The recent financial crisis in East Asia has drawn much attention to the role of short-term capital flows. During the 90s, many East Asian governments, encouraged by the World Bank and the International Monetary Fund, liberalised their financial systems including their capital account, which allowed firms to buy and sell financial assets more freely. This was further augmented by astounding advances in information and telecommunication technology which made international financial transactions much easier and faster. All this has led to a rapid integration of global financial markets. The role of traditional banks as the main intermediary of funds has been eroded in the wake of a sharp increase in international capital mobility. As a consequence, investment funds have grown enormously in importance, operating under intense competitive pressure to earn high returns.

The ageing population profile and the establishment of many pension funds in developed countries have also contributed to the sharp increase in the supply of such capital. Capital tends to move rapidly across the globe in a borderless fashion. There is hardly any barrier for such flows now that many countries have joined the bandwagon of capital account liberalisation. Unlike commodities and manufactures, it costs little to transfer funds from country to country and to store them. Given near-zero transport and storage costs, there is literally no limit to the amounts that can be moved in and out. In fact, investment funds in trillions of dollars move about far too easily. It is estimated that such capital flows amount to more than 70 times the volume of trade and that the bulk of this comprises short-term flows.

Short-term capital flows, in particular, are notoriously volatile, flowing in and out with such speed that it is dubbed as "hot money". Hot money is hypersensitive to small changes of even perceptive or psychological nature, let alone changes of fundamental kind. By contrast, the long-term investors are more concerned about economic fundamentals and sustainability than the short-term ones. Short-term capital is particularly active in currency trading and stock markets. East Asia has been attracting a large proportion of the stream of short-term capital since the early 1990s. Japan, with a large domestic surplus of savings over investment, has been a major source of the capital flowing into East Asian countries. West European and North American capital has also been active in East Asia, as a result of diversion following the 1994-95 Mexican crisis. Not surprisingly, high-flying East Asian economies with excess of investments over savings became an attractive "playground" for such capital.

Although these economies are high savers with savings/gross national income (GNP) ratios of over 35%, domestic investments have been far greater. Hence the need for foreign capital to fill the resource gap. The fact that most East Asian currencies have long been tied to the US dollar with central banks intervening in the forex market to defend the preferred external value of their respective currencies has served to preclude exchange risks. This gave rise inadvertently to a tendency not to hedge foreign currency borrowings, as market participants could interpret currency-rigidity as implicit government guarantees against the risk of currency volatility. Most of these inflows have taken the form of portfolio investments and other speculative dealings including property and land.

While interest rate differentials do provide an incentive for short-term capital to move between countries, its mobility cannot be attributed solely to interest rate changes. East Asia, for example, could attract much short-term capital, despite the fact that their interest rates were not that high. In East Asia, interest rates were kept low not only because of the high savings ratio but also because of the policy bias in favour of high gross domestic product (GDP) growth and buoyant stock market. Portfolio investments have been lured into East Asia by the prospects of high rates of returns, not high interest rates. East Asia could also borrow from abroad at relatively low interest rates, thanks to the high rating by the international rating agencies.

Talking advantage of this, some financial institutions in the region had borrowed short abroad at low interest rates to re-lend long at home at higher rates of interest. Hence the sharp increase in short-term external debts in some countries in the run-up to the crisis. Some companies have also been resorting freely to short-term borrowings from abroad for financing their long-term investments at home. This mismatch represents yet another important source of financial instability for the region. Thus, the lesson learned from the recent experience clearly suggests that unrestricted short-term capital flows can destabilise the system by causing bubbles to grow and burst.

It is, however, pertinent to point out that all this is in the nature of short-term capital flows regardless of whether they are foreign or domestic. After all, what is foreign to one country is domestic to another. Besides, local investors behave exactly like foreigners moving funds in and out, driven by profit motive. What is more, funds that appear to be foreign my well be domestic, as local investors are not averse to sending their funds out of the country or bringing them back.
The fact remains that most countries do not see capital inflows as a serious problem and that they get upset only when capital flows out. What is not clearly understood is that what flows in today will flow out some other day. It is in this sense that controlling capital outflows represents a wrong solution. If volatile short-term capital flows are indeed destabilising, one should control them at the entrance, not at the exit.

