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Chinese investors watch stock prices at a securities firm in Shanghai on March 2.
Chinese investors watch stock prices at a securities firm in Shanghai on March 2. (Afp/Getty Images Photo / Mark Ralston)

Crowd controls

After the 1997 Asian crash, economist Joseph Stiglitz began to ask whether the IMF's laissez-faire policy was flawed, and whether capital market controls might be called for. With the latest sell-off, Stiglitz may be winning the argument.

WHEN THE SHANGHAI stock index dropped 9 percent on Feb. 27, touching off sharp slides in markets across the globe, many were quick to recall the Asian financial crisis of 1997. That crisis was triggered not by a drop in stock prices, but by a collapse in the value of the Thai baht, brought on by currency speculators. But the reason the crash of '97 spread from one country to the next, savaging the economies of Indonesia, South Korea, the Philippines, and ultimately non-Asian countries like Russia, was a broad loss of investor confidence in such so-called "emerging markets."

Investors were excited by these economies' high growth rates, but suspicious of regulatory environments that were far from transparent and governments prone to corruption. As they lost confidence in the countries' currencies and securities, investors pulled their money out en masse. Last week, there were concerns that a dramatic drop in Asian stock values might provoke a similar loss of confidence and capital flight.

A number of Asian governments had been worrying about a '97-style collapse even before the Shanghai market's tumble. In Thailand and Vietnam, where stock markets have soared recently, surging foreign investment had started to push up domestic currency values and inflation, and stoked fears of a bubble.

In response, both governments considered "capital controls" -- measures, like minimum holding periods for foreign investments, that restrict the speed with which money flows in and out of financial markets. In December, Thailand briefly instituted a rule requiring foreign investors to put 30 percent of incoming funds in reserve for one year, earning no interest; early withdrawals would be taxed. Large fund managers reacted angrily, the Bangkok exchange dropped 15 percent in a day, and the rule was rescinded. Vietnam briefly considered a similar measure, but Prime Minister Nguyen Tan Dung ruled it out in late February.

Perhaps the prime minister had read a Wall Street Journal editorial only a few days before, recommending that Vietnam "heed the lessons of the 1997-98 Asian financial crisis -- namely, that open capital markets, not governments, are the best regulators."

But were those really the lessons of the Asian financial crisis? In fact, many economists drew precisely the opposite lessons: That open capital markets sometimes behave like irrational mobs, and that government-imposed capital controls can be essential tools for developing countries to preserve stability.

The most famous exponent of this view is the Nobel Prize-winner Joseph Stiglitz, former chairman of President Bill Clinton's Council of Economic Advisors, who was the World Bank's chief economist during the crisis. Interviewed last week on the risks to Asian markets today, Stiglitz said capital controls are widespread in emerging markets, and in many cases, that's a good thing.

"Neither China nor India allow capital outflows without a whole host of restrictions," Stiglitz said. Such measures can include taxes or banking-sector restrictions on taking short-term investment returns out of the country. "The effect is that it discourages people from putting money in and out overnight. So it helps to stabilize capital flows."

Some powerful voices, on the Wall Street Journal editorial page and elsewhere, continue to push developing countries toward financial market deregulation. Last week, visiting China in the immediate aftermath of the sharp market declines, US Secretary of the Treasury Henry Paulson gave a speech at the Shanghai Futures Exchange calling for reduced government intervention in China's financial markets, and insisting that stability would come from more liberalization and greater liquidity -- "an open, competitive, and liberalized financial market can effectively allocate scarce resources in a manner that promotes stability and prosperity far better than governmental intervention," Paulson proclaimed.

Yet despite the persistence of these laissez-faire views, a quiet shift may be taking place. Economists and financial analysts today are more likely than they were 10 years ago to accept the need for certain capital controls. Some are even willing to admit it.

. . .

