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  • Action for Economic Reforms

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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