robert wade choking the south world finance and underdevelopment
ritics of neoliberal globalization have tended to focus on the role of the international institutions—imf, wto, World Bank—rather than on the world financial system itself. Yet in the post-Bretton Woods era, the functioning of the latter has been a major source of vulnerability for developing countries, exposing large swathes of their populations to sudden falls in real incomes and depressing national growth rates. It is, of course, difficult to disentangle the effects of the financial system from those of, say, the trade system, which also puts obstacles in the way of former ‘Third World’ countries rising up the value-chain into higher value-added activities. In combination, these systems have produced the slow rate of average income growth of most developing countries over the past quarter-century. Per capita international income distribution has become more unequal by several plausible measures, as has income distribution between the world’s households.
In what follows I attempt to show, first, the detrimental effects of the present liberalized world financial system on a majority of developing countries and, second, that the key features driving these effects result from the combination of the free movement of private capital and the ability of the us, as supplier of the main international currency, to run persistent current-account deficits—a combination that continuously raises the level of world liquidity. These features increase structural vulnerability by raising the volatility and destructive impact of key economic parameters: exchange rates, stock markets and interest rates. At the same time, they limit ‘real’ investment opportunities, including in developing countries, where one would expect them to be greatest. Finally, I argue that activists and ngos who have hitherto focused mainly on public-sector targets such as the imf and wto should be pressing governments to do more on the monitoring and regulation of flows of private capital.
From the mid 1940s to the early 1970s, the period of the Bretton Woods international financial system, the world economy operated with fixed exchange rates; an international medium of exchange and store of value—the us dollar—backed by gold; and restrictions on capital movements (closed capital accounts). This combination had three important effects. First, the backing of the main international currency by gold tended to check persistent trade imbalances, since the latter resulted in cross-border transfers of gold, or of dollars fully convertible into gold, and hence effected changes in national price levels which eventually restored trade balances. Second, private international capital flows were small. Public-sponsored international capital flows were much greater, including Cold War-justified military spending by the usa. Third, the main economic parameters—exchange rates, stock market indices, interest rates, price levels—were very steady. World growth rates were also high and stable compared with what was to come; and specifically, developing countries as a group enjoyed relatively fast growth.
After Bretton Woods
When the Bretton Woods system collapsed in 1973 all this changed. Since then, the world financial system has been based on flexible exchange rates between the major currencies; non-convertibility of dollars into gold; the us ability to finance its debts to the rest of the world by issuing debt instruments denominated in its own currency (ious, in the form of, for example, Treasury bills); and free private capital movements (open capital accounts). The adjustment mechanisms that had kept trade imbalances in check under Bretton Woods no longer worked. Now that the us was not obliged to pay for its imports in gold, or in dollars backed by gold, and could instead pay with dollars or Treasury bills without supply-side limits, American deficits began to grow, as did the number of dollars in circulation worldwide. The corollary of the us current-account deficit, now standing at 6 per cent of the country’s gdp, was the swelling of other countries’ central bank reserves, most of which consist of dollars and dollar-denominated debt instruments.
The increase in central bank reserves provided the basis for rapid credit expansion. World liquidity surged, and the owners and managers of finance put pressure on governments to remove restrictions on cross-border capital flows. A few major oecd economies, notably the us and the uk, opened their capital accounts during the 1970s; other oecd economies followed through the 1980s, joined by growing numbers of developing countries in the next decades. At the same time there was a proliferation of private financial organizations, thanks to the removal of the constraints on finance imposed by the Bretton Woods regime. They include insurance companies, pension funds, stockbrokers, investment banks, mutual funds, venture capitalists, hedge funds and financial management companies. These bodies receive and invest revenue flows from sources such as insurance premiums and pension contributions, accumulating huge assets. Insurance companies of developed countries have assets of roughly $14 trillion. Pension funds of developed countries have roughly $13 trillion. By way of comparison, total World Bank lending over its entire existence is below $1 trillion.
These vast pools of funds have changed the face of the world economy. Much of their investment is across borders and involves foreign-currency transactions, accounting for a large part of the $1.5 trillion or so traded daily on world money markets. They affect the balance between sectors—for example, of construction and financial services in relation to manufacturing—and the nature of ownership, national or foreign. They also widen the gulf between ownership and management responsibility, making company accountability even more difficult.
