wade capital controls part 2
Japan
Potentially, the most dramatic development of all may come from the current discussion within Japan on the subject of reintroducing capital controls. Finance Minister Miyazawa, giving a press conference in early September, was asked whether Japan was studying the option of erecting capital controls to protect against speculative attacks. In the words of the Reuters report, ‘He said it was too early to discuss that at the government level but added he had asked Toyo Gyohten, a special advisor to Prime Minister Keizo Obuchi, to study the issue’.footnote33 For the finance minister of the world’s second biggest economy to say this just before meeting us Treasury Secretary Rubin and Federal Reserve Chairman Greenspan—the two most powerful financial officials in the world—who are passionate opponents of capital controls, is quite remarkable.
At the end of the Japan-us meeting, ‘Japanese officials bristled at the mounting American pressure and suggested they were being made scapegoats for problems that are unrelated to Tokyo’s seven years of economic mismanagement. A senior Japanese official [said], “Japan has been overly criticized. My concern is that if anything happens to the us economy, everyone will point to Japan and say it is responsible”.’footnote34
Later, Japan’s vice-minister of finance for international trade, Eisuke Sakakibara, said that Japan wants the g7 countries to review policies towards capital liberalization. He admitted that the move by Malaysia to impose capital controls has been greeted with considerable sympathy in some parts of the Japanese government. Separately, the minister of international trade and industry said, ‘I believe that there are certain sound reasons for adopting capital controls’.footnote35 These comments are the public face of the Ministry of Finance’s private encouragement to both Malaysia and Hong Kong to intervene in the way that they did. If Japan itself goes on to reintroduce capital controls, this would further boost their legitimacy elsewhere.
The Chinese government has called for Japan to reintroduce some form of capital controls—to take ‘measures to limit the flow of yen out of Japan or directly intervene in currency markets’.footnote36
In short, capital curbs are an idea whose time has returned, in the minds of many Asian government officials. It is telling that a respected Thai economist, who is a contender to head the World Trade Organisation, has announced that he finds Malaysia’s capital controls ‘reasonable’ and ‘understandable’.footnote37 He presumably calculates that sentiment in Asia and in the world has moved sufficiently in favour of capital controls for his views not to cost him the position of head of the wto, a staunchly free-trade body.
New Proponents of Capital Controls in the West
Meanwhile, a number of prominent American economists are cautiously embracing the need for some forms of capital controls. The most prominent convert is Paul Krugman, professor of economics at mit. Writing in Fortune magazine in early September, he makes exchange controls the linchpin of his radical plan to ‘save Asia’. Asian governments must lower interest rates and push fiscal expansion, he argues. But without exchange controls the currency will plummet even more as hot money and domestic savings exit in response to lower interest rate differentials. Therefore, for all their costs, exchange controls must be re-imposed.footnote38 Krugman stresses that exchange controls are the least bad of a very bad set of alternatives, and that they must be seen to ‘clearly be temporary’.footnote39 Once they help engineer domestic expansion, they can be removed, for interest rates can be raised to the point where the monetary leakage stops without them.
The reaction from Wall Street has again been swift and predictable. The investment firm, clsa Global Emerging Markets, told its clients, ‘Paul Krugman has a lot to answer for. Not content with getting the analysis of the current Asian downturn completely wrong in his famous article (The Myth of Asia’s Miracle’, Foreign Affairs, November-December 1994) he has sallied forth again with a much more dangerous solution in his latest Fortune magazine musings. The reason his solution of exchange controls—not an unreasonable option for developing countries per se—is so dangerous is that he has no conception of the capacity of some of the leaders in Asia for self-delusion.’footnote40
Others have voiced support for capital curbs. Former Federal Reserve Chairman Paul Volker said that the imf’s stance was over-influenced by the us Treasury, and left many small economies dangerously exposed to turbulent capital flows. ‘The visual image of a vast sea of liquid capital strikes me as apt. The big and inevitable storms through which a great liner like the u.s.s. United States of America can safely sail will surely swamp even the sturdiest South Pacific canoe.’footnote41
Divisions in the IMF
Surprisingly, even the imf, which almost always speaks in public with a single disciplined voice, has shown signs of internal differences. Shortly after Managing Director Camdessus and First Deputy Managing Director Fischer made the passionately anti-capital controls remarks quoted above, the head of the imf’s Asia-Pacific Department, Hubert Neiss, said in Seoul that ‘Short-term capital controls may be adopted to avert the kind of regional contagion that caused a serial swoon among Asia’s economies last year’. He declined to elaborate on what the controls might entail. ‘My only prediction is that it will lead to some measures that will make it difficult for banks to run up shortterm debts to foreigners’. He also said that the imf ‘was keenly watching Malaysia’s experiment with more sweeping capital controls. This is an experiment that everybody will be carefully watching, and whether it succeeds over a short while or on an enduring basis’.footnote42 Neiss’s open-minded statement presumably reflects a calculation that the imf needs to be seen to be responsive, to some degree, to sentiment in the crisis-affected region, and not only to the wishes of the us Treasury. It is all the more remarkable given that the Fund is anxious to avoid doing or saying anything that might upset the us Congress as it deliberates whether to pay over the us share of the imf’s budget.footnote43
The European Response
In continental Europe, support for some form of capital controls is growing. French Prime Minister Lionel Jospin recently provided an umbrella justification, though without mentioning capital controls by name. ‘Capitalism is its own worst enemy’, he declared. ‘The crises we have witnessed teach us three things: capitalism remains unstable, the economy is political, and the global economy calls for regulation.’footnote44 French Finance Minister Dominique Strauss-Kahn further declared, ‘Public authority ought to set the rules of the game and clearly delimit the place of competition in the economic regulation of different sectors’. Apart from the general European sympathy for governing markets, two more specific considerations lie behind European support. Firstly, emergency capital controls can stop a currency crash, and banks which are heavily exposed in Latin America—especially southern European banks—are, like passengers on the stern of the Titanic, desperately looking for anything that floats. Indeed some us commercial and investment banks are said to be privately pushing the us Treasury to endorse exchange controls for Latin America, fearing that they simply could not survive another loss on the Russian scale. Secondly, European governments have serious concerns over the January 1999 launch of the ‘euro’, including the dependence of European banks on interest income for the bulk of their profits and the relatively weak and nationally different banking supervision and regulatory standards. Exposing such a structure to free capital flows could be disastrous.
