Global Trends by Martin Khor

Monday 3 February 2014

Economic turmoil continues

The turmoil of currency decline and capital flight in several developing countries continued, and a re-look into capital controls, Malaysian-style, may be worthwhile.


As the Year of the Horse was ushered in amid Chinese New Year celebrations last week, economic uncertainties continued. 

The turmoil of currency and stock market decline and capital outflows from several developing countries continued into a second week. 

One contributing factor was the decision last week by the United States Federal Reserve to implement the second instalment of its “tapering”, cutting its monthly bond purchase by another US$10 billion to US$65 billion.

The bond purchase is used to massively pump money into the US banking system, and keep interest rates low.

Some of that money has been used by investors to buy shares and bonds in developing countries.  With the phasing out of this scheme, and expectations of higher returns in the US, money is flowing back to the US from the developing countries.     

Particularly affected were Turkey and South Africa, whose currencies were dropping sharply. 

The two countries raised interest rates (Turkey by a large amount) last week as a response, but it did not sufficiently check the downward trend.

Currencies were also weakening in other countries, including Russia, Brazil and Argentina.  India also raised interest rates, and its rupee stabilised.

In the past year, the currencies of major countries like Indonesia, India, Brazil, South Africa and Turkey have fallen by 15 to 20 per cent against the US dollar, and the turmoil in the past two weeks had added to this trend.

Policy makers face a dilemma or trade off.   To stave off further currency decline and capital outflows, they decide to raise interest rates (hoping to retain the country’s attractiveness to investors and local savers).

The increase in rates serve another useful objective, to reduce inflationary pressures. 

However, the rise in interest rates has the negative effect of also putting a brake on economic growth, especially if the rate increase is significant.

This is because it is more costly for businesses to borrow to invest and for consumers to borrow to spend.

The deterioration in the real economy (or expectation of this) can offset the investors’ incentive to retain their assets in the country.  If so, the capital outflow and the fall in currency will continue.

Capital flight may come not only from foreigners but also residents.  How to maintain the confidence and funds of locals is equally important.

A country facing currency fall and capital flight that drains the foreign reserves to dangerously low levels can consider capital controls.

When too much hot money is flowing into the country, controls over capital inflows is quite commonly used.

However, in the present situation when countries instead face excessive outflows, it is control or restrictions over capital outflows which may be needed.  These are more rarely used.

Malaysia provides a good example of selective capital controls over outflows that worked successfully during the 1997-99 crisis.

An International Monetary Fund (IMF) working paper published in January cites the Malaysian case as an exception of capital controls on outflows that worked.

“Following a tightening of restrictions in September 1998, capital flight came to a halt, allowing reserves to rise back to pre-crisis levels, the exchange rate to stabilise, and interest rates to fall,” according to the paper, Effectiveness of Capital Outflow Restrictions.

The Malaysian policies should be studied by countries that today face a similar crisis.  These are countries with significant current account deficits, thus making them dependent on large inflows of foreign capital to finance these deficits.

When global conditions are favourable, the inflows continue, and make the country more dependent.

When conditions change (as is now happening), the country is vulnerable to a reduction or stoppage of inflows or worse still to large capital flight.

Interest rate hikes may not be enough and in any case could induce a recession.  In such a situation, especially when reserves are running low, a resort to capital controls may be needed.

The restrictions must however be administered properly and selectively, with the right accompanying policies, and the country must be prepared for bad media coverage and a negative market response for some time.

The policies may then work, to stem capital flight, stabilise the currency exchange rate, save the country from the emptying of reserves that necessitates an international bail out, and allow the country to set interest rates at a level that facilitates economic recovery and growth.

This, in any case, was the Malaysian policy and experience which is worthwhile for other countries, especially those facing financial turmoil or crisis to reflect upon.