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Flawed Logic of Capital Account Liberalisation

This article presents a brief summary of theoretical analysis and empirical evidence, suggesting that it is unwise to embark on further capital account liberalisation. India may miraculously avoid the boom-bust cycles associated with open capital accounts, but the costs of failure are very high. And India has very little slack with which to gamble.

Flawed Logic of Capital Account Liberalisation

This article presents a brief summary of theoretical analysis and empirical evidence, suggesting that it is unwise to embark on further capital account liberalisation. India may miraculously avoid the boom-bust cycles associated with open capital accounts, but the costs of failure are very high. And India has very little

slack with which to gamble.

AMITAVA KRISHNA DUTT

Logic of Liberalisation

T
he government is exploring the possibility of further liberalising India’s capital account. Despite limited and gradual liberalisation in the 1990s, for instance, relaxation of restrictions on foreign direct investment, allowing limited access for foreign institutional investors (FIIs) to the domestic capital market, and making restricted portfolio investment available to domestic and overseas corporate bodies and to non-resident Indians, numerous restrictions on capital flows are currently in force [Nayyar 2002]. Should the capital account be further liberalised?

The economic logic of the liberalisation of the capital account for less developed countries (LDCs) such as India (as distinct from merely “yielding” to pressure from western financial interests, or wanting India to graduate – prematurely – to the ranks of financially advanced nations) is related to the goals of increasing capital inflows in order to increase GDP and growth (and hence contribute to overall economic development) and of smoothing consumption through international borrowing.

The output-enhancing effect of capital account liberalisation can be seen from a simple textbook model in which one good is produced in two countries with two factors of production, “capital” and “labour”, with given technology under conditions of diminishing returns to each factor. Suppose that the only difference between the two countries is that one – a developed country, DC – has a higher stock of capital than the other, an LDC. Under the assumption of perfect competition, but with labour and capital immobile between the two countries, the return to capital – or the rental rate – will be higher in the LDC than in the DC. If capital is allowed to move from the low-rental country to the high-rental

Economic and Political Weekly May 13, 2006

country in search of higher returns, it will move from the rich country to the poor country, lowering its cost of capital, and adding to its production and income after paying the rental to the rich country (also adding to world production and income, since capital has a higher marginal product in the LDC than in the DC). To the extent that the accumulation of capital leads to higher growth such international capital flows increase growth in LDCs.

The consumption-stabilising impact can be shown with another simple model in which a country with a representative agent can borrow or lend at a given world interest rate. Suppose that the representative individual receives a stream of income which is subject to exogenous fluctuations. If consumption exhibits diminishing marginal utility, the individual (and country) will be able to increase its inter-temporal utility if it can participate in the international capital market and stabilise consumption.

Empirics of Liberalisationand International Capital Flows

Does empirical evidence confirm this logic of capital account liberalisation? A substantial increase in capital flows into emerging markets (consisting of LDCs and transitional economies) in the early and mid-1990s followed their capital market liberalisation. This phenomenon has been extensively studied and the evidence, which suggests that both arguments for capital account liberalisation are flawed, can be briefly summarised with four observations.

One, for reasonably long periods of time, and especially in recent years, there has been a reverse net transfer of financial resources from LDCs to rich countries. For instance, from 1997 onwards net transfers to LDCs have been negative, increasing from $5.2 billion in 1997 to over $350 billion in 2004, explained by a combination of low levels of net financial flows and the accumulation of foreign exchange reserves [Griffith-Jones, forthcoming].

Two, episodes of booms in capital inflows, especially short-term capital flows, end abruptly and turn into sharp outflows [Kaminsky, forthcoming].

Three, capital flows to emerging markets have been pro-cyclical, with large inflows during periods of economic expansion and outflows during recessions [Ocampo 2003; Kaminsky, forthcoming]. Further, fiscal and monetary policies tend to be procyclical in LDCs and therefore exacerbate their business cycles.

Four, most episodes of interrelated banking and currency crises in emerging markets have been preceded by financial liberalisation and increased access to foreign capital markets [Kaminsky and Reinhart 1999].

These findings regarding capital market liberalisation and capital flows, especially portfolio investment and hot money flows, are well known and widely recognised. Bhagwati (2004), an avid defender of globalisation, warns about the perils of free international financial capital movements, and even the IMF has become less doctrinaire in supporting free movements of capital.

