Recent Imposition Of Capital Controls In East Asia

An interesting piece of research has turned up on VoxEU (excerpt):

Emerging markets consider capital controls to regulate speculative capital flows
Kavaljit Singh

Despite recovering faster than developed countries, many emerging markets are struggling to cope with large capital inflows. This column discusses the recent capital controls imposed by Indonesia and South Korea. It argues that while the international community is warming to these policies, it would be wrong to view capital controls as a panacea...

...Just days before the G20 summit in Toronto, South Korea and Indonesia announced several policy measures to regulate potentially destabilising capital flows which could pose a threat to their economies and financial systems...

...Despite recovering faster than developed countries, many emerging markets are finding it difficult to cope with large capital inflows. There is a growing concern that the loose monetary and fiscal policies currently adopted by many developed countries are promoting a large dollar “carry trade” to buy assets in emerging markets.

Apart from currency appreciation pressures, the fears of inflation and asset bubbles are very strong in many emerging markets. Since mid-2009, stock markets in emerging economies have witnessed a spectacular rally due to strong capital inflows. In particular, Brazil, Russia, India and China are the major recipient of capital inflows.

The signs of asset price bubbles are more pronounced in Asia as the region’s economic growth will continue to outperform the rest of the world. As a result, the authorities are adopting a cautious approach towards hot money flows and considering a variety of policy measures (from taxing specific sectors to capital controls) to regulate such flows. In May 2010, for instance, Hong Kong and China imposed new measures in an attempt to curb soaring real estate prices and prevent a property bubble.

In emerging markets, strong capital inflows are likely to persist due to favourable growth prospects but the real challenge is to how to control and channel such inflows into productive economy.

Contrary to the popular perception, capital controls have been extensively used by both the developed and developing countries in the past. There is a paradox between the use of capital controls in theory and in practice (Nembhard 1996). Although mainstream theory suggests that controls are distortionary and ineffective, several successful economies have used them in the past (Nembhard 1996). China and India, two major Asian economies and “success stories” of economic globalisation, still use capital controls today...

...Yet it would be incorrect to view capital controls as a panacea to all the ills plaguing the present-day global financial system. It needs to be underscored that capital controls must be an integral part of regulatory and supervisory measures to maintain financial and macroeconomic stability (Singh 2000). Any wisdom that considers capital controls as short-term and isolated measures is unlikely to succeed in the long run.

The theoretical (or should I say theological) basis for an open capital account, where capital of any sort is allowed to enter and leave freely, is that capital will flow to where it can be used most productively (i.e. where capital is relatively scarce, and would then attract higher returns). An open capital account should therefore result in lower cost of capital for the recipient, which will result in an increase in investment in productive capital which then raises incomes and social welfare. That’s the free-market, neo-classical story anyway.

The problem here is that there is an underlying assumption that the country involved is big enough that capital inflows/outflows won’t have a significant impact on monetary conditions – that’s simply not true of many developing economies in the context of a relatively more massive global financial system. (I’m leaving out here the empirical “puzzle” that capital doesn’t in fact flow to capital-scarce nations – quite the opposite actually occurs. Otherwise, Africa would be the number one destination of foreign capital and investment).

There are a number of ways a country can manage outsized capital inflows and outflows – reserve accumulation as an insurance policy, as is common in East Asia and the oil-rich Middle East; sterilisation through issuance of central bank liabilities, which can get expensive; and of course capital controls.

The general practice has been that if the domestic financial sector and capital markets don’t have the capacity, breadth or depth to absorb large-scale short-term capital, then capital controls are the instrument of choice, never mind investor opprobrium. Malaysia has had more than a few brushes with capital controls, of which 1998 was just the latest.

At the moment, capital flows aren’t an overriding concern here (we’re not as “exciting” an investment story as Indonesia, China or India), but that may change if interest rates and yields in developing countries remain ultra-low for an extended period.

Technical Notes:

Singh, Kavaljit, “Emerging markets consider capital controls to regulate speculative capital flows”, VoxEU.org, July 5 2010