After the devaluation of the Thai baht in July 1997, Southeast Asia suffered from significant capital outflows that led to falling local equity and real estate prices and declining exchange rates. To counter the outflows of capital, the IMF urged many of the countries in the region to increase interest rates, thus making their assets more attractive to foreign investors. Higher interest rates, however, weighed heavily on the domestic economies. In response to this dilemma, Malaysia imposed capital controls on 1 September 1998. These controls prohibited transfers between domestic and foreign accounts, eliminated credit facilities to offshore parties, prevented repatriation of investment until 1 September 1999, and fixed the exchange rate of the Malaysian ringgit at 3.8 per US dollar. In February 1999, a system of taxes on capital flows replaced the prohibition on repatriation of capital. Although the details were complex, the net effect was to discourage short-term capital flows while permitting long-term transactions. By imposing capital controls, Malaysia hoped to regain monetary independence and to be able to cut interest rates without provoking a fall in the value of its currency as investors avoided Malaysian assets. The imposition of outflow controls indeed curtailed speculative capital outflows and allowed interest rates to be reduced substantially. At the same time, under the umbrella of the capital controls, the authorities pursued bank and corporate restructuring and achieved a strong economic recovery in 1999 and 2000. With the restoration of economic and financial stability, administrative controls on portfolio outflows were replaced by a two-tier, price-based exit system in February 1999, which was finally eliminated in May 2001. Although Malaysia’s capital controls did contribute to a stabilization of its economy, they came with long-term costs associated with the country’s removal from the MSCI developed equity market index, an important benchmark in the institutional asset management industry, and its relegation to the emerging market universe. The Malaysian market was no longer seen as on par with developed equity markets whose institutional and regulatory frameworks provide a higher standard of safety for investors. As a result, a number of market analysts suggested that it became more difficult for Malaysia to attract net long-term capital inflows. 

1. Under what economic circumstances were Malaysia’s capital restrictions imposed? 

2. What was the ultimate objective of Malaysia’s capital restrictions? 

3. How successful were the country’s capital restrictions?