VI Experience with the Use of Capital Outflow Controls in the Context of Financial Crises
- Akira Ariyoshi, Andrei Kirilenko, Inci Ötker, Bernard Laurens, Jorge Canales Kriljenko, and Karl Habermeier
- Published Date:
- May 2000
Malaysia is a highly open economy; and its approach to economic development has traditionally included the liberalization of capital flows.39 Following the periodic reviews of exchange controls and their elimination in 1986–87 and 1994–96, the capital account was generally opened. Portfolio inflows were free of restrictions; portfolio outflows were also free except for resident corporations with domestic borrowing; and no restrictions, except for net foreign exchange open position limits, applied to banks’ foreign borrowing or lending in foreign exchange. Net open positions, however, were monitored closely and residents’ foreign currency borrowing was subject to limits. Borrowing in excess of these limits required approval, which was conditional on a project’s foreign exchange earning potential. Cross-border activities in ringgit were also treated liberally, including the use of ringgit in trade, financial transactions with nonresidents, and offshore trading in securities listed on local exchanges. As a result, an active offshore ringgit market developed, with the bulk of ringgit cross-hedging taking place offshore. Until 1997, local banks could provide forward cover against ringgit to nonresidents, facilitating arbitrage between domestic and offshore markets.
Following the onset of the Asian crisis, the ringgit came under significant pressure in 1997, along with the other currencies in the region. The crisis revealed structural weaknesses in the region’s banking systems and led to a general reassessment of regional lending risks. Offshore currency traders took short positions in ringgit in anticipation of a depreciation; and offshore ringgit rates increased relative to domestic rates, inducing an outflow of funds. The authorities temporarily broke the link between the domestic and offshore rates by imposing limits on ringgit non-trade-related swap transactions with nonresidents (August 1997), but outflows continued through various unrestricted channels to take advantage of the large interest differentials created by the swap limits.40 The flow of ringgit funds offshore led to an increase in domestic rates, accelerating the economic contraction and exacerbating the difficulties in the corporate and banking sectors.
Against this background, and after substantial amounts of capital outflows had already taken place, the authorities imposed a number of administrative exchange and capital control measures in September 1998, aimed specifically at containing ringgit speculation and the outflow of capital by eliminating the offshore ringgit market and at stabilizing short-term capital flows. The measures also sought to increase monetary independence and insulate the economy from the prospects of a further deterioration in the world financial environment. The authorities were concerned that, otherwise, interest rates would have to be kept high for a prolonged period, with harmful effects on economic activity and the banking system.
The measures were designed to eliminate all potential avenues for taking speculative positions against ringgit. Though they excluded foreign direct investment flows and current international transactions, they closed all channels for the transfer of ringgit abroad, required repatriation of ringgit held abroad to Malaysia, blocked the repatriation of portfolio capital held by nonresidents for 12 months, and imposed restrictions on transfers of capital by residents. The controls were supported by additional measures to eliminate potential loopholes (prohibiting the trading of ringgit assets offshore, announcing demonetization of large denomination ringgit notes, and amending the Companies Act to limit dividend payments). The authorities also pegged the ringgit to the U.S. dollar (following a managed float since July 1997), further relaxed monetary and fiscal policies to support economic activity, and accelerated the financial and corporate sector reforms that had commenced in early 1998 to deal with the weak financial institutions and strengthen the banking system.
On February 4, 1999, the authorities replaced the 12-month holding restriction on repatriation of portfolio capital with a declining scale of exit levies. The levy applied to principal or profits of nonresidents’ portfolio investments, depending on whether the funds were brought in before or after February 15, 1999, respectively, making it possible to withdraw funds while penalizing early withdrawals. The authorities noted that the rules were meant to “encourage existing portfolio investors to take a longer view of their investments in Malaysia, attract new funds into the country, while at the same time discouraging destabilizing short-term flows.” In addition, “the rule was designed to allow smoother outflow of funds, rather than a sudden and massive outflow upon the expiry of the one year holding period” in September 1999.
