Information about Asia and the Pacific Asia y el Pacífico

V Capital Controls in Response to the Asian Crisis

Yougesh Khatri, Il Lee, O. Liu, Kanitta Meesook, and Natalia Tamirisa
Published Date:
August 2001
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Information about Asia and the Pacific Asia y el Pacífico
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Capital Controls introduced by Malaysia during the Asian crisis have been a subject of much debate. Contrary to the views that the controls would have serious detrimental effects on the economy, only limited economic costs of the Controls have been identified. At the same time, the benefits of the Controls cannot be clearly established. Together with the pegging of the exchange rate, the Controls had been designed to enhance monetary independence, thereby facilitating economic recovery and providing breathing space for the implementation of structural reforms. Given the return of confidence to the region shortly alter the introduction of the Controls, however, it appears expost that Malaysia’s strong fundamentals would have made a more accommodating monetary policy and economic recovery possible without resorting to these measures.1

It is too early to discern the longer-term effects of the Controls on capital flows or on the Development of the financial system in Malaysia. If foreign investors expect Malaysia to resort to Controls on portfolio outflows in future periods of instability, they may attach a higher risk premium to investing in the country. As for the remaining Controls on international transactions in ringgit, these need to be evaluated in the broader context of domestic financial system Development and prudential risk management.


In tandem with the pegging of the exchange rate, the authorities introduced capital Controls in September 1998, aimed at restricting portfolio outflows and eliminating the offshore ringgit market (Table 5.1). Portfolio investors were restricted from withdrawing funds invested in Malaysia for at least a year, and trading of the ringgit outside of the country was prohibited. Additionally, fund transfers abroad became subject to approval; international borrowing and lending in ringgit, as well as trade settlements in ringgit, were prohibited; and exports and imports of ringgit bank notes were restricted. Capital Controls were supported by other regulatory measures, particularly those on trading in Malaysian equities.2

Table 5.1.Key Changes in Capital Account Regulations
Date/Type of TransactionMeasure
January 17, 1994 Bank transactionsA ceiling was placed on the net external liability position of domestic banks, excluding trade-related and direct investment inflows. This was removed on January 20, 1995.
January 24, 1994 Portfolio investmentResidents were prohibited from selling the Following Malaysian securities to nonresidents: banker’s acceptances; negotiable instruments of deposit; Bank Negara Malaysia bills; treasury bills; government securities (including Islamic securities) with a remaining maturity of up to one year; and Cagamas bonds and notes (whether or not sold or traded on a discount basis) with a remaining maturity of up to one year. This was removed on August 12, 1994.
February 7, 1994 Portfolio investmentResidents were prohibited from selling to nonresidents all forms of private debt securities (including commercial papers but excluding securities convertible into ordinary shares) with a remaining maturity of one year or less.
The restriction on the sale of Malaysian securities to nonresidents was extended to both the initial issue of the relevant security and the subsequent secondary market trade.
February 23, 1994 Banking system transactionsForward transactions (on the bid side) and non-trade related swaps by commercial banks with foreign customers were prohibited to curtail the speculative activities of offshore agents seeking long positions in ringgit. This was lifted on August 16, 1994.
August 12, 1994 Portfolio investmentRestrictions on the sale of Malaysian securities were lifted, and residents were permitted to sell to nonresidents any Malaysian securities.
December 1, 1994 Borrowing and lendingMeasures were implemented to control borrowing and lending activities in domestic and foreign currency.
*Nonresident-controlled companies were allowed to obtain credit facilities, including immovable property loans, up to RM 10 million without specific approval, provided that atleast 60 percent of their total credit facilities from banking institutions were obtained from Malaysian-owned banking institutions. Short-term trade facilities, guarantees, and forward foreign exchange facilities were excluded from the computation of the RM 10 million limit in December 1994, while the 60:40 rule continued to apply to total short-term trade facilities.
*Nonresidents with valid work permits were permitted to obtain domestic borrowing to finance up to 60 percent of the purchase price of residential property for their own accommodations.
*Residents were permitted to borrow in foreign currency up to a total of the equivalent of RM 5 million from nonresidents and from commercial and merchant banks in Malaysia.
June 27, 1995 Portfolio investmentCorporate residents with a domestic credit facility were allowed to remit funds up to the equivalent of RM 10 million for overseas investment purposes each calendar year.
February 1, 1996 Payments for invisible transactionsThe threshold for the completion of the statistical forms for each remittance to, or receipt of funds from, nonresidents was raised to RM 100,000 or its equivalent in foreign currency from amounts exceeding RM 50,000.
August 4, 1997 Banking system transactionsControls were imposed on banks to limit outstanding offer-side swap transactions in ringgit that were non-commercial related (i.e., forward order/spot purchases of ringgit by foreign customers) to $2 million or its equivalent per foreign customer. Hedging requirements of foreigners for trade-related and genuine portfolio and foreign direct investments were excluded.
Augusts 8, 1997 Stock market transactionsA ban on short selling of the listed securities on the Kuala Lumpur stock exchange was introduced to limit speculative pressures on equity prices and exchange rates.
October 15, 1997 Real estate trans anionsThe quota on sales to foreigners of high-end condominiums was raised to 50 percent from 30 percent, and foreigners were allowed to acquire two units of condominiums (compared with one earlier) to reduce some of the impending supply in the high end of the property market.
September 1, 1998 Offshore ringgit market transactionsA number of selective exchange control measures were introduced, aimed specifically at eliminating the offshore ringgit market and restricting the supply of ringgit to speculators.
*A requirement was introduced to repatriate all ringgit held offshore, including ringgit deposits in overseas banks, by October 1, 1998; these required Bank Negara Malaysia approval thereafter. An approval requirement was imposed to transfer funds between external accounts and for the use of funds other than permitted purposes (i.e., the purchase of ringgit assets). Licensed offshore banks were prohibited from trading in ringgit assets, which had been allowed up to permitted limits previously.
*A limit was introduced on exports and imports of ringgit by resident and nonresident travelers, effective September 1, 1998. No prior limits existed.
*Residents were prohibited from granting ringgit credit facilities to nonresident correspondent banks and stockbroking companies. This had been subject to a limit previously.
*Residents were prohibited from obtaining ringgit credit facilities from nonresidents. This had been subject to limits previously.
*All imports and exports were required to be settled in foreign currency.
*All purchases and sales of ringgit financial assets could only be effected through authorized deposifory institutions. Trading in Malaysian shares on Singapore’s Central Limit Order Book over-the-counter market was prohibited de facto as a result of strict enforcement of the existing law requiring Malaysian shares to be registered in the Kuala Lumpur stock exchange prior to trade.
September 1, 1998 Portfolio and other forms of investmentA number of additional measures were introduced aimed at preventing heavy capital outflows by residents and nonresidents.
*An approval requirement was imposed for nonresidents to convert ringgit held in external accounts into foreign currency, except for purchases of ringgit assets, conversion of profits, dividends, interest, and other permitted purposes. No such restrictions existed previously. There were, however, no restrictions on conversions of ringgit funds in the external accounts of nonresidents with work permits, embassies, high commissions, central banks, international organizations, and missions of foreign countries in Malaysia.
*A 12-month waiting period was required for nonresidents to convert ringgit proceeds from the sale of Malaysian securities held in external accounts. This excluded foreign direct investment flows, repatriation of interest, dividends, fees, commissions, and rental income from portfolio investment No such restrictions existed previously.
*A prior approval requirement was imposed, beyond a certain limit, for all residents investing abroad in any form. This was previously applied only to corporate residents with domestic borrowing.
*A specific limit was placed on exports of foreign currency by residents up to the amounts brought into Malaysia for nonresidents. Previously there was no restriction on the export of foreign currency notes and traveler’s checks on the person or in the baggage of a traveler. Exports by other means required approval, regardless of the amount.
December 12, 1998 Lending in ringgitCommercial banks and finance companies were allowed to extend loans to nonresidents for the purpose of purchasing residential, commercial, or industrial property, or office space in Malaysia for the period from December 12, 1998 to January 12, 1999, subject to certain conditions.
January 13, 1999 Portfolio investmentCapital flows for the purpose of trading in derivatives on the commodity and monetary exchange of Malaysia and the Kuala Lumpur options and financial futures exchange were permitted for nonresidents, without being subject to the rules governing external accounts, when transactions were conducted through “designated external accounts” that could be created with tier-1 commercial banks in Malaysia.1
February 15, 1999 Portfolio investmentThe 12-month holding period rule for repatriation of portfolio capital was replaced with two measures:
*A graduated system of exit levy was applied on the repatriation on the principal of capital investments—in shares, bonds, and other financial instruments, except property investments—made prior to February 15, 1999. The levy decreased over the duration of the investment, and thus penalized earlier repatriations: the levy was 30 percent if repatriated less than seven months after entry, 20 percent if repatriated in seven to nine months, and 10 percent if repatriated in nine to twelve months. No levy was imposed on the principal if repatriated after twelve months.
*A graduated exit levy was applied on the repatriation of profits from investments made after February 15, 1999 in shares, bonds, and other financial instruments, except property investments. The levy decreased over the duration of investment; the levy was 30 percent if repatriated in less than twelve months after the profit was realized and 10 percent if repatriated after twelve months. No exit levy was imposed on capital repatriation
The aim was to preempt the potential exodus of funds in September when the holding period was set to expire, and to encourage fresh inflows to facilitate the recovery.
February 18, 1999 Portfolio investmentThe repatriation of funds relating to investments in immovable property was exempted from the exit levy regulations.
March 1, 1999 Export and import of ringgit banknotesThe ceiling on the import and export of ringgit for border trade with Thailand in selected areas was raised.
April 5, 1999 Portfolio investmentInvestors in the MESDAQ, where growth and technology shares are listed, were exempted from the exit levy introduced on February 15, 1999.
July 8, 1999 Lending in ringgitCommercial banks were allowed to grant overdraft facilities not exceeding RM 200 million in aggregate for intraday transactions and not exceeding RM 5 million for overnight transactions to foreign stockbroking companies.
September 21, 1999 Portfolio investmentThe two-tier levy system was replaced with a flat 10 percent levy on repatriation of profits on portfolio investment, irrespective of when the profits were repatriated. Bank Negara Malaysia explained there were complaints by foreign fund managers that the graduated system complicated the pricing of their portfolios and that the complex calculation of the amount of the applicable levy raised administrative costs.
September 21, 1999 Swap and forward transactionsTo provide foreign investors with more flexibility in managing their portfolios and risks. Bank Negara Malaysia relaxed Controls on lending in ringgit to foreign stockbroking companies. Commercial banks were allowed to enter into short-term currency swap arrangements with foreign stockbroking companies to cover payment for purchases of shares on the Kuala Lumpur stock exchange and for outright ringgit forward sale contracts with nonresidents who have a firm commitment to purchase shares on the Kuala Lumpur stock exchange, for a maturity period not exceeding five working days and with no rollover option.
Octobers 4, 1999 Lending in ringgitCommercial banks and finance companies were allowed to extend loans to nonresidents for the purpose of purchasing residential, commercial, or industrial property, or office space in Malaysia for the period from October 29 to December 7, 1999. This was to support official housing campaigns and was subject to certain conditions.
March 14, 2000 Portfolio investmentOriginal nonresident holders of securities purchased on the Central Limit Order Book were allowed to repatriate all funds arising from the sale of these securities without payment of the exit levy.
April 24, 2000 BorrowingIn line with the objective of promoting the Development of the domestic bond market, resident companies in Malaysia were allowed to issue private debt securities for permitted purposes without prior written approval from Bank Negara Malaysia. Nonresident-controlled companies raising domestic credit facilities by way of private debt securities were exempted from the RM 19 million limit and the 50:50 requirement for issuance of private debt securities on tender basis through the fully automated system for tendering.
June 29, 2000 Portfolio investmentAdministrative procedures were issued to facilitate the classification of proceeds from the sale of the Central Limit Order Book securities as being free from levy.
June 30, 2000 BorrowingGuidelines on private debt securities were issued.
July 27, 2000 Export and import of currencyResidents and nonresidents were no longer required to make a declaration in the traveler’s declaration form as long as they carry currency notes and/or traveler’s checks within the permissible limits. For nonresidents, the declaration was incorporated into the embarkation card issued by the Immigration Department.
September 30, 2000 Borrowing in ringgit and investment in ringgit assetsLicensed offshore banks in the Labuan international offshore financial center were allowed to invest in ringgit assets and instruments in Malaysia for their own accounts only and not on behalf of their clients. The investments could not be financed by ringgit borrowing.
December 1, 2000 Lending by foreign-owned banksForeign-owned banking institutions in Malaysia were allowed to extend up to 50 percent of the total domestic credit facilities to nonresident-controlled companies, in the case of credit facilities extended by resident banking institutions. This is to fulfill Malaysia’s commitment under the General Agreement on Trade and Services. Previously, foreign-owned banking institutions could only extend up to a maximum of 40 percent funding.
December 20, 2000 Lending in ringgitLicensed commercial banks and Bank Islam Malaysia Berhad in Malaysia were allowed to extend intraday overdraft facilities not exceeding RM 200 million in aggregate and overnight facilities not exceeding RM 10 million to foreign stock broking companies and foreign global custodian banks.
February 1, 2001 Portfolio and other forms Of investmentThe exit levy on profits repatriated after one year was abolished. Portfolio profits repatriated within one year remained subject to the 10 percent levy.
May 2, 2001The 10 percent exit levy was removed altogether.
Source: Information provided by the Malaysian authorities.

