Friday, December 22, 2006 Vincent Lingga, The Jakarta Post, Jakarta
Thailand's imposition of foreign exchange controls that caused a drop of almost 20 percent in local stock prices and systemic, yet smaller falls in other Asian markets Tuesday, is an example of a well-intentioned, but poorly designed and ill-timed policy.
For Thailand to slam controls on its capital account less than three months after the military coup is certainly counterproductive, especially because the military-appointed government has yet to build up its credibility in the market.
The stock market in Bangkok and other Asian exchanges did rally back Wednesday, recouping most of their losses from the previous day, after the Thai government rescinded the capital controls.
However, the Thai attempt to control capital foreign exchange flows will nevertheless resurrect the debate on the merits and drawbacks of controlling short-term capital inflows.
It was strategic, though, for Indonesian Finance Minister Sri Mulyani Indrawati and Bank Indonesia Governor Burhanuddin Abdullah to immediately and repeatedly reassure the market on Tuesday and Wednesday of Indonesia's strong commitment to upholding its fully open capital account.
Bank Indonesia has issued several regulations to minimize the risks of currency speculation against the rupiah without compromising its open capital account. In 2005, the central bank moved to limit foreign exchange derivative transactions with foreign counterparts against the rupiah to a maximum of US$1 million and to cap dollar purchases in outright forward transactions and swaps at $1 million.
The central bank also imposed a three-month minimum investment hedging period on foreign exchange transactions. This means that investors with underlying investment in Indonesia must keep their funds in the country for at least three months. Hedging transactions subjected to this new regulation include outright forward transactions, swaps and call and put options.
These moves aim to prevent wild volatility of the rupiah by reducing the speculative element in the currency market, by among other things decreasing the inflow of hot money to the country.
The return in droves of foreign portfolio investors to the Asian financial market after the 1997
financial crisis has raised great concern about market vulnerability to boom and bust cycles. Thai authorities have been apprehensive over the steady appreciation of its currency, the baht, and worried about the threat of currency speculation.
The reasons for fully liberalizing capital flows were partly pragmatic, as technological innovations, such as new financial instruments, made it easier to circumvent capital controls.
In Indonesia in particular, controls on foreign exchange flows could be highly problematic and vulnerable to corruption, due to the inadequate institutional capacity and high level of venality within the government bureaucracy.
Most studies have also concluded that liberalizing foreign exchange flows could stimulate growth by reducing distortions and enhancing access to foreign financing, as Thailand and Indonesia have proven with the bullish sentiments in their capital markets.
An open capital account may improve economic performance over the business cycle by encouraging more prudent domestic macroeconomic and financial policies, as well as improving short-term access to financing.
Policymakers in countries such as Indonesia with an open capital account are forced to adopt prudent policies because investors are free to bring their money elsewhere, whereas policymakers in countries with capital controls can pursue less prudent policies without being afraid of facing sudden massive withdrawals of funds, at least in the short run.
The potential long-run benefits of an open capital account must, however, be weighed against immediate costs: a country's vulnerability to global shocks or to sudden changes in investor sentiment. Capital flows are subject to pronounced cycles that may induce boom and bust cycles in production and investment.
One source of vulnerability is a mismatching of maturities or currencies, which makes recipient countries illiquid. Such a severe liquidity shortage makes a system vulnerable to panics, while policymakers' options are severely restricted, as painfully apparent in Indonesia during the height of its financial crisis in early 1998.
With capital controls, a central bank can set both the interest rate and the exchange rate simultaneously, at the cost of limiting capital inflows that could finance productive activity.
The question is do the benefits of liberalizing outweigh the costs?
As Indonesia's experience since the early 1980s have proven, the benefits seem to far exceed the costs.
Chile tried to control short-term (portfolio) capital inflows in 1991 by imposing an unremunerated reserve requirement (URR), first on foreign borrowing (except trade credit) and later on short-term portfolio inflows (foreign currency deposits in commercial banks and potentially speculative foreign direct investment).
The reserve requirement was raised from 20 percent to 30 percent. A minimum stay requirement for direct and portfolio investment from abroad also was imposed.
But these controls seemed to be less-than effective because investors found ways to circumvent the controls. The problems lie mostly in the difficulties in the design and application of capital controls.
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