This is the new reality. Asia, which accounts for roughly a quarter of world gdp, is moving strongly towards capital controls. Two of its biggest economies, China and India, have maintained capital controls all along and are now less likely to remove them any time soon. Several other crisis-affected countries have adopted exchange controls or tightened other kinds of financial controls, or are moving in that direction—Japan and Brazil are the most important cases to watch. In continental Europe, too, support for capital controls is growing as the Asia crisis spreads and as the euro launch date nears.
The Case for Capital Controls
Opponents of capital controls commonly cite all the possible things that can go wrong in all kinds of countries as reasons for not having them anywhere. We broadly agree that some forms of capital controls are needed in Asia. But we make an important distinction between two types of control. One is on inflows, especially of borrowing in foreign currency. The other is on outflows. By and large, controls on outflows are more difficult to make effective, especially in the midst of crises. Overor under-invoicing is a favourite technique for getting money out, because it is difficult to police. Inflows are much easier to control. There are plenty of ways by which hedge funds and portfolio investors can be discouraged. Chile’s inflow controls require investors to leave a portion of their funds with the central bank for a minimum period without interest before being able to put them to use. The sooner the funds are taken out of the country, the higher the effective tax. Malaysia’s Mahathir holds up Chile as a model, for all that he is presented in the West as ‘severing Malaysia’s ties to world markets’.
Krugman argues that Asian countries should introduce controls on outflows as a short-term emergency measure. We argue that—with the important exception of Japan—there is a stronger case for controls on inflows, of a semi-permanent kind.
Countries such as Korea and Thailand, which are racking up huge trade surpluses accompanied by foreign exchange inflows, can probably lower domestic interest rates and generate monetary expansion without appreciably weakening the currency. Most of the ‘hot’ money that went into emerging Asia over the 1990s has now left, so controls are not needed to prevent further outflows of institutional funds. Malaysia may need them, for Krugman’s reason, given that its current account surpluses are not nearly as large, and given peculiarities of its situation in relation to Singapore that have made its currency especially exposed to short-selling speculators. All of this is compounded by the fact that its planned stimulus package is very large.
Exchange controls or other forms of capital controls are nevertheless needed for two reasons. One is to avoid entrapping themselves like this in future—to protect against excessive inflows. Here we need to distinguish between three types of inflows: first, short-term capital to refinance foreign loans, until current account surpluses grow to the point where the loans can be paid back from the surpluses; second, foreign additions to domestic savings available for investment—including foreign portfolio investment; and, third, foreign investment that goes along with technology, capital equipment, and management and marketing expertise. These economies do need immediate help in refinancing their top-heavy foreign debt, and they do need technology, capital equipment and some kinds of foreign expertise. But they do not need the huge inflows that they had been receiving—that is, of the second type of short-term financial capital. They have the highest savings rates in the world, and account for over half of world savings. East Asia and the Pacific saved an average of 38 per cent of gdp in 1995, compared to South Asia’s 20 per cent, Latin America’s 19 per cent, and the high income countries’ 21 per cent.footnote45
Weaknesses of the Asian Model
As many critics of the Asian model have pointed out, these countries overinvested in some manufacturing sectors and in essentially speculative ventures in real estate, infrastructure and equities, resulting in inefficient investment, asset bubbles, credit excesses and exchange rate overvaluation—the ills that led to the current crisis. They have not been able productively to absorb even domestic savings, let alone extra foreign savings. It is ironic that most of the critics who point to excessive, crony-steered investment as the root of the crisis insist that Asia will suffer if it limits inflows of short-term financial capital.footnote46
Capital controls are needed, secondly, to make these fairly small, fairly open economies less vulnerable to the whims and stampedes of portfolio and hedge fund managers, and more generally to re-establish stable growth. This is especially the case in economies with high corporate debt-to-equity ratios. Korea is a classic example of how free capital movements in the context of high domestic and foreign debt can destabilize an economy with good ‘fundamentals’. But the Hong Kong case shows how the same thing can happen in a small, open economy with low debt, large exchange reserves, and a current account surplus, once short-selling speculators wielding vast financial resources make it the target of an attack.
Krugman’s argument does hold, however, for the case of Japan—though he does not make the distinction between Japan and the rest. Japanese nominal interest rates are below foreign rates. An aggressive monetary policy sufficient to jump-start demand requires negative real interest rates, which itself necessitates nominal rates much lower than foreign rates. At some point, the disincentive of keeping savings at home will outweigh the risks of a Wall Street crash and a dollar crash. There is now a large potential for savings exports to occur. Until as recently as April 1998, such financial exports were restricted. In April they were allowed as part of the first stage of ‘Big Bang’ financial liberalization. The financial outflows since then have contributed to yen weakness. More aggressive monetary expansion would probably cause more outflows and further yen depreciation, which could destabilize yet further other currencies in the region.
In short, Japan needs exchange controls to stop yen depreciation in response to monetary expansion. Many argue that such controls will not work. But the recently relaxed exchange controls did work, and could be made to work again. The other Asian countries need exchange controls not primarily in order to stop currency depreciation, but, rather, in order to buffer corporate sectors with high debt-to-equity ratios from external shocks, in order to encourage the resumption of the flow of massive domestic savings through banks to firms. They also require controls in order to protect against excessive capital inflows in a situation of extraordinary high domestic savings, where the inflows are likely to blow up speculative bubbles.
Weighing Up the Evidence
What is the empirical evidence on the impact of keeping or removing capital controls? On the one hand, the benefits of removing them have yet to be demonstrated in empirical research.footnote47 On the other, the risks of removing them are illustrated by the comparison between countries with convertible and nonconvertible currencies in the Asian crisis: China and India, with strict controls, have both been relatively untouched. The risks are also suggested by early twentiethcentury history. The free-market financial system in place at the beginning of the twentieth century was direcrly implicated in the financial crises and depression of the 1920s and the 1930s. The postwar Bretton Woods system of regulated currencies and closed capital accounts was a carefully designed response to those crises, and it worked. We enjoyed twenty-five years or more of economic success. As late as the beginning of the 198os only the us, Switzerland and Britain allowed the free flow of capital, and Germany followed in 1984. Economic performance has not improved since the bulk of the oecd countries removed their controls—by many measures it has deteriorated.footnote48
We conclude that, at least in Asian conditions—with very high rates of domestic savings, underdeveloped equity markets, underdeveloped institutions of financial regulation (which make unrealistic the appeal to ‘prudential regulation’ instead of capital controls), and corporate sectors with high ratios of debt-to-equity—such controls, or speed limits, need to be longer-term, not temporary.
