Cristina A. Morales,Policy Analyst and Research Associate of Action for Economic Reforms

* This article was first published in the Yellow Pad column of BusinessWorld o­n 23 Febraury 2004.

The Philippines finds itself today in a conjuncture that makes it necessary to review the lessons that we were supposed to learn from the East Asian Crisis of 1997. With a politically charged environment as a backdrop, the Philippine economy has continued exhibiting disturbing traits and this has called the attention of not a few economic experts.

Most obvious of these troubling characteristics is the ballooning budget deficit that is mainly due to poor revenue collection performance for the past years. Moreover, the stock market has exhibited much volatility, reflecting the ever- fickle and erratic behavior of short-term capital flows, more commonly known as hot money. These two things have undoubtedly contributed to the downward spiral of the exchange rate between the US dollar and the Philippine peso, which undoubtedly is being exacerbated by political woes and uncertainty.

These have led UP Sociology professor and world-renowned activist Walden Bello to remark in BusinessWorld a fortnight ago that the Philippines may in the short term be facing a "Brazilian scenario." As Professor Bello put it, "we must protect ourselves from a destabilizing capital flight … by enacting capital controls now." It may be useful then at this point to revisit past lessons that had been so painfully taught to us by the East Asian Financial Crisis and reconsider the issue of capital controls and other strategies that may help our economy cope with today’s most pressing challenges.

At the outset, it must be stressed that the problems that we face today in our economy do not occur in a vacuum and must therefore be taken in the larger context of the issues that challenge the global economy as well. A paper entitled "The Case for Capital Controls" (2000) by James Crotty, a professor of Economic in the University of Massachusetts, identifies several such related problems, and of which I cite two that are most relevant to our domestic context.

• First, the excessive liberalization of capital accounts has created ever more frequent and ever deeper boom-bust cycles for many economies. The 1997 East Asian financial crisis is a clear testimony to this fact. That it spread like wildfire to Russia, Brazil, and arguably even Turkey fortifies this conclusion even more.
• Second, the dwindling regulation by the state of such cross border capital flows and the resulting swelling in the magnitude and acceleration of these movements have all but nullified the autonomy of domestic economic policies needed to address problems and vulnerabilities in the domestic economy. Lowering of interest rates for example, along with using deficit spending to boost the domestic economy, are policies that are often punished by capital flight, thus resulting in higher interest rates and possibly triggering exchange rate crises. As such, these expansionary policies no longer reside in the state’s economic policy toolbox.

Indeed, these two have been identified as the greatest costs of having liberalized our economy’s capital account. Building upon these, in a paper entitled "Capital Account Controls and Related Measures to Aver Financial Crises" (2002), Ilene Grabel of the University of Colorado identifies the risks of excessive capital account liberalization which imperils many developing country economies today. These are: currency risk, referring to the increased probability of a sudden decline in the value of a county’s currency; flight risk, which refers to the likelihood that holders of liquid financial assets will sell their holding en masse in the face of rightly or wrongly perceived difficulty; fragility risk, or the vulnerability of domestic borrowers to shocks that may jeopardize their capacity to meet obligations, as in for example when a maturity mismatch occurs between a country’s short term liabilities and its foreign currency earning assets; contagion risk which largely refers to Professor Crotty’s first point; and finally, sovereignty risk, or the danger that states will face constraints o­n its ability to pursue independent economic and social policies lest it be punished with a financial crisis. This last o­ne is the Brazilian scenario that we must avoid, according to Professor Bello.

These increasingly apparent problems and risks to capital account liberalization have led many economists and policy-makers to conclude that in truth, the costs of excessive capital account liberalization far outweigh the benefits that it brings. To insulate an economy from these threats, they have also argued for the reimposition of government control over short-term, cross-border capital flows. Professor Bello, in the above cited article, argues precisely for such controls, and so have many leading economic thinkers like Nobel Laureate Joseph Stiglitz, Harvard Professor Dani Rodrik, and University of Cambridge Professor Ajit Singh, to name just a few. Indeed, even staunch advocates of swift and comprehensive capital account liberalization like the economists at the IMF have in recent years admitted to the perils of such, and in fact have even hinted at the need for some degree of prudential regulation for capital flows.

