Controlling capital to prevent crisis

19 January 2000

What should Thailand have done in mid-1997 when it stood on the brink of crisis?

In recent months, the answer has changed. Now more are saying: put on capital controls.

Paul Krugman said it. But he has become Professor of Recantation, regularly disowning his own theories, so we can’t be sure he’ll stick with it. The IMF has said it. But oh so grudgingly. You can sense the IMF person squirming with pain as he wrote out this heresy. More important, Unctad has said it.

The Unctad research team has long provided an international counterweight to the World Bank and IMF. The WB/IMF economists believe free markets are religion. The Unctad economists come from a more European culture. They appreciate the different political economies of different nations. They have a practical, history-based view of how economies grow.

They start from a simple point. What makes modern economic crises so bad is headlong capital flight. It brings currencies tumbling down—wrecking balance sheets, bankrupting companies, and destroying financial systems. And when this starts in one country, others go down like dominoes.

Of course, the capital is flying away for a reason (bad fundamentals, property crisis). But it’s like a man with a knife wound. The knife started the problem. But it’s the bleeding that will kill him. First, put on a tourniquet. Then worry about the wound.

Everyone agrees the best way to solve crises is to prevent them. Since the Asia Crisis threatened to provoke a global depression, international institutions have been debating changes in the international financial system.

The WB/IMF wants better information about international financial flows. Banks would have lent less to countries like Thailand if they knew how bloated they already were. But, Unctad says, this is an idealised view of international finance. There was plenty of information to show that Thailand’s property and finance sectors were in bad shape from 1994. But over the next three years, more money was stuffed in than ever before. International financiers don't behave like data-analysts, but more like a pack of wolves—tumbling over one another in the hunt for food, then fleeing together at the hint of danger.

The second proposal is for tighter bank regulation. Since capital is now much more easily available, banks are tempted to make careless loans. So governments have to make their banks obey stricter rules. Yes, says the Unctad team, this is important. But no amount of bank regulation is going to prevent financial crises. Over recent years, they have happened in countries with well-regulated banking systems, as well as in more rough-and-ready systems like Thailand.

Besides, when capital flees and the economy crashes, all loans go bad. Thousands of Thai companies which were perfectly viable and law-abiding saw their assets and their cash-flow washed away.

The third proposal is to enlarge the IMF’s role to monitor countries' economic policies, and intervene before these policies induce crazy flows. Yes, says the Unctad team, that’s a good idea. But the IMF will have to monitor policies in the advanced countries as well as places like Thailand. The deep, deep reason for the Asia Crisis, they suggest, was the combination of high liquidity and low interest rates in Europe and Japan in the early 1990s, which resulted in reckless overseas lending.

But once anyone suggests greater surveillance of financial markets in the advanced countries, these countries get very grumpy. So this proposal is unlikely to work.

So the discussion of reforms in international finance has bogged down. Nothing is going to happen at the international level to halt the string of financial crises over the last twenty years. So once a crisis happens, how do you contain it or cure it before it affects a significant proportion of the globe?

First, there are the fiscal and monetary packages which have been the IMF’s patent remedy. Here the Unctad team is very clear. They are totally counter-productive. High interest rates and tight fiscal policies send a signal to foreign investors that things are going to get worse. They are an incentive to get out quickly and get out totally. In terms of our wounded man, these policies are like squeezing him so he bleeds even faster.

Next, there is a proposal to upgrade the IMF into a global central bank, which can act as a lender of last resort. Again, Unctad says this sounds like a good idea. But there are two problems. First, where is the capital going to come from? The amount required would be enormous. Second, who would run it? Banks always act in the interests of their shareholders. If this upgraded IMF was funded and managed by the world’s creditor countries (as it is now), it would still make sure that creditor banks survive and the populations of debtor countries suffer (as happens now).

So that leaves capital controls. But unlike Krugman, the IMF, or Mahathir, the Unctad team treats capital controls as part of a recovery strategy, rather than just a delaying measure. They use the analogy of the US Chapter 11 bankruptcy provision. When companies go bankrupt, it may be in the best long-term interest of its creditors to help put the company back on its feet. But each individual creditor wants to grab what he can before the others do. Result: a "grab race". Chapter 11 is designed to prevent this. It consists of three parts. A standstill agreement to forestall the grab race. Input of cash to put the company back on its feet. And reforms to ensure the company becomes profitable and the creditors are eventually paid.

The Unctad team wants to adapt this strategy for international crises. First, a standstill on capital withdrawal to prevent that mad downhill slide which Thailand suffered from November 1997 to April 1998, when the value of the currency halved, the banking system seized, and the economy was slammed viciously into reverse. Second, inputs of cash to keep the economy moving. The cost would be far less than the borrowings to repair social damage which will weigh down the Thai economy for at least a decade.

Third, a plan of reform. This could include the sort of financial restructuring which has been such a key part of the IMF’s management of the Thai crisis. And it should be a lot easier. Two years ago, many people said shock therapy was necessary to provoke reform. Now everything is bogged down in the mire of NPLs, many realise that shock therapy is vastly overrated.

Of course the details of how this would work in practice are tough. But this Unctad proposal is a small ray of light. In 1997, US economists seized on the crisis to argue for further financial liberalisation. People who proposed a debt moratorium in early 1998 were told that Thailand would become a "pariah" in international capital markets, and would be transformed instantly into a second Burma. Chang Noi remembers being beaten to pulp by an international gathering after daring to suggest that IMF policy made little sense. But in recent months, the debate has changed. The Unctad paper concludes, if there is no control on financial flows imposed at the international level, then "the principle of national control over capital flows" has to be reinstated.

[Yilmaz Akyuz and Andrew Cornford, Capital Flows to Developing Countries and the Reform of the International Financial System, Unctad discussion paper 143, November 1999]