Capital controls: From heresy to orthodoxy

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THINK ASIAN By ANDREW SHENG

 Principles for formulating capital control policies must take local conditions into account.

ON Sept 1, 2011, it would be 13 years to the day when Malaysia first introduced capital controls to stem the effects of the Asian financial crisis on the domestic economy. In 1998, it was heresy to introduce capital controls on capital flows, since it was the International Monetary Fund (IMF) orthodoxy to liberalise the capital account.

From the perspective of history, one tends to forget that in 1945, when the IMF was first established, the consensus opinion among bankers and academics alike was for hot money to be controlled. Indeed, the intellectual father of the IMF, John Maynard Keynes, remarked that “what used to be heresy is now endorsed as orthodoxy.”

In the old days, courtesy to living persons and the statute of limitations would allow history to be written only after 60 years when official archives are opened to the public.

Today, we live in an age of unfettered information, when oral and documented history can be published rapidly, from authorised biographies issued shortly after a leader leaves office to unauthorised leakages from Wikileaks.

The publication of a new book by Datuk Wong Sulong, former group chief editor of The Star, called Notes to the Prime Minister: the Untold Story of How Malaysia Beat the Currency Speculators, only two months after the IMF announced in April 2011 new thinking on capital inflows, is a remarkable achievement.

Sixty-six years after the IMF was formed, capital controls have moved full circle from orthodoxy to heresy and back again to (qualified) orthodoxy.

The book comprises 45 Notes written by Tan Sri Nor Mohamed Yakcop, Minister in the Prime Minister's Department, between Oct 3, 1997 and Aug 21, 1998 to then Prime Minister Tun Dr Mahathir Mohamad.
In short, they were the key briefs that helped Dr Mahathir make up his mind on the key economic policies to help combat the Asian financial crisis.



Book offers deep insights

For both historians and practicing policymakers, this new book offers deep insights into the serendipity and the practice of successful policy decision-making. There is an element of serendipity, because Dr Mahathir recalled that he spotted Nor Mohamed walking down a street in Kuala Lumpur just before he left for Buenos Aires in September 1997 via Hong Kong, where he attended the World Bank Annual Meetings and clashed publicly with George Soros on currency trading.

On Sept 29, 1997, he summoned Nor Mohamed to meet him in Buenos Aires, because he needed someone who understood currency trading. It is a tribute to a politician trained as a doctor that he was willing to spend repeated sessions with an experienced currency trader to understand the intricacies of modern financial markets.

Reading the 45 Notes in historical sequence, one gets a far better appreciation of how the decision to impose capital controls was arrived at. The Notes not only have historical value, but also current-day applicability, as they explain not only offshore currency, the psychology of fear and greed that drive markets, but also market manipulation in thinly traded emerging market currencies.

The major problem of the proponents of the Washington Consensus in 1997 was that most of them were macro-economists who had little understanding or experience of how the markets actually worked. Free markets became a dogma and objective in their own right, rather than the means to an end for better livelihood for all.

The Notes also revealed that in complex decisions under uncertainty, it was vital to understand clearly the key parameters for action. Note 7 clearly pointed out that Malaysia was different from other countries under currency attack because it did not have large short-term external debt. Note 11, dated Oct 21, 1997, spelt out the factors that determined exchange rates, with a particularly illuminating explanation of market manipulation.

Market manipulation was seen as due to concerted effort by hedge funds, using large gearing and available tools and then triggering the element of fear among the long-term investors who have legitimate currency risk.

In other words, if the wolves can trigger the herd to move, then the fundamentals can move. The perception of fear changes the whole game.

Effect of CLOB

Note 39 dated July 9, 1998 is an important study of the effect on Malaysia of the central limit order book (CLOB) for trading of Malaysian shares in Singapore. The Note identified that the CLOB was a convenient way for capital outflows.

Hence, one of the most effective ways for exchange control was to impose the condition that Malaysian shares could only be traded on a Malaysian exchange, which came on Aug 31, 1998, with exchange controls imposed on the following day.

In Dr Mahathir's words, “during the financial crisis, we faced two parallel situations; the ringgit was falling rapidly and Malaysian shares were also falling rapidly. So we had to put an end to both.”
Image via Wikipedi
The IMF has come out with six key principles for formulating capital control policies.

The first is that there is no “one-size-fits-all” policy mix. The second is that capital controls should fit long-term structural reforms. Third, capital controls are only one tool and not a substitute for the right macro policies. Fourth, capital controls can be used on a case-by-case basis, in appropriate circumstances. Fifth, the medicine should treat the ailment, and finally, the policy must consider its effect on other market participants.

It is hard to argue against these common sense “motherhood” principles. The trick in real life policy-making is how to apply them to local conditions.

On of the features of the current Chinese capital controls is that China also has a large amount of Chinese shares listed outside capital controls, such as Chinese shares listed in Hong Kong, Singapore and New York.

