Capital controls needed to manage crises

by Chakravarthi Raghavan

GENEVA: An intellectual basis for instituting capital and
exchange controls in developing countries that have liberalized
both, and maintaining them where such controls are in place, is
provided in UNCTAD's Trade and Development Report 1998 (TDR).

While these views would once have been dismissed as unsound
and heterodox, the failure to reverse the Asian crisis, its
spread to Russia and other regions, and Malaysia's action to
institute such controls to promote recovery, have led to their
being increasingly favoured by mainstream economists, and even
the IMF and other citadels of orthodoxy, though this is sought
to be qualified by the power to sanction and lift such controls
being vested in the IMF.

Dealing with the management of financial crises, the TDR
notes that the East Asian experience has laid bare certain
weaknesses in the international approach to the management of
crises involving the sudden withdrawal of foreign capital and
massive and sustained attacks on the currency. As a result of
this approach, what appeared to be a liquidity crisis has been
translated into a solvency crisis, through a collapse of
currencies and asset prices. This process hurts not only those
with external liabilities but also the economy as a whole,
owing to its effects on output and employment.

Lines of defence

There are four possible lines of defence against an attack on
the currency: domestic policies, primarily monetary policy;
maintaining a sufficiently high level of precautionary foreign
reserves and credit lines; recourse to an international lender
of last resort; and imposition of a debt standstill and
exchange restrictions, accompanied by initiation of
negotiations for a rapid debt workout.

While under normal conditions, interest rate differentials
and monetary policy can alter the incentives for capital flows,
as events in East Asia have shown, under conditions of panic,
the effects of monetary tightening can be quite different:
interest rate hikes may simply point to declining
creditworthiness and greater default risk. Intensified
difficulties among debtors can eventually lead to exchange-rate
stabilization owing to the resulting squeeze on sales of the
domestic currency, but at the expense of depressing the economy
rather than through bringing back foreign capital.

Maintenance of precautionary reserves or credit lines in
amounts adequate to meet outflows during a currency attack
poses problems of cost and feasibility. Accumulating reserves
for sterilizing some of the capital inflow, involves purchasing
them with the proceeds of domestically issued debt. It entails
two sorts of costs: the cost to the economy as a whole, since
the rate of interest on foreign loans usually exceeds the
return on foreign reserves; and a cost to the public sector,
since the real interest on government debt typically also
exceeds the return on reserves.

Alternative approaches might be to cover the short-term
external liabilities of the private sector by long-term public
borrowing matched by short-term investment abroad, or to
arrange a private lender of last resort. But the borrowing or
credit lines could be very large, especially if allowance is
made also for withdrawals by non-residents from stocks and
bonds. Moreover, a country may not have access to such
borrowing or credit lines, and there is no assurance that
monies under credit lines would be available as needed.
Besides, net costs in both cases could be substantial.

On the international response, the TDR notes that financial
assistance coordinated by the IMF in recent years has usually
come only after the collapse of the currency, and has taken the
form of bailouts designed to meet the demands of creditors and
to prevent defaults.

Such operations have a number of drawbacks: they protect
creditors from bearing the costs of their decisions, thus
shifting the entire burden to debtors and creating moral hazard
for creditors; and by securing ex-post public guarantees for
private debt, they reduce perceived default risks. And more
importantly, the sums required have been increasing and are
reaching the limits of political acceptability in the countries
providing them. This is also one of the main impediments to the
establishment of a genuine lender-of-last-resort facility which
would stabilize currency markets and thus avoid the
transformation of currency attacks into solvency crises.

In the absence of timely provision of adequate liquidity to
counter attacks on a currency, a liquidity crisis will
eventually lead to widespread defaults and bankruptcies, the
TDR notes.

Standstill principles

The most effective way to prevent such an outcome would be
through the extension and application of insolvency principles
such as those in Chapter 11 of the US bankruptcy code. Based
on the premise that the value of a firm as a going concern
exceeds that of its assets in the event of liquidation, those
principles are designed to address financial restructuring
rather than liquidation. The procedures allow for a standstill
on debt servicing in order to provide the debtor (who is left
in possession) with breathing space from its creditors, and so
prevent a "grab race" for assets that is likely to be
detrimental not only to the debtor but also to unprotected
creditors. The debtor thus has an opportunity to formulate a
debt reorganization plan, and equal treatment for creditors is
also guaranteed. During the reorganization, the debtor is
provided with access to the working capital needed for its
operations, by granting a seniority status to the new debt
contracted. Reorganization is followed by resolution, and
insolvency procedures may accelerate the process by
discouraging holding-out by particular classes of creditors.