The Push for Capital Freedom
In short, Asia is moving strongly in the direction of capital controls, and there are good theoretical reasons why it should. The region saves more than can be productively invested at plausible rates of growth. It does not need to open itself to still more short-term inflows from abroad, given the evident risks. As we have noted, support in Europe for the capital controls case is growing.
Yet it would be quite wrong to conclude that the movement to capital controls is robust. The shift on the ground in Asia has already encountered vehement opposition from the us and the uk, and from the imf. The owners and managers of western financial capital see great dangers in it and can be expected to mount tough resistance once the immediate emergency passes.
Consider the hyperbole with which Alan Greenspan, Lawrence Summers and other us officials denounce the moves in Asia. Greenspan’s testimony to the House Banking Committee is particularly striking. He normally testifies blandly and ambiguously, and about many subjects at the same time. This time, on 16 September, he talked passionately, clearly, and about one subject only: the perils of capital controls. He equated the sort of exchange controls introduced by Malaysia with ‘closing the economy to foreign investment’, which in turn amounted to depriving the economy of ‘the benefits of new technologies’, causing it to be ‘mired at a suboptimal standard of living’.footnote49 This is the voice of panic in the face of a threat to years of success in opening developing countries more completely to both trade and finance. He and other us financial officials see it as imperative to make sure that the troubles in Asia are blamed on the Asians, and that free capital markets are seen as key to world economic recovery and advance—so that the idea does not take root that international capital markets are themselves the source of speculative disequilibria and retrogression.
Indeed, until a few months ago, a campaign to establish free capital movement world-wide was in full swing. The imf, the oecd, the World Trade Organisation (wto) have all been pushing in this direction, supported by many governments, banks and financial service firms.
Structuring the IMF around Capital Freedom
Of these efforts, the one intended to be most irreversible is the revision of the imf’s constitution—its articles of agreement—in order to make open capital accounts a condition of Fund membership. The proposed revision to Article i, which describes the purposesof the Fund, says that promotion of the orderly liberalization of capital is one of the Fund’s main purposes. The revision to Article viii, which describes the jurisdictions of the Fund—and hence the matters subject to sanctions of a legal character—says that the Fund shall have the same jurisdiction over the capital account of its members as it has over the current account. This means, in effect, that the Fund shall oversee and approve any capital account restrictions. Moreover, the language requires countries to commit themselves to open the capital account.
The wto has negotiated a financial services agreement that frees up markets in financial services world-wide, agreeing to it in December 1997. The oecd has been negotiating the Multilateral Agreement on Investment (mai), that will make differences in the treatment of foreign investors and domestic investors illegal—differences that were fundamental to the nurturing of new industries in East Asia.footnote50 The mai, though often presented as being only about foreign direct investment, in fact covers much more liquid forms of investment as well.footnote51 The point is important, because many more people agree on the desirability of removing restrictions on foreign direct investment than on removing those against highly liquid capital.
The New Justification
The Fund and the other bodies have justified the Big Push by saying that capital controls foster the long-term and world-wide misallocation of capital and protect unsound financial systems from salutary crashes or other corrective mechanisms. They have provided remarkably little evidence to substantiate their argument. And they have modified it hardly at all in response to the Asian crisis. For the first several months after the crisis broke in mid 1997, Fund people were to be found lamenting that, ‘Capital account convertibility is dead’. But, soon, a counter-argument was developed: the Asia crisis shows that capital account liberalization should not be slowed down. Quite the contrary, efforts to liberalize while creating appropriate regulatory systems should be speeded up. The buzz-words are ‘sequencing’, ‘orderlycapital account liberalization’, ‘regulations, yes, restrictions, no’.footnote52 It is difficult to escape a sense of déjmvu: for just the same was said after the disasters following the opening of capital accounts in the Southern Cone in the early 1980s. ‘We must learn that opening to highly liquid forms of capital should be the last step in the sequence’, was said then. Now it is being said again.
Deputy Treasury Lawrence Summers takes the argument forward. How can countries build up a regulatory regime adequate to allow capital account opening? By bringing in foreign financial firms. ‘One of the best ways to accelerate the process of developing such a system is to open up to foreign financial service providers, and all the competition, capital and expertise which they bring with them.’footnote53 This is the entry route under imf auspices that the big Wall Street and City firms want. They will be invited to help the country build an appropriate regulatory system and thereby meet the new conditions for imf membership.
Money Politics
Behind this campaign by the Fund and the other multilateral organisations are the us and uk Treasuries. The us has a powerful national interest in establishing the free movement of capital worldwide—there is probably no more important foreign economic policy issue for the us than this. For one thing, the us savings rate is very low by international standards. To maintain its high level of consumption and investment—the overarching economic priority—the us must borrow from the rest of the world’s savings, which is much easier if world financial markets are highly integrated.
For another, Wall Street firms want to do business in the rest of the world using the rest of the world’s savings. They can exploit the great us privilege of being the issuer of the international reserve currency. This allows them to borrow cheaply from the rest of the world using Treasury bills, and recycle the savings in the form of foreign direct investment, portofolio investment, and loans, at much higher returns. The us Treasury under the Clinton administration has been unusually responsive to the interests of Wall Street, particularly since 1995—for reasons related less to Treasury Secretary Rubin’s former career on Wall Street than to the need for the Democrats to elicit the help of Wall Street in overcoming their chronic electoral campaign finance shortage. And behind the Wall Street investment firms are savers and pensioners who wish to ensure that their savings are put wherever returns are highest, who are 110 per cent behind them in bull market times and 80 per cent behind them in bear market times as long as the memories of good times linger.footnote54
More than this, the us sees free capital movements as a battering ram to force other economies to adopt free market structures not only in finance but across the board. Once an economy adopts a regime of free capital movements, it can sustain market-steering arrangements of the ‘Asian political economy’ kind only with difficulty, as the Asian crisis shows. The us national interest is to have the rest of the world play by American rules of both cross-border capital movement and domestic arrangements for finance, corporate governance, labour markets, and the like. Not only Wall Street but most of the bigger us manufacturing and service companies want this broader agenda, for which the Wall Street free capital movement agenda is the most powerful instrument.
