In looking to imagine and crystallise potential alternatives to the seemingly unending vortex of underdevelopment and poverty in third and second world nations, an understanding of the deficiencies and insufficiencies of the current macroeconomic arrangement is an obvious starting point. The post-Bretton Woods monetary consensus, which promised to guarantee mutual ‘real growth’ through endless liberalization of domestic markets and fluctuating exchange rates, has in whole been failure for developing countries. Instead, of self-sufficiency and self-confidence, there isn’t even what one one called ‘multi-lateral beneficence’, but rather, a reliance and dependency on the most powerful players in the game, at the mercy of commodities swings and speculative exuberance (rather than being ’liberated’ and domestically sound, buffered from ‘shocks’). One wonders what one would do if they swapped shoes. What shall we do once we take control of these responsibilities?

The following is an excerpt of an academic work by Economist José Antonio Ocampo, an open-access work which can be freely accessed here.

Effects of Capital Account Liberalization

Boom-Bust Cycles and Associated Market Failures

Advocates of capital market liberalization believed that, by overcoming the negative effects of ‘financial repression’, it would increase economic efficiency, reduce risk, strengthen macroeconomic discipline, and promote institutional development. Opening up the capital account would, according to this view, improve the allocation of savings and, therefore, growth. It would also enhance stability by allowing countries to tap into diversified sources of funds to finance consumption and investment. It would also have ‘collateral benefits’, which include financial market and institutional development, better governance, and macroeconomic discipline.

The basic problem with this view is that it is predicated on well-functioning capital markets (e.g. limited information imperfections and perfect forecasting of future events) and inter-temporal smoothing, characteristics that are generally absent in financial markets (Stiglitz 2008). Critics of capital market liberalization (CML)—and financial liberalization in general—have, therefore pointed out that it could result in severe financial crises with high development costs. According to this alternative view, the pro-cyclical nature of capital flows and the volatility associated with open capital accounts may lead to more rather than less macroeconomic volatility, and particularly to stronger business cycles—real macroeconomic instability, in the terminology that I shall use here. The uncertainties associated with volatile financing may, in turn, reduce investment and long-term economic growth. Similarly, the discipline imposed by open capital accounts on macroeconomic authorities is not necessarily a positive force for long-term sustainable growth, as it may reduce the space for counter-cyclical macroeconomic policies.

Although the evidence that CML was not associated with faster economic growth or higher levels of investment had important precedents (see, for example, Rodrik 1998), the intellectual battle over the effects of CML was for the most part settled by a major IMF study, published in 2003 (Prasad et al. 2003). This study showed that there is overwhelming empirical evidence that CML increases real macroeconomic instability in developing countries, and to a lesser extent in developed countries. This was also the major conclusion of the Commission on Financial Stability convened by the Bank for International Settlements after the outbreak of the North Atlantic financial crisis and chaired by Rakesh Mohan (BIS 2009). Pro-cyclical capital flows have indeed been at the heart of many of the crises in the emerging and developing world since the 1980s. Even when capital flows were not the direct cause of the crises, they played a central role in their propagation. The crises in the European periphery after the outbreak of the North Atlantic financial crisis show that these problems are also present in (at least some) developed countries.

Equally strong evidence comes from later studies which show that countries that have grown more are those which have relied less, not more, on capital flows for growth, and have therefore run stronger current account balances (Prasad, Rajan, and Subramanian 2007, and Gourinchas and Jeanne 2007). In a more recent exercise, Jeanne, Subramanian, and Williamson (2012: ch. 3) performed a ‘meta-regression’ analysis using six measures of financial globalization (three de jure and three de facto measures) for the period 1970–2007 and several sub-periods within that time span, and found very limited evidence of a link between financial liberalization and growth, except partly for developed countries and for portfolio equity flows.

The evidence of the strong pro-cyclicality of cross-border flows and the equally strong effect they exercise, particularly on the dynamics of emerging and developing countries, indicates that there may be macroeconomic failures, which together with imperfections inherent in the functioning of capital markets imply that financial markets are essentially volatile. Imperfections in capital are associated with externalities and coordination failures, which are reflected in the contagion of both optimism and pessimism. In addition, risk (or insurance) markets are imperfect even in developed countries, but such markets are particularly weak, or absent, in most emerging and developing countries.