As a matter of fact, inflows can be as damaging as outflows. Unrestricted capital inflows can disturb the domestic financial market equilibrium and throw the domestic monetary system out of gear. The damage can be minimised by sterilising foreign capital inflows, but sterilisation by the central bank, to be sure, is not costless. However, it is difficult, if not impossible, to ascertain if the capital flows are short-term or long-term at the time of entry.

By definition, "short-term" denotes capital with a maturity of less than a year. Not all portfolio investments are short-term. Some are genuinely long-term. Regardless, financial capital is highly speculative and volatile, quite unlike foreign direct investment (FDI). In other words, the arguments in favour of capital controls relate to financial capital, not FDI.
Chile and Columbia have imposed capital controls at the entry point, where the investors are required by law to deposit a portion of their capital with the central bank interest-free. The deposit requirement is varied according to changing circumstances from zero to 30%. Capital controls imposed by Malaysia last September are quite the opposite as they were targeted at outflows, not inflows, which amounts to holding the wrong end of the stick.

Capital controls a la Malaysia can be justified as a stop-gap measure in an emergency situation, but cannot be a long-term solution to the hot money problem. It is capital inflows, not outflows, that ought to be controlled, if they are so disruptive. Be that as it may, the fact remains that Malaysia has de facto, though not de jure, lifted capital controls with effect from Feb 15, 1999 in the sense that capital coming into the country after that date is free to leave the country without having to pay an exit tax. It is capital that moved in before Feb 15, 1999 that will have to pay exit tax if it were to exit within a year. In other words, there will be no exit tax for any capital after Feb 15, 2000. Profit repatriation tax, however, remains.
A main drawback of the latter, in passing, is that foreigners find it discriminatory, quite unlike a capital gains tax which would be neutral. As there were very little capital inflows into Malaysia between Sept 1, 1998 when capital controls were imposed and Feb 15 1999 when exit tax was introduced, the February ruling means that foreigners are free to take out their funds after August 1999 and this implies that capital controls will virtually cease to exist come September 1999 as far as foreigners are concerned, whereas the preceding analysis calls for selective controls on speculative capital inflows.

To be sure, the argument against free flow of capital is not inconsistent with the argument in favour of free trade. The safeguards in the case of merchandise trade, such as bulkiness, perishability and transportation and storage costs, which impose constraints of sorts on the movement of goods, are conspicuously absent in the case of capital flows. Besides, the traditional trade theory assumes that factors, including capital, are not internationally mobile. Thus, the arguments in favour of balance-of-payments current account convertibility are not necessarily contradicted or negated by that in favour of capital account restrictions.

The case for selective capital controls by individual countries at the entry point becomes all the more persuasive in the absence of an international mechanism that would regulate and monitor capital movements. At present, there is hardly any transparency about the mega fund managers or for that matter the rating agencies which influence their investment decisions. Nor are there any global rules or regulations governing international capital flows. Some may argue that such a "super regulator" idea is not a practical proposition especially because it would impinge on the sovereignty of individual countries. But, then, in a highly integrated, borderless world, under globalisation, shocks resulting from free mobility and extreme volatility of international funds can become increasingly disruptive. Hence the need for a new international financial order. All this does not amount to blaming it all on foreign investors or shifting the responsibility to global bodies. Far from it.

Host countries have only themselves to blame for adopting short-sighted policies that unwittingly encourage speculative capital inflows. In the context of emerging economies, liberal policies towards speculative capital would make good sense only for very small economies like Hong Kong and Singapore which are well equipped to play the role of regional financial centres without having to worry much about the adverse implications of such a strategy for the real sector of the domestic economy.

Mohamed Ariff
Executive Director of the Malaysian Institute of Economic Research (MIER).
This article was first published in the Star, a Malaysian newspaper, on Wednesday, August 11, 1999.