Sept. 1, 1998



Dear Dr. Mahathir:

 I was as surprised as anyone when you announced sweeping new currency controls yesterday, and am still unclear about some of the details. However, since my recent Fortune article did suggest that temporary currency controls are part of the solution for Asia, I cannot deny some responsibility for your policy turn. Let me therefore say that, like yourself, and of course the people of Malaysia, I fervently hope that this dramatic policy move pays off.

The imposition of currency controls is, of course, a risky step, with no guarantees of success. It is, as many people have pointed out, a stopgap measure. There is no shame in that: some gaps desperately need to be stopped. For the new policy to succeed, however, the freedom of action achieved by your willingness to defy orthodoxy must be well used. Let me therefore suggest four guiding principles in the no doubt very stressful months to come.

First, the actual implementation of controls should aim to disrupt ordinary business as little as possible. The devil can be in the details - that is, even a conceptually sound policy can founder if the rules are poorly conceived. The initial announcement of the plan seems to indicate, for example, that Malaysians travelling abroad will be restricted to carrying unreasonably small quantities of currency; this will need to be fixed, as will any other failings that become apparent on further study or through experience.

Second, no matter how well currency controls are executed, the distortions they impose on the economy are serious, and tend to get worse over time. That is why these controls must be regarded as temporary measures, designed to win breathing room for an economic recovery, not as a permanent secession of Malaysia from the international capital market. It would be a good idea to state now a planned date for the removal of controls - at most three years from now, perhaps less - with the strong possibility of early parole as the economy recovers.

Third, experience suggests that currency controls do most damage when they are used to defend an over-valued currency, and thereby inexorably evolve from a temporary defense against speculation into a permanent system of trade protection. Malaysia does not need a strong ringgit - on the contrary, it needs a highly competitive real exchange rate in order to increase exports.

Finally, controls must serve as an aid to reform, not an alternative. The purpose of currency controls is to allow adoption of more expansionary monetary and fiscal policies, and hence to promote a recovery of the real economy. Such a recovery will, if all goes well, reduce the problems of insolvency in the corporate sector and non-performing loans in the banking system. However, it will by no means eliminate these problems; the breathing room given by controls should be used to accelerate, not slow, the pace of financial cleanup.

Remember, above all, that the point of this policy departure should be purely and simply to buy space for economic growth. It should not be used in an attempt to prove points about the soundness of the pre-crisis economy, or about the wickedness of hedge funds, or anything else. If Malaysia truly does succeed in achieving a recovery, that will be lesson enough for the rest of us.



Paul Krugman