---------- Forwarded message ---------- Date: Tue, 1 Sep 1998 17:14:16 -0400 (EDT) From: Robert Weissman <[EMAIL PROTECTED]> To: Multiple recipients of list STOP-IMF <[EMAIL PROTECTED]> Subject: Three articles from Martin Khor Dear Friends: The following are three articles on the financial crisis. Two relate to the need for foreign exchange and capital controls. The other is a general article analysing recent developments, especially in Asia. With best regards, Martin Khor (director, Third World Network, [EMAIL PROTECTED] or fax 60-4- 2264505). KRUGMAN CALLS ON ASIAN COUNTRIES TO IMPOSE FOREGN EXCHANGE CONTROLS. Report by Martin Khor, Third World Network, Penang, Malaysia ([EMAIL PROTECTED] or fax 60-4-2264505). Date: 30 August 1998 The prominent American economist Paul Krugman has launched a high-profile campaign to get East Asian governments to introduce foreign exchange controls as the only way to get out of their economic crisis. Speaking last week (26 August) in Singapore at a seminar organised by Strategic Intelligence, an exclusive business leaders group, Krugman said foreign exchange controls of the type in place in China could be the answer to get troubled Asian economies back on track. Such controls would break the link between domestic interest rates and exchange rates, thus allowing governments to lower interest rates without sending their curencies into another downward spiral. Krugman is an internationally renowned mainstream economics professor at the Massachusetts Institute of Technology, a believer in free trade, and no wild-eyed radical. So when he made what he himself called the "radical proposal" of capital controls, he was almost apologetic and visibly pained for doing so. And that made his case even more persuasive. Whilst in Singapore, Krugman also gave interviews on CNBC cable television, and to a local business newspaper. In the same week, an article by him on the same topic was also published as a cover story in Fortune magazine. Krugman's advocacy of capital controls has already sparked a discussion in Malaysia and is likely to generate wide interest and debate in the Asian region. This is because some of the region's economists and policy makers have been attracted to the possibility of reintroducing some regulations and controls on capital flows to reduce financial volatility, but had been constrained from advocating it as capital control has till now been a "taboo" subject. This is the result of the dominance of the ideology of international agencies such as the International Monetray Fund and the Group of 7 countries that insist on free capital flows as a prerequisite for modern and emerging economies, and also as a condition for IMF-coordinated rescue loans. Krugman is certainly not the first person to advocate capital controls as a part of the solution to the Asian financial crisis. Indeed he is, as he admits, a new convert. But he is such a prominent part of the economics establishment that his proposal can carry enough weight to break the taboo against considering foreign exchange controls as a serious policy option. According to a report in the Malaysian daily, New Straits Times, Krugman in his seminar address said that Asian economies were reaching the end of the road and it was time to "do something radical", including implementing foreign exchange controls since pressures on the Asian economies were too high. He said that at the initial stage of the Asian crisis he thought the affected counties were following the right strategy, "but in the last few months I began to wonder whether Asia is on the right track." Krugman added that after having gone to the IMF and finding that its policies (which he called Plan A) did not work, it was time now for Asian countries to adopt what he termed "Plan B," which comprised foreign exchange control. He noted that China, which had not been fully caught in the regional crisis, had currency controls through the inconvertible capital account. "Chile too has capital inflow control and that is a good idea," he added. Krugman also said that reading articles about the inefficiencies of Asian economies "makes my blood boil." "The rhetoric now is reminiscent of 1932 in the US when there were calls to liquidate everything. But liquidation is not going to pay off unless there is expansion in demand." During a TV interview on the CNBC programme Asia in Crisis last Saturday (29 August), Krugman explained how he came to the "radical proposal" of Plan B. "We tried Plan A (the IMF prescription of austerity)...but it didn't work, then what do you do? It's hard for the IMF and the US Treasury to admit it was wrong and to do something different. But the time has come. "Why did I become a radical? I didn't want to be. But we are in a trap." Krugman added: "We cannot cut interest rates because the currency may fall and we can't get more IMF funds because the IMF didn't have enough. "The only possibility I see is imposing capital controls." These controls would require exporters to sell their earnings to the Central