Boom–bust cycles in financial markets are, therefore, characterized by the twin phenomena of volatility and contagion. The essential reason for volatility is, as emphasized by Keynes, the uncertainty generated by the absence of information about the future, and the need of market players to base their decisions on expectations about the future performance of the economy and capital markets. This means that, in contrast to the orthodox view that rational speculation helps to stabilize markets, financial markets during booms tend to generate the phenomenon that has been called since the late 1990s ‘irrational exuberance’7 followed by the opposite phenomenon, which can be termed ‘unwarranted gloom’. They tend to generate successive phases of ‘appetite for risk’ (which is generally underestimation of risks) followed by ‘flight to quality’ (risk aversion), to use the terminology of financial markets. Bubbles even appear and burst in developed countries with well-functioning markets and the best available standards of prudential regulation and supervision. This is consistent with Minsky’s (1982) view that financial markets follow an unstable endogenous dynamic, as they generate excessive risk-taking by market agents during booms—indeed, this risk-taking increases the longer the boom lasts—that eventually lead to crises. A similar explanation has been suggested by White (2005), who underscored how the ‘search for yield’ characteristic of low interest rate environments generates incentives for credit creation, carry trade, and leverage that easily build up asset bubbles. In developing countries with thin or small markets, there exists a short-term bias in financial markets (as discussed in Section 4.3.2), bubbles are easier to create, and their effects can be devastating.

Volatility is reflected, as we have seen, in the pro-cyclical pattern of spreads and country risk premiums (which narrow during booms, and widen during crises), but also in variations in the availability of financing (the presence or absence of credit rationing) and in maturities (the reduced availability of long-term financing during crises, or the use of options that have a similar effect). The feedback between increases in spreads, debt accumulation, and short-term macroeconomic expectations during crises can be highly destabilizing, particularly in the presence of high debt ratios. Different types of capital flow are subject to different volatility patterns. In particular, the higher volatility of short-term capital indicates that reliance on such financing is highly risky (Rodrik and Velasco 2000), whereas the lower volatility of foreign direct investment (FDI) vis-à-vis all forms of financial flow is considered a source of strength. Nonetheless, as already indicated, FDI has also become more volatile, largely because it has become increasingly financialized.

Capital account cycles involve short-term movements, such as the very intense movements of spreads and the interruption of financing (rationing), as was observed with emerging economies after the 1998 Russian crisis and on a worldwide scale at the peak of the North Atlantic financial crisis. More importantly, however, in the case of emerging and developing countries, they also involve medium-term cycles, as the experience of these countries over the past four decades indicates.

The increasing use of derivative products is an additional source of volatility. Although the accelerated growth of derivative markets has helped to reduce ‘micro-instability’, by creating new hedging techniques that allow individual agents to cover their microeconomic risks, it might have increased ‘macro-instability’. In the words of Dodd (2008), if short-term capital flows can become ‘hot’ money, under critical conditions derivatives can turn into ‘microwave’ money, speeding up market responses to sudden changes in opinion and expectations. Derivatives have also reduced transparency by allowing large off-balance-sheet positions that are difficult to regulate.

The expectations that drive financial agents’ decisions are based on information about current conditions, which is in turn inherently incomplete and costly to process. This makes it rational for every agent to base her/his decisions on the opinions and actions of others, generating the twin phenomena of contagion and associated herding behaviour. Herding behaviour takes place even in ‘normal’ times but can be particularly devastating in periods of high uncertainty when ‘information’ becomes unreliable and expectations become highly volatile. Indeed, when views converge, the information that underlies crises may be factually imprecise or incorrect, but it may still prevail in the functioning of the market, engendering ‘self-fulfilling prophecies’. The worst is the case of ‘correlated mistakes’: unexpected news is reported that contradicts the general opinion, and all market players realize simultaneously that they were wrong and pull their funds out of certain asset classes, triggering panics.

There are many market patterns and practices that exacerbate this problem. Major market players—investment banks, credit rating agencies, international financial institutions—use the same sources of information and tend to reinforce each other’s interpretations of events. Since these market players have better access to relevant information and are better able to process it than others, others are likely to follow their lead, reinforcing herd behaviour. The pro-cyclical patterns of credit ratings and the effect they have on the behaviour of other agents have a similar effect. Furthermore, market-sensitive risk management practices, as well as other features of financial market operations (such as benchmarking indices and evaluation of managers against competitors) also tend to reinforce herding behaviour (Persaud 2000). The tendency of countries (as well as firms) to find themselves clustered in certain risk categories, a standard operating procedure in financial markets, has a similar effect.

