KL experiments in financial controls

By Christopher Lingle

HONG KONG (JP): Malaysia's experiment with capital and foreign exchange controls flies in the face of a 25-year global trend. Bank Negara, Malaysia's central bank, declared that foreigners can repatriate profits made on stock sales but the principal must remain for a year from September 1998.

This rule also covered profits from dealings in stock index futures and in other futures contracts. On the face of it, these moves marked a defiant stand to avoid International Monetary Fund-imposed conditions for resolving its trade and capital account imbalances as well as the search for a means to avoid a recession.

Along with implementation of capital controls, there was also a nostalgic revival of Keynesian remedies of demand management that were discredited during the 1970s and 1980s. In order to "reflate" the sagging Malaysian economy, interest rates were pushed lower and statutory reserve requirements were cut from 6 to 4 percent toward a target level of 2 percent.

Commercial banks were directed by the government to set a minimum credit growth target of 8 percent for 1998 and to reinstate withdrawn credit lines.

In an attempt to prompt this rise, the key intervention rate was cut four times in quick succession and the central bank lowered the three-month interbank rate. However, none of these steps, including the pumping of public money into the economy, changed the fact that potential borrowers were poor credit risks. And so, the mandated increase in lending was not met.

The decision by Prime Minister Mahathir Mohamad to shut off his country from currency and capital markets was in sharp contrast with neighboring Singapore and Thailand.

As Malaysia retreated from the free flow of capital and liberalization of its financial sector, Singapore and Thailand moved forcefully headlong towards engaging and accommodating global capital flows.

Thailand began the crisis from a position which was worse than either Malaysia or Singapore. Its burden of foreign debt was higher, its foreign exchange reserves were largely depleted, and its banking system sustained severe damage.

Facing these dire straits, Thailand turned to IMF for emergency credit and promised to keep its system open as a condition. Singapore's path was based upon historical evidence and current economic theory that supported its decision.

In contrast, Malaysia's experiment with increased controls on capital and exchange flows was undertaken that it would gain greater control over its domestic macroeconomic situation. It was expected that closing off capital flows would allow interest rates cuts designed to stimulate domestic demand.

Yet on this score, both Singapore and Thailand were more successful in having interest rates that were lower than in Malaysia. Recently, overnight interest rates in Malaysia were at 3 percent while in Thailand they stood at 0.8 percent. Similarly, three-month interest rates in Malaysia were higher at 3.4 percent than in Thailand at 2.75 percent.

While Malaysia squandered its credibility in global financial markets, the Singapore and Thai governments sought to build theirs through sound monetary policy. The IMF guided the Thais in large part while the Singaporeans were guided by their own good sense.

It is true that Malaysia has undertaken restructuring and recapitalizing of its banking system. However, these decisions and their momentum have nothing to do with the imposition of capital and exchange controls. On the contrary, it is widely thought that capital controls were designed as to protect political cronies. This is evident in that many of the companies that contributed to the crises have survived largely intact.

In all events, it still has a long way to go. By government estimates, nonperforming loans stand at 30-35 percent of total outstanding loans. Its banking system requires an estimated 60 billion ringgit (about US$15 billion) for recapitalization, an amount greater than estimated total savings in the economy.

The Malaysian leadership insists on declaring its controls and macroeconomic policies to have been a success. If so, why were they altered? In early 1999, the Malaysian government announced changes to allow early exit for the $5 billion trapped by the initial scheme. Those wishing to repatriate capital would face an exit tax of up to 30 percent. New investments encounter a capital gains tax of about the same proportion.

Part of the answer for the change of heart lies in the fact that commitments of foreign capital for direct investment fell by 12 percent in 1998, the second consecutive year of decline. Malaysia's attempt to sell bonds to raise about $8 billion needed for bank recapitalization and corporate restructuring met with resistance.

If the government were truly concerned about dealing with exchange rate uncertainty or capital outflows, controls are unnecessary. Markets provide a more efficient way to achieve the same thing. For example, market competition led to the development of financial derivatives as a mechanism to minimize exposure to financial risks.

In all events, if Malaysia or other countries are thought to be too dependent and vulnerable to foreign capital flows, then opening up their domestic capital markets to competition and foreign ownership will go a long way towards removing this problem.

Consider the impact of removing or reducing foreign-investment ceilings in the country's domestic banks and corporations. This would provide a quick injection of funds for recapitalization of the banks while introducing innovations needed for Malaysia's coddled and inefficient domestic enterprises.

In turn, it would also break the cycle of political patronage while shifting corporate concerns towards customer and shareholder interests.

The writer is an independent corporate consultant and adjunct scholar of the Centre for Independent Studies in Sydney.