Capital controls: From heresy to orthodoxy

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THINK ASIAN By ANDREW SHENG

 Principles for formulating capital control policies must take local conditions into account.

ON Sept 1, 2011, it would be 13 years to the day when Malaysia first introduced capital controls to stem the effects of the Asian financial crisis on the domestic economy. In 1998, it was heresy to introduce capital controls on capital flows, since it was the International Monetary Fund (IMF) orthodoxy to liberalise the capital account.

From the perspective of history, one tends to forget that in 1945, when the IMF was first established, the consensus opinion among bankers and academics alike was for hot money to be controlled. Indeed, the intellectual father of the IMF, John Maynard Keynes, remarked that “what used to be heresy is now endorsed as orthodoxy.”

In the old days, courtesy to living persons and the statute of limitations would allow history to be written only after 60 years when official archives are opened to the public.

Today, we live in an age of unfettered information, when oral and documented history can be published rapidly, from authorised biographies issued shortly after a leader leaves office to unauthorised leakages from Wikileaks.

The publication of a new book by Datuk Wong Sulong, former group chief editor of The Star, called Notes to the Prime Minister: the Untold Story of How Malaysia Beat the Currency Speculators, only two months after the IMF announced in April 2011 new thinking on capital inflows, is a remarkable achievement.

Sixty-six years after the IMF was formed, capital controls have moved full circle from orthodoxy to heresy and back again to (qualified) orthodoxy.

The book comprises 45 Notes written by Tan Sri Nor Mohamed Yakcop, Minister in the Prime Minister's Department, between Oct 3, 1997 and Aug 21, 1998 to then Prime Minister Tun Dr Mahathir Mohamad.
In short, they were the key briefs that helped Dr Mahathir make up his mind on the key economic policies to help combat the Asian financial crisis.



Book offers deep insights

For both historians and practicing policymakers, this new book offers deep insights into the serendipity and the practice of successful policy decision-making. There is an element of serendipity, because Dr Mahathir recalled that he spotted Nor Mohamed walking down a street in Kuala Lumpur just before he left for Buenos Aires in September 1997 via Hong Kong, where he attended the World Bank Annual Meetings and clashed publicly with George Soros on currency trading.

On Sept 29, 1997, he summoned Nor Mohamed to meet him in Buenos Aires, because he needed someone who understood currency trading. It is a tribute to a politician trained as a doctor that he was willing to spend repeated sessions with an experienced currency trader to understand the intricacies of modern financial markets.

Reading the 45 Notes in historical sequence, one gets a far better appreciation of how the decision to impose capital controls was arrived at. The Notes not only have historical value, but also current-day applicability, as they explain not only offshore currency, the psychology of fear and greed that drive markets, but also market manipulation in thinly traded emerging market currencies.

The major problem of the proponents of the Washington Consensus in 1997 was that most of them were macro-economists who had little understanding or experience of how the markets actually worked. Free markets became a dogma and objective in their own right, rather than the means to an end for better livelihood for all.

The Notes also revealed that in complex decisions under uncertainty, it was vital to understand clearly the key parameters for action. Note 7 clearly pointed out that Malaysia was different from other countries under currency attack because it did not have large short-term external debt. Note 11, dated Oct 21, 1997, spelt out the factors that determined exchange rates, with a particularly illuminating explanation of market manipulation.

Market manipulation was seen as due to concerted effort by hedge funds, using large gearing and available tools and then triggering the element of fear among the long-term investors who have legitimate currency risk.

In other words, if the wolves can trigger the herd to move, then the fundamentals can move. The perception of fear changes the whole game.

Effect of CLOB

Note 39 dated July 9, 1998 is an important study of the effect on Malaysia of the central limit order book (CLOB) for trading of Malaysian shares in Singapore. The Note identified that the CLOB was a convenient way for capital outflows.

Hence, one of the most effective ways for exchange control was to impose the condition that Malaysian shares could only be traded on a Malaysian exchange, which came on Aug 31, 1998, with exchange controls imposed on the following day.

In Dr Mahathir's words, “during the financial crisis, we faced two parallel situations; the ringgit was falling rapidly and Malaysian shares were also falling rapidly. So we had to put an end to both.”
Image via Wikipedi
The IMF has come out with six key principles for formulating capital control policies.

The first is that there is no “one-size-fits-all” policy mix. The second is that capital controls should fit long-term structural reforms. Third, capital controls are only one tool and not a substitute for the right macro policies. Fourth, capital controls can be used on a case-by-case basis, in appropriate circumstances. Fifth, the medicine should treat the ailment, and finally, the policy must consider its effect on other market participants.

It is hard to argue against these common sense “motherhood” principles. The trick in real life policy-making is how to apply them to local conditions.

On of the features of the current Chinese capital controls is that China also has a large amount of Chinese shares listed outside capital controls, such as Chinese shares listed in Hong Kong, Singapore and New York.

