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.