The application of such principles to international debtors
was raised in TDR 1986 during the sovereign debt crisis. The
increasingly private character of external debt in developing
countries has not only increased the likelihood of harmful debt
runs and asset-grab races by creditors - and investors - but
has also given greater pertinence to these bankruptcy
principles in the management and resolution of international
debt crises.

However, a full-fledged international "Chapter 11" is
neither practical nor necessary. Article VIII of the Articles
of Agreement of the IMF may provide a statutory basis for the
application of debt standstills through the imposition of
exchange controls if a currency comes under attack, and it can
be combined with the existing practices for restructuring debt
through negotiations.

And while standstills could be sanctioned by the IMF, a
conflict of interest might arise since the countries that would
be affected by its decisions are also its shareholders and the
Fund itself is often a creditor.

"It may be desirable to place standstill authority with an
independent panel whose rulings would have legal force in
national courts. A standstill could be decided unilaterally by
the debtor country facing an attack on its currency, once its
reserves or currency fall below a certain threshold, and then
be submitted for approval to the panel within a specified
period. Such a procedure would help to avoid a panic, and be
similar to GATT safeguard provisions allowing countries to take
emergency actions.

"During the standstill and the subsequent negotiation of a
debt reorganization debtor-in-possession financing could be
provided by IMF 'lending into arrears', which would require
much smaller sums than bailout operations."

Such procedures would meet the need, once again evident in
the East Asian crisis, to safeguard debtor countries from the
over-reaction of financial markets. In the words of the New
York Court of Appeals, which had once ruled in favour of a
debtor government that had imposed a unilateral standstill,
this would be "in entire harmony with the spirit of bankruptcy
laws, the binding force of which ... is recognized by all
civilized nations."

[The court ruling over a Costa Rican standstill was later
reversed at the instance of the State Department, which
insisted on an IMF route to protect its own creditors, and
presented it as the US state policy.]

Inadequate and inappropriate measures

On the issue of preventing future crisis, the TDR notes that
a number of proposals have been made for measures to be taken
at global, national and regional levels. However, global
initiatives regarding the international financial system have
not gone to the root of the problem. On the contrary, some such
initiatives could reduce the autonomy and flexibility of
national policymakers in introducing measures needed to protect
their economies from volatile and speculative capital flows, it

With greater integration of financial markets and increased
scope for contagion, the international surveillance of national
policies has gained added importance in ensuring the stability
of the international monetary and financial system. However, it
has so far been unsuccessful in preventing international
financial crises and currency turmoil; nor is it clear that
recently proposed improvements will lead to more effective

Major financial crises are typically connected to large
shifts in macroeconomic conditions external to countries where
the crisis originated. External factors are as important as
domestic ones in triggering both capital inflows and capital
outflows. However, existing modalities do not address the
problems of policy surveillance due to unidirectional impulses
from changes in the monetary policies of the US and a few other
OECD countries which exert a strong influence on capital
movements and exchange rates. There are no mechanisms under the
existing system of global economic governance for dispute
settlement or redress regarding these impulses.

The focus of attention of the proposed improvements in
surveillance continues to be the role of domestic policies in
generating financial fragility and crisis. However, even in
this more limited area, the record has been mixed, in large
part because of the tendency to ignore that markets can go

While improvements in the timeliness and quality of
information concerning key macroeconomic and financial
variables are essential for effective surveillance, emphasis on
the inadequacy of information as the major reason for the
failure to forecast the East Asian crisis appears misplaced or
exaggerated. Although the crisis has pointed to certain
weaknesses in available information, these did not play an
essential role. Rather, there was inadequate evaluation of the
implications of the available data, including those in the
periodic reports of the Bank for International Settlements
(BIS), for countries' ability to continue to obtain funding
from international financial markets.