The classification of tier-l and tier-2 banks is no longer applicable. As of September 21, 1999, all commercial banks in Malaysia are allowed to open designated external accounts for nonresidents.

Source: Information provided by the Malaysian authorities.

The classification of tier-l and tier-2 banks is no longer applicable. As of September 21, 1999, all commercial banks in Malaysia are allowed to open designated external accounts for nonresidents.

As the economic situation stabilized, Controls on portfolio outflows were eased and eventually removed. However, Controls on international transactions in ringgit remain largely intact (Figure 5.1 and Table 5.1).

Figure 5.1.The Evolution of Capital Controls1

Sources: Information provided by the Malaysian authorities; and IMF staff estimates.

1 To trace the evolution of capital Controls, simple indices are constructed similarly to Tamirisa (1999); and Johnston and others (1999). Indices equal the weighted sum of capital Controls in place in a given month normalized by the weighted sum of capital Controls introduced since 1991. Weights are assigned as follows: prohibition is given the weight of 1; quantitative limit, approval equirement, or a tax greater than ten percent, the weight of 0.5; and notification requirement or a tax less thanten percent, the weight of 0.2, The indices range from 0 to 1, with higher values indicating more extensive Controls.

The impact of the capital Controls appears to have been limited so far, Reflecting in part their easing after less than six months, the Controls had only a transitory adverse effect on Malaysia’s access to international capital markets and its position in major investment indices. The capital Controls appear to have affected portfolio flows to some degree and may have contributed to a decline in foreign direct investment, although isolating the impact of the Controls from that of other policies and identifying a proper counterlactual are particularly difficult. It also appears that Controls on international transactions in ringgit. Which eliminated the offshore ringgit market, helped to reduce speculation against the ringgit at a time of highlv volatile exchange markets. The effect of the capital Controls on the domestic equity market was mixed, but foreign participation in derivatives markets declined.

