Liberal Capital Flows :

How far are the arguments favouring the free movement of capital tenable from both empirical evidence and fi rst principles?

COMMENTARY

Liberal Capital Flows Impacts, Issues and Questions	this in the name of free trade, leading to the notorious Opium Wars. Such examples apart, I accept that, in general, free trade in goods and services
	is beneﬁcial to the buyer and the seller.
	But is this equally true in respect of
A V Rajwade	cross-border movement of capital? Or is

How far are the arguments favouring the free movement of capital tenable from both empirical evidence and ﬁ rst principles?

A V Rajwade (avrajwade@gmail.com) has been a long-standing commentator on the external sector and ﬁ nancial services.

n an earlier article (EPW, 14 January 2012), while arguing for a managed exchange rate, I had written “If the cost of such intervention and sterilisation becomes unaffordable, the correct solution would be to impose controls on capital movement, rather than giving up management of the exchange rate”. Both the arguments are diametrically opposite to what the International Monetary Fund (IMF) advocates.

For example, the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions, September 2011, contends that

The economic beneﬁts of cross-border capital ﬂows are considered to be similar to those emanating from free trade. Capital ﬂows can supplement domestic resources with foreign capital to smooth consumption, boost investment, diversify risk, and deepen ﬁnancial markets in emerging and developing countries (see Dell’Ariccia and others, 2008). The beneﬁts of capital mobility are reduced when recipient countries attempt to control inﬂows through the use of measures that lead to suboptimal resource allocation and introduce distortion.

How far are the arguments favouring the free movement of capital tenable from both empirical evidence and ﬁ rst principles? Or are they as self-serving as a few earlier instances of British imperialists using the free trade argument for selﬁsh interests? Let me quote two speciﬁ c instances:

In 1845, when the potato blight hit Ireland, the land was apparently producing enough food for the population there – but the British Empire insisted on continuing to seize and ship it to England. As one contemporary observer wrote, ‘Insane mothers began to eat their young children who died of famine before them; and still ﬂeets of ships were sailing with every tide, carrying Irish cattle and corn to England’, in the interests of free trade (Review by Johann Hari, Three Famines: Starvation and Politics by Thomas Keneally, New York Times Book Review, 16 September 2011). At one time, China was forced by the British Empire to import drugs from India, justifying

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it, as Jagdish Bhagwati once described, a conspiracy by Wall Street supported by the US Treasury, and propagated by the IMF? More recently, Khairy Tourk of the Stewart School of Business, Chicago, in a letter to the Financial Times (10 March), wrote about the crisis in east Asia that

The 1997 crisis, on the other hand, was a result of an International Monetary Fund policy that reﬂected Wall Street interests. The US Treasury, in the 1980s, prodded the IMF to push for the immediate liberalisation of the capital account in emerging economies. Such advice ran against the grain of the literature on the sequencing of economic reform.

After the 1997-98 crisis in east Asia the IMF advocacy has been somewhat muted. But the bias keeps coming up.

Let me turn to some of the arguments advanced in the February 2010 IMF Research Department paper “Capital Flows: The Role of Controls”. The paper starts with asserting that “These ﬂ ows, and capital mobility more generally, allow countries with limited savings to attract ﬁnancing for productive investment projects, foster the diversiﬁ cation of investment risk, promote intertemporal trade, and contribute to the development of ﬁnancial markets”. True, capital inﬂ ows can ﬁnance the savings: investment gap, i e, the deﬁcit on current account. The second gain is “diversiﬁcation of investment risk”; but surely this is a gain for the investor, and not to the recipient of inﬂ ows?

Financial Markets

What about the development of ﬁ nancial markets? The east Asian crisis was often attributed by analysts to the fact that the relatively less developed ﬁ nancial markets could not absorb the ﬂows for the beneﬁ t of their economies. This argument is, to say the least, very weak. No ﬁ nancial market, howsoever developed, can absorb ever larger capital inﬂ ows without creating ﬁnancial instability. As Carmen Reinhart and Kenneth Rogoff argue in their book This Time Is Different, “The US

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conceit that its ﬁnancial and regulatory system could withstand massive capital inﬂows on a sustained basis...arguably laid the foundations for the global ﬁnancial crisis of the 2000s.” The point was conceded by Ben Bernanke, chairman of the US Federal Reserve himself (Financial Times, 20 October 2009) saying that the recent US-centred ﬁ nancial crisis had many similarities with past emerging market crises – fuelled by giant capital inﬂows that overwhelmed both market discipline and regulatory safeguards. And yet, Bernanke in his February 2011 speech “Global Imbalances: Links to Economic and Financial Stability” argued that, in the Asian crisis, “capital ﬂows posed a problem because of weaknesses in the ﬁnancial systems and regulatory oversight in countries receiving foreign capital”.

