[I wrote this article for a mainstream newspaper in August last year. It should be read in conjunction with this post]
It’s almost that time of the year again, when the Federal Government sets about planning its budget for the year ahead. With Malaysia’s sovereign credit rating at risk, it’s also time to take a look at reforming tax policy. One avenue that should be explored but has gotten little public airing is adding a capital gains tax (CGT).
The stock market is losing ground, the Ringgit is being hammered, interest rates are slowly rising, inflation is increasing, and growth is anaemic. Not a whole lot of good news lately.
Don’t Panic.
The market selldown is general; it’s happening across the region and pretty much affecting most emerging markets. Malaysia is one of many, and we’re not being singled out. Just as expansionary monetary policy in advanced economies and greater global liquidity helped support emerging markets in 2010-2011, we’re seeing a pullback as the Fed begins signalling its willingness to reverse course.
Don’t Panic.
It’s a fairly long explanation and directly targets the Global Financial Integrity reports with respect to Malaysia (I’ve taken the liberty of copying it in full):
Update on Measures to Address Unrecorded Financial Flows
Bank Negara Malaysia would like to provide an update on measures that have been undertaken by members of a High Level Multi-Agency Special Task Force (Task Force) to reduce illicit financial flows. The Task Force comprises of the Attorney General’s Chambers of Malaysia, Royal Malaysian Customs Department, Royal Malaysia Police, Malaysian Anti-Corruption Commission, Inland Revenue Board of Malaysia, Immigration Department of Malaysia and Bank Negara Malaysia. The Task Force’s role is to spearhead more effective coordination and collaboration among key law enforcement authorities in the country as well as between local and international enforcement agencies to mitigate illicit activity and financial flows.
The latest from Global Financial Integrity focuses on illicit outflows and inflows revolving around China (excerpt from press release):
Illicit Financial Flows from China and the Role of Trade Misinvoicing
The Chinese economy hemorrhaged US$3.79 trillion in illicit financial outflows from 2000 through 2011, according to a new report [PDF] released today by Global Financial Integrity (GFI), a Washington, DC-based research and advocacy organization. Amidst increased domestic concern over inequality and corruption, GFI’s study raises serious questions about the stability of the Chinese economy merely two weeks before the once-in-a-decade leadership transition…
In the latest round of research from the NBER, this paper describes some “surprising” results (abstract):
Pegs, Downward Wage Rigidity, and Unemployment: The Role of Financial Structure
Stephanie Schmitt-Grohé, Martín UribeThis paper studies the relationship between financial structure and the welfare consequences of fixed exchange rate regimes in small open emerging economies with downward nominal wage rigidity. The paper presents two surprising results. First, a pegging economy might be better off with a closed than with an open capital account. Second, the welfare gain from switching from a peg to the optimal (full-employment) monetary policy might be larger in financially open economies than in financially closed ones.
East Asia over the years have been variously accused of currency manipulation and neo-merchantilist policies. Massive reserve holdings in the region – e.g. China’s USD3.2 trillion, Japan’s USD1.3 trillion; nine of the top twenty reserve holdings are in East Asia - can be pointed to as proof of this assertion.
A new research paper in this month’s NBER circulation disputes this view however (abstract; emphasis added):
Optimal Holdings of International Reserves: Self-Insurance against Sudden Stop
Guillermo A. Calvo, Alejandro Izquierdo, Rudy Loo-KungThis paper addresses the issue of the optimal stock of international reserves in terms of a statistical model in which reserves affect both the probability of a Sudden Stop–as well as associated output costs–by reducing the balance-sheet effects of liability dollarization. Optimal reserves are derived under the assumption that central bankers conservatively choose reserves by balancing the expected cost of a Sudden Stop against the opportunity cost of holding reserves. Results are obtained without using calibration to match observed reserves levels, providing no a priori reason for our concept of optimal reserves to be in line with observed holdings. Remarkably, however, observed reserves on the eve of the global financial crisis were–on average–not distant from optimal reserves as derived in this model, indicating that reserve over-accumulation in Emerging Markets was not obvious. However, heterogeneity prevailed across regions: from a precautionary standpoint, Latin America was closest to model-based optimal levels, while reserves in Eastern Europe lay below optimal levels, and those in Asia lay above. Nonetheless, there are other motives for reserve accumulation: we find that differences between observed reserves and precautionary-motive optimal reserves are partly explained by the perceived presence of a lender of last resort, or characteristics such as being a large oil producer. However, to a first approximation, there is no clear evidence supporting the so-called neo-mercantilist motive for reserve accumulation.