Imperfect Information,Uncertainty and Instability

Why is the logic of capital market liberalisation at odds with the actual experience of LDCs? It is flawed because it fails to come to grips with some fundamental features of reality of which the most important arguably relates to information.

Contrary to the assumption of perfect information in the standard model, information is imperfect in capital markets. Without deviating too much from the standard neoclassical assumption of optimising agents, models with asymmetric information produce results which are far more consistent with reality. If lenders do not know exactly what borrowers do with borrowed funds and can only observe outcomes of their activity, while borrowers know what they are doing, we have the problem of asymmetric information, and lenders will require collateral to ensure that borrowers do not willfully default. The implication of this that borrowers in rich countries who have higher initial endowments of capital will be able to borrow more than those in poor countries because they can put up collateral to overcome moral hazard problems, while borrowers in poor countries are less able to do so [Gertler and Rogoff 1990]. This may imply that capital will flow from poor to rich countries, making rich countries even richer, resulting in a process of uneven development.1 Borrowers in poor countries will not be able to borrow what they want to and will be rationed, and this rationing will become tighter when poor countries experience bad times, implying that capital flows to poor countries will be pro-cyclical and not stabilise their consumption.

Similar implications emerge from Keynes’ (1936) view of asset markets in which investors are faced with fundamental uncertainty: they simply do not know the returns they can expect from their investments. In such a situation they form expectations of the future, knowing fully well that these expectations are built on flimsy foundations. In forming these expectations they may follow conventions, such as following the lead of others, which gives rise to herd mentality, and such conventions and expectations are likely to be subject to large changes in reaction to new information. At certain times business optimism is high, and that makes firms invest more, and this expansion results in an increase in aggregate demand which further fuels investment. This is possible because, unlike the neo-classical full employment model, the economy has unemployed resources. As the expansion proceeds, some firms may feel overextended and suddenly lose their confidence, and investment is curtailed, resulting in a reverse process of contraction and rising unemployment. Stock markets, in which asset holders try to guess what others believe, as in the famous beauty contest analogy, add to the instability.

Keynes’ ideas have been extended and refined by post-Keynesian economists, most notably Minsky (1982), who analysed how the expectations of firms as borrowers and banks as lenders would change and interact. During the expansion firms borrow more and this leads them to become more indebted. Increased indebtedness leads lenders and borrowers to perceive greater risks, which induces lenders to increase the interest rate and borrowers to cut down on borrowing and investment. This decline in investment reduces aggregate demand in the standard Keynesian manner and results in a decline in profits which, along with the increase in interest rates leads to a downward spiral. Matters can be exacerbated when funds flow into real estate and stock markets. Herd mentality can lead to bubbles in these markets during the expansion, and when the bubbles inevitably burst, the price of assets (including those serving as collateral) tumble, which aggravates the financial positions of borrowers and lenders, leading to sharp reductions in lending and economic activity, as well as to bankruptcies. Keynes and Minsky were mainly discussing the financial markets within advanced capitalist economies, in which central banks can stabilise the economy, but matters are more complicated when we turn to international financial markets and LDCs.

Economic and Political Weekly May 13, 2006

Extending the analysis to international markets complicates matters for a number of reasons, including the following.2 First, the problems of uncertainty and asymmetric information are greater because market participants have less knowledge about situations and borrowers in distant countries. Lenders are therefore more likely to have their expectations built on flimsy foundations, exhibit more of a herd mentality, and rely more on conventions which are subject to sudden changes. Second, the fact that international markets operate with different currencies create additional sources of instability. During the boom, currency appreciation in borrower nations can lead to greater euphoria, and because loans have to be paid back in the currencies of lender nations, when loans are recalled during the downswing, currency depreciation can make it more difficult for borrowers to pay back loans. (Exchange rate fluctuations can in theory stabilise the market, but in practice have been found to amplify the lending cycles). Third, because of contagion effects across borders, for instance because foreign banks who suffer losses in one country can call back loans to another country, problems arising in one country can be transferred to other countries, introducing additional sources of instability. Fourth, since financial capital can move from one country to another, changes in the supply of finance to an economy can be greater than in a closed economy. Finally, the absence of a world central bank and the absence of monetary authorities that can regulate the amount of liquidity reduces the chances of containing the problem. In fact, the IMF, the closest thing to a world central bank, exacerbates the instability, deepening the bust by imposing austerity measures and other contractionary policies on borrowing countries, and by encouraging the imprudent lending boom by being ready to bail out lenders when financial crises occur.

