Capital Management Techniques in Developing Countries: An...

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G-24 Discussion Paper Series

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Capital Management Techniques in Developing Countries:

An Assessment of Experiences from the 1990s and Lessons for the Future

Gerald Epstein, Ilene Grabel and Jomo, K.S.

No. 27, March 2004

G-24 Discussion Paper Series

Research papers for the Intergovernmental Group of Twenty-Fouron International Monetary Affairs

UNITED NATIONSNew York and Geneva, March 2004

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iiiCapital Management Techniques in Developing Countries

PREFACE

The G-24 Discussion Paper Series is a collection of research papers preparedunder the UNCTAD Project of Technical Support to the Intergovernmental Group ofTwenty-Four on International Monetary Affairs (G-24). The G-24 was established in1971 with a view to increasing the analytical capacity and the negotiating strength ofthe developing countries in discussions and negotiations in the international financialinstitutions. The G-24 is the only formal developing-country grouping within the IMFand the World Bank. Its meetings are open to all developing countries.

The G-24 Project, which is administered by UNCTAD�s Division on Globalizationand Development Strategies, aims at enhancing the understanding of policy makers indeveloping countries of the complex issues in the international monetary and financialsystem, and at raising awareness outside developing countries of the need to introducea development dimension into the discussion of international financial and institutionalreform.

The research papers are discussed among experts and policy makers at the meetingsof the G-24 Technical Group, and provide inputs to the meetings of the G-24 Ministersand Deputies in their preparations for negotiations and discussions in the framework ofthe IMF�s International Monetary and Financial Committee (formerly Interim Committee)and the Joint IMF/IBRD Development Committee, as well as in other forums.

The Project of Technical Support to the G-24 receives generous financial supportfrom the International Development Research Centre of Canada and contributions fromthe countries participating in the meetings of the G-24.

CAPITAL MANAGEMENT TECHNIQUESIN DEVELOPING COUNTRIES:

An Assessment of Experiences fromthe 1990s and Lessons for the Future

Gerald EpsteinProfessor of Economics and Co-Director

Political Economy Research Institute (PERI)University of Massachusetts, Amherst

Ilene GrabelAssociate Professor of International Finance

Graduate School of International StudiesUniversity of Denver

Jomo, K.S.Professor of Economics

University of Malaya

G-24 Discussion Paper No. 27

March 2004

viiCapital Management Techniques in Developing Countries

Abstract

This paper uses the term, capital management techniques, to refer to two complementary(and often overlapping) types of financial policies: policies that govern international privatecapital flows and those that enforce prudential management of domestic financial institutions.The paper shows that regimes of capital management take diverse forms and are multi-faceted.The paper also shows that capital management techniques can be static or dynamic. Staticmanagement techniques are those that authorities do not modify in response to changes incircumstances. Capital management techniques can also be dynamic, meaning that they can beactivated or adjusted as circumstances warrant. Three types of circumstances triggerimplementation of management techniques or lead authorities to strengthen or adjust existingregulations: changes in the economic environment, the identification of vulnerabilities, and theattempt to close loopholes in existing measures.

The paper presents seven case studies of the diverse capital management techniques employedin Chile, China, Colombia, India, Malaysia, Singapore and Taiwan Province of China duringthe 1990s. The cases reveal that policymakers were able to use capital management techniquesto achieve critical macroeconomic objectives. These included the prevention of maturity andlocational mismatch; attraction of favoured forms of foreign investment; reduction in overallfinancial fragility, currency risk, and speculative pressures in the economy; insulation from thecontagion effects of financial crises; and enhancement of the autonomy of economic and socialpolicy. The paper examines the structural factors that contributed to these achievements, andalso weighs the costs associated with these measures against their macroeconomic benefits.

The paper concludes by considering the general policy lessons of these seven experiences.The most important of these lessons are as follows. (1) Capital management techniques canenhance overall financial and currency stability, buttress the autonomy of macroeconomic andmicroeconomic policy, and bias investment toward the long-term. (2) The efficacy of capitalmanagement techniques is highest in the presence of strong macroeconomic fundamentals, thoughmanagement techniques can also improve fundamentals. (3) The nimble, dynamic application ofcapital management techniques is an important component of policy success. (4) Controls overinternational capital flows and prudential domestic financial regulation often function ascomplementary policy tools, and these tools can be useful to policymakers over the long run. (5)State and administrative capacity play important roles in the success of capital managementtechniques. (6) Evidence suggests that the macroeconomic benefits of capital managementtechniques probably outweigh their microeconomic costs. (7) Capital management techniqueswork best when they are coherent and consistent with a national development vision. (8) Thereis no single type of capital management technique that works best for all developing countries.Indeed our cases, demonstrate a rather large array of effective techniques.

There are sound reasons for cautious optimism regarding the ability of policymakers in thedeveloping world to build upon these lessons. In particular, we are heartened by the growingunderstanding of the problems with capital account convertibility in developing countries; bythe increasing recognition of the achievements of capital management techniques by importantfigures in academia, the IMF and the business community; and by the potential for somedeveloping countries (such as Chile, China, India, Malaysia and Singapore) to play a lead rolein discussions of the feasibility and efficacy of various capital management techniques.

ixCapital Management Techniques in Developing Countries

Table of contents

Preface ............................................................................................................................................ iii

Abstract ........................................................................................................................................... vii

I. Introduction .............................................................................................................................. 1

II. A brief review of the literature ............................................................................................... 2

III. Capital management techniques: tools, objectives and costs .............................................. 3A. What are capital management techniques? .......................................................................... 3B. Objectives of capital management techniques ..................................................................... 4C. Costs of capital management techniques ............................................................................. 5

IV. Case studies: capital management techniques in developing countries since the 1990s ......... 6A. Objectives and case selection .............................................................................................. 6B. Case studies .......................................................................................................................... 7

V. Lessons and opportunities for capital management in developing countries .................. 26A. Lessons ............................................................................................................................... 26B. Opportunities ..................................................................................................................... 29

Notes ........................................................................................................................................... 30

References ........................................................................................................................................... 31

List of tables

1 Summary: types and objectives of capital management techniquesemployed during the 1990s ........................................................................................................ 8

2 Summary: assessment of the capital management techniquesemployed during the 1990s ...................................................................................................... 28

I. Introduction

Following the Asian crisis of the late 1990s,there has been a renewed interest in the role of capi-tal controls in developing countries within bothpolicy and academic circles.1 The reasons for thisinterest are not hard to find. Even strong proponentsof capital account liberalization have acknowledgedthat many countries that avoided the worst effectsof recent financial crises were also those that usedcapital controls, including Chile, China, India andMalaysia. Consequently, prominent mainstreameconomists and even the IMF have relaxed their in-sistence that immediate capital account liberalizationis the best policy for all countries in all circumstances(IMF, 2000; Fischer, 2002; and Eichengreen, 2002a).2

Adding momentum to the discussion over the lastseveral years, a number of highly respected econo-mists have actively argued in favour of capitalcontrols (Bhagwati, 1998; Krugman, 1998; Rodrik,1998; Stiglitz, 2002).

Despite this apparent increase in the tolerancefor capital controls, most mainstream academic andpolicy economists remain quite skeptical about theviability and desirability of controls, at least in twospecific senses. Whatever increased tolerance forcapital controls exists applies to controls on inflows,not on outflows. Moreover, controls on inflows aregenerally seen as a �temporary evil�, useful only untilall of the institutional pre-requisites for full finan-cial and capital account liberalization are in place.

More generally, there are three principal linesof argument advanced by those who remain scepti-cal of capital controls. First, the benefits of capitalcontrols have been overstated or misunderstood bytheir proponents (Edwards, 1999 and 2001). Second,capital controls impose serious costs on developingeconomies (they raise capital costs and induce cor-ruption). Third, capital controls cannot work intoday�s liberalized environment because of the like-lihood of evasion.

CAPITAL MANAGEMENT TECHNIQUESIN DEVELOPING COUNTRIES:

An Assessment of Experiences fromthe 1990s and Lessons for the Future

Gerald Epstein, Ilene Grabel and Jomo, K.S.*

* The authors are grateful to Peter Zawadzki for excellent research assistance, to Arjun Jayadev for his contributions to theIndia case study, to Robert McCauley and Dani Rodrik for their help at the early stages of this project, and to the participants at theXVIth Technical Group Meeting of the G-24 in Port of Spain, Trinidad and Tobago, 13�14 February 2003 for helpful comments,especially, Ariel Buira, Aziz Ali Mohammed, Esteban Pérez, and Benu Schneider. Please send comments to Gerald Epstein([email protected]) or Ilene Grabel ([email protected]).

2 G-24 Discussion Paper Series, No. 27

In this study we show that critics often over-state the costs of capital controls and fail to acknowl-edge their numerous important achievements. In fact,our study demonstrates that capital controls in manydeveloping countries have recently achieved numer-ous important objectives. We argue that policy mak-ers in the developing world can and should drawupon these achievements in their discussions ofpolicy design.

At the outset we emphasize that a thoroughunderstanding of the policy options available to de-veloping countries necessitates that we expand thediscussion of capital controls to include what we term�capital management techniques�. Capital manage-ment techniques include the traditional menu ofcapital controls but add a set of policies that we term�prudential financial regulations�. We argue thatcertain types of prudential financial regulations ac-tually function as a type of capital control. Moreover,capital controls themselves can function as or com-plement prudential financial regulations. Ourresearch demonstrates that there is often a great dealof synergy between prudential financial regulationsand traditional capital controls.

We also find that it can be difficult (and some-times impossible) to draw a firm line betweenprudential domestic financial regulation and capitalcontrols. For instance, domestic financial regulationsthat curtail the extent of maturity or locational mis-matches may have the effect of influencing thecomposition of international capital flows to a coun-try, even though these types of regulations arecommonly classified as prudential domestic finan-cial regulations and not as capital controls.

The paper presents seven case studies of thediverse capital management techniques employedduring the 1990s. There are eight principal findingsthat follow from our case studies: (i) Capital man-agement techniques can enhance overall financialand currency stability, buttress the autonomy ofmacro and micro-economic policy, and bias invest-ment toward the long term. (ii) The efficacy of capitalmanagement techniques is highest in the presenceof strong macroeconomic fundamentals, thoughmanagement techniques can also improve fundamen-tals. (iii) The nimble, dynamic application of capitalmanagement techniques is an important componentof policy success. (iv) Controls over internationalcapital flows and prudential domestic financial regu-lation often function as complementary policy tools,

and these tools can be useful to policy makers overthe long run. (v) State and administrative capacityplay important roles in the success of capital man-agement techniques. (vi) The macroeconomicbenefits of capital management techniques outweighthe often-scant evidence of their microeconomiccosts. (vii) Capital management techniques work bestwhen they are coherent and consistent with a na-tional development vision. And (viii) there is nosingle type of capital management technique thatworks best for all developing countries. Indeed ourcases, demonstrate a rather large array of effectivetechniques.

This paper is organized in the following man-ner. In section II we briefly survey the literature oncapital account liberalization and capital controls.In section III we discuss capital management tech-niques in some depth, focusing on types oftechniques, achievements and costs. In section IVwe present seven case studies of the capital man-agement techniques employed in developingcountries during the 1990s. In Section V we sum-marize our chief findings and discuss broad policyrelevance. We also discuss the political prospects forbuilding on our chief policy lessons.

II. A brief review of the literature

In recent years, economists have produced anenormous body of empirical literature on capitalcontrols and capital account convertibility. There isa large literature on the effect of capital account lib-eralization on economic and productivity growth,investment, income distribution and financial crises(recent surveys appear in Arteta et al., 2001 and Lee,2002). This research uses primarily cross sectionalor panel techniques, and attempts to assess �broadbrush� claims about regimes of capital controls ver-sus regimes of capital account liberalization. Thisliterature suggests quite clearly that the road to suc-cessful capital account liberalization is rocky at best,and that full capital account liberalization need notbe a goal for all developing countries.

A second strand of the literature looks morespecifically at the effects of controls themselves viacross-sectional econometric analysis (Epstein andSchor, 1992; Grilli and Miles-Ferreti, 1995; Edwards,1999, 2001) or case studies (Ariyoshi et al., 2000;

3Capital Management Techniques in Developing Countries

Rajamaran, 2001; Kaplan and Rodrik, 2002).3 Sev-eral findings emerge from these analyses. Capitalcontrols can reduce the vulnerability of developingcountries to financial crises. Controls over capitalinflows can be effective (at least in the short run) inchanging the composition and maturity structure offlows. Through their effects on composition andmaturity structure, controls on inflows can reducethe vulnerability to crisis (Montiel and Reinhart,1999; references in section IV.B.1). Capital controlscan drive a wedge between onshore and offshoreinterest rates. This wedge can provide monetary au-thorities with limited policy autonomy at least in theshort-run (Crotty and Epstein, 1996; Dooley, 1996).

Despite the emergence of consensus in the ar-eas discussed above, there nevertheless exists muchdebate in the academic and policy community asconcerns capital controls and capital account con-vertibility. The intensive case studies in section IVaim to overcome the inherent limitations of paneland cross-sectional econometric studies by provid-ing a nuanced, rigorous analysis of the achievementsand limitations of capital management techniques.

III. Capital management techniques:tools, objectives and costs

A. What are capital managementtechniques?

We use the term capital management techniquesto refer to two complementary (and often overlap-ping) types of financial policies: policies that governinternational private capital flows, called �capitalcontrols�, and those that enforce prudential manage-ment of domestic financial institutions. Regimes ofcapital management take diverse forms and are multi-faceted. Moreover, some capital managementtechniques are static while others are dynamic.

1. Complementary policies: capital controls andprudential financial regulation

Capital controls refer to measures that managethe volume, composition, or allocation of interna-tional private capital flows (Neely, 1999). Capitalcontrols can target inflows or outflows. Inflow oroutflow controls generally target particular flows

(such as portfolio investment (PI)), based on theirperceived risks and opportunities. Capital controlscan be tax-based or quantitative. Reserve require-ment taxes against certain types of investments arean example of a tax-based control. Quantitative capi-tal controls involve outright bans on certain invest-ments (the purchase of equities by foreign investors),restrictions or quotas, or license requirements.