Stiglitz's views were formed in part during the '97 crisis. As that disaster played out, Stiglitz observed that countries that followed the recommendations of the International Monetary Fund to resist imposing capital controls, such as Thailand and Indonesia, were hit with long, hard recessions, while those that already had controls or quickly adopted them -- like China, India, and Malaysia -- escaped with relatively little damage.

He ultimately became convinced that the entire "Washington Consensus" -- the philosophy of market liberalization and deregulation that guided IMF policy in the 1990s -- was flawed. In his 2002 book "Globalization and Its Discontents," Stiglitz recommended acknowledging the "dangers of capital market liberalization," and stated that where sudden flows of "hot money" develop, "interventions...are desirable."

In the decade since the crisis, many economists have come to share these views -- including some within the IMF itself. "In 2003 their chief economist came to the conclusion that the empirical evidence did not show that capital market liberalization worked," Stiglitz says. "It did not lead to more growth, it did not lead to more stability. They still believe it's true, but what they now say is they can't prove it." In some cases, the IMF is actually telling countries that "soft" capital controls, such as tax measures and banking regulations, may be a good idea.

Dominic Scriven is managing director of Dragon Capital, one of the largest investment funds in the Vietnamese market. In 2006, as the Ho Chi Minh City index climbed a stellar 144 percent, he saw the value of the assets his firm manages rise to nearly $1.5 billion. In the first two months of 2007, the index went up another 45 percent. As someone representing the interests of Western investors who might wish to pull their money out of Vietnam, Scriven could be expected to oppose capital controls.

In fact, he's cautiously in favor. Scriven sees no need for restrictions at the moment; but in the "medium term," he said, "I always thought that it would make sense for the country to have some sort of mechanism of monitoring the flows, and perhaps encouraging those sort of flows with which the country is best able to deal, and discouraging those with which [it's] not."

Fund managers like Scriven know how volatile the emerging Asian markets are. In China and other markets, financial reporting requirements are lax, and accounting is untrustworthy. It is virtually impossible to get a reliable figure for a company's revenues.

And the people doing the investing often have little idea what they're investing in. In Vietnam, most shareholders entered the market for the first time within the last two years, and they have never seen stocks go anywhere but up. A visit to a Hanoi trading office on a weekday morning turned up several people who said they were playing hooky from their jobs to trade.

Joseph Kennedy is said to have gotten out of the stock market in 1929 because his shoeshine boy was offering him tips. In Vietnam, Kennedy would have cashed out some time ago. "My uncle, a farmer in a remote mountainous village in Bac Giang province, called me yesterday evening," said Hang, an employee at a state-owned company. "He said he would sell everything valuable he had for about 5 million dong [$300], and wanted me to invest it in the stock market for him."

Vietnam's government has been concerned about the possibility of a bubble for months, and the IMF's country office shares these concerns. In a mid-February report to the government, the IMF found that 99 percent of Vietnam's stock market value was concentrated in just 20 large publicly owned companies, and that these companies' price-to-earnings ratio had risen to an average of 70. (Other stock markets in the region had average PE ratios of between 10 and 20.) But the summary version of the report released to the public recommended no capital controls at the moment.

The complete version sent to the government, however, included a list of the "pros and cons" of different types of capital controls, including reserve requirements, like the ones Thailand tried to institute; minimum holding periods; and higher taxes on short-term investments. And, last week, Vietnam's Finance Ministry proposed introducing a differential taxation rate to penalize quick investment withdrawals.

In 1997, the IMF kept stridently warning Malaysia against the disasters of capital controls, even in the face of widespread capital flight. That it is now grudgingly cooperating with Vietnam's search for appropriate capital controls shows how far it has moved toward Stiglitz's position.

But Stiglitz feels the IMF still has a long way to go. When advising countries, he suggests, "they will still say, 'For you, capital market liberalization is the right thing,' even though the evidence in general is no longer there."

Matt Steinglass is a journalist in Hanoi, where he writes for the Globe and other publications.