SYNOPSIS: Among other things, examines Krugman's apostatic call to impose temporary Capital Controls.

By Martin Khor

Director, Third World Network



On 1 September 1998, Malaysia became the first Asian country affected by the economic crisis to announce the new track of imposing foreign exchange controls in a bold attempt to lay the ground for a recovery programme. Until recently capital controls were a taboo subject. With its action, Malaysia broke the policy taboo, whilst only a week earlier the American economist Paul Krugman broke the intellectual taboo by advocating that Asian countries to adopt exchange controls.

The Malaysian move involved measures to regulate the international trade in its local currency and regulate movements of foreign exchange aimed at reducing the country's exposure to financial speculators and the growing global financial turmoil.

The new Malaysian policy package included:

** The official fixing of the ringgit at 3.80 to the US dollar, thus removing or greatly reducing the role of market forces in determining the day-to-day level of the local currency (the ringgit's value in relation to currencies other than the dollar will still fluctuate according to their own rates against the dollar). This measure largely removes uncertainties regarding the future level of the ringgit.

** Measures relating to the local stock market, including the closure of secondary markets so that trade can be done only via the Kuala Lumpur Stock Exchange (this is to prevent speculation or manipulation from outside the country); and the measure that non-residents purchasing local shares have to retain the shares or the proceeds from sale for a year from the purchase date (this is to reduce foreign speculative short-term trade in local shares).

** Measures to reduce and eliminate the international trade in ringgit, by bringing back to the country ringgit-denominated financial assets such as cash and savings deposits via the non-recognition or non-acceptance of such assets in the country after a one-month dateline. (Permission will however be given under certain conditions).

** Resident travellers are allowed to import ringgit notes up to RM1,000 only and any amount of foreign currencies, and to export only up to RM1,000 and foreign currencies only up to RM10,000


** Except for payments for imports of goods and services, residents are freely allowed to make payments to non-residents only up to RM10,000 or its equivalent in foreign currency (previously the limit was set at RM100,000).

* Investments in any form abroad by residents and payments under a guarantee for non-trade purposes require approval.

* Prescribed manner of payment for exports will be in foreign currency only (previously it was allowed to be in foreign currency or ringgit from an External Account).

* Domestic credit facilities to non-resident correspondent banks and non-resident stockbroking companies are no longer allowed (previously domestic credit up to RM5 million was allowed).

* Residents require prior approval to make payments to non-residents for purposes of investing abroad for amounts exceeding RM10,000 equivalent in foreign exchange.

* Residents are not allowed to obtain ringgit credit facilities from non-residents.

** Measures imposing conditions on the operations and transfers of funds in external accounts. Transfers between External Accounts require prior approval for any amount (previously freely allowed); Transfers from external accounts to resident accounts will require approval after 30 September; Sources of funding external accounts are limited to proceeds from sale of ringgit instruments and other assets in Malaysia, salaries, interest and dividend and sale of foreign currency.

In general, the ringgit is still to be freely (or at least easily) convertible to foreign currencies for trade (export receipts and import payments), inward foreign direct investment, and repatriation of profit by non-residents. Convertibility up to a certain limit is also allowed for certain other purposes, such as financing children's education abroad. But convertibility for autonomous capital movements for several purposes not directly related to trade will be limited.

The rationale for the move was explained by the Malaysian Prime Minister Datuk Seri Dr Mahathir Mohamad. Asked by a journalist whether the exchange control measures were regressive, said they were not so, but instead the present situation where currency instability and manipulation was prevalent was regressive. He said that when the world moved away from the Bretton Woods fixed-exchange system, it thought the floating rate system was a better way to evaluate currencies. "But the market is now abused by currency traders who regard currencies as commodities which they trade in. They buy and sell currencies according to their own system and make profits from it but they cause poverty and damage to whole nations. That is very regressive and the world is not moving ahead but backwards."

He added the Malaysian measures were a last resort. "We had asked the international agencies to regulate currency trading but they did not care, so we ourselves have to regulate our own currency. If the international community agrees to regulate currency trading and limit the range of currency fluctuations and enables countries to grow again, then we can return to the floating exchange rate system. But now we can see the damage this system has done throughout the world. It has destroyed the hard work of countries to cater to the interests of speculators as if their interests are so important that millions of people must suffer. This is regressive."

Explaining the move to make the use of offshore ringgit invalid, Mahathir said normally it was offshore ringgit that was used by speculators to manipulate the currency. The speculators hold the ringgit in foreign banks abroad and have corresponding amounts in banks in Malaysia.

Mahathir also said that with the introduction of exchange controls, it would be possible to cut the link between interest rate and the exchange rate. "We can reduce interest rates without speculators devaluing our currency. Our companies can revive. If our currency is revalued upwards, the companies can buy imports as they don't have to pay so much." He added the country would not be affected so much by external developments such as the crisis in Russia.