There is a major tension in the world economy between, on the one hand, the rapid increase in liquid funds and the resulting ‘financialization of the economy’—the rise in the ratio of financial assets to real assets, and the rise in the political power of financial interests relative to real-economy interests—and, on the other, the crisis of profitability, meaning limited real investment opportunities. Since too much money is chasing too few real investments, these funds are increasingly invested not on the basis of a forecast of future demand for real goods and services, but on the basis of continuously rising prices of financial assets, fuelled by essentially speculative demand.
The financialization of the economy has shifted the development agenda in the direction of neoliberalism. This requires open competition between producers and would-be producers in developing countries, and producers already established in developed countries. In these conditions, it is difficult for infant industries to get established and grow, except perhaps low-tech, labour-intensive ones. The result is that investment in developing countries, which is where it is most required, has been highly uneven, with China at one end of the spectrum and most of sub-Saharan Africa at the other. The spread of neoliberal policies through developing countries has done little to reduce the geographical clustering of investment.
Increasing volatility
The surge of liquidity since the end of Bretton Woods and the resulting financialization of the economy have created an inherent source of instability in the world economy. The prices in stock markets and currency markets have no strong ‘real’ anchor and are not closely related to ‘fundamentals’ in the sense that prices in product markets are anchored in the costs of production. Hence financial markets are subject to ‘irrational’ exuberance or pessimism, to overshooting or to perverse equilibria. These trends are exacerbated with cross-border finance, since owners and managers often experience sharper information ‘imperfections’ when investing in another country (especially a developing country) than in their own, and are therefore more prone to ‘following the leader’, stampeding in and out.
As illustrated in Figure 1, the last two decades of the 20th century saw the biggest exchange-rate swings between the major currencies since the Second World War. In the words of two analysts, ‘the short-run volatility of G3 real exchange rates is one of the most robust—and to many observers disturbing—characteristics of the post-Bretton Woods floating exchange rates experience’.footnote1 As Figures 2 and 3 reveal, stock market indices and world real interest rates have also been much more volatile in this period. The higher volatility of these key economic parameters in the post-Bretton Woods era has yielded a greater frequency of banking and currency crises worldwide.footnote2 Figure 4 tracks a sample of 21 industrial economies and ‘emerging market economies’ over twelve decades. It shows that the probability of a banking or currency crisis has substantially increased since the Bretton Woods era, and is now more comparable to that of the interwar period.
A list of the sites of major financial crises over the past two decades would include the United States (the Savings & Loan debacle of the late 80s); Japan, with the bursting of the real-estate bubble in 1990 leading to a decade-long recession;Scandinavia, 1991–92; Britain and Italy, with the European Exchange Rate Mechanism crisis of 1992; Mexico in 1994–95, with the 50 per cent devaluation of the peso, a 6 per cent fall in gdp and a barely functioning banking system; Turkey, 1994; East Asia, 1997–98, where the combined gdp of South Korea, Thailand, Malaysia, Indonesia and the Philippines fell by about 11 per cent, with milder damage to Taiwan, Hong Kong and Singapore; Russia in 1998; the Long-Term Capital Management crash on Wall Street, also in 1998; Brazil in 1999, when the real devalued by 80 per cent in a single month, and again in 2002; the Central Asian republics, 1998–2000; and Argentina in 1995 and 2001–02, when the economy contracted by 20 per cent.
On top of these crises, many developing countries have had long periods of recession, such as Latin America’s ‘lost decades’ from the 1980s and Turkey’s from the 1990s. Meanwhile, most countries of sub-Saharan Africa experienced a slow-burning debt crisis during the 1990s, involving levels of debt (private and public) so high relative to gdp or exports as to cause a fiscal crisis and collapse of public services, on top of a currency crisis. In some countries this took the form of major devaluations; in others, with pegged exchange rates, there were burgeoning black markets for foreign exchange. The Jubilee 2000 ‘Drop the Debt’ campaign yielded the hipc initiative for debt cancellation, but in most cases the result has merely prevented an already insupportable burden from becoming worse.