How then did the goals of Wall Street and the City come to be translated into the top-priority goal of amending the constitution of the imf? us and uk banks and other financial enterprises have long wanted all countries to commit themselves to two simple conditions: (i) free entry and exit; (ii) national treatment—same treatment as domestic counterparts, or better. Initially, around 1994-95, the us Treasury—shorthand for us and uk Treasuries—sought to advance these goals by writing them in to the constitution of the wto as it was being formed out of the gatt. But many developing countries objected. Developing countries are powerful in the wto, compared to the imf, because of the one-country one-vote rule and the arbitration board that allows appeals against wto rulings.
The us saw that the wto route would be messy and compromising, with many conditions and qualifications. Likewise, the oecd’s Multilateral Agreement on Investment, beginning to be negotiated among the oecd countries with the intention of later ‘inviting’ developing countries to sign—or risk being by-passed by foreign investors—seemed to be too complicated.
The IMF Route
Then it occurred to the Treasury that the goals could be advanced more effectively through the imf by revising the articles of agreement. A plausible argument for revision could be made along the following lines. Trade flows dominated capital flows at the time when the Fund began. And the architects believed that capital controls were a necessary condition for the successful freeing up of trade around the world. The articles mandated the Fund to be the custodian of current account convertibility—open trade flows—and endorsed the use of capital controls. Now capital flows dominate trade flows. And capital markets are sufficiently sophisticated in the use of hedging instruments for the earlier concerns about exchange rate volatility and financial crises to be mitigated. Thus the need for an organisation to be the custodian of capital account convertibility, and for that organisation to be the Fund. The Fund’s articles need to be modernized to reflect the new realities of capital flows.
This shifts the focus away from the pros and cons of capital account convertibility and towards the advantages and disadvantages of Fund membership. A finance minister who has doubts about the wisdom of capital account convertibility is unlikely to want to signal doubts about Fund membership. Besides, redefined in this way, the revision looks to be no more than an overdue balancing of the articles, as between the current account and the capital account. Transitional arrangements are allowed, so that countries can take their time—four years, six years. Therefore, the revision does not commit members to rapid changes. Its implementation in any particular case can be tailored to specific conditions. In the words of Deputy Treasury Secretary Summers, ‘Each country must choose the approach that is tight for them [sic]. Amending the Articles is entirely consistent with this. Under the proposed approach, countries will accept the obligation to liberalize the capital account fully, but what that means precisely will be up to them to decide in cooperation with the imf. Until they are ready, they could avail themselves of transitional arrangements as approved by the Fund. They would simply have to commit not to backtrack, without imf approval.’footnote55 All this should reassure doubters.
Power to the Fund
In practice, once the new articles are approved, the Fund will acquire much more power, at least over all but the biggest developing countries. In its bilateral consultations with the country it will have the justification of the articles of agreement to push the country to liberalize its finances—as it does not now. The country has no recourse to an appeals procedure, nor can it join with other countries in negotiating with the Fund—both of which are open in the wto. The Fund’s dissatisfaction with the country’s progress in opening the capital account can be a very credible threat. When the Fund’s dissatisfaction becomes known to the owners and managers of international capital, this capital is likely to flee—or risk being sued by shareholders. Even if the information does not become public, the Fund can use its new authority to withhold bailout money in the event of difficulties. It is not hard to imagine situations where the Fund thinks the country—India or Brazil, for example—should come off transitional arrangements long before the ministry of finance does, let alone other parts of the government.
Politics of the US Congress
For the moment, the constitutional revision is proceeding quietly and in low gear at the request of the us Treasury. The Treasury’s first priority is to get the Congress to pay over the us’s $18 billion quota to the Fund. A decision must be reached before the Congress goes into recess in the run-up to the November 1998 elections for the House and the Senate. The Treasury does not want to muddy the quota waters with the prospect of the Congress being asked to ratify a change in the articles.
The Democratic Party and the Clinton administration badly need Wall Street to contribute generously to the campaign costs of their candidates in the 1998 election.footnote56 Wall Street wants capital account opening world-wide, and hence supports revision of the imf’s articles of agreement. To secure the revision, the us must lead, and the us cannot lead if Congress refuses to pay its quota. Once the Congress approves the quota payment and the 1998 election is out of the way—and once the us banks most exposed in Latin America survive the current emergency—the Treasury will begin to push the revision more aggressively. But it will now face an uphill battle in much of the rest of the world.
The oecd’s Multilateral Agreement on Investment
Meanwhile, the oecd has postponed consideration of the draft Multilateral Agreement on Investment until the end of October 1998, or in effect until after the us elections. Then we can expect to see it reactivated. Multinational firms are especially keen to see the mai ratified, for it is, to a remarkable extent, a charter for their untrammelled freedom. It is about their rights, and says little about their obligations to host countries, to civil society.footnote57 It simply assumes that what is good for multi-national corporations (mncs) is good for host countries. It says that mncs are not to receive worse treatment than domestic firms, but pointedly does not say they are not to receive better treatment—which should be equally against the logic of world efficiency. It seems strange that so much fuss is being made to negotiate a charter for the untrammelled freedom of mncs when the direction of change has been so clearly in this direction anyway. The fact that the fuss is being made shows just how thoroughgoing is the push for capital freedom coming from the West.footnote58
More Power to the Fund
The capital liberalizing agendas of the imf, the wto and the oecd are being tied together by a little noticed but important addition to the new world economic architecture. The imf is to be given—if the us Congress and the us Treasury have their way—the power of cross-conditionality with respect to agreements such as the wto’s financial service agreement and the oecd’s Multilateral Agreement on Investment. The legislation in Congress regarding the us payment of its quota to the imf—the Senate version of the imf funding legislation, approved in March 1998, as well as the House version that, as of mid September 1998, awaits approval—specifies that us funds may not be paid until the us Treasury certifies to Congress that all the g7 countries have agreed that they will require the Fund to withhold loans from countries that fail to meet certain conditions. These conditions require borrowing countries, among other things, to eliminate government-subsidized credit to ‘favoured’ businesses or institutions;footn
Potentially, the most dramatic development of all may come from the current discussion within Japan on the subject of reintroducing capital controls. Finance Minister Miyazawa, giving a press conference in early September, was asked whether Japan was studying the option of erecting capital controls to protect against speculative attacks. In the words of the Reuters report, ‘He said it was too early to discuss that at the government level but added he had asked Toyo Gyohten, a special advisor to Prime Minister Keizo Obuchi, to study the issue’.footnote33 For the finance minister of the world’s second biggest economy to say this just before meeting us Treasury Secretary Rubin and Federal Reserve Chairman Greenspan—the two most powerful financial officials in the world—who are passionate opponents of capital controls, is quite remarkable.
