Capital controls may become a boomerang

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.