Capital controls are a policy option, but not for now
February 05, 2013 00:00
By Parson Singha
Capital controls no longer make countries into pariahs, and there is increasing theoretical support for their use. But that does not mean they are always an appropriate solution.
For much of the 1980s and 1990s, countries were encouraged to liberalise and open up capital markets. The thinking was that this would allow them to access lower-cost global capital and stimulate growth. Global investors would also gain, by access to higher returns and more diversified assets.
Over time, some common problems with this liberalisation became apparent. Large flows from abroad could easily destabilise countries with small financial sectors. They could lead to excessive exchange-rate volatility, and trigger asset bubbles. Just as consumers should beware of easy credit-card debt, so too should countries be worried about short-term inflows that can quickly be reversed.
These issues have become even more pronounced over the past few years.
Ever since the Great Recession of 2009, monetary-policy measures in developed nations have created massive liquidity in global markets. As a result, there has been a change in conventional wisdom over the past 10 years.
This is supported by many academic studies showing that capital-market liberalisation in developing countries does not lead to increased economic growth. Even organisations such as the International Monetary Fund (IMF) and the Asian Development Bank have been more accepting of capital controls.
This comes with a few caveats.
Capital controls should be used to correct excessive market forces, rather than distort market functions. This is easier said than done.
For example, in theory, a tax on capital inflows makes sense – the inflows have a negative impact that is not, but should be, reflected in the transaction cost. The tax can correct this imbalance.
But implementing such a tax at the correct rate and to the correct target is difficult – as seen from Thailand’s experience with its 30-per-cent unremunerated reserve requirement in 2006. The rationale for the measure was massive inflows into the country’s bond market. However, the measure initially had a broad impact, and it was the stock market that was hit hardest (a one-day 15-per-cent drop).
The operational challenges of capital controls mean that it is not a magic bullet.
In a recent paper, the IMF recommends that capital controls can be used if three main conditions are satisfied: 1) foreign reserves are in excess of prudential levels, 2) the exchange rate is not undervalued, and 3) economic conditions preclude monetary-policy easing.
Thailand clearly satisfies the first condition, but the other two are less clear. And so the strength of the baht from the first three weeks of January has led to a policy debate. Some have called for more capital controls (implying that all three of the IMF’s conditions are already met). Others are calling for the Bank of Thailand to cut interest rates further (implying that the third condition is not yet met).
And yet there is another possible argument as well – that no action is required at this time.
The baht’s movement in early January was excessive. It is hoped that intra-day volatility will be better managed. Authorities should also avoid sending out confusing signals that lead speculators to believe in a one-way bet on baht strength.
But let us keep things in perspective. More recently, in the past two weeks, the baht’s movements have been more controlled. Also, a longer-term view still shows that baht movements are not excessive. Since the beginning of 2012, the baht has appreciated by 3.1 per cent versus the US dollar – compared with 3.6 per cent by the Malaysian ringgit, 4.4 per cent by the New Taiwan dollar, 6.2 per cent by the Singapore dollar, 7.1 per cent by the Philippine peso, and 8.6 per cent by the South Korean won.
Capital-flow management should indeed be part of the arsenal of Thai authorities. But such ammunition should be preserved for extreme periods, rather than short-term disturbances.
Parson Singha is Chief Markets Strategist, Global Markets Department, HSBC Thailand