At the end of the Japan-us meeting, ‘Japanese officials bristled at the mounting American pressure and suggested they were being made scapegoats for problems that are unrelated to Tokyo’s seven years of economic mismanagement. A senior Japanese official [said], “Japan has been overly criticized. My concern is that if anything happens to the us economy, everyone will point to Japan and say it is responsible”.’footnote34
Later, Japan’s vice-minister of finance for international trade, Eisuke Sakakibara, said that Japan wants the g7 countries to review policies towards capital liberalization. He admitted that the move by Malaysia to impose capital controls has been greeted with considerable sympathy in some parts of the Japanese government. Separately, the minister of international trade and industry said, ‘I believe that there are certain sound reasons for adopting capital controls’.footnote35 These comments are the public face of the Ministry of Finance’s private encouragement to both Malaysia and Hong Kong to intervene in the way that they did. If Japan itself goes on to reintroduce capital controls, this would further boost their legitimacy elsewhere.
The Chinese government has called for Japan to reintroduce some form of capital controls—to take ‘measures to limit the flow of yen out of Japan or directly intervene in currency markets’.footnote36
In short, capital curbs are an idea whose time has returned, in the minds of many Asian government officials. It is telling that a respected Thai economist, who is a contender to head the World Trade Organisation, has announced that he finds Malaysia’s capital controls ‘reasonable’ and ‘understandable’.footnote37 He presumably calculates that sentiment in Asia and in the world has moved sufficiently in favour of capital controls for his views not to cost him the position of head of the wto, a staunchly free-trade body.
New Proponents of Capital Controls in the West
Meanwhile, a number of prominent American economists are cautiously embracing the need for some forms of capital controls. The most prominent convert is Paul Krugman, professor of economics at mit. Writing in Fortune magazine in early September, he makes exchange controls the linchpin of his radical plan to ‘save Asia’. Asian governments must lower interest rates and push fiscal expansion, he argues. But without exchange controls the currency will plummet even more as hot money and domestic savings exit in response to lower interest rate differentials. Therefore, for all their costs, exchange controls must be re-imposed.footnote38 Krugman stresses that exchange controls are the least bad of a very bad set of alternatives, and that they must be seen to ‘clearly be temporary’.footnote39 Once they help engineer domestic expansion, they can be removed, for interest rates can be raised to the point where the monetary leakage stops without them.
The reaction from Wall Street has again been swift and predictable. The investment firm, clsa Global Emerging Markets, told its clients, ‘Paul Krugman has a lot to answer for. Not content with getting the analysis of the current Asian downturn completely wrong in his famous article (The Myth of Asia’s Miracle’, Foreign Affairs, November-December 1994) he has sallied forth again with a much more dangerous solution in his latest Fortune magazine musings. The reason his solution of exchange controls—not an unreasonable option for developing countries per se—is so dangerous is that he has no conception of the capacity of some of the leaders in Asia for self-delusion.’footnote40
Others have voiced support for capital curbs. Former Federal Reserve Chairman Paul Volker said that the imf’s stance was over-influenced by the us Treasury, and left many small economies dangerously exposed to turbulent capital flows. ‘The visual image of a vast sea of liquid capital strikes me as apt. The big and inevitable storms through which a great liner like the u.s.s. United States of America can safely sail will surely swamp even the sturdiest South Pacific canoe.’footnote41
Divisions in the IMF
Surprisingly, even the imf, which almost always speaks in public with a single disciplined voice, has shown signs of internal differences. Shortly after Managing Director Camdessus and First Deputy Managing Director Fischer made the passionately anti-capital controls remarks quoted above, the head of the imf’s Asia-Pacific Department, Hubert Neiss, said in Seoul that ‘Short-term capital controls may be adopted to avert the kind of regional contagion that caused a serial swoon among Asia’s economies last year’. He declined to elaborate on what the controls might entail. ‘My only prediction is that it will lead to some measures that will make it difficult for banks to run up shortterm debts to foreigners’. He also said that the imf ‘was keenly watching Malaysia’s experiment with more sweeping capital controls. This is an experiment that everybody will be carefully watching, and whether it succeeds over a short while or on an enduring basis’.footnote42 Neiss’s open-minded statement presumably reflects a calculation that the imf needs to be seen to be responsive, to some degree, to sentiment in the crisis-affected region, and not only to the wishes of the us Treasury. It is all the more remarkable given that the Fund is anxious to avoid doing or saying anything that might upset the us Congress as it deliberates whether to pay over the us share of the imf’s budget.footnote43
The European Response
In continental Europe, support for some form of capital controls is growing. French Prime Minister Lionel Jospin recently provided an umbrella justification, though without mentioning capital controls by name. ‘Capitalism is its own worst enemy’, he declared. ‘The crises we have witnessed teach us three things: capitalism remains unstable, the economy is political, and the global economy calls for regulation.’footnote44 French Finance Minister Dominique Strauss-Kahn further declared, ‘Public authority ought to set the rules of the game and clearly delimit the place of competition in the economic regulation of different sectors’. Apart from the general European sympathy for governing markets, two more specific considerations lie behind European support. Firstly, emergency capital controls can stop a currency crash, and banks which are heavily exposed in Latin America—especially southern European banks—are, like passengers on the stern of the Titanic, desperately looking for anything that floats. Indeed some us commercial and investment banks are said to be privately pushing the us Treasury to endorse exchange controls for Latin America, fearing that they simply could not survive another loss on the Russian scale. Secondly, European governments have serious concerns over the January 1999 launch of the ‘euro’, including the dependence of European banks on interest income for the bulk of their profits and the relatively weak and nationally different banking supervision and regulatory standards. Exposing such a structure to free capital flows could be disastrous.
