I. Introduction Malaysia's experience with temporary controls on short-term capital flows are germane to the contemporary debate on how developing countries can manage integration with world financial markets. In 1994, Malaysia resorted to controls on inflows of short-term capital to re-establish monetary control amid rising inflationary pressures. Several years later, during the Asian crisis, Malaysia restricted outflows of short-term portfolio capital and deinternationalized the use of its domestic currency, in a bid to contain speculation against the ringgit, stabilize short-term capital flows, and regain monetary policy independence. How successful was Malaysia's strategy of using temporary controls to manage short-term capital flows? A consensus view on this issue has yet to be reached. The literature on Malaysia's 1994 controls is scarce and largely limited to descriptive analyses, while the controversial role of capital controls in Malaysia's recovery from the Asian crisis has come under intense scrutiny in both academic and policy-making circles. (1) The authorities consider that capital controls were a critical component of the policy response to the 1997-98 crisis. By eliminating offshore trading of the ringgit, and thus curtailing the speculative pressures on the exchange rate, controls enabled them to ease monetary and fiscal policies and rehabilitate the banking and corporate sectors. However, analytically, it is difficult to differentiate the effects of capital controls from other contemporaneous factors. As Rudiger Dornbusch summed up in 2001: The costs or benefits of capital controls remain ambiguous. Malaysia had more favorable preconditions, it did not do appreciably better, and the timing of controls coincided with the reversal of the yen appreciation, the end of the crisis elsewhere, and Fed rate cuts that put an end to the crisis atmosphere in world markets. However, because the costs are ambiguous, there is no evidence that the institution of capital controls or the failure to apply an explicit IMF program has yet resulted in any obvious detrimental effects. (2) In tandem with imposing capital controls, Malaysia pegged the ringgit to the U.S. dollar at a rate that many analysts believed undervalued the domestic currency. (3) The undervaluation made capital controls largely redundant: they became necessary neither for sustaining the exchange rate regime, despite an aggressive monetary and fiscal expansion, nor for engineering a recovery, which was largely led by exports. And since they were imposed after a substantial amount of capital had already left Malaysia, the controls were also not tested by any significant pressures for capital outflows. The costs of the 1998 controls are also not obvious. Beyond the immediate but short-lived deterioration in credit ratings and spreads, it would seem far-fetched to attribute the post-crisis decline in foreign investment and activity in financial markets exclusively to capital controls. Moreover, the Malaysian authorities took steps to minimize the costs of controls, relaxing them shortly after introduction, so that in their strongest form capital controls were effectively in place for less than six months. Given the difficulty of disentangling the effects of the 1998 capital controls from other policies, it is not surprising that existing empirical studies tend to attribute Malaysia's successful recovery to these controls. Kaplan and Rodrik (2001), for example, find that Malaysia's recovery was faster and less painful when they compare Malaysia's performance in the year after the introduction of capital controls with Korea's and Thailand's performance in the year after the start of their IMF-supported programmes. This analysis, of course, assumes that the economic situation in Malaysia in September 1998, when the country introduced capital controls, was similar to that in those other crisis countries when they adopted IMF-supported programmes. …
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