�Prudential domestic financial regulations� areanother type of capital management technique. Theserefer to policies, such as capital-adequacy standards,reporting requirements, or restrictions on the abilityand terms under which domestic financial institu-tions can provide capital to certain types of projects.

A strict bifurcation between capital controls andprudential regulations often cannot be maintainedin practice (as Ocampo (2002) and Schneider (2001)observe). Policy makers frequently implement multi-faceted regimes of capital management as no singlemeasure can achieve diverse objectives (as we willsee in section IV). Moreover, the effectiveness ofany single management technique magnifies the ef-fectiveness of other techniques, and enhances theefficacy of the entire regime of capital management.For example, certain prudential financial regulationsmagnify the effectiveness of capital controls (andvice versa). In this case, the stabilizing aspect ofprudential regulation reduces the need for the moststringent form of capital control. Thus, a program ofcomplementary capital management techniques re-duces the necessary severity of any one technique,and magnifies the effectiveness of the regime of fi-nancial control.

2. Static versus dynamic capital managementtechniques

Capital management techniques can be staticor dynamic (although here, too, the strict distinctionis not always maintained in practice). Static man-agement techniques are those that authorities do notmodify in response to changes in circumstances.Examples of static management techniques includerestrictions on the convertibility of the currency, re-strictions on certain types of activities (such asshort-selling the currency), or maintenance of mini-mum-stay requirements on foreign investment.

Capital management techniques can also bedynamic, meaning that they can be activated or ad-


justed as circumstances warrant. Three types ofcircumstances trigger the implementation of man-agement techniques or lead authorities to strengthenor adjust existing regulations.

First, capital management techniques are acti-vated in response to changes in the economic envi-ronment (changes in the volume of internationalcapital flows or the emergence of an asset bubble).4

For example, the Malaysian Government imple-mented stringent temporary inflow controls in 1994to dampen pressures associated with large capitalinflows. The Chilean Government changed its capi-tal management techniques several times during the1990s in response to fluctuations in the volume ofcapital flows to the country. Second, capital man-agement techniques are activated to prevent identi-fied vulnerabilities from culminating in a financialcrisis or to reduce the severity of a crisis.5 For ex-ample, the Malaysian Government implementedstringent capital controls in 1998 to stabilize theeconomy and to protect it from the contagion ef-fects of the regional crisis. Both China and TaiwanProvince of China strengthened existing capital man-agement techniques and added new measures to in-sulate themselves from the emerging regional crisis.Third, capital management techniques are strength-ened or modified as authorities attempt to close loop-holes in existing measures. For example, authoritiesin Chile, China and Taiwan Province of China ad-justed their capital management techniques severaltimes during the 1990s as loopholes in existing meas-ures were identified.

B. Objectives of capital managementtechniques

Policy makers use capital management tech-niques to achieve some or all of the following fourobjectives � to promote financial stability; to encour-age desirable investment and financing arrange-ments; to enhance policy autonomy; and to enhancedemocracy.6

1. Capital management techniques can promotefinancial stability

Capital management techniques can promotefinancial stability through their ability to reduce cur-rency, flight, fragility and/or contagion risks. Capitalmanagement can thereby reduce the potential for fi-

nancial crisis and attendant economic and socialdevastation.

Currency risk refers to the risk that a currencywill appreciate or depreciate significantly over ashort period of time. Currency risk can be curtailedif capital management techniques reduce the oppor-tunities for sudden, large purchases or sales ofdomestic assets by investors (via controls on inflowsand outflows, respectively). Capital management canprotect the domestic currency from dramatic fluc-tuation via restrictions on its convertibility. Finally,capital management can provide authorities with theability to engage in macroeconomic policies thatsterilize the effects of sudden, large capital inflowsor outflows on the currency.

Investor flight risk refers to the likelihood thatholders of liquid financial assets will sell their hold-ings en masse in the face of perceived difficulty.Lender flight risk refers to the likelihood that lend-ers will terminate lending programs or will onlyextend loans on prohibitive terms. Capital manage-ment can reduce investor and lender flight risk bydiscouraging the types of inflows that are subject torapid reversal (namely, PI, short-term foreign loans,and liquid forms of foreign direct investment (FDI)).Capital management can also reduce investor andlender flight risk by reducing or discouraging theopportunities for exit via outflow controls.

Fragility risk refers to the vulnerability of aneconomy�s private and public borrowers to internalor external shocks that jeopardize their ability to meetcurrent obligations. Fragility risk arises in a numberof ways. Borrowers might employ financing strate-gies that involve maturity or locational mismatch.Agents might finance private investment with capi-tal that is prone to flight risk. Investors (domesticand foreign) may over-invest in certain sectors,thereby creating overcapacity and fueling unsustain-able speculative bubbles. Capital managementtechniques can reduce fragility risk through inflowcontrols that influence the volume, allocation and/or prudence of lending and investing decisions.

Contagion risk refers to the threat that a coun-try will fall victim to financial and macroeconomicinstability that originates elsewhere. Capital man-agement techniques can reduce contagion risk bymanaging the degree of financial integration and byreducing the vulnerability of individual countries tocurrency, flight and fragility risks.


2. Capital management techniques can promotedesirable types of investment and financingarrangements and discourage less desirabletypes of investment/financing strategies

Capital management techniques can influencethe composition of the economy�s aggregate invest-ment portfolio, and can influence the financingarrangements that underpin these investments. Capi-tal management techniques (particularly those thatinvolve inflow controls) can promote desirable typesof investment and financing strategies by rewardinginvestors and borrowers for engaging in them. De-sirable types of investment are those that createemployment, improve living standards, promotegreater income equality, technology transfer, learn-ing by doing and/or long-term growth. Desirabletypes of financing are those that are long-term, stableand sustainable. Capital management can discour-age less desirable types of investment and financingstrategies by increasing their cost or precluding themaltogether.

3. Capital management can enhance theautonomy of economic and social policy

Capital management techniques can enhancepolicy autonomy in a number of ways. Capital man-agement techniques can reduce the severity ofcurrency risk, thereby allowing authorities to pro-tect a currency peg. Capital management can createspace for the government and/or the central bank topursue growth-promoting and/or reflationary macr-oeconomic policies by neutralizing the threat ofcapital flight (via restrictions on capital inflows oroutflows). Moreover, by reducing the risk of finan-cial crisis in the first place, capital management canreduce the likelihood that governments may be com-pelled to use contractionary macroeconomic,microeconomic and social policies as signal to at-tract foreign investment back to the country or as aprecondition for financial assistance from the IMF.Finally, capital management techniques can reducethe specter of excessive foreign control or owner-ship of domestic resources.

4. Capital management techniques can enhancedemocracy

It follows from point three that capital man-agement can enhance democracy by reducing the

potential for speculators and external actors to exer-cise undue influence over domestic decision makingdirectly or indirectly (via the threat of capital flight).Capital management techniques can reduce the vetopower of the financial community and the IMF, andcreate space for the interests of other groups (suchas advocates for the poor) to play a role in the designof economic and social policy. Capital managementtechniques can thus be said to enhance democracybecause they create the opportunity for pluralism inpolicy design.

C. Costs of capital management techniques

Critics of capital management techniques ar-gue that they impose four types of costs � they reducegrowth; reduce efficiency and policy discipline; pro-mote corruption and waste; and aggravate creditscarcity, policy abuse, uncertainty and error. Criticsargue that the benefits that derive from capital man-agement (such as financial stability) come at anunacceptably high price.

1. Capital management techniques reducegrowth

Critics of capital management techniques ar-gue that they dampen the volume of internationalprivate capital inflows, and thereby reduce economicgrowth. Note that some economists argue that a lib-eral stance toward international capital flows is onlybeneficial once a country reaches a certain thresh-old level of economic and financial development(Edwards, 2001). Advocates of sequencing liber-alization generally find their case strengthenedfollowing financial crises, as these are seen as a con-sequence of premature financial liberalization.However, the case for sequencing is controversialwithin neoclassical theory because some argue thatit introduces problems (such as corruption, inertiain reform, slow growth, high capital costs) that arefar worse than any financial instability associatedwith the liberalization of financial flows.

Critics of capital management techniques alsoargue that they raise capital costs, and thereby un-dermine investment and growth.7 The argument isthat the rate of return necessary to attract interna-tional capital flows will increase since investorsdemand a premium in order to commit funds to an


economy wherein liquidity or exit options are com-promised.8

2. Capital management techniques reduceefficiency and policy discipline

Many critics of capital management techniquesargue that they undermine efficiency and policy dis-cipline. The need to attract international privatecapital flows and the threat of capital flight (by do-mestic and/or foreign investors) are powerfulincentives for the government and firms to maintaininternational standards for policy design, macroeco-nomic performance and corporate governance. Forexample, governments that seek to attract interna-tional private capital flows will be more likely topursue anti-inflationary economic policies and anti-corruption measures because investors value pricestability and transparency.9

Moreover, the liberalization of internationalcapital flows means that these flows will be allo-cated by markets rather than by governments. Mostcritics of capital management assume that a market-based allocation of capital increases efficiency andensures that finance will be directed towards thoseprojects that promise the greatest net contribution tosocial welfare.

3. Capital management techniques promotecorruption and waste

Critics argue that capital management tech-niques necessitate the creation of elaborate andexpensive bureaucracies. Additionally, critics arguethat capital management techniques stimulate cor-ruption and other wasteful activities as agents seekto evade restrictions through off-shore or disguisedtransactions, trade mis-invoicing, lobbying effortsand the bribery of officials.10 Critics argue that theseevasion efforts ultimately frustrate regimes of capi-tal management.

4. Dynamic capital management techniquesaggravate problems of credit scarcity andpolicy abuse, uncertainty and error

Critics argue that dynamic capital managementtechniques have the potential to introduce or aggra-vate several problems of their own. Though he is by

no means a critic of dynamic capital management,Ocampo (2002) acknowledges that some capitalmanagement techniques have the potential to harmsmall- and medium-sized enterprises (SMEs) in de-veloping countries. This may occur if dynamiccapital management force domestic lenders to raiselending costs during an economic boom. Higherdomestic capital costs may have a disproportionateeffect on SMEs because they tend to raise their fundson domestic capital markets.

Ocampo (2002) also notes that dynamic capi-tal management techniques can introduce concernsabout the abuse of discretionary authority by domes-tic policy makers. There are also inherent technicaldifficulties involved in distinguishing between cy-clical and long run trends. Investor confidence maysuffer if the criteria used for activation of dynamiccapital management techniques are not consistentand transparent.

In sum, many critics argue that there are sig-nificant costs associated with capital managementtechniques. However, there is little consensus in theempirical literature on the size (or even the exist-ence) of these costs. More importantly, researchershave largely failed to investigate the relative weightof costs and benefits. The seven case studies pre-sented below address these important lacunae.

IV. Case studies: capital managementtechniques in developing countriessince the 1990s

A. Objectives and case selection

In this section of the paper we present sevencase studies that analyse the capital managementtechniques employed during the 1990s in Chile,China, Colombia, India, Malaysia, Singapore andTaiwan Province of China. The presentation of thecase studies is guided by five principal goals. First,to provide a detailed institutional guide to the capi-tal management techniques pursued in diverse areasof the world from the 1990s to the present. Second,to examine the extent to which these managementtechniques achieved the objectives of their architects.Third, to elaborate the underlying structural factorsthat explain the success or failure of the techniquesemployed. Fourth, to examine the costs associated


with these measures. And fifth, to draw general con-clusions about the desirability and feasibility ofreplicating or adapting particular techniques to de-veloping countries outside of our sample.

We have limited our examination to the 1990sbecause this period is distinguished by the combi-nation of high levels of financial integration, a globalnorm of financial and economic liberalization, anincrease in the power and autonomy of the globalfinancial community, and by significant advancesin telecommunications technology. It is commonlyheld that any one of these factors (let alone theircombined presence) frustrates the possibility forsuccessful capital management. We have selectedthese seven cases because policy makers employeddiverse capital management techniques (in line withlevels of state capacity and sovereignty) with differ-ent objectives and disparate degrees of success.

B. Case studies

Each case study will include the followingseven components. (i) The context in which authori-ties decided to implement capital managementtechniques (i.e., historical considerations, pastproblems, etc.); (ii) objectives of policy architects;(iii) description of the capital management tech-niques employed; (iv) assessment of the extent towhich they achieved the objectives of their archi-tects; (v) consideration of the structural factors thatcontributed to policy success or failure; (vi) costs orunintended consequences of capital management;and (vii) discussion of any unintended achievementsof the policies. Table 1 presents a summary of themajor capital management techniques and their ob-jectives for each of our cases.

1. The �Chilean model� of the 1990s:Capital management techniques in Chileand Colombia11

In the aftermath of the Asian crisis, heterodoxand even prominent mainstream economists (Eichen-green, 1999) focused a great deal of attention on the�Chilean model�, a term that has been used to referto a policy regime that Chilean and Colombian au-thorities began to implement in June 1991 andSeptember 1993, respectively.

� Context in Chile and Colombia

During the 1990s, policy makers in Chile andColombia sought to improve investor confidence andto promote stable, sustainable economic and exportgrowth. The capital management techniques of the1990s were an integral component of the overalleconomic plan in both countries. Capital manage-ment techniques in Chile and Colombia can perhapsbe best understood in the context of the economicchallenges that confronted the region�s economiesduring the 1970s and 1980s. These problems in-cluded high inflation, severe currency and bankinginstability, financial crises, high levels of externaldebt and capital flight, and low levels of investorconfidence.

� Chilean context

Chile experienced a �boom-bust cycle� in thetwo decades that preceded the capital managementtechniques of the 1990s. During the neo-liberal ex-periment of the 1970s, surges in foreign capitalinflows led to a consumption boom and createdsignificant pressure for currency appreciation. Ex-perience with the �Dutch disease� in the 1970sreinforced policy maker�s commitment to prevent-ing the fallout from surges in private capital inflowsin the 1990s. The financial implosion, reduction ininternational capital flows, and the deep recessionof the early to mid-1980s also played a powerfulrole in the design of capital management techniquesin the 1990s. Thus, the experiences of the 1970s and1980s created a consensus around the idea that itwas necessary to insulate the economy from vola-tile international capital flows.

