(FORTUNE Magazine) – It is true that in general, capital controls don't work. But one Asian country suggests that under special circumstances they can. We refer, of course, to Taiwan.

Taiwan? Wasn't it Malaysia that instituted capital controls recently? Indeed it did, and at first blush it appears to be a success--Malaysia's stock market has risen, and its interest rates have fallen. But the benefits of Malaysia's heavy-handed controls are likely to be short-lived. Neither foreign investors, who may have as much as $10 billion of their money tied up in Malaysia, nor their domestic counterparts will inject more of the capital and expertise the country needs anytime soon. The jailhouse beating of Anwar Ibrahim, Malaysia's reform-minded ex-finance minister, and the political unrest there reinforce suspicions that these controls are designed to protect the ruling class, not to give breathing room for restructuring.

Taiwan's methods have avoided all these side effects, while doing what controls are supposed to do: allow growth with stability. The Taiwanese economy will still grow by 4% to 5% this year, the second-best record in Asia after China's (whose statistics are dubious). The stock market has fallen by 45% in dollar terms since July 1997, one of the least bad results in Asia. The 25% fall in the currency is a relatively slight decline and has happened gradually. And the government has lowered interest rates by a third this year while keeping capital flows on an even keel.

The secret of this success--apart from the fact that Taiwan established its controls before the crisis--is that the Taiwanese managed to modulate capital flows without interfering with free-market forces. For instance, Taiwan has no restrictions on the use of foreign currencies for trade in goods and services. The authorities must be notified of incoming foreign direct investment, but no permission is needed to take capital or profits out. Taiwanese who want to make direct investments overseas are free to do so, with one national-security exception, China itself. A Taiwanese citizen can send up to $5 million out of the country per year, no questions asked; a company can send out $50 million. And foreign investment in stocks can be taken out under a variety of restrictions, from none to heavy, depending on how it was put in.

Turnover in the foreign-exchange market is often only $150 million to $200 million a day, and banks are limited in lending local currency for foreign-exchange dealing. Combined with a trifling foreign debt, equal to 11% of GDP, this has allowed the authorities to let the market pretty much determine the level of the currency while they adjust interest rates to domestic business conditions--without worrying about hedge-fund speculators, who can't get a toehold in such a thinly traded market.

This may sound like a mess, and it is--which is precisely its virtue. The trouble with clean-cut controls a la Malaysia is that they create political favorites, corrupt constituencies, and market distortions that lead to black-market trading. Taiwan's method offers enough scope for individuals and companies to do most of their foreign-exchange business unhindered by bureaucrats, for foreign portfolio capital to enter and leave in adequate volumes to reflect true market signals, and--most important of all--for financial transactions not to distort the allocation of resources in the real economy. For a model of effective capital controls, Taiwan is the place to look.

--Jim Rohwer