beyondbrics

Are Asian emerging economies moving closer to endorsing the use of capital controls to combat economic disruption caused by extreme volatility? Although none have admitted to preparing themselves, there are growing signs that some might seek to do so if faced with sudden large scale withdrawals of foreign funds.

The latest hint comes from the Asian Development Bank, which on Tuesday devoted a full chapter to the issue in its annual Asian Capital Markets Monitor, in effect warning emerging markets that they need to be ready to use all available weapons to deal with potentially destabilising reversals of capital flows.

Better to be prepared

Srinivasa Madhur, senior director of the ADB’s office of regional economic integration, told the FT he was not aware of any countries with open capital accounts that were preparing to implement controls. But he also pointed to the switchback in flows between 2008 and this year as clear evidence of the need to be ready.

According to the ADB, net private capital flows to emerging Asia are expected to reach $272.4bn in 2010, down slightly from $282.9bn in 2009, but still up dramatically from just $107bn in 2008, during the global financial crisis. The strong rebound in capital inflows has been driven by portfolio equity flows, with a net inflow amounting to $63.3bn in 2009 – a significant turnround from a net outflow of $54.4bn in 2008.

“What we are saying is that capital flows are back, and large inflows are putting pressure on exchange rates,” said Mr Madhur. “Capital flows need to be managed. They cannot just be left to happen because they create distorting effects in the economies [concerned]. Generally speaking countries should resort to conventional policies – keeping fiscal and monetary policies stable and exchange rates as much as possible flexible – so investors do not get a one way bet situation,” he said.

“But if these things fail to yield a result then countries should introduce capital controls of one kind or another.”

Armoury for emerging markets

Capital controls have a mixed reputation in Asia. On the whole they have worked well for China, and the surprise imposition of restrictions by Malaysia in 1998 during the Asian financial crisis has been credited by some with keeping it relatively immune from the aftermath of the Asian financial crisis. But controls imposed by Thailand in 2006 during a political crisis sparked the largest one-day fall in Thailand’s stock market that forced the authorities to retreat.

One issue driving the current revival of interest in capital controls is that the view among international institutions has changed dramatically since Malaysia’s action in 1998 was greeted by howls of protest and forecasts of imminent disaster. There has been a lot of academic research on the issue in the last decade, much of it favourable, and even the International Monetary Fund said in its recent Global Financial Stability Report that capital controls were a legitimate part of the policy armoury for emerging markets.

Long road ahead

Imposing controls is not easy, though, especially for the more open economies. The usual methods are imposing discretionary controls on specific flows, requiring investors to place part of their investment in non-interest bearing accounts with the central bank (known as unremunerated reserve requirements), or prudential measures such as restrictions on private sector net external exposure or currency positions.

However, all of these methods require a substantial administrative effort that may be beyond the capacity of some countries. Some of the research also suggests that the efficiency of such controls declines over time as investors find ways of getting around the rules.

There is also a potential legal problem for some countries, pointed out by Kevin Gallagher at Boston University. This is that many of the world’s trade and investment treaties make it very difficult for emerging countries to use capital controls effectively.

A study written by Gallagher for the United Nations suggests that countries that have liberalised their financial services sectors in line with World Trade Organisation rules will find if difficult to deploy capital controls, while US trade and investment agreements with many emerging countries typically contain clauses that would allow private investors a claim for losses against countries imposing controls.

Related reading:
Emerging Asia Should Be Ready to Act on Potentially Destabilizing Capital Inflows – ADB Report