With classic timing on my part, I have chosen the very week that governments in industrializing Asia are imposing capital controls to lessen hot money inflows to disappear into the Malaysian rain forest with my little brother. Unfortunately, this update will be little more than a promissory note in lieu of a longer analysis. Look for a more complete discussion of these new control measures this coming Sunday when we reemerge from our forest retreat. By we, I mean my littlest brother Jake, who is visiting Malaysia for the last two weeks of my grant, and I.
But to tantalize you until Sunday, here is a brief rundown of the recent measures. Last October, you’ll recall that I posted about the renewed interest in using capital controls to slow hot money inflows into emerging market economies in the wake of stagnant growth and low investment returns in Western developed economies (South Korea – which strengthened its controls this past Sunday – is classified as a developed economy hence the “Western” qualifier). My post followed close on Brazil’s decision to impose a tax on portfolio investments and closely preceded a decision by Taiwan and China to restrict foreign access to some classifications of bank deposits. The decision to use capital controls to manage the unprecedented scale of capital inflows to these emerging growth champions last fall was followed this past February by the publication of an IMF Working Paper that analyzed the use of limited short-term controls on capital inflows to manage capital flows – and reached favorable a conclusion regarding their past effectiveness. The Asian Development Bank, often a barometer of opinion among Asia’s bank regulators and financial officials, in its most recent Asian Capital Markets Monitor endorsed use of capital controls to manage inflows, specifically in the context of burgeoning flows to Asia.
The latest development is that today the Bank of Indonesia, under the leadership of Acting Governor Darmin Nasution, announced a series of capital control measures designed to discourage short term investment flows in favor of longer term investments. To encourage a shift toward longer term investments, Indonesia has simultaneously imposed a one month holding period on investments in SBIs (Bank of Indonesia issued short term debt certificates), raised the interest rate on bank deposits with the central bank, and issued longer maturity central bank debt securities. These measures both impose modest penalties on short term investments while increasing the options that investors have for longer term investments in Indonesia. One other aspect of the new control measures that has gone largely unremarked in financial coverage so far is Bank of Indonesia’s decision to decrease the permissible net open FX position for domestic banks. Foreign commentators may be less interested these days in foreign exchange rate risks, especially given renewed speculation about a coming appreciation in the yuan which would most likely strengthen other currencies in the region by proxy, but Indonesian regulators have not forgotten that their country was the hardest hit in 1997 by the Asian Financial Crisis which was significantly worsened by high levels of foreign denominated debt circulating in the domestic economy.
Two quick thoughts on these developments in the world of capital controls before we head for the forest:
First, both the recent Bank of Korea and the Bank of Indonesia announcements strengthening controls in their respective countries were framed from a macro-prudential standpoint using the most cautious and conciliatory language. This is a far cry from the “Measures to Regain Monetary Independence” manifesto that Bank Negara released in Sept. 1998, which at the time was as close to a battle cry as you can muster in the language of central banks. This change in tone reflects both the preventive nature of these controls, which absent an actual crisis can more easily claim an aura of rational calm, and how far accepted wisdom on the use of capital controls has come. Central banks no longer have to declare independence from common wisdom in order to consider capital controls as a precautionary measure.
Second, who and where to next? The first question applies to the other emerging markets that are experiencing large inflows of capital. Malaysia has already largely denied that it is considering capital controls, but it is far from the only other emerging market country that has seen massive inflows seeking higher returns. The second question concerns the impact of these controls on investors’ decision calculus. Will these controls encourage longer term investments in the countries in question, motivate investors to go elsewhere, or merely redirect investors to other non-sovereign short-term investments in the country? Most likely, it will be a mixture of all three. But the answer will also depend largely on the institutional capacity of the countries in question to fairly enforce and monitor the controls and on investors’ confidence that controls will continue to be signaled and impose with similar delicacy in the future. Anyone willing to pick favorites on this one?
Ok, it’s off to the forest! More to come on Sunday!
