Massive capital flows into Asia led many Asian countries to introduce capital controls and other mechanisms in a bid to stem flows and limit rising currency valuations. However, rising inflation and talk of interest rate rises have raised fears about slowing growth, leading to money flowing the other way.

From bailing out the banks to laying down the law, an apparently lasting impact of the financial crisis is a bigger role for the state. One beneficiary of this new orthodoxy is capital controls, sneered at in the free-wheeling past but increasingly seen as a pragmatic tool to manage economic imbalances and try to halt rising currency valuations.

The shift in mindset was highlighted in February when G-20 ministers meeting in Paris raised barely a murmur against moves last year by several Asian governments to impose barriers to inflows of foreign capital. Instead the emphasis was on developing frameworks and creating common understandings.

John Lipsky, first deputy managing director at the International Monetary Fund (IMF), told reporters at the meeting that there is broad agreement that guidelines may be a useful way forward but shied away from formal rules. “I don’t think there would be agreement quickly on a set of iron-clad laws or rules; that’s probably for down the road,” he said.

Stampede of investment

A primary motivation for the IMF to tiptoe around the issue is, of course, that the root cause of Asian capital controls can be found in Western economies, where the lowest interest rates on record have prompted a near stampede of investment money toward the East.

With cash pouring into emerging markets from around the globe, it would no doubt seem churlish for those sitting at the financial world’s top table to condemn those trying to limit the impact on currency valuations, local inflation and exports.

Still, policy-makers recognise that they must tread a fine line. While it might make sense for smaller economies to introduce limited breaks on capital inflows as a temporary measure, it does not make sense from a global trade perspective for larger economies to unilaterally protect their own interests.

“It is very clear that what is not acceptable is the attitude that says 'this is our currency and it is your problem',” says Dr Paola Subacchi, research director in international economics at think tank Chatham House. “If everybody acts in a unilateral manner then it is not optimal because it triggers currency wars. The use of controls should very much be a question of circumstance.”

Record inflows

In Asia, a raft of currencies have been pushed steadily higher by the record inflows of nearly $150bn into emerging market bond and equity funds in 2010, according to fund tracker EPFR Global. The Bloomberg-JPMorgan Asia Dollar Index, which tracks the continent's 10 most-active currencies, added 5.2% over the year.

As inflows into Asian economies rose, several countries moved to limit foreign holdings of local currency investments such as government bonds, and to channel capital inflows away from short-term investments.

Taiwan became the first Asian economy to impose capital controls after the financial crisis, banning foreign funds in late 2009 from investing in time deposits.Two months later it went further, passing the names of foreign investors with substantial deposits in Taiwan dollars to financial regulators and giving them a week to pull money out or invest in stocks.

“The controls are a direct result of the huge influx of foreign investors,” says Seohan Soo, head of debt capital markets at AmInvestment Bank in Kuala Lumpur.

“Following the crisis in the late-1990s, Asian governments became extremely wary of the destabilising effect of money flowing in and out. It’s very tough for central bankers in these countries who want to support exports and keep rates low.”

Holding period

In June, Indonesia’s central bank introduced a one-month minimum holding period for bills and offered a wider range of debt maturities, while in November Thailand imposed a 15% withholding tax on capital gains and interest payments for government and state-owned corporate bonds, after a surge of money drove the baht to its highest rate against the dollar for 13 years.

The South Korean government also moved to protect its currency and the country's exports, announcing curbs on foreign banks' currency derivative trades in June 2010, and capping holdings at 250% of equity capital. It also cut lending in foreign currencies, in a move aimed at limiting borrowing to finance speculative financial trades.

New rules

While it would be an exaggeration to say the new rules were met in Europe and the US with universal acclaim, neither did they attract decisive contempt.

In a report last year, World Bank economist Swati Ghosh seemed to sum up the ambivalent mood when he listed capital controls as one of a range of measures that Asian governments might consider when faced with inflows of hot money, but summed up their limitations.

 “When available macro-policy options are not sufficient, or cannot provide a timely response to an abrupt or large surge in capital inflows, capital controls may be a useful tool,“ wrote Mr Ghosh.

“However, the efficacy of capital controls may be of limited duration; empirically, capital controls have been found to enable countries to initially reduce the pressures on the exchange rate and to maintain a difference between domestic and foreign interest rates, but over time, countries were generally not able to achieve both the interest rate and exchange rate targets.”

Controls in general seemed to be more effective at reducing short-term flows rather than their overall magnitude, Mr Ghosh concluded.

The Unholy Trinity

In economic terms, Asian policy-makers are faced with a truncated version of the classic problem known as the Mundell-Fleming Trilemma, frequently called the ‘Unholy Trinity’. The model measures exchange rates against output and shows that it is nearly impossible to simultaneously maintain a fixed exchange rate alongside free capital movement and independent monetary policy.

The theory was exemplified by Thailand in the 1990s, which combined liberalised capital inflows with a fixed exchange rate, leading to inflation and overheating and still higher interest rates, exacerbating inflows of capital.

Today, most Asian currencies are no longer fixed and the Unholy Trinity is undone. The result, as global capital pours into the continent, is upward pressure on both inflation and local currencies. The aggregate rate of regional consumer price inflation in Asia was running at an annual 5.8% in December – down from a peak of 12.2% in 2008 but still uncomfortably high on a medium-term basis.

New dynamic

With US monetary policy remaining accommodative and little sign of an end to the Federal Reserve’s most recent bout of quantitative easing, structural demand for non-dollar assets remains in place.

However, in early 2011 a new dynamic emerged which may take some pressure off Asian governments – and their currencies. First, the dollar started to regain some poise, and then the recovery in the US economy appeared to be gathering pace. Meanwhile, amid strong rises in food and energy prices, inflationary pressures in some Asian countries showed signs of spiralling out of control. Vietnam’s consumer prices rose 12.31% in February from a year earlier, while in Singapore, consumer prices rose an annual 5.5% in January, up from 4.6% in December.

In Hong Kong, financial secretary John Tsang said inflation and the risk of a property bubble were the “two main challenges” for the city in the coming year. In response to rising prices, central banks in China, India, Indonesia, South Korea, Thailand and Vietnam have raised interest rates this year, a move that has help encourage some investors to commence pulling money out of Asian equity markets.

Value erosion

The worry is that inflation would erode the value of equity investments and as interest rates push higher, so economic growth will slow. Funds chasing higher GDP growth found their way to emerging markets last year. But as growth slows down, the money is taking a flight back to safe havens.

According to bankers' estimates, about $1.6bn has left the Indian equity market this year, while about $2bn and $640m have been withdrawn from Korean and Thai equities, respectively.

“Investors are beginning to worry that central banks in emerging countries are going to have to raise rates sharply,” says Stephen Lewis, chief economist at Monument Securities. “The dollar is a little stronger, and in terms of the divergence of economic performance between Asia and the rest, we may have passed the widest point.”

Appreciation acceptance

While recent fund flows mitigate in favour of a reducing requirement for capital controls, there also seems to be a growing domestic acceptance among Asian government that local currencies may need to appreciate to offset the impact of rising prices.

The Indonesian central bank has made several public statements that a stronger rupiah will help mitigate inflation, and the bank has even been seen selling dollars, with HSBC estimating that about $3bn went under the hammer in January.

“In terms of capital controls, the pressure is a bit less now than it was a few months ago,” says Daniel Hui, senior Asian foreign exchange strategist at HSBC in Hong Kong. “The perception in any event is that governments have been less slamming the door and more putting up turnstiles. [Capital controls and other such mechanisms are seen as] tools that augment foreign exchange policy; in practice they are actually quite incremental and minor.”

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