The timing of the imposition of these capital Controls mitigated their short-term negative impact. They were introduced well into the Asian crisis after a substantial amount of capital had already left the country, and thus their effects on portfolio outflows were limited. By then, the external environment had improved, and market sentiment about the region had reversed for the better, expost, the ringgit became undervalued, further reducing incentives for capital outflows. The subsequent easing of Controls on portfolio outflows led to the reinclusion of Malaysia in the Morgan Stanley Capital Indices and helped generate new portfolio inflows. Improvement in investors’ sentiment was further enhanced by the authorities’ resolve to take advantage of the breathing space provided by capital Controls and their pursuit of financial and corporate reforms. Finally, careful design and effective enforcement of the Controls helped to focus on their intended objectives, thereby lessening their adverse effects. The Controls were selective and did not extend to payments for current international transactions or foreign direct investment. Overall, there appears to be no evidence of a large-scale circumvention, the emergence of a black market, or a nondeliverable forward market.

It is too early, however, to conclude whether capital Controls will have any long-term effect on capital flows and financial system Development in Malaysia. Foreign investors may view Malaysia’s recent resort to the exit levy, and Controls on portfolio outflows more generally, as a major reversal of its traditional policy and expect the authorities to repeat this in times of instability. Accordingly, the risk premium on foreign investment in Malaysia may rise. Consideration of the potential usefulness of the remaining Controls over the medium term needs to lake into account these broader economic costs, as well as their effectiveness. As regards the regulation of international transactions in ringgit, cross-country experiences suggest that this regulation needs to be considered carefully in the context of a longer-term policy approach to capital account regulation and financial Development, particularly the deepening of onshore financial markets.

The remainder of this section discusses the design and enforcement of the 1998 capital Controls, followed by a review of their impact on foreign investment, financial markets, and access to international capital markets. A preliminary empirical analysis is presented. Policy considerations relating to the exit levy on portfolio outflows and Controls on international transactions in ringgit are assessed in a crosscountry context.

Design and Enforcement of Capital Controls

There is no evidence that the Controls were circumvented on a large scale, and neither the nondeliverable forward market nor a black market emerged.3 Incentives for circumvention were generally weak, because expost undervaluation of the ringgit until improved regional and domestic economic prospects encouraged investors to keep their funds in ringgit.

The design of the Controls contributed to limiting their circumvention. They were selective in that they targeted offshore ringgit transactions and portfolio flows, and not current account transactions nor foreign direct investments. Thus, there was no direct reason for circumvention in relation to trade and direct investment transactions. At the same time, the Controls covered the targeted types of flows comprehensively whereby all key identifiable channels for the leakage of ringgit offshore and for the access of nonresidents to ringgit funds were closed. Along with the introduction of capital Controls, for example, offshore trading of ringgit assets was prohibited (inducing a closure of the Singapore Central Limit Order Book), large denomination ringgit notes were demonetized, and the Companies Act was amended to limit dividend payments.

Additionally, effective enforcement of Controls helped reduce circumvention. While their introduction initially led to confusion and uncertainty—in particular, in regard to outstanding contracts in the offshore market—Bank Negara Malaysia subsequently disseminated information on the Controls to ensure clarity. Bank Negara Malaysia succeeded in monitoring and enforcing the Controls through close collaboration with commercial banks, building on the preexisting relationship with the banks that reelected the fact that many capital account transactions had already been subject to Bank Negara Malaysia approval. Bank Negara Malaysia’s reputation as a strict regulator may have also prevented foreign banks from exploring ways to circumvent Controls, for fear of losing their local branches.

Capital Controls and Economic Performance

Access to International Capital Markets and Short-Term Financing

The capital Controls had an adverse, albeit temporary, effect on Malaysia’s access to international capital markets and short-term financing. Following the introduction of the Controls in September 1998, international rating agencies downgraded Malaysia’s credit and sovereign debt ratings (Table 5.2). Country risk, as reflected in the sovereign bond spread and international credit ratings, increased to a greater extent than the ratings of other emerging markets in the region (except Indonesia), which were negatively affected by Russia’s default that had taken place the previous month (Figure 5.2).4

Table 5.2.Sovereign Credit Ratings
Standard and Poor’sMoody’s
1998 first quarterAA2
1998 second quarterA-A2
1998 third quarterBBB-Baa3
1998 fourth quarterBBB-Baa3
1999 first quarterBBB-Baa3
1999 second quarterBBBBaa3
1999 third quarterBBB-Baa3
1999 fourth quarterBBBBaa3
2000 first quarterBBBBaa3
2000 second quarterBBBBaa3
2000 third quarterBBBBaa3
2000 fourth quarterBBBBaa2
Sources: Standard and Poor’s; Moody’s and Bloomberg (various dates).
Sources: Standard and Poor’s; Moody’s and Bloomberg (various dates).

Figure 5.2.Sovereign Bond Spreads of Selected Asian Countries

(In basis points, end of period)

Source: Bloomberg.

Following the easing of Controls and a strengthening of the domestic recovery in 1999, Malaysia’s 140 basis points.5 The favorable financing outlook in 2000, owing in part to high oil prices, prompted Malaysia to proceed with the issue of its first euro-denominated bond of €650 million and the refinancing of its $1.35 billion five-year sovereign syndicated loan at 52 basis points over Libor, well below its original December 1998 issue price of 290 basis points. In line with Developments in its country risk, access to short-term financing was affected by the capital Controls, but only temporarily. The decline in short-term borrowing in 1999–2000 was due mainly to repayments of existing loans and lower demand for hedging and trade financing.

Capital Flows

The capital Controls appear to have had a limited impact on portfolio flows in 1999–2000. This was largely due to the fact that a substantial amount of capital—about $10.4 billion—had already left Malaysia during 1997–98, before the Controls were imposed (Figure 5.3). Thus, outflows that occurred Following the easing of Controls and the expiration of the one-year holding period were relatively small.

Figure 5.3.Net Portfolio Flows

(In millions of U.S. dollars)

Source: Data provided by the Malaysian authorities.

Portfolio inflows increased starting in mid-1999, with the market sentiment turning bullish in response to Bank Negara Malaysia’s monetary easing, the upgrading of Malaysia’s outlook and credit ratings, and the improvement in the overall regional prospects. The inflows increased further in early 2000, as the rising equity market stirred up investors’ interest and political uncertainly related to the November 1999 general elections had dissipated. The prospects for Malaysia’s reinstatement in the Morgan Stanley Capital Indices also firmed up, and fund managers who benchmarked against these indices raised the share of their portfolios allocated to Malaysia.6 Later in 2000, however, portfolio flows reversed, discouraged by a weakening equity market that followed the trends in the United States. All in all, portfolio flows during 1999–2000 seem to have been driven largely by factors other than capital Controls. A preliminary empirical analysis shows that the tightening of Controls on outflows and on international transactions in ringgit had insignificant effects on portfolio investment so far (Appendix).

Despite the explicit exemption of foreign direct investment flows from capital Controls and a more liberal policy starting in July 1998,7 foreign direct investment declined during 1999–2000 to less than half of precrisis levels (Table 5.3). As a share of GDP, foreign direct investment flows fell to the levels observed in other crisis countries, after exceeding them significantly before the crisis. Several factors unrelated to capital Controls may have contributed to this decline, including slower growth in Japan and Taiwan Province of China, the worsening of investor sentiment during the Asian crisis, and the decline in overall investment in Malaysia. Capital Controls, however, could have exerted an indirect negative effect on foreign direct investment in Malaysia. Foreign investors had reportedly become increasingly concerned about a higher risk of investing in Malaysia, changes in investment regulations, delays and administrative costs associated with additional verification and approval requirements for transfers between external accounts, and more limited hedging opportunities.

Table 5.3.Net Foreign Direct Investment in Selected Asian Countries
(In billions of U.S. dollars)
(As a percentage of GDP)
Source: IMF World Economic Outlook (various issues).


Source: IMF World Economic Outlook (various issues).


Nevertheless, drawing any conclusions regarding the effect of capital Controls on foreign direct investment from the limited evidence available is difficult. Foreign direct investment is an inherently longer-term phenomenon, and in each country it is determined by a gamut of factors, including the country’s policy on foreign equity participation in domestic activities and on investment abroad by residents, and strategy for—and progress with—financial and corporate sector restructuring.