Asked if the IMF would be unhappy with the measures, Dr Mahathir said the agency's actions had benefitted the foreign companies but were not to the country's interests. "They see our troubles as a

means to get us to accept certain regimes, to open our market to foreign companies to do business without any conditions. It says it will give you money if you open up your economy, but doing so will cause all our banks, companies and industries to belong to foreigners."

He said the Malaysian measures were aimed at putting a spanner in the works of speculators, to take speculators out of currency trade. He added the period of highest economic growth was during the Bretton Woods fixed exchange system. But the free market system that followed the Bretton Woods system has failed because of abuses. There are signs that people are now losing faith in this free market system, but some countries benefit from the abuses, their people make more money, so they don't see why the abuses should be curbed."



The Malaysian measures should be seen as a bold attempt to enable the economy to have a reasonable chance to recover. By restricting the availability of ringgit in offshore markets and restricting the international trade in ringgit, the measures are aimed at greatly reducing the conditions and opportunities for speculators to make profits out of fluctuations in the ringgit's value.

The move to have the ringgit's rate fixed by the financial authorities, rather than by the market, will also restore greater financial stability by reducing the uncertain conditions under which businesses and consumers now have to operate.

Instead of fixing the exchange rate through a Currency Board system (where money supply and domestic interest rates are determined by the foreign reserves and inflows and outflows of funds), Malaysia has chosen the route of controlling the flows of ringgit and foreign exchange.

The great advantage of this approach is that it allows the government greater degrees of freedom to determine domestic policy, particularly in influencing domestic interest rates.

It can now reduce interest rates without being overly constrained by the reaction of the market and by fears of the ringgit falling. Since the introduction of the measures, interest rates have fallen by about four to five percentage points. This has eased the debt servicing burden of businesses and consumers (especially house buyers), and the financial position of banks.

The decision to make ringgit that is held abroad invalid after one month will encourage an inflow of ringgit to return to the country. It will also dry up the sources of ringgit held abroad that speculators can borrow to manipulate the ringgit, for example by "selling short."

No doubt some Malaysians who hold ringgit accounts abroad, or who travel frequently and who need to transfer funds abroad may suffer some inconveniences. But these personal sacrifices can be taken as a contribution to generating some conditions that are needed to get a serious recovery going.

The Malaysian exchange control measures are a response to the basic causes of the crisis afflicting both the country and the region. The crisis began with funds being allowed to freely move in and out of the affected countries. Those countries had recently liberalised their financial systems, allowing locals and foreigners alike to freely convert foreign currency into local currency, and vice versa.

This currency convertibility has been allowed not only to finance current transactions of trade and direct investment (which in the past had also been permitted), but also in the capital account, i.e. for short-term flows such as investment in the stock markets; loans from and to abroad; remittances to abroad by individuals and companies for savings or property purchases overseas.

By introducing this "capital account convertibility", the countries exposed themselves to autonomous inflows and outflows of funds by foreigners and locals, subjecting their local currency to speculation as well as exchange-rate volatility.


The crisis was sparked by speculation and a stampede of foreign funds moving out, followed shortly by locals also sending their money abroad, whilst the local currencies fell sharply.

Now that the countries are in deep recession, capital account convertibility is now causing another equally vexing problem. It has prevented them from taking policies they need for recovery.

A major policy needed is to lower interest rates (to relieve consumers and companies from their heavy debt service burden) and increase its spending (so that there is more demand for businesses and incomes for workers). However they are constrained from this line of action because speculators may again attack the local currency. Also, some residents may be tempted to send more of their savings abroad in search of higher interest rates.

The possibility of funds exiting in an environment of free capital account convertibility of the local currency thus puts a dampener on measures that are needed for a recovery.

Therefore, one logical move would be for the affected countries to partly re-impose some control over the convertibility of the local currency. This could reduce the conditions in which currency speculators can profitably operate, reduce the exit of funds and discourage the inflows of undesirable forms of short-term capital.

Many observers point to China and India as examples of countries that have not been subjected to volatile capital flows and currency instability because they do not allow full convertibility of their currencies.

The lesson is that developing countries that want shield themselvesfor externally-generated financial crises should retain (or regain) some controls over the convertibility of their currency.

However, the option of reintroducing some capital controls has till recently not been openly discussed, because it is considered a "taboo" subject. The prevailing ideology held and spread by the International Monetary Fund and the Group of Seven rich countries is that countries should liberalise their capital account, and those that have done so will suffer damage if they reimpose controls.

Policy makers in the affected countries are worried that if they were to even discuss the advantages of capital control, their country would be black-listed by the IMF, the rich countries and financial speculators. By keeping silent, their countries will continue to be subjected to the views and interests of "market players", suffer the consequences of a relatively high interest rate policy, and be prevented from speedy recovery.





Since Malaysia's announcement, the policy measures have been received controversially abroad. The IMF has in particular been hostile, as well as monetary authorities in many Western countries. The Japanese authorities have however given at least some limited support. Policy makers in many developing countries are closely watching to see if the measures work. If they do, it can be expected that pressures will build for them to also introduce some capital controls.