But to come back to the IMF’s February 2010 paper, “inter-temporal trade” means “importing goods today (running a current account deﬁcit) and, in return, exporting goods in the future (running a current account surplus then)” – (“Do Current Account Deﬁcits Matter?”, Atish Ghosh and Uma Ramakrishnan, Finance and Development, December 2006). This once again means that capital inﬂ ows ﬁ nance deﬁcits on the current account. It is good to see even the IMF conceding, if only by implication, that no country can keep on incurring deﬁcits on the current account year after year (unless, of course, your currency is the world’s principal reserve currency) But the problem is that the inﬂows in the ﬁrst period may well appreciate the currency so that the surplus in the following year keeps receding. As the 2010 paper itself concedes, while “currency appreciation is likely to be temporary,...damage to the tradable sector (through hysteresis) [lagged effects in English] may be more permanent”.

Given this, one does not know what to make of the following argument in the paper: “if the increase in ﬂows is expected to be more persistent, by contrast, the economy should adjust to the (permanently) higher real exchange rate”.

The IMF’s Global Financial Stability Report, April 2010, articulates the same point slightly differently saying that “more permanent increases in inﬂ ows tend to stem from more fundamental factors, and will require more fundamental economic adjustment”. So the suggestion seems to be that some kinds of capital controls are tolerable if inﬂ ows are transitory, but not if they are of a more permanent nature.

The ﬁrst objection to this line of thinking is that one cannot foresee whether inﬂows are transitory or permanent. Even the 2010 paper concedes that

policymakers are again reconsidering the view that… that all ﬁ nancial ﬂows are the result of rational investing/borrowing/lending decisions. Concerns that foreign investors may be subject to herd behaviour, and suffer from excessive optimism, have grown stronger; and even when ﬂows are fundamentally sound, it is recognised that they may contribute to collateral damage, including bubbles and asset booms and busts.

The fact is that too much of investment activity in the domestic or crossborder markets is driven not by a rational analysis of the risks and rewards, but by trying to anticipate “what average opinion expects the average opinion to be” as Keynes said – in other words, the herd instinct. It would be naive to have too much faith in the efﬁciency of the markets, in the rational expectations of the investors!

Fundamental Adjustments?

But this apart what exactly are the “more fundamental” economic adjustments “to the (permanently) higher real exchange rate” the wise men are referring to? One could be productivity growth in the tradables sector to make the economy competitive at the higher exchange rate. But this surely is a slow, gradual process: the exchange rate can appreciate much faster and do permanent damage to the tradables sector as the paper acknowledges, well before productivity catches up with the exchange rate. The second is deﬂ ation of the domestic economy, through tight monetary and ﬁscal policy, lower consumption and price levels to make d omestic costs in the tradable sector competitive at the higher exchange rate. A fall in domestic prices would require a cut in wages. The British actually tried this in the 1920s while restoring the pound’s gold parity to pre-ﬁ rst world war levels, succumbing to the arguments of the City that this was needed to maintain London’s position as the global ﬁnancial capital. It led to a general strike by the unions, and a deep depression inﬂicting huge misery on the people, before the foolish policy was abandoned. (Currently, Greece is undergoing exactly this treatment.)

The fact is that in a ﬂ oating exchange rate regime, inﬂows in excess of the current account deﬁcit merely go to appreciate the currency, and asset prices – e quities, real estate, etc – adding little to the productive capacity or growth of the recipient economy. In fact, to quote from an earlier IMF research paper “Financial Globalisation: A Reappraisal” by M Ayhan Kose, Eswar Prasad, Kenneth Rogoff, and Shang-Jin Wei (August 2006), “The majority of empirical studies are unable to ﬁnd robust evidence in support of the growth beneﬁts of capital account liberalisation”. Jagdish Bhagwati, in his In Defence of Globalisation, is highly sceptical of ﬁnancial globalisation, as distinct from free trade in goods and services, arguing that, “the claims of enormous beneﬁts from free capital mobility are not persuasive”.

