Capital controls may become a boomerang

By Eddy Soeparno

JAKARTA (JP): As expected by many analysts, the government recently announced that it would study Chile's treatment of short-term fund flows as well the possibility of requiring exporters to surrender their dollar earnings.

The flows of "hot money" -- a terminology used to describe fast-moving institutional capital -- has been widely blamed for much of the financial and economic chaos Indonesia and the rest of Asia are now experiencing. As such, there has been a growing interest among economists and policymakers around the globe to implement measures that would clamp down on these types of short- term and speculative capital flows.

In a world of almost nonexistent financial borders, capital moves in and out of countries and fast-moving industries make ill-prepared economies vulnerable to such movements.

Malaysia realized this fact and as a result, imposed strict if not controversial controls limiting cross-border investments and currency conversions on Sept. 1. One month after imposing such controls, Malaysia's special economic minister, Daim Zainuddin, recently spoke about the success of the policy: "The currency is stable, banks have started lending, the private sector is now borrowing and economic activity is picking up."

What he failed to mention though, was the additional risk the banking sector must take by recognizing nonperforming loans after not being serviced for six months as compared to three months previously. Moreover, liquidity is being forced back into the market by cutting reserve requirements from 4 percent to 2 percent, while banks are strongly encouraged to grow their loan portfolio at an annual 8 percent growth rate (which will eventually trigger unnecessary expansions in industries already suffering from a severe lack of consumer demand).

Most importantly, in an environment where a currency is fixed and considerable sums of liquidity enter the market, prices of goods and services can go nowhere but up, fueling further inflation.

Now to Indonesia and its capital control intentions. The question is: How would these measures work for Indonesia?

When Chile suffered from a similar financial crisis in 1982, it decided to discourage inflows of foreign capital, despite being a robust supporter of the United States free market doctrine. All loans and bank deposits were in effect taxed, as 30 percent of a loan had to be deposited in a non-interest bearing account at the central bank.

Although the controls proved to be effective for a while in bringing down the overall level of short term capital and further encouraged long-term investment, subsequent studies have indicated that the impact of the controls may have been smaller than previously anticipated.

Chilean economist Marcelo Soto concluded in his analysis that even though the corporate sector may have reduced foreign short- term borrowings, other short-term flows increased (including indirect foreign borrowings). Thus total short-term flows were not reduced. It now remains in the hands of Indonesian whether to completely control the flow of foreign capital or limit its control to foreign borrowings only.

Noting that Indonesian corporations are well over-leveraged by their current debt, curbing the inflow of short-term money would not be a bad idea after all. In addition, more options could also be studied by taking examples from other countries, such as Brazil which at one point levied a 1 percent tax on foreign investment in its stock market to discourage short-term trading.

In addition, Mexico temporarily restricted bank foreign- currency liabilities to 10 percent of their total loans, while the Czech Republic imposed a fee on all foreign-exchange transactions with banks.

Furthermore, the possibility of forcing exporters to repatriate their export earnings in an attempt to regain badly needed foreign exchange (to help stabilize the rupiah), could also pose a problem of its own -- an incentive problem.

Over the past year now, Indonesian exporters basically parked their foreign exchange revenues in offshore accounts in reaction to rumors of a possible government-imposed deposit-to-bond conversion and because of difficulties in withdrawing foreign exchange from local banks on request.

As such, requiring exporters to surrender their foreign exchange earnings without any guarantees of freely converting or withdrawing their money would only encourage the exporters to find loopholes in the regulation, such as by under-invoicing exports.

An Indonesian company could, for instance, export its goods to a subsidiary in Singapore or Hong Kong for a minimum price. The product could then be on-sold to the final buyer at its actual market price, thereby allowing a significant amount of the foreign exchange export margins to be kept safely in offshore accounts.

Obviously, monitoring the proposed foreign exchange repatriation scheme would require significant bureaucratic support, which would be costly but not necessarily efficient. Moreover, bureaucracies are normally no match for determined capital exporters and such a bureaucratic system for the scheme could well be the cause of new forms of corruption and collusion.

Actually, what Indonesia should realize today is the fact that its problems lie in the political arena along with erroneous monetary policies and weak measures to overcome the mounting debt problem. Therefore, aside from the political situation, the government should focus on bringing down interest rates and successfully restructuring the country's debt -- all addressable even without the implementation of strict capital controls.

At present, Jakarta should see the role of capital controls as a "confidence gainer" rather than a "problem solver".

Let lower interest rates and the settlement of the foreign debt be the answer to the country's economic predicament. Capital controls, though, could be used over the short term to avoid future financial chaos.

As for export-related revenue, the only way to push local businesses to repatriate their foreign exchange earnings into the country is by giving them some form of incentive; and economic stability will most likely do the job.

Although the introduction of the above proposed "limited capital controls" could very likely discourage short-term money flows into Indonesia, as well as harvest direly needed foreign exchange, local and foreign investor confidence should be prioritized.

The country now needs to focus on regaining market confidence. Imposing any form of strict capital controls could risk putting off a great number of investors and creditors.

Therefore, unnecessary or excessive curbs on the movement of capital could backfire on the government and result in another stampede of fleeing investors. Malaysia is a perfect example which should discourage Indonesia from implementing a "Hotel California" type of control, where "you can check in any time you want, but you can never leave..."

The writer is a corporate finance director at American Express Bank.

Window: The country now needs to focus on regaining market confidence. Imposing any form of strict capital controls could risk putting off a great number of investors and creditors.