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Professor Peter G. Warr
The Asian crisis which began in 1997 has led to renewed interest in capital controls - government-imposed restrictions on the rate at which financial capital can move internationally. Several Asian countries, including Thailand, had such controls in place until the early 1990s. Would their retention have averted the crisis and should they be reinstated now, as has occurred in Malaysia?
The prolonged boom which preceded the crisis in Thailand and elsewhere was fueled by high levels of direct foreign investment. As the boom developed, these high levels of capital inflow, combined with Thailand's fixed exchange rate policy, set in train a 'Dutch disease' real appreciation - an increase in non-traded goods prices relative to traded goods prices within Thailand - in which real wages increased unsustainably, undermining the competitiveness of the traded goods sector. In 1996 this produced a dramatic slowdown in export growth which provoked the expectation of a devaluation.
Over the same pre-crisis period, the vulnerability of the country's foreign exchange reserves to a financial panic had increased very substantially. The vulnerability derived from a greatly increased stock of volatile capital within Thailand which could be presented for conversion into foreign exchange at short notice. The growth of this stock of volatile capital relative to reserves was itself the outcome of macroeconomic policies. First, controls on capital movements were largely eliminated in the early 1990s. Second, the Bangkok International Banking Facility, established by the government in 1993, encouraged domestic banks to borrow abroad, short-term. Third, non-bank financial institutions were encouraged to borrow abroad as well, in the hope of qualifying for highly profitable domestic banking licenses. Finally, the Bank of Thailand's attempts to sterilise capital inflows raised domestic interest rates and induced very large inflows of short-term foreign capital.
Thailand had capital controls in place for several decades until they were largely dismantled from 1990 onwards. The controls were justified by the need to regulate speculative and destabilising capital movements. But during most of the period prior to 1990, when the controls were operative, large capital movements were not occurring. Large capital inflows did not begin until around 1987, but during this brief period before they were abolished the controls were indeed inhibiting capital movements and that was a major reason for their removal.
If Thailand had retained its capital controls, short-term capital flows would have been slowed. This may have reduced the rate of growth during the period of economic boom, but would also have restrained the development of vulnerability arising from the build-up of stocks of short term capital. Removal of the capital controls while still retaining a fixed exchange rate was a mistake. Nevertheless, evidence from the period in which these controls were in place suggests that if they had been retained the effect would have been small. Capital controls are not a substitute for effective prudential regulation of the banking sector or for a sensible exchange rate policy.
WATCHPOINT: Will Thailand move to reinstate capital controls?
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