This is a book that is a must read for all emerging market policymakers interested in liberalising their capital accounts and for IMF experts to ponder emerging market experience.

I recommend that this new book be translated into Chinese, so that Chinese policymakers interested in internationalising the renminbi can look at the Malaysian experience.

Tan Sri Andrew Sheng is author of the book, From Asian to Global Financial Crisis.

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The untold story of Malaysia foreign exchange controls 

The untold story of Malaysia foreign exchange controls

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Book reveals how Malaysia beat currency speculators in 1997/98 crisis
By Thean Lee Cheng, Starbiz

 
Nor Mohamed (left) and Wong at the book launch

KUALA LUMPUR: Former Prime Minister Tun Dr Mahathir Mohamad toyed with the idea of exchange controls as early as May 1998 but was met with resistance from within the National Economic Advisory Council, the Cabinet and the central bank.

This was revealed in Notes to the Prime Minister, a new book that chronicles one of the biggest challenges and triumphs in Dr Mahathir's 22 years as Malaysia's Prime Minister.

Notes to the Prime Minister: The Untold Story of How Malaysia Beat the Currency Speculators was launched yesterday in Kuala Lumpur by Minister in the Prime Minister's Department Tan Sri Nor Mohamed Yakcop. Tun Dr Mahathir was not present as he was advised by doctors to rest at home.

The book, published by MPH Publishing, is based on 45 sets of notes written between Oct 3, 1997 and Aug 21, 1998 by Nor Mohamed when he became Dr Mahathir's unofficial and unpaid economic adviser.

The Asian financial crisis, which first engulfed Thailand in the middle of 1997, hit Malaysia soon after. Selective capital controls were imposed on Sept 1.

The book is written by veteran journalist Datuk Wong Sulong, the former business editor and group chief editor of The Star.

In an excerpt from the book, Dr Mahathir told Wong that he decided on foreign exchange controls “after Nor Mohamed explained to me how currency trading works ... millions and millions of ringgit can be transferred from a domestic account to a foreign account by a stroke of a pen ... I realised that foreign currency trading can be stopped by stopping this balance transfer.



“But I must say it was not as easy as that. We needed to do a lot of background work and monitoring and Bank Negara (needed to) set up many committees to do that to ensure that the controls were effectively implemented. (Tan Sri) Dr Zeti (Akhtar Aziz, then deputy governor of Bank Negara) did a lot in that respect and also in the economic recovery.”

Notes to the Prime Minister is not only a valuable lesson on how Malaysia took unorthodox steps to solve the Asian financial crisis but it is also a story of how two Malaysians met halfway around the world and came up with the Malaysian solution to the Asian financial crisis.

It is an intriguing story of how Nor Mohamed, then chief executive officer of Mun Loong Bhd, was summoned by Dr Mahathir to meet him in Buenos Aires, Argentina, on Oct 2, 1997. The first set of those notes was written a day later, on Oct 3.

Prior to this unique flow of notes, Nor Mohamed was a Bank Negara adviser.

His expertise in foreign exchange landed him and then Bank Negara governor Tan Sri Jaafar Hussein in trouble. Both of them resigned to take responsibility for Bank Negara's speculation on foreign exchange losses that went into billions of ringgit in the early 1990s. Nor Mohamed joined the private sector after that.

Said Nor Mohamed at the launch: “We learn in history that sometimes the lives of individuals and the fate of nations hinge on a millimetre's difference in the trajectory of a bullet, a road not taken on a whim, or the random stray of a shrapnel.

“In my case, my fate was sealed ... by the turn of a head Tun Dr Mahathir's ... It was a sunny afternoon in September 1997, when the PM's motorcade was speeding along the streets of Kuala Lumpur.

“At one junction, as the motorcade slowed, Tun Dr Mahathir turned his head to look out. And he saw a forlorn-looking man walking towards a row of shops for lunch. That forlorn-looking man was me!”

Nor Mohamed was summoned a few days later to go to Argentina. In April 1998, Nor Mohamed resigned from Mun Loong to concentrate on being Dr Mahathir's unofficial adviser.

During that period of assessement, Nor Mohamed went to Singapore to observe the operations of Central Limit Order Book (CLOB), a board on the Singapore Stock Exchange which dealt with a great number of Malaysian shares. Dr Mahathir felt that Malaysia's currency crisis could not be solved as long as CLOB exists.

Dr Mahathir, aware that his adviser was unemployed, asked: “Do you have money to go down to Singapore?” Nor Mohamed laughed and assured him that the trip would not cost a lot of money. The rest, as they say, is history.

As for Wong, who shares a deep liking for Nor Mohamed, he was asked by his friend to write the book.

“I felt a sense of excitement and a heavy responsibility. These notes had never seen daylight and it shed a new light (on more than just the economic and political aspects of this country). You have to tell a story as honestly as possibile, but not technically, because it has to appeal to the average reader. So that was my dual challenge.”

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Capital controls: From heresy to orthodoxy