This is the new reality. Asia, which accounts for roughly a quarter of world gdp, is moving strongly towards capital controls. Two of its biggest economies, China and India, have maintained capital controls all along and are now less likely to remove them any time soon. Several other crisis-affected countries have adopted exchange controls or tightened other kinds of financial controls, or are moving in that direction—Japan and Brazil are the most important cases to watch. In continental Europe, too, support for capital controls is growing as the Asia crisis spreads and as the euro launch date nears.
The Case for Capital Controls
Opponents of capital controls commonly cite all the possible things that can go wrong in all kinds of countries as reasons for not having them anywhere. We broadly agree that some forms of capital controls are needed in Asia. But we make an important distinction between two types of control. One is on inflows, especially of borrowing in foreign currency. The other is on outflows. By and large, controls on outflows are more difficult to make effective, especially in the midst of crises. Overor under-invoicing is a favourite technique for getting money out, because it is difficult to police. Inflows are much easier to control. There are plenty of ways by which hedge funds and portfolio investors can be discouraged. Chile’s inflow controls require investors to leave a portion of their funds with the central bank for a minimum period without interest before being able to put them to use. The sooner the funds are taken out of the country, the higher the effective tax. Malaysia’s Mahathir holds up Chile as a model, for all that he is presented in the West as ‘severing Malaysia’s ties to world markets’.
Krugman argues that Asian countries should introduce controls on outflows as a short-term emergency measure. We argue that—with the important exception of Japan—there is a stronger case for controls on inflows, of a semi-permanent kind.
Countries such as Korea and Thailand, which are racking up huge trade surpluses accompanied by foreign exchange inflows, can probably lower domestic interest rates and generate monetary expansion without appreciably weakening the currency. Most of the ‘hot’ money that went into emerging Asia over the 1990s has now left, so controls are not needed to prevent further outflows of institutional funds. Malaysia may need them, for Krugman’s reason, given that its current account surpluses are not nearly as large, and given peculiarities of its situation in relation to Singapore that have made its currency especially exposed to short-selling speculators. All of this is compounded by the fact that its planned stimulus package is very large.
Exchange controls or other forms of capital controls are nevertheless needed for two reasons. One is to avoid entrapping themselves like this in future—to protect against excessive inflows. Here we need to distinguish between three types of inflows: first, short-term capital to refinance foreign loans, until current account surpluses grow to the point where the loans can be paid back from the surpluses; second, foreign additions to domestic savings available for investment—including foreign portfolio investment; and, third, foreign investment that goes along with technology, capital equipment, and management and marketing expertise. These economies do need immediate help in refinancing their top-heavy foreign debt, and they do need technology, capital equipment and some kinds of foreign expertise. But they do not need the huge inflows that they had been receiving—that is, of the second type of short-term financial capital. They have the highest savings rates in the world, and account for over half of world savings. East Asia and the Pacific saved an average of 38 per cent of gdp in 1995, compared to South Asia’s 20 per cent, Latin America’s 19 per cent, and the high income countries’ 21 per cent.footnote45
Weaknesses of the Asian Model
As many critics of the Asian model have pointed out, these countries overinvested in some manufacturing sectors and in essentially speculative ventures in real estate, infrastructure and equities, resulting in inefficient investment, asset bubbles, credit excesses and exchange rate overvaluation—the ills that led to the current crisis. They have not been able productively to absorb even domestic savings, let alone extra foreign savings. It is ironic that most of the critics who point to excessive, crony-steered investment as the root of the crisis insist that Asia will suffer if it limits inflows of short-term financial capital.footnote46
Capital controls are needed, secondly, to make these fairly small, fairly open economies less vulnerable to the whims and stampedes of portfolio and hedge fund managers, and more generally to re-establish stable growth. This is especially the case in economies with high corporate debt-to-equity ratios. Korea is a classic example of how free capital movements in the context of high domestic and foreign debt can destabilize an economy with good ‘fundamentals’. But the Hong Kong case shows how the same thing can happen in a small, open economy with low debt, large exchange reserves, and a current account surplus, once short-selling speculators wielding vast financial resources make it the target of an attack.
Krugman’s argument does hold, however, for the case of Japan—though he does not make the distinction between Japan and the rest. Japanese nominal interest rates are below foreign rates. An aggressive monetary policy sufficient to jump-start demand requires negative real interest rates, which itself necessitates nominal rates much lower than foreign rates. At some point, the disincentive of keeping savings at home will outweigh the risks of a Wall Street crash and a dollar crash. There is now a large potential for savings exports to occur. Until as recently as April 1998, such financial exports were restricted. In April they were allowed as part of the first stage of ‘Big Bang’ financial liberalization. The financial outflows since then have contributed to yen weakness. More aggressive monetary expansion would probably cause more outflows and further yen depreciation, which could destabilize yet further other currencies in the region.
In short, Japan needs exchange controls to stop yen depreciation in response to monetary expansion. Many argue that such controls will not work. But the recently relaxed exchange controls did work, and could be made to work again. The other Asian countries need exchange controls not primarily in order to stop currency depreciation, but, rather, in order to buffer corporate sectors with high debt-to-equity ratios from external shocks, in order to encourage the resumption of the flow of massive domestic savings through banks to firms. They also require controls in order to protect against excessive capital inflows in a situation of extraordinary high domestic savings, where the inflows are likely to blow up speculative bubbles.
Weighing Up the Evidence
What is the empirical evidence on the impact of keeping or removing capital controls? On the one hand, the benefits of removing them have yet to be demonstrated in empirical research.footnote47 On the other, the risks of removing them are illustrated by the comparison between countries with convertible and nonconvertible currencies in the Asian crisis: China and India, with strict controls, have both been relatively untouched. The risks are also suggested by early twentiethcentury history. The free-market financial system in place at the beginning of the twentieth century was direcrly implicated in the financial crises and depression of the 1920s and the 1930s. The postwar Bretton Woods system of regulated currencies and closed capital accounts was a carefully designed response to those crises, and it worked. We enjoyed twenty-five years or more of economic success. As late as the beginning of the 198os only the us, Switzerland and Britain allowed the free flow of capital, and Germany followed in 1984. Economic performance has not improved since the bulk of the oecd countries removed their controls—by many measures it has deteriorated.footnote48
We conclude that, at least in Asian conditions—with very high rates of domestic savings, underdeveloped equity markets, underdeveloped institutions of financial regulation (which make unrealistic the appeal to ‘prudential regulation’ instead of capital controls), and corporate sectors with high ratios of debt-to-equity—such controls, or speed limits, need to be longer-term, not temporary.