There is undoubtedly a strong case o­n the side of arguing for the imposition of capital controls as the Philippine economy teeters towards possible disaster. The currency risk that we face is quite significant, and in fact has already been manifesting itself in the foreign exchange market.

However, while there is some degree of consensus in academic and policy-making circles as to the need for such controls and regulatory measures, divergence in opinion plagues the task of designing proper mechanisms to safeguard the economy from the risks of hot money. This is perhaps the most important factor why many economies, while admitting that they need some degree of insulation from hot money, have yet to institute any form of regulation or control thereof.

A recent joint work of three prominent heterodox economists outlines the options for regulating capital flows that are available to countries today. Gerald Epstein of the University of Massachusetts, Ilene Grabel, and Jomo K. Sundaram of the University of Malaya assert in "Capital Management Techniques in Developing Countries: An Assessment of Experiences from the 1990s and Lessons for the Future" (2003) that by using capital management techniques, or quite simply put, a strategy that employs the traditional menu controls o­n capital flows as well as certain types of prudential financial regulations, a government may be able to reduce the risks and vulnerabilities that plague its economy due to its open capital account.

In particular, capital controls are those measures which seek to manage the volume, composition, and or allocation of international private capital flows. Such controls may be in the form of price-based measures, a la the Keynes tax, or a tax o­n securities transactions, or a Tobin tax, a tax o­n currency exchange transactions. They may also be quantitative in nature, such as limits o­n short-term sales of securities abroad, or the Chinese restriction o­n the types of securities that may be owned by non-residents.

Moreover, these capital controls may be static or dynamic in nature. Static capital controls are those which policy-makers do not alter in response to changed circumstances. Minimum stay requirements for foreign direct investments and portfolio investments is an example of such a control. o­n the other hand, dynamic capital controls are those which are initiated and / or adjusted in response to changes in the economic environment. These types of controls have become more popularly known as "trip wires and speed bumps", where you have "trip wires" or pre-determined indicators that are appropriately sensitive to subtle changes in the risk environment, and speed bumps or controls that will be kicked into effectivity in order to reduce and control the risk exposure. An example of such would be using the ratio of foreign-currency denominated debt to domestic currency-denominated debt as an indicator for locational mismatch in a country’s debt exposure, and the appropriate restriction o­n debtor behavior needs to be put in place.

Prudential regulation of the financial sector, o­n the other hand, is yet another policy toold that may help protect an economy from the down-side risks of capital account opennes. Prudential regulation refers to policies that seek to strengthen and stabilize the domestic financial sector and are oft called the "market-friendly approach" to regulating hot money. Examples of such are reserve requirements for foreign-denominated loans, with short-term loans requiring a higher reserve ratio.

Indeed, the menu of options for controlling capital flows is wide-ranging, and it is not hard to understand why the debate as to which are the appropriate controls has not abated. What is clear from the debates, however, is the each country needs to evaluate the risks that it faces and according to these risks, design policy controls that would be most responsive and appropriate given their domestic context. Moreover, these regulations are not mutually exclusive to each other, and as a matter of fact, by maintaining a program of complementary capital management techniques, o­ne can reduce the required severity of any o­n technique and even magnify its effectiveness.

All this however is not to say that skeptics no longer abound. The more fiercely ideological of economists have remained unconvinced about the benefits and wary of the costs of capital management techniques. Moreover, the typical distrust of authorities’ capacity and motivations also make many doubtful of the viability of implement these controls.

Nevertheless, it must be noted that not a few countries have successfully been able to design and implement techniques that successfully altered and modified the risks that their economies faced. Chile, for example, imposed a o­ne-year minimum residence requirement for all foreign direct and portfolio investments, while at the same time instituting an 30% unremunerated reserve requirement for all foreign currency liabilities. These controls along with several other regulatory mechanisms served to improve the composition and maturity of capital inflows to the Chilean economy, stabilized the currency, and reduced the risk of contagion, especially in light of the crises-ridden Mexican economy. Other examples may be found by looking at Colombia, Malaysia, Taiwan, and Singapore.

These countries’ experiences are proof that capital management techniques are indeed viable and effective in achieving their objectives. It may do Philippine policy-makers well to review these lessons from past financial crises and take the necessary steps to avert danger.