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International Finance

Malaysian Capital Controls: Macroeconomics and Institutions By: Simon Johnson, Kalpana Kochhar, Todd Mitton, and Natalia Tamirisa
Prepared for IMF Research Department February 2006

Malaysian Capital Controls: Macroeconomics and Institutions Simon Johnson, Kalpana Kochhar, Todd Mitton, and Natalia Tamirisa
Presented by: Safia Nizari (0900154) Saad Wasim (0900160) Nermin Klopic (0900148) Syed Aun Raza Rizvi (0900335) Mohammed Arshadullah (0800905)

All views expressed in the presentation are not of the presenters but are expressed by the authors of the paper. This is only an analysis of their paper done by the presenters.

About the Authors
• Natalia Tamirisia – Asst to Director Research IMF – PHD Economics – Hawaii University • Kalpana Kochar – Senior Advisor Asia & Pacific Dept. IMF – PHD Economics – Brown University

• Simon Johnson – Economic Counselor & Director Research IMF March 2007August 2008 – PHD Economics – MIT

In economics capital controls is the monetary policy device that a country's government uses to regulate the flows into and out of a country's capital account, i.e., the flows investment oriented money into and out of a country or currency.

Until the late 1970s, capital controls were widely used to prevent the free flow of funds between countries.

Cautious relaxation of such controls in the 1980s proved consistent, as globalization started taking roots.

Post Asian Crisis – Role of capital controls being reconsideration

Early 1990s, capital controls no longer used as serious policy tool by open economies (Bhagwati, 1998a)

Recent experience in Malaysia which re imposed capital controls in September 1998 has two main views.

1. View with emphasis on Macroeconomics

If a country faces severe external crisis, caused by pure panic, krugman(1998) argues that capital controls may not be an effective way to stabilize economy.

Bhagwati (1998a,1998b) & Rodrik (2000) oppose that free capital flows help countries benefit from trade liberalization and argues that liberalization invites speculative attacks.

In this context – Malaysia’s experience with capital controls:

It can have positive macroeconomic effects (Kaplan and Rodrik,2001) Claim fiercely opposed by Dornbusch(2001)

2.View with emphasis on Institutions ( rules, practices & organizations that govern an economy)

Rajan& Zingales (1998): Argues capital controls are an essential part of package of policies allowing “relationshipbased” capitalism to function. Relationship between Politicians and banks channel lending towards approved firms becomes easier if isolated from international capital flows. If capital controls are relaxed it can lead to over borrowing and financial collapse.

Suggestion (Rajan& Zingales (1998) Capital controls may be attractive – if politicians support financing particular firms.
This leads to two testable implications. Firms with political connection should:

1. Suffer when a macroeconomic shock reduces government’s ability to provide advantage.
2. Benefit more when the imposition of capital controls allows support for particular firms.

For a Macroeconomic debate – Malaysian Experience inconclusive

Firm-level evidence supports Rajan and Zingales view:

July 97-Aug 98 (initial crisis phase) – 9% of $ 60b market value loss by politically connected firms, may be attributed to fall in expected value of their connections.
With the imposition of capital control in Sept 98, 32% of $ 5b gain in market value for firms connected to prime minister, may be attributed to increase in value of their connections.

Literature review

• Fisman (2001)

– Value of Political Connections in Indonesia – Analyzing stock price movement with Suharato's health shocks

La porta, Lopez-de-Silanes, and Zamarippa (2003)

– Well connected Mexican Banks,- irresponsible lending – Enhanced the severity of crisis
• Mitton (2002)

– Weaker Corporate Governance – Worse stock Price Movement in Asia

Chronology of Capital Controls - 1

History of Malaysian capital controls 1968-1973 adherence to IMF obligations-relax regulations .

Move from fixed to floating exchange rate. 1986-1987 liberalized capital controls.
Since 1992 crises-portfolio flows free of restrictions-active . Unregulated offshore market in Ringgit.

In July 1997 Thai Baht devalued-increase in movement of Ringgit funds offshore - initial response was tightening macroeconomic policies (rise in interest rates, limit ringgit swap, restrict trading in blue chip stocks) with effect

Chronology of Capital Controls - 2

In September 1998 crises not returning to stability - Malaysia imposes Capital Controls & pegged Ringgit to USD Repatriated all Ringgit held offshore back to Malaysia.
Prohibited trading in Ringgit assets. Residents couldn't get Ringgit credit grant. Prohibited off-shore trading of Ringgit assets . Preconditions facilitated implementing Capital Controls: History of Controls . using Capital

Effective state capacity. Strong bank supervision & regulation.

