Curbs on Capital Flows Gain New Respectability

When the Asian financial crisis broke out in 1997, Malaysian Prime Minister Mahathir Mohamad accused Western investors of using global financial markets to bring Malaysia to its knees. Few listened.

This month, after a year’s worth of further economic deterioration, Mahathir abruptly prohibited the trading of Malaysia’s currency, the ringgit, outside the country. This time, the concept of limits won grudging endorsement from some Western economists.

Between then and now, the world changed. The currency collapse that began in Thailand has now engulfed Asia, Latin America and Russia. In self-defense, some free-marketeers are beginning to change their stripes.

Malaysia is not the only country imposing more restrictions on markets. Hong Kong is pouring billions of dollars into its stock market in a duel with speculators. Russia unilaterally decided not to pay some of its foreign debt. Some right-wing political leaders in Mexico want to put a 12-month leash on foreign investment.

And political leaders protecting their flanks aren’t alone in rethinking the virtues of the unfettered movement of capital.

Robert A. Litan, a Brookings Institution analyst, says the idea that emerging-market countries should seek to control capital flows at their borders--at least in a limited fashion--has gained new respectability among Western strategists as a way smaller economies can protect themselves from increasingly large speculative flows.

“It’s wise for countries to at least slow down their foreign currency borrowing. That’s the main lesson of this crisis,” Litan said. “There’s been a tremendous sea change on this issue, and there’s a major rethinking going on.”

Similar endorsements have come from such diverse free-market advocates as Joseph Stiglitz, the World Bank’s chief economist, and Massachusetts Institute of Technology economist Paul Krugman, who argued in a recent Fortune magazine article that imposing limits on currency trading might give hard-hit countries some breathing room to tackle their other problems.

The admittedly modest shift in thinking nevertheless constitutes a conspicuous departure from the rigid free-market doctrine that Western policymakers and economists have been preaching. For months, both U.S. and International Monetary Fund officials have been telling governments of severely affected countries that the best way to overcome the Asian crisis is to open their markets further.

But now, Krugman argues that while currency controls inevitably cause distortions and work badly if kept in place too long, “when you face the kind of disaster now occurring in Asia, the question has to be: badly compared with what?”

By any standard, global capital markets have swelled to enormous proportions. World currency markets alone handle more than $1.5 trillion worth of transactions a day--up from only $190 billion a decade ago. Analysts say that figure is a reasonable proxy for all financial markets because cross-border stock trades involve currency trading.

But the huge flows into emerging markets are a relatively recent phenomenon. As late as 1991, most developing countries were getting most of their money from abroad via so-called official capital flows, such as foreign aid and World Bank loans. Private foreign investment was relatively minimal--about $44 billion, according to the Institute of International Finance, a Washington think tank created by international banks.

During the following years, however, that figure soared. By 1996, private investors were pumping a net $304.5 billion into poorer countries through global financial markets, while net official flows had shrunk to $1.4 billion. (Private flows fell to a net $232.6 billion in 1997, thanks largely to the Asian crisis, and are expected to slide to $221.3 billion in 1998.)

The last year’s tsunami in global financial markets has severely damaged Asian economies. South Korea’s stock market has plunged a staggering 73%, in U.S. dollar terms, since the start of the crisis. Indonesia’s has fallen 90%, Thailand’s 75% and Malaysia’s 83%. Their currencies have suffered similar declines.

Moreover, the deluge has spread to other countries--Russia and South Africa, to name just two--and moved on to several nations in Latin America and elsewhere that had followed sound economic policies.

Mexican Finance Minister Jose Angel Gurria complained this month that “markets are overreacting and not discriminating” among countries that are following sound principles and those that are not. “You can’t put all of us in the same bag,” he said angrily after a conference of Latin American economic officials at the IMF.

Economists are increasingly sympathetic.

“The Asian crisis [showed] that capital movements can generate major crises that these countries just aren’t equipped to deal with,” said Jagdish Bhagwati, an international economics expert at Columbia University. Bhagwati calls “the pretty face” of unfettered capital flows “a mask that hides the warts and wrinkles underneath.”

The problem is, there is little unanimity on what might work--and under what circumstances. Most analysts predict that Mahathir’s controls will backfire once again, leaving Malaysia worse off than it was before.