A new IMF working paper looks at capital inflows and what can be done about them (abstract):
Surging Capital Flows to Emerging Asia: Facts, Impacts, and Responses
Balakrishnan, Ravi and Sylwia Nowak; Sanjaya Panth & Wu YiqunSummary: Net capital flows to emerging Asia rebounded at a record pace following the global financial crisis, raising concerns about overheating and financial stability. This paper documents the size and composition of the most recent surge to Asian emerging markets from a historical perspective and compares developments in the broader economy, asset prices, and corporate variables across the different episodes of strong inflows. We find little evidence of a significant build-up of imbalances and resource misallocation during the most recent surge. We also review country experiences in managing the risks associated with inflows and argue that Asian countries have used regulatory measures during past surges, although there is not strong evidence of their efficacy without supporting monetary and fiscal policies.
You might remember Global Financial Integrity’s report on illicit money flows early last year, where they reported Malaysia as being the fifth highest victim of uncategorised capital outflows in the last decade.
At the time, I partially validated their findings at least in terms of the trade mispricing channel – wildly different reported values for exports and imports between different trade partners.
So since I had a bit of time, and lots of curiosity, I decided to take a bit of a deeper look into the question of Malaysian trade mispricing, using the United Nations Commodities Trade database (Comtrade), which carries data on both imports and exports as reported by nearly every trading nation (Taiwan not included).
Did I find capital outflows? Yes, I did, and on a scale that conforms to the GFI report.
Ok, second speech, this time from Lim Guan Eng:
Pakatan blames BN for turning Malaysia into ‘king of black money’
KUALA LUMPUR, Dec 16 — Pakatan Rakyat (PR) leaders faulted the Barisan Nasional (BN) government today for bleeding the country’s coffers through corruption, saying its mismanagement of the economy had turned Malaysia into the “king of black money”.
Pointing to the Global Financial Integrity’s (GFI) findings that Malaysia had lost RM150 billion in 2009 through the siphoning of illicit money, the leaders warned of a bleak future for the country should the ruling pact be allowed to continue its reign.
In two seminal papers, Nobel Laureate Robert Mundell and Marcus Fleming extended the basic Hicks IS-LM model to incorporate an external sector. The most interesting finding is what’s called the Trilemma – a country cannot simultaneously have exchange rate stability, free capital mobility and an independent monetary policy. You can at best target two of these variables, with the third left to market forces. Trying to achieve all three is effectively impossible, as it sets up inconsistencies in the economy that can and will be exploited by economic agents (read: financial markets).
That’s the real basis for the 1997-98 Asian Financial Crisis a decade ago – you can’t have your cake and eat it too. Most of the crisis victims opted for dropping exchange rate stability; Malaysia famously choose to drop capital mobility, then in 2005 followed the others towards exchange rate flexibility as well.
However, there’s nuances to the stark choices implied by Mundell-Fleming. In this new paper highlighted at VoxEU, the Trilemma choices are evaluated for China and India (excerpt; emphasis added):
The financial trilemma in China and a comparative analysis with India
Joshua Aizenman Rajeswari SenguptaEmerging markets face what some economists are calling a trilemma. They cannot simultaneously target exchange-rate stability, conduct an independent monetary policy, and have full financial integration. So what to do? This column looks at how Asia’s giants are responding – and in different ways...
