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.