Two south-east Asian neighbours provide a fascinating contrast in their attitudes towards capital controls and the consequences of them. Thailand, once one of the most open Asian nations to foreign investment and capital, has spent much of the last six months putting barriers up; Malaysia, long seen as the epitome of a protectionist and paranoid capital policy, is tearing them down.
The results to date seem to be a ringing endorsement of liberalisation. Business and consumer confidence in Thailand has sunk; investment flows into Malaysia are soaring. Neither situation is quite as straightforward as it looks – Thailand appears to be unwinding many of its measures within months of implementing them, and Malaysia has much more to do before it convinces the world of its competitiveness – but the sense is of markets being rewarded for openness and punished for distance.
It is 10 years since the Asian financial crisis kicked off, and nine since most of Malaysia's onerous capital controls were put in place by former prime minister Mahathir Mohammad. Today, most of them have gone. Even short-selling has been permitted since the start of this year, albeit in a rather limited and unfunctional sense.
Malaysia's liberal approach
Liberalisation caught up with foreign exchange (FX) in March, with the announcement of 17 new measures in Malaysia. Among others, there is no longer any limit on open foreign exchange positions for banks, whereas previously the cap was 20% of the capital base. Other measures, which affect investment and therefore indirectly foreign exchange, include an increase of the cap on domestic institutional investors going overseas, from 30% to 50%; and the removal of limits on property financing by foreigners, where previously the maximum was three loans. A RM200 million (US$58.5 million) overdraft limit for non-resident brokerages has been axed, and licenced onshore branches are allowed to appoint overseas branches to help their offshore customers settle ringgit transactions.
Local companies will be allowed to borrow in foreign currency, and Malaysian residents will be able to have an unlimited number of foreign currency accounts. The ramifications for foreign exchange are "very significant", according to Richard Yetsenga, Asian FX strategist at HSBC. "Leaving aside the substance of the reforms, the spirit of them was truly international in nature. A lot of Asian countries say they have reformed but it's been code for trying to liberalise outflows to achieve an FX objective. Malaysia's appear genuinely two-sided."
"There is talk," adds Niklas Olausson, CLSA's head of research in Kuala Lumpur, "that the abundance of tweaking on the FX front is a precursor to internationalising the ringgit proper."
Certainly that's what many are waiting for. The ringgit is at its highest level since the financial crisis, but it is still not tradable offshore. Some economists think that final restriction might be removed in the course of the year, and the government appears to want to see further strengthening of the currency before allowing it to be traded offshore.
For Malaysia, the attempts to add liquidity to its forex markets fit in a broader context of change affecting much of society and industry. The new Iskander Development Region in South Johor, a multi-billion dollar development that has been described as Malaysia's answer to the Chinese manufacturing hub of Shenzhen, has a host of incentives attached to it but none more groundbreaking than the one that will exempt companies from having to give guaranteed equity participation and jobs to Bumiputras, or ethnic Malays. Elsewhere there is mixed progress in the reform of Malaysia's government-linked companies, and there are promising economic indicators, with gross domestic product (GDP) rising 5.9% in 2006. Foreign direct investment (FDI) climbed to RM22.2 billion in 2006, from RM15.1 billion the year before.
It's a big contrast with Thailand. In December, the country implemented capital controls including a requirement that 30% of foreign capital inflows be deposited in non-interest-bearing accounts at the Bank of Thailand (BOT), the central bank, for a year. The rule has been eased a little since then – in some cases foreigners are allowed to hedge their investments instead of depositing the inflows; and investments in the Thai stock market have been exempted – but there are still onerous restrictions on foreign capital coming in to buy, for example, bonds and money market instruments. This measure was expected to be repealed in March. It wasn't.
The idea of these restrictions was to curtail the rise in the Thai baht, which like the ringgit has also recently hit its highest levels since the Asian financial crisis a decade ago.