Bank, which in turn would sell the foreign exchange. "It's a dirty word, capital controls, but we need them to get out of the bind." In his Fortune article, entitled "Saving Asia: it's time to get RADICAL", Krugman agrees with the IMF critics that high interest rates imposed by the IMF would cause even healthy banks and companies to collapse. Thus, there is a strong case for countries to keep interest rates low and try to keep their real economies growing. However, says Krugman, the problem is that the original objection to interest rate reductions still stands, that the region's currencies could again go into free fall if the interest rate is not high enough. "In short, Asia is stuck: Its economies are dead in the water, but trying to do anything major to get them moving risks provoking another wave of capital; flight and a worse crisis. In effect, the region's economic policy has become hostage to skittish investors." Krugman says there is a way out, what he calls Plan B, "but it is a solution so unfashionable, so stigmatised, that hardly anyone has dared to suggest it.. The unsayable words are exchange controls." Exchange controls, he adds, used to be the standard response of countries with balance of payments crises. "Exporters were required to sell their foreign-currency earnings to the government at a fixed exchange rate; that currency would in turn be sold at the same rate for approved payments to foreigners, basically for imports and debt service. "Whilst some countries tried to make other foreign-exchange transactions illegal, other countries allowed a parallel market. Either way, once the system was in place, a country didn't have to worry that cutting interest rates would cause the currency to plunge. "Maybe the parallel exchange rate would sink, but that wouldn't affect the prices of imports or the balance sheets of companies and banks." Krugman points out some problems posed by exchange controls in practice, such as abuse by traders and distortions, so that economists think these controls work badly. "But when you face the kind of disaster now occurring in Asia, the question has to be: badly compared to what?" Asking why China hasn't been so badly hit as its neighbours, Krugman answers that China "has been able to cut, not raise, interest rates in this crisis, despite maintaining a fixed exchange rate; and the reason it is able to do that is that it has an inconvertible currency, a.k.a. exchange controls. "Those controls are often evaded, and they are a source of lots of corruption, but they still give China a degree of policy leeway that the rest of Asia desperately wishes it had. "In short, Plan B involves giving up for a time the business of trying to regain the confidence of international investors and forcibly breaking the link between domestic interest rates and the exchange rate. "The policy freedom Asia needs to rebuild its economies would clearly come at a price, but as the slump gets ever deeper, that price is starting to look more and more worth paying." In a note on the cover story, Fortune editor John Huey states that Paul Krugman has something very important and very un-economically correct to say, and that this piece is expected to "spark debate from Basel to Bangkok." A press release by Fortune also said that Krugman warned that if Asia did not act quickly, the crisis could worsen into a depession similar to that experienced in the 1930s, and that IMF programmes that required higher interest rates to stop a currency freefall had made the matter worse. The statement said that being a longtime colleague of IMF deputy managing director Stanley Fisher and US deputy treasury secretary Lawrence Summers, Krugman addresses the awkwardness of proposing such an extremne measure (exchange controls). Krugman discusses the implicit "gag rule" that prevents not only officials but anyone asociated with the current strategy (bankers, major institutional investors) from being too vocal about an alternative strategy. The Krugman campaign has already sparked public interest. Over the weekend, journalists referred to the Krugman proposal and asked Malaysia's political leaders whether the government intended to impose restrictions on capital movements. Malaysian premier Dr Mahathir Mohamad replied the country had no such intention. For many economists and serious analysts observing the Asian economic crisis, it has become obvious that the problem began with the free flows of funds moving in and out of the affected countries. Those countries had recently liberalised their financial systems, extending the convertibility of their currencies from the current account to the capital account. Many observers point to China and India as examples of countries that have not been subjected to volatile capital flows and currency instability or speculation, because the two countries do not allow full convertibility of their currencies. The lesson is that developing countries that want shield themselves for externally-generated financial crises should retain (or