Foreign Exchange Market

The activity in the Kuala Lumpur interbank foreign exchange market declined dramatically during 1999–2000 (Figure 5.4). Controls on international transactions in ringgit eliminated the offshore market, and, together with the exchange rate peg and restrictions against onshore position taking, the activity in the foreign exchange market was limited to trade and investment-related transactions. Major players in the foreign exchange market were domestic corporations, although many of them relied on natural hedging through matching payables and receivables. The volume of interbank foreign exchange transactions fell by 61 percent in 1999 and by a further 10 percent in 2000, to the level prevailing in 1992. The share of swap transactions fell to about half of total transactions in 1998–2000 from 70 percent in 1997 because the August 1997 restrictions on non-trade related swaps had the impact of lowering trading in the swap market. Transactions in U.S. dollars against the ringgit continued to dominate, but their volume share in total transactions declined to 68 percent in 2000 from 78 percent in 1998.8

Figure 5.4.volume of Interbank Spot and Swap Transactions in Kuala Lumpur Foreign Exchange Market

(In billions of ringgit)

Source: Data provided by the Malaysian authorities.

Equity Market

The capital Controls had a mixed effect on the equity market in 1998–2000 (Figure 5.5). The introduction of a one-year holding period for portfolio investment and Controls on international transactions in ringgit (particularly on lending to nonresidents) caused an influx of ringgit funds into domestic equities, while at the same time curtailing short selling and capital outflows.9 As a result. Malaysia’s equity market rathed, outperforming other markets in the region during September 1998–January 1999. Equity prices continued to rise in 1999, in line with the domestic and regional recovery. The market was largely driven by local retail buying, in the face of Controls on investment abroad by residents. The replacement of the one-year holding period with a graduated levy system in February 1999 had a mixed effect on the equity market. While helping to improve market sentiment, it disrupted activities of fund managers by making portfolio pricing and risk management more complicated. The unification of the levy in the Following September, Along with the relaxation of Controls on offers of credit and swap facilities to foreign stockbrokers, apparently had a positive effect on the market. The major boost came in early 2000 from the prospects for Malaysia to be reinstated in the Morgan Stanley Composite Indices. This effect was short lived, however. Similar to other markets in the region, the Kuala Lumpur equity market turned in losses by end-2000. in correlation with U.S. financial markets, particularly the NASDAQ, despite favorable domestic developments.

Figure 5.5.Selected Asian Countries: Stock Market Composite Indices

(January 1997 = 100)

Sources: Wharton Econometric Forecasting Associates.

Bloomberg, and CEIC Data Company Limited.

The capital Controls appear to have dampened activity in futures and options markets. Foreign participation in these relatively nascent and thin markets declined after the Controls were introduced in September 1998 and did not recover even after trading in derivatives was exempted from restrictions on repatriation of capital and profits in January 1999. Economic recovery and the improved market sentiment in other financial markets did not help lift the futures market either. As a result, the average daily trading volume in the Kuala Lumpur Stock Exchange Composite Index Futures on the Kuala Lumpur Options and Financial Futures Exchange (KLOFFE) declined by 44 percent in 1999 and by a further 14 percent in 2000 (Figure 5.6). Trading in three-month Kuala Lumpur Interbank Offered Rated futures contracts on the Commodity and Monetary Exchange of Malaysia (COMMEX) increased to a daily average of 180 contracts in 2000 from 101 contracts in 1998. This increase, however, was mainly due to improved liquidity in the underlying cash market and the decline in interest rates, which encouraged interest rate hedging. The reinlroduction of the market-maker scheme in mid-August 1999, which had been discontinued in July 1998, also contributed to the market recovery. Trading was dominated by local financial institutions, and foreign participation declined to 1.2 percent in 1999 from 14 percent in 1998.

Figure 5.6.Average Daily Trading volume at the KLOFFE and the COMMEX1

(Number of contracts)

Source: Data provided by the Malaysian authorities.

1 The Kuala Lumpur Options and Futures Exchange (KTOFFE). The Commodity and Monetary Exchange of Malaysia (COMMEX).

Policy Considerations

The Exit Levy

A key control on capital outflows in effect from February 1999 to May 2001 was the levy related to portfolio capital repatriated within a year. There are several arguments for using such a levy to manage capital flows. It is a market-based measure and thus is less distortionary than an administrative control. It targets nondebt, short-term capital flows rather than portfolio flows in general. In principle, the authorities could vary the rate to achieve the appropriate degree of monetary policy autonomy and to alter the level and maturity composition of portfolio flows. As a side benefit, the levy facilitates Bank Negara Malaysia in its monitoring of short-term portfolio flows.

Other things being equal, however, the levy in the form introduced by Malaysia raises the pretax return required by foreign investors. The levy generally cannot be offset by double taxation treaties because it is collected at the time of conversion of ringgit into foreign exchange for repatriation rather than at the time of the transaction; therefore, the full burden of paying the levy, including higher transaction costs, falls on foreign investors. Since the levy is not indexed to inflation, the required pretax return is increased further. A higher pretax return would imply a higher cost of external financing for domestic firms, thus possibly weakening stock market performance and domestic investment in the longer run.

More generally, even if the levy applies only to short-term portfolio profits, investors may attach a risk premium to investment in the country. The presence of the levy may negatively influence investors’ sentiment and discourage portfolio inflows, and such effects are likely to be magnified if the levy is varied frequently. There are also limitations associated with the exit levy, which, without accompanying macroeconomic and prudential policies, is unlikely to be an effective instrument for shifting the maturity composition of capital flows to those of longer term.10

The levy may place the country at some disadvantage compared to most other emerging markets. Available data suggest that, until recently, Malaysia was the only middle-income country that taxed repatriation of capital gains from portfolio investment (Table 5.4). When the levy is examined in combination with other taxes, Malaysia’s overall taxation on capital gains from portfolio investment still appeared to be more restrictive than that in most other emerging markets, which tend to exempt portfolio investment from both repatriation taxes and capital gains taxes (Table 5.5). This tendency may reflect the emerging markets’ efforts to attract foreign investors, in light of the fact that most developed countries do not provide a full tax credit or deduction for capital gains taxes.11

Table 5.4.A Summary of Investment Regulations for Entry into and Exit from Selected Markets, end-1998
CountryAvailability of listed stocks to foreign investorsRepatriation of interest, dividends, profits, and capital
ChileRelatively freeRestricted1
ChinaSpecial classes of sharesFree
Czech RepublicFreeFree
Hong Kong SARFreeFree
IndiaAuthorized investors onlyFree
IndonesiaRelatively freeFree
MalaysiaRelatively freeRestricted2
South AfricaFreeFree
ThailandRelatively freeFree
Sources: International Finance Corporation, Emerging Stock Markets Factbook; and IMF, Annual Report on Exchange Arrangements and Exchange Restrictions.

Unremunerated reserve requirement on debt and certain other flows. Repatriation of capital is free after one year.

The 12-month holding period for repatriation of portfolio capital from September 1998 to February 1999 and an exit levy system from February 1999 to May 2001. For more details, see Table 5.1.

Sources: International Finance Corporation, Emerging Stock Markets Factbook; and IMF, Annual Report on Exchange Arrangements and Exchange Restrictions.

Unremunerated reserve requirement on debt and certain other flows. Repatriation of capital is free after one year.

The 12-month holding period for repatriation of portfolio capital from September 1998 to February 1999 and an exit levy system from February 1999 to May 2001. For more details, see Table 5.1.

Table 5.5.Taxation of Capital Gains on Portfolio Investment in Selected Emerging Markets, 19991(In percent)
CountryTop Marginal RateShortLongShortLong
Czech Republic32Ordinary incomeExemptOrdinary incomeExempt
Hong Kong SAR15ExemptExemptExemptExempt
Indonesia300.130.13Ordinary incomeOrdinary income
Poland46ExemptExemptOrdinary incomeOrdinary income
Source: IMF Fiscal Affairs Department, based on data from Price water house Coopers and Detoitte Touche, Johmatsu.