Many of these practices tend to reinforce the short-term bias of financial agents. Others may have similar effects, such as the practice of requiring firms, even in advanced financial markets, to announce short-term profit forecasts — which are inherently uncertain. The fact that bank regulations require less capital for short-term debt to satisfy capital adequacy standards tends to reinforce this market pattern.

Contagion of opinions and expectations is only one of several explanations for the spread of crises from one country to another. The financial linkages that characterize a globalized financial world can spread problems from one area to another. Financial agents that incur losses in some markets are often forced to sell their assets in other markets to recover liquidity (or pay off their short-term obligations, including margin calls). Similarly, in periods of euphoria, access to finance in one part of the world economy can facilitate investments in others, and gains in one country can lead to investments elsewhere, often involving greater risk. Trade linkages can also play an important role in this regard, as can the correlation in the movements of different commodity prices—which may have been exacerbated by the ‘financialization’ of commodity markets—and their effects on commodity-dependent economies.

Contagion is an externality, and thus a market failure. An interrelated set of market failures involves creditor or investor coordination problems, which is particularly relevant during periods of capital flight. Investors are more likely to remain in a country as long as other investors also do so. But if some investors start to believe that the country will face a crisis and begin to move their money, it will be in the interest of others to do the same. This may lead to a rush to pull out their funds, causing the markets to collapse, and leading to domestic responses in recipient countries—exchange rate overshooting, stock market collapses, rising interest rates to stop capital flight, and recession — that further feed into the run. Since the markets usually rebound afterwards, investors would be better off collectively if they had left their funds in the country.

Real macroeconomic instability has adverse effects on growth. The higher risks associated with such instability increase the return required by investors, reducing long-term investment. Crises are often followed by an extended period of slow economic growth. Indeed, strong crises generally shift the growth trajectory, placing countries onto a lower GDP growth path when they start to recover. This is the story of Latin America after the debt crisis of he 1980s, of Indonesia and some other East Asian economies after the Asian crisis, and of the European periphery after the North Atlantic crisis. In turn, crises are characterized by an enormous destruction of organizational and informational capital, as firms and financial institutions are forced into bankruptcy.

The economic effects of CML also have social implications, because new opportunities accrue disproportionately to the rich, whereas the adverse effects of volatility may disproportionately impact the poor. There is, indeed, an empirical relationship between capital account openness and income inequality, which is associated with the fact that inequality frequently increases after capital account liberalization.8 There may be multiple reasons for this result: the poor are most vulnerable to macroeconomic volatility because they have the least ability to cope with risk; the increasing mobility of capital weakens the bargaining position of labour; and international financial integration may constrain governments’ redistributive policies. The supporters of CML generally recognize that liberalization requires sufficiently strong and stable financial institutions, which means, in turn, that a strong regulatory framework needs to be in place before liberalization takes place. It is generally recognized in the literature that this warning was not taken into account in the case of many emerging and developing countries, which generally liberalized their capital accounts without strong regulatory frameworks in place. But even economically advanced countries have found it difficult to establish sufficiently effective regulatory structures to avoid crises.

This is reflected in the financial crises experienced by Japan and Scandinavia in the last decade of the twentieth century, or of the US and several Western European countries during the North Atlantic financial crisis. In many cases this shows the strong power of financial interests, which are able to avoid strengthening regulation, particularly during periods of euphoria, when even regulators tend to underestimate risks. Furthermore, authorities tend to lag behind financial innovations, many of which are actually designed to circumvent or avoid regulation. The regulatory lag in the face of the growth of derivative markets in recent decades is a clear demonstration of this fact.

Particular Issues for Emerging and Developing Countries

There is a fairly general recognition that the problems analysed above are more powerful in the case of emerging and developing countries, and therefore that CML has generated risks and has made it more difficult for developing countries to achieve real macroeconomic stability (see, for example, Schmukler 2008). There is a relatively broad recognition that it has also failed to help these countries achieve faster rates of economic growth.

One of the basic reasons why CML has a particularly strong negative effect on emerging and developing countries is that their financial markets are thinner. In particular, they are characterized by a strong prevalence of short- term financial assets and liabilities, which generates variable mixes of maturity and currency mismatches in portfolios. This means that, during crises, creditors might not allow borrowers to roll over short-term loans, thus generating a liquidity crunch; but if the loans are rolled over, borrowers are subject, in any case, to the risks associated with interest rate fluctuations. To overcome the short-term bias of domestic financial markets, firms that have access to foreign credit (generally larger firms) often borrow abroad for their longer-term needs; but if they lack revenues in foreign currencies, they incur currency mismatches. When domestic financial institutions use foreign funds to finance domestic currency loans, they incur a currency mismatch that increases the risk of a meltdown if the currency depreciates; if they lend those funds domestically in foreign currencies to avoid currency mismatches in their portfolios, they merely transfer the associated risk to those firms that lack foreign-exchange revenues.