regain) some controls over the convertibility of their currency. This could reduce the conditions in which currency speculators can profitably operate. It could also reduce the exit of funds and discourage the inflows of undesirable forms of short-term capital. However, the option of reintroducing some capital controls has till recently not been openly discussed, because it is considered a "taboo" subject. The prevailing ideology held and spread by the International Monetary Fund and the Group of Seven rich countries is that countries should liberalise their capital account, and those that have already done so will suffer damage if they reimpose controls. Policy makers in the affected countries are worried that if they were to even discuss the advantages of capital control, their country would be black-listed by the IMF, the rich countries and financial speculators. But by keeping silent, their countries will continue to be subjected to the views and interests of "market players", suffer the consequences of a relatively high interest rate policy, and be prevented from speedy recovery. Krugman's open advocacy may help make capital controls a more acceptable option for governments wanting an effective policy instrument to prevent further financial turbulence. BREAKING THE TABOO ON CAPITAL CONTROLS Analysis by Martin Khor, Third World Network, Penang, Malaysia ([EMAIL PROTECTED] or fax 60-4-2264505). Date: 30 August 1998 SUMMARY: There is a growing belief that the East Asian countries' crisis started with their rapid relaxation of previous rules regulating their local currency and foreign exchange as it allowed the volatile flows of speculative funds. If this is true, then one policy option should be the reimposition of capital controls. Until recently this was a taboo subject. Last week, however, the taboo was broken by establishment economist Paul Krugman. This article gives a background to the rationale for capital controls. ----------------------------------------------- For many economists and serious analysts observing the Asian economic crisis, it has become obvious that the problem began with the free flows of funds moving in and out of the affected countries. Those countries had recently liberalised their financial systems, allowing locals and foreigners alike to freely convert foreign exchange into local currency, and local currency into foreign exchange. This currency convertibility has been allowed not only to finance current transactions of trade and direct investment (which in the past had also been permitted), but also for other transactions and short-term flows such as investment in the stock markets; loans from and to abroad; remittances to abroad by individuals and companies for savings or property purchases overseas. Since these short-term flows are not recorded in the current account of the balance of payments, the ability to convert local into foreign currency for these purposes is termed "capital account convertibility." Many economists have concluded that when countries introduce capital account convertibility, they expose themselves to autonomous inflows and outflows of funds by foreigners and locals, subjecting their local currency to speculation as well as exchange- rate volatility. The Asian crisis was sparked by speculation and a stampede of foreign funds moving out, followed shortly by locals also sending their money abroad, whilst the local currencies fell sharply. Now that the countries are in deep recession, capital account convertibility is now causing another equally vexing problem. It is preventing or discouraging the countries from taking the policies they urgently need to get the recovery process moving. To counter the recession, the government needs to lower interest rates (to relieve consumers and companies from their heavy debt service burden) and increase its spending (so that there is more demand for businesses and incomes for workers). However they are constrained from this line of action because of fears that managers of investment funds and currency speculators (known as "market players") will attack the local currency because a lower interest rate makes it less attractive for people to park their money in the country. Also, there is fear of local capital flight, as some residents may be tempted to send more of their savings abroad in search of higher interest rates. The possibility of funds exiting in an environment of free capital account convertibility of the local currency thus puts a dampener or even a stop to measures that are needed for a recovery. Therefore, one logical move would be for the affected countries to consider partly re-regulating their financial system, and re- imposing some forms of control over the convertibility of the local currency. This could reduce the conditions in which currency speculators can profitably operate. It could also reduce the exit of funds and discourage the inflows of undesirable forms of short-term capital. Many observers point to China and India as examples of countries that have not