What happens if Asian countries impose capital controls? :: UBS

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What happens if Asian countries impose
capital controls?
In recent months, there have been increasing talk (and action) of capital controls
in the emerging markets. We think this is particularly relevant for Asia given
that ample liquidity and the general reluctance of Asian governments to
appreciate their currencies leaves them with limited policy tools. So what could
be the impact to the equities markets if Asian countries imposed capital
controls?
Capital controls typically take the form of administrative or market-based
measures: the former imposes direct government controls whereas the latter
raises the cost of transactions. Controls that have been imposed in Asia include
requiring part of the inward flowing capital to be deposited in non-interest
bearing accounts at the central bank, restricting ownership of assets by
foreigners, tightening controls over bank lending and trading activities,
imposing taxes on capital flow and effectively suspending conversion of foreign
currencies. It is important to remember most countries regulate capital flows
anyway so in some instances it is simply a matter of stricter enforcement.
Jonathan Anderson, our Emerging Markets economist, and Bhanu Baweja, our
EM currency strategist, have for some time flagged the risk of capital controls
(Capital Controls – Coming To A Country Near You? dated 21 October 2009).
Their view is the sort of full-scale shut-down in the capital account to foreign
portfolio investors in Malaysia in 1998 was unlikely to repeat in the current
environment. However, some form of capital controls is a distinct possibility.
This is especially true for countries that have strong relative growth and prefer
stable currencies (most Asian countries).
What are the past episodes of capital controls?
We list the instances over the past 20 years in Table 2 below.
Table 2: Episodes of capital controls in Asia
Country Date Measures taken
Malaysia 17-Jan-94 Ceiling placed on net external liabilities of domestic banks; residents prohibited from selling short-term debt securities to non-residents
Thailand 8-Aug-95 Introduced a 7% reserve requirement (to be held at non-interest bearing accounts at the central bank) on non-resident baht accounts
Thailand 18-Dec-06 30% of any baht exchanged from foreign currencies were required to be deposited with the central bank (except for FDI and equity
investments)
Taiwan 10-Nov-09 NT dollar funds held by foreigners are banned from being invested in time deposits
Korea 13-Jun-10 Restrictions on currency derivatives trades, bank loans in foreign currencies and borrowings by banks in foreign currencies
Indonesia 16-Jun-10 Introduced 1 month minimum holding period on Sertifikat Bank Indonesia (SBIs)
Source: UBS
How have they affected Asian equities?
As we show in Table 2, there have been limited instances of a step-up in
controls in Asia since the Asian crisis. The immediate market reactions are
generally negative in the historical episodes, though we note that the impact
does not seem to be long-lasting when the regulators imposed measures against
inflows. In all those instances, market resumed their uptrend after the initial fall.


Relative to the Asia ex Japan market, the capital controls do seem to have an
impact. In other words, capital controls do not seem to affect the direction of an
equities market per se if the fundamentals do not change, though it could affect
its relative attractiveness by raising the cost of investing in the particular market.


Which countries in Asia are the most at risk to capital controls?
Jonathan Anderson and Bhanu Baweja believe that Korea and India are the
Asian countries that could be the most susceptible to capital controls. The
factors they consider include the size of the capital inflow, the ease with which
the countries could absorb them, and finally the politics around capital controls.
Based on recent history, Taiwan, Thailand and Indonesia could also be
candidates. The whole of Asia is essentially a ‘high risk zone’ given the general
preference amongst policy makers to keep exchange rates stable, and we note
the stigma to imposing controls lessens as more countries get on the bandwagon.
Implications on equities
Although Asia is a ‘high risk’ zone for capital controls and controls have
historically been negative for equity markets, we would add the following
caveats. First, it is unlikely that Asian countries will try to ‘shut off’ foreign
capital, so the chances of overbearing controls are slim. Second, equities appear
to offer the path of least resistance for asset price appreciation due to liquidity –
the governments will be keener to avoid volatility in the foreign exchange,
government bond and physical property markets than equities given it is
politically the least sensitive. We have highlighted in our note last week that
bond flows dwarf equity flows in Indonesia; whereas the year-to-date flows into
India and Taiwan have gone mostly into equities (Are equity investors to blame
for FX moves? dated 22 October 2010). Third, it is questionable whether capital
controls are very effective at stemming asset price appreciation longer-term.
The historical instances of government measures to dampen inward capital flow
had only temporary effects.