An evaluation of Malaysian capital controls

Abstract

PurposeThis research has been carried out to look into the long run impact of the controls on capital inflows imposed during the years 1998‐2001 in Malaysia. The paper intends to capture the long‐term impact of capital controls in changing the composition of capital flows into Malaysia and to examine whether the controls have been able to divert the short‐term capital inflows to longer‐term investments.Design/methodology/approachThe autoregressive first differenced ordinary least square models have been used to examine whether the controls have been able to divert the short‐term capital inflows to longer‐term investments.FindingsThe capital controls have been successful in the short run in switching some of the short‐term capital inflows into longer‐term portfolio investments, without jeopardizing the Malaysian investment environment in the longer‐term. Such controls did not have an impact on the decisions of foreign investors in the long run even if the rating agencies downgraded the Malaysian investments immediately after the controls were imposed. This paper suggests that capital flows into Malaysia were more a result of interest rate differentials between the domestic and the US interest rates and hardly depended on the Malaysian risk adjusted returns.Research limitations/implicationsOne of the limitations of this research is the ephemeral nature of the econometric analysis. All the variables, except government spending, are first differenced, in order to overcome the problem of spurious regression. However, while taking the first difference, there is a possibility of losing valuable long‐term relationship between the capital flows and the explanatory variables. Further, the analysis was carried out without much reference to the derivative market, which might have disguised some of the capital flows.Social implicationsCapital controls are adopted to prevent the volatility in domestic markets caused due to capital flight. The capital flight has huge macroeconomic implications on a society, including unemployment, interest rate volatility and subsequent economic slowdown and recession. If adopted with an intention to provide a temporary breathing space, it might help the countries manage their domestic imbalances.Originality/valueThis paper provides a fresh look at the implications of capital controls with longer‐term data that also include the period after the controls were withdrawn. The study is expected to be independent of market distortions, which might arise with narrow time frames that cover periods during and/or immediately after the crisis.