This is a book that is a must read for all emerging market policymakers interested in liberalising their capital accounts and for IMF experts to ponder emerging market experience.

I recommend that this new book be translated into Chinese, so that Chinese policymakers interested in internationalising the renminbi can look at the Malaysian experience.

Tan Sri Andrew Sheng is author of the book, From Asian to Global Financial Crisis.

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The untold story of Malaysia foreign exchange controls 

China’s US$3.2 trillion headache

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ENTER THE DRAGON By YAO YANG

WHILE the downgrade of US government debt by Standard & Poor's shocked global financial markets, China has more reason to worry than most: the bulk of its US$3.2 trillion in official foreign reserves more than 60% is denominated in dollars, including US$1.1 trillion in US Treasury bonds.

So long as the US government does not default, whatever losses China may experience from the downgrade will be small. To be sure, the dollar's value will fall, imposing a balance sheet loss on the People's Bank of China (PBC, the central bank). But a falling dollar would make it cheaper for Chinese consumers and companies to buy American goods.

If prices are stable in the United States, as is the case now, the gains from buying American goods should exactly offset the PBC's balance sheet losses.

The downgrade could, moreover, force the US Treasury to raise the interest rate on new bonds, in which case China would stand to gain. But S&P's downgrade was a poor decision, taken at the wrong time. If America's debts had truly become less trustworthy, they would have been even more dubious before the agreement reached on Aug 2 by Congress and President Barack Obama to raise the government's debt ceiling.

That agreement allowed the world to hope that the US economy would embark on a more predictable path to recovery. The downgrade has undermined that hope. Some people even predict a double-dip recession. If that happens, the chance of an actual US default would be much higher than it is today.

Reason to worry: China’s US$3.2 trillion problem will become a 20-trillion-renminbi problem if China cannot reduce its current account surplus and fence off capital inflows. — AP

These new worries are raising alarm bells in China. Diversification away from dollar assets is the advice of the day. But this is no easy task, particularly in the short term. If the PBC started to buy non-dollar assets in large quantities, it would invariably need to convert some current dollar assets into another currency, which would inevitably drive up that currency's value, thus increasing the PBC's costs.

Another idea being discussed in Chinese policy circles is to allow the renminbi to appreciate against the dollar. Much of China's official foreign reserves have accumulated because the PBC seeks to control the renminbi's exchange rate, keeping its upward movement within a reasonable range and at a measured pace.

If it allowed the renminbi to appreciate faster, the PBC would not need to buy large quantities of foreign currencies.



International experience

But whether renminbi appreciation will work depends on reducing China's net capital inflows and current account surplus. International experience suggests that, in the short run, more capital flows into a country when its currency appreciates, and most empirical studies have shown that gradual appreciation has only a limited effect on countries' current account positions.

If appreciation does not reduce the current account surplus and capital inflows, then the renminbi's exchange rate is bound to face further upward pressure. That is why some people are advocating that China undertake a one-shot, big-bang appreciation large enough to defuse expectations of further strengthening and deter inflows of speculative “hot” money. Such a revaluation would also discourage exports and encourage imports, thereby reducing China's chronic trade surplus.

But such a move would be almost suicidal for China's economy. Between 2001 and 2008, export growth accounted for more than 40% of China's overall economic growth. That is, China's annual gross domestic product (GDP) growth rate would drop by four percentage points if its exports did not grow at all. In addition, a study by the China Centre for Economic Research has found that a 20% appreciation against the dollar would entail a 3% drop in employment more than 20 million jobs.

There is no short-term cure for China's US$3.2 trillion problem. The government must rely on longer-term measures to mitigate the problem, including internationalisation of the renminbi. Using the renminbi to settle China's international trade accounts would help China escape America's beggar-thy-neighbour policy of allowing the dollar's value to fall dramatically against trade rivals.

But China's US$3.2 trillion problem will become a 20-trillion-renminbi problem if China cannot reduce its current account surplus and fence off capital inflows. There is no escape from the need for domestic structural adjustment.

To achieve this, China must increase domestic consumption's share of GDP. This has already been written into the government's 12th Five-Year Plan. Unfortunately, given high inflation, structural adjustment has been postponed, with efforts to control credit expansion becoming the government's first priority. This enforced investment slowdown is itself increasing China's net savings, i.e., the current account surplus, while constraining the expansion of domestic consumption.

Real appreciation of the renminbi is inevitable so long as Chinese living standards are catching up with US levels. Indeed, the Chinese government cannot hold down inflation while maintaining a stable value for the renminbi. The PBC should target the renminbi's rate of real appreciation, rather than the inflation rate under a stable renminbi. And then the government needs to focus more attention on structural adjustment the only effective cure for China's US$3.2 trillion headache. - Project Syndicate

● Yao Yang is Director of the China Center for Economic Research at Peking University.

