Trading in the Malaysian ringgit accounted for 0.1% of the roughly $1.5 trillion in currencies traded last year. So Malaysia's Sept. 1 move to restrict ringgit transactions should have produced barely a ripple in world markets. Instead, investors everywhere fretted that other nations would follow suit. With any currency move likely to set off reactions around the globe, it's no wonder terms such as currency contagion, capital controls, dollarization, and currency boards have entered our lexicon. But what they signify can be confusing. Herewith, some clarification:
What is "currency contagion"?
Once, currencies were bought and sold mainly to finance international trade and long-term investment. Money did not flow freely across borders: Most countries fixed exchange rates against a gold or dollar standard, and controls on capital flows were common. Over the past two decades, though, global finance has been untethered. Most exchange rates are not fixed but float freely--although central banks sometimes peg or manage rates. Many governments have eased restrictions on capital and welcomed foreign investors. And while exporters and importers still buy currencies, it is investors who propel the markets, swapping currencies to buy stocks and bonds or placing huge bets on the movement of different currencies.
In good times, investors' bullishness buoys markets. But contagion works in reverse, too: With few exits barred, global capital fled many Asian economies over the past year, forcing governments to risk recession as they raise interest rates to attract foreign capital.
So what are capital controls, anyway, and would they counteract contagion?
Capital controls come in two flavors: bitter and bitterer. Less onerous controls usually involve taxing short-term capital flows. Chile, Colombia, and other countries use them to discourage "hot money"--fickle investments that flow in and out on a whim. Ironically, at a time when other nations are contemplating controls, the Chilean government in July declared short-term flows less of a threat and cut the tax on foreign deposits under one year's duration to 10% from 30%.
More onerous are controls such as Malaysia's, which curb foreign exchange transactions in an effort to wall off the economy. The idea was to allow Malaysia to follow domestically oriented policies. In fact, interest rates fell, and after an initial sell-off, the Malaysian stock market recovered.
Does that mean controls should be adopted?
Certainly, hot money affects small economies. A vocal--and growing--minority of economists now suggest that controls on short-term flows might be useful, provided they are temporary and not subject to abuse--a fairly tall order. More restrictive measures, such as exchange controls, are still more problematic, especially because they can shut off foreign investment.
Just what is dollarization?
In certain countries where inflation is running high, the dollar has become a parallel or second currency, widely--but illegally--used for private transactions. Russians hold an estimated $40 billion in greenbacks. Such dollarization could ease the adoption of a currency board, though.
O.K., so what's a currency board?
Currency boards have worked in places such as Argentina to stave off hyperinflation by cinching the monetary system into a straitjacket. Boards, which may have non-national representatives, supersede central banks. The domestic currency is backed by foreign reserves and fixed against the dollar. There's no way to counteract recessions, but prices are stabilized and fiscal measures may be taken to shore up the economy.
Currency boards are meant to be free of political interference to ensure their credibility. It's difficult to see that happening in countries verging on economic chaos, such as Russia. Indeed, keeping politics out of global finance may be impossible. These days, world leaders feel the need to do something--almost anything--to guard against the tidal waves of global capital.