The Push for Capital Freedom
In short, Asia is moving strongly in the direction of capital controls, and there are good theoretical reasons why it should. The region saves more than can be productively invested at plausible rates of growth. It does not need to open itself to still more short-term inflows from abroad, given the evident risks. As we have noted, support in Europe for the capital controls case is growing.
Yet it would be quite wrong to conclude that the movement to capital controls is robust. The shift on the ground in Asia has already encountered vehement opposition from the us and the uk, and from the imf. The owners and managers of western financial capital see great dangers in it and can be expected to mount tough resistance once the immediate emergency passes.
Consider the hyperbole with which Alan Greenspan, Lawrence Summers and other us officials denounce the moves in Asia. Greenspan’s testimony to the House Banking Committee is particularly striking. He normally testifies blandly and ambiguously, and about many subjects at the same time. This time, on 16 September, he talked passionately, clearly, and about one subject only: the perils of capital controls. He equated the sort of exchange controls introduced by Malaysia with ‘closing the economy to foreign investment’, which in turn amounted to depriving the economy of ‘the benefits of new technologies’, causing it to be ‘mired at a suboptimal standard of living’.footnote49 This is the voice of panic in the face of a threat to years of success in opening developing countries more completely to both trade and finance. He and other us financial officials see it as imperative to make sure that the troubles in Asia are blamed on the Asians, and that free capital markets are seen as key to world economic recovery and advance—so that the idea does not take root that international capital markets are themselves the source of speculative disequilibria and retrogression.
Indeed, until a few months ago, a campaign to establish free capital movement world-wide was in full swing. The imf, the oecd, the World Trade Organisation (wto) have all been pushing in this direction, supported by many governments, banks and financial service firms.
Structuring the IMF around Capital Freedom
Of these efforts, the one intended to be most irreversible is the revision of the imf’s constitution—its articles of agreement—in order to make open capital accounts a condition of Fund membership. The proposed revision to Article i, which describes the purposesof the Fund, says that promotion of the orderly liberalization of capital is one of the Fund’s main purposes. The revision to Article viii, which describes the jurisdictions of the Fund—and hence the matters subject to sanctions of a legal character—says that the Fund shall have the same jurisdiction over the capital account of its members as it has over the current account. This means, in effect, that the Fund shall oversee and approve any capital account restrictions. Moreover, the language requires countries to commit themselves to open the capital account.
The wto has negotiated a financial services agreement that frees up markets in financial services world-wide, agreeing to it in December 1997. The oecd has been negotiating the Multilateral Agreement on Investment (mai), that will make differences in the treatment of foreign investors and domestic investors illegal—differences that were fundamental to the nurturing of new industries in East Asia.footnote50 The mai, though often presented as being only about foreign direct investment, in fact covers much more liquid forms of investment as well.footnote51 The point is important, because many more people agree on the desirability of removing restrictions on foreign direct investment than on removing those against highly liquid capital.
The New Justification
The Fund and the other bodies have justified the Big Push by saying that capital controls foster the long-term and world-wide misallocation of capital and protect unsound financial systems from salutary crashes or other corrective mechanisms. They have provided remarkably little evidence to substantiate their argument. And they have modified it hardly at all in response to the Asian crisis. For the first several months after the crisis broke in mid 1997, Fund people were to be found lamenting that, ‘Capital account convertibility is dead’. But, soon, a counter-argument was developed: the Asia crisis shows that capital account liberalization should not be slowed down. Quite the contrary, efforts to liberalize while creating appropriate regulatory systems should be speeded up. The buzz-words are ‘sequencing’, ‘orderlycapital account liberalization’, ‘regulations, yes, restrictions, no’.footnote52 It is difficult to escape a sense of déjmvu: for just the same was said after the disasters following the opening of capital accounts in the Southern Cone in the early 1980s. ‘We must learn that opening to highly liquid forms of capital should be the last step in the sequence’, was said then. Now it is being said again.
Deputy Treasury Lawrence Summers takes the argument forward. How can countries build up a regulatory regime adequate to allow capital account opening? By bringing in foreign financial firms. ‘One of the best ways to accelerate the process of developing such a system is to open up to foreign financial service providers, and all the competition, capital and expertise which they bring with them.’footnote53 This is the entry route under imf auspices that the big Wall Street and City firms want. They will be invited to help the country build an appropriate regulatory system and thereby meet the new conditions for imf membership.
Money Politics
Behind this campaign by the Fund and the other multilateral organisations are the us and uk Treasuries. The us has a powerful national interest in establishing the free movement of capital worldwide—there is probably no more important foreign economic policy issue for the us than this. For one thing, the us savings rate is very low by international standards. To maintain its high level of consumption and investment—the overarching economic priority—the us must borrow from the rest of the world’s savings, which is much easier if world financial markets are highly integrated.
For another, Wall Street firms want to do business in the rest of the world using the rest of the world’s savings. They can exploit the great us privilege of being the issuer of the international reserve currency. This allows them to borrow cheaply from the rest of the world using Treasury bills, and recycle the savings in the form of foreign direct investment, portofolio investment, and loans, at much higher returns. The us Treasury under the Clinton administration has been unusually responsive to the interests of Wall Street, particularly since 1995—for reasons related less to Treasury Secretary Rubin’s former career on Wall Street than to the need for the Democrats to elicit the help of Wall Street in overcoming their chronic electoral campaign finance shortage. And behind the Wall Street investment firms are savers and pensioners who wish to ensure that their savings are put wherever returns are highest, who are 110 per cent behind them in bull market times and 80 per cent behind them in bear market times as long as the memories of good times linger.footnote54
More than this, the us sees free capital movements as a battering ram to force other economies to adopt free market structures not only in finance but across the board. Once an economy adopts a regime of free capital movements, it can sustain market-steering arrangements of the ‘Asian political economy’ kind only with difficulty, as the Asian crisis shows. The us national interest is to have the rest of the world play by American rules of both cross-border capital movement and domestic arrangements for finance, corporate governance, labour markets, and the like. Not only Wall Street but most of the bigger us manufacturing and service companies want this broader agenda, for which the Wall Street free capital movement agenda is the most powerful instrument.