London Bridge is falling down !

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WHY NOT? By WONG SAI WAN

The recent riots in Britain have given this nursery rhyme new significance about all that is wrong, but sadly it is nothing new.
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THE world was shocked to see thugs, many barely in their teens, rioting and looting in various cities in England, which many Malaysians consider a heaven, with some unabashedly saying that going there is “balik kampung” (going back to the hometown).

The horror of the whole thing was brought even closer to home by the video clip of Malaysian student Mohd Asyraf Rafiq Rosli being robbed by the rioters after he had been assaulted. It was uploaded onto YouTube for the world to see, and then picked up by all TV stations.

The assault and robbery of Asyraf and the burning of a century-old furniture shop in Hackney were the main haunting images of the riot.

British Prime Minister David Cameron was quick to recall Parliament for an emergency session, where he condemned the rioters and at the same time dismissed the mid-summer nightmare as greed and thuggery.

He rejected any suggestion that his government’s budgetary cuts was the cause of the riots, and declared “all-out war” on gangs, which he blamed for fuelling four nights of frenzied looting, saying they were “a major criminal disease that has infected streets and estates across our country”.

“This has been a wake-up call for our country. Social problems that have been festering for decades have exploded in our face,” he said, adding that a redoubling of efforts to tackle broken families, welfare dependence and educational failure was needed.



“Do we have the determination to confront the slow-motion moral collapse that has taken place in parts of our country these past few generations?”

But has this come a little too late?

Well-known London social worker Sheldon Thomas, an ex-gang member who runs a mentoring programme, pointed out that British society is “broken” and the government action may be too late.

“People like me have been saying this for decades,” he said. “People are angry, people are frustrated. There are no jobs, there is no aspiration.”

Thomas and many of his fellow youth leaders said Cameron’s government was only reacting to the visuals that were seen all over the world, especially when the rioting and looting affected the wealthier part of the cities.

Youth and social workers have been sounding the warning for years but successive British governments were more interested in projecting the growing materialistic part of Britain while the inner city problems were swept underneath the proverbial carpet.

People like Thomas are right. Go to YouTube and type “Moss Side” to see hundreds of CCTV video clips by the Greater Manchester Police on gang problems there.



National Geographic produced an excellent series on Manchester’s underworld, titled Gunchester. It seems there are more guns in this former industrial centre than in any other city in Britain.

Moss Side, the centre of these violent gangs, is one of many inner city projects started in the 1950s after World War II that have turned into a social mess. There used to be thousands of council flats in Moss Side and neighbouring Hulme, where hundreds of Malaysian students stayed in their student days.

Among these, almost 30 years ago, was yours truly. Moss Side then was filled with blacks from the Caribbean and Africa. And they still form the majority today.

It was here in 1985 that the first race riots occurred, and spread to the rest of Britain. As a consequence, the British government decided to do away with the flats, blaming them for the inner city problems.

The truth was that Moss Side and many such inner city areas were a different country from the rest of Britain. They were improvised areas with many unemployed. Moss Side was – and still is, I am told – a bastion of drugs, vice and gangsterism.

A colleague, a fanatical Manchester United supporter, said he had been to the city many times, but he never ventured into Moss Side.

“Be careful when you see a boy wearing a hoodie (a sweatshirt with a hood) walking towards you. I will normally cross the street when I see one,” he said.

I don’t blame him because records show there had been more than 800 gang-related murders in Manchester in the past decade.

About five years ago, a 14-year-old boy was killed by a rival gang in Manchester.

His was not an isolated incident. There have been scores of teenage murders up and down England, especially in the inner cities, like Moss Side.

But to blame the gangs alone for the recent riots is a convenient excuse at best, or political naivete at worst.

Morality is not a word with any meaning in places like Moss Side, where the social structure has broken down. In this kind of place, one competes to be the youngest mother or grandmother.

Most parents do not know where their kids are at any time of the day. Anyway, most fathers and mothers have criminal records or had served time at the nearby city prison.

I recall being in a newspaper shop in Moss Side and the local postman strolled in and greeted the woman shopkeeper, who replied: “What can I do for you today, Mick?”

He said: “Can I have a 12-year-old virgin, please?”

To this, the elderly woman replied: “There are no such thing as 12-year-old virgins here. This is Moss Side.”

This conversation has stayed in my mind for the past 30 years and, of course, it was an exaggeration by the shopkeeper and the postman, but not by much.

We in Malaysia must be aware that we are also building inner city estates all over Kuala Lumpur and Petaling Jaya. Tall council or public housing flats are a sure-fire formula for such problems as in Moss Side.

The Women’s and Family Development Ministry must study these areas carefully to ensure that social problems are solved before they become tinder to a highly inflammable situation.

Executive editor Wong Sai Wan was kept awake for three days in Moss Side by Bob Marley’s No Women No Cry when he died on May 11, 1981



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