been subjected to volatile capital flows and currency instability or speculation, because the two countries do not allow full convertibility of their currencies. Although the local currency can be converted for trade and direct investment purposes, there are restrictions and regulations for changing local currency to foreign exchange (and vice versa) for other purposes. The lesson is that developing countries that want shield themselves for externally-generated financial crises should retain (or regain) some controls over the convertibility of their currency. However, the option of reintroducing some capital controls has till recently not been openly discussed, because it is considered a "taboo" subject. The prevailing ideology held and spread by the International Monetary Fund and the Group of Seven rich countries is that countries should liberalise their capital account, and those that have done so will suffer damage if they reimpose controls. Policy makers in the affected countries are worried that if they were to even discuss the advantages of capital control, their country would be black-listed by the IMF, the rich countries and financial speculators. By keeping silent, their countries will continue to be subjected to the views and interests of "market players", suffer the consequences of a relatively high interest rate policy, and be prevented from speedy recovery. Recently there was a major breakthrough against the taboo when the prominent economist Paul Krugman of the Massachusetts Institute of Technology launched a personal campaign to persuade Asian governments to reimpose capital controls as the only way out of their crisis. To be fair, it must be noted that Krugman is not the first person to advocate capital controls as a way out of the Asian crisis. Indeed he is, as he admits, a new convert. But as he is so much a part of the economics establishment, his radical proposal will carry more weight. Now that the taboo is broken, capital controls could become a respectable option for governments wanting an effective policy instrument to prevent further financial turbulence. ON THE BRINK OF GLOBAL RECESSION by Martin Khor, Third World Network, Penang, Malaysia ([EMAIL PROTECTED] or fax 604-2264505) Date: 31 August 1998 The world economy has entered a tumultuous period, with many Asian countries announcing latest reports of even deeper declines in economic output, Russia plunging into chaos, Hongkong fighting a deadly and expensive battle with speculators, Japan's stocks taking another battering and Latin American share markets catching the finacial flu. The crisis that originated just over a year ago in Asia also appears to have finally hit the American and European stock markets, which were also badly hit at the end of last week, sparking predictions of more significant declines there in the days ahead. The deep plunge of the Dow Jones index by over 500 points on 31 August has generated a panic-like situation in the US, which could now well spread to industrial-country markets and thus mark the arrival of a global-level crisis. Suddenly this financial crisis no longer belongs only to the Asian region, or even only to the "emerging markets." The world economy is quickly unravelling, in new and unexpected ways. We are looking down the cliff at a global recession. The new depths of the recession in Asia were revealed last week by the latest reports on Gross Domestic Product data showing declines that were steeper than expected. In Malaysia, the GDP fell by a steep 6.8 percent in the second quarter of this year, coming after a revised 2.8 percent drop in the first quarter. The South Korean GDP fell by 6.6 percent in April-June, following a 3.9 percent drop the previous quarter. Also in the second quarter, Hongkong's GDP dropped by 5 percent whilst in the Philippines the GDP contracted 1.2 percent. Most stock markets in the region recorded sharp falls to new lows, some to levels that had not been seen for a decade. An exception was Hong Kong, where the financial authorities pumped an estimated US$10 billion into the stock market in an unprecedented battle against speculators. Hong Kong had been proud of its "free market, hands off" policy but decided to abandon this when it came under massive attack by speculators who had devised a "double play" on the currency and stock markets. The speculators' tactic was to sell Hong Kong dollars, knowing that this would drive interest rates up as the authorities protect the currency's peg to the US dollar. At the same time, they bought futures contracts short on the Hang Seng stock-market index, in the expectation that the rise in interest rates would cause share prices (and thus the index) to fall significantly. If that happened, the speculators would make spectacular profits at Hong Kong's expense. The authorities thus spent massively to prop up shares and the Hang Seng index to force losses on the speculators. The biggest battle was on Friday, when the Hang Seng futures contracts for August fell due. As a result of the