The gathering support for capital controls devaluation of the bolivar is imminent.
devaluation of the bolivar is imminent. Colombia already has devalued its currency, in
by Robert Wade , Frank Veneroso
The authors trace the evolution of the East Asian financial crisis. They think controls on
the flow of capital would have mitigated the current crisis.
We may well be on the verge of a world slump. The Thai crisis of July 1997 soon became
the Southeast Asian crisis, then in October turned into the Asian crisis, and now has
become the Great Asian Depression. The sudden intensification of insecurity and poverty
that confronts hundreds of millions of people in Asia makes this one of the worst
economic calamities of the twentieth century. Spending on education, health care, and
social welfare is shrinking rapidly, creating gaping "social deficits." The abrupt shift to
negative growth in what had been the world's fastest-growing region has sent a
contractionary wave coursing through the world economy, setting off a cycle of events in
other places.
The Gathering Slump
Commodity prices have fallen to their lowest levels in more than twenty years.(1) From
Venezuela to Chile, Canada to New Zealand, Nigeria to South Africa to Russia - and
places in between - the low prices make it hard to sustain economic growth and public
spending. Commodity producers are experiencing downward pressure on their exchange
rates against the U.S. dollar. They can buy fewer and fewer imports with a given volume
of exports.
The Asian crisis has also triggered a "gestalt shift" in the minds of the owners and
managers of banks, hedge funds, pension funds, and other forms of mobile capital. They
now see danger everywhere. Their defection from one market causes withdrawal from
others. The Morgan Stanley Capital International Index of emerging market stocks
plummeted 33 percent between mid-July and late August. In Europe the effects of events
in Asia have been strong enough to force the Italian central bank to intervene to support
the lira.
On the face of it, the dynamics are peculiar. In normal times short-term capital has an
incentive to move to countries with current-account surpluses and to flee from those with
deficits. Asia is building up huge current-account surpluses. Korea's current-account
surplus, for example, is running at an annualized rate of about 10 percent of gross
domestic product (GDP), which is gigantic. Thailand's is nearly as big. The surpluses are
more a result of import compression than of export expansion. The four worst affected
economies (Korea, Thailand, Malaysia, Indonesia) have undergone import declines of 30-
40 percent in the past year. The reductions reflect deep recessions, which spell debt
default, bankruptcies, still lower domestic interest rates, and possible further "beggar thy
neighbor" currency devaluations.
The Asian surpluses, of course, must be matched by deficits elsewhere. The Western
Hemisphere economies have been thrown into deficit, and Latin America has now
entered a full-blown crisis. To give a few examples: Since June, money has been
withdrawn from Latin American money funds at three times the rate of withdrawal from
Asian and Pacific funds.(2) Venezuela's current account has gone deeply into deficit, and a
early September. The Mexican current-account deficit has widened, and the peso has
fallen against the U.S. dollar. Chile now has a current-account deficit of around 5
percent of GDP and has been devaluing its currency. Even the Canadian dollar has
fallen to its lowest level ever against the U.S. dollar, in part because of the commodity
collapse and in part just because of the prophecy that it would fall. The Organization
for Economic Cooperation and Development (OECD) predicted in early 1998 that in
the coming year Canada would have the fastest growth of any OECD member, a
prediction now seen as wildly inaccurate.
The United States and Europe, at the core of the world economy, have so far benefited
from debt repayments by the rest of the world, as well as by the flight to quality that
boosts the value of their currencies and cheapens their imports. But they are not the
oases of expansion that they appear to be. They are hurtling toward a deficit precipice
as the rest of the world tries desperately to escape difficulties by exporting more to
them and importing less. The U.S. dollar is currently being held a',off by its safe haven
status, making imports cheap and exports expensive. The United States is already
running a current-account deficit of almost 3 percent of GDP. As Asia cranks up its
export machine and as Latin American and Canadian exports become more
competitive at newly devalued exchange rates, U.S. imports will surge again.