LDCs are particularly prone to these problems while rich countries seldom experience currency crises. The small size of their financial markets – especially stock and currency markets – implies that a given change in capital flows has a large proportional effect on these markets. Poor prudential regulation and supervision of financial institutions, and the inexperience of financial agents in evaluating risks make them less able to reduce the instability of capital flows. Their thin securities markets reduce the ability of their monetary authorities to follow counter-cyclical policies which could dampen the fluctuations.

Consequences of UnstableCapital Flows

Unstable capital flows (although some components, such as foreign direct investment may be less unstable than others) can be expected to have adverse consequences on economic growth and social indicators in LDCs. The following discussion draws on available theoretical analysis and empirical investigations to present likely scenarios.

During the boom, private and public sector borrowing-financed expenditure increases [Ocampo 2003]. For the private sector, there may be some increase in real investment, but given that capital inflows are of short maturities, investments are more likely to be in the stock market and in real estate than in real capital formation [Demir 2005]. When interest rate spreads rise and credit is rationed and the bust occurs, the availability of funds falls, reducing investment and output.

The precise effects depend on the exchange rate regime. If the country has a flexible exchange rate, during the boom its currency will appreciate and this can affect growth adversely in a number of ways. If the economy is supply constrained, the decline in the profitability of the traded goods sector will shift resources to the non-traded sector, a shift which can slow down technological change if the traded goods sector has greater scope for learning by doing and has more technological externalities for other sectors. If the economy is aggregate demand-constrained, the reduction in net exports will result in a decline in aggregate demand, and hence output and investment and consequently, technological change driven by growth and investment. In either case, the result will be lower growth. The inflow of foreign capital is more likely to finance investments in stock markets and real estate than real capital formation, and the resultant asset price bubbles make real investment less attractive. Banks borrowing short abroad and lending long to firms for investment will also become fragile. When the bubble bursts and overextended lenders call back loans and capital leaves the country, the cost of borrowing for investment increases for firms and investment falls, as does output if it is constrainted by the availability of finance for working capital. The exchange rate depreciates, but this is unable to win back lost markets abroad because of hysteresis effects and kinked demand curves. Depreciation makes imported goods more expensive and can thereby fuel inflation and if money wages are sticky this can result in a worsening of the income distribution. Depreciation also has a wealth effect, especially with currency mismatches, if loans have to be repaid in foreign currency and revenues are earned in domestic currency. All this results in a downturn, which is exacerbated by cuts in government expenditure due to reduced access to credit and reduced revenue due to the downturn, which further reduces capital inflows.

If a country maintains a fixed exchange rate, or at least does not let the exchange rate float freely, capital inflows will result in the accumulation of foreign exchange reserves. Large foreign exchange reserves may serve to stabilise the currency and prevent outflows, but comes at the cost of holding low-return foreign assets as reserves which can lead to significant interest costs for the economy. Meanwhile, the credit boom spills over into financial markets and results in bubbles, and fails to increase capital formation. If the central bank leans against the wind and reduces domestic credit, this may fuel capital inflows by raising interest rates and further constrain investment. When the bubble bursts, there will be an outflow. The outflow will result in a contraction in money supply. Reserve losses of the central bank can lead to currency crises and the currency will have to be devalued and eventually floated, with the consequences discussed earlier.

The instability caused by capital flows further increases uncertainty and reduces investment. The resultant fall in output and reduced external financing leads to cuts in government expenditure, especially in infrastructure and social programmes. The fall in employment and decline in government programmes increase poverty and a general deterioration in social indicators, unless expenditures are reallocated to the social sector [Taylor 2001].

Conclusion

The theoretical analysis and empirical evidence briefly summarised here suggests that it is unwise to embark on further capital account liberalisation for India.