Krugman asserts, for example, that new restrictions must be temporary and crafted to minimize disruption on day-to-day business. He believes they should be used as an aid to reform rather than an alternative to it--tests that Mahathir’s latest maneuver fails to meet.

Chile has a long-standing policy of discouraging short-term “hot money” flows by prohibiting foreign investors from taking their money out for a year and requiring them to keep 30% on deposit with the central bank. But the effect has been a slowdown in all inflows of foreign capital. As a result, Chile recently cut the reserve requirement to 10%.

Litan and other analysts have suggested that the IMF press emerging-market countries to require that big international banks agree to forfeit a 10% or 20% penalty if they call in their outstanding loans when a crisis erupts, a move designed to make bankers more cautious about the loans they make. But any agreement seems far away.

Bhagwati urges authorities to continue to insist that emerging-market countries follow free-trade and direct-investment policies. But they should support controls on short-term capital flows, which Bhagwati says are too volatile for them to cope with on a day-to-day basis. Other economists say the two are too closely linked to separate so finely.

Finally, Yale University professor James Tobin has resurrected a proposal from the 1970s that calls for a small fee on all foreign currency transactions worldwide in an effort to penalize speculators who buy and sell frequently. The fee would be levied by individual countries and turned over to the IMF.

But there are drawbacks. The charge would have to be imposed worldwide in order to be effective, a prospect that detractors assert is unlikely. Money havens such as the Cayman Islands almost certainly would provide investors with a way to get around the rules.

Perhaps the reform most likely to be adopted is now being hammered out by the IMF for possible consideration at its annual meeting here in October, an approach that would ease pressures on developing countries to open their capital markets before they are fully prepared for the consequences.

The plan would allow emerging-market countries to phase in the opening of their capital markets to provide more time to bolster their banking and accounting structures. Until now, the IMF has pressed developing countries to open all their markets at once.

The agency also is considering a move to discourage developing countries from linking their currencies to the value of the dollar--a practice that almost always brings trouble when a financial crisis hits. Analysts contend that the best system by far would be for Third World countries to allow their currencies to float, adjusting gradually rather than overnight.

There also is the question of how much emerging-market countries themselves are to blame. Many economists argue that free markets as such are not the problem, but rather lax systems that fostered secrecy, corruption and government influence.

“It was their abuses of the capitalist system--not capitalism itself--that led to the financial turmoil that has taken place,” said Gregory B. Fager, an Asia expert with the Institute of International Finance.

Not all emerging-market countries have joined Mahathir’s revolt against the globalization of financial markets. Latin American governments, for the most part, have been combating market contagion the old-fashioned way--by paring their budget deficits and boosting interest rates to slow capital outflows. Asian countries such as South Korea, Thailand and Singapore also remain on board.

But David D. Hale, chief economist for the investment firm Zurich Group, believes that the recession engulfing Asian economies has become so severe that governments will come under heightened pressure to intervene to hold down unemployment and ward off the social unrest that has begun to appear.

“The Asian governments accepted orthodox economic policies from the IMF last year because they were committed to the principle of an open economy and felt they had little alternative,” he said in a letter to clients distributed last week. Now that situation has changed.

U.S. and IMF officials worry that if the backlash continues to spread, it could pose a major threat to the long-term prosperity of these countries by cutting off the flows that have financed their growth. Deputy U.S. Treasury Secretary Lawrence H. Summers warned last week that such policies would hurt their own citizens the most.

More broadly, Robert B. Zoellick, a former U.S. economic policymaker now with the Center for Strategic and International Studies, warns that unless it is held in check, the move toward tighter controls could widen into a backlash against globalization that threatens to reverse the worldwide gains capitalism has made since the end of the Cold War.

Yet for all of the pain that emerging-market countries are experiencing these days, some Asia experts such as W. Robert Warne, head of the Korean Economic Institute, contend that despite their current travail, the newly industrializing countries are reordering their financial systems and are likely to emerge even stronger in perhaps two years.

Indeed, analysts point out that Latin American countries made a similar adjustment following the Third World debt crisis of the early 1980s, eventually putting their houses in order and bolstering their financial structures. Although they have not escaped the fallout from the Asian crisis, they have fared far better than they would have before.