At some point, footloose capital will flee a country with so severe a balance-of-
payments disequilibrium and profits squeeze. But the United States has the lowest
aggregate savings rate among the OECD members. It needs foreign savings to sustain
its consumption. It also needs a high stock market for the same purpose. High interest
rates to attract savings may undo the stock market and reduce demand. So even the
United States may succumb to the gathering slump, and Europe as well.(3)
The Crisis of Crisis Management
The crisis is also one of global crisis management. In Asia the International Monetary
Fund (IMF) not only led the international rescue effort but in effect monopolized it,
with conspicuously little regional coordination and with the World Bank and the Asian
Development Bank in distinctly subordinate roles. Japan's August 1997 proposal for a
$100 billion Asia Monetary Fund, with pledges mostly from Japan, China, Hong Kong,
Taiwan, and Singapore, was shot down by the U.S. Treasury, which did not want a
competitor to the IMF outside its control.(4) The Asia Fund could probably have
deterred the currency runs and stopped the crisis from being even a fraction of what it
has become, because speculating against a currency backed by $100 billion is less likely
to be a winning game than speculating against one backed by only $25 billion. The
Treasury's failure to support the Fund was a major mistake in terms not of U.S. foreign
policy goals in Asia but of stopping the crisis.
The IMF, given sole control, pursued a twofold strategy. First, it promoted the idea that
the crisis represented the well-warranted punishment of Asian economies by
international financial markets for the governments' gross mismanagement. As the
IMF's first deputy managing director, Stanley Fischer, kept repeating, the crisis had
"homegrown causes" (that became, in the words of other commentators, "Asian crony
capitalism"). This comment came from the representative of an organization that until
September 1997 lavished praise on these countries' economic performance, which it
attributed largely to their financial liberalization. Second, the IMF mobilized large standby
credits and loans in return for changes in government policies: (1) government guarantees
of private sector foreign debt; (2) domestic demand contraction by sharp increases in real
interest rates and government budget surpluses; and (3) structural reforms, in finance,
corporate governance, labor markets, and the like, going far beyond what was necessary to
stabilize the situation. These reforms were aimed at market-constraining institutional
arrangements of a kind common in major European industrial countries. The Fund would
not dare demand the same of Europe in the unlikely event that crisis-affected European
countries called on it for help. Moreover, the Fund then disbursed the committed funds
very slowly in order to force the restructuring, in its own version of the game of chicken.
The strategy has been criticized from across the political spectrum, especially since it has
not worked. The requirement that the government guarantee foreign private debt, thereby
largely protecting foreign creditor banks from default, encouraged them to go slowly on
rescheduling their short-term Asian loans. This sent local debtors rushing to buy foreign
exchange to cover their increased dollar needs, adding to the downward pressure on the
exchange rate. Also, the insistence on major structural reforms sent a signal that the
economies were basically unsound, redoubling capital exit. The IMF claims that the
situation would have been even worse with any other strategy (such as one that
emphasizes monetary and fiscal stimulus and limits policy reform to those things directly
needed to bring about expansion). But by now the Fund's claims ring hollow. The
organization has lost credibility in the region.
The Swing to Capital Controls
There are three broad ways to escape the depressionary effects of debt and deflation. One
is monetary and fiscal expansion sufficient to devalue or vaporize financial claims through
inflation. This is, of course, not favored by the holders of financial assets or organizations
that represent their interests. A second is bankruptcy and default, which destroys the debt
but at the cost of crisis and collapse. A third is dogged repayment over a long period
accompanied by painful squeeze of the real economy - the "water torture" route. The last
tends to be the preferred option of financial capitalists and of the IMF.
Until recently most Asian governments mostly acquiesced in the IMF's strategy, in part
because they needed the IMF's money and approval, in part because they believed in it.
Now that the cost of this option has become apparent, a policy backlash has begun. It
constitutes what the Wall Street Journal has called "the most serious challenge yet to the
free-market orthodoxy that the globe has embraced since the end of the Cold War."
In the face of steep losses of output and the threat of social unrest, Asian governments
are lowering interest rates and promoting a Keynesian fiscal expansion. Indeed, they are
becoming more interventionist across the board in order to regain control of their
economies. Some have described their actions as a rejection of Anglo-American
capitalism, and they look to China as a model because it has escaped relatively unscathed.