The major cause of exchange rate, stock market and interest rate instability, and of many of the financial crises of the 1980s and 1990s, has been the volatility of ever-growing global private capital flows. It was not meant to be this way: the champions of floating exchange rates and free capital movements claimed that the new system would yield smoother adjustments and faster growth, thanks to the equilibrium-seeking tendency of private markets. Instead, the experience of the 1990s raised the spectre of a repeat of the crisis decade that stretched from the stock market crashes of 1929 to the outbreak of the Second World War.
Not only has volatility risen, but world economic growth was lower in the 1990s and deflationary momentum increased. As Table 1 illustrates, deflationary momentum is now strong in Japan, Germany, Taiwan, Hong Kong, China,footnote3 and even the us. Arguably, such deflation can be more damaging to economic welfare than inflation, below a fairly high ceiling. It seems likely, too, that the deflationary constellation results from the same factor implicated in the trend to higher volatility and crisis: the removal of restrictions on capital mobility that began after the collapse of Bretton Woods.
Effects on developing countries
A comparison of the fourth and fifth panels in Figure 4 above shows that the frequency of financial crises in the 1973–97 period was substantially greater in newly industrializing countries than in advanced economies. (The inclusion of another 35 developing countries in the fifth panel greatly increases the frequency of crisis.) As Barry Eichengreen has argued: ‘Sharp changes in asset prices—sometimes so sharp as to threaten the stability of the financial system and the economy . . . are likely to be especially pervasive in developing countries, where the information and contracting environment is least advanced’.footnote4
Since the 1980s, private capital flows to developing countries have come to vastly exceed public flows. Whereas official financial flows to developing countries have gone from $50bn in 1986, to $88bn in 1995, and $66bn in 2000, the figures for net private flows have risen far higher: from $25bn in 1986, to $171bn in 1995, with $140bn in 2000.footnote5 At the same time, developing countries have been loaded down with foreign debt, as shown in Table 2—raising their vulnerability to currency volatility.
The degree of vulnerability depends not only on the amount of external debt, relative to foreign-exchange reserves or gdp, but also on interest rates. As interest rates rise, debt-service obligations in hard currencies also increase, regardless of ‘ability to repay’. So when a developing country’s currency depreciates and the government raises interest rates, economic agents with foreign debt are hit with a double whammy, unless and until the higher real interest rate succeeds in curbing the fall in the value of the national currency. As Figure 3 above showed, real interest rates in developing countries have been more volatile over the 1990s than those of the leading industrial countries, and much higher than in the us and Japan. High domestic interest rates not only slow down investment and growth, but also provide an incentive to borrow abroad through open capital accounts, and hence tend to generate rising levels of foreign indebtedness.
The deregulated global capital markets of the post-Bretton Woods era force currencies to compete with each other, since economic actors can easily keep their wealth in home or in foreign currencies. This introduces another source of financial vulnerability and makes macroeconomic management more difficult for developing-country governments. As Table 3 shows, there has been a significant trend in these countries towards holding wealth in foreign currencies, mainly dollars and euros.
These figures reflect the declining competitiveness of national currencies in developing countries. One reason for this decline is that, as Table 1 (above) shows, average inflation rates are still much higher in developing countries; around 6 per cent, compared to 2 per cent for the advanced countries. The risks of currency devaluation are significant. Hence domestic wealth-holders will tend to shift out of the national currency into one considered more likely to retain its value.footnote6 The result of such competition is to produce a hierarchy of currencies: those at the top fulfil both domestic and international functions; those in the middle fulfil domestic but not international functions; those at the bottom (the majority) fulfil neither function.
This last condition—the non-acceptance of the currency, and hence the ‘dollarization’ of the economy—is one that no central bank can ignore. One result of non-acceptance is to limit the effectiveness of monetary policy. A central bank that wants to expand economic activity creates domestic currency which it gives to commercial banks, who in turn lend it to customers. If, however, customers see the domestic economy as weak, and can easily choose between currencies, they tend to change much of this into foreign currency as a preferred store of value and transactions medium, even for domestic transactions. This creates downward pressure on the value of domestic currency (pressure towards devaluation). If the central bank fights depreciation by raising interest rates, this stops credit expansion and thus slows aggregate economic expansion: undermining the original goal. In other words, dollarization limits the domestic credit creation mechanism, which is basic to investment growth and economic development.