The predominant tax treatment is indicated.


Rate applies to sales value.

Source: IMF Fiscal Affairs Department, based on data from Price water house Coopers and Detoitte Touche, Johmatsu.

The predominant tax treatment is indicated.


Rate applies to sales value.

Controls on International Transactions in Domestic Currency

During the Asian crisis, the Controls on international transactions in ringgit helped abate speculation against the currency. In the context of postcrisis policies, these Controls—and particularly their long-term implications—warrant examination from the broader perspective of Malaysia’s strategy on financial Development and the capital account regime.

Demand for the international use of a country’s currency outside of the country depends on international invoicing practices; the level of Development of the country’s financial institutions, including the breadth and depth of its markets: the regulatory regimes of the financial system and the capital account; and the country’s political and economic stability. For an emerging market like Malaysia, there is relatively little demand for the use of its currency as a unit of account in invoicing trade transactions and denominating financial instruments, or as a store of value outside Malaysia, whereby nonresidents hold ringgit as an investment asset. Such demand emanates largely from potential use of the currency within the country, and is limited by international invoicing practices.12 In addition, the risk preferences of foreign investors influence demand for ringgit-denominated instruments.

Regulations pertaining to nonresidents’ ringgit accounts, especially transfers to and from them, have important implications for both international trade and financial transactions in ringgit. In effect, the international use of the ringgit is linked to Controls on the settlement of trade transactions in ringgit, on ringgit credit operations, and on the issuance of ringgit-denominated instruments. Regulations concerning Malaysia’s offshore financial center in Labuan also come into play, as they determine the extent of “seepage” between international and domestic markets through the offshore center.

Most emerging markets control international transactions in domestic currencies, albeit to a different degree (Table 5.6). The Controls are typically effected through approval and reporting requirements, quantitative limits, and sometimes outright prohibitions. Financial transactions tend to be regulated more intensively than trade transactions. In particular, many countries restrict lending to nonresidents in order to constrain their ability to lake large positions against the currency. Industrial countries, in contrast, generally have a more liberal approach to international transactions in their currencies, suggesting that a country’s level of economic Development and the degree of its integration into the world economy are associated with a gradual liberalization of international transactions in domestic currencies.

Table 5.6.A Summary of Controls on the International Use of Domestic Currency, end-19981
Type of ConcrolChinaHong Kong SARIndiaIndonesiaJapanKoreaMalaysiaPhilippinesSingaporeThailand
Controls on the settlement of trade transactions in domestic currencyNNN2NNYYY3NN
Controls on the import and export of domestic currency notes by residents and nonresidentsYNYYNYYYNY
Controls on residents’ granting credit facilities in domestic currency to nonresidentsYNYYNYYYYY
Controls on residents’ obtaining credit facilities in domestic currency from nonresidentsYNYYNYYYYY
Controls on transfers of domestic currency funds from nonresidents’ domestic currency accountsYNYNNYYYYN
Controls on nonresidents’ issuing domestic currency-denominated securitiesYNYYNYYYYY
Controls on residents’ issuing domestic currency-denominated securities abroadYNYYNYYYYY
Source: IMF, Annual Report on Exchange Arrangements and Exchange Restrictions (1999).

“Y” indicates yes, “N” indicates no.

Except for member countries of the Asian Clearing Union arrangement, other than Nepal.

Only for export proceeds.

Source: IMF, Annual Report on Exchange Arrangements and Exchange Restrictions (1999).

“Y” indicates yes, “N” indicates no.

Except for member countries of the Asian Clearing Union arrangement, other than Nepal.

Only for export proceeds.

Experiences in select Asian countries suggest that regulation of international transactions in domestic currencies is generally influenced by considerations related to the effectiveness of monetary control, the scope for nonresidents to take large positions against the domestic currency, and implications for financial Development (Box 5.15.4).

Considerations Regarding the Liberalization of Controls in Malaysia

In Malaysia, a liberalization of Controls on international transactions in ringgit requires policy measures to minimize the associated risks. Clearly such a policy should be implemented at a time of relative market stability. Furthermore, in order to limit disintermediation of financial activities off shore, it is important that the onshore financial markets—especially foreign exchange markets—become more liquid and gain more depth and breadth, and that domestic financial institutions become more efficient and resilient. Monetary management also needs to be strengthened because the easing of Controls on international transactions in ringgit may speed up the transmission of changesin international interest rates to domestic rates and complicate control over monetary conditions. Additionally, in order to prevent seepage between the domestic economy and the Labuan offshore financial center, the policy of limiting ringgit transactions of Labuan banks needs to be continued, and consolidated bank supervision must be further strengthened.

Box 5.1.Singapore: Reconciling Policy on the Internationalization of the Singapore dollar and Financial Development Objectives

Since the late 1960s, Singapore has pursued a strategy of Developing the city-state into an international financial center, while strictly limiting the internationalization of the Singapore dollar to maintain control over monetary conditions. In the 1990s, Controls on the international use of the Singapore dollar were substantially relaxed to promote financial Development and facilitate regionalization efforts of the private sector.

Traditionally, Singapore’s strategy has been to prevent the internationalization of the Singapore dollar by separating offshore from domestic financial markets and restricting the operations of offshore units. The authorities have been concerned that, given the high degree of openness of the economy, the internationalization of the Singapore dollar will increase the exchange rate volatility and the probability of speculative attacks, and will complicate control over monetary conditions.

Accordingly, banks maintain distinct operations or “units,” with separate books and balance sheets, for transactions in the domestic and offshore markets. Domestic banking units may engage in transactions in both foreign and local currencies, and are subject to stringent regulatory requirements and the standard corporate income tax rate of 26 percent. Offshore units, also known as Asian currency units, enjoy a concessionary tax rate of 10 percent and are not subject to reserve and liquidity requirements. Asian currency units focus on operating in the Asian dollar market and are not permitted to transact in Singapore dollars. Offshore banks may accept fixed deposits in Singapore dollars only above S$250.000 and only from nonresidents and other financial institutions. There is a ceiling on lending to resident in Singapore dollars. To limit the short selling of the Singapore dollar and the funding of portfolio and property investments by nonresidents, lending to nonresidents is subject to quantitative limits. Until 1998, loans to residents for use outside the country required approval of the Monetary Authority of Singapore. In sum, the authorities facilitated the participation of Asian currency units in regional banking activities but limited in domestic banking activities.

Over the last decade, the government has eased Controls on offshore banks’ wholesale operations in Singapore dollars as part of financial reforms aimed at promoting the Development of the financial sector, (i) Offshore banks had, since 1973, been permitted to make limited Singapore dollar loans to residents; the relaxation was in response to the argument that restrictions on lending to royal customers in the domestic market might cost the banks offshore business. With a view to providing more flexibility to offshore banks, the government raised the limit on such lending in the early 1990s (i.e., the maximum amount in domestic loans that offshore banks may have outstanding at any given time) in several steps; to S$100 million in 1993; S$200 million in 1997 (binding the latter commitment in the 1997 Financial Services Agreement of the World Trade Organization); and further to S$300 million in 1998. The limit is expected to be increased further. (ii) Since 1992, banks—including offshore banks—have been allowed to make Singapore dollar loans overseas through their domestic banking units for Singapore-related trade, performance bonds, and for hedging (for imports) purposes, (iii) In August 1998, the government further relaxed some of the restrictions on borrowing in Singapore dollars for use abroad; the Monetary Authority of Singapore indicated that the regulation requiring resident banks to consult them on the overseas use of Singapore dollar credit facilities exceeding S$5 million and on financing of trading activities in Singapore dollar–denominated assets applies only to nonresidents, (iv) More flexible guidelines have been adopted to allow subsidiaries of Singaporean companies and joint ventures between Singaporean and foreign companies to borrow in Singapore dollars for regionalization projects, (v) Finally, foreign entities are now permitted to issue Singapore dollar-denominated bonds for use outside Singapore upon consultation with the Monetary Authority of Singapore and as long as the Singapore dollars are first converted into foreign currencies.