Jeff Frankel of Harvard summarises the current thinking:
The 2008-09 Global Financial Crisis: Lessons for Country Vulnerability
After the currency crises of 1994-2001, and especially the East Asia crises of 1997-98, a lot of research investigated what countries could do to protect themselves against a future repeat. More importantly, policy makers in emerging markets took some serious measures. Some countries abandoned exchange rate targets and began to float. Many accumulated high levels of foreign exchange reserves. Many moved away from dollar-denominated debt, toward other kinds of capital inflow that would be less vulnerable to currency mismatch, such as domestic currency debt or Foreign Direct Investment. Some instituted Collective Action Clauses in their debt contracts to facilitate otherwise-messy restructuring of debt in the event of a severe negative shock. A few raised reserve requirements or otherwise tightened prudential banking regulations (clearly not enough, in retrospect). And so on.
One of the basic tools used by emerging market central banks to manage high capital inflows is intervention in the foreign exchange markets. While foreign capital inflows are generally welcomed, they cause problems through overly expanding the domestic money supply (and credit), putting upward pressure on the exchange rate, and – the biggest problem – can be the trigger for a liquidity crisis should they reverse.
A new working paper from the IMF seeks to discover just under what conditions forex intervention can be effective, or if it’s any use at all (abstract):
Foreign Exchange Intervention: A Shield Against Appreciation Winds?
Adler, Gustavo ; Tovar Mora, Camilo EThis paper examines foreign exchange intervention practices and their effectiveness using a new qualitative and quantitative database for a panel of 15 economies covering 2004 - 10, with special focus on Latin America. Qualitatively, it examines institutional aspects such as declared motives, instruments employed, the use of rules versus discretion, and the degree of transparency. Quantitatively, it assesses the effectiveness of sterilized interventions in influencing the exchange rate using a two-stage IV-panel data approach to overcome endogeneity bias. Results suggest that interventions slow the pace of appreciation, but the effects decrease rapidly with the degree of capital account openness. At the same time, interventions are more effective in the context of already ‘overvalued’ exchange rates.
Along with yesterday’s GDP report, BNM has also reduced the already low barriers for overseas investment:
Liberalisation on direct investment abroad, inter-company loans and trade financing
As part of the efforts to continuously increase business efficiency and enhance competitiveness of the economy, Bank Negara Malaysia wishes to announce with effect from June 1, 2011 the following liberalisations on direct investment abroad, inter-company loans and trade financing facilities obtained by residents:
I usually publish only the abstracts when highlighting research papers, but this one’s so fascinating and not a little controversial from a Malaysian perspective, that I’m taking excerpts from the introduction instead (excerpts, emphasis added):
Rethinking The Effects Of Financial Liberalization
Fernando A. Broner & Jaume Ventura...The conventional view, part of the so-called Washington Consensus, was quite optimistic regarding the effects of financial liberalization...
Not something to be proud of – Global Financial Integrity released a report yesterday on capital outflows from developing countries, and Malaysia ranks in the top ten:
Illicit Financial Flows from Developing Countries: 2000-2009
Illicit outflows increased from $1.06 trillion in 2006 to approximately $1.26 trillion in 2008, with average annual illicit outflows from developing countries averaging $725 billion to $810 billion, per year, over the 2000-2008 time period measured…
….Top 10 countries with the highest measured cumulative illicit financial outflows between 2000 and 2008 were:
- China: $2.18 trillion
- Russia: $427 billion
- Mexico: $416 billon
- Saudi Arabia: $302 billion
- Malaysia: $291 billion
- United Arab Emirates: $276 billion
- Kuwait: $242 billion
- Venezuela: $157 billion
- Qatar: $138 billion
- Nigeria: $130 billion
Menzie Chinn at Econbrowser sends us to the World Economic Forum’s Financial Development Report 2010, which has a nice broad summary of capital control tools and their strengths and weaknesses. I won’t reproduce the graphic (that’s a breach of netiquette), so head on over to Econbrowser if you’re interested in the subject.