Another effect of dollarization is to magnify the impact of currency changes. When a large portion of domestic wealth and transactions are conducted in foreign currency units, devaluation inflicts amplified shocks on the domestic economy, on top of those resulting from the increased costs of servicing foreign loans. Central banks of countries with uncompetitive currencies therefore try to maintain high interest rates, in order to induce people to hold the domestic currency. High real interest rates—of 8 per cent or more—restrict economic growth, since few investment projects can earn a rate of return above the cost of borrowed money.
‘Competition between currencies’ is one cause of the slow economic growth in most developing regions and of widening world income inequality. Another is the amplified volatility of developing-country currencies in conditions of free capital movement, which forces their central banks to tie up resources in foreign-exchange reserves—thereby lowering interest rates and enhancing investment in the core economies, using funds that could have been invested domestically. The same conditions push developing-country interest rates up to a level needed to compensate foreign investors for ‘exchange-rate risk’, making it more difficult for local companies to use debt as a means of financing investment. These factors may more than counterbalance the positive effects of increased inflows of private capital made possible by financial liberalization.
Points of resistance
Leading states have responded to the rising volatility and crisis-prone nature of financial markets by trying to improve technical coordinationof the regulatory and supervisory policies of national authorities. New forums have been established for this purpose, such as the Financial Stability Forum established by G7 finance ministers in the late 1990s, or the Joint Forum on Financial Conglomerates set up by the Basel Committee on Banking Supervision in 1996. The response of the G7 and imf to the East Asian crisis of 1997 was to urge further opening of national financial systems, but now with more attention paid to ‘sound regulation’—by the borrowinggovernments. Above all, the G7 and imf urged developing countries not to be tempted to use restrictions on capital movements as a tool for economic management. ‘Regulations, yes. Restrictions, no’, was the mantra.footnote7
It could be argued that technical coordination has worked to a degree, in that there has not been a 1930s-type meltdown in the wake of the successive financial crises of the last twenty years. However, the system has only weak means to ensure compliance. And, at a more basic level, the call for ‘sound regulation’ conceals a fundamental ignorance about how to judge when a country may safely open its financial markets. Exhibit A of such ignorance is the April 1997 World Bank publication, Private Capital Flows to Developing Countries. Urging developing countries to open their capital markets, the report listed those with sufficiently robust regulatory regimes to do so:
Developing countries show considerable variation in the capital market attributes needed for financial integration. The most dynamic emerging markets, where progress has been particularly intense during the last five years, include most of high-growth Asia (Korea, Malaysia, and Thailand, with Indonesia and the Philippines not far behind) and two markets in Latin America (Chile and Mexico, with Brazil also ranking well) . . . The lagging emerging markets in the sample are in South Asia (India, Pakistan, and Sri Lanka) and China.
Just a few months later the East Asian crisis had engulfed the countries congratulated by the report, while none of the economies that it identified as ‘lagging’ were so badly affected. The latter retained substantial restrictions on capital movements.
Since the 1980s, anti-poverty activists and ngos have played a vital role in monitoring and publicizing the activities of the institutions that shape the development agenda and send public capital flows to industrializing countries, culminating in the demonstrations between 1999 and 2001 at World Bank, imf and wto summits. There has been a series of proposals to restructure these bodies in favour of developing countries. Yet the private firms who direct the vastly greater international capital flows to developing-country economies receive far less public scrutiny. Whatever the specific merits of the proposals, the debate around the Tobin tax, or currency transaction tax, constitutes a welcome opening in this regard. The recent establishment of the Continuous Linked Settlement (cls) Bank, owned by central banks and regulators, provides a way by which one or many governments can easily levy a tax on foreign exchange transactions in their currencies—whether a very low tax to raise revenue (perhaps to finance global public goods) or a higher tax to discourage capital surges in or out.footnote8
A revivified alter-globalization movement should pay far more attention to private financial organizations and their capital flows. Equally, it should push for much greater regulation of financial markets.footnote9 This would have to include explicit recognition of various sorts of capital controls as legitimate instruments of national economic management. There is little evidence to support the proposition that open capital markets generate a more stable and equitable world order; and much to suggest that they increase volatility and propensity to financial crisis. We need a new discourse for an alternative approach to capital markets to replace the current ‘ever more open’ doxa.