In parallel with liberalizing international transactions in Singapore dollars, the government proceeded with other financial reforms. More competition will gradually be allowed in the domestic retail banking market and, in particular, the 40 percent limit on foreign shareholding in local banks will be lifted. Various measures are being introduced to promote the fund management industry. The focus of prudential policies will largely shift to supervision and, in particular, to the review of banks’ risk management systems.

Sources: Cassard (1994); Bercuson (1995); and Cardarelli, Gobat, and Lee (2000).

Box 5.2.Korea: Gradual Liberalization with a Focus on Control of Won Lending to Nonresidents

International transactions in won were liberalized, albeit cautiously and only partially, during 1987–97. In particular, lending to nonresidents was deliberately restricted. The government intends to liberalize the Controls further by end-2000 to broaden risk management and investment opportunities for investors and to promote competition in the financial sector. Controls on nonresidents’ won funding, however, will remain in place for the next one or two years.

International transactions in won are controlled mainly through approval requirements. While there appears to be no explicit policy against the international use of the won or criteria for allowing these transactions, the authorities are clearly concerned about the potentially destabilizing effects of such liberalization. Starting from 1987, Controls on the international use of the won were liberalized as part of the general liberalization of the capital account, but this liberalization lagged behind that of transactions in foreign currency, and approval requirements continued to apply to most transactions even after liberalization. The settlement of trade transactions in won is prohibited, and the export and import of won banknotes are subject to quantitative limits and approval.1 Rules for nonresidents’ won accounts in domestic banks and overseas branches are relatively liberal. The use of won for financial purposes is also controlled through approval requirements. In particular, the issue of won securities abroad by residents and domestically by nonresidents requires official approval. Nonresidents may list shares locally in the form of depository receipts and may issue won-denominated bonds domestically, subject to reporting requirements. The issue of collective investment securities in the domestic market by nonresidents is allowed, provided they establish themselves in Korea and submit a prior report to the Ministry of Finance and Economy. For residents, the purchase of short-term, won-denominated securities abroad requires Ministry of Finance and Economy approval and prior reporting. To limit potential speculation, credit facilities in won granted to nonresidents by institutional investors of more than W 100 million per borrower require Ministry of Finance and Economy approval.

During the Asian crisis, speculation against the won was limited. In contrast to the currencies of other crisis countries, the won was not overvalued, and the current account deficit was relatively small and manageable. Nonresidents’ access to won funds was restricted, and short-selling of the currency became more costly, owing to the initial high interest rate policy. Additionally, the foreign exchange market was relatively thin, as major Korean exporters, the chaebols, tended to hedge in-house by matching receivables and payables. Although there was a viable nondeliverable forward market for won in Singapore and Hong Kong SAR, it was also relatively thin, and position taking there tended to be transparent and costly. An offshore market for the won did not emerge, in part because the authorities allowed the rate to be determined in the market in line with the prevailing flexible exchange rate regime.

In the aftermath of the Asian crisis, the government continued to liberalize the capital account with the aim of broadening investment and risk management opportunities available to investors and enhancing competition in the financial sector. In April 1999. The government streamlined procedures for current account transactions and changed from a positive list system for capital account transactions to a negative one. Offshore transactions in won, nonresidents’ won deposits and trust accounts with maturities greater than one year, and offshore and domestic issuance of won securities with maturities greater than one year were decontrolled. Controls on international transactions were relaxed further during the second stage of liberalization by end-2000. Some controls, however, particularly those on won funding of nonresidents, are likely to remain in place for the next one or two years (albeit possibly in a more relaxed form). The authorities are concerned about the reaction of hedge funds to the liberalization and intend to strengthen prudential supervision before continuing the reforms.

Sources: Johnston and others (1999); IMF (1998, 1999); and Park (1998).1 Nonresidents are permitted to carry out current account transactions in won, provided remittances are made in foreign currencies. For this purpose, nonresidents may open settlement accounts in won (free won accounts) for current account transactions, reinsurance contracts, and investments in domestic securities.

Policy considerations on this matter must also recognize that the effectiveness of Controls on international transactions in ringgit is not guaranteed in the future, particularly in times of instability. The successful experience of the 1998 Controls so far is largely due to the appropriate macroeconomic policy mix that prevailed at that time. Even wide-ranging Controls, however, are likely to become inadequate in preventing both residents and nonresidents from taking positions against the ringgit if sufficiently strong incentives were to reemerge. In this case, leakages in capital Controls may develop, for example through intercompany accounts, underinvoicing of exports and overinvoicing of imports, leads and lags in transactions related to foreign trade, and small-scale exports of ringgit banknotes. Driven by fundamentals, such position taking against the ringgit may occur illegally onshore, in the newly emerged offshore market, or in the nondeliverable forward market. To the extent that the offshore market might offer more channels for arbitrage than the onshore market, its presence may accelerate a speculative attack; however, its absence is not a guarantee against position taking. Thus, key to preventing destabilizing position taking is strong fundamentals, especially consistent monetary and exchange rate policies, and effective prudential risk management.

Box 5.3.Thailand: Relatively Liberal Policy in Normal Times, Temporary Capital Controls to Limit Currency Speculation

Thailand’s policy concerning international transactions in baht was relatively liberal before the Asian crisis. In 1997, prior to the floatation of the baht, Thailand imposed temporary capital Controls, including those on baht lending to nonresidents, which created a two-tier currency market. These Controls were removed for the most part in early 1998.

Controls on international transactions in baht were substantially liberalized in line with the general opening of the capital account during 1989–92. Trade transactions were allowed to be settled in baht. Limits on exports and imports of baht banknotes were relatively generous. Transfers and uses of funds from nonresidents’ transferable baht accounts were allowed. Policies concerning baht lending to nonresidents were also relatively liberal.

A widening of internal and external imbalances and a weakening of the banking system induced a series of speculative attacks on the baht beginning in late 1996. The attacks were facilitated by the relatively free capital account, well-developed spot and swap markets, and relatively liberal access of nonresidents to baht credit from domestic banks. Onshore and offshore speculation took place in the form of direct position taking in the forward market and short selling of the currency through explicit baht credits. Investors who were taking positions against the baht included commercial and investment banks, portfolio managers of mutual funds, proprietary trading desks, as well as hedge funds.

To limit speculation against the baht and stabilize foreign exchange markets, Thailand imposed capital Controls in May 1997. The measures sought to segment the onshore and offshore currency markets; to limit the supply of baht credit to nonresidents for position taking against the baht; and to raise the cost of carrying positions overnight, while at the same time allowing foreign exchange conversion for the underlying trade and investment transactions. Financial institutions were required to suspend baht lending to nonresidents through swaps, outright forwards, and sales of baht against other currencies. They were also required to report daily on foreign exchange transactions with nonresidents. Any purchase before the maturity of baht-denominated bills of exchange and other debt instruments required payment in U.S. dollars. Foreign equity investors were prohibited from repatriating funds in baht. Nonresidents were required to use the onshore exchange rate to convert baht proceeds from sales of stocks. Exempt from Controls were the underlying transactions related to current account operations, and foreign direct and portfolio investment.

The capital Controls created a two-tier market with different exchange rates in the onshore and offshore markets. They squeezed offshore players with short baht positions and forced them to liquidate these positions at a loss, while domestic holders of baht positions apparently maintained their positions. Large differentials emerged between onshore and offshore interest rates, and the swap market dried out. However, the wide differentials created strong incentives for arbitrage, expectations of baht depreciation persisted, and capital outflows continued. Speculation in the offshore market resumed, and eventually in July 1997 the authorities were forced to float the baht.