Worth a glance, since capital controls are the flavour of the day, and likely to remain so for some while.
Charles Santiago of the DAP is calling for capital controls:
Govt urged to consider capital controls
KUALA LUMPUR: An Opposition MP has urged the Government to view capital controls as a protective policy to insulate the local economy from destabilisation.
Charles Santiago (DAP-Klang) said China, Indonesia, Thailand, Brazil, South Korea and other developing countries had recently adopted such a policy.
"Capital controls should be viewed as a policy response to regulate speculative capital, in order to protect the domestic economy from volatile capital flows.
Menzie Chinn explains, in theoretical terms, about QE2, currency wars and capital controls:
Losing the Battle, Winning the War?
…I have also been thinking about the anger with which the policymakers and economists in the rest-of-the-world (as well as certain US politicians [5]) have greeted QE2 with. In some ways, the fact that they are angry speaks volumes about the effectiveness or ineffectiveness of QE2. (In other words, to criticize QE2 as having no effect, and then to be angry that it is being undertaken, are internally inconsistent views.)
My view is that anger at the US position is currently being driven by an understanding that QE2 has been surprisingly effective at depreciating the dollar, and that the rest-of-the-world has limited scope in countering that depreciation. In a game theoretic context, we usually think of competitive devaluation as a form of the prisoner’s dilemma, where the devalue option dominates the no-devalue option, and both parties end up with a devalued currency, but no net improvement because countries cannot all devalue against each other…
…However, because of the radically different post-recession economic conditions facing the US and China, the payoff matrix has changed. The US gains by allowing the currency to depreciate against the rest-of-the-world, but the Chinese (and to a lesser extent the other BRICs) have competing goals of maintaining rapid growth, high exports, and stable inflation. This point has become apparent as inflation has surged in China. [6] The conflicting goals Chinese policymakers face can be illustrated by reference to the Mundell-Fleming model. (See this post for detail)…
If you want to suss out the policy options that are facing the major economies right now, you could do worse than to read this.
As a Nobel prize winner, Joseph Stiglitz’s views have some weight. Now he considers capital controls a legitimate policy option for emerging markets:
Stiglitz Sees Bubble Risk in Emerging Markets as Fed Expands U.S. Stimulus
The U.S. Federal Reserve’s plan to expand stimulus will fuel potential asset bubbles in emerging countries with strong growth that don’t have capital control measures, Nobel Prize laureate Joseph Stiglitz said.
“I do have worries on countries like India,” Stiglitz, a Columbia University economics professor, said today at a conference in Hong Kong. “The strong economies that don’t yet have capital control become the focal point for all this money.”
I’ve an awful lot of research papers that I want to highlight, in addition to going through the ETP proposals in detail. As such there won’t be any posts for the next couple of days, so in the interim, I’d just like to showcase a book and a working paper that supports it.
Back in July, I highlighted an article on VoxEU regarding the imposition of capital controls in East Asia. The author got in touch with me, and has now published a book on the subject:
Fixing Global Finance
A Developing Country Perspective on Global Financial Reforms
Kavaljit SinghThe financial crisis which erupted in mid-2007 has been widely viewed as the most serious financial crisis since the Great Depression of the 1930s. The crisis which originated in developed countries quickly spread to developing countries and the rest of the world. The turbulence in financial systems was followed by a significant reduction in real economic activity throughout the world. The crisis has highlighted that financial markets are inherently unstable and market failures have huge economic and social costs. The crisis has renewed debate on the role of global finance and how it should be regulated.
The aim of this book is to encourage and stimulate a more informed debate on reforming the global finance. It examines recent developments and problems afflicting the global financial system. From a developing country perspective, it enunciates guiding principles and offers concrete policy measures to create a more stable, equitable and sustainable global financial system. Several innovative measures have been proposed to reform the global finance and to ensure that it serves the real economy.
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