Preventing the Dutch disease was of paramountimportance in the 1990s because of the Govern-ment�s commitment to an export-led economicmodel. Chilean economic policy in the 1990s is dif-ficult to characterize. In some senses, it was ratherstrongly neo-liberal. For instance, the country�s sta-tus as a pioneer in the area of pension fundprivatization earned it much respect in the interna-tional investment community. The Government alsopursued a vigorous program of trade liberalizationand privatization of state-owned enterprises. Butat the same time, the Government also providededucation and income support to the poor and un-employed and maintained a stringent regime ofcapital management techniques. It should also benoted that the health of the country�s banking system

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Table 1

SUMMARY: TYPES AND OBJECTIVES OF CAPITAL MANAGEMENT TECHNIQUES EMPLOYED DURING THE 1990s

Country Types of capital management techniques Objectives of capital management techniques

Chile Inflows: � Lengthen maturity structures and stabilize inflows� FDI and PI: one-year residence requirement � Help manage exchange rates to maintain export competitiveness� 30 per cent URR � Protect economy from financial instability� Tax on foreign loans: 1.2 per cent per yearOutflows:� No significant restrictionsDomestic financial regulations:� Strong regulatory measures

Colombia Similar to Chile Similar to Chile

Taiwan Province Inflows: � Promote industrialization of China Non-residents: � Help manage exchange for export competitiveness

� Bank accounts can only be used for domestic spending, � Maintain financial stability and insulate from foreign financial crisesnot financial speculation

� Foreign participation in stock market regulated� FDI tightly regulatedResidents:� Regulation of foreign borrowingOutflows:� Exchange controlsDomestic financial regulations:� Restrictions on lending for real estate and other speculative purposes

Singapore Inflows: � To prevent speculation against S$� �Non-Internationalization� of Singapore $ (S$) inflows � To support �soft peg� of S$Outflows: � To help maintain export competitivenessNon-residents: � To help insulate Singapore from foreign financial crises� Financial institutions cannot extend S$ credit to non-residents

who are likely to use it for speculation� If they borrow for use abroad, must swap first into foreign currencyDomestic financial regulations:� Restrictions on creation of swaps, and other derivatives that could be

used for speculation against S$

9C

apital Managem

ent Techniques in Developing C

ountries

Malaysia (1998) Inflows: � To maintain political and economic sovereignty� Restrictions on foreign borrowing � Kill the offshore ringgit marketOutflows: � Shut down offshore share marketNon-residents: � To help reflate the economy� 12 month repatriation waiting period � To help create financial stability and insulate the economy from contagion� Graduated exit levies inversely proportional to length of stayResidents:� Exchange controlsDomestic financial regulations:Non-residents:� Restrict access to ringgitResidents:� Encourage to borrow domestically and invest

India Inflows: � Support industrial policyNon-residents: � Pursue capital account liberalization in an incremental and controlled fashion� Strict Regulation of FDI and PI � Insulate domestic economy from financial contagionOutflows: � Preserve domestic savings and forex reservesNon-residents: � Help stabilize exchange rate� NoneResidents:� Exchange controlsDomestic financial regulations:� Strict limitations on development of domestic financial markets

China Inflows: � Support industrial policyNon-residents: � Pursue capital account liberalization in incremental and controlled fashion� Strict regulation on sectoral FDI investment � Insulate domestic economy from financial contagion� Regulation of equity investments: segmented stock market � Increase political sovereigntyOutflows: � Preserve domestic savings and foreign exchange reservesNon-residents: � Help keep exchange rates at competitive levels� No restrictions on repatriation of funds� Strict limitations on borrowing Chinese Renminbi for speculative purposesResidents:� Exchange controlsDomestic financial regulations:� Strict limitations on residents and non-residents

Source: See section IV.


improved significantly during the 1990s, thanks to anumber of prudential banking and regulatory reforms.

� Colombian context

As in Chile, the architects of Colombia�s capi-tal management techniques in the 1990s wereinfluenced by the economic problems of the previ-ous two decades. The promotion of investorconfidence was a far more daunting task in Colom-bia than in Chile because of the country�s politicaland civil uncertainties. Inflation was also a severeproblem in Colombia in the 1970s and 1980s (andindeed, remained a problem during the 1990s aswell). The 1990s was a time of far-reaching eco-nomic reform in Colombia. Authorities sought toattract international capital flows and promote tradeand price stability through a number of structuralreforms. These reforms included trade liberalization,increased exchange rate flexibility, tax reductions,labour market liberalization, partial privatization ofsocial security and state-owned enterprises, and cen-tral bank independence. Most of the economicreforms in the 1990s were in the direction of neo-liberalism; however, the capital managementtechniques and the increases in public expenditurewere important exceptions in this regard.

� Objectives

Though there were national differences inpolicy design, Chilean and Colombian policiesshared the same objectives. The policy regime soughtto balance the challenges and opportunities of finan-cial integration, lengthen the maturity structure andstabilize capital inflows, mitigate the effect of largevolumes of inflows on the currency and exports, andprotect the economy from the instability associatedwith speculative excess and the sudden withdrawalof external finance.

� Capital management techniques in Chile,1991�1999

Financial integration in Chile was regulatedthrough a number of complementary, dynamic meas-ures (the most important of which are describedhere). During the lifetime of the Chilean model, au-thorities widened and revalued the crawling ex-change rate band that was initially adopted in theearly 1980s. The monetary effects of the rapid ac-cumulation of international reserves were also largelysterilized.

Central to the success of the Chilean model wasa multi-faceted program of inflows management.Foreign loans faced a tax of 1.2 per cent per year.FDI and PI faced a one-year residence requirement.And from May 1992 to October 1998, Chilean au-thorities imposed a non-interest bearing reserverequirement of 30 per cent on all types of externalcredits and all foreign financial investments in thecountry. Note that the level and scope of the reserverequirement ratio was, in fact, changed several timesduring the lifespan of this policy regime in responseto changes in the economic environment and to iden-tified channels of evasion. The required reserveswere held at the Central Bank for one year, regard-less of the maturity of the obligation.

The Central Bank eliminated the managementof inflows (and other controls over international capi-tal flows) in several steps beginning in September1998. This decision was taken because the countryconfronted a radical reduction in inflows in the post-Asian/Russian/Brazilian crisis environment (render-ing flight risk not immediately relevant). Chileanauthorities determined that the attraction of interna-tional private capital flows was a regrettable neces-sity in light of declining copper prices and a risingcurrent account deficit. Critics of the Chilean modelheralded its demise as proof of its failure.

But others viewed the dismantling of the modelas evidence of its success insofar as the economyhad outgrown the need for protections. For exam-ple, Eichengreen (1999: 53) notes that by the summerof 1998 it was no longer necessary to provide disin-centives to foreign funding because the Chileanbanking system was on such strong footing follow-ing a number of improvements in bank regulation.12

In our view, the decision to terminate inflow andother controls over international capital flows wasimprudent given the substantial risks of a future surgein capital inflows to the country and the risk that thecountry could experience contagion from financialinstability in Argentina, Brazil, Paraguay and Uru-guay. It would have been far more desirable tomaintain the controls at a low level while address-ing the current-account deficit and the need to attractinflows through other means. Indeed, flexible de-ployment of the inflows policy was a hallmark ofthe Chilean model (consistent with the dynamic ap-proach to capital management in section III.A), andit is regrettable that authorities moved away fromthis strategy at the present juncture.


� Capital management techniques in Colombia,1993�1999

Colombia�s inflows management policies re-lating to foreign borrowing were similar to (thoughblunter than) those in Chile. This difference is per-haps attributable to limitations on state capacity inColombia. Beginning in September 1993, the Cen-tral Bank required that non-interest bearing reservesof 47 per cent be held for one year against foreignloans with maturities of eighteen months or less (thiswas extended to loans with a maturity of up to fiveyears in August 1994). Foreign borrowing related toreal estate was prohibited. Moreover, foreigners weresimply precluded from purchasing debt instrumentsand corporate equity (there were no comparable re-strictions on FDI). Colombian policy also sought todiscourage the accretion of external obligations inthe form of import payments by increasing the costof import financing. Authorities experimented witha variety of measures to protect exports from cur-rency appreciation induced by inflows. Thesemeasures ranged from a limited sterilization of in-flows, to maintenance of a managed float, to acrawling peg. As in Chile, regulations on interna-tional capital flows were gradually eliminatedfollowing the reduction in flows after the Asian cri-sis.

� Assessment

The array of capital management techniquesthat constitute the Chilean model represent a highlyeffective means for achieving the economic objec-tives identified by the architects of these policies.The capital management techniques achieved theseobjectives via their effect on currency, flight, fragil-ity and contagion risks.

Chilean authorities managed currency risk viaadjustments to its crawling peg, sterilization and in-flows management. Taken together, these measuresgreatly reduced the likelihood that the currencywould appreciate to such a degree as to jeopardizethe current account, and the policies made it diffi-cult for investor flight to induce a currency collapse.Indeed, the appreciation of the Chilean currency andthe current-account deficit (as a share of GDP) weresmaller than in other Latin American countries thatwere also recipients of large capital inflows (Agosin,1998). Moreover, the currency never came underattack following the Mexican and Asian crises.

Colombian efforts to manage currency riskwere less successful than those in Chile. This is thecase for three reasons. There was a lack of consist-ency in the exchange rate regime in Colombia as aconsequence of the frequent changes in the exchangerate strategy employed (managed float, crawling peg,etc.) Inflow sterilization was rather limited in scopewhen compared to sterilization in Chile. And infla-tion continued to be a problem in Colombia duringthe 1990s. Nonetheless, currency and inflows man-agement offered some protection to exports inColombia when the country was receiving relativelylarge capital inflows. The currency also held up fairlywell following the Mexican crisis.

Chilean and Colombian policies reduced thelikelihood of a sudden exit of foreign investors bydiscouraging those inflows that introduce the high-est degree of flight risk. The reserve requirementtax in Chile was designed to discourage such flowsby raising the cost of these investments. The Chil-ean minimum stay policy governing FDI reinforcedthe strategy of encouraging longer-term investmentswhile also preventing short-term flows disguised asFDI. Colombian policy precluded the possibility ofan exit of foreign investors from liquid investmentby prohibiting their participation in debt and equitymarkets (while maintaining their access to FDI). Thereduction in flight risk in both countries comple-mented efforts to reduce currency risk, particularlyin Chile where policy effectively targeted currencyrisk.

Chilean and Colombian inflows managementalso mitigated fragility risk. The regime reduced theopportunity for maturity mismatch by demonstrat-ing an effective bias against short-term, unstablecapital inflows. In Chile, taxes on foreign borrow-ing were designed precisely to discourage thefinancing strategies that introduced so much fragil-ity risk to Asian economies and Mexico. InColombia, the rather large reserve requirement taxon foreign borrowing and the prohibition on foreignborrowing for real estate played this role as well.

Numerous empirical studies find that inflowsmanagement in Chile and Colombia played a con-structive role in changing the composition andmaturity structure (though not the volume) of netcapital inflows, particularly after the controls werestrengthened in 1994�1995 (Ffrench-Davis andReisen, 1998; LeFort and Budenvich, 1997; Ocampoand Tovar, 1998; Palma, 2000). These studies also


find that leakages from these regulations had nomacroeconomic significance. Following implemen-tation of these policies in both countries, the maturitystructure of foreign debt lengthened and external fi-nancing in general moved from debt to FDI.Moreover, Chile received a larger supply of exter-nal finance (relative to GDP) than other countries inthe region, and FDI became a much larger propor-tion of inflows than in many other developingeconomies. Colombia�s prohibition on foreign eq-uity and bond market participation dramaticallyreduced the relative importance of short-term, liq-uid forms of finance. More strikingly, FDI becamea major source of finance in the country despite po-litical turbulence and blunt financial controls.

The move toward FDI and away from short-term, highly liquid debt and PI flows is a clearachievement of the Chilean model. However, it isimportant to note that FDI is not without its prob-lems. It can and has introduced sovereignty risk insome important cases (such as Chile�s earlier expe-rience with ITT) and can introduce other problemsto developing countries (Chang and Grabel, 2004:chap. 10; Singh, 2002).

The Chilean model also reduced the vulnerabil-ity to contagion by fostering macroeconomicstability. It is noteworthy that the transmission ef-fects of the Asian crisis in Chile and Colombia werequite mild compared to those in other Latin coun-tries (such as Brazil), let alone elsewhere. The declinein capital flows in Chile and Colombia followingthe Mexican and Asian crises was rather orderly, anddid not trigger currency, asset and investment col-lapse. Contrary to the experience in East Asia, thedecision to float the currency in Chile and Colom-bia (in the post-Asian crisis environment) did notinduce instability.

Some analysts challenge the generally sanguineassessment of the Chilean model. Edwards (1999),for example, argues that the effectiveness of themodel has been exaggerated. However, in a paperpublished a year later, De Gregorio, Edwards andValdés (2000) conclude that Chilean controls affectedthe composition and maturity of inflows, though nottheir volume. The De Gregorio et al. (2000) result isconfirmed for Chile in other studies that claim todemonstrate the failure of the model, even thoughtheir reported results show just the opposite (Ariyoshiet al., 2000; Valdés-Prieto and Soto, 1998). AsEichengreen (1999: 53) aptly remarks, the controls

affected only the composition and maturity and notthe volume of inflows is �hardly a devastating cri-tique�, since this was precisely their purpose.

� Supporting factors

Capital management techniques in both Chileand Colombia were able to achieve the economicobjectives of their architects for several reasons. Thepolicies were well designed, consistent and reason-ably transparent throughout their life. Policy makersin both countries were �nimble� in the sense thatthey dynamically modified capital management tech-niques as the economic environment changed,13 andas loopholes in the policies were revealed (seeMassad (1998: 44) for discussion of the Chileancase).14 Both countries offered investors attractiveopportunities and growing markets, such that inves-tors were willing to commit funds despite theconstraints imposed by the capital management re-gime.