In January 1998 capital Controls were lifted, and the two-tier market was unified. In particular, prohibition of offering baht credit facilities (including—but not limited to—loans, currency and interest rate swaps, options, and forwards) to nonresidents was replaced with a maximum outstanding limit of 50 million baht per counterparty without an underlying trade or investment transaction. Easing of the Controls helped improve investors’ confidence and contributed to the appreciation of the baht. The enforcement of the new measures was strengthened further in August 1999.

Sources: Ariyoshi and others (2000); and IMF (1998).

With an easing of Controls on international transactions in ringgit, the liquidity of the foreign exchange market is likely to increase as speculators enter the market as risk takers and counterparties of hedgers. The increased liquidity could facilitate portfolio rebalancing and unwinding of leveraged positions; this in turn would help smooth the adjustment of asset prices, facilitate hedging and portfolio management, and generally promote financial market Development. Pricing of financial instruments, such that it becomes more reflective of returns and risks involved, will also be made easier, thereby promoting the domestic bond market. In addition, more liberal regulation on credit operations and the invoicing of trade transactions in ringgit may facilitate the regionalization efforts of Malaysian companies in the longer run.

The presence of an offshore market could also improve financial intermediation, enhancing efficiency and investors’ opportunities for risk management. Such a market tends to offer a narrower interest ratespread than the domestic market—where depositors can earn higher returns and borrowers can get access to cheaper financing—because it is not subject to reserve requirements and other regulations: it is a wholesale market and can respond more quickly to investors’ needs. Therefore, reemergence of an offshore market could complement The onshore counterpart and provide both domestic and foreign investors access to diversified financial instruments at lower transaction costs and bid-ask spreads. This would allow investors to take advantage of high yields and safe, liquid investments. Owing to its efficiency, the offshore market could he a convenient instrument, especially for large corporations, for holding excess corporate liquidity and obtaining short-term financing for working capital needs.

Box 5.4.Japan: Toward the Internationalization of the Yen

Japan liberalized cross-border transactions in yen during the second half of the 1980s, in tandem with deregulating domestic financial markets and opening them to foreign participation, strengthening prudential policies, and modernizing monetary policy management. An offshore center was established to promote the international use of the yen.

Until the mid-1970s. Japan’s policy was designed to discourage the international use of the yen. The main concern was that substantial yen holdings by nonresidents would jeopardize the Bank of Japan’s control over money supply and increase exchange rate volatility.1 Capital flows and domestic financial activities were tightly regulated.

In response to a slowdown in economic growth and widening budget deficits during the late 1970s–early 1980s, Japan started to deregulate domestic financial markets and the capital account. Interest rates were deregulated, and access of nonresidents to the Gensaki market for repurchase agreements on government bonds and to fiscal bits was liberalized. The positive list system for regulating capital account transactions was replaced with the negative list system in 1980, although many capital Controls remained in place.

Cross-border yen transactions were decontrolled during 1984–89. Policy orientation concerning the internationalization of the yen was changed in 1984, after the Yen-Dollar Committee (a working group of Japanese and U.S. officials) and the Ministry of Finance acknowledged the potential role of financial liberalization and the increasing internationalization of the Japanese economy and proposed a program of liberalizing the international use of the yen,2 Subsequently, the conversion of foreign currencies into yen was decontrolled. Residents were allowed to lend to and borrow from nonresidents in yen. Controls on the issuance of yen bonds domestically by nonresidents and abroad by residents were relaxed. The market for euro-yen certificates of deposit was created, euro-yen credit operations were liberalized, and the euro-yen market for commercial papers was decontrolled. Foreign banks were allowed to issue euro-yen bonds, and the withholding tax on nonresidents’ interest earnings on euro-yen bonds issued by residents was removed. In parallel, domestic financial deregulation continued, monetary policy management was modernized, and prudential policies were strengthened.

In addition to the liberalization of international transactions in yen, the Japanese offshore market was created in 1986 to promote the international use of the yen and to attract euro-yen banking to Japan. Offshore banks were allowed to accept yen deposits from nonresidents, and these deposits were freed from reserve requirements and other Controls. By design, the offshore market was separated from onshore banking to prevent “seepage” between them and to ensure the effectiveness of domestic financial regulations.3 In particular, residents were not allowed to participate in the offshore market, transfers between domestic and offshore accounts were restricted, and loans contracted in the offshore market could not be used to finance domestic activities. In addition, securities transactions were restricted. Since its creation, the offshore market has grown rapidly, becoming a major international center for yen transactions.

The deregulation of foreign exchange transactions and the promotion of the internationalization of the yen continued in the 1990s. Regulations on securities investments and lending, as well as on residents’ deposits in foreign banks were liberalized. Withholding taxes on government papers for nonresidents were lifted in 1999 as part of the “big bang” initiative.

Sources: Eken (1984); Tavlas and Ozeki (1992); Dominguez (1999); and Morsink and others (1999).1 The loss of monetary control was expected to be less in Japan than in other countries, however, given that the economy was relatively closed.2 This was in part aimed at addressing U.S. concerns that the closed nature of Japanese financial markets would artificially depress the value of the yen.3 The model of the Japanese offshore market is similar to that of the international banking facilities, which were created in New York in 1981.

All in all, the liberalization of controls on international transactions in ringgit needs to be approached cautiously as part of a well-sequenced medium-term strategy of capital account liberalization and financial Development. The liberalization of Controls on trade-related international transactions in ringgit (e.g., on invoicing of trade transactions) could precede the liberalization of international financial transactions in ringgit. Benefits and risks of the relaxation of Controls with need to be carefully assessed, and proper safeguards and supporting policies to control the risks associated with liberalization with need to be put in place. In this regard, a strengthened financial market environment, the maintenance of internally consistent monetary and exchange rate policies, and adequate prudential surveillance are particularly important.

Appendix: A Preliminary Empirical Analysts of Malaysia’s Capital Controls

The effect of capital Controls on portfolio investment is examined in a simple error-correction model. Portfolio investment is modeled as a function of internal and external factors, including the domestic and foreign interest rates and prices, the real exchange rate, and capital Controls.13 The study covers the period from January 1991 to October 2000, and the evolution of capital Controls during this period is shown in Figure 5.7. Table 5.7 describes the data.14

Figure 5.7.Capital Controls

Table 5.7.Data
PFANet foreign portfolio assets in Malaysia, billions of U.S. dollarsEstimated based on Bank Negara Malaysia Cash Balance-of-Payments Reporting System and IMF International Financial Statistics
REXReal exchange rate, indexCalculated based on IMF International Financial Statistics
PConsumer price indexIMF International Financial Stofistics
FPU.S. consumer price indexIMF Internmiona/ Financial Stofistics
RMoney market interest rate adjusted for expected depreciation, percentCalculated based on IMF Internationa Financial Statistics and Bloomberg
FREurodollar rate in london, percentIMF Internauonal Financial Statistics
CPFINControls on portfolio inflows, index
CPFOUTControls on portfolio outflows, index
CRMControls on international transactions in ringgit. indexCalculated based on the IMF Annual Report on Exchange Arrangements and Exchange Restrictions and Malaysia’s exchange control regulations1
NKFXControls on bank transactions and foreign exchange market operations, index
CSMControls on stock market operations, index
ASIADummy variable taking the value of 1 for the period of the Asian crisis, and 0 otherwise

For more detaits on the methodology for constructing the capital control indices, see the footnote to Figure 5.1.

For more detaits on the methodology for constructing the capital control indices, see the footnote to Figure 5.1.

Dickey-Fuller (ADF) tests are used to determine the order of integration for the variables in question (Table 5.8.). Portfolio assets, domestic prices, and the real exchange rate appear as I(1). The domestic interest rate and the foreign interest rate in real terms FRR) are found to be stationary.

Table 5.8.Unit Roof Tests1,2

ADF statistics are based on the highest significant lag. Constant and trend included.