Their turn away from the United States and toward China may have important long-term
implications.
This backlash may be the harbinger of the second stage of Karl Polanyi's "double
movement." Polanyi identified a recurrent pattern in the evolution of capitalism, in
which a period of free market policies gave rise to such instability and inequality as to
trigger a social and political response, resulting in tighter social and political controls
over markets - especially over finance.
In particular, the Asian governments and policy analysts are urgently discussing whether
they should continue to allow financial capital to flow freely across their borders, as the
IMF and the U.S. Treasury have insisted they should. They realize that whatever the
balance between "real" and "financial" causes of the crisis, the capital-account opening
that they undertook mostly in the 1990s is centrally implicated. Capital-account
liberalization first allowed large and uncoordinated inflows and then torrential outflows
in the second half of 1997 and into 1998. The switch in flows between 1996 and 1997
amounted to some 11 percent of the combined GDP of the main crisis-affected
countries. No nation can survive such a whipsaw without great disruption, especially
when weakly institutionalized political structures are unable to support a negotiated
sharing of the burden. China has escaped the direct impact of the crisis largely because
its currency was nonconvertible, preventing both inflows and outflows of hot money
(but not preventing foreign direct investment, of which China has had a great deal).
Much the same applies to India.
Malaysia, which had been among the most open economies in terms of the capital
account, has gone furthest in reintroducing capital controls - explicitly following China.
The new special functions minister, Diam Zainuddin, announced: "Malaysia's new
currency controls are based on China's model."
Western financiers chorused disapproval. Salomon Brothers described the measures
taken by Malaysia's prime minister, Mahathir Mohamad, as "regressive" and "ultimately
destined to failure." Credit Lyonnais Securities (Asia) said that capital controls would
part, Malaysia into "an equity black hole" for foreigner investors. Indosuez W. I. Carr
said the measures make "Malaysia virtually uninvestable."
The underlying assumption is that Malaysia, despite having one of the highest savings
rates in the world (37 percent of GDP in 1995), needs Western finance not only for
immediate refinancing purposes but also in the longer term. "With capital controls
slapped on, many investors will not return to Malaysia for a decade or more, regardless
of how attractive their asset values become. . . . The capital account problems will be
dragged out for many years. Any prospects of getting this crisis over with by 'doing the
right thing' have been shot."(5)
Hong Kong is the most dramatic case. Its GDP is likely to contract more than 4
percent in 1998, and throughout the summer of 1998 its currency (pegged to the U.S.
dollar in a quasi currency-board arrangement) was under intense attack by hedge funds.
In response the government bought up about 6 percent of the stock market in the last
two weeks of August alone, acquiring a national stake in the private sector, at the cost
of 15 percent of its foreign exchange reserves. In particular the government, by
intervening to keep the price of stocks high, showed speculators that shorting stocks
was not a one-way bet.(6) It worked. The hedge funds took big losses and backed off.
Moreover, "after Hong Kong markets shut [on August 28] Hong Kong's financial
secretary, Donald Tsang, said the government would propose new laws to restrict short
selling and stock borrowing, which enable people to bet against stocks. He said it was in
the public's interest to do so."(7) It is ironic that the hedge funds, arch champions of free
financial markets, have driven Hong Kong to adopt policies that resemble those of China
more than those of British colonial Hong Kong - and driven Hong Kong into
dependence on China.
Even Taiwan, which has weathered the crisis better than most others, has seen a 7 percent
drop in its export earnings in the first half of 1998 compared with the first half of 1997,
and a 20 percent stock market descent between March and August 1998. Despite the
country's huge foreign exchange reserves, the New Taiwan dollar also faces intense
speculative pressure. When asked, "Is your currency under pressure from the yen?" the
prime minister replied, "Yes, day after day, day after day."