The exit levy on profits from portfolio investments exempted dividends, interest earned, and proceeds related to current international transactions and foreign direct investment flows. Certain investments in growth and technology shares listed in a separate stock exchange were also exempted. Hence, the levy is expected to fall primarily on capital gains in equity investments. Other forms of portfolio capital flows (including nonresident investments in short-term instruments, bank deposits, bonds, derivatives, and property investments) will be less affected, as interest payments comprise a larger share of the return on such investments. This suggests that the profit levy may provide only limited protection from volatile flows.
It is difficult to disentangle the impact of Malaysia’s capital controls from broader international and regional developments, since the pattern of Malaysia’s economic performance from the onset of the crisis has in many respects been similar to that of other countries in the region. Nevertheless, preliminary evidence suggests that the controls have been effective in eliminating the offshore ringgit market, which was the locus of much of the speculative activity. In conjunction with the 12-month holding period and restrictions on resident outward investments, the suppression of the offshore ringgit market effectively constrained capital outflows.41 Speculative pressures on the ringgit have been absent since the controls were imposed. Thus far, there is also no sign that parallel or nondeliverable forward markets are emerging, and there have been relatively few reports of circumvention. Preliminary indications are that the exit levy may have contributed to an improvement in investor confidence, as market participants viewed the levy (a market-based control) as an improvement over an outright prohibition of repatriation of investment.42 But negative investor reaction to the controls has not been fully overcome, as evidenced by a decline in new foreign direct investment and some disinvestment.
The containment of capital outflows reflects a combination of factors. The wide-ranging and strictly enforced controls in place prior to the revision of the control regime in February 1999 certainly played a role. But prudent macroeconomic policies, rapid progress in financial sector reform, improved economic prospects, the general return of confidence in the region, and the ex post undervaluation of the ringgit relative to other regional currencies were also important. Overall, the controls appear to have provided a breathing space in which to implement more fundamental policy reforms.
The results achieved so far, however, do not seem to have come without costs. Although domestic business viewed positively the relatively greater stability of the ringgit and faster cuts in interest rates that were facilitated in part by the controls, the reaction of international financial markets has been more negative. The confidence of international investors in Malaysia has weakened relative to other countries in the region. The cost of funding from foreign sources has increased,43 foreign direct investment continues to be relatively weak, and the strict implementation of the controls imposed significant administrative costs on investors, commercial banks, and the authorities. Spot, forward, and futures market activity fell significantly, possibly hampering appropriate hedging and risk management by market participants.
After joining the European Community (EC) in 1986, Spain progressively liberalized its capital account in line with EC requirements, while moving forward with financial sector reform. Prior to 1986, tight controls on capital flows were maintained on concerns that free capital flows might disrupt domestic financial markets and reduce monetary policy autonomy. Following membership in the European Union, Spain gradually liberalized long-term foreign borrowing by the private sector (within certain limits), inward and outward foreign direct investment, foreign exchange operations of commercial banks, outward investment in medium and long-term securities, forward operations, issue of foreign assets in domestic markets, and resident foreign exchange accounts.
