South-Western College Publishing - Economics  
Open Markets Closing
Subject Recession, Fiscal Policy
Topic International Finance
Key Words Recession, Economic Growth, Devaluation, Fiscal Policy
News Story

The belief that capital markets should be open was the prevailing market philosophy in the 90s -- it was the key to rapid growth and development, especially in emerging market economies. The turmoil in Asia's financial markets that has spread to Russia and Brazil has caused some countries to rethink this policy and partially close their capital markets to foreigners. The adoption of these isolationist policies is alarming U.S. government officials who fear that this will be a dangerous precedent for the global economy.

While most of the Asian countries still operate open markets, Hong Kong and Malaysia recently placed curbs on their stock markets, seeking to stop certain types of trading that result in increased volatility. Malaysia also discontinued trading in its currency, the ringgit, and imposed controls on its capital market. Malaysian currency held outside of the country will be worthless in a month. Foreign investors cannot withdraw their capital for a year. Hong Kong took a different approach. In addition to passing restrictions on the selling short of stock, Hong Kong spent an estimated $15 billion in about two weeks to support its stock market.

Capital inflows boost the economy, resulting in increases in employment and income. However, rapid outflows of capital also have the predicted effect -- increasing unemployment and reducing the value of the currency. The problem, according to Malaysia and Hong Kong, is that the process is strongly influenced by speculators and capricious capitalists and their actions can cause a country much pain.

The appeal of capital controls is that it gives a government more flexibility in its monetary and fiscal policies and, as Malaysian officials stated, time to repair their economy. Soon after Malaysia applied control measures, it lowered its interest rate, a policy that was not supportable with free currency exchange. Malaysia's stock market responded by increase in stock prices. The fear is that other countries suffering from the same ills will resort to the same measures.

Economists argue that installing controls will scare off new investment, restrain economic reform and thereby hurt the country. Milton Friedman said that Hong Kong's intervention in its stock market was a "crazy idea" and would undermine its reputation as a financial center. (Updated October 15, 1998)
Questions

1. Describe how an influx of foreign capital can aid the growth of an economy.

2. Describe the effect of an outflow of capital on the country's exchange rate

3. How did Malaysia attempt to halt the outflow of capital?

4. The Hong Kong dollar is linked to the United States dollar at a fixed exchange rate. Does a fixed exchange rate mean that the country can insulate itself from external economic influences?
Source Mark Landler, "Two Economies Seek to Keep Global Market at Bay," The New York Times, September 12, 1998

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