Chile certainly had advantages over Colombia.The greater degree of state capacity in Chile maywell explain why its policies (particularly in regardsto exchange rate management) were more success-ful. Moreover, Chile�s status as a large developingeconomy certainly rendered it more attractive to for-eign investors, and may have granted the country agreater degree of policy autonomy than was avail-able to Colombia. The general soundness of itsbanking system and macroeconomic policy, themaintenance of price stability and the high level ofofficial reserves were important sources of investorconfidence in Chile. Finally, international supportfor the neo-liberal aspects of Chile�s economic re-forms provided the Government with the politicalspace to experiment with capital management tech-niques.

� Costs

At this point, compelling evidence on the costsof capital management techniques in Chile and Co-lombia is not available. Indeed, the two mostcomprehensive studies of this issue deal only withChile (and in an unsatisfactory manner).

Forbes (2002) is the most extensive study avail-able on the microeconomic costs of Chilean capitalmanagement techniques. Using a variety of empiri-cal tests (and sensitivity analysis thereof), Forbesshows that capital management techniques in Chile


resulted in an increase in capital costs to small-sizedenterprises.15 Forbes is careful to note that the re-sults themselves must be treated cautiously becauseof limitations on data availability.

In a broad study of the macroeconomic effectsof the Chilean capital management techniques,Edwards (1999) notes in passing that capital man-agement techniques increased capital costs for theSMEs that had difficulty evading controls on capi-tal inflows. He reports that the cost of funds tosmaller enterprises in Chile was more than 21 percent and 19 per cent per year in dollar terms in 1996and 1997, respectively. Edwards does not, however,place these data into the necessary comparativecontext, rendering them entirely unpersuasive as anindictment of the Chilean capital management tech-niques.

Both Forbes and Edwards conclude their stud-ies with the argument that the cost to smaller firmsof Chilean capital management techniques is far froma trivial matter because these enterprises play animportant role in investment, growth, and employ-ment creation in developing countries. Neither studyprovides empirical support for the argument thatthese firms do, in fact, play a significant role in mac-roeconomic performance. And neither study providesunambiguous evidence that the macroeconomic ben-efits of Chilean capital management techniques failto outweigh even the modest evidence of theirmicroeconomic costs (and much the same could besaid of Colombian experience).

On the issue of costs versus benefits, it shouldbe noted that Forbes (2002) remains agnostic on therelative importance of microeconomic costs versusmacroeconomic benefits. Edwards (1999), by con-trast, is entirely clear on this matter. He argues thatproponents of Chilean capital management tech-niques vastly overstate their macroeconomic benefitsand fail to acknowledge their microeconomic costs.On this basis, he argues that the Chilean capital man-agement techniques should not serve as a model forother developing countries. We find the empiricalbasis for this conclusion entirely unconvincing.

� Other achievements

As discussed above, the capital managementtechniques associated with the Chilean model

achieved the most important goals of its architects(though to a greater extent in Chile than in Colombia).Additionally, the capital management techniques inboth countries can be credited with enhancing thesovereignty of macroeconomic and microeconomicand social policy. The importance of this achieve-ment warrants discussion.

The capital management techniques of the Chil-ean model afforded policy makers insulation frompotential challenges to macroeconomic and micro-economic and social policy sovereignty through thereduction in various types of risks (particularly,through reduction in flight and fragility risks). Bothcountries were able to maintain relatively autono-mous, somewhat restrictive monetary policiesbecause of the protections afforded by the capitalmanagement techniques (LeFort and Budenvich,1997).16 Moreover, the protection from flight riskafforded by the capital management techniques madeit possible for policy makers to implement somegrowth-oriented fiscal policies (LeFort and Buden-vich, 1997). Finally, as LeFort and Budenvich (1997)argue, the protections and advantages conferred onboth countries by their capital management tech-niques were essential to the success of the entireregime of macroeconomic and microeconomicpolicy.17 For instance, the attraction of certain typesof international capital flows promoted economicgrowth in both countries, and the protection fromcurrency appreciation (to a large extent in Chile, andto a modest extent in Colombia) contributed to suc-cess in current-account performance.

The insulation afforded to both countries by thecapital management techniques also meant that mon-etary authorities were able to navigate the transitionto a floating exchange rate far more smoothly. Inmany other countries (such as in East Asia), the tran-sition to a floating rate involved significant currencydepreciations and financial instability.

The capital management techniques employedin both countries also reduced the risk of financialcrisis, and thereby buttressed the sovereignty of eco-nomic and social policies in both countries. Capitalmanagement techniques reduced the potential forIMF involvement in both countries. Policy makerswere therefore never pressed to change the direc-tion of (macro or micro) economic or social policy tosatisfy the demands of the IMF or to calm investors.


2. Taiwan Province of China

� Context

The capital management techniques employedin Taiwan Province of China can only be understoodin the context of a �developmentalist state� and anextended notion of national security that includeseconomic and financial stability.18 That is, capitalmanagement techniques are an integral componentof the macroeconomic and security objectives ofTaiwan Province of China (see below for discussionof objectives). These economic and security objec-tives were, and largely still are, the guiding forcesbehind extensive regulation of domestic financialinstitutions and credit flows, monetary and exchangerate policy and controls over international capitalflows. Taiwan Province of China built its industrialbase on the basis of restrictive policies toward FDIin �strategic sectors� (Chang and Grabel, 2004).Capital management techniques played a critical rolein promoting industrialization and export perform-ance.

� Objectives

Prior to the mid-1980s, Taiwan Province ofChina�s policy makers employed a multi-faceted setof capital management techniques in the service ofthree aims: to promote industrialization and exportsupremacy, economic growth, and economic stabil-ity. Since the goal of industrialization had beenachieved by the mid-1980s, capital managementtechniques are directed towards growth and stabil-ity objectives. Capital management techniques thatrestrict investment in unproductive assets are criti-cal in this regard.

Extensive capital management techniques arestill in use, though policy makers began to liberalizeaspects of the financial sector and to loosen somecontrols over international capital flows in 1995 aspart of the Asia Pacific Regional Operations CenterPlan (APROC) and the goal of joining the WTO.The APROC aimed at making Taiwan Province ofChina a regional center for high value-added manu-facturing, transportation, finance, telecommuni-cations, and several other areas. However, as Chinand Nordhaug (2002: 82) make clear, financial lib-eralization in Taiwan Province of China in the 1990sin no way weakened prudential financial regulationin the country.

� Capital management techniques inTaiwan Province of China

As discussed above, Taiwan Province of Chinamaintains an extensive set of capital managementtechniques that are tied to economic and securityobjectives.19

Policy makers maintain rather tight reins on thedomestic currency, the New Taiwan dollar, and oncurrency risk more generally. Most important amongthe capital management techniques that relate tocurrency risk is the lack of convertibility of the NewTaiwan dollar. There are a number of other waysthat the Central Bank of China (the CBC) managesthe New Taiwan dollar. Prior to September 1994,foreign nationals (without residency visas) were pro-hibited from opening New Taiwan dollar accounts.But as of September 1994, the CBC has permittednon-resident foreign nationals and corporations tohold savings accounts denominated in New Taiwandollars, although the use of these is limited to do-mestic spending or to the purchase of imports. Theseaccounts may not be used to purchase foreign ex-change or for securities trading. The CBC alsoadjusts the reserve ratios that must be held againstforeign currency deposits in order to prevent inflowsof foreign investment from leading to an apprecia-tion of the New Taiwan dollar.

The domestic banking system is highly regu-lated by the state. Indeed, domestic banks in TaiwanProvince of China were primarily owned by the stateuntil the early 1990s. In 1995, 71.9 per cent of Tai-wan Province of China�s total banking assets werehoused in banks that were controlled fully or partlyby the Government. In the same year, 62.2 per centof overall credit was provided by government-con-trolled credit and financial institutions (Chin andNordhaug, 2002: 81). Authorities maintain restric-tions on bank participation in speculative activities.Bank involvement in securities holdings is limited.In 1989, the Central Bank imposed a 20 per centceiling on bank lending to the real estate sector forsix year following problems associated with a realestate bubble in the 1980s (Chin and Nordhaug,2002).

Authorities also regulate foreign borrowing.Foreign-owned companies must apply to the CBCand the Investment Commission of the Ministry ofEconomic Affairs to secure government approval forborrowing from abroad. Control over foreign bor-


rowing aims to concentrate most private foreignborrowing from international banks in Taiwan Prov-ince of China�s banks rather than in the hands ofindividuals. In fact, at the end of June 1997, 62 percent of all private foreign borrowing in the countrywent to its banks (Chin and Nordhaug, 2002: 93).

Foreign investment in Taiwan Province ofChina remains tightly regulated. During the 1990scertain strategic sectors were off-limits to foreigninvestors. These restrictions have been loosenedconsiderably beginning in March 1996. However,authorities retain the ability to manage foreign in-vestment: at present what are termed �qualifiedforeign institutional investors� are subject to a ceil-ing on maximum investment; foreign individualinvestors are also subject to a ceiling on maximuminvestment and must receive approval from the CBC.

The stock market and PI are closely regulatedas well. Chin and Nordhaug (2002: 89) point outthat Taiwan Province of China�s stock bubble in the1980s exposed some regulatory weaknesses, lead-ing authorities to improve the quality of capitalmarket regulation and to increase control over PIinflows. They also note that a number of events inthe 1990s reinforced the CBCs regulatory cautiontoward the stock market and PI inflows. These eventsalso encouraged the CBC to develop new strategiesfor discouraging speculation and channelling capi-tal toward developmentally productive uses. TheCBCs power to regulate the stock market and PI in-flows increased following the country�s stock marketcrash in 1990, and following its interventions to sup-port the currency and the stock market in theaftermath of the cross-strait tensions and the ensu-ing missile crisis from August 1995 to March 1996.The CBC also monitored evasion of its regulationsand had the political will to enforce penalties whenmalfeasance was uncovered. For example, in 1995the CBC closed Taiwan Province of China�s foreignexchange market for one year when it was discov-ered that a major share of the foreign inflows that ithad approved for equity investment had been usedto speculate against the currency (Chin and Nord-haug, 2002: 88). During the Asian financial crisis,Taiwan Province of China�s authorities also tooksteps to prevent illegal trading of funds by financierGeorge Soros (because these funds were blamed forcausing the stock market to fall).

Taiwan Province of China�s stock market wasnot very �internationalized� during the 1990s as a

direct result of its policies toward PI. In 1997, for-eign investors held only 4 per cent of stocks on thedomestic exchange (Chin and Nordhaug, 2002: 94).Moreover, authorities maintained firm entry and exitbarriers and high withholding taxes on dividends (in1996 the tax rate on dividends was 35 per cent) (Chinand Nordhaug, 2002: 87). Today, buying stocks onmargin and short selling are still prohibited.

� Assessment

It is clear that Taiwan Province of China�s capi-tal management techniques have achieved theobjectives of its architects. The regime of capitalmanagement clearly plays an essential role in Tai-wan Province of China�s industrialization, exportperformance, economic growth and economic andfinancial stability. The strategic stance toward FDIwas critical to industrialization.

Capital management techniques are central toTaiwan Province of China�s financial stability. Therestrictions on currency convertibility mean that itis difficult for Taiwan Province of China to experi-ence a currency collapse (and related currency-induced fragility risk). Investors have little reasonto fear a collapse of currency values, and they be-have accordingly (as was evident during the regionalcrisis of 1997�1998). Thus, even a decline in assetvalues (stocks) is unlikely to translate into a cur-rency crash.

Taiwan Province of China�s exposure to cur-rency, fragility and flight risks is reduced by therestrictions on foreign investors� ability to use thecurrency for speculation. The regulation of the stockmarket (prohibitions on buying on margin and shortselling) and the cautious stance toward PI curtail thefragility and flight risks to which Taiwan Provinceof China is exposed. It is notable that regulatoryauthorities have responded to the evasion of finan-cial controls and the appearance of regulatory gapsby dynamically refashioning their capital manage-ment techniques.

The regulations that govern banks and foreignlending support the objective of promoting finan-cial and economic stability. Banks in Taiwan Prov-ince of China do not have a high exposure tosecurities and real estate transactions. As a conse-quence, banks do not hold a large portfolio of non-performing or under-collateralized loans. Curbs onforeign lending also reduce fragility in the economy


and render the risk of lender flight not terribly im-portant.

Taiwan Province of China�s resilience duringthe Asian financial crisis is in no small part due tothe economic and financial stability fostered by itscapital management techniques. It was simply not vul-nerable to the currency, flight, or fragility risks thatproved so devastating to many countries in the region.


The achievements of Taiwan Province of Chi-na�s capital management techniques were facilitatedby a number of structural and geopolitical factors.20

Critical among these are the high degree of regula-tory capacity and the independence of the CBC frompolitical bodies. This independence allowed the CBCto exercise its authority to curb speculation, closeloopholes in policy, and to resist international andexternal pressures to liberalize the financial systemimprudently. The policy independence of the CBCstemmed from its Presidential backing and the Gov-ernment�s historic commitment to financial stability.National security concerns and geopolitical uncer-tainties reinforced the commitment to financialstability, as stability is seen as essential to the taskof withstanding diplomatic, military, and/or eco-nomic shocks. The reaction of the CBC to severalevents in the 1990s �served as an unplanned rehearsalfor the subsequent 1997�1998 regional financial cri-sis� (Chin and Nordhaug, 2002: 91).

As part of its national development vision, Tai-wan Province of China channelled rents to promoteexports and upgrade industry. These efforts wereaccompanied by strict performance criteria and dis-ciplinary measures. In this context, stringent anddynamic capital management techniques were es-sential to the promotion of productive investmentand industrial dynamism.

