Tide turning on financial 'free market'

The recent introduction of capital controls in Malaysia was the biggest blow so far against the orthodoxy of laissez faire and total freedom for financial markets. With Hong Kong and Taiwan also acting against speculation, and Russia's experiment with the free market in tatters, the tide has begun to turn against the inflexible free-market approach. Will a new paradigm emerge?

by Martin Khor

IS the tide beginning to turn against the financial 'free- market' system that has been dominating the real economies of so many countries that underwent financial liberalisation in recent years?

In the first week of September, Malaysia led the backlash movement - through its imposition of wide-ranging controls over foreign exchange transactions and new rules in the stock market.

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 Hong Kong and Taiwan (which both tightened regulations against manipulation) and Russia (which was forced to default on government bonds and at one stage suspended all trade in its beleaguered ruble).

Shift of paradigm

Interestingly, although many market analysts and international commentators have condemned the market interventions, some influential economists, Western media commentators and international direct investors have looked more favourably upon the attempts to regulate the financial markets.

This could represent the beginning of a shift of opinion, perhaps even a shift of paradigm, about the net benefits and costs of allowing financial markets to operate in a free- wheeling, laissez-faire manner.

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.

  • The measure that non-residents purchasing local shares will not be able to withdraw from the country the proceeds from sale of the shares for a year from the purchase date (this is to reduce foreign speculative short-term trade in local shares).

  • All dealings in securities listed on the Kuala Lumpur Stock Exchange must be effected through the exchange or a stock exchange recognised by the KLSE (this is to bring offshore trading of Malaysian equities, now done mainly in Singapore, back to the local bourse).

  • 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 deadline. (Permission will, however, be given under certain conditions.)

  • For trade settlement, payments for exports will have to be made in foreign currencies.

  • Measures curbing the taking out or bringing in of funds. For instance, Malaysian travellers are limited to carrying RM1,000 when entering or leaving, and to another RM10,000 worth of foreign currency when leaving. Non-resident travellers can take out foreign currencies up to the amount they brought in. There is no limit on import of foreign currencies.

  • Measures imposing conditions on the operations and transfers of funds in external accounts. For example, transfers of ringgit funds between external accounts require Central Bank approval and, after a month, similar approval is needed for transfers to accounts in the country.

  • Stricter controls on payments by residents for investments abroad, credit facilities in foreign currencies, and ringgit securities.

Up to the end of the first week of September, there was still considerable uncertainty over the details of several of the measures, and the Central Bank issued a second statement interpreting some of the rules.

The then acting governor of the Central Bank, Dr Zeti Akhtar Aziz, said foreign direct investors, who are free to repatriate their earnings, are not affected as the controls are aimed at containing the impact of short-term fund flows.


Many brickbats were thrown at the Malaysian authorities for this clear break with financial orthodoxy. 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.'

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 positive responses as well. Business groups, consumer groups and trade unions in the country supported the measures.

Significantly, the Malaysian International Chamber of Commerce and Industry (MICCI), which represents foreign companies in the country, issued a statement saying the currency controls were a good short-term solution to provide the country with breathing space to put its house in order.

'MICCI members would normally find it difficult to approve steps that contravene free-market principles,' said its president Jorgen Bornhoft. 'But the current situation is abnormal. Under the circumstances, the chamber sincerely hopes the measures will achieve their objectives of bringing about economic stability and enable Malaysian organisations to buy time and rebuild their strength.'


The director of the American financial giant, American International Group (AIG) (which has a subsidiary in Malaysia), also expressed support.

In an editorial, the Financial Times stated that there was an argument for temporary capital controls in times of crisis. It 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 of the kind that was at the heart of the Asian crisis.

It added that controls on short-term capital would give crisis-hit countries greater 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 creates better conditions for reforms but lessens the incentive for undertaking them.

The American economist Paul Krugman published an open letter to the Malaysian Prime Minister stating that he fervently hoped the dramatic policy move pays off.