The International Monetary Fund expressed dismay, stating that in general it believes that "any restrictions imposed on the movement of capital are not conducive to building investor confidence." The IMF, which generally reflects the views of the financial establishment of the rich countries, is the main upholder of the prevailing strong orthodoxy that countries must allow the unrestricted inflow and outflow of capital. It has been advising (and in cases where it provides loans, it has been insisting as a condition for the loans) countries to liberalise and open up their economies to the free flows of funds.

Some analysts, especially those related to investment funds that depend on free capital movements to make speculative or investment gains, have been vitriolic in their criticism. One London-based analyst said Malaysia was now suffering from an "IQ crisis" as the measures were the stupidest action possible.

However there were many bouquets as well. Business groups, consumer groups and trade unions in the country supported the measures and the local stock market went up. Foreign investors in the country, through the International Chamber of Commerce, also expressed support.

The Financial Times, which represents an independent and conservative opinion within the financial establishment, gave guarded support, stating that there was an argument for temporary capital controls in time of crisis.

An editorial noted that some economists argued that controls on short-term capital should be a standard part of policy for emerging markets to avoid destabilising capital inflows and outflows that were at the heart of the Asian crisis.

Controls on short-term capital would give crisis-hit countries great monetary flexibility, making banking reform easier, whilst lower interest rates would give a boost to growth. Without controls, the Asian countries had great difficulty restructuring their banks whilst maintaining tight monetary policies in order to keep their currencies stable.

It cautioned however that capital controls should be temporary and should be used to assist in economic reforms and not avoid them, warning that they are a double-edged sword that create better conditions for reforms but lessen the incentive for undertaking them.



On the academic level, the taboo was broken in August 1998 when the MIT economist Paul Krugman advocated that Asian governments should reimpose capital controls as the only way out of their crisis. Krugman is a renowned trade economist, a believer in free trade, and no wild-eyed radical, so that made his advocacy more newsworthy.

In his Fortune article, entitled "Saving Asia: it's time to get RADICAL", Krugman agrees with the IMF critics that high interest rates imposed by the IMF would cause even healthy banks and companies to collapse. Thus, there is a strong case for countries to keep interest rates low and try to keep their real economies growing. However, says Krugman, the problem is that the original objection to interest rate reductions still stands, that the region's currencies could again go into free fall if the interest rate is not high enough.

"In short, Asia is stuck: Its economies are dead in the water, but trying to do anything major to get them moving risks provoking another wave of capital; flight and a worse crisis. In effect, the region's economic policy has become hostage to skittish investors."

Krugman says there is a way out, what he calls Plan B, "but it is a solution so unfashionable, so stigmatised, that hardly anyone has dared to suggest it. The unsayable words are exchange controls."


Exchange controls, he adds, used to be the standard response of countries with balance of payments crises. "Exporters were required to sell their foreign-currency earnings to the government at a fixed exchange rate; that currency would in turn be sold at the same rate for approved payments to foreigners, basically for imports and debt service. Whilst some countries tried to make other foreign-exchange transactions illegal, other countries allowed a parallel market. Either way, once the system was in place, a country didn't have to worry that cutting interest rates would cause the currency to plunge. Maybe the parallel exchange rate would sink, but that wouldn't affect the prices of imports or the balance sheets of companies and banks."

Krugman points out some problems posed by exchange controls in practice, such as abuse by traders and distortions, so that economists think these controls work badly. "But when you face the kind of disaster now occurring in Asia, the question has to be: badly compared to what?"

Asking why China hasn't been so badly hit as its neighbours, Krugman answers that China "has been able to cut, not raise, interest rates in this crisis, despite maintaining a fixed exchange rate; and the reason it is able to do that is that it has an inconvertible currency, a.k.a. exchange controls. Those controls are often evaded, and they are a source of lots of corruption, but they still give China a degree of policy leeway that the rest of Asia desperately wishes it had.

"In short, Plan B involves giving up for a time the business of trying to regain the confidence of international investors and forcibly breaking the link between domestic interest rates and the exchange rate. The policy freedom Asia needs to rebuild its economies would clearly come at a price, but as the slump gets ever deeper, that price is starting to look more and more worth paying."

A press release by Fortune also said that Krugman warned that if Asia did not act quickly, the crisis could worsen into a depression similar to that experienced in the 1930s, and that IMF programmes that required higher interest rates to stop a currency freefall had made the matter worse. The statement said that being a longtime colleague of IMF deputy managing director Stanley Fisher and US deputy treasury secretary Lawrence Summers, Krugman addresses the awkwardness of proposing such an extremne measure (exchange controls). Krugman discusses the implicit "gag rule" that prevents not only officials but anyone associated with the current strategy (bankers, major institutional investors) from being too vocal about an alternative strategy.