� Costs

There is scant evidence available on the costsof Taiwan Province of China�s capital managementtechniques. A study by the Institute for InternationalEconomics (1998), for instance, reports that capitalmanagement techniques in Taiwan Province of Chinahave created a concentration of credit in large firmsand an illiquid financial system, have provided in-centives for a rather large informal financial sectorto flourish, and have reinforced conservatism on the

part of its banks. Chin and Nordhaug (2002: 83) re-port that this conservatism leads banks to favour shortterm lending backed by tangible collateral, such asreal estate. This study also reports that banks arelimited in their ability to engage in project, com-pany and credit assessments, and do not have reliableaccounting and auditing systems.

Clearly, the evidence on costs reviewed here islimited and anecdotal. Even if one were to acceptthis evidence fully, these costs in no way outweighthe macroeconomic benefits afforded to Taiwan Prov-ince of China by its capital management techniques.


Capital management techniques afforded Tai-wan Province of China insulation from the Asianfinancial crisis. This insulation from crisis, coupledwith China�s vast resources, meant that Taiwan Prov-ince of China did not confront challenges to thesovereignty of macroeconomic and microeconomicand social policy associated with IMF involvementor with the need to regain investor confidence.

3. Singapore21

Singapore is widely believed to have a com-pletely free and open capital account, a �fact� that isoften cited as an essential component of Singapore�soutward-oriented economic policy and its rapid post-war economic growth.22 It is true that Singaporeeliminated its exchange controls in 1978, and sincethen both residents and non-residents have been freeto engage in a broad range of international financialmarket activities. However, it less well known thatthe �Monetary Authority of Singapore (MAS) has along-standing policy of not encouraging the inter-nationalization of the Singapore dollar (S$)� (MAS,2002: 1). The Singapore dollar �non-internationali-zation policy� limits the borrowing of Singaporedollar by residents and non-residents for �currencyspeculation� (MAS, 2002: 13, fn. 9). This policy isclearly a type of capital management technique, andevidently has been successful in the sense of con-tributing to Singapore�s macroeconomic and indus-trial policy and economic stability.

� Context

By virtually any measure, Singapore�s economyhas been a major success story of post-war economic


development. To just cite one statistic, the per capitaincome in Singapore has more than quadrupled inless than 20 years, growing from US$ 5,200 in 1981to US$ 23,000 in 1999. Moreover, Singapore�seconomy has been relatively stable for the last 20years, notably escaping the worst ravages of theAsian financial crisis of the late 1990s (MAS, 2001).The Government of Singapore has used a creativemix of macroeconomic tools and other governmentpolicies to achieve these outcomes. Macroeconomicpolicy has been rather conservative in a number ofways. The Government has sought to maintain fis-cal surpluses and low rates of inflation and has soughtto attract large amounts of FDI. Few would deny thesuccess of these policies. To take just one example,between 1981 and 1999, Singapore attracted FDI inan amount of over 9 per cent of its GDP, far higherthan any of its neighbours (MAS, 2001: 11).

At the same time, the Government of Singa-pore has projected an image of greater adherence toeconomic orthodoxy than is actually the case. Forexample, Singapore has pursued a very successfulindustrial policy, huge infrastructure investments andlarge investment in public housing for its popula-tion, all of which have contributed to a rapid growthof living standards. Most important for our purposes,the Government has pursued a managed exchangerate policy designed to stabilize the exchange rateand maintain the competitiveness of Singapore�sindustry. It turns out that Singapore�s capital man-agement techniques have played an important, butlittle understood role, in many of these successfulpolices.23

� Objectives

According to the MAS, the aim of the policyof non-internationalization of the Singapore dollar�is to prevent the exchange rate from being de-sta-bilized and to ensure the effective conduct of ourmonetary policy� (ibid.). The policy is also designedto help Singapore maintain the �soft peg� that hasbeen crucial for its export-led strategy of develop-ment. Singapore�s successful maintenance of its softpeg defies the conventional wisdom that soft pegsare not viable (Eichengreen, 1999).

� Capital management techniques in Singapore

Singapore progressively dismantled exchangecontrols in the 1970s until virtually all restrictionswere removed in 1978. In 1981, the MAS moved to

an exchange rate-centred monetary policy. As theMAS puts it: �the absence of exchange or capitalcontrols, coupled with the small size and opennessof our economy, made the conduct of monetarypolicy that much more difficult when Singaporeshifted to an exchange rate-centered monetary policyin 1981� (MAS, 2002: 2).

To support this policy, the MAS instituted anexplicit policy of discouraging the internationaliza-tion of the Singapore dollar by discouraging �theuse of the Singapore dollar outside Singapore foractivities unrelated to its real economy�. In 1983,when the policy was first codified, financial institu-tions located in Singapore were forbidden to lendSingapore dollar to any residents or non-residentsthat planned to take the Singapore dollar outside ofthe country. Moreover, there were restrictions onequities and foreign bond listings by foreign com-panies in Singapore dollar to limit the developmentof an internationally connected domestic capitalmarkets denominated in Singapore dollars. After nineyears, in 1992, the policy was loosened somewhat,when it was amended to allow the extension of Sin-gapore dollar credit facilities of any amount tonon-residents provided that the Singapore dollarfunds were used for real activities in Singapore.(MAS, 2002: 4). Under that amendment, non-resi-dents can only borrow Singapore dollar to financetheir activities outside Singapore provided the Sin-gapore dollar proceeds are swapped into foreigncurrency (MAS, 2001: 13, fn. 9). In addition, somerestrictions were placed on inter-bank Singaporedollar derivatives, such as FX, currency and interestrate swaps and options, which could facilitate theleveraging or hedging of Singapore dollar positions(MAS, 2002: 2). As the MAS puts it, �These restric-tions made it harder for potential speculators to shortthe Singapore dollar and signalled unambiguouslyour disapproval of such speculation� (ibid.).

In response to pressures from the domestic andforeign financial sectors for more liberalization, theMAS has reviewed the non-internationalizationpolicy four times since 1998, and has liberalized itto some extent during these years. In August 1998,the MAS issued a new directive, MAS 757, reaffirm-ing the basic thrust of the non-internationalizationpolicy, but establishing clearer and more explicitprovisions than previously. These more explicit regu-lations reduced the need for banks to consult theMAS, and then, to some extent, reduced the abilityof the MAS to implement �moral suasion� and �su-


pervision�. Moreover, some activities, specificallyin relation to the arrangement of Singapore dollarequities listings and bond issues of foreign compa-nies were relaxed to foster the development of thecapital market in Singapore (MAS, 2002: 4).

In late-1999, there was further liberalization ofSingapore dollar interest rate derivatives. Moreover,foreign companies were allowed to list Singaporedollar equity, provided the proceeds are convertedinto foreign currency before being used outside Sin-gapore. And in late 2000, key changes were made toMAS 757 to allow banks to lend Singapore dollarsto non-residents for investment purposes in Singa-pore. These changes to MAS 757 were intended toallow non-residents to obtain Singapore dollar fund-ing for investment in Singapore dollar equities, bondsand real estate and broaden the investor base for Sin-gapore dollar assets, and to extend Singapore dollarcredit facilities to non-residents to fund offshoreactivities, as long as the Singapore dollar proceedswere first swapped into foreign currency before be-ing used outside Singapore. Finally, in March 2002,the policy was further liberalized, exempting indi-viduals and non-financial entities from the Singa-pore dollar lending restrictions, �recognizing � thatsuch entities were not usually the prime drivers ofdestabilizing currency speculation� (MAS, 2002: 5).Moreover, the amendments significantly loosenedup restrictions on non-resident financial entities, to:transact freely in asset swaps, cross currency swapsand cross-currency repos; and end any amount ofSingapore dollar-denominated securities in exchangefor both Singapore dollar or foreign currency-denominated collateral. Previously, lending of Sin-gapore dollar securities exceeding $5 million had tobe fully collateralized by Singapore dollar collat-eral; transact freely in Singapore dollar FX optionswith non-resident entities. Previously, such transac-tions had been allowed only if they were supportedby underlying economic and financial activities inSingapore (MAS, 2002).

Thus, following the revisions of March 2002,only two core requirements of the policy remain.First, financial institutions may not extend Singa-pore dollar credit facilities in excess of S$ 5 millionto non-resident financial entities, where they havereason to believe that the proceeds may be used forspeculation against the Singapore dollar. This con-tinues to be necessary to prevent offshore speculatorsfrom accessing the liquidity in Singapore�s onshoreFX swaps and money markets (MAS, 2002: 5). Sec-

ond, for a Singapore dollar loan to a non-residentfinancial entity exceeding S$ 5 million, or for a Sin-gapore dollar equity or bond issue by a non-residententity, that is used to fund overseas activities, theSingapore dollar proceeds must be swapped or con-verted into foreign currency before use outsideSingapore.

� Assessment

Observers attribute at least part of the successof Singapore�s macroeconomic policy to the signifi-cant capital management techniques that havehindered speculation against the Singapore dollar andallowed authorities to pursue a managed exchangerate. The MAS itself finds its capital managementtechniques extremely useful. A recent report statesthat: �The Singapore dollar has served Singaporewell. The strength and stability of the Singaporedollar have instilled confidence and kept inflationlow. These have in turn provided the foundation forsustained economic growth as well as continuedstrengthening of the Singapore dollar� (ibid.).

According to the MAS, interest rates in Singa-pore dollar instruments have generally been lowerthan corresponding United States dollar rates. Thishas helped to keep the cost of capital low in Singa-pore. Moreover, as a result, domestic banks andcorporations did not suffer from the currency andmaturity mismatches that existed in other emerging-market economies. (MAS, 2001: 13). Part of thereason that it was able to keep lower interest rateswas an expectation of exchange rate appreciation. Itis important to note that Singapore avoided the fa-miliar problems associated with expectations ofappreciation: namely massive capital inflows,overvaluation, and then crash (Taylor, 2002). Itseems likely that Singapore�s capital managementtechniques, which discouraged speculation againstthe currency, helped the country avoid that all toofamiliar malady. It also helped to support Singapore�sexport-led model by keeping the exchange rate frombecoming excessively overvalued.


The success of this policy is partly due to theability of the MAS to use �moral suasion� to dis-courage banks and other financial institutions fromusing the Singapore dollar for purposes of speculat-ing against (or in favour) of the local currency. Close,ongoing interaction between the MAS and interna-


tional and domestic financial institutions has allowedthe MAS to shape and monitor implementation ofwhat appear to be deliberately vague formal regula-tions. Moral suasion allows the MAS to make surethat loans are �tied to economic activities in Singa-pore�. Singapore�s �strong fundamentals� are oftencited as the key to its policy success. These includelow inflation, fiscal surpluses, stable unit labour costsand current account surpluses � factors that are un-doubtedly important.24 But often ignored is the roleof capital management techniques in enhancing thesefundamentals. In short, Singapore�s experience dem-onstrates that there is two-way causation betweencapital management techniques and fundamentals.

� Costs

There has been no systematic analysis of thecosts of Singapore�s capital management techniques;hence only qualitative guesses exist. Some haveargued that the restrictions have hindered the devel-opment of Singapore�s capital markets, especiallythe bond markets, and may have also reduced theinflow of foreign investment, though there is littlehard evidence to support these assertions (MAS,2001). Another possible cost is that the Governmentof Singapore forgoes the opportunity to earn seignor-age from the international use of the Singaporedollar; but there have been no quantitative estimatesof these costs to date.


Singapore has been able to maintain a high levelof FDI and political stability. Singapore�s capitalmanagement techniques have contributed to this suc-cess by allowing the MAS to maintain a stableexchange rate and avoid the financial crises that havegenerated so much instability elsewhere in the re-gion.

4. Malaysia25

� Context

In the first two-thirds of the 1990s, Malaysiaexperienced rapid economic growth due to growthin spending on infrastructure, FDI and exports. Dur-ing this period, the Malaysian capital account wasso liberalized that there was an offshore market inringgit, perhaps the only case of an offshore marketin an emerging-market currency (Rajamaran, 2001).

Indeed, by most conventional measures, Malaysiahad had one of the longest running open capital ac-counts in the developing world (Rajamaran, 2001).

Rapid economic growth in Malaysia came to ahalt with the Asian financial crisis of 1997. TheGovernment of Malaysia bucked trends in the re-gion and, rather than implement an IMF stabilizationprogramme, implemented capital controls andadopted an expansionary monetary policy 14 monthsafter September 1998. Malaysia�s introduction ofcapital controls was widely seen as a major depar-ture from its long reputation for a liberal capitalaccount. The Government of Malaysia, of course,had implemented capital controls in 1994, but thesewere eliminated within a few months.

� Objectives

The 1994 controls sought to reduce the threatof capital flight and protect the exchange rate byreducing the volume of highly reversible capital in-flows (Ariyosi et al., 2000; Jomo, 2001). The 1998controls had somewhat different goals. These wereto facilitate expansionary macroeconomic policywhile defending the exchange rate, reduce capitalflight, preserve foreign exchange reserves and avoidan IMF stabilization program (Kaplan and Rodrik,2002).

� Capital management techniques in Malaysia

Capital management in 1994. The 1994 meas-ures sought to deter volatile capital inflows by taxingthem. This contrasts with the 1998 measures thatrestricted capital outflows. Had the 1994 controlsnot been withdrawn so soon, it is quite likely thatthe magnitude of capital flight from mid-1997 wouldhave been much less, and the 1997�1998 crisis wouldhave been far less catastrophic.

The following measures sought to manage ex-cess liquidity, especially to contain speculativeinflows, restore stability in financial markets andcontrol inflationary measures.26 The eligible liabili-ties base for computing statutory reserve andliquidity requirements was redefined to include allfunds inflows from abroad, thus raising the cost offoreign funds compared to domestic funds; limitson non-trade-related external liabilities of bankinginstitutions were introduced; sale of short-term mon-etary instruments was only limited to Malaysianresidents to prevent foreigners from using such in-


vestments as substitutes for placements of deposits(this measure was lifted on 12 August 1994); com-mercial banks were required to place ringgit fundsof foreign banks in non-interest bearing vostro ac-counts; commercial banks were not permitted toundertake non-trade-related swaps (including over-night swaps) and outright forward transactions onthe bid side with foreign customers to prevent off-shore parties from establishing speculative longforward ringgit positions while the ringgit was per-ceived to be undervalued (this measure was liftedfrom 16 August 1994); the statutory reserve require-ments of all financial institutions were raised thriceduring 1994 � by one percentage point each time �to absorb excess liquidity on a more permanent ba-sis, absorbing an estimated RM4.8 billion from thebanking system.