** (*) indicates significance at the 1 percent (5 percent) level, lowercase denotes togarithm.

For the period from 1993(3) to 1997(1). Prior to 1993(3) and after 1997(1) pfa also appears as I(1).

ADF statistics are based on the highest significant lag. Constant and trend included.

** (*) indicates significance at the 1 percent (5 percent) level, lowercase denotes togarithm.

For the period from 1993(3) to 1997(1). Prior to 1993(3) and after 1997(1) pfa also appears as I(1).

Cointegration is tested using Johansen’s maximum likelihood procedure with six lags (Table 5.9). The null of no cointegration is rejected in favor of one cointegrating relationship. The recursively estimated eigenvalue is reasonably stable over time. Individual tests on the feedback coefficients imply that the real exchange rate is weakly exogenous, i.e., there is no feedback from the cointegrating relationship to the real exchange rate. Portfolio assets, domestic prices, the real exchange rate, and the trend are all significant in the cointegrating vector.

Table 5.9.A Cointegration Analysis1
Maximum eigenvalue statistics
p = 0p≤1p≤2
Standardized eigenvectorsβ
Standardized eigenvectorsα
Tests of weak exogeneity X2(1)
Tests of significance X2(1)

Indicates significance at the 1 percent (5 percent) level. Constant, trend, and a dummy for 1991 included.

Indicates significance at the 1 percent (5 percent) level. Constant, trend, and a dummy for 1991 included.

With weak exogeneity restrictions, the cointegrating vector is given by:

CI = pfa – 3.13 rex – 7.43 p – 0.01 trend.

The restricted feedback coefficients for pfa and p are 0.03 and 0.004, respectively. The positive relationship between pfa and rex and p is consistent with economic theory.

Weak exogeneity implies that the cointegrating vector can be analyzed in a two-equation conditional error-correction model, whereby portfolio investment and prices are modeled as changing in response to a disequitibrium in portfolio assets, changes in macroeconomic variables, and capital Controls. An autoregressive distributed lag model is reduced to the Following parsimonious model through general-to-specific modeling (Table 5.10):

Table 5.10.A Conditional Error Correction Model of Portfolio Investment1,2
Equation for∆pfatEquation for∆pt
Single equation testsPortmanteau = 32.27Portmanteau = 24.10
AR 1-7 F(7,58) = 1.94AR 1-7 F(7, 58) = 1.95
Normality X2(2)=0.90Normality X2(2)=0.51
AREH 7 F(7,51) = 0.48AREH 7 F(7, 51) = 0.26
Heteroscedasticity test:Heteroscedasticity test:
X2(55)=55.77, F(55,9)=0.17X2(55)=50.99, F(55,9)=0.15
Number of observations = 108, 1991 (11) to 2000(10).
Full information maximum likelihood estimation. Strong convergence.
Tog-likelihood = 1172.235. LR test of over-identifying restrictions: X2(14)=12.03.
Vector tests: Portmanteau = 77.07. AR 1-7 F(28, 112) = 1.12. Normality X2(4)=0.94
Heteroscedasticity test: X2(165) = 150.54 and F-form (165, 39) = 0.22.

*** (**, *) indicates significance at the 1 percent (5 percent, 10 percent) level.

The model Controls for seasonality and the Following time periods: 1991, 1993(11), 1994(1), and 1995(2).

*** (**, *) indicates significance at the 1 percent (5 percent, 10 percent) level.

The model Controls for seasonality and the Following time periods: 1991, 1993(11), 1994(1), and 1995(2).

The model is fairly well specified. The goodness-of-fit, autocorrelation, and heteroscedasticity statistics are acceptable. Normality holds. The Chow tests imply constancy.

The results suggest that capital Controls (their level and/or changes in them) generally had statistically significant effects on portfolio investment in Malaysia during January 1991–October 2000. The direction and magnitude of these effects, however, varied by the type of capital control. More specifically.

  • The regulation of portfolio inflows per se had no significant effects on portfolio investment. The tightening of these Controls, however, tended to discourage portfolio investment.
  • Controls on portfolio outflows had no significant effects on portfolio investment, neither in terms of their level nor changes in them.
  • The regulation of bank operations and foreign exchange transactions tended to reduce portfolio investment. By influencing banks’ risk-taking incentives, regulatory measures pertaining to bank operations apparently affected capital account transactions. Controls on swap and forward transactions with nonresidents, in turn, directly constrained hedging and portfolio management opportunities of foreign investors.
  • The regulation of international transactions in ringgit had a positive, albeit a relatively small, effect on portfolio investment. This positive effect may reflect the role of these Controls in abating speculative pressures on the ringgit. Changes in Controls on international transactions in ringgit had no significant effects on portfolio investment.
  • The tightening of Controls on equity market transactions tended to discourage portfolio investment. The regulation of trading in equities per se had no significant effects on portfolio investment.

The results should be considered only preliminary. Their interpretation is subject to a caveat because the time series used in this study are relatively short to fully reflect effects of the capital Controls introduced recently during the Asian crisis.


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2A discussion of capital Controls during September 1998-February 1999 can be found in Kochhar and others (1999). Chapter I.
3Circumvention could occur, for example, through leading and lagging in the settlement of commercial transactions, dividend payments, intrufirm transfers, or misinvoicing of current account transactions.
4The increase in the sovereign bond spread caused the government to abandon its original plans to underwrite an international issue for launching Danaharta in November 1998.
5The bond carried a coupon of 8.75 percent, and was priced to yield 8.86 percent, about 330 basis points above the 30-year benchmark U.S. Treasury yield. It was assigned a BBB senior unsecured rating by Standard and Poor’s. The relatively high premium induced the government to reduce the size of the issue by halt.
6Malaysia was reinstated in the IFC and Dow Jones investment indices in November 1999 and in the Morgan Stanley Capital Indices in May 2000.
7Measures introduced in mid-1998 to encourage foreign direct investment included allowing total foreign ownership of manufacturing (except in specified sectors), regardless of the degree of export orientation; increasing the foreign ownership share limit in the telecommunications, stockbroking, and insurance industries; and relaxing curbs on foreign investment in landed property.
8In contrast, transactions in U.S. dollars against the Singapore dollar increased sharply to 19 percent in 1998 and 22 percent in 2000 from 2 percent of the total volume of transactions in possibly reflecting the requirement to settle trade transactions in foreign currencies.
9At the same time, new requirements on share trading, which were introduced in tandem with capital Controls, temporarity hindered trading in American depository receipts for Malaysian companies.
10A preliminary empirical analysis shows that prudential measures tended to be more effective than direct capital Controls in influencing portfolio investment in Malaysia (see Appendix). For a detaited discussion of effectiveness of Controls on short-term capital flows, see Ariyoshi and others (2000).
11Notwithstanding the above comparison, definitive conclusions regarding the role of the levy in the cross-country context would require a comprehensive study or investment barriers in the countries concerned, which is beyond the scope of this paper. In this connection, empirical evidence suggests that withholding taxes on dividends are less likely to affect pretax rates of return because the developed countries tend to provide a tax credit or deduction for such taxes (Dcmirgüç-Kunt and Huizinga, 1995).
12Recent empirical studies have identified the Following international invoicing practices: (i) trade in differentiated manufactured products between developed countries tends to be invoiced in the exporter’s currency; (ii) trade between a developed and a Developing country tends to be invoiced in the currency of the developed country, (iii) trade in primary products and transactions in financial instruments tend to be denominated in U.S. dollars; and (iv) exports to the United States tend to be invoiced in U.S. dollars (Tavlas and Ozeki, 1992; and Dominguez, 1999).
13The analysis draws on the existing literature on the economics of capital flows. See, e.g., Fernandez-Arias and Montiel (1995); Calvo, leiderman and Montiel (1996): and Cardoso and Goldfajn (1998). For surveys on capital Controls, see Eichengreen and others (1998); and Ariyoshi and others (2000).
14Data on government expenditures and budget balance are not available on a monthly basis and were not included in the model.

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