The true legacy of Malaysia's capital controls

The true legacy of Malaysia's capital controls

By David DeRosa

NEW CANAAN, Connecticut (Bloomberg): Why didn't foreign
capital stampede out of Malaysia when capital controls were
lifted on Sept. 1? Does this mean that capital controls, Malaysia
style, are a successful policy tool that might be used in other
countries?

For openers, there are some factors specific to Malaysia.
Prime Minister Mahathir Mohamad had some help from Japan in the
form of a US$2.5 billion standby swap facility that was concluded
and made known to the public on July 7. The unstated but widely
recognized purpose of this was to provide Malaysia with backup
funding in case of a massive capital flight.

Despite its small size, the existence of this swap facility
may have given some sense of assurance that at least one major
economic nation, Japan, cared about whether Malaysia would
collapse after the controls were lifted.

A second factor that may have convinced investors not to dump
their holdings was that Morgan Stanley Capital International
declared Aug. 12 that Malaysian equities might be re-included in
some of their benchmark indexes (the Emerging Markets Free Index
and All Country Free index) as early as February 2000. MSCI made
this conditional on the removal of the capital controls and
liberalization of Malaysian financial markets.

Yet the best explanation as to why no hemorrhage of foreign
capital has taken place, at least so far, is the one that you
learn on the trading desk. Investors didn't sell their holdings
because there was no pressing reason for them to sell.

Investors look to the future, not to the past. The great
Southeast Asian currency and stock market crisis has receded into
the history books. With the passage of time, the crisis has
become less significant to investors, much as the October 1987
stock market rout is generally forgotten in the United States.

Things have been returning to normal in Malaysia, at least by
that country's sometimes bizarre standards of normalcy. But why
has Malaysia improved and what role did the capital controls play
in the recovery?

The single most important reason for the improvement in the
Malaysian economy is that the government engineered a substantial
devaluation of the ringgit during the period of capital controls.

The ringgit has been pegged to the dollar at a rate of 3.80
while other Asian currencies have been appreciating. While
capital controls were in place, from Sept. 1, 1998, to Sept. 1,
1999, the ringgit fell 40 percent against the Indonesian rupiah,
5 percent against the Thai baht, 15 percent against the Korean
won, and most importantly, 25 percent against the Japanese yen.

The result, to nobody's surprise, was a boom in Malaysian
export (commercial trade was exempt from the capital controls).

Exports had contracted by 10.8 percent, year-over-year, in the
third quarter of 1998, after the controls were established, but
then promptly rebounded. Export growth was 5.2 percent in the
fourth quarter of last year, 4.6 percent in the first quarter of
this year, and 15.8 percent in the second quarter of this year,
all measured year-over-year. This is the reason why Malaysian GDP
rose by a surprising 4.1 percent in the second quarter of this
year. Exports of semiconductors and electrical components have
been particularly strong.

Malaysia can thank the world for allowing it to devalue its
currency and then export its way out the crisis. This, and not
the capital controls, is the reason for the recovery.

This introduces an interesting question -- how long will
Malaysia be able to keep the ringgit pegged at 3.80 to the
dollar? Malaysia may now have the opposite problem that China
has.

China, by resisting a devaluation of the yuan, is suffering
from an overvalued currency. If things are as good as Mahathir
says they are, one would expect that a floating ringgit would be
much higher. Malaysia's new problem may be an undervalued
ringgit. My guess is that if the ringgit ever floats again,
Malaysia's central bank, Bank Negara, would be instructed to
fight tooth and nail to prevent a rise in the currency --
Malaysia can't afford to lose the exports.

The ringgit may also be on the minds of foreign holders of
Malaysian securities. After all, if you dump your shares you get
ringgits, which you presumably would want to sell as well. But
sell at what price?

If I am correct that the ringgit is undervalued, possibly by
as much as 25 percent (judging by the yen), then the official
rate of 3.80 to the dollar is the same thing as a 25 percent exit
tax. It is also an exit tax that effectively would be rescinded
if the ringgit is floated and goes to its fair value. This is a
second important reason why no large capital exodus occurred last
week.

The fact that the Malaysian market didn't fall on Sept. 1 is
less strange than the fact that it also didn't rise. Ordinarily,
the good news, such as when the market learns that destructive
economic policies have been abandoned, gets a hero's welcome.

The fact that the market didn't rise is testament to
investors' reservations about the future of a regime that might
pull another stunt like putting in new capital controls.

A surprising number of pundits and institutions have stepped
up to praise Mahathir's handling of the Malaysian crisis since
the capital controls were lifted. He is seen as having pulled off
a world-class coup, having outsmarted the IMF and most of the
leading economists and financial advisers. Throwing garlands at
Mahathir goes beyond merely stretching credulity -- it comes
dangerously close to being an endorsement for this morally
bankrupt government.

What Mahathir did one year ago was not so much a bold economic
measure as an act of creating a diversion to distract attention
from his own government's mismanagement of the economy. Faced
with a collapse of its currency and financial markets, Mahathir
invented an invisible enemy, currency speculators. Soon he gave
that enemy the name and a face of legendary hedge fund manger
George Soros, although there is no evidence to suggest that Soros
or his Quantum Fund, or for that matter the entire hedge fund
community, had any involvement in the ringgit.

Not content with smearing Soros, Mahathir went on to blame an
international conspiracy of Jewish financiers for the Asian
crisis. Next, Mahathir dismissed his respected deputy Prime
Minister and finance minister Anwar Ibrahim. Bent on totally
destroying and demonizing Anwar, Mahathir framed him with a set
of preposterous sexual perversion charges.

All this was a desperate scheme to stay in power despite a
crumbling economy. Mahathir didn't want to end up like President
Soeharto, who was kicked out of power in Indonesia. So he went on
a rampage, declaring there would be "no more currency trading,"
instituting capital controls, and vilifying the IMF along with
Soros and Anwar.

It is premature to conclude that Mahathir's capital control
experiment is any kind of success. The financial community hasn't
pardoned Malaysia. Rather it has put the country on probation for
the indefinite future. The country will always be viewed
differently for as long as Mahathir and his followers are in
power. As an investor, you now know that you have fuzzy property
rights in Malaysia. It's anybody's guess what Mahathir will do
next time if, or more likely when, there is another crisis. It
only takes rumors of new currency controls to start a capital
flight, and this isn't a environment conducive to investment and
capital formation.

Capital controls are bad medicine for sick economies. The
Malaysian experiment was a dangerous and reckless act for which
Mahathir deserves no praise. The worst thing about this sorry
mess is that other financially strapped governments may think
Mahathir's experiment is a magic pill. I predict they'll find
this alleged cure is far worse than the original disease.

The writer is president of DeRosa Research and Trading and
manages an investment fund. He is also an adjunct finance
professor at Yale School of Management. His opinions don't
necessarily represent those of Bloomberg News.