In what follows I attempt to show, first, the detrimental effects of the present liberalized world financial system on a majority of developing countries and, second, that the key features driving these effects result from the combination of the free movement of private capital and the ability of the us, as supplier of the main international currency, to run persistent current-account deficits—a combination that continuously raises the level of world liquidity. These features increase structural vulnerability by raising the volatility and destructive impact of key economic parameters: exchange rates, stock markets and interest rates. At the same time, they limit ‘real’ investment opportunities, including in developing countries, where one would expect them to be greatest. Finally, I argue that activists and ngos who have hitherto focused mainly on public-sector targets such as the imf and wto should be pressing governments to do more on the monitoring and regulation of flows of private capital.
From the mid 1940s to the early 1970s, the period of the Bretton Woods international financial system, the world economy operated with fixed exchange rates; an international medium of exchange and store of value—the us dollar—backed by gold; and restrictions on capital movements (closed capital accounts). This combination had three important effects. First, the backing of the main international currency by gold tended to check persistent trade imbalances, since the latter resulted in cross-border transfers of gold, or of dollars fully convertible into gold, and hence effected changes in national price levels which eventually restored trade balances. Second, private international capital flows were small. Public-sponsored international capital flows were much greater, including Cold War-justified military spending by the usa. Third, the main economic parameters—exchange rates, stock market indices, interest rates, price levels—were very steady. World growth rates were also high and stable compared with what was to come; and specifically, developing countries as a group enjoyed relatively fast growth.
After Bretton Woods
When the Bretton Woods system collapsed in 1973 all this changed. Since then, the world financial system has been based on flexible exchange rates between the major currencies; non-convertibility of dollars into gold; the us ability to finance its debts to the rest of the world by issuing debt instruments denominated in its own currency (ious, in the form of, for example, Treasury bills); and free private capital movements (open capital accounts). The adjustment mechanisms that had kept trade imbalances in check under Bretton Woods no longer worked. Now that the us was not obliged to pay for its imports in gold, or in dollars backed by gold, and could instead pay with dollars or Treasury bills without supply-side limits, American deficits began to grow, as did the number of dollars in circulation worldwide. The corollary of the us current-account deficit, now standing at 6 per cent of the country’s gdp, was the swelling of other countries’ central bank reserves, most of which consist of dollars and dollar-denominated debt instruments.
The increase in central bank reserves provided the basis for rapid credit expansion. World liquidity surged, and the owners and managers of finance put pressure on governments to remove restrictions on cross-border capital flows. A few major oecd economies, notably the us and the uk, opened their capital accounts during the 1970s; other oecd economies followed through the 1980s, joined by growing numbers of developing countries in the next decades. At the same time there was a proliferation of private financial organizations, thanks to the removal of the constraints on finance imposed by the Bretton Woods regime. They include insurance companies, pension funds, stockbrokers, investment banks, mutual funds, venture capitalists, hedge funds and financial management companies. These bodies receive and invest revenue flows from sources such as insurance premiums and pension contributions, accumulating huge assets. Insurance companies of developed countries have assets of roughly $14 trillion. Pension funds of developed countries have roughly $13 trillion. By way of comparison, total World Bank lending over its entire existence is below $1 trillion.
These vast pools of funds have changed the face of the world economy. Much of their investment is across borders and involves foreign-currency transactions, accounting for a large part of the $1.5 trillion or so traded daily on world money markets. They affect the balance between sectors—for example, of construction and financial services in relation to manufacturing—and the nature of ownership, national or foreign. They also widen the gulf between ownership and management responsibility, making company accountability even more difficult.