Krugman, who recently came out in favour of capital controls as a way out of the Asian crisis, however warned that these controls are risky, with no guarantee of success.

He gave four guidelines, namely 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 rather than be an alternative to reforms.

The measures were already having some of their intended effects. Firstly, the ringgit's value was fixed and stable at 3.80 to the dollar as from 2 September onwards. There were slight fluctuations relating to other foreign currencies, reflecting changes in their values vis-a-vis the US dollar.

Secondly, the local stock market reacted positively. After falling on the day of the announcement (1 September) by 13% to 263 points, the KLSE Composite Index climbed by a total of 38% in the next three days to close at 363 points on 4 September.

Reduction of interest rates

Thirdly, the authorities lost no time in sharply reducing the interest rate. The Central Bank on 3 September cut the three-month intervention rate to 8% from 9.5%, which in turn had been revised from 10% a week earlier. Lending rates have also come down correspondingly, easing the debt service burden of companies and consumers.

The easing of monetary policy has become a major priority for Malaysia. The ability to do this without triggering currency depreciation was one of the major reasons for the decision to impose capital controls.

Prior to the capital controls, there had been a policy dilemma involving a trade-off between lowering the interest rate and the maintenance of the currency level. With the introduction of a new policy instrument, i.e. capital controls, the link between the interest rate and the currency rate is cut off, as the currency value is now fixed and there is greater freedom to vary the interest rate.

Whether, and to what extent, the interest-rate reduction will help the economy recover is a development that will be closely watched. If there is some success, the Malaysian measures will become more attractive for other countries facing a similar predicament.

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

The Hong Kong 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.

In the first week of September, they introduced measures to curb the short-selling of Hong Kong 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 of the shares of three of Hong Kong'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 into contracts to sell shares short without even having those shares on hand.

There have been howls of protest from dealers, investors, analysts and commentators about how the series of interventions by the Hong Kong authorities would cause tremendous damage to Hong Kong'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 the first week of 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 last Saturday's Malaysian daily, The Star, on 29 August said a task force was formed to investigate sales and trading by Soros-managed hedge funds via proxy accounts in Taiwanese markets.

Extraordinary achievement

Although local sales by Soros' funds are banned, at least six local securities firms are selling those funds on proxy accounts, according to officials. The Securities and Futures Commission announced that securities firms would have their licences revoked and dealers could face two years' jail for selling the unauthorised funds.

Taiwan's Central Bank has also been taking control measures to keep the Taiwan dollar steady since the regional crisis erupted last year. According to a recent article in the Economist, it has overtly instructed Taiwanese banks not to lend local currency to foreign banks.

The Bank also suspended new issues of local-currency bonds by multilateral institutions such as the Inter-American Development Bank; delayed authorisation of foreign-currency mutual funds; and introduced administrative hurdles to cut the turnover in the interbank lending market by nearly half, to around US$150m a day.

All of this has been designed to prevent capital flight and keep currency out of the reach of foreign speculators, says the Economist, and it has proved successful. After sliding for the past year, the New Taiwan dollar has finally stabilised against the American dollar.

This, adds the Economist, is an extraordinary achievement, given that the island's exporters have been battered by the regional crisis and by the strength of the currency both at home and in China, where many Taiwanese companies do their manufacturing.

Regulations or interventions by the Central Bank include: banning non-delivery forward contracts (the main hedging tool for big Taiwanese corporations) in May; corporate foreign- exchange remittances in excess of US$1m must be reported to the Central Bank (and are likely to be scrutinised for evidence of tax evasion); and Central Bank officials telephoning corporate treasurers to urge them to convert their export earnings into New Taiwan dollars.

Meanwhile, in Russia, the country's experiment with the free market lies in tatters, with the government announcing a default on government bonds, currency trade grinding to a halt for some days recently, a continuous devaluation, a run on the banks and thousands of firms facing bankruptcy.

'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 at 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 September 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.

Martin Khor is the Director of Third World Network.