Imposed controls on portfolio outflows .

Macroeconomic Issues

Motivations Financial stability emphasized by Malaysian authorities but: Ringgit had fallen 70%, pressure was letting up, swap differentials trend decreasing and crises had bottomed out by 1st Quarter of 1998.

Worried about political & social fall out - controls guarded against increased off-shore Ringgit speculation & domestic turmoil .

Macroeconomic Impact - 1
Recovery: Capital Controls enabled a faster, less painful recovery (Kaplan & Rodrik, 2001)

Macroeconomic Impact - 2

No data suggesting controls made visible difference in Malaysia recovery.

Malaysia well placed for a recovery, decrease in downturn.

faster No Evidence lasting costs . that controls had

(Rise in government’s effectiveness, regulation quality , rule of law & control & corruption)
Main credit goes to: Responsible macroeconomic policies.

Regained previous ranking.

Maintained FDI “potential “ranking. Slipped in capital attracted 5th-10th world before to 70th-75th in the world after crisis.
Private investment (as % of GDP) low <10% in Malaysia (1/2 regional average).

Commitment to finance or corporate sector reforms. Strong initial conditions. Institutional capacity.

Firm Level Evidence - 1

Political connections in Malaysia: Since 1970 New Economic Policy-NEP giving priorities and privileges . Businesses dominated by Chinese-NEP aimed to correct this imbalance.

UMNO promoted Bumiputra capitalism-increased state intervention . Firms were promoted by PMC-Prime minister connected or FMC-Finance minister connected (Dr. Mahatir / FM Anwar Ibrahim).

Firm Level Evidence - 2

Based on worldscope database for firms on KLSE. Connected firms had significantly worse returns during crisis . NO difference between PMC & FMC. Politically connected firms had increased returns after capital controls in September 1998 . PMC better than FMC-no difference after September 1998.

Total assets of politically connected firms . Larger (2x) but were less profitable (not well run) before crises . Politically connected firms had 11% higher debt-asset ratio or leverage & size . characterizes differences between connected & unconnected firms.

Crisis Period July 1997- August 1998

Politically connected firms experienced significant decline, This is broadly consistent with the Rajan and Zingales (1998) view: That firms with strong political connections suffer more in a financial crisis, presumably because the expected value of government support declines.

Effects of Capital controls

Capital Controls & simultaneous downfall of Finance Minister. Decreased value of politically connected firms with strong ties to Finance minister.

Politically connected rebounded in September 1998 . PMC firms had higher returns while FMC had lower returns . Value of political connections . Significantly important determinants when capital controls were imposed. Politically connected firms did better than firms with foreign capital access when capital controls were imposed . Consistent with capital controls, affected Malaysian firms’ access to foreign finance .

Economic significance of Political connections

During crises, because of Political connections connected firms lost $5.7 billion total market value.

Political connections continued to add to firm’s value after crises .

Post Capital Controls (1999-2003) - 1

General reflationary measures:
Cut interest rates . Make more credit available (Kaplan & Rodrik, Mahatir, 2000).

Expansionary budget in Oct 1998 (Perkins and Woo, 2000).
Macroeconomic policy cautions & responsible after controls were imposed.

Government’s gave short term capital inflows to advantage favored firms.
State owned oil company provided bailouts .

Post Capital Controls (1999-2003) - 2

Political connected firms received “deals” from government. Banking sector got new consolidation plan . Allowing for repeated roll over of debts .
PMC firms before crisis : Showed higher investments, growth & leverage & decreased profitability. After crisis effects reversed: Lower investment, growth & higher leverage .

PMC advantages didn’t lead to better performance after crisis .

Conclusion - Macroeconomic

Capital Controls not essential . September 1998 recovery or structural reforms. Controls imposed late . After depreciation & loss macroeconomics benefits.






Controls played preventive role . Guarded against perceived risks to financial stability . Misleading to compare other countries with Malaysia’s experience. For the factors listed above for Malaysia’s recovery .

Conclusion – Firm Level

Capital controls neither beneficial nor costly. Stock Market’s take Controls favored firms with stronger political connections .
Connected firms outperform unconnected firms. Before 1997-1998 crises but not afterward. Post crisis connected firms not supported . Not as much as market expected or not published in their accounts.

Political connected firms hit harder during crisis. But data suggests not as punishment for past misdeeds.

Thank you for your time.