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Sri Lanka's central bank has faced two runs on its reserves in 2018, as a soft-peg with the US dollar weakened amid unsterilized excess liquidity.
"One policy tool which we haven’t discussed or considered is temporary controls on capital outflows," said Dushni Weerakoon, Executive Director of Colombo-based Institute of Policy Studies, a think tank.
"I know there will be some opposition to these particular controls, but countries like Malaysia used them very successfully during the East Asian Financial Crisis against the advice of the IMF (International Monetary Fund)."
Any central bank that operates a soft-peg targeting a policy rate and sterilizes interventions in forex markets (fills liquidity shortages) with unlimited volumes of printed money in the money market is vulnerable to losing unlimited amounts of forex reserves.
Sri Lanka enacted an exchange control law in 1952, after creating a money printing soft-peg in August 1950, replacing a hard peg which could not sterilize interventions and the interest rates floated.
Draconian trade and exchange controls were put in place in the 1970s after the Bretton Woods system of soft-pegs failed.
Many of them are still in place. Only investors who bring in money can take them out.
The need for exchange controls in a county with a policy rate enforced with printed money is explained by economists as the impossible trinity of monetary policy objectives which says a central bank cannot have a fixed exchange rate, independent monetary policy and free capital flows at the same time.
International media, prompted by interventionists like Paul Krugman had tended to glorify Malaysia's capital controls in the wake of the Asian Financial Crisis, where countries with budget surpluses and a record of maintaining fairly stable pegs (meaning they generally knew how to run pegged regimes) were badly hit.
Whether capital controls actually helped Malaysia is not clear, since countries without them also recovered (Korea is now almost a developed nation), and currency board style countries recovered faster or were less affected in the first place.
Malaysia got over the crisis without an International Monetary Fund program but with many of the same tools; raising policy rates, floating the exchange and then capitalizing banks as bad loans mounted with business failures coming in the wake ofa combined hit on domestic demand from a currency collapse and higher rates.
Even before the capital controls in 1998, a surplus budget was designed initially in Malaysia with 2.5 percent of gross domestic product prompting from the IMF, but later relaxed a little.
The Malaysian ringgit fell from 2.47 to 4.2 to the US dollar and was re-pegged at 3.8, when capital controls were imposed.
The Korean won fell from around 900 to 1900 to the US dollar when it was floated and bounced back to 1,400 and later appreciated to 1,100.
More significantly, Malaysia’s Bank Negara closed off-shore trading in currency swaps, which could be used by speculators to get hold of Ringgits to hit the peg.
All offshore ringgits were asked to be repatriated. Repatriated ringgits (in theory) could be sterilized by domestic securities rather than forex, analysts who closely studied the crisis point out.
The Bank of Thailand also closed the offshore swap market in Baht, after first becoming counterparty to swaps which generated domestic currency, helping hit its own forex reserves.
But bad loans in Malaysia rose to about 17.5 percent of loans, World Bank data showed later, indicating the level of distress of domestic firms, requiring bailouts of banks and asset management firms.
The Baht fell from 25 to 56 to the US dollar when it was floated, stabilized around 42, later appreciated to around 37. Bad loans rose to about 42 percent in 1998 and fell to about 37 percent of gross loan by 1999 and fell away rapidly as the economy recovered.
The evidence on currency board nations in East Asia is very clear, analysts say.
Hong Kong, which has an orthodox currency board, operates a free capital account. But speculators using swaps were hammered when short term rates rocketed up. They retreated with losses. The hard peg held at 7.8 to the US dollar.
The Hong Kong Monetary Authority, which also manages a sovereign wealth fund, took the unusual step of buying stocks, and squeezing out short sellers, (later making billions of dollars in profits when the stocks were sold), leaving pundits and speculators alike, nonplussed.
Bad loans were about 7.2 percent of gross loans in Hong Kong by 1999 according to Fed data.
Soft-pegged Malaysia reached the pre-crisis GDP of 108.3 billion US dollars with an output measured at 108.29 billion US dollars by 2002.
Korea exceeded the pre-crisis GDP of 589 billon US dollars in 1996 to reach 609 billion dollars by 2002.
Hard pegged Hong Kong which posted pre-crisis GDP of 159 billion US dollars in 1996, exceeded it to reach 165 billion US dollars in 1999, before the soft-pegs.