The controls � introduced after the sudden col-lapse of the Malaysian stock market in early 1994 �were withdrawn after about six months. The centralbank saw the problem as one of excess liquidity dueto the massive inflow of short-term funds fromabroad due to higher interest rates in Malaysia, thebuoyant stock market and expectations of ringgitappreciation.

Capital management in September 1998. Thepolicy package is generally recognized as compre-hensive and well designed to limit foreign exchangeoutflows and ringgit speculation by non-residentsas well as residents, while not adversely affectingforeign direct investors. The offshore ringgit mar-ket had facilitated exchange rate turbulence in1997�1998. Thus, the measures were designed toeliminate this source of disturbance.

The measures introduced on 1 September 1998were designed to achieve the following objectives(Rajamaran, 2001; Bank Negara Malaysia; Mahathir,2000; Jomo 2001):

� Eliminate the offshore ringgit market, by pro-hibiting the transfer of funds into the countryfrom externally held ringgit accounts except forinvestment in Malaysia (excluding credit to resi-dents), or for purchase of goods in Malaysia.The offshore ringgit market could only func-tion with externally held ringgit accounts incorrespondent banks in Malaysia because off-shore banks required freely usable access toonshore ringgit bank accounts to match theirringgit liabilities, which the new ruling prohib-

ited. Holders of offshore deposits were giventhe month of September 1998 to repatriate theirdeposits to Malaysia. This eliminated the ma-jor source of ringgit for speculative buying ofUnited States dollars in anticipation of a ringgitcrash. Large-denomination ringgit notes werelater demonetized to make the circulation of theringgit currency outside Malaysia more diffi-cult.

� Eliminate access by non-residents to domesticringgit sources by prohibiting ringgit credit fa-cilities to them. All trade transactions now hadto be settled in foreign currencies, and only au-thorized depository institutions were allowedto handle transactions in ringgit financial as-sets.

� Shut down the offshore market in Malaysianshares conducted through the Central LimitOrder Book (CLOB) in Singapore.

� Obstruct speculative outward capital flows byrequiring prior approval for Malaysian residentsto invest abroad in any form, and limiting ex-ports of foreign currency by residents for otherthan valid current account purposes.

� Protect the ringgit�s value and raise foreign ex-change reserves by requiring repatriation ofexport proceeds within six months from the timeof export.

� Further insulate monetary policy from the for-eign exchange market by imposing a 12-monthban on the outflow of external portfolio capital(only on the principal; interest and dividendpayments could be freely repatriated).

The September 1998 measures imposed a12-month waiting period for repatriation of invest-ment proceeds from the liquidation of externalportfolio investments. To pre-empt a large-scale out-flow at the end of the 12-month period in September1999 and to try to attract new portfolio investmentsfrom abroad, a system of graduated exit levies wasintroduced from 15 February 1999, with differentrules for capital already in the country and for capi-tal brought in after that date. For capital already inthe country, there was an exit tax inversely propor-tional to the duration of stay within the earlierstipulated period of 12 months. Capital that had en-tered the country before 15 February 1998 was free


to leave without paying any exit tax. For new capi-tal yet to come in, the levy would only be imposedon profits, defined to exclude dividends and inter-est, also graduated by length of stay. In effect, profitswere being defined by the new rules as realized capi-tal gains.

Credit facilities for share as well as propertypurchases were actually increased as part of the pack-age. The Government has even encouraged itsemployees to take second mortgages for additionalproperty purchases at its heavily discounted interestrate.

The exchange controls, still in place, limit ac-cess to ringgit for non-residents, preventing there-emergence of an offshore ringgit market. Freemovement from ringgit to dollars for residents ispossible, but dollars must be held in foreign exchangeaccounts in Malaysia, at the officially approved for-eign currency offshore banking centre on Labuan.

� Assessment

Did Malaysia�s September 1998 selective capi-tal control measures succeed? They clearly succeededin meeting some of the Government�s objectives. Theoffshore ringgit market was eliminated by the Sep-tember 1998 measures. By late 1999, internationalrating agencies had begun restoring Malaysia�s creditrating, the Malaysian market was re-inserted on theMorgan Stanley Capital International Indices inMay 2000.

But, did these controls succeed in the sense ofallowing more rapid recovery of the Malaysianeconomy? The merits and demerits of the MalaysianGovernment�s regime of capital controls to deal withthe regional currency and financial crises will con-tinue to be debated for a long time to come.Proponents claim that the economic and stock mar-ket decline came to a stop soon after the controlswere implemented (Kaplan and Rodrik, 2002; Jomo,2001; Palma, 2000; Dornbusch, 2002). On the otherhand, opponents argue that such reversals have beenmore pronounced in the rest of the region. Kaplanand Rodrik present strong evidence that the controlsdid have a significant positive effect on the abilityof Malaysia to weather the 1997 crisis and reflate itseconomy. While this debate is likely to go on forsome time, our reading of the evidence suggests thatKaplan and Rodrik are correct: controls segmentedfinancial markets and provided breathing room for

domestic monetary and financial policies; and theyallowed for a speedier recovery than would havebeen possible via the orthodox IMF route.


In the other cases we discuss in section IV, priorexperience with capital management techniques havebeen important to the success of capital managementin the 1990s. However, the case of Malaysia seemsquite different: the country had a highly liberalizedcapital account prior to the 1990s. Nonetheless, theGovernment was able to implement numerous capi-tal management techniques, all under rather difficultcircumstances. This suggests that a history of capi-tal management is not a necessary pre-requisite forpolicy success.

� Costs

It is difficult to identify any significant costsassociated with the short-lived 1994 controls. Themost important cost of the 1998 controls was thepolitical favouritism associated with their imple-mentation. It is difficult, however, to estimate theeconomic costs of political favouritism (Jomo, 2001;Kaplan and Rodrik, 2002; Johnson and Mitton 2003).Moreover, these costs (if quantified) must beweighed against the significant evidence of the mac-roeconomic benefits of the 1998 controls.


The Malaysian experience in 1994 and 1998enriches debate on the policy options available todeveloping countries. The experience of 1998, inparticular, demonstrates that it is possible for out-flow controls to achieve their objectives.

5. India27

Following Independence from Britain, Indiahad for many decades a highly controlled economy,with exchange and capital controls an integral partof the developmental state apparatus. Over time, andpartly in response to economic crisis, India gradu-ally liberalized and with respect to the capitalaccount, this process of liberalization greatly accel-erated in the 1990s. Most mainstream observers havesuggested that the pace of liberalization is far tooslow. However, supporters of gradual liberalizationpoint to the relative success India has had in insulat-


ing itself from the excesses of the international fi-nancial markets which led to the crises of some ofits neighbours in 1997.

� Context

The Indian financial system and Indian ap-proach to capital management are best understoodin the context of its history of colonization, and thesubsequent developmentalist plan that it pursuedfollowing independence in 1947. Given the historyof British colonialism, policy makers were under-standably guarded in terms of their openness toforeign capital. In terms of the external account, inthe first few years following independence, anintricate set of controls evolved for all external trans-actions. Equity investments were further restrictedin 1977 when many multinational companies leftIndia, rejecting the Government�s effort to enforcea law that required them to dilute their equity in theirIndian operations to 40 per cent. Although the eight-ies saw the beginning of new industrial reforms, thegeneral consensus was still that export orientationand openness could not provide a reasonable basisfor growth.

Like many other developing countries, India�sdecision to dramatically liberalize its intricatelyplanned economy in 1991 was necessitated by a bal-ance-of-payments crisis. By March 1991, the crisishad reached severe proportions. India turned to theIMF for an emergency loan, and the resultantconditionalities led to the adoption of extensive lib-eralization measures.

� Objectives

The goals of India�s capital management tech-niques are to foster financial development (throughgradual capital account liberalization) and attractforeign investment. Prudential financial regulationsaim to reduce the likelihood of speculative crisesdriven by excessive foreign borrowing and to helpauthorities manage the exchange rate. To further thisgoal, capital management has attempted to shift thecomposition of capital inflows from debt to equity.In addition, capital management techniques havebeen oriented towards maintenance of domestic fi-nancial stability by limiting foreign equity andforeign currency deposit investments in the finan-cial sector. In addition, the Government has soughtto retain domestic savings, stabilize the domestic fi-nancial sector by limiting the deposits of foreign

currencies, and allocate foreign equity investmentto strategic sectors, such as information technology.

� Capital management techniques in India

India has had significant controls on both in-flows and outflows. These controls have applied toa broad spectrum of assets and liabilities, applyingto debt, equity and currency. These capital manage-ment techniques have involved strict regulation offinancial institutions, as well as controls of externaltransactions. Although the Indian economy hasmoved towards a progressively freer capital market,this has been an extremely gradual process.28 In par-ticular, the management of integration into the worldfinancial market has been based, until very recently,on fundamental asymmetries between residents andnon-residents, and between corporates and individu-als. While non-resident corporates enjoy substantialfreedom to repatriate funds, until recently this hasbeen severely limited in the case of individual non-residents. Resident corporates have had to obtainapproval of various sorts before exporting capital,and resident individuals are, for all practical pur-poses subject to very strict and low limited withrespect to these. Moreover, three have been restric-tions on debt accumulation as well as foreign currencydeposits and loans by domestic financial institutions.

Controls on outflows. As mentioned above, theliberalization process has maintained a clear distinc-tion between residents and non-residents: it hasmaintained strict controls on outflows by residents,while giving significant latitude to non-residents torepatriate funds. In the most recent budget, however,this fundamental tenet of India�s recent capital man-agement techniques, has been changed, at least onan experimental basis. Restrictions on individualsand domestic corporates have been loosened to al-low substantial investments abroad. Mostsignificantly, mutual funds in India are now permit-ted to invest up to $1 billion abroad. Moreover,individuals are now permitted to invest abroad with-out limit. In addition, companies can now invest inforeign companies too, but there is a quantitativerestriction on the amount (less than 25 per cent ofthe company�s worth). If this recent liberalization isretained on a permanent basis, it will represent afundamental change in India�s capital managementtechniques.

Borrowing and short-term debt accumulationand prudential regulation. Prudential regulations


having capital account implications are widespreadin India. Responding to the lessons of the 1997 Asiancrisis, commercial borrowing in foreign currencieshas remained significantly curtailed. Commercialbanks, unlike in some East Asian countries, have notbeen and are still not allowed to accept deposits orto extend loans which are denominated in foreigncurrencies. As Nayyar (2000) describes the crisiscontext of India�s initial reform: �It prompted strictregulation of external commercial borrowing espe-cially short-term debt. It led to a systematic effort todiscourage volatile capital flows associated withrepatriable non-resident deposits. Most important,perhaps, it was responsible for the change in em-phasis and the shift in preference from debt creatingcapital flows to non-debt creating capital flows.�

Foreign direct investment. Before liberaliza-tion, FDI and equity investments were strictlycontrolled in virtually all sectors. By early-2000,however, these restrictions have been significantlylifted. The first steps in liberalization involved lift-ing restrictions on FDI. By 1993 there were farreaching changes in the Foreign Exchange Regula-tion Act (FERA) of 1973. Some of these reformsmay have been used as a tool of industrial policy,guiding FDI into certain industries, including com-puter hardware and software, engineering industries,services, electronics and electrical equipment, infra-structure projects, chemical and allied products, andfood and dairy products. Recent changes have meantthat by 2001�2002, most sectors are open to FDI.Still, important restrictions remain. In particular, FDIis severely restricted in banking, finance, real estateand infrastructure.

Portfolio investment. The attitude towards port-folio investment liberalization has been equallygradual. India�s first attempt to capture part of thegrowing funds being channelled into emerging mar-kets came during the second half of the 1980s, asIndia opened five closed-end mutuals for sale onoffshore markets. They also reformed the structureof equity regulations on the Stock Exchanges. Bylate-1990, the limits on foreign institutional inves-tor ownership of share capital had been lifted almostup to the level of majority stakes.

� Assessment

India has had some successes and a few ques-tion marks in this decade of capital accountmanagement. On the credit side, India has had con-

sistent net inflows (a legacy of its discriminationbetween residents and non-residents) and has not hadany major financial meltdowns in a decade that sawthree serious crises around the world (and one liter-ally next door). Some of this has certainly been dueto the prudential discrimination between varioustypes of flows.

Another major element on the credit side hasbeen India�s success in increasing the share of non-debt creating inflows. There has been a particularlyimpressive reduction in short-term loans. However,India has had only limited success in attractingforeign direct investment instead of portfolio invest-ment. In fact, the decade has seen a marginallygreater percentage of foreign inflows being ac-counted for by FPI than by FDI (52 per cent to 48 percent).

India�s exchange rate policy seems to haveworked. Although there has been a steady decline inthe external value of the rupee, there have been rela-tively few periods of volatility, and the only reallydifficult period (in 1997) saw the external value fallby 16 per cent.


Among the contributing factors to the successof India�s partial liberalization process and continu-ing use of capital management techniques, three aremost important. First is the widespread institutionalexperience of the Indian authorities in managingcontrols, including long-standing experience withregulating Indian financial institutions. Second, thecontrols themselves were well designed, clearly de-marcating the distinction between resident andnon-resident transactions. Finally, liberalization ofFDI and the very success of the controls themselvescontributed to the ability of India to accumulate for-eign exchange reserves and limit the accumulationof foreign debt, both of which reduced the vulner-ability of the Indian economy.

