Friday 10 Jul 1998
The dangers of financial liberalisation
by Martin Khor, Director, Third World Network
East Asian countries have endured the consequences of rapidly liberalisaing their financial systems. In recent years, foreign funds and banks have been free to invest or lend to the countries, and just as free to withdraw their funds when the wind changed. In 1996, a total of US$96 billion of private capital entered the region but in the second half of 1997, $102 billion flew out, sparking the financial crisis that has now led to recession.
The on-going financial crisis is now focusing attention on the instability and damage caused by global financial liberalisation. In recent years, due to deregulation, many countries have lifted most of their previous controls on the inflow and outflow of funds.
Foreign institutions and individuals are allowed to bring in money either as loans to local institutions or as investment in the stock market. Local companies and banks are allowed to lend from abroad. In reverse, it is also much easier to send funds out of the country. Foreigners are allowed to remit money to abroad, and local people can open bank accounts overseas and send their money out of the country.
Until a few years ago, such capital flows had been restricted in most countries. There were laws forbidding or limiting the inflow of foreign money (either as loans or investments) as well as prohibition or restrictions on funds moving out.
At the least, the permission of the Central Bank would have to be obtained, and this would be granted only on certain conditions and up to a certain amount.
The lifting of these restrictions is what economists call "capital account liberalisation." This refers to the capital account in the balance of payments, which involves the inflows and outflows of funds into a country that is not accounted for by trade and services (these two are recorded in the "current account").
Most countries used to allow for foreign exchange to be converted to local currency (and vice versa) for purposes of paying for (or receiving revenue from) trade and services, but not for non-trade related autonomous flows of short-term capital.
In such cases, it is said that a country allows for "current account convertibility" but not for "capital account convertibility."
Some countries still have this cautious policy as they fear the potentially destabilising effect of short-term capital flows. For example, China and India do not have significant capital account convertibility. Because of this, their currencies are not subjected to much speculation and have been relatively sheltered from the East Asian financial crisis.
But under the advice of Western countries and international financial agencies such as the IMF, many developing countries have liberalised their capital account in the past few years.
The theory was that such liberalisation would bring in foreign funds that can speed up a country's growth. From a global perspective, there would be also be "a more efficient allocation of financial resources", as funds move across borders to seek the highest returns.
In reality, the move towards financial liberalisation has been prompted by the private financial institutions (such as investment and commercial banks, mutual funds, hedge funds).
They have campaigned for the removal of national barriers so that they can shift their huge funds from country to country to obtain the maximum profits from speculating or investing in currencies and shares and to earn higher returns for providing loans.
With the expansion of computer technology, financial markets are increasingly wired globally, and funds can shift with the blink of an eye and the touch of a computer button.
At present, the equivalent of two trillion American dollars (that is, US$2,000 billion) is shifted across borders EVERY DAY. Almost all of this (98 percent) is not related to trade or direct long- term investment, but comprises short-term capital funds.
A large part of it is moved for short periods to take advantage of differences between different countries in interest rates, or changes in currency exchange rates. Even a lot of the funds invested in stock markets are short-term in that the shares are bought and then sold for speculative gains (or to prevent losses).
With deregulation in developing countries and the advance of computer technology, the giant financial institutions of rich countries have moved aggressively into "emerging markets" in recent years, in search of higher capital gains and profits.
Due to the excessive hype about the "East Asian Miracle" (the title of a famous World Bank study), the funds and the banks poured investment capital and loans to the East Asian countries.
But even more rapid than the change in fashion, the feelings of investors about prospects can shift suddenly. The devaluation of the baht triggered a massive run of capital out of Asia.
According to data from the Bank of International Settlements, a total of US$184 billion entered Asian developing countries as net private capital flows in 1994-1996. In 1996, US$94 billion came in and even as late as the first half of 1997, US$70 billion poured in.
With the financial crisis starting in June, a total of US$102 billion flew out in the second half of 1997. The haemmhorage has continued since then.
These figures show how volatile international capital flows can be. And the volatility is of far greater magnitude for developing countries.
This is because the investment funds place only a small fraction of their total resources in emerging markets. But for a developing country that has opened its doors, foreign investment could be a very significant portion of the value of the stock market and foreign loans could be a large part of financial resources in the economy.
Thus what to the international funds is a small shift in the composition of their portfolio is a massive movement of funds for a developing country.
Moreover, a stampede of foreign capital moving out of a country can also generate a loss of confidence by local people who see the prices of their shares and the level of their currency depreciating. This may thus cause more capital flight, this time by local people.
The result can be a devastating collapse of the financial economy (with corporate loan defaults and bankruptcies and a weakening of the banks), translated soon into a deep recession in the real economy of production.
There has been two types of intellectual responses to this scenario, which has been so frighteningly played out in the East Asian crisis.
The first response is that of the Western governments and the IMF (which is after all under their control). They argue that there is nothing wrong with capital account liberalisation, which should proceed around the world.
Instead, the balme is put on the weak corporate governance and the poor banking practices of developing countries. The solution then is to strengthen the corporate and banking systems and proceed with further liberalisation.
The second response is that of increasing numbers of economists. They put the blame on the financial liberalisation process itself which has allowed the fund managers to have free rein in the global market, wreaking havoc in country after country as their funds flow in and out, currencies topple and economies are destabilised.
They are putting forward suggestions such as the need to discourage developing countries from liberalising unless their financial systems are already sophisticated and strong enough, the need to impose a tax on cross-border financial transactions to discourage speculation, and the need for developing countries to impose controls (or at least to have the option to have controls) over capital inflow and outflow.
This policy debate is a crucial one as it may help determine whether developing countries make the right or wrong choices that will affect their future economic prospects.