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Introduction
Efficacy and effectiveness of capital controls have gained renewed interests after
Malaysia re-imposed controls on capital flows at the height of the 1997-98 Asian
financial crises. The Mundell Trilemma suggest that policy makers can only choose two
out of the three macroeconomic policy objectives; i.e., independent monetary policy;
stable exchange rate, and freedom of capital flows to maintain fundamental policy
consistency. In the Malaysian case, the freedom of capital flows has been sacrificed for
the sake of independent monetary policy and the stable exchange rate. Although the
verdict is still out regarding whether capital controls have facilitated Malaysia’s rapid
recovery from the crisis (IMF, 2000), recent empirical evidences do show that emerging
market economies, because of their lack of credible nominal anchor and their
undeveloped capital markets, often suffered from “the fear of floating” (Calvo and
Reihart, 1998) when they opt to maintain exchange rate stability while pursing free
capital mobility and independent monetary policy.
China has in the past put great emphasis on independent monetary policy and
stable exchange rate at the expense of the freedom of capital flows. However, such
objectives have recently been under increased scrutiny and pressure. Some observers
argue that its undervalued currency was blamed for the economic overheating in 2003-
2004 and its pegged exchange rate regime has been blocking the global adjustment
process in light of the unsustainable current account deficit in the United States
(Goldstein, 2004). Indeed, these assertions implicitly assume that China’s capital controls
have not been effective so that both legal and illegal cross-border capital flows
effectively arbitraged out the interest rate differentials between onshore and offshore,
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thus making the independent monetary policy objective less obtainable. Some, before
China’s interest rate hike in October 2004, prematurely pointed out that the Chinese
monetary authorities were afraid of raising interest rates to cool the economy because
higher interest rate would attract more capital flows. However, some recent empirical
studies have shown that, despite the onshore and offshore interest rate differentials have
been shrinking over time, China’s capital controls are still effective as these interest rate
differentials still remain large (Ma, Ho, and McCauley, 2004).