a Hearing as Crisis in Asia Takes Its Toll'.

55. 'Deputy Secretary Summer's Remarks before the International Monetary Fund', Treasury News, 9 March 1998. This is the same Lawrence Summers who as an academic economist at Harvard in the 1980s wrote papers about the irrationalities of capital markets and the need for controls.

56. Many of the Democrats' campaign-finance difficulties in the 1996 presidential election stemmed from Wall Street's reluctance to finance them, partly because of anger at the 1994 low-dollar policy. The Democrats resolved to do more to please Wall Street so as to elicit more generous contributions in the 1998 congressional races and the 2000 presidential race. A swing of only six seats would give the Democrats a majority in the House of Representatives. See Thomas Ferguson, Golden Rule, Chicago 1995. Thanks to Ferguson for discussion of these matters.

57. MAI defenders say that social obligations of corporations are covered by the separate OECD Guidelines for Multinational Enterprises. But the Guidelines are voluntary, non-legal, non-enforceable, whereas the MAI is to be legally binding and enforceable. Hence foreign investors' rights dominate their obligations.

58. Thanks to Jagdish Bhagwati and Jan Kregel for discussion of this argument.

59. On subsidized and targeted credit as the flashpoint for conflict between Japan and the World Bank/US Treasury, see Wade, 'Japan, the World Bank, and the Art of Paradigm Maintenance', NLR 217, May-June 1996.

60. Senators Hagel and McConnell crafted this legilation at the behest of business and agricultural interests. The US Treasury is strongly backing the congressional push, but keeping its own position out of public view and pressing Democrats in Congress not to draw attention to these conditions as they seek to mobilize public support for US funding for the IMF. See Nancy Alexander, News and Notes for World Bank Watchers, 21 September 1998, Bread for the World Institute, Silverspring, Maryland. Thanks to John Fitzgerald, of Accounting for the Environment, National Wildlife Federation, for clarifications.

61. See Wade, 'From "Miracle" to "Cronyism"'.

62. 'Capital Controls', Bridgewater Daily Observations, emphasis added.

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