There is a major tension in the world economy between, on the one hand, the rapid increase in liquid funds and the resulting ‘financialization of the economy’—the rise in the ratio of financial assets to real assets, and the rise in the political power of financial interests relative to real-economy interests—and, on the other, the crisis of profitability, meaning limited real investment opportunities. Since too much money is chasing too few real investments, these funds are increasingly invested not on the basis of a forecast of future demand for real goods and services, but on the basis of continuously rising prices of financial assets, fuelled by essentially speculative demand.
The financialization of the economy has shifted the development agenda in the direction of neoliberalism. This requires open competition between producers and would-be producers in developing countries, and producers already established in developed countries. In these conditions, it is difficult for infant industries to get established and grow, except perhaps low-tech, labour-intensive ones. The result is that investment in developing countries, which is where it is most required, has been highly uneven, with China at one end of the spectrum and most of sub-Saharan Africa at the other. The spread of neoliberal policies through developing countries has done little to reduce the geographical clustering of investment.
Increasing volatility
The surge of liquidity since the end of Bretton Woods and the resulting financialization of the economy have created an inherent source of instability in the world economy. The prices in stock markets and currency markets have no strong ‘real’ anchor and are not closely related to ‘fundamentals’ in the sense that prices in product markets are anchored in the costs of production. Hence financial markets are subject to ‘irrational’ exuberance or pessimism, to overshooting or to perverse equilibria. These trends are exacerbated with cross-border finance, since owners and managers often experience sharper information ‘imperfections’ when investing in another country (especially a developing country) than in their own, and are therefore more prone to ‘following the leader’, stampeding in and out.
As illustrated in Figure 1, the last two decades of the 20th century saw the biggest exchange-rate swings between the major currencies since the Second World War. In the words of two analysts, ‘the short-run volatility of G3 real exchange rates is one of the most robust—and to many observers disturbing—characteristics of the post-Bretton Woods floating exchange rates experience’.footnote1 As Figures 2 and 3 reveal, stock market indices and world real interest rates have also been much more volatile in this period. The higher volatility of these key economic parameters in the post-Bretton Woods era has yielded a greater frequency of banking and currency crises worldwide.footnote2 Figure 4 tracks a sample of 21 industrial economies and ‘emerging market economies’ over twelve decades. It shows that the probability of a banking or currency crisis has substantially increased since the Bretton Woods era, and is now more comparable to that of the interwar period.
A list of the sites of major financial crises over the past two decades would include the United States (the Savings & Loan debacle of the late 80s); Japan, with the bursting of the real-estate bubble in 1990 leading to a decade-long recession;Scandinavia, 1991–92; Britain and Italy, with the European Exchange Rate Mechanism crisis of 1992; Mexico in 1994–95, with the 50 per cent devaluation of the peso, a 6 per cent fall in gdp and a barely functioning banking system; Turkey, 1994; East Asia, 1997–98, where the combined gdp of South Korea, Thailand, Malaysia, Indonesia and the Philippines fell by about 11 per cent, with milder damage to Taiwan, Hong Kong and Singapore; Russia in 1998; the Long-Term Capital Management crash on Wall Street, also in 1998; Brazil in 1999, when the real devalued by 80 per cent in a single month, and again in 2002; the Central Asian republics, 1998–2000; and Argentina in 1995 and 2001–02, when the economy contracted by 20 per cent.
On top of these crises, many developing countries have had long periods of recession, such as Latin America’s ‘lost decades’ from the 1980s and Turkey’s from the 1990s. Meanwhile, most countries of sub-Saharan Africa experienced a slow-burning debt crisis during the 1990s, involving levels of debt (private and public) so high relative to gdp or exports as to cause a fiscal crisis and collapse of public services, on top of a currency crisis. In some countries this took the form of major devaluations; in others, with pegged exchange rates, there were burgeoning black markets for foreign exchange. The Jubilee 2000 ‘Drop the Debt’ campaign yielded the hipc initiative for debt cancellation, but in most cases the result has merely prevented an already insupportable burden from becoming worse.
The major cause of exchange rate, stock market and interest rate instability, and of many of the financial crises of the 1980s and 1990s, has been the volatility of ever-growing global private capital flows. It was not meant to be this way: the champions of floating exchange rates and free capital movements claimed that the new system would yield smoother adjustments and faster growth, thanks to the equilibrium-seeking tendency of private markets. Instead, the experience of the 1990s raised the spectre of a repeat of the crisis decade that stretched from the stock market crashes of 1929 to the outbreak of the Second World War.
