Under Control
Is Malaysia's daring gamble to impose capital controls working? If strengthening exports and declining interest rates are any indication, yes. But Malaysia's isolation could come at a high price.
By Murray Hiebert in Kuala Lumpur
Issue cover-dated January 28, 2000
F our and half months after Malaysia's hard-charging prime minister stunned financial markets by imposing strict curbs on capital moving in and out of the country, his supporters have some reason for cheer.

For starters, the controls haven't sent Malaysia's economy into a tailspin, as some champions of economic globalization had forecast. Instead, numerous improvements have followed: The local currency has stabilized; interest rates have plunged; exports in U.S.-dollar terms have started picking up, boosting foreign reserves; car and home sales have stopped falling; the stockmarket has surged and ailing banks are being restructured.

The problem is, much of the same can be said about Asia's other troubled economies--Thailand and South Korea, in particular. In fact, in some cases, these countries seem to be improving faster than Malaysia. And their recovery, which followed the International Monetary Fund's free-market prescriptions, has not come at the price of instituting draconian measures that could keep foreigners nervous about investing for years to come.

On September 1, Prime Minister Mahathir Mohamad placed his bet that by imposing controls on Malaysia's currency, he would be able to loosen credit and increase government spending to fire up the economy--without sending the ringgit into a tailspin. That day, among other things, he declared that effective October 1, the ringgit would become worthless outside of Malaysia and that foreign portfolio investment must remain in the country for at least one year. "The only way to manage our economy is to insulate us from currency and stockmarket speculators--and that is to take the foreign exchange from them," the prime minister said at the time.

Mahathir's plan, critics predicted, would almost certainly lead to a currency blackmarket as demand for foreign exchange outstripped supply permitted by the central bank. But that hasn't been the case. Since exports--which, under the controls, must be paid for in foreign currency--continue to exceed imports, there's been no shortage of foreign exchange. Nor have the controls hammered Malaysia's foreign reserves by sparking illegal capital flight--another doomsday scenario. At the end of November, foreign reserves stood at $23.8 billion, a $3.5 billion increase from just before the controls went into effect. According to Zainal Aznam Yusof, an economist working on the government's economic recovery plan: "This undermines earlier worries that people would find all kinds of ways to get out of Malaysia by under- and over-invoicing" if they lacked confidence in the economy and wanted to park money offshore.

Interestingly, the IMF, normally a staunch critic of capital controls, has said it's too early to judge the measures' effectiveness. "At this point, it is not clear if such controls would assist nor does it show any harm," a senior IMF official told reporters in late December.

Still, some economists are willing to give Malaysia's gambit an interim grade. At least a few of them note that the steadying effect of capital controls might have been more obvious had region-wide currency stability not taken hold in mid-October. The U.S. Federal Reserve's decision to cut U.S. interest rates by 25 basis points at the time paved the way for Asian countries to more aggressively lower their own interest rates free from fear that their currencies would be hit.

In the last quarter of 1998, the controls helped Malaysia achieve some of the region's "best export performance," says P.K. Basu of Credit Suisse First Boston. Malaysian exports increased 2% in U.S.-dollar terms in October from a year earlier, compared with an 18% decline in August. By comparison, Thailand's exports fell 12.5% in dollar terms in October. "A stable currency made it easier for exporters to plan," the Singapore-based economist says. On top of that, the ringgit's fixed exchange rate of 3.8 to the U.S. dollar helped Malaysia's competitiveness at a time when many other Asian currencies were appreciating, he adds.

That's the good news. But so far, the controls haven't helped industrial production, which is crucial in a country where manufacturing comprises 34% of GDP. Malaysia's industrial production fell through November, the last month for which year-on-year figures have been released. Bank lending remains flat; it grew only 0.5% in November from a year earlier even though interest rates have plunged to 6.5% from 10.2%--suggesting that domestic demand remains in the doldrums.

But the worst news is that the controls appear to have scared away foreign direct investors, who in the past played a key role in transferring new technology and boosting productivity. While a dearth of monthly statistics makes it impossible to quantify this, anecdotal evidence suggests that Malaysia has attracted nothing like the level of foreign interest that South Korea has. According to South Korea's Ministry of Finance and Economy, foreign direct-investment commitments have increased each month since May on a year-on-year basis. In December, foreign investors committed $1.9 billion to South Korea--the largest single-month amount ever recorded.