The government has been intensifying existing controls since May. The central bank
virtually shut down trade in futures instruments used to pressure the local currency. On
September 1 President Lee Teng-hui, meeting with a group of twenty investment
professionals, announced a variety of further interventions. One Taiwan currency analyst
commented, "The president coming out and meeting with brokerages is very rare. The
government is getting serious. They are trying to block speculation as much as they
can."(8)
All along Korea has kept in place some capital-account restrictions on the convertibility of
the won. Also, as noted, Korea is now accumulating huge current-account surpluses. Its
foreign exchange reserves as of August 1998 stood at $41 billion, an all-time record, apd
are projected to exceed the IMF's target of $40 billion by the end of 1998. This reflects,
however, savage import cutbacks, including raw materials and capital goods.
Although the Korean government has not moved to reimpose Malaysian-type exchange
controls, it has become much more interventionist - and much more authoritarian. Many
labor leaders are in jail, and riot police are deployed in force to suppress strikers or
demonstrators against the government. But capital as well as labor is being disciplined.
Potentially the most dramatic development of all may come from the current discussion in
Japan of reintroducing capital controls. A variety of Japanese officials have discussed the
possibility. Japan's vice minister of finance for international trade, Eisuke Sakakibara, said
Japan wants the Group of Seven members to review policies toward capital liberalization.
He admitted that Malaysia's move to impose capital controls has been greeted with
considerable sympathy in some parts of the Japanese government. Also, the Chinese
government has called for Japan to reintroduce some form of capital controls - to take
"measures to limit the flow of yen out of Japan or directly intervene in currency markets."
In short, capital curbs are an idea whose time, in the minds of many Asian government
officials, has come back.
The Case for Capital Controls
We broadly agree that some forms of capital controls are needed in Asia, but with an
important distinction between two types of control. One is on inflows, especially of
borrowing in foreign currency, and the other is on outflows. It is more difficult to make
controls on outflows effective, especially in the midst of crises. Over- or underinvoicing
is a favorite technique for getting money out, because it is difficult to police. Inflows
are much easier to control. There are plenty of ways in which hedge funds and
portfolio investors can be discouraged from coming in. Chile's inflow controls require
investors to leave a portion of their funds with the central bank for a minimum period
without interest before they can put them to use. The sooner the funds are taken out of
the country, the higher the effective tax. Malaysia's Mahathir holds up Chile as a model,
for all that he is presented in the West as "severing Malaysia's ties to world markets."
We argue that (with the important exception of Japan) there is a stronger case for
inflow controls, of a semipermanent kind, than of controls on outflows.
Countries like Korea and Thailand that are racking up huge trade surpluses
accompanied by foreign exchange inflows can probably lower domestic interest rates
and generate monetary expansion without appreciably weakening their currency. Most
of the "hot" money that went into emerging Asia in the 1990s has now left, so controls
are not needed to prevent further outflows of institutional funds.
But we believe that exchange controls or other forms of capital controls are
nevertheless needed for two reasons. One is to avoid getting into such messes in the
future - to protect against excessive inflows. Here we need to distinguish between three
types of inflows: first, short-term capital to refinance foreign loans until current-
account surpluses grow to the point where the loans can be paid back; second, foreign
additions to domestic savings available for investment (including foreign portfolio
investment); and, third, foreign investment that accompanies technology, capital
equipment, and management and marketing expertise. These economies do need
immediate help in refinancing their top-heavy foreign debt, and they do need
technology, capital equipment, and some kinds of foreign expertise. But they will not
need the huge inflows they had been receiving of our type-two short-term financial
capital. They have the highest savings rates in the world and account for more than half
of world savings. East Asia and the Pacific saved an average of 38 percent of GDP in
1995, compared with South Asia's 20 percent, Latin America's 19 percent, and the high
- income countries' 21 percent.
As many critics of the Asian model have pointed out, these countries overinvested in
some manufacturing sectors and in essentially speculative ventures in real estate,
infrastructure, and equities, resulting in inefficient investment, asset bubbles, credit
excesses, and exchange rate overvaluation - the ills that led to the current crisis. They
have not been able productively to absorb even domestic savings, let alone extra
foreign savings. It is ironic that most of the critics who point to excessive, crony-
steered investment as the root of the crisis insist that Asia will suffer if it limits inflows
of short-term financial capital.
Capital controls are also needed to make the economies less vulnerable to the whims
and stampedes of portfolio managers and, more generally, to reestablish fast growth.