According to a report in the New Straits Times, Krugman in a seminar address in Singapore in August 1998 said that Asian economies were reaching the end of the road and it was time to "do something radical", including implementing foreign exchange controls since pressures on the Asian economies were too high. At the initial stage of the Asian crisis he thought the affected counties were following the right strategy, "but in the last few months I began to wonder whether Asia is on the right track."

Krugman added that after having gone to the IMF and finding that its policies (which he called Plan A) did not work, it was time now for Asian countries to adopt what he termed "Plan B," which comprised foreign exchange control. He noted that China, which had not been fully caught in the regional crisis, had currency controls through the inconvertible capital account. "Chile too has capital inflow control and that is a good idea," he added.

During a TV interview on the CNBC programme Asia in Crisis on 29 August, Krugman explained how he came to the "radical proposal" of Plan B. "We tried Plan A (the IMF prescription of austerity)...but it didn't work, then what do you do? It's hard for the IMF and the US Treasury to admit it was wrong and to do something different. But the time has come. Why did I become a radical? I didn't want to be. But we are in a trap."

Krugman added: "We cannot cut interest rates because the currency may fall and we can't get more IMF funds because the IMF didn't have enough. The only possibility I see is imposing capital controls." These controls would require exporters to sell their earnings to the Central Bank, which in turn would sell the foreign exchange. "It's a dirty word, capital controls, but we need them to get out of the bind."

Krugman is certainly not the first person to advocate capital controls as a part of the solution to the Asian financial crisis. Indeed he is, as he admits, a new convert. But he is such a prominent part of the economics establishment that his proposal can carry weight to break the taboo against considering foreign exchange controls as a serious policy option.

As more economists like Krugman speak up, capital controls are being recognised as a respectable option for governments wanting an effective policy instrument to prevent further financial turbulence.

After the announcement of the Malaysian measures, Krugman published an open letter to the Malaysian Prime Minister stating that he fervently hoped the dramatic policy move pays off. He however warned that these controls are risky with no guarantee for success.

He gave four guidelines, that the controls should aim at minimal disruption of business, that they be temporary, that the currency should not be pegged at too high a level, and that they serve to aid reforms and not be an alternative.



Although the Malaysian policies were the most radical and prominent, indicating a systemic change, some other countries

have also recently introduced measures aimed at limiting the exposure of their markets to speculation and sudden shifts in capital flows. They include Hongkong and Taiwan (which both tightened regulations against manipulation) and Russia (which was forced to default on some of its debts and at one stage suspended all trade in its beleaguered ruble).

Interestingly, although the majority of market analysts and international commentators have condemned the market interventions, some serious and influential components of the economics profession and the Western media have looked more favourably upon the attempts to regulate the financial markets.

This represents the beginning of a shift of opinion, indeed a shift of paradigm, about the net benefits and costs of allowing financial markets to operate in a laissez-faire manner.

Besides Malaysia, two other Asian countries known to be free-market champions also recently took measures to curb speculation.

In September, the Hongkong authorities reportedly spent over US$14 billion to buy shares in the local stock market to prop up the Hang Seng index in an attempt to defeat speculators that had placed heavy bets on a fall in the index.


It also introduced measures to curb the short selling of Hongkong shares. The new rules are aimed against speculators who have been short-selling shares whilst at the same time speculating that the currency will drop. Firstly the stock exchange reinstated a rule that shares in a company can be sold short only when they are rising. Secondly, the exchange also announced it had temporarily banned short sales on the shares of three of Hongkong's biggest companies, HSBC Holdings, HK Telecommunications and China Telecom (Hong Kong). Thirdly, the Hong Kong Securities Clearing Co. increased regulations on settlement of stock trades, giving brokers two days after a deal is executed to deliver the shares. Previously more time was allowed.

According to the Asian Wall Street Journal, this change of rules will hurt speculators who had entered contracts to sell shares short without even having those shares on hand. There have been protest from dealers, investors, analysts, and commentators about how the series of interventions by the Hongkong authorities would cause tremendous damage to Hongkong's free market reputation.

The authorities have however countered that manipulation of the financial markets itself has distorted the market and has to be curbed.

Also in September, the Taiwan authorities took measures to prevent illegal trading of funds managed by George Soros, which have been blamed for causing the local stock market to fall. A report in The Star said a task force was formed to investigate sales and trading by Soros-managed hedge funds via proxy accounts in Taiwanese markets. Although local sales by Soros' funds are banned, at least six local securities firms were selling those funds on proxy accounts, according to officials. The Securities and Futures Commission announced that securities firms would have their licenses revoked and dealers could face two years jail for selling the unauthorised funds.

Meanwhile in Russia, the country's experiment with the free market, lies in tatters, with the government having to announce a default on government bonds and a temporary moratorium on external debt. "Russia's economic upheaval has profoundly shaken the confidence of Russians in the goals of a free-market economy and democracy that the West championed," said an International Herald Tribune article on 31 August. "Perhaps more than an any time in Russia's quest over the last six and a half years to remake itself after the collapse of Soviet rule, the concepts of liberal market reform and democracy are in retreat."