These mismatches would cause less concern if there were an adequate development of futures markets where firms could cover their risks. However, those markets, when available, tend to have relatively short-term coverage and a strong pro-cyclical performance, and become even shorter-term or even entirely shut down during crises. All of this implies that the fact that developing countries’ agents bear the brunt of exchange rate and interest rate risk, even when the source of the capital account fluctuations is external in origin, is a fundamental market failure of international capital markets.

Furthermore, when capital accounts are liberalized, the scope for counter- cyclical monetary policy is restricted. In particular, if, to avoid the ‘trilemma’ of open economies, authorities opt for more exchange rate flexibility, they face a difficult trade-off between monetary autonomy and exchange rate stability. During booms, authorities can adopt counter-cyclical monetary policies, but only at the cost of a stronger exchange rate appreciation, which may lead to unsustainable current account deficits and rising risks of a balance-of- payments crisis; it may also lead to deterioration in the competitiveness of tradable sectors that may have adverse effects on long-term growth. During crises, authorities may be forced to increase interest rates to avoid capital flight. If they avoid this and instead reduce interest rates, exchange rates may over-shoot, leading to a rise in domestic inflation and increasing debt burdens for firms indebted in external markets, some of which may be forced into bankruptcy. Avoiding exchange rate overvaluation during booms is therefore critical to escape a destabilizing trajectory of external debts associated with sharp exchange rate depreciations during crises.

Governments may also be expected by external financial agents to behave in ways that generate ‘credibility’ during crises, which means that they are judged according to their capacity to adopt pro-cyclical austerity policies. But such policies generate economic and political economy pressures to also adopt equally pro-cyclical policies during booms: private agents will then resist the restrictions that authorities may impose on their ability to spend, and governments may be only too happy to have some breathing space after a period of austerity. Therefore, although counter-cyclical fiscal policy can potentially be used to help moderate booms, it faces severe pressures to do so; as is widely recognized, it is also not as flexible an instrument as monetary or exchange rate policies. This helps explain why there is widespread evidence that fiscal accounts are highly pro-cyclical in the developing world (Kaminsky, Reinhart, and Végh 2004). Therefore, in contrast with the notion that financial markets should have a disciplining effect, unstable external financing distorts, to a great extent, the incentives that all domestic agents face throughout the business cycle, inducing pro-cyclical behaviour from both private agents and macroeconomic authorities.

There are ways to avoid these trade-offs, the most important of which is the accumulation of foreign exchange reserves during booms which can be used to increase the policy space that authorities have during crises. Countercyclical foreign exchange reserve management has indeed been a widespread practice in recent decades. However, such ‘self-insurance’ is costly: from a country perspective, it involves accumulating an asset that has low yields (foreign exchange reserves) to compensate for the entry of private capital inflows which have higher yields/costs; if reserve accumulation is sterilized, central banks will also incur losses associated with the difference between interest receipts from the investment of reserves and the costs of the domestic instruments used for sterilization purposes.

Other ways to manage the associated risks may merely shift those risks, rather than correct them. For example, the risks faced by the domestic financial sector can be counterbalanced by prudential regulation of domestic financial activities that is stricter than international (Basel) standards, but this raises the cost of financial intermediation and may restrict the development of new financial services. The move to a ‘hard peg’—a currency board regime or dollar/ euro-ization—to eliminate currency risks reduces even further or may altogether eliminate the space for counter-cyclical policies. There is, therefore, a very profound sense in which the financial and macroeconomic constraints faced by emerging and developing countries that have opened up their capital accounts are inescapable. Furthermore, the pro-cyclical fiscal policies induced by CML have long-term costs. Cuts in social sector spending generate losses—e.g. forgone nutrition, education, or healthcare—that may never be reversed for those who did not have access to the associated government programmes and services during crises; government services may themselves lose human and organizational capital, which generates long-term losses in terms of efficiency and effectiveness. In turn, stop-and-go public-sector investment policies might leave some projects (e.g. roads) unfinished, at least for several years, increasing the cost and reducing the productivity of public-sector investment (Ocampo 2003b).

References

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