The earlier success of these economies was predicated on firms' being able to borrow
heavily in order to finance investment. This mechanism has to be restarted, but now
with much less foreign borrowing. Firms cannot carry high ratios of debt to equity if
they are subject to the financial shocks generated by free-market inflows and outflows
of capital. Eventually equity markets will develop to the point where they can supply more 5. Bridgewater Associates, "Capital Controls: The Latest Shoe to Fall," Bridgewater
investment financing, but the crisis has set back the development of equity markets by Daily Observations, September 8, 1998.
many years. 6. Speculators were borrowing stocks they did not own - from an investment bank with
Japan may well need exchange controls. An aggressive monetary policy sufficient to jump- a stock lending operation - and selling the borrowed stocks the expectation of later
start demand requires negative real interest rates, which necessitates nominal rates much repaying them at a lower cost.
lower than foreign rates. At some point the disincentive of keeping savings at home will 7. Bloomberg, Hong Kong, August 28, 1998.
outweigh the risks of a Wall Street crash and a dollar crash. There is now a large potential 8. "Taiwan President Mulls Further Intervention to Boost Stocks," Bloomberg, Taipei,
for savings exports to occur. Until as recently as April 1998 such financial exports were September 1, 1998.
restricted. In April they were allowed as part of the first stage of "Big Bang" financial ROBERT WADE is professor of political science and international political economy
liberalization. The financial outflows since then have contributed to yen weakness. More at Brown University. FRANK VENEROSO is an investment adviser and head of
aggressive monetary expansion would likely cause more outflows and further yen Veneroso Associates, Portsmouth, New Hampshire. This paper is adapted from "The
depreciation, which could destabilize other currencies in the region. Gathering World Slump and the Battle over Capital Controls," New Left Review 231
In short, japan needs exchange controls to stop yen depreciation in response to monetary (September/October 1998).
expansion. Many argue that such controls will not work. But the recently relaxed exchange Publication Information: Article Title: The Gathering Support for Capital Controls?.
controls did work and could be made to work again. Contributors: Frank Veneroso - author, Robert Wade - author. Journal Title: Challenge.
There is no doubt that capital controls have costs - not least in the army of people needed Volume: 41. Issue: 6. Publication Year: 1998. Page Number: 14. COPYRIGHT 1998
to administer them and the difficulty of plugging leaks on outflows. Malaysia and other M.E. Sharpe, Inc.; COPYRIGHT 2002 Gale Group
countries may be able to clamp down hard for twelve months but later will have to relax
controls somewhat, at which point the hunger for U.S. dollars may destroy the currency.
The battles will continue, but now less one-sidedly than before the Asian crisis. A new
political landscape is emerging. Asian nations led by China and Japan will not readily
accept a further push to liberalize capital. Neither will many other countries now suffering
in the grip of deflationary dynamics, in Latin America, Russia, and elsewhere. The United
States, with a fallen dollar and stock market, will carry less clout. Many on Wall Street will
continue to insist, "You need our capital," but Asians will be more confident in saying,
"We have more savings than we can use productively, so no thanks." The battle would be
still less one-sided if those who favor some form of capital controls agree to ban that
phrase and use only "capital prudential regulations" to denote the same thing. After all,
words are weapons, and no one can oppose prudential regulations.
Notes
1. Gary Mead, "Commodity Price Index at 21-Year Low," Financial Times, August 28,
1998, p. 24.
2. Jonathan Fuerbringer, "The Emerging Markets: Uncovering Few True Deals in a
Global Bargain Basement," New York Times, September 6, 1998.
3. On the long buildup to turbulence, see Robert Brenner, "The Economics of Global
Turbulence," New Left Review 229 (May/June 1998): 141, 251-62. Brenner's argument
centers on the growing and long-term overcapacity in manufacturing. The problem has
been made much worse in the 1990s by the slow growth of world demand, resulting
mainly from cuts in government spending and a squeeze on wage growth. This has forced
all countries to orient their economies toward exports in the face of stagnant domestic
markets.
4. Robert Wade, "The Asian Debt-and-Development Crisis," World Development
(August 1998).