How then did the goals of Wall Street and the City come to be translated into the top-priority goal of amending the constitution of the imf? us and uk banks and other financial enterprises have long wanted all countries to commit themselves to two simple conditions: (i) free entry and exit; (ii) national treatment—same treatment as domestic counterparts, or better. Initially, around 1994-95, the us Treasury—shorthand for us and uk Treasuries—sought to advance these goals by writing them in to the constitution of the wto as it was being formed out of the gatt. But many developing countries objected. Developing countries are powerful in the wto, compared to the imf, because of the one-country one-vote rule and the arbitration board that allows appeals against wto rulings.
The us saw that the wto route would be messy and compromising, with many conditions and qualifications. Likewise, the oecd’s Multilateral Agreement on Investment, beginning to be negotiated among the oecd countries with the intention of later ‘inviting’ developing countries to sign—or risk being by-passed by foreign investors—seemed to be too complicated.
The IMF Route
Then it occurred to the Treasury that the goals could be advanced more effectively through the imf by revising the articles of agreement. A plausible argument for revision could be made along the following lines. Trade flows dominated capital flows at the time when the Fund began. And the architects believed that capital controls were a necessary condition for the successful freeing up of trade around the world. The articles mandated the Fund to be the custodian of current account convertibility—open trade flows—and endorsed the use of capital controls. Now capital flows dominate trade flows. And capital markets are sufficiently sophisticated in the use of hedging instruments for the earlier concerns about exchange rate volatility and financial crises to be mitigated. Thus the need for an organisation to be the custodian of capital account convertibility, and for that organisation to be the Fund. The Fund’s articles need to be modernized to reflect the new realities of capital flows.
This shifts the focus away from the pros and cons of capital account convertibility and towards the advantages and disadvantages of Fund membership. A finance minister who has doubts about the wisdom of capital account convertibility is unlikely to want to signal doubts about Fund membership. Besides, redefined in this way, the revision looks to be no more than an overdue balancing of the articles, as between the current account and the capital account. Transitional arrangements are allowed, so that countries can take their time—four years, six years. Therefore, the revision does not commit members to rapid changes. Its implementation in any particular case can be tailored to specific conditions. In the words of Deputy Treasury Secretary Summers, ‘Each country must choose the approach that is tight for them [sic]. Amending the Articles is entirely consistent with this. Under the proposed approach, countries will accept the obligation to liberalize the capital account fully, but what that means precisely will be up to them to decide in cooperation with the imf. Until they are ready, they could avail themselves of transitional arrangements as approved by the Fund. They would simply have to commit not to backtrack, without imf approval.’footnote55 All this should reassure doubters.
Power to the Fund
In practice, once the new articles are approved, the Fund will acquire much more power, at least over all but the biggest developing countries. In its bilateral consultations with the country it will have the justification of the articles of agreement to push the country to liberalize its finances—as it does not now. The country has no recourse to an appeals procedure, nor can it join with other countries in negotiating with the Fund—both of which are open in the wto. The Fund’s dissatisfaction with the country’s progress in opening the capital account can be a very credible threat. When the Fund’s dissatisfaction becomes known to the owners and managers of international capital, this capital is likely to flee—or risk being sued by shareholders. Even if the information does not become public, the Fund can use its new authority to withhold bailout money in the event of difficulties. It is not hard to imagine situations where the Fund thinks the country—India or Brazil, for example—should come off transitional arrangements long before the ministry of finance does, let alone other parts of the government.
Politics of the US Congress
For the moment, the constitutional revision is proceeding quietly and in low gear at the request of the us Treasury. The Treasury’s first priority is to get the Congress to pay over the us’s $18 billion quota to the Fund. A decision must be reached before the Congress goes into recess in the run-up to the November 1998 elections for the House and the Senate. The Treasury does not want to muddy the quota waters with the prospect of the Congress being asked to ratify a change in the articles.
The Democratic Party and the Clinton administration badly need Wall Street to contribute generously to the campaign costs of their candidates in the 1998 election.footnote56 Wall Street wants capital account opening world-wide, and hence supports revision of the imf’s articles of agreement. To secure the revision, the us must lead, and the us cannot lead if Congress refuses to pay its quota. Once the Congress approves the quota payment and the 1998 election is out of the way—and once the us banks most exposed in Latin America survive the current emergency—the Treasury will begin to push the revision more aggressively. But it will now face an uphill battle in much of the rest of the world.
The oecd’s Multilateral Agreement on Investment
Meanwhile, the oecd has postponed consideration of the draft Multilateral Agreement on Investment until the end of October 1998, or in effect until after the us elections. Then we can expect to see it reactivated. Multinational firms are especially keen to see the mai ratified, for it is, to a remarkable extent, a charter for their untrammelled freedom. It is about their rights, and says little about their obligations to host countries, to civil society.footnote57 It simply assumes that what is good for multi-national corporations (mncs) is good for host countries. It says that mncs are not to receive worse treatment than domestic firms, but pointedly does not say they are not to receive better treatment—which should be equally against the logic of world efficiency. It seems strange that so much fuss is being made to negotiate a charter for the untrammelled freedom of mncs when the direction of change has been so clearly in this direction anyway. The fact that the fuss is being made shows just how thoroughgoing is the push for capital freedom coming from the West.footnote58
More Power to the Fund
The capital liberalizing agendas of the imf, the wto and the oecd are being tied together by a little noticed but important addition to the new world economic architecture. The imf is to be given—if the us Congress and the us Treasury have their way—the power of cross-conditionality with respect to agreements such as the wto’s financial service agreement and the oecd’s Multilateral Agreement on Investment. The legislation in Congress regarding the us payment of its quota to the imf—the Senate version of the imf funding legislation, approved in March 1998, as well as the House version that, as of mid September 1998, awaits approval—specifies that us funds may not be paid until the us Treasury certifies to Congress that all the g7 countries have agreed that they will require the Fund to withhold loans from countries that fail to meet certain conditions. These conditions require borrowing countries, among other things, to eliminate government-subsidized credit to ‘favoured’ businesses or institutions;footn
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