But the measures haven't arrested that rise, and Thailand's economy is not looking good since controls came in. In April, the Bank of Thailand lowered its gross domestic product forecast to between 3.8% and 4.8% for 2007, having previously expected it to be as high as 5% – its Malaysian equivalent, Bank Negara, meanwhile, is upgrading its expectations to 6%. The BOT has specifically said that a recovery in domestic demand, which would boost GDP, will be delayed by political uncertainty. Private investment fell 1.8% year-on-year in February, a second consecutive decline; and the consumer confidence survey issued by the Thai Chamber of Commerce fell five months in a row to March and has hit its lowest level in five years. Credit Suisse estimates that net foreign direct investment into Thailand will fall from US$8.8 billion in 2006 to US$5.5 billion in 2007.
"Thailand, I think, has sent a very useful message to the rest of the region," deadpans Yetsenga. "If you're looking to try to achieve FX outcomes, restricting inflows is about the least desirable way to do that. In that sense, there's very little risk of policy contagion from Thailand."
Why didn't it work? Cem Karacadag, an economist at Credit Suisse, reckons "the baht's strength is being primarily driven by current account inflows, not capital account inflows" and that if Thailand really wants to slow the baht's rise it has to do so by shifting aggregate demand from external to domestic. "To achieve this, the Bank of Thailand would need to allow the baht to gradually appreciate towards its fair value and cut interest rates to spur consumption and investment demand, and along with them, demand for imports," says Cem. "Ideally, fiscal policy would also play a key role."
A particular problem has been the differential between the onshore and offshore rates for the baht against the dollar – a divergence that stood at 9% by the end of March. "What usually happens with an NDF [non-deliverable forward] market is you have a fixing rate which is based pretty much on the spot market rate onshore, and you have the onshore forward market which is determined a little bit by demand and supply and mostly by interest rate differentials," explains one Asia-based FX strategist. "The offshore players, segregated from that, play in a completely separate market that is settled in dollars." And although the two markets are separate, "all of your trades decay to a common fix, and that fix is spot." In other words, when implementing a trade, the segregation between onshore and offshore markets rarely matters at the end of that trade.
"What's happened in Thailand," continues the strategist, "is the two markets have completely separated." The effect of capital controls has been to drive the divergence between the two wider and wider. "Now you might as well call the offshore market the dollar-banana for all the relevance it has to the onshore. It really has no relevance at all."
Yetsenga says: "The fact that we have this bizarre situation where there are two spot rates, one onshore and one offshore, is indicative of the poor structure of the changes that were implemented in Thailand. Two spot markets can't persist indefinitely," and if the Thai authorities don't do something about it, "a non-deliverable market may gain more credence offshore and ultimately take over from the poorly functioning offshore deliverable market".
One strategist notes: "The irony is the people who have been hurt, particularly in the offshore market, are the guys that should never have been hurt from the BOT's perspective." That is, long-term equity buyers who specifically don't want an FX risk, so try to hedge it out, doing so in the offshore markets. The drift between the onshore and offshore rates has penalised them for being conservative. "Now they're in this predicament: do they cut out and take the loss, or stick with a completely unintended forex risk?"
Learning from mistakes
Many Malaysians believe they have gained from Thailand's approach. "We are benefiting from the situation in Thailand," says Franklin Tan at ECM Libra in Kuala Lumpur. "You can see money that was destined for Thailand coming here."
But there are mixed opinions on whether Malaysia needs to go any further towards full tradability. "It's not immediately obvious what the problems are at the moment, or why they need to do much more," says a strategist. "If it's for more capital account transactions, then great, but it's not clear why that's an impediment on FDI."
But at least that's a healthier position than Thailand's. And the problem now is how to fix it. "Certainly it's fixable but it will be a long road back," says Yetsenga. "The region has moved on while Thailand has gone backwards. For equity investors, Indonesia now has a larger market cap than Thailand; the need for investors to be focused on the Thai market has diminished substantially."
One strategist sees no obvious way out. "The BOT has said eventually it will roll back the rules, but their precondition is that the onshore market is no longer under pressure for the Thai baht to appreciate. For that to happen, you have to see onshore dollar-baht clearly trend higher."
But as soon as restrictions come off, he argues, everyone will want to buy dollars in the offshore market and sell them in the onshore market for the arbitrage, "and that act of selling dollars onshore will push the dollar-baht onshore down, which is exactly what they don't want. They're in a 'catch 22'."