The IMF’s 2006 paper also argued that “There is little formal empirical evidence to support the oft-cited claims that ﬁnancial globalisation in and of itself is responsible for the spate of ﬁ nancial c rises that the world has seen over the last three decades”. To my mind, the key words are “in and of itself”. While there is little to quarrel with the point made, with that proviso, the fact remains that a liberal capital account can amplify and prolong a crisis. One experience from the east Asian crises of 1997-98 is worth noting: Malaysia imposed capital controls and faced far lower costs and hardships than Thailand, Indonesia and South Korea which were countries which took the IMF medicine. Ben Bernanke, in his speech cited above cautioned that, “we have seen a number of episodes in which international capital ﬂ ows have brought with them challenges for macroeconomic adjustment, ﬁnancial stability, or both... The Asian crisis imposed heavy costs in terms of ﬁnancial and macroeconomic instability in the affected countries….”

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Excessive capital inﬂows can trap the recipient country into a vicious circle. From Mexico in 1994-95 to east Asia in 1997-98, Russia and Brazil (1998), Argentina (2001) and more recently Iceland and Latvia: in each case, the crisis was the result of excessive capital inﬂows, appreciating domestic currencies leading to an uncompetitive tradables sector, and increasing deﬁcits on the current account. One day “the music stops playing”, resulting in a balance of payments crisis and misery for the people, particularly the relatively worse off. The IMF’s own Independent Evaluation Ofﬁce concluded that “the crisis (in east Asia) was triggered by massive reversal of capital ﬂ ows, short-term ﬂ ows played a prominent role, and contagion was an important factor...” (“The IMF and Recent Capital Crises”, 2003).

IMF’s Questionable Proposition

Capital Controls and Prudential Policies in Managing Large Inﬂows” by Karl Habermeier, Annamaria Kokenyne, and Chikako Baba persists with the biases on the subject of capital ﬂows and controls. It contends,

A broader review of the experiences of 13 emerging market economies in the 2000s also does not provide unambiguous support for the effectiveness of capital controls and prudential measures. However, prudential measures appear to have had more success in stemming credit growth and addressing ﬁnancial stability concerns than capital controls, but they only rarely reduced appreciation pressures and aggregate ﬂ ows.

Clearly, the ideology needs “unambiguous support for the effectiveness of capital controls” but none for propagating the virtues of uncontrolled capital

Table: Incidence of Financial Crises

Period	Number of Crises
1	2
1875-1913	58
1919-39	51
1945-71	17
1973-2007	399

century after the second world war, and

(ii) that this was the period with the least number of crises as compared to the prewar era or the last three decades (see the table).

Even Bernanke conceded that “Those countries that have allowed their exchange rates to be determined primarily by market forces have seen their competitiveness erode relative to countries that have intervened more aggressively in foreign exchange markets” (ibid). If ﬁ nancial stability, which the money men keep emphasising, is the objective, it is best to forgo, out of the impossible trinity, liberal capital ﬂ ows but not managed exchange rates or an independent monetary policy. Indeed, volatile exchange rates are an impediment to greater globalisation of the real economy! On the subject of capital ﬂows and exchange rates, we perhaps need to learn much more from China than from the IMF.

Even in terms of the types of capital inﬂows to be encouraged, our policy stance seems to be perverse when the objective is promoting growth, employment and ﬁnancial stability. Surely the hierarchy should be FDI, long-term debt, other equity ﬂows, and lastly the most volatile short-term credit. In terms of our regulatory prescriptions, however, we are most restrictive on the ﬁ rst, and least on the last!

The IMF’s 2010 paper makes another questionable proposition while discussing the sterilisation of an increase in money supply resulting from central bank intervention in the market. It claims that “sterilisation means that domestic interest rates continue to be relatively high, perpetuating inﬂows.” The assertion is less than sound on both the issues:

* To the extent sterilisation is limited to the money pumped in the system through intervention, the market liquidity and interest rates should remain where they would have been in the absence of intervention and sterilisation. The rates will remain “relatively high” only if they were so before the intervention and sterilisation, for reasons of monetary policy.

* Equally questionable is the proposition that higher interest rates may perpetuate inﬂows. The assertion is certainly wrong in relation to equity markets, as high interest rates reduce growth and have a bearish inﬂuence on equity prices. Even in the case of debt markets, it could be argued that the prospects of higher rates through sterilisation, if apprehended, may well lead to capital outﬂ ows with existing foreign investors liquidating their investments in anticipation of a price fall, and taking money away.

A more recent (August 2011) IMF Staff Discussion Note on “The Effectiveness of

Cited in original Report on Currency and Finance, RBI, 2010. Original source: Laeven and Valencia (2008), Reinhart and Rogoff (2008).

ﬂows. This, to say the least, is strange when the 2006 IMF paper cited above clearly ﬁnds no “evidence in support of the growth beneﬁts of capital account liberalisation”! The fact is that (i) the global economy lived with capital controls and managed exchange rates for a quarter