Jakarta should not copy Malaysia's capital controls

Jakarta should not copy Malaysia's capital controls

By Eddy Soeparno

JAKARTA (JP): It is just amazing how an economist's views
published in a magazine had a larger-than-life impact on a
nation's economy and practically changed the course (and maybe
fate?) of that nation in an increasingly global environment.

It was Massachusetts Institute of Technology's Paul Krugman,
who, in last month's edition of Fortune magazine, reminded us how
Asia got to where it is today, that is Asia's fall from grace.

Krugman also reiterated the many efforts put together by the
region's savior of last resort, namely the International Monetary
Fund (IMF), to resuscitate the badly damaged patients, among
others, Indonesia. Not failing to criticize the IMF for its
incompetence to prescribe the right medicine for Asia's illness,
Krugman also reemphasized governments' and policymakers' failure
to assuage the panic waves that hit the public at the start of
the crisis.

But approaching the end of his column. Krugman finally dropped
his bomb by supporting the imposition of controls on capital
movements across borders. By cutting themselves loose from global
financial markets, these afflicted countries would stand a chance
of rehabilitating their economies without the worries of volatile
movements in their currency.

Unexpectedly, Malaysia, embraced the idea of capital controls
and immediately announced new currency and capital controls,
directed at containing speculation in the ringgit and minimizing
the impact of short-term capital inflows on the domestic economy.
Subsequently, two of the country's central bank senior officials
were fired, followed by the dismissal of Finance Minister and
Deputy Prime Minister Datuk Seri Anwar Ibrahim, now a symbol of
reform in the country. The concept of implementing capital
controls also sparked criticism and comments from various
Indonesian economists are still debating whether or not to go
down a similar road.

India is among the few nations that still actively imposes
cross border capital restrictions. As such it comes as no
surprise that India survived the Asian crisis almost unscratched.
However, it is this elaborate system that caused the country to
miss out on the foreign capital flood and missed Asia's bandwagon
of economic growth in the 1980s.

For a period of 40 years that ended in 1990, India's per
capita income rose by less than 50 percent to a mere $350. Today,
Malaysia remains a test case of the success or failure of
Krugman's advocacy.

By implementing capital controls, Malaysian authorities hope
to finally fend off currency speculators; bring inflation under
control and finally allow liquidity to flow into the real economy
again. However, by doing so, Malaysia has put itself on the brink
of capital market isolation and, as expected, provoked another
wave of capital flight. The country's attractiveness to global
investors evaporated almost overnight as investors found no
incentive to invest in a country where a 12-month holding period
prevented them from redeeming their investment proceeds
immediately.

And how would it work for Indonesia? Let's just put it this
way: even the rumor of possible capital controls caused massive
capital flight out of the country. The stock market practically
went into a free-fall as investors hurried toward the exit in
fear of capital and exchange controls. In addition, the
establishment of a large bureaucratic structure to support the
system would not only eat into the taxpayers' pockets, but also
give birth to new forms of corruption and collusion.

Moreover, any attempt to impose controls would not only upset
the market, but more importantly jeopardize badly needed IMF
funding and preclude Indonesian investors from repatriating vast
quantities of capital that left the country in the first half of
this year.

And finally, implementing a radical change in policy when a
country is facing a loss of confidence, would only spark another
round of unwanted panic, resulting in a major economical mess. If
anything, Indonesia would experience an even larger outflow of
capital. Therefore, in the interest of maintaining credibility in
front of a global international community, the government should
maintain its consistency by not imposing such controls.

If capital controls are an unfavorable option, what needs to
be done to prevent other currency crises in the future? If
Malaysia directly blamed speculators for causing chaotic currency
fluctuations over the past 10 months, Indonesia seems to point
the finger at the heavy foreign debt burden in both the private
and public sectors.

Speculative foreign exchange buying by Indonesian corporates
to cover their rising debt obligations accelerated the weakening
of the rupiah in the early weeks of 1997. In this case capital
controls might prove to be overeffective in handling a future
debt overhang. In fact they might cease the foreign debt problem
permanently, as no foreign party, be it bank or investor, would
dare to extend any line of credit or investment to Indonesia ever
again.

To better address the problem of an over-volatile rupiah, it
might be wise to implement controls on offshore borrowings;
short-term loans in particular, rather than curbing the movement
of capital. Implementing a "queuing system" for instance, would
allow the government to constantly monitor the country's net
foreign exchange exposure and at the same time analyze the
utilization of foreign borrowings by industry sector (thus
preventing a potential overheat in a particular industry).

Short-term currency transactions, especially those relating to
currency derivatives, should in addition be revisited, if not
reregulated. It is no secret that Indonesian corporates treat
derivatives as a tool to maximize profits rather than minimize
losses, therefore creating a massive wave of speculation in the
"forward" markets. This has further resulted in a growing number
of foreign exchange obligations, which to date remain unresolved
and often, unpaid.

One expert, however, has reminded that imposing controls over
short-term capital would, in return, increase the cost of such
capital. But, so what? This would finally force borrowers to seek
long-term funding, instead of short-term money to finance their
investments and further open the opportunity for the development
of long-term financial instruments. Thus, the funding mismatch
(i.e. short-term funding for long-term projects) that has brought
many Indonesian corporates to their knees will hopefully not
reappear again in the future.

In the world of deregulation and globalization, foreign
capital flies in and out of countries at rapid speeds. The
ability of capital to move freely from one industry to another,
from one country to another, remains top priority to investors in
their quest to maximize returns and minimize risk on their
investments. Foreign capital has always been critical for
developing countries, including Japan after World War II and the
U.S. in the 19th century.

It is therefore imperative for Indonesia to remain attractive
to foreign investment by not reducing economic freedoms through
misguided attempts to control international markets. It is
equally important to realize that movements of capital (i.e.
inflow and outflow) are a reflection of a country's economic
fundamentals. In the event of an economic upswing the amount of
capital inflow automatically increases, taking advantage of a
favorable "money making" environment. Naturally, in a downturn
the movement of capital travels in reverse. Therefore, it would
make more sense to overhaul the problems in a country's
fundamentals rather than go through the pains of curbing the flow
of capital.

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