Greater integration with international capital markets, and high interest rate differentials associated with tight monetary policy, led to a surge in capital inflows. In response, some restrictions were reimposed in the late 1980s, mainly on short-term flows: authorization requirements on all new foreign borrowing by residents with a maturity of less than one year—subsequently extended to three years—and unremunerated deposit requirements on all foreign borrowing by banks and residents. These restrictions allowed monetary policy to pursue both domestic and external objectives, while protecting domestic financial markets, which were not yet fully developed. The restrictions were abolished in 1990–91, and all remaining capital controls were lifted by February 1992, ahead of the schedule established by EC directives. The liberalization of the capital account was followed by an increase in capital flows, and by a shift from portfolio investment to credit operations. The composition of portfolio investment shifted toward investment in government securities.44
In connection with the ERM crisis of late 1992, the peseta came under significant speculative pressure, reflecting not only the general tensions within the ERM, but also the weakening of the credibility of Spain’s exchange rate peg (maintained within a ±6 percent fluctuation band since 1989).45 A weak fiscal position, high unemployment, and the widening of the current account deficit contributed to this loss of credibility, which in turn provided only limited room for a credible interest rate defense of the currency. The peseta was subsequently devalued within the ERM on September 17, 1992. Downward pressure on the currency continued, but further immediate realignments were difficult owing to the generally high level of tensions within the ERM, where decisions on changes in exchange rates were subject to agreement with other members of the system. In view of the authorities’ desire to remain with the ERM and their commitment to EMU, they opted to introduce a number of market-based controls on short-term capital flows on September 22, 1992. Sharp interest rate increases to defend the currency at this point were seen as counterproductive in managing the speculative pressures.
The controls consisted of several compulsory non-interest-bearing deposit requirements on domestic banks. A speculative attack typically requires a speculator to establish a net short position in domestic currency. The measures adopted were designed to interfere with such position-taking by requiring banks to deposit with the central bank at zero interest a proportion of any net short position in domestic currency (or long position in foreign currency). The specific measures required domestic banks to place with the central bank a one-year non-interest-bearing deposit of an amount in pesetas, equivalent to 100 percent of (1) the increments from the September 22 same-day, next-day, and two-day value (i.e., spot) long foreign currency positions against pesetas; and (2) the increments in loans and deposits to nonresidents denominated in pesetas. The measures also included a 100 percent reserve requirement on the increments in peseta-denominated liabilities of domestic banks (national and foreign) with their branches, subsidiaries, and parent companies. These requirements were thus designed to limit capital flows by making the flows more sensitive to domestic interest rates, and thereby to discourage potential speculative activities by making it costly for Spanish banks to engage in transactions that could be used by non--residents to take speculative positions against the peseta.46
These controls were modified on October 5, 1992. The previous measures were replaced with a requirement for domestic banks to place with the central bank a non-interest-bearing deposit of an amount in pesetas equivalent to 100 percent of (1) the peseta sales against foreign currency to nonresidents with same-day value (to constrain peseta sales to cover overdrafts), (2) the increment in net sales of peseta against foreign exchange to nonresidents with value “next day,” and (3) the increment in the forward sale of foreign exchange against pesetas to nonresidents.47 The authorities, upon reflection, determined that the earlier measure had been unnecessarily wide and not clear enough in its formulation. In effect, the revised measure was designed to penalize only swap operations of nonresidents against the peseta by effectively raising the cost to nonresidents of raising funds for speculation through the swap market (simultaneous spot purchase and forward sale of peseta by nonresidents); such transactions are costly to nonresidents because banks pass on the costs of the deposit requirement. Hence, the revision of the initial regulations sought to target the financing of foreign exchange speculation more precisely and shield nonspeculative activity. (See Eichengreen, Tobin, and Wyplosz, 1995, and Garber and Taylor, 1995). It has been argued that the wide-ranging and restrictive nature of the first set of measures had in fact paralyzed most short-term operations given the broad range of activities they covered, including the financial operations associated with foreign trade. In particular, the measure had the effect of hindering nonresident exporters’ and importers’ ability to hedge against exchange rate risk. (See Garber and Taylor, 1995). Moreover, initial uncertainty about the precise scope of the September measures may also have dampened activity in the market in the period just after the imposition of controls.
