Have capital controls helped or hindered Asian financial markets?

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ImageThailand made financial news on March 3 by lifting capital controls on the Thai Baht that were imposed 14 months ago.  The Bank of Thailand (BOT), the central bank, had imposed the measures to limit the rapid appreciation of the Baht against the US Dollar, which was reportedly hurting exports, and to prevent speculative investment in the capital markets.  Thailand’s capital controls imposed in December 2006 did not stem the appreciation of the currency (the Baht appreciated by about 14% since that time) and in spite of this appreciation, exports rose by over 30% in 2007.  This leaves open two key questions: (1) if the controls did not ultimately prevent the currency from appreciating, what impact did they have on financial market development? and (2) what can the rest of Asia learn from this incident, if anything? 

Thailand’s original capital control required that 30% of ¬all foreign capital inflows be deposited with the central bank for a year without interest.  This triggered a 15% one-day sell-off in the stock market – the biggest one day drop in its history – which wiped out US$ 22 billion in market value and caused other emerging markets to also suddenly drop.  This forced the BOT to immediately exempt foreign equity inflows from the capital controls. 

Since that reversal, the Stock Exchange of Thailand (SET) did turn positive again and is now about 16% above the market level the day prior to the imposition of the controls.  In addition, the target of the capital controls, foreign investors, became more active after the controls were imposed even though one would expect them to be even more cautious.  In the 14 months since December 2006, foreign trading volume on the SET was on average over 10% higher than the preceding 14 months.  Although the BOT removed the controls for equity investments, the capital controls remained for other foreign inflows, particularly for investments in the bond market.  Again, the market did not appear to be hindered due to the controls.  The bond market expanded and deepened since November 2006, with the monthly trading value up by over 100%, the number of transactions and daily average trading up by 70%, and a 60% increase in foreign bonds outstanding. 

Modern-style capital controls (pdf) have been seen around the world since the 1930s and the original Bretton Woods Agreement explicitly allows for such controls, but most developed economies have phased these controls out as have many developing economies.  In Asia, capital controls are in place in many of the major economies.  Many countries in Asia are now contemplating imposing or changing their capital controls to better manage the inflows of short-term foreign financial flows in the domestic capital markets. 

For example, new reports indicate growing concern in China over “hot money” that has been flowing into the country from foreign investors is driving inflation and has increased speculation in the domestic financial markets.  This inflow  was estimated to be around $200 billion in 2007, far exceeding the $83 billion in foreign direct investment and 20 times the official ceiling for foreign portfolio investors (under the Qualified Foreign Institutional Investor, or QFII, program).  Although the authorities are planning to raise the QFII limit to $30 billion, the actual inflows are coming into China in a variety of ways. 

For instance, reports indicate that domestic and local banks take foreign exchange deposits overseas and lend in a corresponding amount in China.  The Government has tried to crack down on such practices and in mid-2007, the Chinese foreign exchange authority penalized 29 banks for breaching the country’s foreign exchange regulations.  While it may be impossible to tell how the “hot money” inflows impacted the financial markets, the controls and penalties did not prevent the domestic share (A share) markets in Shanghai and Shenzhen from growing by 93% and 165% respectively in 2007.       

Admittedly, there are many causality problems when trying to isolate the impact of various factors on the financial markets and capital controls are difficult to measure precisely.  On top of this, capital controls link to a complex set of macro-financial issues (i.e., foreign exchange and monetary policy, trade policy, etc.), the types of controls are diverse – from quotas to taxation, the controls can be applied to market segments (i.e., equities, debt, etc.) differently, and the sequencing of the introduction or removal of controls can vary widely. 

There are volumes of academic research on this topic, which one can find easily online, and much of the academic literature on capital controls concludes that capital controls are indeed generally bad for financial market development.   To summarize, this research finds that despite the possibility for short-run volatility in financial markets after liberalization (i.e., elimination of capital controls), in the long-run such liberalization results in larger, more stable financial markets with greater liquidity.     

However, looking across the horizon at Asia, where most countries have some form of capital controls, it’s difficult to draw the conclusion that capital controls have hindered the (recent) development of the financial markets.  Such a broad conclusion would be supported by the school of thought that supports the use of capital controls.  In Asia, Malaysia is held up as the example (pdf) to show that the controls the country put into place in 1998 in the aftermath of the Asian financial crisis helped to produce faster economic recovery and turn around of the stock market as compared to other countries in the region (i.e., Thailand and Korea) that did not impose controls.  Of course, there are also counter-arguments to this conclusion with some (pdf) research pointing to strong fundamentals in Malaysia being the driving recovery factor.         

So, after all of the years of experience and reams of paper used in the research of topic of capital controls, what can policy makers across Asia make of all of this in terms of financial sector development policy?  Are there any specific lessons that can be applied across countries in Asia or is issue this simply too complex to be dealt with on a regional or multilateral basis?   


James Seward

Senior Financial Officer

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