Revisiting capital controls

The author is Policy Analyst of Action for Economic Reforms.

The Philippines finds itself today in a conjuncture that makes it
necessary to review the lessons that we were supposed to learn from the
East Asian Crisis of 1997. With a politically charged environment as a
backdrop, the Philippine economy has continued exhibiting disturbing
traits and this has called the attention of not a few economic experts.

Most obvious of these troubling characteristics is the ballooning
budget deficit that is mainly due to poor revenue collection
performance for the past years. Moreover, the stock market has
exhibited much volatility, reflecting the ever-fickle and erratic
behavior of short-term capital flows, more commonly known as hot money.
These two things have undoubtedly contributed to the downward spiral of
the exchange rate between the US dollar and the Philippine peso, which
undoubtedly is being exacerbated by political woes and uncertainty.

These have led UP Sociology professor Walden Bello to remark in
BusinessWorld a fortnight ago that the Philippines may in the short
term be facing a “Brazilian scenario.” As Professor Bello put it, “we
must protect ourselves from a destabilizing capital flight…by
enacting capital controls now.” It may be useful then at this point to
revisit past lessons that had been so painfully taught to us by the
East Asian Financial Crisis and reconsider the issue of capital
controls and other strategies that may help our economy cope with
today’s most pressing challenges.

At the outset, it must be stressed that the problems that we face today
in our economy do not occur in a vacuum and must therefore be taken in
the larger context of the issues that challenge the global economy as
well. A paper entitled “The Case for Capital Controls” (2000) by James
Crotty, a professor of Economic in the University of Massachusetts,
identifies several such related problems, and of which I cite two that
are most relevant to our domestic context.

First, the excessive liberalization of capital accounts has created
ever more frequent and ever deeper boom-bust cycles for many economies.
The 1997 East Asian financial crisis is a clear testimony to this fact.
That it spread like wildfire to Russia, Brazil, and arguably even
Turkey fortifies this conclusion even more.

Second, the dwindling regulation by the state of such cross border
capital flows and the resulting swelling in the magnitude and
acceleration of these movements have all but nullified the autonomy of
domestic economic policies needed to address problems and
vulnerabilities in the domestic economy. Lowering of interest rates for
example, along with using deficit spending to boost the domestic
economy, are policies that are often punished by capital flight, thus
resulting in higher interest rates and possibly triggering exchange
rate crises. As such, these expansionary policies no longer reside in
the state’s economic policy toolbox.

Indeed, these two have been identified as the greatest costs of having
liberalized our economy’s capital account. Building upon these, in a
paper entitled “Capital Account Controls and Related Measures to Avert
Financial Crises” (2002), Ilene Grabel of the University of Colorado
identifies the risks of excessive capital account liberalization which
imperils many developing country economies today. These are currency
risk, referring to the increased probability of a sudden decline in the
value of a county’s currency; flight risk, which refers to the
likelihood that holders of liquid financial assets will sell their
holding en masse in the face of rightly or wrongly perceived
difficulty; fragility risk, or the vulnerability of domestic borrowers
to shocks that may jeopardize their capacity to meet obligations, as in
for example when a maturity mismatch occurs between a country’s
short-term liabilities and its foreign currency earning assets;
contagion risk, which largely refers to Professor Crotty’s first point;
and finally, sovereignty risk, or the danger that states will face
constraints on its ability to pursue independent economic and social
policies lest it be punished with a financial crisis. This last one is
the Brazilian scenario that we must avoid, according to Professor Bello.

These increasingly apparent problems and risks to capital account
liberalization have led many economists and policy makers to conclude
that in truth, the costs of excessive capital account liberalization
far outweigh the benefits that it brings. To insulate an economy from
these threats, they have also argued for the reimposition of government
control over short-term, cross-border capital flows. Professor Bello,
in his column, argues precisely for such controls, and so have many
leading economic thinkers like Nobel Laureate Joseph Stiglitz, Harvard
Professor Dani Rodrik, and University of Cambridge Professor Ajit
Singh, to name just a few. Indeed, even staunch advocates of swift and
comprehensive capital account liberalization like the economists at the
IMF have in recent years admitted to the perils of such, and in fact
have even hinted at the need for some degree of prudential regulation
for capital flows.

