Policy Dilemmas and the Case for Capital Controls over Outflows

In the past year, the currencies of major countries like Indonesia, India, Brazil, South Africa and Turkey have fallen by 15 to 20 per cent against the US dollar, as at the end of January. There has been an improvement in recent months. But there are also fears that the market and currency turmoil may reappear sometime this year.

Policy makers face a dilemma or trade off.   To stave off further currency decline and capital outflows, they decide to raise interest rates (hoping to retain the country’s attractiveness to investors and local savers).

The increase in rates serves another useful objective, to reduce inflationary pressures.  However, the rise in interest rates has the negative effect of also putting a brake on economic growth, especially if the rate increase is significant.

This is because it is more costly for businesses to borrow to invest and for consumers to borrow to spend.

The deterioration in the real economy (or expectation of this) can offset the investors’ incentive to retain their assets in the country.  If so, the capital outflow and the fall in currency will continue.

Capital flight may come not only from foreigners but also residents.  How to maintain the confidence and funds of locals are equally important.

A country facing currency fall and capital flight that drain the foreign reserves to dangerously low levels can consider capital controls.

When too much hot money is flowing into the country, controls over capital inflows are quite commonly used.

However, in the present situation when countries instead face excessive outflows, it is control or restrictions over capital outflows which may be needed.  These are more rarely used.

Malaysia provides a good example of selective capital controls over outflows that worked successfully during the 1997-99 crisis.

An IMF working paper published in January cites the Malaysian case as an exception of capital controls on outflows that worked.

“Following a tightening of restrictions in September 1998, capital flight came to a halt, allowing reserves to rise back to pre-crisis levels, the exchange rate to stabilise, and interest rates to fall,” according to the paper, Effectiveness of Capital Outflow Restrictions.

The Malaysian policies should be studied by countries that today face a similar crisis.  These are countries with significant current account deficits, thus making them dependent on large inflows of foreign capital to finance these deficits.

When global conditions are favourable, the inflows continue, and make the country more dependent.

When conditions change (as is now happening), the country is vulnerable to a reduction or stoppage of inflows or worse still to large capital flight.

Interest rate hikes may not be enough and in any case could induce a recession.  In such a situation, especially when reserves are running low, a resort to capital controls may be needed.

The restrictions must however be administered properly and selectively, with the right accompanying policies, and the country must be prepared for bad media coverage and a negative market response for some time.

The policies may then work, to stem capital flight, stabilise the currency exchange rate, save the country from the emptying of reserves that necessitates an international bail out, and allow the country to set interest rates at a level that facilitates economic recovery and growth.

This, in any case, was the Malaysian policy and experience which is worthwhile for other countries, especially those facing financial turmoil or crisis, to reflect upon.