Rethinking Malaysia’s Capital Controls
Ethan Kaplan and Dani Rodrik
2001-07-12
In confronting East Asia’s financial crisis of 1997-98, Malaysia and South Korea faced similar conditions but responded in radically different ways. South Korea sought IMF aid; Malaysia imposed controls on capital outflows. In a world where Turkey, Argentina, Brazil, Russia, South Korea, Thailand, Malaysia, Indonesia, and Mexico were victimized by attacks on their currencies, policy experiments such as in Malaysia cannot be ignored.
The 1997-98 financial crisis savaged some very successful economies. South Korea’s GDP contracted by -6.7% in 1998 after growing a positive 6.7% in 1996. Similarly, Malaysia grew by 10.0% in 1996 and declined by -7.4% in 1998 - a total decline of 17.4%.
Thailand, South Korea, and Indonesia embarked on IMF-supported - many would say IMF-designed and mandated - programs to cope with the financial crisis of those years. In return for IMF backing, these countries committed to floating their exchange rates, raising interest rates, tightening fiscal policy (at least initially), opening financial markets to foreigners, closing troubled banks and financial institutions, as well as other structural reforms.
Malaysia chose differently. Instead of going to the IMF, Malaysia imposed sweeping controls on capital outflows, fixed the exchange rate, lowered interest rates, and increased spending. From September 2, 1998, foreigners were banned from removing portfolio capital for one year. On February 15, 1999, this was replaced by a graduated tax on outflows, which still remains in place.
Initial reactions were harsh. Moody’s, the international bond rating agency, downgraded all Malaysian bonds almost to junk bond level; Morgan Stanley dropped Malaysia from its emerging market index, claiming that Malaysia’s inclusion was a mistake all along. Many academics castigated Malaysia’s controls.
Instead of fulfilling prophecies of doom by collapsing, Malaysia improved rapidly after imposing capital controls. No surprise, then, that reactions to the controls became muted. By June 1999, the Wall Street Journal editorialized “there never was any doubt that preventing money from fleeing Malaysia could provide short-lived relief.”
Critics of conventional economic wisdom demurred, arguing that, although capital controls didn’t hurt Malaysia, they didn’t help either. Economist Paul Krugman claimed: “the market panic of 1997-98 was, it turns out, coming to an end just about the time that Malaysia decided to make its big break with orthodoxy.”
With hindsight, economists and policymakers have assessed the impact of the controls by comparing Malaysia’s growth rates with growth rates in Korea between 1997-1999. Seeing that they looked reasonably similar, they concluded that Malaysia’s controls didn’t help or hurt any more or any less than going to the IMF. Malaysia’s economy recovered, it was said, because the external environment improved.
That simple before-and-after comparison misses the point: Malaysia established its controls 9 months after Korea embraced the IMF and 15 months after Thailand’s stabilization program began. Moreover, when Malaysia enacted its controls, its economy was declining sharply while Korea’s was improving fast. In other words, the first signs of improvement came only a few months after Malaysia adopted its own home remedy, but a year after Korea began IMF treatment and a year and a half after Thailand began IMF therapy.
So, when comparing Malaysia’s actions with the IMF treatment by comparing growth rates in early 1999 versus early 1998, the fact that Malaysia’s policies don’t look horrible is testimony to the rapid response of Malaysia’s economy to capital controls. In fact, Malaysia grew over 5% faster than Korea (the country that recovered quickest among those aided by the IMF) in the year after starting treatment.
Though capital controls seem to have done a decent job in stimulating recovery, two potential negative side-effects exist:
• capital controls can free governments to pursue nasty political actions they might not otherwise attempt. In Malaysia, Prime Minister Mahathir might not have sacked, put on trial, and imprisoned Finance Minister Anwar had he been in fear of capital flight. But although limitations on political autonomy may prevent capricious and/or brutal actions, they may also forestall governments from undertaking needed social programs.
• capital controls may attract less foreign capital. So far, Foreign Direct Investment in Malaysia as a percentage of GDP is lower than before the crisis, whereas FDI levels have returned to pre-crisis levels in Korea and Thailand. Recently, however, FDI levels have rebounded without Malaysia abolishing its controls. Thus the jury remains out on the long-term impact of capital controls on foreign investment.
History often trashes elegant theories. Restricting capital inflows was once almost universally condemned as irresponsible and damaging. Then, starting with Chile, some countries with open capital markets experienced financial turmoil as large capital inflows caused exchange rates to appreciate, reducing the competitiveness of exports. Banks went bankrupt; financial systems collapsed. Eventually, international organizations, governments, and economists learned that what they once thought good was not always a good idea.
Policies changed: some countries started taxing financial transactions. Most international organizations, governments, and economists, however, remain vehemently opposed to restrictions on capital outflows. Malaysia’s record suggests that a rethink on capital controls is overdue.
Ethan Kaplan and Dani Rodrik are professors of economics at Harvard University’s John F. Kennedy School of Government.
Copyright Project Syndicate 2010
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