Not only has volatility risen, but world economic growth was lower in the 1990s and deflationary momentum increased. As Table 1 illustrates, deflationary momentum is now strong in Japan, Germany, Taiwan, Hong Kong, China,footnote3 and even the us. Arguably, such deflation can be more damaging to economic welfare than inflation, below a fairly high ceiling. It seems likely, too, that the deflationary constellation results from the same factor implicated in the trend to higher volatility and crisis: the removal of restrictions on capital mobility that began after the collapse of Bretton Woods.
Effects on developing countries
A comparison of the fourth and fifth panels in Figure 4 above shows that the frequency of financial crises in the 1973–97 period was substantially greater in newly industrializing countries than in advanced economies. (The inclusion of another 35 developing countries in the fifth panel greatly increases the frequency of crisis.) As Barry Eichengreen has argued: ‘Sharp changes in asset prices—sometimes so sharp as to threaten the stability of the financial system and the economy . . . are likely to be especially pervasive in developing countries, where the information and contracting environment is least advanced’.footnote4
Since the 1980s, private capital flows to developing countries have come to vastly exceed public flows. Whereas official financial flows to developing countries have gone from $50bn in 1986, to $88bn in 1995, and $66bn in 2000, the figures for net private flows have risen far higher: from $25bn in 1986, to $171bn in 1995, with $140bn in 2000.footnote5 At the same time, developing countries have been loaded down with foreign debt, as shown in Table 2—raising their vulnerability to currency volatility.
The degree of vulnerability depends not only on the amount of external debt, relative to foreign-exchange reserves or gdp, but also on interest rates. As interest rates rise, debt-service obligations in hard currencies also increase, regardless of ‘ability to repay’. So when a developing country’s currency depreciates and the government raises interest rates, economic agents with foreign debt are hit with a double whammy, unless and until the higher real interest rate succeeds in curbing the fall in the value of the national currency. As Figure 3 above showed, real interest rates in developing countries have been more volatile over the 1990s than those of the leading industrial countries, and much higher than in the us and Japan. High domestic interest rates not only slow down investment and growth, but also provide an incentive to borrow abroad through open capital accounts, and hence tend to generate rising levels of foreign indebtedness.
The deregulated global capital markets of the post-Bretton Woods era force currencies to compete with each other, since economic actors can easily keep their wealth in home or in foreign currencies. This introduces another source of financial vulnerability and makes macroeconomic management more difficult for developing-country governments. As Table 3 shows, there has been a significant trend in these countries towards holding wealth in foreign currencies, mainly dollars and euros.
These figures reflect the declining competitiveness of national currencies in developing countries. One reason for this decline is that, as Table 1 (above) shows, average inflation rates are still much higher in developing countries; around 6 per cent, compared to 2 per cent for the advanced countries. The risks of currency devaluation are significant. Hence domestic wealth-holders will tend to shift out of the national currency into one considered more likely to retain its value.footnote6 The result of such competition is to produce a hierarchy of currencies: those at the top fulfil both domestic and international functions; those in the middle fulfil domestic but not international functions; those at the bottom (the majority) fulfil neither function.
This last condition—the non-acceptance of the currency, and hence the ‘dollarization’ of the economy—is one that no central bank can ignore. One result of non-acceptance is to limit the effectiveness of monetary policy. A central bank that wants to expand economic activity creates domestic currency which it gives to commercial banks, who in turn lend it to customers. If, however, customers see the domestic economy as weak, and can easily choose between currencies, they tend to change much of this into foreign currency as a preferred store of value and transactions medium, even for domestic transactions. This creates downward pressure on the value of domestic currency (pressure towards devaluation). If the central bank fights depreciation by raising interest rates, this stops credit expansion and thus slows aggregate economic expansion: undermining the original goal. In other words, dollarization limits the domestic credit creation mechanism, which is basic to investment growth and economic development.