And in a front-page article entitled "Acceptance of capital curbs is spreading", the Asian Wall Street Journal of 2 Sept. said that "the failure of IMF orthodoxy to arrest the contagion sweeping through Asia has made ideas like capital controls intellectually respectable again. Policy makers can't help but notice that China and Taiwan both have capital controls and neither has succumbed to the region's contagion."


The tide that has made an orthodoxy of deregulation and absolute freedom to financial operators is now beginning to turn. Regulation of financial markets and capital and exchange controls have made an entry. With that, the battle between paradigms will be watched closely by the public, the market and policy makers.



The need for developing counties to make use of capital controls to prevent and manage financial crises has also been stressed by UNCTAD (the UN Conference on Trade and Development). In fact, UNCTAD has been the international agency that has consistently been warning about the dangers of financial liberalisation and the risks posed by a policy of allowing freedom for the inflows and outflows of funds.

UNCTAD's Trade and Development Report 1998 published in September 1998 makes a central point that to protect themselves against international financial instability, developing countries need to have capital controls, since these constitute a proven technique for dealing with volatile capital flows.

This is a key part of the report's proposals to prevent and deal with financial crises. The report comes to this conclusion after surveying several other measures (such as more disclosure of information and greater banking regulation) that have been proposed by the industrial countries and the International Monetary Fund. UNCTAD finds these proposals to have merit but inadequate to deal with the present and future crises.

It therefore stresses that developing countries should be allowed to introduce capital controls, as these are "an indispensable part of their armoury of measures for the purpose of protection against international financial instability."

Although it was released on 16 September, the UNCTAD report was finalised in July. The writing of the report thus predates the sweeping capital control measures taken by the Malaysian government on 1 September. The new Malaysian policy seems to be consistent with the rationale and advice provided by the UNCTAD Report, which in turn marks the first time since the Asian crisis began that an influential international agency has called for the use of capital controls.

The Report notes that good economic fundamentals, effective financial regulation and good corporate governance are necessary may be needed to avoid financial crises, but by themselves they are not sufficient.

Experience shows that to avoid these crises, a key role is played by capital controls and other measures that influence external borrowing, lending and asset holding.


Control on capital flows are imposed for two reasons: firstly, as part of macroeconomic management (to reinforce or substitute for monetary and fiscal measures) and secondly to attain long-term national development goals (such as ensuring residents' capital is locally invested or that certain types of activities are reserved for residents).

Contrary to the belief that capital controls are rare, taboo or practised only by a few countries that are somehow "anti-market", the reality is that these measures have been very widely used.

UNCTAD notes that they have been a "pervasive feature" of the last few decades. In early post-war years, capital controls for macroeconomic reasons were generally imposed on outflows of funds as part of policies dealing with balance of payments difficulties and to avoid or reduce devaluations.

Rich and poor countries alike also used controls on capital inflows for longer-term development reasons.

When freer capital movements were allowed from the 1960s onwards, large capital inflows posed problems for rich countries such as Germany, Holland and Switzerland. They imposed controls such as limits on non-residents' purchase of local debt securities and on bank deposits of non-residents.

More recently, some developing countries facing problems due to large capital inflows also resorted to capital controls.

For example, when faced with a surge of short-term capital inflows, Malaysia in January 1994 imposed these capital controls: banks were subjected to a ceiling on their external liabilities not related to trade or investment; residents were barred from selling short-term monetary instruments to non-residents; banks had to deposit at no interest in the central bank monies in ringgit accounts owned by foreign banks; and banks were restricted in outright forward and swap transactions they could engage in with foreigners. These measures were gradually removed from 1995 onwards.

When Chile was faced with large capital inflows in the early 1990s, it took measures to slow short-term inflows and even to encourage certain types of outflows. The main step was that foreign loans entering Chile were subjected to a reserve requirement of 20 percent (later raised to 30 percent). In other words, a certain percentage of the each loan had to be deposited at the central bank for a year, without being paid any interest.

Also to prevent excessive inflows, Brazil in mid-1994 imposed controls such as an increase in the tax paid by Brazilian firms on bonds issued abroad, a tax on foreigners' investment in the stock market, and an increase in tax on foreign purchases of domestic fixed-income investments.


The Czech Republic faced large inflows in 1994-95 and it imposed a tax of 0.25 percent on foreign exchange transactions with banks, and also imposed limits on (and the need for official approval for) short-term borrowing abroad by banks and other firms.


Besides the specific cases above, the UNCTAD Report also lists down examples of capital controls on inflows as well as outflows.

Controls on inflows of foreign direct investment and portfolio equity investment may take the form of licensing, ceilings on foreign equity participation in local firms, official permission for international equity issues, differential regulations applying to local and foreign firms regarding establishment and permissible operations and various kinds of two-tier markets.

Some of these controls can also be imposed on capital inflows associated with debt securities, including bonds. Such inflows can be subject to special taxes or be limited to transactions carried out through a two-tier market.