This conclusion is further strengthened when one examines India’s experience with limited capital account liberalisation in recent years. First, liberalisation led to a large increase in FII, which has proved to

Economic and Political Weekly May 13, 2006

be somewhat volatile. Most of the evidence suggests that capital inflows have driven stock prices and real estate prices, but stock prices have had little effect on real investment and growth [Rakshit 2006; Rao and Dutt 2006:150-51]. Second, the limited nature of liberalisation allowed India (as well as China) to escape from the Asian financial crisis of 1997 relatively unscathed. Third, India and China, both with capital controls, are among the fastest growing economies in the world today. One is led to ask: “If it ain’t broke, why fix it?”

India, of course, may miraculously avoid the boom-bust cycles and adverse consequences of capital account liberalisation through effective regulation and macroeconomic policies. But suitable regulation is hard to pursue, as shown, for instance, by the facts that: even rich countries (which liberalised their capital accounts at a far later stage of their development than India is at now) are not free from financial instability; countries as developed as South Korea had a severe currency crisis; and several financial instruments – including derivatives – are very difficult to monitor. India would not need just one miracle, but many, to ride the boom-bust waves successfully. Finally, it must not be forgotten that costs of failure are very high indeed. Per capita income in India is low and the incidence of poverty is high compared to most Latin American and east Asian countries that have suffered the consequences of the instability of capital flows: India has very little slack with which to gamble.

m

Email: adutt@nd.edu

Notes

1 There are other explanations for uneven development due to international capital flows.Unlike what is assumed in the standard textbook model, capital may be subject to non-diminishing or even increasing returns, which means that DCs with higher stocks of capital may have higher rates of return on capital, so that capital will flow from LDCs to DCs unless preventedfrom doing so due to capital market restrictions. This explanation, however, appears to be more relevant for LDCs that receive little or no private capital from abroad.

2 See, for instance, Stiglitz (2002), Taylor (2002) and Ocampo (2003).

References

Bhagwati, Jagdish (2004): In Defense of Globalisation, Oxford University Press, Oxford.

Demir, Firat (2005): Three Essays on FinancialLiberalisation, Country Risk and Low GrowthTraps in Argentina, Mexico and Turkey, unpublished PhD dissertation, Economics, University of Notre Dame.

Gertler, Mark and Kenneth Rogoff (1990): ‘North-South Lending and Endogenous Domestic Capital Market Inefficiences’, Journal of Monetary Economics, 26(2), October,pp 245-66.

Griffith-Jones, Stephany (forthcoming): ‘Private Capital Flows and Development: Can Boombust be Curtailed?’ in A Dutt and J Ros (eds),International Handbook of DevelopmentEconomics, Edward Elgar, Cheltenham, UK.

Kaminsky, Graciela (forthcoming): ‘International Capital Flows to Emerging Economies: Blessing or curse?’ in A Dutt and J Ros (eds), International Handbook of Development Economics, Edward Elgar, Cheltenham, UK.

Kaminsky, Graciela and Carmen Reinhart (1999):‘The Twin Crises: The Causes of Banking and Balance of Payments Problems’, American Economic Review, 89(3), June, pp 473-500.

Keynes, John Maynard (1936): The General Theoryof Employment, Interest and Money, Macmillan, London.

Minsky, Hyman (1982): Can ‘It’ Happen Again? Armonk, M E Sharpe, New York.

Nayyar, Deepak (2002): ‘Capital Controls and the World Financial Authority: What Can We Learn from the Indian Experience?’ in J Eatwell and L Taylor (eds), International Capital Markets, Oxford University Press, Oxford.

Ocampo, Jose Antonio (2003): ‘Developing Countries’ Anti-cyclical Policies’ in A Dutt and J Ros (eds), Development Economics andStructuralist Macroeconomics, Edward Elgar, Cheltenham.

Rakshit, Mihir (2006): ‘On Liberalising Foreign Institutional Investments’, Economic and Political Weekly, March 18, pp 991-98.

Rao, J Mohan and Amitava K Dutt (2006): ‘A Decade of Reforms: The Indian Economy in the 1990s’ in Lance Taylor (ed), External Liberalisation in Asia, Post-Socialist Europeand Brazil, Oxford University Press, Oxford and New York.

Stiglitz, Joseph E (2002): Globalisation and Its Discontents, W W Norton, New York.

Taylor, Lance (2001): External Liberalisation, Economic Performance and Social Policy, Oxford University Press, Oxford.

Economic and Political Weekly May 13, 2006

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