There is undoubtedly a strong case on the side of arguing for the
imposition of capital controls as the Philippine economy teeters
towards possible disaster. The currency risk that we face is quite
significant, and in fact has already been manifesting itself in the
foreign exchange market.

However, while there is some degree of consensus in academic and
policy-making circles as to the need for such controls and regulatory
measures, divergence in opinion plagues the task of designing proper
mechanisms to safeguard the economy from the risks of hot money. This
is perhaps the most important factor why many economies, while
admitting that they need some degree of insulation from hot money, have
yet to institute any form of regulation or control thereof.

A recent joint work of three prominent heterodox economists outlines
the options for regulating capital flows that are available to
countries today. Gerald Epstein of the University of Massachusetts,
Ilene Grabel, and Jomo K. Sundaram of the University of Malaya assert
in “Capital Management Techniques in Developing Countries: An
Assessment of Experiences from the 1990s and Lessons for the Future”
(2003) that by using capital management techniques, or quite simply
put, a strategy that employs the traditional menu controls on capital
flows as well as certain types of prudential financial regulations, a
government may be able to reduce the risks and vulnerabilities that
plague its economy due to its open capital account.

In particular, capital controls are those measures which seek to manage
the volume, composition, and or allocation of international private
capital flows. Such controls may be in the form of price-based
measures, a la the Keynes tax, or a tax on securities transactions, or
a Tobin tax, a tax on currency exchange transactions. They may also be
quantitative in nature, such as limits on short-term sales of
securities abroad, or the Chinese restriction on the types of
securities that may be owned by nonresidents.

Moreover, these capital controls may be static or dynamic in nature.
Static capital controls are those that policy makers do not alter in
response to changed circumstances. Minimum stay requirements for
foreign direct investments and portfolio investments is an example of
such a control. On the other hand, dynamic capital controls are those
which are initiated and/or adjusted in response to changes in the
economic environment. These types of controls have become more
popularly known as “trip wires and speed bumps,” where you have “trip
wires” or pre-determined indicators that are appropriately sensitive to
subtle changes in the risk environment, and speed bumps or controls
that will be kicked into effectivity in order to reduce and control the
risk exposure. An example of such would be using the ratio of foreign
currency-denominated debt to domestic currency-denominated debt as an
indicator for locational mismatch in a country’s debt exposure, and the
appropriate restriction on debtor behavior needs to be put in place.

Prudential regulation of the financial sector, on the other hand, is
yet another policy tool that may help protect an economy from the
downside risks of capital account opennes. Prudential regulation refers
to policies that seek to strengthen and stabilize the domestic
financial sector and are oft called the “market-friendly approach” to
regulating hot money. Examples of such are reserve requirements for
foreign-denominated loans, with short-term loans requiring a higher
reserve ratio.

Indeed, the menu of options for controlling capital flows is
wide-ranging, and it is not hard to understand why the debate as to
which are the appropriate controls has not abated. What is clear from
the debates, however, is each country needs to evaluate the risks that
it faces and according to these risks, design policy controls that
would be most responsive and appropriate given their domestic context.
Moreover, these regulations are not mutually exclusive to each other,
and as a matter of fact, by maintaining a program of complementary
capital management techniques, one can reduce the required severity of
any on technique and even magnify its effectiveness.

All this however is not to say that skeptics no longer abound. The more
fiercely ideological of economists have remained unconvinced about the
benefits and wary of the costs of capital management techniques.
Moreover, the typical distrust of authorities’ capacity and motivations
also make many doubtful of the viability of implement these controls.

Nevertheless, it must be noted that not a few countries have
successfully been able to design and implement techniques that
successfully altered and modified the risks that their economies faced.
Chile, for example, imposed a one-year minimum residence requirement
for all foreign direct and portfolio investments, while at the same
time instituting a 30% unremunerated reserve requirement for all
foreign currency liabilities. These controls along with several other
regulatory mechanisms served to improve the composition and maturity of
capital inflows to the Chilean economy, stabilized the currency, and
reduced the risk of contagion, especially in light of the crises-ridden
Mexican economy. Other examples may be found by looking at Colombia,
Malaysia, Taiwan, and Singapore.

These countries’ experiences are proof that capital management
techniques are indeed viable and effective in achieving their
objectives. It may do Philippine policy makers well to review these
lessons from past financial crises and take the necessary steps to
avert danger.

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