intervention, the Hang Seng index ended only slightly lower, and the authorities declared victory. But according to reports in the Hong Kong's South China Morning Post, some speculators have rolled over their contracts to September, and thus further battles between speculators and the authorities can be expected. The South China Morning Post last Friday also reported that George Soros' Quantum Fund had mobilised funds against Hongkong, thus naming one of the major speculators. It quoted Quantum Fund manager Stanley Druckenmiller as saying the Fund had mobilised funds against Hongkong as the currency and stock markets were "overvalued." He said the Hongkong government's intervention would fail as basic economic fundamentals imply either higher interest rates or a lower valuation for the currency. Two weeks ago, the Financial Times published a controversial letter by Soros, stating that Russia's financial system was at a terminal stage, and that the rouble should be devalued by 20 percent. The Financial Times itself later admitted in an editorial that it was this letter that sparked a massive selling off, forcing President Yeltsin to take extreme measures such as declaring a moratorium on Russia's foreign debt as well as on the government's domestic debt. Last week the Russian financial system exploded as the rouble threatend to go into a free fall, Indonesian style. The monetary authorities suspended all foreign exchange trade in the second half of the week. Many banks have been unable to meet depositors' demands as customers queue up for panic withdrawals. Forced to sack the government again and replace the Prime Minister, Yeltsin's own position is under threat as angry members of the Russian parliament or Duma call for his resignation. It is likely that forces within Parliament and Russian society will pressure the new government to turn back from its policy of extreme financial openness to the outside world that had exposed the country to such heavy dependence on foreign funds, and the currency and stock market to the risks of speculation and volatility. Russia thus became the latest case of an IMF-inspired and IMF- funded model that ended up as a massive failure, and in this case a catastrophe. The Russian economic crisis is likely to be as severe as Indonesia's, but because of its political significance, it has greater global ramifications. As a commentator put it crudely, Russia is Indonesia plus nuclear weapons. Russia also has strong connections to the West. For example, German banks have lent US$30 billion to Russia and are thus hit with potentially big losses. Last Thursday (27 Aug) and Friday (28 Aug) the European and US stock markets fell sharply as the so-called "contagion effect" hit them. The Dow Jones index fell 4.2 percent or 357 points to 8166 on Thursday and dropped another 114 points to 8051 on Friday. (On Monday 31 August it again plunged, by over 500 points, thus marking the arrival of a real crisis in the US and global markets). European stock market indices also declined on Thursday (27 Aug), including in London (by 3.2 percent), Frankfurt (3.2 percent), Zurich (5.1 percent), Athens (7.7 percent) and Madrid (5.8 per cent). In Japan the Nikkei index fell 3 percent to 14413 on Thursday and dropped another 500 points to 13915 on Friday. Japan is the first industrial nation that has entered recession, but the widening consequences of the Asian and Russian crises may well pull Europe and the United States into the path of the financial cyclone. Economists and the public across the world are becoming increasingly aware that over-exposure of countries' financial systems to global market forces can be dangerous and in fact has become a threat to the global economy. The myth that the financial markets know best and increase efficiency in allocating financial resources to different countries has been exploded by the spreading crisis and its damage to the real economy. Even die-hard believers and practitioners of the "free market" are now blaming financial speculators for having been given too much freedom, and are acting to curb or calling for curbs on their activities. Hong Kong is of course the latest example of a free-market advocate that has been bitten by the speculators and has now, in an about- turn, committed its reputation and its many billions of dollars to a do-or-die battle with hedge funds and other speculators. The respected trade economist Paul Krugman of the Massachusetts Institute of Technology is now advocating the abandonment of free capital flows and the imposition of capital controls by the affected Asian countries as the only way out of the crisis. At present many Asian countries and Russia are already in the midst of a depression, whilst the rest of the world is standing on the edge of a recession. It is the most dangerous situation since the Great Depression of the 1930s. The coming two weeks will be crucial in determining whether the global economy can withstand the shocks or if instead it will roll off that edge into recession.