Daily data on onshore-offshore interest rate differentials and the movements of the peseta within its ERM band suggest that the controls were initially effective in preventing speculation against the peseta, but provided only temporary relief (see Eichengreen, Tobin, and Wyplosz, 1995,). Between September 22 (when the controls were first imposed) and mid-October, interbank interest rates declined, with a subsequent widening of the onshore-offshore interest rate differentials. The peseta stabilized close to the more depreciated margin of the fluctuation band, and the reserve loss slowed to $2 billion in October, compared with a decline of $13 billion in September (the largest one-month reserve loss ever). From mid-October 1992, however, the interest rate differential fell close to zero and increased only modestly when the peseta again came under pressure in November, reflecting market expectations of another realignment. The reserve loss accelerated to $9 billion in November. On November 23, the peseta was devalued for the second time, all the controls imposed since September 1992 were removed, and the authorities moved to raise interest rates. No further speculative attacks occurred until May 1993, when the peseta was devalued for the third time, followed by the general widening of the ERM fluctuation margins to ±15 percent in August 1993.
It is difficult to determine whether the reduction in the onshore-offshore interest differential from mid-October and the need for large interventions in November to defend the rate reflected limiting of the scope of the controls or growing circumvention.48. There is some support for both views. It has been argued that Spanish banks sent pesetas to their London subsidiaries to circumvent the deposit requirement (see Eichengreen, Tobin, and Wyplosz, 1995.). Also, it appears that nonbanks may have been used to channel domestic currency offshore in response to the imposition of a deposit requirement on bank lending operations (for example, through the transfer of resident deposits to foreign branches of domestic banks, or leads and lags in the operations of exporters and importers). And, certainly, focusing the controls on only one method of financing from early October to avoid penalizing desirable transactions restored additional avenues for speculation, which appear to have been exploited given persistent expectations of further exchange rate depreciation.
Spain’s experience with the use of temporary controls on capital outflows may suggest that (1) to be effective, controls need to be wide-ranging, and limiting the measures to the most widely used speculative instruments may not suffice as currency traders will quickly shift to other instruments; and (2) though capital controls may have provided the authorities a temporary breathing space until a second realignment was negotiated within the ERM, they did not provide lasting protection when there were strong incentives for circumvention, notably expectations of exchange rate depreciation.
After more than a decade of exchange rate stability and impressive economic growth, the Thai baht came under severe speculative pressure in May 1997. There were growing signs of overheating in the economy as early as 1993, reflected in persistent inflation and a significant widening of the current account deficit (with the latter in part reflecting a loss of competitiveness associated with the baht’s close link with the appreciating U.S. dollar). Although the current account deficit was more than financed by inflows of capital in 1994–95, a growing component of these inflows was short term, increasing vulnerability to a sudden change in market sentiment. As discussed above, the inflows were encouraged by interest rate differentials and the belief that the peg of the baht provided an implicit exchange rate guarantee.
Growing domestic and external imbalances and the emergence of banking problems since late 1996 raised questions about the sustainability of the peg and induced speculative attacks on the baht. Speculative pressures had emerged periodically during 1997 in the belief that the prevailing high interest rates would eventually have to be lowered on concerns about the state of the economy and the banking system, and that the baht would have to be devalued. The attacks were facilitated by the relatively open foreign exchange system of Thailand at the time,49 the presence of well– developed spot and swap markets, and freedom of nonresidents to obtain baht credit from domestic banks. Speculation against the baht took the form of direct position-taking in the forward market, which created downward pressure on the forward rate, and use of explicit baht credits, which, when converted into foreign currency, created a short position on the baht. The conversion of baht credit into foreign currency represented a capital outflow, placing downward pressure on the spot exchange rate. To the extent pressures were offset by the central bank, they resulted in a decline in reserves and/or increase in the central bank’s forward commitment.