Singapore, which has a modified currency board (floating policy rates), suffered minimal damage and bad loans were about 5.9 percent of loans. A large volume of bad loans came from credit given by Singapore banks to other Asian nations which saw currency collapses.
The Singapore Monetary Authority in any case did not allow credit to foreigners in domestic money including through currency swaps and other derivatives, even before the crisis.
By law the Singapore Monetary Authority also cannot engage in unlimited sterilization of interventions as it is required to hold forex reserves in excess of the monetary base. As overnight rates rise, sterilization is squeezed out.
Singapore's GDP reached 95.8 billion dollars, a little short of the 96.4 billion dollars in 1996 by 2000, a year after Hong Kong.
Both Singapore and Hong Kong economies grew in 1997, unlike the soft-pegged East Asia. Brunei, which has a currency board with Singapore, was largely unaffected.
The worst affected was Indonesia, which arguably has the worst central bank in the region. Bad loans spiked to about 48 percent in 1998 and fell to 32 percent in 1999.
Bailouts of banks by the central bank created more money, sending the Rupiah crashing further.
There were charges at the time that Malaysia capital controls were put in place to help politically connected firms.
Meanwhile, Weerakoon said that if Sri Lanka is to use capital controls, the rules have to be transparent.
"In the use of such controls, it is also better to have them upfront, so that investors are not taken unawares," she said.
"But Sri Lanka, I think they will not use temporary controls," Weerakoon said. "It will remain somewhat of a hypothetical option for the simple reason that we have to keep going to international capital markets from 2018 onwards to settle our large outstanding debt settlements."
"If we are to refinance some of these outstanding foreign debt, we need to keep going to capital markets and that means retaining investor confidence," she said.
Exchange controls allow the state and central bank to expropriate assets of people and investors by depreciation. Ordinary people buy dollars or investors run simply to protect themselves.
"Nothing would at first seem to affect private life less than a state control of the dealings in foreign exchange, and most people will regard its introduction with complete indifference," explained economist Friedrich von Hayek in his works The Road to Serfdom.
"Yet the experience of most Continental countries has taught thoughtful people to regard this step as the decisive advance on the path to totalitarianism and the suppression of individual liberty.
"It is, in fact, the complete delivery of the individual to the tyranny of the state, the final suppression of all means of escape — not merely for the rich but for everybody."
Modern exchange controls were pioneered by Russia's Tsar Nicholas II in 1905-06 explains economist Steve Hanke at Johns Hopkins University in Maryland.
"Hayek’s message about convertibility has regrettably been overlooked by many contemporary economists," says Hanke (Siren song of Exchange Controls).
"Exchange controls are nothing more than a ring fence within which governments can expropriate their subjects’ property. Open exchange and capital markets, in fact, protect the individual from exactions, because governments must reckon with the possibility of capital flight.
Soft-pegs and exchange controls impose long term damage on economies.
"When convertibility is restricted, risk increases, because property is held hostage and is subject to a potential ransom through expropriation," Hanke says.
"As a result, the risk-adjusted interest rate employed to value assets is higher than it would be with full convertibility.
"This result, incidentally, is the case even when convertibility is allowed for profit remittances.
"With less than full convertibility, there is still a danger the government will confiscate property without compensation.
"That explains why foreign investors are less willing to invest new money in a country with such controls, even with guarantees on profit remittances."
Unlike countries that habitually use capital controls, there is no evidence to show that Malaysia had suffered any permanent damage from the capital controls, analysts say.
Up to the Great Recession, most East Asian countries had progressed, though growth slowed in Hong Kong after the handover to China and Thailand was hit by political unrest.
Corruption is another outcome of exchange controls.
"Restrictions on convertibility also promote other noxious activities," Hanke says.
"For example, if capital account convertibility is restricted or limited and convertibility on the current account is allowed, a two-tier currency market will be either formally or informally established.
"In that case, the "investment currency" will trade at a premium over the price of the relevant foreign currency on the official market for current account transactions.
"With two prices for the same currency, there are profits to be derived from having capital account transactions "reclassified" as current account transactions. That ad hoc reclassification can usually be bought by crony capitalists, for a price." (Colombo/Oct19/2018)
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