In Malaysia's case, "foreign investment inflows have been lethargic at the same time as there's been a noticeable inflow into neighbouring countries," says Mohamed Ariff, a prominent economist who heads up the independent think-tank, Malaysian Institute of Economic Research. "In the medium and longer term, the capital controls will hurt us."

Malaysia's political scene has only exacerbated any damage capital controls may have done to foreign-investor sentiment. Political turmoil has engulfed the country since Mahathir fired his deputy, Anwar Ibrahim, just a day after imposing the controls, and put him on trial on sex and corruption charges. "Politics has taken away from the attractiveness of investing in Malaysia," says Neil Saker of SG Securities. "In the average investor's mind, Malaysia has lost its sparkle."

True, Malaysian companies simply aren't as desperate for foreign help as their Asian counterparts, contends Simon Ogus, an economist at Warburg Dillon Read in Hong Kong. Malaysia's recession isn't as deep as many of its neighbours' and the government has shown itself more willing to protect struggling companies. But even if a distressed company were interested in taking on a non-Malaysian investor, it would find it difficult given government restrictions on the role of foreigners.

For their part, government officials say a lack of foreign interest is of little concern. They contend that the government will be able to raise domestically two-thirds of the 62 billion ringgit it says it needs to restructure bad bank loans, recapitalize struggling banks and pump-prime the economy.

Officials say the country will borrow the remaining third abroad. But economist Ariff warns these funds will not be enough to stimulate new spending by businesses. By using funds from the government-backed retirement fund and the state-owned oil firm Petronas, Ariff says, Malaysia "will divert funds from the private to the public sector. This won't solve the problem. The whole economy will remain impoverished."

Instead, he says, the country should look to foreign private capital and open industries such as banking, insurance, advertising, tourism and agriculture, all of which have traditionally been off-limits to foreigners. "We need to liberalize services if we want to attract foreign investment," Ariff points out. "Otherwise, I think we may miss the boat."

Foreign portfolio investment will likely continue to suffer, too. "Foreign equity investors are rightly aggrieved and some may not come back for a long time," says Ogus. But a change in investment rules could be enough to attract a critical mass of the typically fickle investment community. "Enough will come back if the market looks good," Ogus adds.

Already, analysts are impressed with Malaysia's progress in taking nonperforming loans off bank books and recapitalizing troubled financial institutions. During the last few months, Danaharta, the government's asset-management arm, has worked with 14 different financial institutions to acquire 1.1 billion ringgit in nonperforming loans and place loans worth another 8 billion ringgit under government management. It has also agreed in principle to acquire another 12.8 billion ringgit in loans from the same groups.

But much less has happened in restructuring ailing corporations. Political economist K.S. Jomo of the University of Malaya is concerned that Malaysia could use the capital controls as "a window of opportunity to save certain interests" since it must no longer worry about how news of a bailout would shatter investor confidence and hurt share prices. He cites the example of Renong, a construction conglomerate long linked to the ruling party. In October, the company had proposed using its future tax payments to float a government-backed bond to pay off overdue debt. Although the plan was scrubbed following widespread protest, economists remain worried that companies linked to Malaysia's ruling party may still receive preferential treatment.

The next major hurdle facing Malaysia is how to ease out of the capital controls. Foreign portfolio investors, who hold roughly $10 billion or 10% of the total stockmarket, were angered when Mahathir banned the withdrawal of capital from the country for one year. To avoid another shock to the financial system on September 1, when these investors will be allowed to withdraw their money, Finance Minister Daim Zainuddin has hinted in recent months that the government may modify the current restrictions with a more flexible "exit tax." Such a tax would allow investors to pull their money out ahead of September 1, but would require that they pay a tax on profits.

Even Zainal, who works on the government's recovery plan, says it's still too early to give a fair evaluation of the capital controls. But others argue that Malaysia does not have the luxury to wait much longer before deciding what to do. "If the controls stay until September, Malaysia will lose out," Ariff says. "The longer they're kept, the more damage they'll do."