SYNOPSIS: Capital Controls are drastic, but might be necessary. Examines several ways to go about them
In the last few weeks there has been a definite change in the tone of discussion about policies for troubled emerging markets. True, the official IMF-Treasury line remains that austerity-plus-reform will eventually work, that in the end the Mexico 1995 scenario will be repeated. And they could still be right - a result devoutly to be wished, even if it does make people like me look somewhat silly. But the woes of Brazil, the events in Hong Kong and Malaysia, and the apparent spread of market panic to some classes of assets in advanced economies have led to a new sense that something more is needed.
All of the proposals might be summarized under the general heading of "curfews" on capital flight: something designed to give a country a cooling-off period during which the market panic is held at bay, a period during which the country can both try to clean up its financial system and pursue sensible policies - reflation, moderate devaluation, etc. - that would otherwise be ruled out by the threat of speculative attack. Leaving aside the question of whether any such curfew is possible or desirable, there is still a big question about what sort of curfew is likely to succeed.
Broadly speaking, proposals for such a curfew may be arrayed along a continuum. The mildest proposals call for "voluntary" actions by creditors: at recent meetings I have attended there has been widespread support among bankers and government officials for the idea of trying to arrange concerted action among commercial banks, 1982-style, to maintain credit lines to countries such as Brazil. A more dramatic step that has started to attract support among respectable people is the idea of some form of "Chapter 11" for countries, a formal or informal procedure that would protect a country from a sudden run by its foreign creditors. And the most extreme view is, of course, the idea (which only a few of us are foolish enough to espouse) that rescheduling foreign-currency debt is not enough - that controls must be established over the outflow of capital in general, either directly via capital controls or indirectly via a dual-exchange rate system.
The purpose of this note is to explain why those of us who are at the extreme end of this continuum have taken that position. I will not repeat the arguments for doing something to relax the constraints now placed on troubled economies, having already laid these arguments out at some length both in my New Republic article and my note on Brazil's dilemma . Instead, the focus is on what might work - and the reasons why either a voluntary or an imposed standstill on repayment of foreign-currency debt will not be sufficient.
Both those who want to enlist bankers for concerted action to help crisis economies, and those who want a mechanism for "orderly default", start from the proposition that the major problem facing countries in crisis is their short-term foreign currency debt: when confidence is lost, the story goes, foreign lenders refuse to roll over this debt, creating a rapid drain of foreign exchange. So the idea is to put a stop to this process. Optimists believe that moral suasion on the banks, an appeal to their enlightened (alas, collective rather than individual) self-interest can do the trick. More pessimistic, and probably more realistic observers believe that some coercion will be necessary: that countries should be able to impose a temporary standstill (perhaps only after receiving a seal of approval from the IMF) under which short-term liabilities would be rolled over rather than repaid. Such a standstill might actually be welcomed, or at least accepted, by the creditors.
The main appeal of such proposals, I believe, is that they seem to deal with capital flight in a manner that does not violate the basic principle of freedom of contract - that does not invoke the dreaded specter of capital control. After all, it is standard practice for firms threatened with bankruptcy to ask for patience on the part of their creditors, and if they cannot get it, to seek temporary court protection. So why not countries? However, on closer examination the apparent advantages of such schemes turn out to be largely illusory.
First of all, a country is not a company. Specifically, the debts we are talking about are, in most cases, private rather than public. (This is one of the ways in which the current difficulties are very different from the debt crisis of the 1980s). And in a crisis - when private investors, foreign and domestic, fear a devaluation of the currency - those who owe these foreign currency debts will, in general, want to repay them as soon as possible. For example, a Brazilian company that has short-term dollar debts, and fears a devaluation of the real in the near future, will be eager to borrow more reais and pay off its dollar debts in advance of that devaluation. So an effective standstill on debt will in fact mean forcing domestic private debtors to roll over their debts - in effect, a kind of capital control.
Second, and more important, a standstill on debt repayments blocks only one channel of capital flight; in an economy with full currency convertibility, there are many others, since anyone who expects devaluation and has access to domestic currency can convert it into foreign. To take only one of many examples: suppose that foreign hedge funds have engaged in the carry trade, borrowing in dollars or yen to buy high-interest domestic securities; and now, fearing devaluation, decide to unwind their positions. The initial positions of the funds will not produce any domestic foreign-currency debt; nonetheless, the unwinding of those positions will produce a rapid drain on foreign exchange reserves. Nor need the problem be limited to foreign hedge funds: a domestic investor could equally well decide to dump or borrow domestic securities and buy dollars, with the same effect. Not to put too fine a point on it: the clear and present danger in Brazil is not that foreign banks will withdraw their credit lines, but that Brazilian holders of short-term government debt will refuse to roll it over, and buy dollars instead. It is hard to see how a gentlemen's agreement by foreign banks, or even a debt moratorium, would make much difference.
One side implication of this analysis, incidentally, is that Chilean-type capital inflow controls may do little good, even if they succeed in limiting the amount of short-term foreign- currency-denominated debt. The point is that as long as free capital mobility and convertibility are maintained, the absence of such debt offers scant protection against speculative attack.
In short, the appeal of measures that address the problem of foreign-currency debt, but leave domestic residents free to engage in capital flight, seems to me at least to be based on a failure to think the matter through. If countries did not have full convertibility, so that external debt was in effect sovereign (because it could only be repaid if the government made the foreign exchange available) that would be a different matter. But the idea that such procedures offer a way to save full convertibility seems confused.
So what options remain? If one still wants a defense against capital flight, either capital movement must be controlled directly, Malaysian-style; or (my preferred version), a country must impose surrender requirements on export earnings, and in turn sell that foreign exchange only for current-account purposes (imports and debt service). In the latter case capital export need not be made illegal; indeed, the natural thing would be to allow a dual exchange rate regime to develop.
I would summarize the current state of debate as being one in which a growing number of reasonable people now agree that the demands the financial markets place on countries in crisis are impossible to meet, but still believe that imposing currency or capital controls is unthinkable. They are therefore looking for some palatable middle ground. Unfortunately, that middle ground does not exist.