The authorities imposed capital controls on May 15, 1997, to stabilize the foreign exchange market and stem speculative attacks on the baht. These measures were adopted against the background of a sharp decline in free international reserves, and the potential adverse effects of an interest rate defense on economic activity and the banking system. The measures attempted to close the channels for speculation identified above. First, financial institutions were asked to refrain from, and then suspend (June 1997), transactions with nonresidents that could facilitate a buildup of baht positions in the offshore market (including baht lending through swaps, outright forward transactions in baht, and sales of baht against foreign currencies). Second, any purchase before maturity of baht-denominated bills of exchange and other debt instruments required payment in U.S. dollars. Third, foreign equity investors were prohibited from repatriating funds in baht (but were free to repatriate funds in foreign currencies). Finally, nonresidents were required to use the onshore exchange rate to convert baht proceeds from sales of stocks. These measures gave rise to a two-tier currency market, with separate exchange rates for investors who buy baht in domestic and overseas markets. Financial institutions were also required to submit daily reports of foreign exchange transactions with nonresidents.
The 1997 measures were clearly targeted at decoupling the onshore and offshore markets. The two-tier system attempted to deny nonresidents without bona fide commercial or investment transactions in Thailand (identified as “speculators”) access to domestic credit needed to establish a net short domestic currency position (particularly through the first three measures), and inflict punitive costs on speculators (through the first and last measure), while allowing nonspeculative credit demand to be satisfied at normal market rates. The controls exempted genuine underlying business related to current international transactions, foreign direct investment flows, and various portfolio investments. Banks were asked, however, to maintain documentary evidence supporting such transactions for auditing and inspection.
The measures seem to have reduced sharply the volume of trading in Thailand’s swap market, where foreign investors often buy and sell to hedge currency risks for investments in Thailand. They also temporarily ended speculative attacks on the baht, by causing large losses for speculators (reportedly about $1 billion to $1/2 billion), as both onshore and offshore banks, in response to official pressures, segmented the two markets by refusing to provide short-term credit to speculators. (See IMF, 1997, pp. 33–35.) In particular, banks’ refusal to provide baht credit imposed a severe squeeze on offshore players who had acquired short baht positions during the speculative attacks and had to close their forward positions. As a result of the squeeze, offshore swap interest rates rose sharply relative to onshore rates, and induced speculators to settle their forward positions through the spot market, putting upward pressure on the spot exchange rate. This forced investors who had taken positions against the baht in expectation of a devaluation to unwind their forward positions at a loss. Thus, in the absence of extensive liquidation by domestic holders of baht positions, the authorities were able to withstand the pressures on the baht by relying on extensive application of the selective capital controls until early July.
Controls did not prevent outflows through alternative channels, however, as the sharp rise in the spread between the onshore and offshore interest rates (from about 2.5 percent in mid-May to 7.6 percent at the end of the first trading week in June and to 12.9 percent by June 13 before dropping to 9.8 percent on June 18, 1997) created arbitrage opportunities, and thus incentives for circumventing the controls. With the persistent expectations of baht devaluation driving capital outflows, foreign exchange reserves remained under pressure, and the authorities eventually abandoned their pegged exchange rate regime and floated the baht on July 2, 1997, in view of the high cost of defending it. The swap premium in onshore and offshore markets started to converge after end-August 1997, suggesting further diminishing of the effect of controls. The baht continued to depreciate until a comprehensive stabilization package with the needed structural reforms was seen as being firmly implemented, including the strengthening of weak financial institutions.
Thailand’s capital controls provided very short lived relief. There is no solid evidence on the reasons for the erosion in the effectiveness of the controls, nor on the channels used to circumvent the controls. Circumvention was, however, facilitated by the fact that the controls were not very wide ranging and did not eliminate the offshore market, which continued to provide arbitrage opportunities, particularly in view of continuing problems in the financial sector and macroeconomic imbalances. Notably, fiscal policy became loose in 1996–97, with a fiscal impulse amounting to some 4–5 percent of GDP. The controls, in addition to the weak economic fundamentals, undermined investor confidence, and discouraged foreign capital inflows, resulting in a decline in net private inflows of capital to Thailand during this period (from more than 5 percent of GDP in 1996 to an average of about –12 percent in 1997–98). Once the economic environment showed signs of improvement and the Bank of Thailand lifted the controls on January 30, 1998, the baht appreciated, stock market prices increased, and sovereign yield differentials narrowed.50