� Costs

In India�s case, this is a complex question be-cause the Indian economy has been undergoing adramatic liberalization process, which is only tenyears old. It is hard to disentangle the costs of thecontrols from the costs of previous controls, or in-deed, from the costs of the liberalization process itselfand other factors, both internal and external. For


example, many observers still point to the relativelyunderdeveloped financial markets in India comparedto other semi-industrialized economies. But these arecertainly due to many factors, including previouscontrols, and cannot be necessarily attributed to thecurrent controls, which fall mostly on residents, and,in any case, have been in place for a relatively shorttime. In short, assessing the costs of the current sys-tem will undoubtedly have to wait for moreinformation.


As suggested above, India�s capital manage-ment techniques clearly helped to insulate India�seconomy from the ravages of the 1997 Asian finan-cial crisis (Rajamaran, 2001). By limiting capitalflight by residents, they have also helped to retaindomestic savings that are critical for domestic in-vestment.

6. China29

Among the cases we study in this paper, Chinahas the most comprehensive foreign exchange andcapital controls, by far. At the same time, China�srecord of economic growth and development in thelast several decades, as well as its ability to attracthigh levels of foreign direct investment has beengreatly admired by many countries both in the de-veloped and developing world. Finally, like itsneighbour India, China was able to avoid highly sig-nificant negative repercussions from the Asianfinancial crisis of the late 1990s. The relatively strictcapital controls alongside enviable economic growthand the ability to attract large quantities of foreigncapital starkly calls into question the common viewamong economists that capital controls necessarilyhinder economic growth and deter capital inflows.Indeed, China�s policies suggest that, under the rightconditions, strong capital management techniquesmight be useful in protecting macroeconomic stabilityand enhancing economic growth and development.

� Context

As is well known, China has achieved an ad-mirable record of success in terms of economicgrowth and development in the last decade or more,averaging an annual growth rate of GDP of 8 percent or more, depending on one�s view of the accu-racy of China�s government statistics. This record

has been associated with a high savings rates, 40 percent of GDP or more, a long record of current-account surpluses, a large inflow of foreign directinvestment (even discounting for the fact that halfor more of it may really be �domestic investment�which is �round-tripped� through Hong Kong China,or elsewhere in order to take advantage of preferen-tial treatment afforded to foreign investors), a hugestock of foreign exchange reserves, and, even in lightof a substantial foreign debt, a likely net creditorstatus (see for example, Icard, 2002). After a shortperiod of high inflation and interest rates in the mid-1990s, China has experienced low domestic interestrates and, more recently, deflation.30 In terms of ex-change rate management, China has maintained afairly consistent United States dollar peg. Whetherthis is a �hard� or �soft� peg is a matter of somecontroversy.

� Objectives

Capital management techniques in China arean integral part of China�s development strategy,implemented by its �developmental state�. The ob-jectives of the controls evolved over time, but gen-erally have included the following: to retain savings;to help channel savings to desired uses; to help in-sulate China�s pegged exchange rate in order tomaintain China�s export competitiveness; to reducethe circumvention of other controls such as tariffs;to protect domestic sectors from foreign investment;to strengthen China�s macroeconomic policy au-tonomy; and to insulate the economy from foreignfinancial crises.

� Capital management techniques in China

China has followed a fascinating pattern ofeconomic liberalization since the early 1980s, onethat does not conform to any simplistic view ofsequencing commonly found in the economics lit-erature. The typical, currently prescribed liberaliza-tion sequence starts with liberalizing the tradeaccount, then relaxing foreign exchange restrictions,then the long-term capital account, then the short-term capital account (Johnston et al., 1999). Instead,China has liberalized quite selectively within eachof these categories, often on an experimental basis,and sometimes moving a step or two backwards be-fore moving once again forward This complex pat-tern of experimentation and liberalization thus defieseasy description, and makes over-simplification ina short summary such as this almost inevitable.


When China, under the leadership of Deng XiaoPing embarked on its experimentation with liberali-zation and integration into the world economy, it hadcomprehensive controls over foreign exchange, cur-rent account and capital account transactions. In itsexperimentation with Special Economic Zones itbegan to allow foreign investment in foreign minor-ity owned joint ventures, and liberalized to someextent controls over necessary imports for these �for-eign invested enterprises�. (See Braunstein andEpstein, 2001, for a brief summary and references.)

Many of these restrictions were loosened overtime, and a major change in capital managementtechniques occurred in 1996 with China�s accept-ance of IMF Article VIII, and the consequentliberalization of foreign exchange controls with re-spect to current account transactions. Moreover,since that time, controls over inflows and outflowsby non-residents have been significantly loosened.Still, strict foreign exchange controls have been re-tained. In addition, controls over foreign ownershipof domestic assets have been retained to allow in-dustrial policy tools with respect to foreigninvestment to be effective. Moreover, strict controlsover outflows and inflows of capital by domesticresidents have been retained. Still, significant ex-ceptions have been made, partly by choice and partlyby necessity, to allow a somewhat porous capitalaccount, and thereby facilitating some capital out-flows (capital flight) and round tripping of foreigndirect investment.

China�s current capital management techniqueshave the following characteristics (Icard, 2002; IMF,2000; Haihong, 2000):31 strict exchange controls onthe capital account but few restrictions on the cur-rent account; some liberalized sectors for equityinflows and outflows by non-residents accompaniedby some sectors of quite strict controls on non-resi-dent equity inflows, e.g. banking, insurance and thestock market; strict controls on foreign borrowingby residents, including on currency denominationand maturity structure of debt inflows; strict butporous controls on inflows and outflows by residents;tight regulations over domestic interest rates.

� Assessment

The system of capital and exchange controlshas been an integral part of China�s developmentstrategy of the last twenty years. The Chinese Gov-ernment could not have pursued its policy of

incremental liberalization based on exports, exten-sive infrastructure spending, and labour-intensiveFDI, expansionary monetary and fiscal policy andcompetitiveness oriented exchange rate policy with-out its system of exchange and capital controls.Given that China�s growth record in the past twentyyears is the envy of much of the world, and the im-portant role played by the capital managementtechniques, one must deem them a success in termsof reaching the Chinese Government�s objectives.

Most recent commentary has focused on therole that the controls may have played in insulatingthe Chinese economy from speculative excesses.More specifically, this system of controls is widelycredited with helping China avoid the boom-bustcycle associated with the Asian financial crisis(Fernald and Babson, 1999; Eichengreen, 2002b;Haihong, 2000). Controls on foreign debt accumu-lation prevented the excessive accumulation ofunsustainable amounts and maturities of foreign debtby resident institutions; controls on equity inflowsprevented a speculative bubble in the stock marketfrom spilling over into over sectors of the economy,and limited, to some extent, the fall out from bub-bles in real estate and other assets; controls onoutflows prevented devastating surges of capitalflight; exchange controls and the control over de-rivative and futures markets limited the desirabilityand feasibility of domestic and foreign residentsspeculating on the renminbi.

At the same time, we note the paradox of tightcontrols with large amounts of �capital flight� and�round-tripped� investment. The Chinese authori-ties have clearly tolerated a degree of flexibility inthe controls. Some of this is undoubtedly related topossible corruption and unwanted evasion. But someof it reflects a �safety valve�, allowing some eva-sion at the margins in order to protect the averageeffectiveness of the controls; and some of the �eva-sion� is allowed in order to allow other objectives.This ebb and flow of capital flight thus to some ex-tent reflects, the �dynamic� nature of the controls,with the Chinese authorities tightening enforcementduring periods of perceived need, including duringcrisis periods and then loosening them when the cri-sis subsides.


The most important factors supporting the suc-cess of capital management techniques in China are:


the Government�s extensive experience with imple-menting economic controls; the comprehensivenature of the controls; the success in building for-eign exchange reserves through exports and FDI; andthe flexibility of policy.

� Costs

Capital management in China is not withoutcost. China�s financial system does not have thebreadth and depth of financial systems in more ad-vanced economies, such as the United States. Capitalmanagement, while facilitating China�s industrialpolicies, has also facilitated the accumulation of baddebts at China�s state banks (Lardy, 2001). Capitalmanagement (as with other aspects of China�s state-guided policies) has facilitated credit allocation andindustrial policies. But it has also created opportu-nities for corruption by government officials. Thesecosts are likely to have been outweighed by the sig-nificant contributions that capital management hasplayed in China�s highly successful economic de-velopment over the past several decades.


Even though there has been significant capitalflight from China, most observers have suggestedthat capital flight would have been significantlygreater in the absence of the capital managementtechniques employed. Further, capital managementpolicies have allowed the Chinese Government tofollow an expansionary monetary policy to try tocounter the strong deflationary forces pressures fac-ing the Chinese economy. Finally, China is the largestrecipient of FDI among developing countries. Whilesome argue that capital management discourages FDIinflows (Wei, 2000), the econometric evidence onthis point lacks robustness. Moreover, interviews onthis subject do not suggest that capital managementhas been an obstacle to FDI. Indeed, sound capitalmanagement appears to encourage FDI inflows(Rosen, 1999).

V. Lessons and opportunities forcapital management in developingcountries

A. Lessons

What lessons can we learn from these case stud-ies about capital management techniques and theirpossible use to developing countries that are tryingto navigate the often-treacherous waters of the worldeconomy? To clear the field for the positive lessonsthat we draw from our cases, we first consider fivecommonly held mistaken claims about capital man-agement techniques.

One common view of capital management isthat it can only work in the �short run� but not the�long-run�. However, with the exception of Malay-sia, all of our cases show that management canachieve important objectives over a significantnumber of years. Taking China and Singapore as twocases at different ends of the spectrum in terms oftypes of controls, we have seen that both countrieseffectively employed capital management techniquesfor more than a decade in the service of importantpolicy objectives.

A second common view is that for capital man-agement to work for a long period of time, measureshave to be consistently strengthened. In fact, the re-ality is much more complex than this. As the casesof Malaysia, Chile and China show, during times ofstress, it may be necessary to strengthen controls toaddress leakages that are exploited by the privatesector. However, as these same cases demonstrate,controls can be loosened when a crisis subsides orwhen the international environment changes, andthen reinstated or strengthened as necessary. Moregenerally, looking at a broad cross-section of coun-try experiences, one finds that the use of dynamiccapital management means that management evolvesendogenously according to the situation and the evo-lution of government goals (Cardoso and Goldfajn,1997).

We see that in the case of Chile, for example,capital management techniques were adjusted sev-eral times (and ultimately abandoned) during the1990s in response to changes in the economic envi-ronment. Chilean policy makers sought and won theright to reinstate these controls during its bilateraltrade negotiations with the United States. In Malay-


sia, capital management was strengthened to addressevasion during the Asian financial crisis, and thenwas eventually loosened. In Singapore, the Govern-ment strengthens enforcement and moral suasionduring times of stress, and then steps away from thisstrategy when the situation changes. In China, theenforcement of capital management is loosened ortightened depending on exchange rate pressures orreserve levels. In short, dynamic capital managementtechniques have been successfully utilized in a rangeof countries.

A third common but misleading view is thatfor capital management to work, there must be anexperienced bureaucracy in place. It is certainly truethat having experience helps. China, India, Singa-pore are all examples of countries that have long-termexperience with government direction of theeconomy. Malaysia, however, is an important coun-ter-example: it was a country that was able tosuccessfully implement capital management evenwithout having had a great deal of experience indoing so. In the case of Chile, to take another exam-ple, the central bank had had no obvious previousexperience implementing the reserve requirementscheme, though it had had some negative experi-ences in trying to implement capital controls in the1970s. In short, having experience is no doubt help-ful, but it does not seem to be a pre-requisite forimplementing successful capital management tech-niques. What is more important is state capacity andadministrative capacity as discussed in sections IIIand IV.

Fourth, a recent view that has gained currencyis that controls on capital inflows work, but thoseon outflows do not. However, in our sample we haveseen examples of policy success in both dimensions.For example, Chile and Colombia maintained con-trols on inflows, while China, India and Malaysiamaintained controls on outflows. In addition, Sin-gapore and Taiwan Province of China maintaincontrols on the ability of residents and non-residentsto use domestic currency offshore for purposes of�speculating� against the home currency. This is acontrol on outflows that has successfully insulatedthese countries from crises and has helped govern-ments to manage their exchange rates.

Fifth, a common view is that capital manage-ment techniques impose significant costs by leadingto higher costs of capital, especially for small firms.As we have seen, in some cases there may be some

merit to these arguments. But much more evidenceneeds to be presented before this is established as awidespread cost.32

We turn, now, to the positive lessons that wedraw from our case studies of capital managementtechniques. Tables 1 and 2 summarize our findings.

First and most generally, we find that capitalmanagement techniques can contribute to currencyand financial stability, macroeconomic and micro-economic policy autonomy, stable long-term invest-ment and sound current account performance. Thereare some costs associated with capital managementtechniques: for instance, there is evidence that insome countries the cost of capital to small firms isincreased; and capital management can create spacefor corruption.

Second, successful implementation of controlsover a significant period of time depends on the pres-ence of a sound policy environment and strongfundamentals. These include a relatively low debtratio, moderate rates of inflation, sustainable cur-rent account and fiscal balances, consistent exchangerate policies, a public sector that functions wellenough to be able to implement coherent policies(i.e., administrative capacity), and governments thatare sufficiently independent of narrow political in-terests so that they can maintain some degree ofcontrol over the financial sector (i.e., state capacity).

But, third, as our cases show, causation worksboth ways: from good fundamentals to successfulcapital management techniques, and from success-ful capital management techniques to good funda-mentals. Good fundamentals are important to thelong-run success of capital management techniquesbecause they reduce the stress on these controls, andthereby enhance their chance of success. On the otherhand, these techniques also improve fundamentals.Thus, there is a synergy between capital manage-ment techniques and fundamentals.