Another effect of dollarization is to magnify the impact of currency changes. When a large portion of domestic wealth and transactions are conducted in foreign currency units, devaluation inflicts amplified shocks on the domestic economy, on top of those resulting from the increased costs of servicing foreign loans. Central banks of countries with uncompetitive currencies therefore try to maintain high interest rates, in order to induce people to hold the domestic currency. High real interest rates—of 8 per cent or more—restrict economic growth, since few investment projects can earn a rate of return above the cost of borrowed money.
‘Competition between currencies’ is one cause of the slow economic growth in most developing regions and of widening world income inequality. Another is the amplified volatility of developing-country currencies in conditions of free capital movement, which forces their central banks to tie up resources in foreign-exchange reserves—thereby lowering interest rates and enhancing investment in the core economies, using funds that could have been invested domestically. The same conditions push developing-country interest rates up to a level needed to compensate foreign investors for ‘exchange-rate risk’, making it more difficult for local companies to use debt as a means of financing investment. These factors may more than counterbalance the positive effects of increased inflows of private capital made possible by financial liberalization.
Points of resistance
Leading states have responded to the rising volatility and crisis-prone nature of financial markets by trying to improve technical coordinationof the regulatory and supervisory policies of national authorities. New forums have been established for this purpose, such as the Financial Stability Forum established by G7 finance ministers in the late 1990s, or the Joint Forum on Financial Conglomerates set up by the Basel Committee on Banking Supervision in 1996. The response of the G7 and imf to the East Asian crisis of 1997 was to urge further opening of national financial systems, but now with more attention paid to ‘sound regulation’—by the borrowinggovernments. Above all, the G7 and imf urged developing countries not to be tempted to use restrictions on capital movements as a tool for economic management. ‘Regulations, yes. Restrictions, no’, was the mantra.footnote7
It could be argued that technical coordination has worked to a degree, in that there has not been a 1930s-type meltdown in the wake of the successive financial crises of the last twenty years. However, the system has only weak means to ensure compliance. And, at a more basic level, the call for ‘sound regulation’ conceals a fundamental ignorance about how to judge when a country may safely open its financial markets. Exhibit A of such ignorance is the April 1997 World Bank publication, Private Capital Flows to Developing Countries. Urging developing countries to open their capital markets, the report listed those with sufficiently robust regulatory regimes to do so:
Developing countries show considerable variation in the capital market attributes needed for financial integration. The most dynamic emerging markets, where progress has been particularly intense during the last five years, include most of high-growth Asia (Korea, Malaysia, and Thailand, with Indonesia and the Philippines not far behind) and two markets in Latin America (Chile and Mexico, with Brazil also ranking well) . . . The lagging emerging markets in the sample are in South Asia (India, Pakistan, and Sri Lanka) and China.
Just a few months later the East Asian crisis had engulfed the countries congratulated by the report, while none of the economies that it identified as ‘lagging’ were so badly affected. The latter retained substantial restrictions on capital movements.
Since the 1980s, anti-poverty activists and ngos have played a vital role in monitoring and publicizing the activities of the institutions that shape the development agenda and send public capital flows to industrializing countries, culminating in the demonstrations between 1999 and 2001 at World Bank, imf and wto summits. There has been a series of proposals to restructure these bodies in favour of developing countries. Yet the private firms who direct the vastly greater international capital flows to developing-country economies receive far less public scrutiny. Whatever the specific merits of the proposals, the debate around the Tobin tax, or currency transaction tax, constitutes a welcome opening in this regard. The recent establishment of the Continuous Linked Settlement (cls) Bank, owned by central banks and regulators, provides a way by which one or many governments can easily levy a tax on foreign exchange transactions in their currencies—whether a very low tax to raise revenue (perhaps to finance global public goods) or a higher tax to discourage capital surges in or out.footnote8
A revivified alter-globalization movement should pay far more attention to private financial organizations and their capital flows. Equally, it should push for much greater regulation of financial markets.footnote9 This would have to include explicit recognition of various sorts of capital controls as legitimate instruments of national economic management. There is little evidence to support the proposition that open capital markets generate a more stable and equitable world order; and much to suggest that they increase volatility and propensity to financial crisis. We need a new discourse for an alternative approach to capital markets to replace the current ‘ever more open’ doxa.
Comments
Post a Comment