Sticky Currency

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What a difference a global financial panic makes. In slumping Hong Kong, once an icon of free markets, "speculators" who dump stocks may be thrown in jail. In recession-plagued Malaysia, which has banned trading of its currency, authorities roam the streets looking for black markets in foreign exchange. Half a world away, Russia is virtually bankrupt: officials have reneged on debts to foreign lenders, the ruble is all but worthless and the stock market has collapsed. "The global capitalist system that has been responsible for our remarkable prosperity is coming apart at the seams," says financier George Soros, who has lost $2 billion on investments in Russia over the past year.

Most Americans and people around the world will join Soros in the losers' column if the trend away from the free movement of capital continues. It is already sapping the profits of even the most competitive U.S. multinational firms, like Boeing and Citicorp, whose stocks are widely held in the retirement accounts of U.S. workers. And if more and more countries manipulate their capital flows and currencies for competitive advantage--as they did on the cusp of the Great Depression--the threat could spread to U.S. jobs.

Yet the temptation to meddle grows. Just as foreign funds largely financed the boom in Malaysia and its Asian neighbors, so the exodus of foreign investment has accelerated the crash. But while the Sept. 1 freeze that Malaysia imposed on the trading of its ringgit will prevent more funds from fleeing the country, it will also keep sorely needed foreign capital out. "I seriously doubt that we will invest in Malaysia for at least the next several years," says Dale Griffin, who manages a $4.7 billion international portfolio for the AIM group of mutual funds. "What Malaysia did was a real turnoff to us."

The appeal of controls to leaders like Malaysian Prime Minister Mahathir Mohamad--who took his cue from a recent article in Fortune magazine by M.I.T. economist Paul Krugman--could prolong the financial crisis that has spread from Asia to Russia to Latin America and hammered Wall Street stocks. Controls "might look good on a theoretical basis," says Thomas Mayer, managing director of Goldman Sachs in Frankfurt. "But on the ground they become pervasive. Investors would feel the rules of the game changing under their feet." Even Krugman, in a follow-up open letter to Mahathir in Fortune, remarked, "I'm worried that your approach may be tending toward the draconian." Standard & Poor's would agree. The credit-rating agency last week downgraded Malaysia's long-term debt to one notch above junk status.

So far, no country has rushed to follow Malaysia's lead. But Western experts say Russia could be the next to impose full currency controls. Already, says Bill Browder, American founder of the Hermitage Fund in Moscow, "bank accounts are frozen, treasury bills are frozen, wires are frozen. No one has any cash."

All eyes are now on Brazil, South America's largest country, which is teetering on recession and has been hemorrhaging foreign funds. That puts the country, which pegs its real to the U.S. dollar, under growing pressure to either devalue the currency or slap tough controls on capital. So far, it has vowed to use its $52 billion in foreign-exchange reserves to defend the real and maintain its link with the dollar. In addition, Brazil's central bank recently jacked up interest rates to 50% to slow the flight of funds.

The collapse of Brazil would clobber the rest of Latin America, starting with Argentina, which sells 30% of its exports to its giant neighbor. Such a blow would deepen Argentina's own recession and test the country's "currency board," which pegs the Argentine peso to the U.S. dollar at the rate of 1 to 1. Under that strict arrangement, Argentine interest rates rise automatically to halt heavy outflows of dollars and preserve the 1-to-1 peg.

But in the present climate of crisis, even countries with currency boards may have to impose controls to keep their currencies stable. Hong Kong did that last month when speculators attacked the Hong Kong dollar and sold stock short, expecting that rising interest rates would cause the market to fall. (Short sellers profit when stocks tumble.) Outraged authorities imposed new restrictions on such maneuvers and spent more than $15 billion in government reserves to buy up stock and keep the market from plunging. While the moves beat back the speculators, they damaged Hong Kong's reputation as a champion of free markets and exposed the weakness of its currency board. Warns Chen Nai-fu, a finance professor at the Hong Kong University of Science and Technology: "If the free market is rigged, it's hard to imagine how to invest."

Yet the impulse to rig markets is likely to spread along with the Asian contagion. "Capital controls are getting more discussion because countries are growing impatient with the lack of recovery from the crisis," says Morris Goldstein, a senior fellow at Washington's Institute for International Economics. "They're looking for a shortcut." But no country can isolate itself for long and hope to thrive in the global marketplace. If foreign capital creates risks for struggling countries like Malaysia and Russia, controls that discourage investors pose risks that are greater still.