Prime Minister Mahathir bin Mohamad of Malaysia must feel somewhat vindicated now.  He was widely criticized for imposing limited capital controls amid financial turmoil almost a year ago.

In recent report endorsed by their heads of government in Cologne, the finance ministers of the Group of Seven acknowledged that controls on capital outflows may be necessary "in certain exceptional circumstances".  This sudden hedging on capital controls reflects increasing awareness that the risks that countries face in opening up to the global financial market are much greater than was previously thought. Four years, the Group of Seven and the IMF preached the benefits to emerging markets of capital account convertibility - the unfettered movement of money in and out of countries for purposes of trade, investment, business and profit repatriation.

But after the Mexican financial crisis of 1994 - 1995, and the turmoil that started in East Asia two years ago before spreading to other markets, including Latin America and Russia, apprehensions about the downside of freeing capital flows have resurfaced. Such fears are hardly new.  In his 1944 proposal for an international monetary fund, John Maynard Keynes railed against the "mischief of unregulated capital movements". What accounts for the volatility of capital flows, and what should be done to deal with them, are subjects of a never-ending academic debate.  There are basically two views.  One of them tags financial sector weaknesses and bad policies and practices as the main culprits.

For those who hold this view, the solution lies in strengthening domestic financial sectors.  Better supervision and regulation, improved transparency and disclosure standards, better corporate governance and the right macroeconomic policies will do the job.

But there is another view, which asserts that volatility is intrinsic to short-term capital flows.  It occurs because private investors in stocks, bonds, currencies and their derivatives are driven by capital-protecting, rather than system-protecting, behavior.  The private risk of investing in foreign markets is much less than the social risk involved.  This situation is aggravated by the absence of  international regulations to help prevent speculative conspiracies, which are normally punishable under domestic laws.

As a consequence, the argument goes, capital flows remain subject to herd behaviour, panics and destabilizing speculation, which lead to market failure.  In such an environment, better domestic policies and strong financial institutions alone would not be enough to shield economies, especially small ones, from crises and contagion.
Those who subscribe to this view think that the key lies in capital controls.

There are disagreements, however, on the extent and scope of such controls. There are those who believe that developing countries which have not opened their doors to free movement of money are better off staying that way. Some would just like controls on "speculative" capital in-flows.  Examples of these measures are taxes on short-term capital to deter quick round-trips, and deposit requirements on short-term inflows, like those imposed by Chile.

Others disagree, saying that these measures would be inadequate to prevent capital flight when large currency depreciations are anticipated, as happened in Thailand in July 97 at the start of the East Asian financial crisis. Furthermore, these measures do not address the problem caused when residents of a country get nervous and send their money elsewhere.  The only recourse left for countries faced with recurrent speculative attack would be currency controls to prevent the massive out-flow of funds.

Proponents of this view admit that such measures cause serious economic damage over time, but say that they are the "least bad" option, and are meant to provide temporary breathing space to allow countries to recover and undertake reforms. As the scholars debate, the Group of Seven and the IMF are moving ahead to repair the leaky global financial architecture.  The G-7 finance ministers have outlined a six-point blue-print, covering such areas as transparency, market discipline and risk management among creditors and investors, regulatory and legal regimes, and crisis prevention and management.  These measures try to address both domestic financial sector weaknesses in emerging markets and problems related to creditors' assessment of risks.

The G-7 blueprint does contain numerous initiatives that would help international capital markets operate better than they do today.  However, some key issues remain unresolved.  One is how to replicate at the international level the protective mechanism provided for the financial system by leaders of last resort at the national level. Another is how to deal with institutions that borrow huge amounts for speculative investment, including unregulated hedge funds.  They played a significant role in the unfolding of the recent financial crisis.

A common global currency and financial regulatory mechanism would solve many of these problems, but that will not be on the agenda for decades to come.  Meanwhile, an unprecedented expansion of cross-border capital flows is gathering pace.  As of mid-1998, average daily turnover at the global foreign exchange market reached $1.8 trillion a 200 percent increase 10 years. It should therefore come as no surprise that the idea of capital controls, at least as an emergency measure, is suddenly out of the bag.  The question now is how much liberty we are willing to trade for a little more safety.

Julius Caesar Parrenas

The writer, senior adviser to the Taiwan Institute of Economic Research and the Chinatrust Commercial Bank, contributed this comment to the International Herald Tribune.