Similarly, the contribution to the East Asian crisis of
weaknesses in domestic financial regulation and supervision has
led to increased attention being focused on reform in this
area. However, while such reform can reduce the likelihood of
financial crises, experience indicates that, owing to the
vulnerability of the financial sector to changes in economic
conditions and to unavoidable imperfections in the regulatory
process itself, even a state-of-the-art system of financial
regulation does not provide fail-safe crisis prevention.

There are serious weaknesses in the regulatory framework for
the cross-border lending and investment at the source of such
flows. They have been an important cause of the shifting of a
disproportionate share of the cost of resulting crises onto
debtors. A number of proposals have been made for new rules
and institutions directed at exerting tighter control over
international lenders and investors. While some could be
adopted without major changes in existing institutions and
policy regimes, others would require, to varying degrees, new
and far-reaching international agreements, which might be
difficult to achieve owing to uncertainties with regard to
their effectiveness or to the concentration of power which they
would entail.

Collaboration and consultation at the regional level are
capable of contributing to the prevention of financial crises.
Their potential role is particularly important with respect to
the prevention of currency disorders and contagion effects.
Initiatives in this area, which may involve monitoring
mechanisms or more ambitious arrangements linked to the
provision of mutual external financial support, can benefit
from the long and wide-ranging experience of the European

Exchange rate policies and controls

However, none of these proposals for crisis prevention is
capable of eliminating the need for active national policies in
respect of the balance of payments and external liabilities. In
this respect, exchange rate policies and controls over capital
movements merit particular attention, says the TDR.

There is no reason to condemn managed-exchange-rate regimes
and sacrifice currency stability in the interest of free
capital mobility. The alternative of freely floating rates,
combined with capital mobility, would undermine currency
stability, with attendant consequences for trade, investment
and growth.

A currency board system, the TDR says, can eliminate
problems of debt management due to currency mismatches, and has
proved a useful vehicle in certain countries for halting

"But such systems do not insulate economies from instability
of external origin, since the effects of capital inflows and
outflows are transmitted to levels of economic activity and to
goods and assets prices, and may include threats to banking
stability." But managed-exchange-rate regimes are vulnerable to
large accumulations of short-term external debt and to other
potentially volatile capital inflows. Even if used flexibly,
such regimes are likely to be sustainable only if accompanied
by active management of external liabilities, which may often
entail recourse to capital controls.

Capital controls are a tried technique for dealing with
unstable capital movements. The measures traditionally focused
mainly on cross-border transactions of residents and non-
residents. However, owing to deregulation and recent
developments in banking technique, accounts and transactions
denominated in foreign currencies are now often available to
residents. Since they can affect macroeconomic variables such
as the exchange rate in much the same way as cross-border
transactions, they are also a legitimate target for controls.
Post-war experience has been marked by frequent use of such
controls in industrial countries, and they have also played an
important role in policies adopted by several developing
countries during recent years in response to large capital

The extent of successful recourse to capital controls
suggests that current initiatives aiming to restrict national
freedom of action in this area are inappropriate. The
probability of financial crises can be reduced by better
macroeconomic fundamentals, effective prudential regulation and
supervision of the financial system, and improved corporate
governance. But these entail structural reforms with an
unavoidably long time-scale: in industrial countries, decades
were typically required to complete such reforms and to build
the institutions needed. Moreover, such actions at national
level will not provide fail-safe insulation against currency
attacks, which also respond to conditions in international
financial markets and in the countries of international lenders
and investors. The harm inflicted by currency attacks could be
contained by new arrangements for crisis management such as a
proper international lender of last resort or a framework for
debt standstills and workouts, but these too are powerless to
prevent them from starting and causing damage.

Thus, in the absence of global mechanisms for stabilizing
capital flows, controls will remain an indispensable part of
developing countries' armoury of measures for the purpose of
protection against international financial instability, so that
for the foreseeable future, flexibility regarding governments'
options rather than the imposition of new constraints is
required. (Third World Economics No. 193, 16-30 September 1998)

Chakravarthi Raghavan is the Chief Editor of the South-North
Development Monitor (SUNS)from which the above article first appeared.