Fourth, the dynamic aspects of capital manage-ment techniques are, perhaps, their most importantfeature. Policy makers need to retain the ability toimplement a variety of management techniques andalter them as circumstances warrant. Nimble andflexible capital management is very desirable. Chileand Taiwan Province of China�s experience withthese techniques is a good example of this type offlexibility. Countries with successful experiences

28G

-24 Discussion Paper Series, N

o. 27Table 2

SUMMARY: ASSESSMENT OF THE CAPITAL MANAGEMENT TECHNIQUES EMPLOYED DURING THE 1990s

Country Achievements Supporting factors Costs

Chile � Altered composition and maturity of inflows � Well-designed policies and sound fundamentals � Limited evidence of higher capital costs for SMEs� Currency stability � Neoliberal economic policy in many domains� Reduced vulnerability to contagion � Offered foreign investors good returns

� State and administrative capacity� Dynamic capital management

Colombia � Similar to Chile, but less successful � Less state and administrative capacity than in � No evidence availablein several respects Chile meant that blunter policies were employed

� Economic reforms in the direction of neoliberalism

Taiwan Province � Debt burdens and financial fragility are � High levels of state and administrative capacity � Limited evidence of concentration of lending to large of China insignificant � Policy independence of the CBC firms, conservatism of banks, inadequate auditing and

� Competitive exchange rate and stable currency � Dynamic capital management risk and project assessment capabilities� Insulated from financial crises � Large informal financial sector� Enhanced economic sovereignty � Limited evidence of inadequate liquidity in financial

system

Singapore � Insulated from disruptive speculation � Strong state capacity and ability to use � Possibly undermined financial sector development� Protection of soft peg moral suasion � Loss of seignorage� Financial stability � Strong economic fundamentals

Malaysia (1998) � Facilitated macroeconomic reflation � Public support for policies � Possibly contributed to cronyism and corruption� Helped to maintain domestic economic � Strong state and administrative capacity

sovereignty � Dynamic capital management

India � Facilitated incremental liberalization � Strong state and administrative capacity � Possibly hindered development of financial sector� Insulated from financial contagion � Strong public support for policies � Possibly facilitated corruption� Helped preserve domestic saving � Experience with state governance of the economy� Helped maintain economic sovereignty � Success of broader economic policy regime

� Gradual economic liberalization

China � Facilitated industrial policy � Strong state and administrative capacity � Possibly constrained the development of the financial� Insulated economy from financial contagion � Strong economic fudamentals sector� Helped preserve savings � Experience with state governance of the economy � Possibly encouraged non-performing loans� Helped manage exchange rate and facilitate � Gradual economic liberalization � Possibly facilitated corruption

export-led growth � Dynamic capital management� Helped maintain expansionary macro-policy� Helped maintain economic sovereignty

Source: See section IV.


with controls must maintain the option to continueusing them as circumstances warrant.

Fifth, capital management techniques work bestwhen they are coherent and consistent with the over-all aims of the economic policy regime; or betteryet, when they are an integral part of a national eco-nomic vision. To be clear, this vision does not haveto be one of widespread state control over economicactivity. Singapore is a good example of an economythat is highly liberalized in some ways, but one wherecapital management techniques are an integral partof an overall vision of economic policy and devel-opment.33

Sixth, prudential regulations are often an im-portant complement to capital controls, traditionallydefined, and vice versa. In Singapore, for example,government moral suasion aimed at discouragingbanks from lending to firms or individuals intend-ing to speculate against the currency is an exampleof an effective prudential regulation. In Chile, taxeson short-term inflows that prevent maturity mis-matches are an example of a capital control that alsoserves as a prudential regulation. Our case studiespresent many such examples.

Seventh, there is not one type of capital man-agement technique that works best for all countries:in other words, there is not one �best practice� whenit comes to capital management techniques. We havefound a variety of strategies that work in countrieswith very different levels of state and administra-tive capacities, with financial systems that differaccording to their depth and degree of liberaliza-tion, with different mixes of dynamic and staticcontrols, and different combinations of prudentialfinancial regulations and capital controls.

Many countries that have had extensive con-trols in the past are now liberalizing them. Do ourcase studies offer any insight as to whether coun-tries that employ extensive capital managementtechniques should begin to abandon them? Our re-search suggests, that in many cases, it is not in theinterests of developing countries to seek full capitalaccount liberalization. The lesson of dynamic capi-tal management is that countries need to have theflexibility to both tighten and loosen controls. How-ever, if countries completely liberalize their capitalaccounts, they might find it very difficult to re-establish any degree of control when the situationwarrants or even demands it. This is because market

actors might see the attempt to re-establish capitalmanagement as abandonment of a liberalized capi-tal account, and then might react rather radically tothis perceived change. By contrast, if investors un-derstand that a country is maintaining a system ofdynamic capital management they will expect man-agement to tighten and loosen over time. It istherefore less likely that investors will over-react ifmanagement techniques are tightened.

In sum, we have shown that the capital man-agement techniques employed in seven developingcountries during the 1990s have achieved many im-portant objectives. The achievements of these capitalmanagement techniques therefore warrant close ex-amination by policy makers in developing countries.

B. Opportunities

Clearly, there are many obstacles confrontingefforts to pursue the most stringent forms of capitalmanagement in developing countries. However, wesubmit that at present there are many reasons forcautious optimism regarding the ability of develop-ing countries to pursue various capital managementtechniques.

(i) All capital management techniques are notequally controversial or potentially costly tocountries that pursue them. Our cases show thatrather stringent regimes of capital managementare often consistent with economies that arelargely liberalized. Moreover, we are unable tofind convincing evidence that investors havepenalized countries with attractive investmentopportunities and well-designed regimes ofcapital management.

(ii) There is growing recognition of the achieve-ments of certain capital management techniques(Eichengreen, 1999; Kaplan and Rodrik, 2002;Krugman, 1998; Ocampo, 2002; Rodrik, 1999;)and of the costs of premature capital accountliberalization (Bhagwati, 1998; Edwards, 2001;Eichengreen, 1999, 2002; Krugman, 1998;Rodrik, 1998, 2002).

(iii) The recent deliberations during the UnitedStates� bilateral trade negotiations with Chileand Singapore revealed interesting fractureswithin the United States Treasury and the


United States business community over theright of developing countries to impose capitalcontrols as they are deemed necessary. In thereporting on these negotiations it appeared thatprominent members of the United States manu-facturing and export community and variousTreasury Department officials were not in sup-port of the hard-line stance against capitalcontrols initially held by the United States ne-gotiating team (Wall Street Journal, 2002a: A4;New York Times, 2002: C1). The shape of thefinal agreements signed with Chile and Singa-pore suggest that those favoring at least a degreeof national autonomy on the matter of capitalcontrols have more influence than was initiallyapparent (New York Times, 2003b: C3; 2003a:C19). The commitment of the negotiators fromChile and Singapore to maintain their right toimpose controls is a stance that other countriesmay wish to build upon.

(iv) There is a clear softening in the stance on capi-tal controls (and acknowledgement of theirachievements in some countries) in the UnitedStates business press since the Asian crisis (WallStreet Journal, 2002b: A14). The IMF, too, ap-pears to be softening its stance toward capitalcontrols (Prasad et al., 2003). Reports by somestaff economists and statements by keydecision makers at the institution have ac-knowledged that capital managementtechniques explain the resilience of some coun-tries during the Asian crisis (Ariyoshi et al.,2000; Fischer, 2002; Wall Street Journal,2002b).34 It may also be the case that there isincreased tolerance for administrative controlsover capital movements in the post-September11 environment. In this context, security con-cerns and new regulations aimed at reducingmoney laundering may make capital controlsfar easier to enforce and far easier to defend.

Recent events suggest that this may be a propi-tious time for policy makers in developing countriesto build on the successful experiences with capitalmanagement in some countries, and to avail them-selves of their right in Article 6 to pursue them. It isimportant to recognize that the greater the numberof developing countries that pursue capital manage-ment, the easier and less costly it will be for othersto follow this path. In this connection, it might alsobe a fruitful time for those countries that have hadsuccess with particular techniques to play a larger

role in financial policy discussions in the develop-ing world. In this connection, we believe that theGroup of 24 can play an important role in providinga forum for such discussions.

Notes

1 See also Epstein and Grabel (2003).2 Of course, doctrinaire holdouts on capital account liber-

alization still exist. For instance, some members of theUnited States Treasury took this stance in recent nego-tiations with Chile and Singapore over free trade agree-ments (section V).

3 Recent surveys appear in Dooley (1996), Ariyoshi et al.(2000), and Edwards (2001).

4 Ocampo (2002)) proposes dynamic, counter-cyclical do-mestic financial regulation as a complement to perma-nent, adjustable capital controls. Palley (2000) proposescounter-cyclical, variable asset-based reserve require-ments.

5 Grabel (1999, 2003a) proposes �trip wires and speedbumps� as a framework for dynamic capital management.This approach aims to identify the risks to which indi-vidual countries are most vulnerable, and to prevent theserisks from culminating in crisis.

6 Discussion of objectives and costs draws on Chang andGrabel (2004: chap. 10) and Grabel (2003b); discussionof the means by which capital management techniquesattain their objectives draws on Grabel (2003a).

7 Miller (1999) applies the capital cost argument to Ma-laysia.

8 However, there is no strong evidence that growth is re-duced by capital management techniques (Rodrik 1998;Eichengreen, 2002a).

9 However, during the Latin American and Asian crises ofthe 1990s large amounts of capital went to countries withfundamentals that critics found wanting after the crisisensued. Thus, the �disciplinary� role of internationalcapital flows seems far less significant than some econo-mists assume.

10 A strong version of this view is captured in �Goodhart�slaw�. It states that �financial regulations that seek to raisethe costs of certain kinds of financial activity tend to becircumvented over time� (Wilson, 2000: 275).

11 This case study draws heavily on Grabel (2003a). De-tails and assessment of Chilean and Colombian capitalmanagement techniques are drawn from Agosin (1998),Eichengreen (1999), Ffrench-Davis and Reisen (1998),LeFort and Budenvich (1997), Ocampo (2002) and Palma(2000).

12 Nevertheless Eichengreen (1999) makes clear that au-thorities erred in terminating inflows management.

13 Chile�s reserve requirement was adjusted several timesbecause of changes in the volume of capital flows.

14 Ocampo (2002: 7) points out that the frequency withwhich authorities changed the rules pertaining to ex-change rates in Chile and reserve requirements in Co-lombia were not, however, without cost.

15 To date, Forbes� (2002) findings have not been chal-lenged in the literature. This, however, is not surprising


given that the draft paper only became available in No-vember 2002.

16 Even Edwards (1999: 77), a prominent critic of capitalmanagement techniques in Chile, shows that they in-creased the autonomy of monetary policy in the coun-try. However, he argues the extent of increased autonomywas trivial insofar as the small benefit accruing from in-creased monetary policy autonomy was outweighed bythe increase in capital costs that were associated withthe capital management techniques.

17 Note, however, that capital management techniques andmacroeconomic policy did not succeed in promotingprice stability in Colombia (LeFort and Budenvich,1997).

18 See Chin and Nordhaug (2002) on the extended notionof security in Taiwan Province of China and, more gen-erally, for a rich discussion of the broader context of itseconomic and financial policies.

19 The description of capital management techniques drawsheavily on Chin and Nordhaug (2002). Details are alsodrawn from the Economist Intelligence Unit (EIU)(2002), and the United States Commercial Service(2002).

20 This discussion draws heavily on Chin and Nordhaug(2002); for their in-depth historical examination of rel-evant structural considerations.

21 This section draws heavily on the Monetary Authorityof Singapore (2001; 2002), Errico and Musalem (1999),IMF (1999, 2001), McCauley (2001) and Ishi et al.(2001).

22 See IMF (1999; 2001) for useful surveys of the Singa-pore economy during this period.

23 Since 1981, monetary policy in Singapore has been cen-tred on exchange rate management. First, the exchangerate is managed against a basket of currencies of Singa-pore�s major trading partners. The composition of thebasket is revised periodically to take account of Singa-pore�s trade patterns. Second, the MAS operates a man-aged float. The trade-weighted exchange rate is allowedto fluctuate within an undisclosed policy band. If theexchange rate moves outside the band, the MAS willstep in, buying or selling foreign exchange to steer theexchange rate back within the band. In conducting thispolicy, the MAS has generally given up control overdomestic interest rates in order to maintain its exchangerate within its target band. McCauley (2001) argues thatthe main target of this policy is inflation.

24 IMF (2001) emphasizes the role of fundamentals and dis-counts the importance of capital management.

25 This section draws mainly on Bank Negara Malaysia(various issues); Jomo (2001); Kaplan and Rodrik (2002);Mahathir (2000); Rajamaran (2001).

26 For a fuller account, see Bank Negara Malaysia 1994Annual Report (especially the Foreword, Boxes A to Jand pp. 42�44).

27 This section draws mainly on Rajaraman (2001) andNayyar (2000).

28 Rajaraman calls this the �incremental dribble� of Indianpolicy-making.

29 This section is based on Icard (2002), Haihong (2000),Fernald and Babson (1999), Jingu (2002), Lardy (1998),Naughton (1996).

30 Of course, the Chinese economy and society also facesignificant problems and challenges, including high un-employment and underemployment, significant envi-

ronmental destruction, and the perceptions, if not real-ity, of widespread government corruption.

31 This list is a very short summary of a very long and com-plex set of controls. See the references cited above formuch more detail.

32 In any case, this observation is just the beginning of theanalysis since it says nothing about the balance of costsand benefits. As economists are fond of pointing out,there are always trade-offs. Our cases demonstrate thatcapital management techniques can have important mac-roeconomic or prudential benefits. Of course, these ben-efits must be weighed against the micro costs. But asJames Tobin was fond of remarking, �It takes a lot ofHarberger Triangles to fill an Okun Gap�.

33 See Nembhard, 1996, for an excellent discussion of theseissues.

34 For instance, Stanley Fischer (2002) writes: �The IMFhas cautiously supported the use of market-based capi-tal inflow controls, Chilean style. These could be help-ful for a country seeking to avoid the difficulties posedfor domestic policy by capital inflows.� Eduardo Aninat,Deputy Managing Director of the IMF, recently statedthat: �In certain scenarios and in some circumstances,these controls on capital inflows can play a role in re-ducing vulnerability created by short-term flows � Theinvestment restrictions appear to have served Chilewell �� (Wall Street Journal, 2002b).

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