Ceilings (as low as zero) may apply to non-residents' holdings of debt issues of firms and government; or foreigners may need approval to buy such issues. Foreigners can also be excluded from auctions for government bonds and paper.

UNCTAD also lists other controls commonly used to restrict external borrowings from banks.

They include a special reserve requirement concerning liabilities to non-residents; forbidding banks to pay interest on deposits of non-residents or even requiring a commission on such deposits; taxing foreign borrowing (to eliminate the margin between local and foreign interest rates); and requiring firms to deposit cash at the central bank amounting to a proportion of their external borrowing.

As for controls on capital outflows, they can include controls over outward transactions for direct and portfolio equity investment by residents as well as foreigners.

Restrictions on repatriation of capital by foreigners can include specifying a period before such repatriation is allowed, and regulations that phase the repatriation according to the availability of foreign exchange or to the need to maintain an orderly market for the country's currency.

Residents may be restricted as to their holdings of foreign stocks, either directly or through limits on the permissible portfolios of the country's investment funds.

Two-tier exchange rates may also be used to restrict residents' foreign investment by requiring that capital transactions be undertaken through a market in which a less favourable rate prevails, compared to the rate for current transactions.


Some of these techniques are also used for purchases of debt securities issued abroad and for other forms of lending abroad. Bank deposits abroad by residents can also be restricted by law.

UNCTAD also notes a current trend where accounts and transactions denominated in foreign currencies are increasingly made available to residents.

It says that capital controls can include restrictions on residents' bank deposits denominated in foreign currencies and on banks' lending to residents in foreign currencies.

Such loans and deposits can increase currency mismatching, which is a potential source of financial instability, as it enables large shifts between currencies during crises, putting pressure on the exchange rate and resulting in insolvencies among debtors.

Besides capital controls, UNCTAD also makes two other proposals for better managing external assets and liabilities.

Firstly it warns of the dangers of a country allowing its residents to undertake easy borrowing in foreign currencies, and allowing them to make bank deposits denominated in foreign currencies.

To guard against this UNCTAD says there should be strict enforcement of prudential rules that match the currency denominations of financial firms' assets and liabilities with measures that increase the costs of foreign borrowing (through imposing taxes, special reserve requirements or cash deposits at the central bank).

Also, limits can be placed on bank lending and deposits in foreign currencies.

Non-interest bearing reserve requirements can be imposed on deposits in bank deposits in foreign currencies, thus reducing or eliminating the interest paid on them and diminishing their attractiveness.

Secondly, UNCTAD says the Asian crisis starkly showed the risks of failure to enforce separation between the onshore and offshore activities of a country's banks.

Some countries set up offshore centres whose activities are subject to lighter regulations and some tax privileges.

One such centre, the Bangkok International Banking Facility (BIBF), set up in 1992, was a conduit for funds received from abroad, which were recycled to the domestic market, much of it used to finance speculation in stocks and property. As much of 95 percent of the funds raised by the BIBF was lend domestically.

In contrast, the Asian Currency Units, which conducts offshore banking in Singapore, has stricter rules that restrict the use of the Singapore dollar as an international currency and control the ACU's involvement in domestic banking business. In 1996, 63 percent of the ACU's liabilities were from overseas sources and 42 percent of its assets were loans to banks abroad.

Pointing to this contrast between the Thai and Singapore offshore centers, UNCTAD says it is feasible to have measures that insulate offshore banking from the domestic market, and thus contribute to financial stability.

In conclusion, UNCTAD says recent financial crises and frequent use of capital controls by countries to contain the effects of swings in capital flows point to the case for continuing to give governments the autonomy to control capital transactions.

It questions recent moves in the IMF to restrict the autonomy or freedom of countries to control capital flows.

Ways have not yet been found at a global level to eliminate the cross-border transmission of financial shocks and crises due to global financial integration and capital movements.

Thus, conclude UNCTAD, for the forseeable future, countries must be allowed the flexibility to introduce capital control measures, instead of new obligations being imposed on these countries to further liberalise capital movements through them.

The UNCTAD report has quite clearly made out the case for capital controls. It is important to note, however, that these controls should not be treated as a panacea that by themselves can cure recession ills.

Capital controls can also have some disadvantages, and have their own limitations. They however can be an important part of a set of policies that can protect a country facing a turbulent and hostile external situation, so that it can reduce exposure to financial and economic chaos, at least for some time.



Capital controls are useful especially for preventing a crisis from taking place. However should a country already find itself in a serious debt-repayment crisis, such controls need to be accompanied by other measures, most important of which is an international mechanism for a fair and effective debt workout.

The UNCTAD's Trade and Development Report 1998 makes the key point that countries coming under speculative attack and who want to avoid an uncertain economic recession or collapse may have little choice but to resort to two presently unconventional measures -- capital controls and a "debt standstill" (or temporary stop in servicing external loans).



