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 controls on capital flows, since it was International Monetary Fund orthodoxy to liberalize 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 “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 authorized biographies issued shortly after a leader leaves office to unauthorized leakages from Wikileaks.

The publication of a new book by Wong Sulong, former 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 move full circle from orthodox to heresy and back again to (qualified) orthodoxy.

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

For both historians and practicing policymakers, this book offers deep insights on 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, spelled 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 amongst 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.

Note 39 dated July 9, 1998, is an important study on 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.”

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. Thirdly, capital controls are only one tool and not a substitute for the right macro policies. Fourthly, capital controls can be used on a case-by-case basis, in appropriate circumstances. Fifthly, 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 policymaking is how to apply them to local conditions.

One 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 liberalizing 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 internationalizing the renminbi can look at the Malaysian experience. 

By Andrew Sheng 

Andrew Sheng is an adjunct professor at Tsinghua University, Beijing, and University of Malaya. He was formerly chairman of the Securities and Futures Commission, Hong Kong. ― Ed.

(Asia News Network)