In a chapter on "the management and prevention of financial crises", the Report says that theoretically there are four lines of defence an indebted country can take if faced with a massive attack on its currency:

** Domestic policies (especially monetary and interest rate policy) to restore market confidence and halt the run;

** Maintain sufficient foreign reserves and credit lines;

** Use of an international lender-of-last resort facility to obtain the liquidity needed;

** A unilateral debt standstill accompanied by foreign exchange restrictions, and initiation of negotiations for an orderly debt workout.

Examining each of these options, UNCTAD finds that although the first three are theoretically possible, in reality they either don't work or are not in existence. Therefore, in the present crisis, the fourth option should be considered seriously.

The first option (tight monetary policy and high interest rates), favoured by the International Monetary Fund, has not worked for ailing Asian countries. On the contrary, says UNCTAD, higher domestic interest rates increase the financial difficulties of the debtors and reduce their incomes and net worth, increasing the likelihood of default. "Thus, they provide no incentive for foreign lenders to roll over their existing loans or extend new credits."

The second option (maintaining high reserves) might work if the reserves are large enough and have been built up through trade surpluses, as a few countries have. But there are many problems if reserves are increased through borrowing: the cost for carrying such reserves would be very high, the reserves may not be enough to stem a big attack or large fund withdrawals, and moreover the borrowed funds in the reserves are also vulnerable to withdrawals.

On the third option, there has not been an international lender of last resort to provide liquidity to stabilise currencies in developing countries facing currency crises. Instead, after the currency has collapsed, there have been IMF-coordinated bailouts.

These bailouts are however designed to meet the demands of creditors and to prevent default, says UNCTAD, and they pose three problems: they protect creditors from bearing the costs of poor lending decisions, putting the burden entirely on debtors; they create "moral hazard" for international lenders, encouraging imprudent lending practices; and the funds needed are increasingly large and difficult to raise.

UNCTAD thus proposes the fourth option: setting up an international insolvency procedure whereby a country unable to service its foreign debts can declare a standstill on payment and be allowed time to work out a restructuring of its loans, whilst creditors would agree to this "breathing space" instead of trying to enforce payment.

What UNCTAD is proposing is actually an extension of national bankruptcy procedures (similar to Chapter 11 of the US Bankruptcy Code) to the international level for countries facing debt difficulties.

Bankruptcy procedures are especially relevant to international debt crises resulting from liquidity problems as they are designed to address financial restructuring rather than liquidation.

In the US Code, no receiver or trustee is appointed to manage the debtors' business and debtors are left in possession of their property. The procedure is to facilitate a three-stage orderly workout.

In stage one, the debtor files a petition and there is an automatic standstill on debt servicing, giving debtors-in-possession a breathing space from their creditors, who are not allowed to pursue lawsuits or enforce debt payment. This prevents a "grab race" by creditors, and the debtor can formulate a reorganisation plan.

In stage two, the Code provides the debtor with access to working capital to carry out its operations, by granting a seniority status to debt contracted after the petition is filed. This debtor-in- possession financing can be granted if approved by the court and does not depend on the existing creditors' agreement.

Stage three sees the reorganisation of the debtor's assets and liabilities and its operations. The plan does not need unanimous support by creditors (acceptance by 50 percent of the creditors in number and two thirds in amount of claims is sufficient) and the debtor can get court approval of the plan.

These procedures are used not only for private debt. Chapter 9 of the US Code deals with public debtors (municipal authorities), applying the same principles as Chapter 11. The recent successful workout of the Orange County debt was under Chapter 9. There are similar arrangements in most other industrial countries.

UNCTAD proposes an international mechanism using the same principles. One suggestion, by K. Raffer in a 1990 academic article, is an international bankruptcy court that applies an international Chapter 11 drawn up in a United Nations treaty.

The court would have powers to impose automatic stay, allow debtor- in-possession financial status and also restructure debt and grant debt relief.

UNCTAD says a less ambitious and perhaps more feasible option is to set up a framework to apply key insolvency principles (debt standstill and debtor-in-possession financing) combined with established debt-restructuring practices, with the IMF playing a major role.


However, there are many objections to giving so much power to the IMF, on grounds of conflict of interest (as the IMF is also a creditor, imposes conditionality, and its shareholders are countries affected by its decisions).

An alternative, which UNCTAD seems to favour, is to set up an independent panel to determine if a country is justified in imposing exchange restrictions with the effect of debt standstills according with the IMF's article VIII, section 2(b).

The decision for standstill could be taken unilaterally by the debtor country, then submitted to the panel for approval within a period. This would avoid "inciting a panic" and be similar to safeguard provisions in the World Trade organisation allowing countries to take emergency actions.

These debt standstills should be combined with debtor-in-possession financing so the debtor country can replenish its reserves and get working capital. This would mean the IMF "lending into arrears."

UNCTAD argues that the IMF funds for such emergency lending would be much less than the scale of bailout operations. The IMF can also help arrange for private-sector loans with seniority status.

As regards government debt to private creditors, reorganisation can be carried out through negotiations with creditors, with the IMF continuing to play an important role of bringing all creditors to meet with the debtor government. For private sector debt, negotiations could be launched with private creditors immediately after the imposition of debt standstill.

The above proposal by UNCTAD has been badly needed. In the absence of such an international system, developing countries have been at the mercy of their foreign creditors and investors, who can suddenly pull out their funds in herd-like manner.

Without protection, these countries first face a liquidity crisis which in turn produces a solvency crisis and then an economic crisis.

If a Chapter 11 type of international bankruptcy procedure is in place, a country facing the imminent prospect of default can declare a debt standstill, get court clearance for protection from creditors, obtain fresh working capital, restructure its debts, and plan for economic recovery which in turn can eventually service the debts adequately.

With such procedures, countries facing a "cashflow problem" can nip it before it worsens and thus prevent a major crisis. Both the debtor country and its creditors gain.

Contrast this with the present messy situation, where in the absence of a fair system, all creditors rush to exit the country, each hoping to recoup its loan before other creditors take out their loans.

And then when the debtor country has its back to the wall, the creditors as a group usually demand, in a restructuring plan, that the government not only pay higher interest on its loans, but also take over or guarantee the payment of the loans contracted by private banks and firms.

It might be argued that a country already near default could unilaterally declare a debt moratorium and then dictate its own terms for debt restructuring. However, few countries have the courage to do so, as the foreign banks may probably gang up and deny any new credit, thus threatening the countries' capacity to pay for essential imports.

Last month, however, a rapidly ailing Russia did declare a moratorium not only on its foreign debt but also on its domestic government bonds (most of which are held by foreign investors), at the same time as floating the rouble, which has since devalued sharply. It is also stating the terms of debt restructuring.

The foreign banks have expressed outrage at these terms and are clamoring to negotiate with the government, even threatening to seize the assets of Russian banks located abroad.

By taking unilateral action, Russia was trying to preempt an even greater crisis for itself, and is forcing the foreign investors and creditors to take their share of the loss.

This on-going drama also shows how necessary it is to have an internationally agreed debt workout procedure. In its absence, the situation is bound to be messy, whether in the case of a country unilaterally declaring a default and moratorium (as Russia did), or in the case of countries that helplessly watch as the foreign creditors pull their money out.

If the rich creditor countries are serious about reforming the global financial system, then the international bankruptcy procedures put forward by UNCTAD (and also by others in the past) should be urgently considered.

For there are many more countries that presently face the threat of capital flight and could be on the brink of debt default. Action should be taken before the financial bleeding spreads to these many other countries.



Given an international environment of big financial players with huge blocs of money for speculation and investment, financially small countries are now subjected to great volatility and financial and economic danger. For instance, the LTCM affair revealed that a hedge fund with $4-5 billion equity could manage to raise so much credit that the banks had $200 billion exposure to it. Few governments can withstand a determined bid by a few big hedge funds to speculate on their currencies and financial markets. And besides the hedge funds are other gigantic investment funds (such as mutual and pension funds) as well as investment banks, commercial banks, insurance companies etc.

The almost total freedom given to international investors and speculators has wreaked financial and now economic and social chaos. The time has now come to regulate these big players.

But there are serious doubts whether there is the political will to act as the financial institutions and those that own and manage them are very powerful and it is in the vested interest of politicians and their parties to cater to these powerful institutions.

Meanwhile developing countries need to protect themselves from the free flow of funds. Capital controls are thus a necessary part of economic instruments that must be an option. In these days of financial turbulence they may even be a necessary option.

This does not mean of course that capital controls by themselves are a panacea or "magic bullet." They should be accompanied for instance by an international mechanism for debt standstill to help seriously indebted countries.

Moreover there are weaknesses and loopholes in capital controls, such as leakages through transfer pricing mechanisms, false invoicing, possible black markets, etc.

Also, capital controls should not merely be a shield for a country to protect itself from having to carry out changes and reforms made necessary by the financial crisis, or reforms that are structurally needed for the longer run.

Thus, the success of efforts to revive a financially economy will also depend greatly on the effectiveness, efficiency and fairness (in burden sharing) of recapitalisation, restructuring and reforms in the financial institutions and corporations.

It will also depend on the right mix of monetary and fiscal policies that can spur recovery without causing greater financial or economic burdens on ordinary citizens, especially the poor.

In other words, capital controls are a necessary but not sufficient condition to protect a country from unresolvable crisis and to enable conditions for recovery. They have to be accompanied by other measures.

On the other hand, the fact that there are weaknesses in capital controls, and that other measures are also needed, does not make capital controls a wrong or evil policy option, as some opponents of capital controls appear to portray them.


Total freedom for capital flows is a principle championed by the big financial players and institutions who stand to gain from extreme financial liberalisation. Capital controls to limit such freedom on the other hand is needed, from a scientific point of view and from the viewpoint of ordinary citizens who need to be protected from predatory speculation and from economic chaos.




Martin Khor

Third World Network

Fax: 60-4-2264505

Email: twn@igc.apc.org